(Classroom Companion - Business) Shveta Singh, Surendra S. Yadav - Security Analysis and Portfolio Management - A Primer-Springer (2021) PDF

Classroom Companion: Business
Shveta Singh
Surendra S. Yadav
Security
Analysis and
Portfolio
Management
A Primer
The Classroom Companion series in Business features foundational and introductory books aimed
at students to learn the core concepts, fundamental methods, theories and tools of the subject. The
books offer a firm foundation for students preparing to move towards advanced learning. Each
book follows a clear didactic structure and presents easy adoption opportunities for lecturers.
More information about this series at 7 http://www.springer.com/series/16374

Shveta Singh · Surendra S. Yadav
Security Analysis
and Portfolio
Management
A Primer
Shveta Singh Surendra S. Yadav
Department of Management Studies Department of Management Studies
Indian Institute of Technology Delhi Indian Institute of Technology Delhi
New Delhi, Delhi, India New Delhi, Delhi, India
ISSN 2662-2866 ISSN 2662-2874 (electronic)

ISBN 978-981-16-2519-0 ISBN 978-981-16-2520-6 (eBook)
https://doi.org/10.1007/978-981-16-2520-6
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V
To
The Almighty
and
Our Family Members

Preface
The course “Security Analysis and Portfolio Management” is typically taught as

an elective subject for students specializing in financial management. The authors
have an experience of teaching this course for more than two decades. A large
part of this experience has been at the Department of Management Studies, the
Indian Institute of Technology, Delhi, where the student audience comprises en-
gineers in large proportion.
A majority of textbooks available on this subject in India are targeted to-
wards students who have a finance/commerce undergraduate degree, thus assum-
ing a professional knowledge of financial management. Such textbooks prove to
be somewhat inappropriate for engineering graduates (in terms of both volume
and language), as has been evident from the feedback the authors receive in class.
Motivated by such feedback, the authors have prepared a textbook which covers
all the basic concepts related to “Security Analysis and Portfolio Management”.
However, the same is done in a rather concise and simple manner (compared to
the other textbooks which are rather voluminous).
The objective behind writing this book is to provide a textbook which is easy
to comprehend and can be used to teach a course like “Security Analysis and
Portfolio Management” or “Investment Analysis and Management” to any audi-
ence, even to those students who may not have a commerce/finance background.
Further, it can be used as a ready reckoner for investors who seek to gather
some understanding about the concepts and fundamentals at play in the world of
investments.
The aspects in which this book can be considered better than the competing
titles are:
1. The greatest USP of this book is that it contains real empirical evidence and
examples from the Indian capital markets, much of which are a result of the
analysis undertaken by the authors themselves. This empirical evidence and
analysis help the reader in understanding basic concepts through real data of
the Indian stock market. No other textbook on this subject can boast of the
same.
2. Even though the content remains the same as other competing titles, effort has
been made to make it simple and concise.
3. The competing titles contain around 1000 pages of text, which makes them
rather bulky and heavy. Keeping in with the latest trends adopted by top busi-
ness schools like Harvard, textbooks are now being made concise and simple
to ensure that students can carry them around and also for better readability.
4. The focus of the book is to keep it simple and away from rather complicated
formulations and discussions, that only commerce and finance students can
appreciate.
Preface
VII
5. Textbook sales (hard copies) have been falling across the world. One of the
reasons for the same is the bulkiness and heaviness of textbooks that become
cumbersome to carry around. In spite of the online content available, stu-
dents desire textbooks that are simple and concise so that they can get all the
fundamental concepts in one place. This book is a humble attempt in that di-
rection.
6. Also, this book presents a fresh perspective to the subject citing recent data
and examples.
Shveta Singh
Surendra S. Yadav
New Delhi, India
Acknowledgements
At the outset, we would like to thank the Almighty for His blessings to inspire us
to accomplish this academic endeavour. This work has been possible because of
the help, encouragement, cooperation and guidance of many people, and we con-
vey our heartfelt thanks to all of them. We are grateful to Prof. V. Ramgopal Rao,
Director, IIT Delhi, for his encouragement and support.
We would like to thank the Head of the Department of Management Studies,
Prof. Seema Sharma, for her unstinting support to all our endeavours. We thank
all our colleagues in the Department of Management Studies (DMS) for their
good wishes. We thank our scholar, Vikas Gupta, for his help during the prepara-
tion of the manuscript of the book.
Professor Shveta Singh takes this opportunity to express her deepest gratitude
to her gurus, Prof. Surendra S. Yadav and Prof. P. K. Jain, for their valuable guid-
ance, inspiration and motivation. She also thanks her parents, her husband, Anil,
and her son, Shashvat, for their unwavering support and encouragement.
Last but not least, we are thankful to all those, not mentioned above, who
helped in this endeavour, our family members and loved ones for their continuous
encouragement and support.
Shveta Singh
Surendra S. Yadav
IX
Contents
1 Introduction to Investments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 A Broad Map of the Territory of Investments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2.1 Money. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2.2 Sectors in an Economy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.2.3 Real Assets and Financial Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
1.2.4 Importance of Financial Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
1.2.5 Financial Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
1.2.6 Financial Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
1.2.7 Who is an Investor?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
1.2.8 What is an Investment?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
1.3 Concept of Risk and Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
1.4 Basic Criteria/Factors/Attributes for Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
1.5 What is Security Analysis and Portfolio Management?. . . . . . . . . . . . . . . . . . . . . . . . 34
1.5.1 What is a Portfolio?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
1.6 Contemporary Trends in the Investment Environment . . . . . . . . . . . . . . . . . . . . . . 34
1.7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
1.8 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
1.8.1 Objective (Quiz) Type Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
1.8.2 Solved Numericals (Solved Questions). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
1.8.3 Unsolved Numericals (Unsolved Questions). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
1.8.4 Short Answer Questions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
1.8.5 Discussion Questions (Points to Ponder). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
1.8.6 Activity-Based Question/Tutorial. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Additional Readings and References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
2 Behavioural Finance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
2.1 Introduction to Behavioural Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
2.2 Efficient Market Hypothesis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
2.3 Concept of Utility Maximization and Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
2.4 The Behavioural Critique. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
2.4.1 Information Processing/Cognitive Errors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
2.4.2 Behavioural Biases. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
2.5 Bubbles and Behavioural Economics. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
2.6 Equity Premium Puzzle and Myopic Loss Aversion (MLA). . . . . . . . . . . . . . . . . . . . . . 64
2.7 Equity Premium Puzzle and Corporate Governance. . . . . . . . . . . . . . . . . . . . . . . . . . . 64
2.8 Common Behavioural Errors in Investing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
2.9 Behavioural Qualities for Successful Investing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
2.10 Socially Responsible Investing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
2.11 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
2.12 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
X Contents

3 Concept of Risk and Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

3.1 Introduction to Risk and Return. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
3.2 Concept and Measurement of Return and Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
3.2.1 Measuring Return. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
3.2.2 Measuring Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
3.3 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
3.4 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
4 Fundamental Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

4.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
4.2 Fundamental Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
4.2.1 Economy Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
4.2.2 Industry Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
4.2.3 Company Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133
4.3 Classification of Companies’ Stock from an Investment Perspective. . . . . . . . . . . 137
4.4 Examples of Different Aspects of Fundamental Analysis . . . . . . . . . . . . . . . . . . . . . . 139
4.5 Why Might Fundamental Analysis Fail to Work?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
4.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
4.7 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
4.7.4 Activity Based Question/Tutorial. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
5 Technical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

5.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
5.2 Technical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
5.2.1 Economic Basis of Technical Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
5.2.2 Assumptions of Technical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
5.2.3 Difference Between Fundamental and Technical Analysis. . . . . . . . . . . . . . . . . . . . . . . 154
5.2.4 Market Trends/Phases Under Technical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
5.3 Tools Deployed in/for Technical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
Contents
XI
5.3.1 Tools for Assessing Overall Market Movements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
5.3.2 Tools for Assessing Individual Stock’s Movements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
5.4 Technical Indicators of the Witchcraft Variety. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
5.4.1 Super Bowl Indicator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
5.4.2 Sunspots. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
5.5 Price Formation Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
5.6 Critiques of Technical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
5.7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
5.8 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
6 Bond and Equity: Valuation and Investment Strategies. . . . . . . . . . . . . . . . . 181

6.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
6.2 Bonds/Debt Instruments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
6.2.1 Reasons for Issuing Debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184
6.2.2 Features/Nomenclatures of a Debt Instrument. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
6.2.3 Concept of Time Value of Money. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
6.2.4 Bond Valuation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
6.2.5 Risk in Debt Instruments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
6.2.6 Factors Affecting Interest Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
6.2.7 Effect of Interest Rate Changes on Bond Prices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
6.2.8 Yield Curve (or Term Structure of Interest Rates) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201
6.2.9 Bond Portfolio Management Strategies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
6.3 Equity (Shares) Instruments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
6.3.1 Equity Valuation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211
6.3.2 Equity Investment Strategies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
6.4 Difference Between Bond and Equity Valuation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
6.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223
6.6 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
7 Market Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237

7.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238
7.2 Efficient Market Hypothesis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 238
7.3 Degrees of Market Efficiency. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
7.3.1 Strong Form Efficiency. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
7.3.2 Semi-strong Form Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241
XII Contents
7.3.3 Weak Form Efficiency. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242

7.4 Stock Market Anomalies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
7.4.1 Size Effect Anomaly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
7.4.2 Calendar Anomaly. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
7.4.3 Value Effect Anomaly. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
7.4.4 Liquidity Effect Anomaly. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
7.4.5 Postearnings-Announcement Drift (PEAD) Anomaly. . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
7.5 Critique of the Efficient Market Hypothesis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
7.6 Merits of the Efficient Market Hypothesis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246
7.7 Normative Framework for Investors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
7.8 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
7.9 Objective (Quiz) Type Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
8 Diversification of Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255

8.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
8.2 Markowitz’s Modern Portfolio Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
8.2.1 Concept of Efficient Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256
8.2.2 Portfolio Construction Under Markowitz Portfolio Theory (MPT). . . . . . . . . . . . . . . . . 259
8.2.3 Critiques of Markowitz Portfolio Theory (MPT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
8.3 Sharpe’s Single-Index Model and the Capital Asset Pricing Model (CAPM). . . . . 265
8.3.1 Sharpe’s Single-Index Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265
8.3.2 Capital Asset Pricing Model (CAPM) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 265
8.4 Advent of the Multi-factor Models. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
8.4.1 Two-Factor CAPM. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
8.4.2 Fama and French Three-Factor Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277
8.4.3 Arbitrage Pricing Theory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
8.5 Normative Framework for Investors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280
8.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
8.7 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
8.7.1 Objective (Quiz)-Type Questions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
9 Portfolio Management: Process and Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . 295

9.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
9.2 Basic Aspects of a Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
9.3 Underlying Principles in Portfolio Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
9.4 Portfolio Management Strategies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
9.4.1 Active Portfolio Management Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
Contents
XIII
9.4.2 Passive Portfolio Management Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
9.5 Portfolio Management Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
9.5.1 Portfolio Planning Stage. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
9.5.2 Portfolio Implementation Stage. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311
9.5.3 Portfolio Monitoring Stage. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313
9.6 Formula Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
9.6.1 Constant Rupee Value Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
9.6.2 Constant Ratio Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321
9.6.3 Variable Ratio Plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322
9.6.4 Rupee Cost Averaging. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323
9.7 Mutual Funds in India. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324
9.8 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
9.9 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
10 Derivatives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341
10.1 Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
10.2 Forwards. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344
10.3 Futures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345
10.3.1 Features of Futures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346
10.3.2 Hedging with Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348
10.3.3 Speculating with Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348
10.3.4 Examples of Financial Futures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348
10.3.5 Pricing the Future. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
10.3.6 Benefits of Futures Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
10.4 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
10.4.1 Call Option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
10.4.2 Put Option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
10.4.3 Pay-Offs of Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354
10.4.4 Speculative Strategies Based on Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
10.5 Swaps. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
10.6 Advantages of Derivatives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
10.7 Participants in the Derivatives Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 360
10.8 Risks in Derivatives Contracts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
10.9 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363
10.10 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
XIV Contents

Supplementary Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373

Index. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374
XV
About the Authors
Prof. Shveta Singh

is a Professor and the Area Chair of Finance at the Department
of Management Studies (DMS), Indian Institute of Technology
(IIT Delhi), India. She is also the co-coordinator of the National
Centre on Corporate Governance (accredited by the National
Foundation on Corporate Governance (NFCG)) at DMS. She
teaches courses like Entrepreneurial Finance, Management
Accounting and Financial Management, Indian Financial System,
Security Analysis and Portfolio Management, Professional Ethics,
Corporate Governance & CSR. She has contributed to various
research and consulting assignments for organizations like the Chief
Information Officers’ (CIO Foundation), the Chief Information
Security Officers’ (CISO) Foundation, the Lok Sabha (Parliament),
the National Foundation on Corporate Governance (NFCG), the
Directorate General of Supplies & Disposals (DGS&D), National
Buildings Construction Corporation (NBCC), the Indian Council
of Social Science Research (ICSSR), the United Kingdom (UK)-
India Education and Research Initiative (UKIERI), ReNew Power
Limited, the Ministry of Agriculture and Farmers’ Welfare, the
Ministry of Food and Consumer Affairs, the Indian Navy and the
Indian Air Force.
Overall, she has nearly two decades of professional experience,
having spent three years in the corporate sector prior to joining
academics. She has published nearly 100 research papers in journals
and conferences of national and international repute. She has co-
authored three research monographs: (i) Cash Dividend and Shares
Repurchase Announcements: Impact on Returns, Liquidity and Risk
in the Indian Context published by Hamilton, UK, (ii) Financial
Management Practices: An Empirical Study of Indian Corporates
published by Springer, USA and (iii) Equity Market in India:
Returns, Risk and Price Multiples, published by Springer, USA. She
has been the recipient of the Lok Sabha Fellowship and the Fetzer
Fellowship of the Academy of Management (AoM), USA for her
research on corporate social responsibility (CSR) and the National
Stock Exchange—Indira Gandhi Institute of Development Research
(NSE-IGIDR) Corporate Governance Research Initiative grant for
her research on corporate governance. She has been honoured by
the “Leadership” award, which she accepted on behalf of IIT Delhi
from the Institute of Business and Finance Research at the Global
Conference on Business and Finance in USA. She has also been
honoured twice with the “Literati” award for outstanding research
by Emerald Publishing Inc.
XVI About the Authors
Prof. Surendra S. Yadav

received his Bachelor of Technology (B.Tech.) from Indian
Institute of Technology (I.I.T.) Kanpur, MBA from University
of Delhi, DESS (equivalent to M.Phil.) from University of Paris
and Ph.D. in management from University of Paris 1 Pantheon-
Sorbonne, France. He teaches Corporate Finance, International
Finance, International Business, and Security Analysis & Portfolio
Management. His research interests are in all these areas and general
management.
He has been delivering lectures at various institutions in India as
well as abroad. He has been visiting professor at University of Paris,
INSEEC Paris, Paris School of Management and at University of
Tampa, Florida, USA. Professor Surendra S. Yadav has published
14 books—13 in areas of finance and international finance in
English and one on India in French. He has guided 23 Ph.Ds. He
has published 180 research papers in research journals. He has
contributed more than 125 papers in academic conferences and
four chapters in edited books. Besides, he has published about three
dozen articles in financial/economic newspapers. He is editor-in-
chief of the Journal of Advances in Management Research (JAMR),
published by Emerald, UK.
He has carried out several sponsored/consultancy projects. He
conducted an online e-learning Executive Development Programme
in collaboration with Macmillan India Ltd. for several years. He
is on the editorial board of half a dozen research journals. He is/
has been an expert member of several committees for selection/
evaluation/preparation of reports. He has had several administrative
responsibilities, including being Head of the DMS for 6 years. He
has travelled to several countries such as France, UK, Switzerland,
Belgium, Italy, The Netherlands, Denmark, Singapore and USA.
Apart from English and Hindi, he has perfect command on French
language.
XVII
Abbreviations
APT Arbitrage pricing theory ROEF Return on equity funds

BSE Bombay stock exchange ROR Rate of return
CAPM Capital asset pricing model S&P Standard & Poor’s
CPI Consumer price index SEBI Securities and Exchange
D/P Dividend pay-out ratio Board of India
E&Y Ernst and Young SEC Securities and Exchange
EAT Earnings after taxes Commission
EBIT Earnings before interest and SENSEX Sensitive index
taxes SOX Sarbanes–Oxley Act
EIC Economy industry company SWOT Strength, weakness, opportu-
EMH Efficient market hypothesis nity and threat
EPS Earnings per share UK United Kingdom
EVA Economic value added ULIPs Unit-linked insurance plans
FD Fixed deposit USA United States of America
FDI Foreign direct investment VaR Value at risk
GDP Gross domestic product WPI Wholesale price index
HPY Holding period yield WTO World Trade Organization
ICT Information and communi- YTM Yield to maturity
cations technology
INR Indian rupee
IRR Internal rate of return
IVP Indira Vikas Patra
KVP Kisan Vikas Patra
MPS Market price per share
NASDAQ National Association of Se-
curities Dealers Automated
Quotations
NSCs National Savings Certificates
NSE National Stock Exchange
NWPS Net worth per share
P/B Price-to-book value ratio
P/E Price-to-earnings ratio
PEAD Post earnings-announcement
drift
PESTLE Political, economic, social,
technological, legal and envi-
ronmental
PPF Public provident fund
PSU Public sector undertaking
PwC PricewaterhouseCoopers
RBI Reserve Bank of India
ROE Return on equity
Symbols
ßi Beta of security i
Cov(i,m) Covariance of security i’s
returns with underlying
market’s returns
D0 Dividends paid at time 0
DSCR Debt service coverage ratio
EBIT Earnings before interest
and taxes
E(Ri) Expected return on security i
E(Rm) Expected return on market
portfolio
E(Rm) − Rf Market risk premium
FV Future value
g Rate of growth
I Interest
ICR Interest coverage ratio
ke Cost of equity
n Number of observations/
time periods
pi Probability of the ith state
P0 Price/value of share at time 0
PV Present value
R Mean (average) return
−
Rf Risk-free return
Ri Return on security i
Rm Market return
SF Sinking fund created to
meet principal payments
σ Standard deviation
σ2 Variance
σm2 Variance in the market
t Company’s income tax rate
wi Proportion or weight of
portfolio invested in
security i
XIX
List of Figures
Fig. 1.1 Two-sector economy. Source Authors’ compilation . . . . . . . . . . . . . . . . . . . 8

Fig. 1.2 Three-sector economy. Source Authors’ compilation . . . . . . . . . . . . . . . . . . 9
Fig. 1.3 Four-sector economy. Source Authors’ compilation . . . . . . . . . . . . . . . . . . . 10
Fig. 1.4 Classification of financial markets by maturity of claim.
Source Authors’ compilation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Fig. 1.5 Classification of financial markets by type of claim. Source Authors’
compilation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Fig. 1.6 Negotiable certificate of deposit (CD). Source RBI (c) (2020) . . . . . . . . . . . 23
Fig. 1.7 Policy repo rates and returns on treasury bills and bonds in India,
2014–2018. Source RBI (d) (2020) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Fig. 2.1 Investment process—roller coaster of emotions. Source Credit
Suisse (2016) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Fig. 2.2 Home bias in international equity portfolio. Source Cooper et al.,
(2012). Note The shorter green line indicates the contribution of the
country’s investors in the world equity market and the longer brown
line indicates the contribution of the country’s investors in the domes-
tic equity market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Fig. 2.3 Prospect theory. Source Behavioral Economics.com . . . . . . . . . . . . . . . . . . 60
Fig. 2.4 Maximum financial risk and maximum financial opportunity
for the contrarian investor. Source The ETF Bully website (2020).
Available at 7 https://theetfbully.com/2007/05/have-we-reached-the-
point-of-maximum-financial-risk/, Accessed on April 1, 2020 . . . . . . . . . . . 69
Fig. 3.1 Rates of Return 1926–2000: US Economy. Source Skloff.com . . . . . . . . . . 83
Fig. 3.2 Microsoft—daily percentage change, 1990–2001. Source Authors’
compilation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
Fig. 3.3 a Pattern of returns of Investment A, b pattern of returns
of Investment B. Source Authors’ compilation . . . . . . . . . . . . . . . . . . . . . . . 89
Fig. 5.1 Rise and fall of the NASDAQ during the Dotcom Bubble
and Crash. Source Wall Street Journal (WSJ) (2018) . . . . . . . . . . . . . . . . . . 156
Fig. 5.2 Buy and sell signal through the Dow theory. Source Authors’
compilation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
Fig. 5.3 Elliott wave. Source Authors’ compilation . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Fig. 5.4 Chaos theory—a pictorial representation. Source Forbes (2018) . . . . . . . . . 160
Fig. 5.5 Line chart of the Indian Oil Corporation (IOCL), July–October, 2017 . . . 164
Fig. 5.6 Head and shoulders and inverse head and shoulders
(reversal patterns). Source Authors’ compilation . . . . . . . . . . . . . . . . . . . . . 165
Fig. 5.7 Pennant and flag (continuation patterns). Source Authors’
compilation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166
Fig. 5.8 Lehman Brothers Bankruptcy and support/resistance level
in stock prices. Source Stocktrader.com (2018) . . . . . . . . . . . . . . . . . . . . . . . 167
Fig. 5.9 Triangle pattern in Google’s stock prices. Source Stockcharts.com
(2018) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
XX List of Figures
Fig. 5.10 Candlestick chart of IOCL (July–October, 2017). Source Authors’

compilation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
Fig. 5.11 Simple moving average. Source Commodity.com . . . . . . . . . . . . . . . . . . . . . 170
Fig. 5.12 Bollinger band. Source Authors’ compilation . . . . . . . . . . . . . . . . . . . . . . . . 171
Fig. 5.13 Weaknesses of Bollinger bands. Source Authors’ compilation . . . . . . . . . . . 171
Fig. 5.14 Price formation process. Source Authors’ compilation . . . . . . . . . . . . . . . . . 174
Fig. 6.1 Yield curve. Source Authors’ compilation . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
Fig. 6.2 Inverted yield curve. Source Authors’ compilation . . . . . . . . . . . . . . . . . . . . 203
Fig. 7.1 Three forms of market efficiency. Source Authors’ compilation . . . . . . . . . 240
Fig. 7.2 Movement of stock prices after public announcement.
Fig. 7.3 Popular stock market anomalies. Source Authors’ compilation . . . . . . . . . . 243
Fig. 8.1 Efficient frontier. Source Investing Answers (2017) . . . . . . . . . . . . . . . . . . . 257
Fig. 8.2 Goal of the investor within the efficient frontier. Source Authors’
compilation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258
Fig. 8.3 Efficient frontier interspersed with indifference (utility) curves.
Fig. 8.4 Risk versus return of portfolios of stocks and bonds, 1970–2009
(USA). Source Morningstar (2017) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
Fig. 8.5 Efficient frontier with real-life borrowing and lending curves.
Fig. 8.6 Unique risk and market risk. Source Authors’ compilation . . . . . . . . . . . . . 267
Fig. 8.7 Security market line (SML). Source Authors’ compilation . . . . . . . . . . . . . . 268
Fig. 8.8 Capital market line. Source Authors’ compilation . . . . . . . . . . . . . . . . . . . . 269
Fig. 8.9 Smart beta. Source Bloomberg . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
Fig. 8.10 Sample asset (* Bonds represents government bonds only).
Source Fidelity (2017a, 2017b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
Fig. 9.1 Sector rotation across economic cycles. Source Seeking Alpha
(2018) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
Fig. 9.2 Portfolio management process. Source Authors’ compilation . . . . . . . . . . . 304
Fig. 9.3 Portfolio planning stage. Source Authors’ compilation . . . . . . . . . . . . . . . . 305
Fig. 9.4 Portfolio implementation stage. Source Authors’ compilation . . . . . . . . . . . 312
Fig. 9.5 History of mutual fund sector in India (1965–2016).
Source AMFI (2018) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
Fig. 9.6 Growth of mutual fund sector in India (2011–2017). Source AMFI,
Bloomberg . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
Fig. 9.7 Net inflows in mutual fund sector in India (2011–2017).
Source AMFI, Bloomberg . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
Fig. 10.1 Some underlying assets for derivatives. Source Kotak securities.com
(2020) 7 https://www.kotaksecurities.com/ksweb/Research/
Investment-Knowledge-Bank/what-is-derivative-trading . . . . . . . . . . . . . . . 343
Fig. 10.2 Types of derivatives. Source Kotak securities.com (2020)
7 https://www.kotaksecurities.com/ksweb/Research/Investment-
Knowledge-Bank/what-is-derivative-trading . . . . . . . . . . . . . . . . . . . . . . . . 344
List of Figures
XXI
Fig. 10.3 Contract specifications on Chicago Mercantile Exchange (CME)
and Philadelphia Board of Trade (PBOT). Source 7 www.cme.com
and 7 www.phlx.com . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349
Fig. 10.4 Chicago mercantile exchange’s bitcoin futures contract.
Source Bloomberg (2018) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 352
Fig. 10.5 Pay-off of a call option buyer. Source Authors’ compilation . . . . . . . . . . . . 355
Fig. 10.6 Pay-off of a put option buyer. Source Authors’ compilation . . . . . . . . . . . . 356
Fig. 10.7 Pay-off of a call option seller. Source Authors’ compilation . . . . . . . . . . . . 357
Fig. 10.8 Pay-off of a put option seller. Source Authors’ compilation . . . . . . . . . . . . 358
Fig. 10.9 Advantages of derivatives. Source Kotak securities.com (2020)
Fig. 10.10 Derivatives trading participants. Source Kotak securities.com (2020)
Fig. 10.11 Process of creating a Mortgage Backed Obligation (MBO).
Source Huffingtonpost (2018) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363
List of Tables
Table 1.1 Consumer spending (transaction motive) in percentage for some

expense items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Table 1.2 Indian individual wealth (2017–2018) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Table 1.3 Constituents of S&P BSE SENSEX (as on 13 January 2020) . . . . . . . . . . . 17
Table 1.4 Changing pattern of asset-wise retail investor wealth in India . . . . . . . . . . 26
Table 1.5 Comparison of different investment avenues—2020 . . . . . . . . . . . . . . . . . . 35
Table 1.6 Foreign direct investment flows to India: country-wise
and industry-wise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
Table 3.1 Growth of $1 investment: 1926–2019 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
Table 3.2 Returns and their probabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
Table 4.1 Financial aggregates of cement sector in India . . . . . . . . . . . . . . . . . . . . . . 128
Table 4.2 Financial aggregates of software sector in India . . . . . . . . . . . . . . . . . . . . . 130
Table 4.3 Financial ratios and their significance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
Table 4.4 Top 20 Multi-baggers in the India Stock Market (2005–2015) . . . . . . . . . . 143
Table 5.1 Daily prices of security X . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
Table 6.1 Differences between the active and passive strategy . . . . . . . . . . . . . . . . . . 220
Table 10.1 Differences between futures and Forward contracts . . . . . . . . . . . . . . . . . . 353
1 1
Introduction
to Investments
Contents
1.1 Background – 3
1.2 A Broad Map of the Territory of Investments – 3

1.2.1 Money – 3
1.2.2 Sectors in an Economy – 7
1.2.3 Real Assets and Financial Assets – 11
1.2.4 Importance of Financial Assets – 12
1.2.5 Financial Markets – 14
1.2.6 Financial Assets – 20
1.2.7 Who is an Investor? – 27
1.2.8 What is an Investment? – 27
1.3 Concept of Risk and Return – 28
1.4 Basic Criteria/Factors/Attributes

for Investments – 29
1.5 What is Security Analysis and Portfolio

Management? – 35
1.5.1 What is a Portfolio? – 35
1.6 Contemporary Trends in the Investment

Environment – 35
1.7 Conclusion – 40
1.8 Exercises – 43
1.8.1 Objective (Quiz) Type Questions – 43
1.8.2 Solved Numericals (Solved Questions) – 44
© The Author(s), under exclusive license to Springer Nature Singapore Pte Ltd. 2021
S. Singh and S. Yadav, Security Analysis and Portfolio Management,
Classroom Companion: Business, https://doi.org/10.1007/978-981-16-2520-6_1
1.8.3 Unsolved Numericals (Unsolved Questions) – 47
1.8.4 Short Answer Questions – 48
1.8.5 Discussion Questions (Points to Ponder) – 48
1.8.6 Activity-Based Question/Tutorial – 49
Additional Readings and References – 49

1.1 · Background
3 1
n Learning Objectives
The objective of this chapter is to provide a bird’s eye view of the environment sur-
rounding investments. This chapter covers the following topics.
1.1 Background
For most people, it is a daunting task to figure out as to where and how to invest
their hard earned money. The major reasons behind this dilemma are the erratic
behaviour of the stock markets, the wide array of complex securities available, the
difficult jargon and terminology used in investments and the bewildering techno-
logical innovations being deployed in the field. However, it does not need to be a
daunting task at all. The purpose of this book is to explain the process and con-
cepts behind Security Analysis and Portfolio Management or, in general, invest-
ments, in a simple manner so as to increase the comfort level of all who are in-
volved directly or indirectly in the activity of investments. This text would enable
the reader to understand the basics behind investments, analysing a security and
then managing a portfolio of securities effectively.
Once one understands the basic concepts behind investment, Security Anal-
ysis and Portfolio Management, and learns how to apply certain techniques and
ideas and inculcate a certain amount of discipline in one’s investment behaviour,
one will discover that investing is both enjoyable and rewarding.
Warren Buffet, one of the greatest investors of all times, summarizes the art
of investment as follows: “To invest successfully over a lifetime does not require a
stratospheric IQ, unusual business insights or inside information. What’s needed
is a sound intellectual framework for making a decision and the ability to keep
emotions from corroding that framework”.
Before we embark on the definitions of the terms used in investment, Security
Analysis and Portfolio Management, let us discuss the economic concepts which
form the background behind these.
1.2 A Broad Map of the Territory of Investments
Economics is the forerunner of finance. Hence, to understand any financial topic

well, one must have sound understanding of some economic concepts. The defini-
tion of money is a good start.
1.2.1 Money
Definition
Broadly, money is anything that can be used as a medium of exchange and is a
measure of value.
4 Chapter 1 · Introduction to Investments
Much before money (as it is known today in the form of currency) was invented,
1 people followed the barter system to transact.
► Example
In older times, a person who lived in the plains pursued agriculture as a profession
and grew rice. Another stayed on a river bank and fished for a living. Now both these
persons, with the desire of a full meal, wanted to consume both rice and fish. Hence,
the person with the rice bartered or exchanged some of his rice for some fish from the
fisherman and vice versa, and both of them ended up with a satisfying and complete
meal. ◄
However, some of the problems with the barter system were:

a. Fish and rice, and other commodities as well, grew stale and unusable after
some time.
b. It was difficult to carry huge quantities of such commodities around.
c. Such commodities were prone to theft and pilferage.
d. Not everyone wanted these commodities at all times.
Around three centuries ago, precious commodities like pepper (a spice) were used
to barter in other commodities as it was so heavily in demand across the world.
At that time, India was a sought-after country in trade and commerce due to its
supply of spices. Cattle and cowries (sea shells) have also been used in the past to
denote currency. Later, in order to overcome some of the problems stated earlier,
noble metals like gold and silver (which would not get corroded over time) were
used as a measure of value and also to trade in other commodities and services.
Again, since it was difficult and dangerous to haul huge quantities of these pre-
cious metals across the world to make transactions, countries decided to print pa-
per currency which had its value denoted in the gold or silver which the countries
possessed.
► Example
Both the US dollar and the Indian rupee are denoted by the value of gold reserves
these countries possess, while the UK pound sterling was based on silver. Every coun-
try has a central bank which is in charge of printing currency. The Indian central bank
is the Reserve Bank of India (RBI). ◄
With the advent of technology, however, the world is now moving rapidly towards
a paperless economy, wherein transactions are happening virtually over the Inter-
net or through credit/debit cards or even through a mobile phone, thus obliterat-
ing the need to have a physical form of currency. It is true that technology has,
perhaps, impacted the world of finance and the way people transact the most,
when compared to other domains.
1.2 · A Broad Map of the Territory of Investments
5 1
Illustration 1.1: Evolution of Money

5 9000 B. C.—The first record of barter exists in Egypt where people bartered in
cattle and grain.
5 1200 B. C.—Areas around the Indian ocean use cowrie shells as currency for
trade.
5 1100 B. C.—Small replicas of bronze goods used in Chinese trade and com-
merce.
5 600 B. C.—King Alyattes of Lydia in modern day Turkey minted the first “offi-
cial” currency. Widely used in the Mediterranean sea trade.
5 1250 A. D.—Florence minted the gold coin “Florin” used extensively for inter-
national trade across medieval Europe.
5 1290 A. D.—Marco Polo introduced the concept of “paper” money in China.
However, it did not gain popularity until the seventeenth century.
5 1661 A. D.—The first bank notes printed in Sweden. Gained popularity across
the world.
5 1860 A. D. – Western Union ushered in e-money for the first time by introduc-
ing electronic fund transfer via telegram.
5 1946 A. D.—“Charg-It” became the first credit card invented by John Biggins.
5 1999 A. D.—Mobile banking offered by European banks.
5 2008 A. D.—Contactless payments offered in the UK.
2014 onwards—New innovations are being introduced. For example,
– Apple Pay introduced by iPhone for its users;
– Bitcoins ushered in the age of cryptocurrency;
– Barclays introduced contactless “wristbands” for payment.
» In fact, history may come full circle with Bartercard offering a platform for the bar-
ter of surplus goods and services.
(Source Authors’ compilation).
Motives for Money
Definition
According to Lord John Maynard Keynes, a person requires money for three ba-
sic motives:
i. Transaction motive: in order to make transactions, that is, to buy or sell prod-
ucts or services like food, clothing, entertainment, as is true in day-to-day life;
ii. Precautionary motive: to put money aside to be able to meet a substantially
large expense in future like getting one’s child a higher education or buying a
house. This would be an expenditure that typically cannot be met through a
month’s earnings, and one may need to save and put money aside for the same.
It would not be a bad idea, then, to earn some return on this money one is put-
ting aside, provided of course, it remains safe and is available when one needs
to make the large transaction in future;
iii. Speculative motive: people who put money aside under this motive are typically
1 traders who speculate on the rise or fall in prices of certain products and com-
modities based on the changing demand–supply situation.
► Example
A car manufacturer foresees a rise in the price of steel in future due to an increased
global demand for cars. He may then want to get into a contract today to buy steel at
the prevailing rate from a vendor with the delivery sometime in future (such a contract
is called a forward contract), and to execute this transaction, he may put aside required
amount of money. ◄
z Point to Ponder 1.1: Consumer Spending Pattern in India

. Table 1.1 provides the consumer spending pattern (transaction motive) of ru-
ral Indians (Indians living in villages), compared with Indians residing in urban
areas.
zz Discussion Point
This comparison will highlight how similarly/differently urban India spends as
compared to rural India. Ask the students why it is so? This will help students in
understanding the rural and urban economic scenarios.
Interest/Dividends: Reward for Sacrificing Consumption

Whenever a person sacrifices his consumption for one of these three motives and
gives his/her money to some other person or financial institution (which can help
someone else use the same to meet any one or more of these motives), this sacri-
. Table 1.1 Consumer spending (transaction motive) in percentage for some expense items
Items Rural India Urban India

Food 54.70 34.80
Housing 1.70 23.00
Energy 9.40 6.60
Transport 6.80 5.20
Education 2.20 4.90
Information and communication technologies (ICT) 2.70 3.80
Others 22.50 21.70
Total 100 100
Source Reserve Bank of India (RBI) (a) (2020)

7 1
fice earns a reward in the form of an extra income or return for the investor. This
reward can have different names, for example, interest in case of a fixed deposit or
dividends in case of equity shares.
1.2.2 Sectors in an Economy
Initially, the world economy depended on physical goods or commodities—items

like food grain, cotton, fish, etc., whose supply was natural and limited to certain
parts of the world. With the advent of technology and the Industrial Revolution
in the early eighteenth century, the world economy started manufacturing prod-
ucts with the aid of machines.
Definition
Any modern domestic economy has three constituents/sectors. These sectors can
also be considered the clients of the financial system in the economy and are di-
vided into three categories:
i. Household sector;
ii. Business sector;
iii. Government sector.
The “household” sector comprises people like you and me who contribute what are
known as “factors of production” to the economy. These factors of production are
land, labour, capital and entrepreneurship, the basic ingredients required for setting
up a production unit. The other terms are self-explanatory, but the term capital de-
notes any form of capital that has the ability to generate further income, for exam-
ple, machines, technology, etc.
The “business” or “firm” sector is vital sector of an industrialized economy which
utilizes the factors of production to manufacture products and services. These fac-
tors of production are rewarded for their usage—land earns rent, labour earns
wages, capital earns interest and/or dividend, and the entrepreneur earns profit.
The products and services are sold to the household, business and government sec-
tors which pay the price for them. It is important to note that the mining and ag-
riculture sectors also fit in here as these sectors produce an output through a com-
mercial/economic process.
The “government” sector acts as a hybrid of the household and business sectors in
the sense that it acts both as the provider of factors of production and as the pro-
ducer of products and services. This is because the government provides its own
land on lease or sale for commercial purposes, has administrative services which
provide labour/human resources to undertake activities, invests its capital in vari-
ous public and private ventures and also acts as a promoter/entrepreneur by setting
up many government-owned companies.
The extent of growth of material wealth in any economy is dependent on how

1 productively it deploys the resources available. As stated earlier, all production of
goods and services happens through the factors of production which earn a re-
ward for their usage. The other sectors which consume these products and ser-
vices pay the price for these products and services. It is through this price that the
factors of production get paid for their products and/or services. Hence, the pay-
ments move around in a circular flow from one sector of the economy to another.
Initially, however, governments were simply political entities and most of the
economic flow of factors of production and the resultant goods and services hap-
pened between the household and business/firm sectors only. Not anymore. They
are active as economic entities as well.
Important
The economy can be looked upon as consisting of real economy and monetary
economy. The actual usage of factors of production and the resultant production
of goods and services form part of what is known as the real economy. The ac-
companying money flows form part of what is known as the monetary economy.
Financial markets (comprising capital and money markets) form the financial
backbone of the economy and organize the monetary flows in the economy. They
channelize the savings of different sectors of the economy and provide them to the
sectors which need investment.
. Figure 1.1 presents the two-sector economy with the capital market acting as
the financial intermediary. As is evident from the figure, the capital markets help
mobilize the savings of the household and business sectors and provide the same
as borrowings and equity to these sectors. It is primarily the business sector which
uses its borrowings and equity to fund the production of goods and services and,
Business Savings Capital Savings

Sector Market Households
Borrowings Income
and equity
Goods and services
Consumption expenditure
on goods and services
. Fig. 1.1 Two-sector economy. Source Authors’ compilation

9 1
Labour/Payments
Income/Goods and services

Business Savings Savings
Capital
Sector
Market Households
Borrowings Income
and equity
Services/Payments Taxes/Labour
Government
Taxes/goods and services Services/Income
. Fig. 1.2 Three-sector economy. Source Authors’ compilation
thereby, leads the economic development. The business sector sells goods and ser-
vices to the household sector and gets paid by them for the same.
Similarly, . Fig. 1.2 presents the three-sector economy. It clearly depicts the
household sector providing factors of production (land, labour, capital and en-
trepreneurship) to the business sector and getting paid for them (rent, wages, in-
terest and profits, respectively). The three-sector economic model features the
government sector as well. Being the governing sector of the economy, the govern-
ment raises income for itself by taxing the firm and the household sectors. This
money is then used for the development of the economy’s infrastructure, edu-
cation, health care, etc. The government also provides one-sided finance to the
other sectors which are called transfer payments. For the firms, this can be in the
form of leases, grants, subsidies, etc., and for the household sector, it can be in the
form of scholarships, subsidies, etc. The government as an entity also borrows
from the capital markets to finance its expenditures and investments and lends its
savings to the same, as well.
All the three sectors have a symbiotic relationship with each other which com-
pletes the cycle of a three-sector economy. All of them are interdependent, and
thus, the financial system cycle is complete only when all these sectors drive the
economic activities in congruency. The interdependence amongst them is as fol-
lows:
1. Household sector –business sector: The household sector provides labour, land,
capital and entrepreneurs to the business sector for production and other
commercial activities. The household sector also consumes goods and services
from the business sector in exchange of some payment which becomes the
source of revenue for the business sector. On the other hand, the business sec-
tor provides income to the household sector in the form of wages and salaries,
rent, interest and profits.
1 Consumption plus net exports Rest of Labour/Payments

the
World
Services/Payments Services/Income
Business Capital
Sector Savings Savings Households
Market
Borrowings Income
and equity
Services/Payments
Taxes/Labour
Government
Taxes/goods and services S ervices/Income
. Fig. 1.3 Four-sector economy. Source Authors’ compilation
2. Household sector –government sector: The household sector also provides la-
bour, land, capital and entrepreneurs to the government sector against wages
and salaries, rent, interest and profits, respectively. The household sector also
provides income to the government in the form of taxes. On the other hand,
the government sector provides services to the household sector. Also, the gov-
ernment is one of the sources of income for the household sector through gov-
ernment jobs and employment schemes.
3. Business sector –government sector: The business sector provides goods and
services to the government. Also, it is one of the biggest sources of taxes to
the government. The government also provides various services to the busi-
ness sector. Further, the government provides various subsidies and rebates to
the business sector. Along with this, the government also acts as an investor
to open gateways for business, for instance, opening special economic zones
(SEZs), road infrastructure development, etc.
Since we are living in a global world, it is important for us to also under-

stand the four-sector economy, where the “rest of the world” or RotW forms the
fourth component in the economy. The RotW or other countries/economies act
again as a hybrid sector and provide both factors of production (like the tradi-
tional “household” sector) as well as produce goods and services (like the tradi-
tional “firm” sector). As a result of this, we have foreign labour, capital and entre-
preneurs travelling across the world and foreign brands and products being sold
across other economies. This enables everyone to have access to the cheapest fac-
tors of production available across the world and also allows for the consumption
of the best products and services produced across the world economies. . Figure
1.3 presents the four-sector economy. Here, imports and exports are introduced as
11 1
the movement of factors of production and goods and services into the domestic
economy and selling of factors of production and goods and services to the out-
side world, respectively.
These three entities provide the economy with two kinds of assets.
1.2.3 Real Assets and Financial Assets
Definition
Real assets is the term used for the factors of production and the actual goods and
services produced therefrom, which flow through the economy from one sector to
the other. The production plan for goods and services as well as the usage of the
factors of production at the level of the national economy forms the subject matter
of the fiscal policy of the government. The corresponding money flow as the pay-
ment for the produced goods and services and for the factors of production forms
the matter of the monetary policy, and the money assets which mirror the flow of
the real assets are called financial assets, for example, stocks, bonds, deposits, etc.
Financial assets do not represent a society's wealth directly. In fact, they contrib-
ute indirectly to the productive capacity of the economy, allowing for the separa-
tion of ownership and management of the firm and more importantly enabling the
transfer of funds from the savers to the spenders. Real assets lead to the production
of goods and services; financial assets allocate income or wealth amongst investors.
Hence, financial assets are the monetary terms in which the real assets are denomi-
nated in the economy. Due to the intangible nature of the financial assets and their
comparative sophistication due to the help of technology, financial assets can be
reengineered into complex derivative instruments.
To sum up, real assets, for example, land, buildings, equipment, intellectual capi-
tal, technology, etc., are the assets which can be used to produce goods and ser-
vices. The material wealth of any economy is determined by the productive capac-
ity of its goods and services. Financial assets, on the other hand, are the money
that flows alongside the real assets and are the means through which individuals
and businesses hold their claims on the income generated from real assets. For ex-
ample, if one cannot own a car company (a real asset), one can still buy shares (fi-
nancial asset) of a company that manufactures cars and thus partake in the in-
come generated from the production of cars.
Discussion Point: Discuss Whether the Following Assets are Real or Finan-
cial in Nature?
5 Patent on technology developed;
5 Lease payments;
5 Real estate;
1 5 Professional education;
5 An INR 100 note.
As you may have already guessed—patent on technology developed, real estate and
professional education are all real assets as they can be utilized in generating further
income and their ownership lies with the business and/or person. Lease payments and
an INR 100 note are financial assets as their value is derived or based on a real asset.
This text, focusing on investments, will explore financial assets in greater detail.
1.2.4 Importance of Financial Assets
Financial assets allow us to make the best use of the economy's real assets due to
the following reasons:
i. Consumption timing: We have already read about the motives of money. The
consumption timings of individuals may vary, depending on their individual
circumstances.
► Example
A young individual with a job at multinational company (MNC) without any loans/li-
abilities or dependents may not have the need for a large amount of funds as he/she is
independent and earning at that time. As a result, he may be able to sacrifice his con-
sumption and allow another person to use his savings, for example, a middle-aged man
wanting to send his young daughter abroad for higher education. The young man may
thus hold his savings in the form of a financial asset, say a fixed deposit with a bank,
and the middle-aged man may avail of someone else’s savings through an education
loan (another financial product) from a bank. Thus, financial assets allow for the dif-
ference in consumption timings by making the savings of some persons available for
the consumption of some others. ◄
ii. Allocation of risk: Different individuals may have different risk appetites de-
pending upon their financial stature and circumstance in life. The young man
in the previous example may have a higher risk appetite in terms of returns ex-
pected as he does not have any liabilities (say in the form of dependent par-
ents), and so, he can afford to put his savings into shares of growing compa-
nies which provide higher returns due to the greater degree of risk undertaken.
The middle-aged man, on the other hand, due to the expenses he needs to un-
dertake may decide to put his savings into government bonds which are con-
sidered safer so that he is sure about the returns at the time of his consump-
tion requirement. His risk appetite, thus, is low at that time. Thus, financial as-
sets allow consumers with different risk appetites to coexist in the market and
avail themselves of financial products as per their requirements.
13 1
. Table 1.2 Indian individual wealth (2017–2018)
Category FY 2018 FY 2017 Y-O-Y % Proportion % Proportion

amount (in amount (in change FY 2018 % FY 2017
INR crores) INR crores)
Financial 23,634,730 20,128,861 17.42 60.22 58.48
assets
Physical 15,610,118 14,289,371 9.24 39.78 41.52
assets
Total 39,244,848 34,418,232 14.02 100 100
*Y-O-Y indicates the year-over-year change. FY is the acronym for financial year
Source RBI (b) (2020)
iii. Separation of ownership and management: Financial products like shares and
debentures allow for the separation of ownership and management, a crucial
aspect in the management of the “firm” sector. Individuals with savings may
have a high-risk appetite and may be desirous of investing in a company which
can provide them with high returns. However, they may not have the necessary
professional acumen required to start a new business. A financial asset like a
share allows such persons to provide their funds to “promote” a business by
becoming its shareholders (owners), which can, then, be managed by a set of
professional managers. Hence, the shareholders are the owners of a company,
but it is the managers who manage it professionally. This is possible due to fi-
nancial assets.
Illustration 1.2: Holding of Financial and Physical Assets in India

. Table 1.2 depicts the individual wealth in India and its demarcation into finan-
cial and physical assets. Further, the table indicates the change in the holding of fi-
nancial assets and physical assets by Indians over the years 2017 and 2018. As is
evident, there has been a greater increase in the holding of financial assets (17.42
per cent) vis-à-vis physical assets (9.24 per cent). This is perhaps an indication of a
robust financial market and growing financial inclusion.
1.2.5 Financial Markets
Definition
A market is a place, real or virtual, where the buyers and sellers of a particular
product or service transact.
► Example
1 Examples of popular markets in India are Palika Bazaar (market) in Delhi for elec-
tronic goods, Firozabad market in Uttar Pradesh for bangles, Benaras market for silk
sarees, etc. ◄
Definition
The market for financial products like shares, debentures, etc., is called financial
market, for example, the Bombay Stock Exchange (BSE) or the National Stock Ex-
change (NSE). However, it is not necessary that a market for any asset (especially
a financial asset) be located at a specific geographical area. For example, all banks
dealing in currency markets constitute the foreign exchange market.
1.2.5.1 Classification of Financial Markets

Financial markets can be classified on the basis of maturity of claims, type of
claim and whether the securities/products being offered for trade are new issues
or outstanding issues.
i. Maturity of claim: If the claims are short term, the financial market is called
a money market, and if the claims are long term, it is called a capital mar-
ket. The cut-off time period of distinction between short-term and long-term
markets is taken as one year; however, money markets, these days, function
on overnight lending and borrowing as well. Further, it is ironic to note that
shares/stocks1 which traditionally represent a long-term ownership of the
company (to which they belong) are traded almost instantaneously on the
stock exchanges through the use of high-tech computer terminals.
Anyway, as a matter of distinction, money markets would have short-term debt

instruments and capital markets would have long-term debt instruments, equity
and preference shares. Equity shares theoretically are a perpetual instrument as
they have no maturity date associated with them. . Figure 1.4 presents the classi-
fication of financial markets by maturity of claims.
► Example
Call money market (a part of the money market) refers to the market for short-term
funds, with maturity period ranging between 1 and 14 days. In India, banks and pri-
mary dealers are allowed to both borrow and lend money in the call money market.
Primary dealers are entities which are registered with the RBI and have the license to
purchase and sell government securities.
(Source Indianeconomy.net, 2020). ◄
1 It is to be noted that the words “shares” and “stocks” are used interchangeably throughout the
text. This is because their meaning is the same. “Shares” is used in British English, and “stocks” is
used in American English.
15 1
Debt Instruments Preference Equity Stock

Stock
Maturity Maturity
≤ 1 Year ≥ 1 Year
Money Capital Market

Market
. Fig. 1.4 Classification of financial markets by maturity of claim. Source Authors’ compilation
ii. Type of claim: The type of claim could be fixed (in the case of a debt instru-
ment) or residual (in the case of equity). As the name suggests, fixed claim en-
titles the holder to a fixed and predetermined rate of return, while a residual
claim entitles the owner to a varying rate of return which may be provided
from the income which remains (residue) with the entity after meeting the
fixed claims. Some securities, however, have a hybrid nature in terms of claims.
For example, preference shares are shares that provide the owner a fixed ben-
efit. Similarly, convertible bonds and debentures also have both fixed and re-
sidual features. . Figure 1.5 presents the classification of financial markets by
type of claim.
iii. New issues or outstanding issues: The market for new issues is called a primary
market, and the market where investors trade in outstanding (already issued)
securities is called a secondary market. This classification is typically associ-
ated with the capital markets as the money markets are generally short-term
markets with shorter maturities. Further, primary market activities are also re-
ferred to those activities where the investment entity, for example, a company,
deals directly with its investors. A company may buy back shares, issue fol-
low-on shares, etc. These can all be termed as primary market activities. Sec-
ondary market activities are beyond such activities, when investors trade (buy
and sell shares, etc.) amongst themselves.
1 Fixed Income Instruments Residual Income Instruments
Debt Preference Stock Equity Stock

Instruments
Debt Market Equity Market
. Fig. 1.5 Classification of financial markets by type of claim. Source Authors’ compilation
> Index
An index is an economic measure that tracks the price movements of products in
any market: financial, commodities, etc. For example, the wholesale price index
(WPI) is a popular index used to measure the level of inflation in the economy. It
tracks the movement of the wholesale prices of a basket of commodities. Several fi-
nancial indices measure price movements of shares, bonds, T-bills and other securi-
ties. Similarly, stock market indices indicate the behaviour of equity markets.
Importance of Indices
1. Indices enable comparison of returns amongst various investment alternatives.
2. Indices can be used as a performance standard.
3. Indices are considered indicators of economic/sectoral performance.
4. Indices provide real-time information.
> Illustration 1.3: The Most Popular Stock Market Index in India: BSE SENSEX
Standard and Poor’s (S&P) Sensitivity Index (SENSEX) is an index of the Bom-
bay Stock Exchange (BSE). The methodology deployed in its creation is called the
“free-float market capitalization”. The index value reflects the free-float market
capitalization of the shares of 30 companies relative to a base period. The com-
putation of market capitalization of a company is done by multiplying the cur-
rent price of its stock by the number of shares issued by the company. This is then
multiplied by the free-float factor (number of shares available for trade upon total
shares issued) to determine the free-float market capitalization. Care is taken to en-
sure representation of companies from important sectors to provide a broad base.
. Table 1.3 presents the thirty companies that constitutes of S&P BSE SENSEX
as on 13 January 2020.
17 1
. Table 1.3 Constituents of S&P BSE SENSEX (as on 13 January 2020)
Sr. no. Companies Sector

1 Asian Paints Paints and varnishes
2 Axis Bank Banking
3 Bajaj Auto Automotive
4 Bajaj Finance Finance
5 Bharti Airtel Telecommunications
6 HCL Technologies Ltd. Software
7 HDFC Bank Banking
8 Hero MotoCorp Automotive
9 Hindustan Unilever Personal care
10 Housing Development Finance Corporation Finance
11 ICICI Bank Banking
12 IndusInd Bank Banking
13 Infosys Software
14 ITC Cigarettes and FMCG
15 Kotak Mahindra Bank Banking
16 Larsen & Toubro Infrastructure
17 Mahindra & Mahindra Automotive
18 Maruti Suzuki Automotive
19 Nestle India Ltd FMCG
20 NTPC Power
21 Oil and Natural Gas Corporation Oil and gas
22 Power Grid Corporation of India Power
23 Reliance Industries Conglomerate
24 State Bank of India Banking
25 Sun Pharmaceutical Pharmaceutical
26 Tata Consultancy Services Software
27 Tata Steel Steel
28 Tech Mahindra Ltd. Software
29 Titan Co Ltd. Diversified
30 UltraTech Cement Ltd. Cement
Source Bombay Stock Exchange (2020)

> Example of the Effect of a Crisis on Indices

1 SENSEX fell by 1941.67 points on March 9, 2020 amid the fears of the corona-
virus pandemic. This was further exacerbated by the Yes Bank crisis. One of the
worst single-day fall in the history of the exchange, it led to the loss of investor
wealth to the tune of INR 6.50 lakh crores. Further, INR 11.2 lakh crores worth
of investor wealth was lost again on 12 March 2020 when the index fell by 2,919.26
points. The next day, March 13, saw a halt in trading for 45 min for the first time in
12 years due to lower circuit (sharp fall and lower volume). Continuing the losing
streak, investor wealth worth INR14.22 lakh crore was lost on 23 March 2020 as
SENSEX lost 3,934.72 points to close at 25,981.24.
z Bond Market Indices in India

Just like stock market indices, one can have bond market indices that target and
track the movement of prices of fixed income securities.
► Example
In India, the National Stock Exchange (NSE) issues various government security
(G-sec) indices. The indices have a base date of 3 September 2001 and a base value of
1000. Reconstituted and rebalanced on a monthly basis, such indices measure the per-
formance of most liquid Government of India (GoI) bonds across distinct durations.
They are an objective indicator of the bond market performance in India.
(Source National Stock Exchange, 2020). ◄
iv. Timing of the claim: Spot markets indicate a market for securities which are
bought and sold at the “spot” price which is the price at that point of time
(e.g. stock markets), whereas future markets are markets where commodities
are sold at a predetermined “future” price (e.g. the derivative market). In fact,
most financial derivatives are based on future prices.
1.2.5.2 Functions of Financial Markets

The main role of financial markets (like any other market) is to get buyers and
sellers together for transacting in financial instruments/products and services.
They perform three important functions:
i. Facilitate price discovery: The interaction amongst buyers and sellers, depend-
ing on the demand and supply of financial products and services, helps in the
determination of market prices.
ii. Provide liquidity: A financial market helps buyers and sellers of financial prod-
ucts transact with relative ease and at the time of their choosing. This helps
in providing the much needed liquidity (in terms of trading volume) to hold-
ers of financial assets, which is one of the primary motivators of investments.
Also, thanks to this liquidity and transferability of ownership, companies are
able to raise funds from investors who may have different investment horizons.
19 1
iii. Reduce costs of transacting: Transaction costs are made up of basically two
sub-costs: search costs and information costs. Direct costs like advertising and
indirect costs such as the time and effort required when locating a customer
are reduced. Information costs, on the other hand, refer to the costs incurred
in gathering information about and analysing the merits/demerits of different
financial assets.
1.2.5.3 Role of Financial Markets

Financial assets and their markets are crucial to any developing/developed econ-
omy. The various roles that financial markets play are:
i. Informational role: Financial markets play a very important role in the alloca-
tion of resources. Investors in the stock markets are able to influence the fu-
ture of businesses. If the share prices (stock) of a particular company rise, it
becomes easier for it to raise finance and expand further. Share prices typically
reflect the collective judgement of the investors. However, the information in
the market can rarely be complete (efficient) and normally developing stock
markets exhibit volatility (fluctuating share prices) as a result of this.
ii. Matching consumption timing: Some individuals could be earning more than
they wish to spend in the current time. Similarly, someone else may have an ur-
gent requirement (to spend on a product or service) for which their current in-
come is insufficient. A financial market helps these two individuals to get to-
gether; the individual with savings can lend them to another individual/organ-
ization which can utilize this saving. In a sophisticated financial market, this
transaction is made possible through the service of a financial intermediary
like a bank. The saver is rewarded for the sacrifice he/she makes for forgoing
current consumption, through what is called interest payments.
Further, the use of financial assets like shares, bonds, fixed deposits, for park-
ing excess funds, allows the investor to “shift” his/her consumption to any
other period in future, especially to times that provide the greatest utility/satis-
faction.
iii. Matching allocation and management of risk: Virtually, all real assets entail
some risk. Whether a particular product will sell or not and whether a par-
ticular raw material will be available or not, are all uncertain events and busi-
nesses try to organize and manage these uncertain events. Similarly, as inves-
tors, depending on the income levels and liabilities, one person may be able to
invest in a riskier asset than another investor. For example, a young man with
a lucrative job and no family responsibilities may be able to invest in shares
of technology stocks which may have a risky future. At the same time, an old
pensioner with no income would like to invest his money in an asset which is
safe and can provide him with a constant stream of cash flows.
1.2.6 Financial Assets
1
1.2.6.1 What is a Security?
Definition
A “security”, as the name suggests, is any financial product that “secures” a return
in future. This return may be a promised return, the quantum of which may or may
not be determined at the time of purchase of the security.
All securities are essentially financial instruments or claims on money. These finan-
cial assets fall in various categories with different characteristics.
In the legal sense, the Securities Contracts Regulation Act (SCRA), 1956 (the law
that governs various securities in India), defines a security “as an instrument of
promissory note or a method of borrowing or lending or a source of contributing
to the funds needed by a corporate body or non-corporate body” (SEBI, 2020). De-
rivatives, insurance products and security indices are also included in the definition
of securities.
1.2.6.2 Kinds of Securities
Investments can be done through a wide array of options available in the market.
They may be debt instruments that typically assure the investor of a fixed return,
or they could be instruments like equity and real estate that would allow for vary-
ing returns, dependent on the underlying risk of the instrument as well as the tim-
ing in the market. There could also be instruments catering to the specific require-
ments of the investor, for example, tax saving schemes, life insurance or even pre-
cious metals and/or art. The quality and type of investment choices available are
also an indication of the sophistication of the financial system and market.
Some of the popular and commonly discussed investment choices/avenues in
terms of securities are:
1. Equity
Definition
Equity represents the ownership capital of an enterprise. This essentially means
that the shareholder has a residual claim (after every other liability has been paid
off) on the income and wealth of the business. Further, it would be the equity
shareholders’ representatives in the form of directors who would lead the company.
Equity shares carry no fixed return, and as owners, equity shareholders bear all the
risk the company faces. Hence, equity shareholders are also called the “risk class”
of the company.
Equity shares can be classified into various categories. Details would be provided in
the chapters on fundamental and technical analysis.
21 1
Concept in Practice 1.1: How to Start Trading in Shares

When one thinks of an investment portfolio, shares/stocks are the first investment
option that come to mind after classic debt-based instruments like fixed deposits.
The simplest way to invest in shares is to go through a mutual fund. However, for di-
rectly investing in shares, one needs to understand the procedure to trade in shares.
To initiate an investment in shares, an investor needs:
a. A dematerialized (demat) account—a demat account is like a locker that stores
shares in a dematerialized form. An investor can open a demat account with ei-
ther the National Securities Depository Ltd. (NSDL) or the Central Depository
Services India Ltd. (CDSL), both of which are share depositories in India.
b. A trading account—a trading account is the account that allows one to trade
shares on stock exchanges. It is typically opened through a brokerage firm.
c. A bank account—this is the account that would be used to buy shares and re-
ceive the proceeds of sale.
Once an investor has created these accounts, he/she can use their trading account
to make bids for buying and selling shares. In case the buying bid is successful,
shares will be transferred to his/her demat account, and in case the selling bid is
successful, shares will be transferred out of his/her demat account. His bank ac-
count would be used for the financial transactions.
2. Bonds or fixed income securities
As the name suggests, these securities carry a fixed term (maturity period) and a
fixed income (interest) associated with them. Some examples of marketable fixed
income securities are:
(a) Government securities (G-secs)
the Government of India (GoI) borrows funds extensively to finance its ex-
penditure by selling government securities (G-secs). G-secs have varying matur-
ities that can go up to 30 years. They require a minimum subscription of INR
10,000 and multiples of INR 10,000, thereafter. Interest payments on G-secs
are generally semi-annual.
(b) Savings bonds—such bonds can be issued by the government, financial institu-
tions as well as infrastructure companies to raise funds. They carry a fixed rate
of interest and can have different maturities. Depending on the entity issuing it,
they carry varying levels of risk that is typically reflected in their credit rating.
► Example
RBI bonds carry virtually no risk as they are backed by sovereign guarantee. They can
be bought for as low as INR 1,000 and are a popular investment choice. ◄
(c) Private sector debentures—once a private company gets listed on a stock ex-
1 change, it can also raise finance by issuing public debt instruments called de-
bentures. Such debentures are backed by the underlying company’s credit wor-
thiness and are typically long term in nature.
(d) Public sector undertaking (PSU) bonds—the Indian government has promoted
many companies and retains majority stake in them. Such firms are commonly
called public sector undertakings (PSUs). When PSUs issue bonds, they
can be considered as carrying sovereign (government) guarantee with them.
Hence, they are considered relatively safer than private sector debentures.
(e) Preference shares—a hybrid instrument, preference shares carry features of
both equity and debt instruments. Like debt instruments, they carry a fixed
rate of return, called preference dividend, and a fixed payment period as well.
Like equity shareholders, they have the right to vote in the company’s affairs,
however, only in the case of non-payment of preference dividend. Preference
shares may be cumulative (where the dividend gets accumulated if not paid
in a certain year) and/or convertible (where they can be converted into equity
shares).
(f) Deposits—like fixed income securities, deposits also provide fixed returns. The
basic difference between deposits and other fixed income securities, however,
is the fact that deposits are not tradeable. The popular deposits in India are
bank deposits and postal deposits.
3. Money market instruments
Money markets denote the short-term and wholesale market for debt instru-
ments. The players in the money market are typically the government, banks
and other financial institutions, large companies and high net worth individuals
(HNI). Some of the money market instruments are:
(a) Treasury bills—treasury bills (T-bills) are short-term debt instruments, issued
by the central government of a country. They have varied durations, lasting
less than a year. Considered nearly “risk-free”, treasury bills are the most pop-
ular investment choice in the country due to the safety accorded to such in-
struments.
► Example
The government of India issues three types of treasury bills, namely 91 days, 182 days
and 364 days. They have a minimum subscription amount of INR 25,000 and are avail-
able in multiples of INR 25,000 after that. They are issued at a discount and are re-
deemed at par. For example, a 91-day treasury bill of INR 100 (face value or the base
denomination) can be issued at say INR 96.5, that is, at a discount of INR 3.5 and re-
deemed at the face value of INR 100. The return (INR 3.5) is the difference between
the maturity value or the face value (i.e. INR 100) and the issue price (INR 96.5).
While 91-day T-bills are auctioned every Wednesday, both 182-day and 364-day T-bills
are auctioned every alternate Wednesdays.
(Source Moody’s Analytics, 2020). ◄
23 1
. Fig. 1.6 Negotiable certificate of deposit (CD). Source RBI (c) (2020)
(b) Certificate of deposit (CD)—a certificate of deposit, or CD, is a time deposit

with a bank. It is issued as a promissory note against deposits.
► Example
As per the RBI guidelines, CDs are issued at a discount to the face value just like
T-bills. They are issued in denominations of INR 1 lakh (maturity value) and are nego-
tiable; that is, they can be sold before their maturity date. CDs are issued for maturity
periods ranging from 7 days to 1 year. . Figure 1.6 presents a format of a negotiable
certificate of deposit (CD). ◄
(c) Commercial paper (CP)—a commercial paper (CP) is a popular money market
instrument issued by companies in the form of a promissory note for short-
term borrowings. Such borrowings are targeted towards meeting working cap-
ital needs.
► Example
Only large and successful companies in India (with rating of A2 or an equivalent rat-
ing, as per rating symbol and definition prescribed by SEBI) are allowed to issue com-
mercial papers in India. CPs are unsecured and do not carry any collateral. Certain fi-
nancial institutions (as per RBI guidelines) can also raise short-term funds by issuing
commercial papers.
The maturity period of commercial papers ranges between 15 days and 1 year. CPs
are issued in denominations of INR 5 lakhs or multiples thereof. Like the CDs, CPs
are also issued at a discount to the face value. ◄
(d) Repurchase (Repos) and Reverse Repos—repurchase rate (repo) is the rate at
which the central bank of any country (RBI in the case of India) lends to
. Fig. 1.7 Policy repo rates and returns on treasury bills and bonds in India, 2014–2018. Source RBI
(d) (2020)
other banks. In a repo transaction, a bank would transfer government securi-

ties to the RBI on a typically overnight basis and buy back those securities af-
ter the repo period, at a higher price. This difference in price is the interest for
the repo period.
As the name suggests, a reverse repo is the opposite of a repo. In this case, the
RBI borrows funds from the banks. Here, government securities (held by the
banks) are purchased and then sold back after the repo period.
> In the light of the coronavirus pandemic and as a stimulant for the economy,
the RBI revised its repo rate to 4.4% on 27 March 2020 from 5.15% (a cut of 75
points). This, at that time, became the highest repo rate cut in the last decade. This
was aimed at increasing liquidity of funds available in the economy.
► Example
. Figure 1.7 represents the policy repo rates, returns on treasury bills and bonds over
the period of 2014–2018 in India. As is evident from the graph, repo rates during the
period varied from 8% to around 6%. As stated in the previous example, repo rates
have been further lowered in the wake of the coronavirus pandemic. Treasury bill
yields varied between a high of 9% and a low of around 5.5%, while treasury bond
yields fluctuated from around 9% to a low of around 6%, during the period. ◄
4 Non-marketable fixed income securities or tax-sheltered savings schemes: As the

name suggests, such schemes can be used to legally avoid tax as such invest-
ments are exempt from tax. The most popular schemes in India are employee
provident fund (EPF), public provident fund (PPF), post office time depos-
its (POTD), Kisan Vikas Patra (KVP), National Savings Certificates etc. Such
schemes were also designed to provide an avenue for investors to create retire-
ment funds/pensions for their future and to encourage overall savings in the
economy.
25 1
Since they target individual savings, such securities cannot be traded. Each of
them carries specifications with respect to the amount that can be invested, matu-
rity period and rate of interest payable. They are popular instruments to manage
personal wealth and investments.
Their terms and conditions keep changing with time. Hence, it is a good prac-
tice to keep a track of their latest specifications through authentic government
websites like that of the RBI.
5. Mutual fund schemes: Mutual funds are a financial intermediary through
which instead of buying equity shares and/or fixed income securities directly,
one can participate in various schemes built around such instruments by the
mutual fund. This allows an investor access to a professionally managed port-
folio and safer returns than what one could have managed on one’s own.
There are three broad types of mutual fund schemes: growth schemes, income
schemes and balanced schemes. These schemes can comprise pure equity or
pure debt or even a hybrid of both equity and debt securities.
6. Insurance products: As has been discussed later in this chapter, investments are
not simply targeted at increasing returns but also at minimizing risk. It is ob-
vious that sustainable returns can be enjoyed only when the underlying risk
has been mitigated. The case in point is the life of an investor. He/she will con-
tinue to earn returns only when he/she is alive and earning. Insurance prod-
ucts are aimed at mitigating risk that can arise due to different factors like
death (life insurance), sickness (health insurance), accidents (accident insur-
ance) and even general insurance. In this case, the insurance premium repre-
sents the sacrifice the investor makes and the assured sum represents the ben-
efit he receives. Needless to say, insurance products are a wise investment
choice.
7. Real estate: It is typically every individual’s dream to own a house as it rep-
resents a very basic need to have shelter and security. It becomes one of the
most important assets in any person’s investment portfolio. In addition to a
residential house, the other kinds of real estate investments could include agri-
cultural land, semi-urban land/plot, etc.
8. Precious objects: Such objects include precious metals or commodities and
even rare art and crafts. Such items are highly valuable in monetary terms and
generally appreciate in value over time due to their rarity and subsequent de-
mand. Some examples of such objects are gold, silver, precious stones and
paintings/sculptures.
9. Financial derivatives: As the name suggests, a financial derivative is a finan-
cial product whose value is derived or based on the value of an underlying as-
set (that can be a real or a financial asset). It provides the investor with certain
rights and options on the underlying asset which can help to hedge his/her risk
in case the price of the underlying asset fluctuates. Like insurance, financial
derivatives also help an investor to mitigate risk (arising due to price fluctua-
tions in the underlying asset) along with providing/earning returns. Financial
derivatives would be discussed in greater detail in the chapter on derivatives.
1 Concept in Practice 1.2: Changing Pattern of Asset-Wise Retail Investor

Wealth in India
In the financial year (FY) 2018, asset-wise retail investor wealth was distributed
under some select investment avenues as per . Table 1.4.
. Table 1.4 Changing pattern of asset-wise retail investor wealth in India
Financial FY 2018 FY 2017 Y-O-Y % FY 2018 FY 2017

assets amount (in amount (in change proportion proportion
INR crores) INR crores)
Direct eq- 4,897,574 3,758,255 30.32 20.72 18.67
uity
Fixed de- 4,209,745 3,909,252 7.69 17.81 19.42
posits and
bonds
Insurance 3,335,909 3,001,230 11.15 14.11 14.91
Savings 3,096,806 2,883,697 7.39 13.10 14.33
bank de-
posits
Cash 1,759,712 1,264,124 39.20 7.45 6.28
Provident 1,448,241 1,304,316 11.03 6.13 6.48
funds
Mutual 1,169,954 868,396 34.50 4.94 4.31
funds
*Please note that the total of the proportions’ columns is not 100 as these are just
some select and popular investment avenues, provided here for illustration purposes
Source RBI (e) (2020)
From the data in . Table 1.4, one can observe that over the two years, the savings
pattern of the individual/retail investor has changed. The salient features of the
change are:
a. Investments in direct equity and mutual funds have recorded a significant in-
crease.
b. Interestingly, however, the proportion of total investor wealth invested in mu-
tual funds still remains low at nearly 5 per cent.
c. Fixed income securities and debt instruments (fixed deposits and bonds, insur-
ance, savings bank deposits, provident fund, etc.) continue to be more popular
than direct equity instruments indicating the risk-averse nature of the investors.
It should be borne in mind that mutual funds also allow investments in debt se-
curities.
27 1
1.2.7 Who is an Investor?
In simple words, if one’s income is higher than one’s consumption, that is, if one
has savings, one is a potential investor. One can simply put these savings in a
bank locker, in which case there would be no extra benefit accruing to him/her ex-
cept for the fact that the money would be safer than keeping it at home. However,
if one sacrifices holding on to one’s money in the present, in lieu of some benefit
in future, one is essentially investing. One may do this by putting one’s money in a
fixed deposit in a bank or buying the shares of a company or buying gold or buy-
ing a house. Any of these activities may ensure some return or benefit for the in-
vestor in future. Such a return can augment the investor’s current income and can
indeed come in handy when the investor retires from employment or when his/her
income level lowers in the event of an accident or illness or termination of em-
ployment. If one is the sole earner in one’s family, the entire family may be de-
pendent on not just his/her current income but also his/her investments for their
well-being. Hence, a person’s economic success and well-being in future depend
on how wisely he/she invests today.
z Are Investments Only Targeted Towards Increasing Returns?

The two basic tenets of investments are risk and return. Investors are keen to in-
crease returns and/or decrease/minimize risk. Therefore, most of the investment
products are aimed at maximizing returns but there are some which are focused
on minimizing risk, as well. The prime case in point is insurance. Insurance as a
financial product is aimed at minimizing the risk (whether life or medical or fire,
etc.) instead of maximizing returns.
1.2.8 What is an Investment?
Every rational investor desires maximum returns and minimum risk. Hence, con-
ceptually, investments can be built around two objectives—increasing returns or
decreasing risk. More often than not, we think of investments as products for in-
creasing returns, for example, shares, debentures, deposits, etc. However, invest-
ments can also be targeted towards the reduction of risk, the prime case in point
being insurance products. Even though such products may provide very low (in
fact sometimes negative) returns, they fulfil the important function of reducing
risk. Another example of risk mitigating products can be financial derivatives like
forwards, futures and options.
As an activity, investment includes parting with one’s funds/savings as pro-
vider of funds, so that they can be consumed by another party as user of funds,
for an economic activity (in case of the “business” sector) or for meeting a con-
sumption need (in case of the household sector).
z Difference Between Investment and Speculation

1 The difference is only of motive. In investment, the objective of earning returns is
typically long term or medium term. The investor books a return when the future
value of his investment becomes greater than its present value. In speculation, the
perspective is short term and the speculator maximizes the return through buying
and selling. The stakes of risk and return are higher in speculation than in invest-
ments. An investor would, typically, go through a detailed analysis of fundamen-
tals, while a speculator looks at technical trends for his decision.
An investment is done after considering all environmental, industry and eco-
nomic factors and is usually done for a longer time horizon. On the other hand,
speculation is a short-term trade driven with an intent of removing any price
anomaly or capturing some information that is not reflecting in the stock prices.
> It is important to understand that speculation based on fundamental infor-
mation regarding future demand and supply scenarios actually makes markets.
Speculators provide a service as they make markets by predicting increase/decrease
in prices. It is unfortunate that in some stock markets, speculation acquires a nega-
tive connotation and is sometimes reduced to price predictions based on emotions
and irrelevant information (this is referred to as noise in stock market parlance).
1.3 Concept of Risk and Return
Before one learns about the process of investments, it is important to first grasp
the concepts of risk and return. Risk and return are two sides of the same coin.
In layman terms, returns are the excess of benefits received over costs incurred for
a product or service. Risk is the variability in the returns which could be expected
due to various factors.
► Relationship Between Risk and Return

Why is it that in case of a new product which is designed and manufactured by a sin-
gle seller (monopoly), the seller is able to make high returns? It is simply because in
any economy which is driven by the forces of demand and supply, if the demand for
the product is high and the supply is low (one or very few sellers), the resultant price
would be high as the seller(s) would like to satisfy the demand at the price which yields
the highest returns for them. The reason why the supply of such products would be
low would typically be the high risk associated with the product; for example, the ini-
tial investment required would be too high or the raw material required would be rare
and difficult to obtain or the technology could be rapidly changing, market conditions
and resultant demand could be erratic, etc. This could lead to the revenues and returns
(from such products) fluctuating dramatically over time. In fact, more often than not,
entrants into such sectors fail to establish their businesses due to these risks. It is for
this reason that high-risk products and businesses demand a higher price (return) for
the product or service that they supply to the market. The market is also willing to re-
ward these risk takers as they meet the demand for that product or service. ◄
1.4 · Basic Criteria/Factors/Attributes for Investments
29 1
1.4 Basic Criteria/Factors/Attributes for Investments
i. Rate of Return (RoR)
Earning returns is the primary objective for most investors.
i The rate of return (RoR) on any investment for a period (generally one year) is
computed as follows:
Rate of return = (Annual Income + Ending price − Beginning price)/Beginning price . . . (1.1)
Let us consider an example to illustrate the same.
? Question 1.1: Rate of Return (RoR)

Consider the following information about a particular equity share:
5 Price at the beginning of the year = INR 50.
5 Dividend paid during the year = INR 5.
5 Price at the end of the year = INR 55.
Calculate the RoR for the share for the period.
v Answer 1.1
As per Eq. 1.1,
Rate of return = (Annual income + Ending price - Beginning price)/Beginning
price.
Hence, the RoR on this share would be calculated as:
[5 + (55–50)]/50 = 10/50 = 0.20 or 20%.
Components of RoR
Further, the RoR can also be split into two parts, viz., current yield and capital
gains/losses as follows: how to evaluate the marketability
5 Current yield = annual income/beginning price.
5 Capital gains yield = (ending price-beginning price)/beginning price.
Therefore, RoR = current yield + capital gains yield.
RoR for a portfolio is the weighted average rate of return of its constituent secu-
rities. This will form part of the subject matter of the chapter on risk and return.
ii. Risk/Variability in Returns

1
As discussed, the RoR from investments like equity shares, real estate, commod-
ities like gold and silver, etc., can vary rather extensively and this variability is
termed as risk. In quantitative terms, the difference between the actual return and
the average expected return denotes the variation.
In statistical terms, risk is denoted through various measures:
Range Range is a measure of dispersion in the values of returns; in simple terms,

it is the difference between the highest and the lowest values.
Variance In statistical parlance, variance is the mean of the squares of the devia-
tions of the individual returns from the average return.
i Variance is denoted by σ2 (sigma-square), and the formula for calculating it is as

per Eq. 1.2:
2
Rj − R
2
σ = (1.2)
n−1
where
σ2 = variance,
Ri = actual return,
R = mean (average) return,
n = number of observations.
Standard Deviation (SD) Another statistical measure, standard deviation, is the

square root of variance.
i Standard deviation is denoted by σ (sigma), and the formula for calculating it is as

per Eq. 1.3:
2 1/2
Ri − R
σ = (1.3)
n−1
where
σ = standard deviation,
Ri = actual return,
31 1
Beta Beta is the measure of the covariance of a particular security’s returns with
the underlying market’s returns divided by the variance of market returns. It re-
flects the relative volatility/risk of a security vis-à-vis the underlying market.
i Beta is denoted by ß (beta) and is calculated as per Eq. 1.4:
Cov(i, m)
βi = (1.4)
σm2
where
βi = beta of security i,
Cov(i,m) = covariance of security i’s returns with underlying market’s returns
σm2 = variance in the market.
Beta calculations would be presented in the chapter on risk and return.
? Question 1.2: Risk

The returns of security X (in percentage) over a ten-day period are recorded as fol-
lows:
Day 1 Day 2 Day 3 Day 4 Day 5 Day 6 Day 7 Day 8 Day 9 Day 10
12 14 10 20 16 4 −2 8 12 12
Calculate the different measures of risk (variability) in the returns of security X over the period.
v Answer 1.2
The different measures of risk (variability) in the returns of security X over the ten-
day period have been calculated as:
(i) Range (difference between the highest and the lowest values)
On observing the data in the question, it is evident that the range in the returns has
been 20−(−2) = 22%.
(ii) Variance
As per Eq. 1.2, variance can be calculated using the formula:
2
2 Ri − R
σ = ;
n−1
where
σ2 = variance,
Ri = actual return,
In this case, R or mean (average) return = [12 + 14 + 10 + 20 + 16 + 4 + (-2) + 8 + 12 +

12]/10 = 10.60%.
Hence, variance can be calculated as:

σ 2 = � (12 − 10.6)2 + (14 − 10.6)2 + (10 − 10.6)2 + (20 − 10.6)2 + (16 − 10.6)2 + (4 − 10.6)2
1
+ (−2 − 10.6)2 + (8 − 10.6)2 + (12 − 10.6)2 + (12 − 10.6)2 /(10 − 1)

= � (1.4)2 + (3.4)2 + (−0.6)2 + (9.4)2 + (5.4)2 + (−6.6)2 + (−12.6)2 + (−2.6)2 +

+(1.4)2 + (1.4)2 /9
= �[1.96 + 11.56 + 0.36 + 88.36 + 29.16 + 43.56 + 158.76 + 6.76 + 1.96 + 1.96]/9
= 344/9 = 38.22%
(iii) Standard deviation (SD)

As per Eq. 1.3, standard deviation is calculated as:
2 1/2
Ri − R
σ =
n−1
where
Ri = actual return,
Since we have already calculated variance, the standard deviation would be the
square root of variance:
σ = √variance = √38.22   =  6.18%.
iii. Safety: Safety of funds is paramount for investors. Each investor would try to
explore investment opportunities where at least the principal amount is secure.
Debt instruments provide this feature, whereas equity markets, if volatile, may
pose a threat to the basic principal invested, as well.
iv. Liquidity/Marketability: A financial product is said to be marketable or liquid
if it can be bought or sold readily and the transaction cost is low particularly
due to a robust demand and supply scenario. As a result of its liquidity, the
price differential between the buy and sell quotes is minimal.
There are terms like depth, breadth and resilience that measure/gauge the liquid-
ity of any market.
Depth It relates to the availability of buy and sell orders around the current mar-
ket price. Basically, it denotes the availability of buyers and sellers (traders) for
the security around a given price level.
Breadth It implies a large depth in the sense that the presence of buy and sell or-
ders at different prices is in large volume indicating the size of the trade.
33 1
Resilience It indicates that the market continues to exist for the particular secu-
rity in spite of price changes; that is, buyers and sellers continue to exist for differ-
ent prices.
An example of a liquid security would be the shares of a large, well-estab-
lished and profit making company or the treasury bills of the government.
Concept in Practice 1.3—How to Evaluate the Marketability/Liquidity of An

Investment?
If one wants to evaluate the “marketability” of an investment, the following ques-
tions could provide the required answer:
5 Can withdrawals be made easily or can loans be taken against this security?
5 Can a substantial part of the accumulated total be withdrawn without any sig-
nificant penalty?
5 Can the security be bought/sold easily?
If the answers to the questions are yes, then the security can be considered marketable.
v. Tax shelter: A major motivator for investments in current times is income tax
savings or avoidance. These can be in the form of:
Initial Tax Benefit This represents the tax relief provided at the time of making the
investment. For example, when you invest in the Kisan Vikas Patra (KVP), you
get a rebate under Sect. 80C of the Income Tax Act, 1961.
Continuing Tax Benefit It refers to the tax shield provided on the periodic returns
from the investment.
Terminal Tax Benefit It refers to the exemption from taxation at the time of liqui-
dating or terminating the investment. For example, withdrawal from the public
provident fund after the maturity period is exempt from tax.
vi. Convenience: The aspect of convenience refers to the ease with which the in-
vestment can be undertaken and thereby monitored. The degree and level of
convenience vary widely with different investment avenues. At one end, one
may invest in a fixed deposit with a bank that can be created readily and with
relative ease and does not require much monitoring or maintenance. On the
other end, an investment in property may involve legal and procedural chal-
lenges at the time of acquisition. Its maintenance is relatively difficult, as well.
vii. Maturity: The maturity period of the security is a major consideration when
analysing investment opportunities. For investors who can part with their
savings for a longer and known duration, fixed period securities like fixed
deposits are an attractive option. However, for investors who prefer liquid
securities, shares or mutual funds can provide this feature.
viii. Credit worthiness: It is important to assess the credit worthiness of the bor-
rowing institution/company before parting with funds. Central government
securities like treasury bills are considered most creditworthy as they are
1 backed by the central government holding the largest pool of assets in the
economy. Shares in a small start-up which is new in the business and faces
an uncertain future may be considered relatively low in terms of credit wor-
thiness when compared to treasury bills.
ix. Nature of investment: Debt is a secured instrument in the sense that it typ-
ically carries assets as collateral. Equity is unsecured. Hence, in terms of
surety of payments, debt is considered a safer bet than equity.
> . Table 1.5 presents a comparative analysis of select investment options against
their risks/liquidity, returns, taxation and suitability parameters.
1.5 What is Security Analysis and Portfolio Management?
The criteria of making an investment choice rest on the risk and return character-
istics of a security.
The process of analysing individual securities with respect to their risk and re-
turn (especially in relation to the underlying market) with a view to identifying
undervalued securities for buying and overvalued securities for selling is termed as
security analysis. It is both an art and a science.
1.5.1 What is a Portfolio?
A combination of securities with different risk–return profiles is called a portfo-

lio. A portfolio may have its own unique risk and return profile, different from the
risk and return profiles of its components. Calculating a portfolio’s risk and re-
turn forms the subject matter of another chapter.
Portfolio analysis and management is analysing the risk–return characteristics
of individual securities in the portfolio and then managing the changes that may
take place in the risk and return profile of the overall portfolio due to changes in
the risk–return characteristics of the underlying securities.
1.6 Contemporary Trends in the Investment Environment
Several ongoing trends have affected the contemporary investment scenario.

Some of them are
i. Globalization: The advent of globalization has ensured that most economies
in the world are now a four-sector (household, business, government and the
rest of the world (RotW)) economy with factors of production moving from
one country to another in search of better opportunities. Further, goods and
services now have a global market and companies have started setting up pro-
duction centres across the world (multinational companies). This has led to a
growth in foreign investments in financial markets.
. Table 1.5 Comparison of different investment avenues—2020
Investment Risks/liquidity Returns Taxation Suitability

option
Equity High risk and high liquidity. No Market linked returns. Taxable at varying Suitable for investors with high-risk ap-
limit on amount invested Good potential rates depending on petite
long-term versus short-
term capital gains
Bank fixed de- Very low risk and low liquidity. No Low but assured returns Returns are fully tax- Good for low-risk investors and for those
posits (FDs) limit on amount invested (interest) able in the nil or low tax brackets
However, high inflation may eat into the
returns
Post office Low risk and low liquidity. Limit Low but assured returns Since returns are tax- Good for very low-risk investors and those
schemes on amount to be invested (interest) decided by able, the post-tax rein the nil or low tax brackets. However,
government turns will be still lower high inflation may eat into the returns
Public prov- Low risk with very low liquid- Assured returns. Gener- Interest is tax-free Good tax saving investment option. Suita-
ident fund ity (15-year lock-in period. Partial ally amongst the highest ble for investors in high-tax bracket
1.6 · Contemporary Trends in the Investment Environment
(PPF) withdrawal allowed after 6 years). offered in the govern-

Limit on amount to be invested ment debt securities
Kisan Vikas Low risk with low liquidity (2 years Amount doubles in 100 Interest fully taxable Not very attractive vis-à-vis other options
Patra (KVP) and 6 months lock-in). No limit on months like 5-year bank FDs
amount to be invested
National Sav- Low risk with low liquidity (5 years Assured returns Interest fully taxable Not very attractive vis-à-vis other options
ings Certifi- lock-in). No limit on amount to be like 5-year bank FDs
35
cate (NSC) invested

Unit linked Low to high risk depending on the Low to high depend- Depends on investment Not an attractive option due to high
insurance investment option, i.e. pure debt or ing on the investment option charges, low flexibility and low diversifi-
plans (UL- mixed or pure equity. Low liquidity option cation
IPs)
Source Authors’ compilation

1
1 Concept in Practice 1.4: Foreign Institutional Investment (FII) Growth

Foreign institutional investment (or FII) is an investment by non-resident institu-
tional investors in Indian markets. The investments can be in the form of shares,
government bonds, corporate bonds, etc.
A significant rise in the FII in India has been seen in the recent past. The Securi-
ties and Exchange Board of India (or SEBI) FII regulation of 2014 encourages FII
and simplifies the processes for FII in India. New programmes have been launched
to boost the economy of the country. All these initiatives are attracting FII.
As it is evident from the above figure, there has been a steady increase in the FII
in the recent times in both equity and debt securities. Equity, however, attracted
greater FII to the tune of INR 89,868 crores as compared to debt (INR 27,220
crores) as in December, 2019.
(Source Central Depository Services (India) Limited (CDSL), 2020).
ii. Securitization/Financial Engineering: A financial product, unlike any other

physical product, has the flexibility to be customized to match the investors’
needs. With some of the brightest minds in the area of investments, traditional
debt and equity instruments are engineered and new securities devised easily
and frequently, for example, collateral debt obligations (CDOs) and complex
derivatives. As is evident from the financial crisis of 2008, however, such com-
plex securitization must be treated with a lot of caution as they have the abil-
ity to wreck economies, especially when the real assets these financial assets
are based on collapse.
► Example
In India, the origin of securitization can be traced back to 1991 when Citibank raised
INR 16 crores for the General Insurance Company (GIC) Mutual Fund by securitiz-
ing a part of its auto loans. There was a lull after that, however, and most of the secu-
ritization deals in India happened only after 1999. This was mainly due to the initiative
taken by the then government to boost mortgage backed securitization (MBS) in India
in the form of the National Housing and Habitat Policy, in 1998. The National Hous-
1.6 · Contemporary Trends in the Investment Environment
37 1
ing Bank of India (NHB), a subsidiary of the RBI, was asked to play the lead role in
the development of MBS market in India.
In 2005, Indian Railways Finance Corporation (IFRC) completed India’s first securiti-
zation of sovereign lease receivables of INR 196 crores with the help of Citibank. ◄
Long-term loans, typically, auto loans, loans for construction equipment and
mortgage backed receivables (housing loans) and even short-term liabilities like
credit card receivables, have been securitized in India. Basically, the idea behind
securitization is to enhance liquidity in the financial system by converting the re-
ceivables from long-term loans into smaller bundles that can be marketed. By sell-
ing these securities, loan providers and banks get back the much needed liquidity
which they can lend out again.
iii. Revolution in Information and Communications Network: Perhaps, no other
sector has been affected as much as the investment/finance sector, with the re-
cent revolution in the information and communications network. You can now
trade in securities across the world with the click of a button on your computer
and even through your cell phones. Products and services like credit cards, In-
ternet banking, mobile banking, PayPal, Paytm, etc., are moving us towards a
world of paperless currency. However, safety of funds remains a mounting con-
cern with chances of hacking of computers and communications networks.
Concept in Practice 1.5: Demonetization

One of the main motives of money is to make transactions, and over 95 per cent
of money is exchanged for this motive. The surge in the use of information and
communication technologies (ICTs) has led to the development of digital modes
of transactions which are gaining popularity as they are faster, relatively secure,
easy and convenient for the end user.
In 2016, the Government of India launched the demonetization drive to curb the
black money menace and with an aim of promoting digital transactions and use
of e-money (to minimize the exchange of traditional money sources for transac-
tions). However, every strategy has its pros and cons. Digital transactions offer the
benefits mentioned earlier but are also marred by some drawbacks such as fraud,
cloning and misuse of online passwords, thus raising concerns over their security.
Also, it raises issues about the privacy of data. Questions like the ones mentioned
below are plaguing investors and citizens alike:
5 What if the technology apparatus breaks down?
5 What happens if your account gets debited but the payment doesn’t get realized?
5 What if someone hacks into such systems?
5 What will happen if the next-generation cryptocurrencies become rogue? Who
will regulate them?
Answers to these questions hold the key to the future of the digital payments and
transactions and their consequent success in removing paper-based money and
currency as their competitor.
iv. Corporate Governance in Financial Sector—the basic aim of corporate govern-

1 ance is the alignment of the interests of management and shareholders (own-
ers), i.e. removal of agency cost. Good governance is one which is account-
able, transparent, responsive, equitable and inclusive, effective and efficient,
participatory (consensus oriented) and which follows the rule of law.
The financial services sector forms the backbone of any economy. This is the sec-
tor that mobilizes savings from across the economy into desired investments. Fi-
nancial institutions like banks and mutual funds become the custodian of pub-
lic wealth and have the highest fiduciary duties and standards to uphold. The fi-
nancial crisis which originated in the USA in 2008 brought out glaring aspects of
mis-governance which are crucial and need to be effectively addressed in the mod-
ern corporate governance framework, built around these financial institutions.
With the faster pace of corporatization, the volumes of market capitalization
have increased globally at an exponential pace. More and more investors across
the globe explore equity markets for investments and profit earning opportuni-
ties. Innovative methods of accessing funds and efforts of leveraging capital have
accentuated the sensitivity to risk. Thus, the influx of funds into the money and
capital markets from various sources has heightened the onus of regulators to
protect investor interest, thereby making the task much more challenging. Ensur-
ing that the end use of investor funds is prudent and is in conformity with the
global best practices is a tough task posing a sustained pressure on regulators to
innovate to find better ways and means of governance.
In this context, corporate governance has come to occupy a prominent posi-
tion in modulating the conduct of the financial institutions like banks and mu-
tual funds, accessing funds from the public. They have to be made to follow rigid
discipline in their governance, more so in the application of funds to protect the
long-term interests of the organizations.
1.7 Conclusion
The objective of this chapter is to provide a bird’s eye view of the environment
surrounding investments. Building upon the background of the territory of in-
vestments, it highlights the role that money and the sectors of the economy play.
A clear demarcation between real assets and financial assets is established. Finan-
cial markets, their classifications, functions and roles form the subject matter of
subsequent sections. Focusing more on financial assets (the crux of the subject
of Security Analysis and Portfolio Management), different kinds of securities are
presented. The answers to “who is an investor?” and “what constitutes an invest-
ment?” follow. The fundamental concept of risk and return is introduced. The im-
portant attributes of investments are laid out with numerical examples wherever
appropriate. The meaning of Security Analysis and Portfolio Management is de-
tailed followed by some contemporary trends in the investment environment.
1.7 · Conclusion
39 1
All through the text, real-life examples are presented to enhance the under-
standing of the reader. Further, concepts in practice are interspersed to help the
reader link the theory to practice. It also encourages critical thinking beyond the
text. In sum, the chapter lays down the background required to comprehend the
subject of Security Analysis and Portfolio Management in a simple and lucid
manner.
Tutorial: Foreign Direct Investment (FDI)
Foreign direct investment (FDI) is a of US$ 7,919 million, followed by the

crucial driver of economic growth in financial services sector at US$ 6,372
India. Foreign companies invest in million.
India to take advantage of its large
Note: This caselet can be used for a class
market, lower wages and attractive
discussion on the overall Indian economy
investment privileges like tax exemp-

in terms of its investment potential.
tions, etc. For India, it allows for the
Some part of the discussion can focus
efficient utilization of its capital re-
around the key FDI initiatives and their
sources, provides the opportunity to
interpretation (as given in the end of
leapfrog technologically and generates
the caselet). This case can also be used
employment as well as goods and ser-
as an introduction to the economic ana-
vices for its population.
lysis section in Chapter 4 on Fundamen-
The Indian government’s favoura-
tal Analysis. The Indian economy can be
ble foreign policy regime and attractive
substituted by the economy of the coun-
markets have ensured that foreign cap-
try where this book is used to teach this
ital flows readily into the country. The
course.
government has relaxed FDI norms
across various sectors. Investments/Developments
Discuss the recent developments in
Market Size
terms of new FDI announcements.
According to the Department of Indus-
This can be a group activity/assignment
trial Policy and Promotion (DIPP), the
with presentations in class. The groups
total FDI investments received by In-
may be divided to look into specific
dia increased from US $ 24,748 million
sectors.
in 2014–2015 to US $ 38,744 million in
2018–2019, indicating that the govern- Road Ahead: Indicative Interpretations/
ment's efforts are yielding results. Discussion Points
Over the five years, Singapore (US$ *Please note that this is just an indic-
14,632 million in 2018–2019) and Mau- ative list. Actual discussions will focus
ritius (US$ 6,570 million in 2018–2019) on the recent FDI deals/announcement
continue to remain the countries from in the country where the course is being
where India received the maximum taught.
FDI equity inflows. Further, data for 5 Joining hands with Japan for inf-
the five years 2014–2015 to 2018–2019 rastructure in India—technologi-
indicates that the manufacturing sector cally, Japanese industries are more
attracted the highest FDI equity inflow advanced than their Indian coun-
1 terparts. India stands to gain both

technical and managerial know-how
5 Increasing FDI in defence sector—
traditionally, the defence sector in
from this alliance. Geopolitically as India has been a closed sector. The
well, this alliance works in favour of sector has significant capital expend-
both countries by reducing the dom- iture outlays as most advanced air-
inance of China in the region. Also, crafts and equipment are imported.
with the latest threats from North 5 Raising of bonds worth INR 2360 cro-
Korea, the Japanese government has res by the Indian Renewable Energy
taken wise steps to develop bilateral Development Agency (IREDA)—this
ties with India that are of strategic initiative has multi-fold advantages:
importance to it. it will promote development of the
5 Allowing Amazon India’s INR 3500 renewable energy sector and reduce
crores investment—the government dependence on oil and coal, thereby
wants to promote e-commerce plat- promoting clean energy.
forms for associated stakeholders
such as suppliers/vendors. Thus, al- Note: It is important to discuss the ongo-
lowing Amazon FDI will send a ing COVID-19 pandemic and the impact
positive signal to other global play- it will have on the domestic economy, the
ers and local suppliers. world economy and investments.
. Table 1.6 Foreign direct investment flows to India: country-wise and industry-wise
Foreign direct investment flows to India: country-wise and industry-wise

(US$ million)
Source/industry 2014–15 2015–16 2016–17 2017–18 2018–19 P*
Total FDI 24,748 36,068 36,317 37,366 38,744
Country-wise inflows
Singapore 5137 12,479 6529 9273 14,632
Mauritius 5878 7452 13,383 13,415 6570
USA 1981 4124 2138 1973 2823
Japan 2019 1818 4237 1313 2745
Netherlands 2154 2330 3234 2677 2519
UK 1891 842 1301 716 1211
South Korea 138 241 466 293 982
Cayman Islands 72 440 49 1140 863
UAE 327 961 645 408 853
Germany 942 927 845 1095 817
Hong Kong 325 344 134 1044 598
(continued)
1.7 · Conclusion
41 1
. Table 1.6 (continued)
Foreign direct investment flows to India: country-wise and industry-wise

(US$ million)
Source/industry 2014–15 2015–16 2016–17 2017–18 2018–19 P*
Canada 153 52 32 274 548
Ireland 11 8 12 108 427
France 347 392 487 403 375
British Virgin Islands 30 203 212 21 290
Switzerland 292 195 502 506 280
Luxembourg 204 784 99 243 251
Others 2846 2476 2012 2464 1959
Sector-wise inflows
Manufacturing 9613 8439 11,972 7066 7919
Financial services 3075 3547 3732 4070 6372
Communication services 1075 2638 5876 8809 5365
Retail and wholesale trade 2551 3998 2771 4478 4311
Computer services 2154 4319 1937 3173 3453
Business services 680 3031 2684 3005 2597
Electricity and other en- 1284 1364 1722 1870 2427
ergy generation, distribu-
tion and transmission
Construction 1640 4141 1564 1281 2009
Miscellaneous services 586 1022 1816 835 1226
Transport 482 1363 891 1267 1019
Restaurants and hotels 686 889 430 452 749
Education, research and 131 394 205 347 736
development
Mining 129 596 141 82 247
Real estate activities 202 112 105 405 213
Trading 228 0 0 0 0
Others 232 215 470 226 102
P Provisional
Note Includes FDI through approval and automatic routes only
Source RBI (f) (2020)

Summary
1 5 Money is anything that can be used as a medium of exchange and is a measure
of value.
5 A person requires money for three basic motives: transaction motive, precautio-
nary motive and speculative motive:
5 The three basic sectors of any economy are the household, business and gover-
nment sectors. The fourth sector is known as the rest of the world, and it comes
into the picture when a country opens up its economy internationally.
5 The economy can be looked upon as consisting of real economy and monetary
economy. The actual usage of factors of production and the resultant produc-
tion of goods and services form what is known as the real economy. The ac-
companying money flows form what is known as the monetary economy.
5 Real (physical) assets is the term used for the actual assets in terms of the fac-
tors of production and the actual goods and services produced therefrom,
which flow through the economy from one sector to another. Real assets help
in creating wealth. Financial assets, on the other hand, represent claims to
parts or all of that wealth. Financial assets, based on the real assets, help in
timing of consumption, allocating of risk and separation of ownership and
management.
5 One way to classify financial markets is through the maturity of claims. The
market for short-term claims is called the money market, and the market for
long-term claims is called the capital market.
5 Another way to classify financial markets is by the type of claim. This could be
fixed (in the case of a debt instrument) or residual (in the case of equity).
5 Yet, another way to classify financial markets is based on securities being
traded as new issues or outstanding issues. The market for new issues is called a
primary market, and the secondary market is one where investors trade in out-
standing securities.
5 Financial markets help in facilitating price discovery, providing liquidity and
reducing costs of transacting.
5 Different roles of financial markets include informational, matching consump-
tion timing, matching allocation and management of risk.
5 A “security” as the name suggests is any financial product that “secures” a re-
turn in future. This return may be a promised return, the quantum of which
may or may not be determined at the time of purchase of the security.
5 Different investment avenues include equity, bonds or fixed income securities,
money market instruments, non-marketable fixed income securities or tax-shel-
tered savings schemes, mutual fund schemes, insurance, real estate, precious
objects and financial derivatives.
5 An investor is one who sacrifices holding on to his/her money in the present, in
lieu of some benefit in future.
5 Conceptually, investments can be built around two objectives—increasing re-
turns or decreasing risk.
5 Risk and return are two sides of the same coin. In layman terms, returns are
the excess of benefits received over costs incurred for a product or service. Risk
is the variability in the returns which could be expected due to various factors.
1.8 · Exercises
43 1
5 Rate of Return: The rate of return (RoR) on any investment for a period (gen-
erally one year) is defined as follows:
5 Rate of return = (Annual income + Ending price − Beginning price)/Beginning
price
5 Risk/Variability in Returns: The RoR from investments like equity shares, real
estate, commodities like gold and silver, etc., can vary rather widely, and this
variability in returns is termed as risk.
5 A combination of securities with different risk–return characteristics consti-
tutes a portfolio.
5 Several ongoing trends have impacted the contemporary investment scenario
—globalization, securitization/financial engineering, information and commu-
nications network and corporate governance in the financial sector.
1.8 Exercises
1.8.1 Objective (Quiz) Type Questions
? 1. Fill in the blanks:

(i) Money is anything that can be used as a medium of _________ and is a meas-
ure of ___________.
(ii) The three motives of money are ___________, ____________ and _________.
(iii) People who put money aside under the ________ motive are typically traders
who speculate on the rise or fall in prices of commodities, etc.
(iv) The three basic sectors of an economy are ___________, ____________ and
____________.
(v) The _____________ sector is that vital sector of an industrialized economy
that utilizes the factors of production to manufacture products and services.
(vi) The ___________ is a popular index used to denote the level of inflation in
the economy.
(vii) ___________ represents the ownership capital of an enterprise.
(viii) The actual usage of factors of production and the resultant production of
goods and services form part of what is known as the __________ economy.
(ix) A combination of securities with different risk–return characteristics is called
a ________________.
(x) ___________ is the rate at which the central bank of any country (RBI in the
case of India) lends to other banks.
v (Answers: (i) exchange, value; (ii) transaction, precautionary and speculative; (iii)
speculative; (iv) household, firm and government; (v) business/firm; (vi) wholesale
(WPI) ; (viii) real; (ix) portfolio; and (x) repurchase (repo) rate)
? 2. True/False
1 (i) The transaction motive for money is used to make transactions, that is, buy
or sell products or services like food, clothing, entertainment, etc.
(ii) The “firm” sector comprises people who contribute to what are known as
factors of production to the economy.
(iii) Real (physical) assets is the term used for the actual assets in terms of the
factors of production and the actual goods and services produced there-
from.
(iv) A price index is an economic measure used to provide information about the
price movements of products in any market: financial, commodities, etc.
(v) A debenture holder has a residual claim (after every other liability has been
paid off) on the income and wealth of the business.
(vi) In a repo transaction, a bank would transfer government securities to the
RBI on a typically overnight basis and buy back those securities after the
repo period at a higher price.
( vii) Risk and return are generally positively correlated.
(viii) The flow of foreign direct investment (FDI) in an economy does not help in
anyway in its development.
(ix) SENSEX is not an example of an index.
(x) Financial markets help in mobilizing the growth of the real economy.
v (Answers: (i) True; (ii) False; (iii) True; (iv) True; (v) False; (vi) True; (vii)
True; (viii) False; (ix) False; and (x) True)
1.8.2 Solved Numericals (Solved Questions)
Rate of Return
? SQ1. An investor bought a share of ABC Limited at INR 200 one year back. Over
the last year, ABC has distributed dividend of INR 5 per share. If the share of
ABC sells at INR 220 today, what is the return? If the share sells at INR 250 today,
what is the return earned?
v 5 The total return in the first case is INR 25 that comprises INR 5 of dividend
(current yield) and INR 20 (INR 220—INR 200) in terms of appreciation in
the market price of the share (capital gain yield).
5 The percentage return is INR 25/INR 200 = 12.5%.
5 Similarly, in the second case (when the share is trading at INR 250), the return
earned is INR 55 that comprises INR 5 of dividend (current yield) and INR 50
(INR 250—INR 200) in terms of appreciation in the market price of the share
(capital gain yield).
5 The percentage return is INR 55/INR 200 = 27.5%.
1.8 · Exercises
45 1
? SQ2. The price of a bond at the beginning of the year was INR 90. Price of the
bond at the end of the year is INR 96. Interest received for the year is INR 6. Com-
pute the rate of return.
v The rate of return can be computed as:
Rate of return = (Annual Income + Ending price − Beginning price)/Beginning price

= 6 + (96 − 90)/90
= 13.33 percent
The return of 13.33% consists of 6.67% current yield and 6.67% capital gain yield.
Risk
? SQ3. The returns of equity shares of company ABC (in percentage) over a ten-
month period are recorded as follows:
Month 1 Month 2 Month 3 Month 4 Month 5 Month 6 Month 7 M o n t h Month M o n t h

8 9 10
20 25 30 28 10 4 −4 −8 10 14
Calculate the different parameters of risk (variability) in the returns of equity
shares of company ABC over the ten-month period.
v (i) Range (difference between the highest and the lowest values)
As is evident, the range in the returns has been 30-(-8) = 38%.
(ii) Variance (the mean of the squares of the deviations of the individual re-
turns from the average value)
Denoted by σ2, variance can be calculated using the formula:
2
� Ri − R
2
σ = ;
n−1
where
σ2 = variance,
Ri = actual return,
Here, R or mean (average) return = [20 + 25 + 30 + 28 + 10 + 4 + (−4) + (−8) +
10 + 14]/10 = 12.90%.
Hence, variance can be calculated as

σ 2 = � (20 − 12.9)2 + (25 − 12.9)2 + (30 − 12.9)2 + (28 − 12.9)2 + (10 − 12.9)2
1
+ (4 − 12.9)2 + (−4 − 12.9)2 + (−8 − 12.9)2 + (10 − 12.9)2 + (14 − 12.9)2 /(n − 1)

= � (7.1)2 + (12.1)2 + (17.1)2 + (15.1)2 + (−2.9)2 + (−8.9)2 + (−16.9)2

+(−20.9)2 + (−2.9)2 + (1.1)2 /(10 − 1)
= �[50.41 + 146.41 + 292.41 + 228.01 + 8.41 + 79.21 + 285.61 + 436.81 + 8.41 + 1.21]/9
= 1536.9/9 = 170.77%
(iii) Standard deviation (SD) (the square root of variance)

Denoted by σ, standard deviation is calculated as:
2 1/2
Ri − R
σ =
n−1
where
Ri = actual return,
σ = √variance = √170.77 = 13.07%.
? SQ4. The returns of debenture A (in percentage) over a ten-year period are re-
corded as follows:
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
12 14 11 13 14 11 12 14 13 12
Calculate the different parameters of risk (variability) in the returns of debenture A over the ten-
year period.
v (i) Range (difference between the highest and the lowest values)
As is evident, the range in the returns has been 14–11 = 3%.
(ii) Variance (the mean of the squares of the deviations of the individual re-
turns from the average value)
Denoted by σ2, variance can be calculated using the formula:
2
2 Ri − R
σ = ;
n−1
where
σ2 = variance,
Ri = actual return,
1.8 · Exercises
47 1
Here, R or mean (average) return = [12 + 14 + 11 + 13 + 14 + 11 + 12 + 14 + 13 +
12]/10 = 12.60%.
v Hence, variance can be calculated as

σ 2 = � (12 − 12.6)2 + (14 − 12.6)2 + (11 − 12.6)2 + (13 − 12.6)2 + (14 − 12.6)2

+ (11 − 11.26)2 + (12 − 12.6)2 + (14 − 12.6)2 + (13 − 12.6)2 + (12 − 12.6)2 /(n − 1)

= � (−0.6)2 + (1.4)2 + (−1.6)2 + (0.4)2 + (1.4)2 + (−1.6)2 + (−0.6)2

+ (−1.4)2 + (0.4)2 + (−0.6)2 /(10 − 1)
= �[0.36 + 1.96 + 2.56 + 0.16 + 1.96 + 2.56 + 0.36 + 1.96 + 0.16 + 0.36]/9
= 12.4/9 = 1.37%
(iii) Standard deviation (SD) (the square root of variance)

Denoted by σ, standard deviation is calculated as:
1/2
(Ri − R)2
σ =
n−1
where
Ri = actual return,
σ = √variance = √1.37 = 1.17%.As is seen here, risk in debt securities is relatively

much lower when compared to equity.
1.8.3 Unsolved Numericals (Unsolved Questions)
Rate of Return
? UQ1. Mr X purchased 100 shares of ABC Limited at INR 100 per share in
2005. The company declared a dividend of INR 4 per share for the year 2006.
The market price of the share on 31 December 2006 was INR 115. What will be
the return on the investment for Mr X as on 31 December 2006?
[Answer: 19%].
? UQ2. Mr Y purchased a debenture at the beginning of the year for INR 50.
Price of the debenture at the end of the year is INR 54. Interest received for the
year is INR 4. Compute the rate of return.
[Answer: 16%].
? UQ3. The returns of equity shares of company PQR (in percentage) over a ten-
1 year period are recorded as follows:
40 45 30 28 10 14 18 10 25 30
Calculate the different parameters of risk (variability) in the returns of equity
shares of company PQR over the ten-year period.
[Answer: Range = 35, Variance = 144.89, Standard deviation = 12.04].
? UQ4. The returns of a government bond (in percentage) over a ten-year period
are recorded as follows:
5 6 6 5 4 5 7 6 6 6
Calculate the different parameters of risk (variability) in the returns of deben-

ture A over the ten-year period.
v [Answer: Range = 3, Variance = 0.71, Standard deviation = 0.84].
1.8.4 Short Answer Questions
? 1. What is money? Discuss its evolution in brief.

2. What are the basic motives for money?
3. What are the constituent sectors of a closed economy? Discuss the role of
each sector in brief.
4. Differentiate between real and monetary economies.
5. How are financial assets beneficial/important?
6. How are financial assets beneficial/important?
7. What is (a) a price index and (b) a stock market index? Give an example of
each.
8. What is (a) a price index and (b) a stock market index? Give an example of
each.
9. Briefly enumerate the functions of financial markets.
10. What role do financial markets play in the development of an economy?
11. What is an investment?
12. Describe briefly the different investment avenues/securities available in India.
13. What attributes/parameters are relevant for evaluating investment avenues?
How do various investment avenues compare on these parameters?
14. What is the difference between an investor and a speculator?
15. What are the functions performed by the financial markets?
1.8 · Exercises
49 1
1.8.5 Discussion Questions (Points to Ponder)
? 1. What would happen to the Indian economy if there were no financial mar-
kets?
(Hint: In the absence of financial markets, investors may find it difficult
to look for investment opportunities and companies may find it difficult to
raise capital)
? 2. Write a note on the potential investment areas in a developing economy like
ours.
(Hint: The important sectors can be healthcare infrastructure, education,
housing)
? 3. Suppose you win the lottery of INR 10 million.
a. Is this asset real or financial?
b. Is the economy richer because of this event or are you?
c. Can you reconcile your answer to (b)? Is anyone worse off as a result of
your win?
(Hint: Locate the difference between real and financial assets based on
their characteristics)
? 4. Name three financial intermediaries and explain how they act as a conduit be-
tween small investors and large capital markets and companies?
(Hint: Such intermediaries can be banks, mutual funds, insurance companies)
? 5. The average rate of return on investments in large stocks (as measured by re-
turn on SENSEX) has outpaced that on investments in government securities
(treasury bills) by about 10 per cent. Why do investors still invest in them?
(Hint: It could be due to the different risk perceptions of investors)
1.8.6 Activity-Based Question/Tutorial
? 1. Taking advantage of the Internet revolution, online brokerage flourished in

India. Visit the websites off the following four online brokerage houses:
5 Indiabulls;
5 Kotak Mahindra;
5 SBI Securities;
5 HDFC securities.
Explore the services provided by these companies and the prices they charge
for the same.
2. Financial Markets
– Visit the Securities and Exchange Board of India (SEBI) website
7 www.sebi.gov.in. Discuss the role of SEBI and the services it offers to
investors.
– Visit the Bombay Stock Exchange (BSE) website 7 www.bseindia.com.
What is the mission of BSE? What information does the BSE offer to
investors?
– Visit the National Stock Exchange (NSE) website 7 www.nse.com.
What is the role of NSE? What services does the NSE offer to investors?
Additional Readings and References

1
Additional Readings
Bodie, Z., Kane, A., Marcus, A. J., & Mohanty, P. (2005). Investments, 6th edn. Tata McGraw-Hill.
Chandra, P. (2009). Investment analysis and portfolio management, 3rd edn. Tata McGraw-Hill.
Fisher, D. E., & Jordan R. J. (1995). Security analysis and portfolio management, 4th edn. Pren-
tice-Hall.
Gordon, A., Sharpe, J., William, F., & Bailey, J. V. (2009). Fundamentals of investment, 3rd edn. Pear-
son Education.
Graham, B., & Dodd, D. L. (2009). Security analysis, 6th edn. New York: McGraw Hill.
Reilly, F., & Brown, K. (2003). Investment analysis & portfolio management, 7th edn. Thomson
South-Western.
References
Bombay Stock Exchange. (2020). Available at 7 https://www.bseindia.com/sensex/code/16/, Accessed
on March 20, 2020.
Central Depository Services (India) Limited (CDSL). (2020). Available at 7 https://www.cdslindia.
com/publications/FIIreports.html, Accessed on January 24, 2020.
Indianeconomy.net Website. (2020). Available at 7 https://www.indianeconomy.net/splclassroom/who-
are-primary-dealers-pds/. Accessed on March 1, 2020.
Moody’s Analytics. (2020). Available at 7 https://www.economy.com/india/treasury-bills-over-31-days,
Accessed on March 15, 2020.
National Stock Exchange. (2020). Available at 7 https://www.nseindia.com/products-services/in-
dices-fixed-income-g-sec-indices, Accessed on April 1, 2020.
Reserve Bank of India (a). (2020). Available at 7 https://m.rbi.org.in/Scripts/QuarterlyPublications.as-
px?head=Consumer%20Confidence%20Survey, Accessed on May 1, 2020.
Reserve Bank of India (b). (2020). Available at 7 https://rbidocs.rbi.org.in/rdocs/PublicationReport/
Pdfs/HFCRA28D0415E2144A009112DD314ECF5C07.PDF, Accessed on April 15, 2020.
Reserve Bank of India (c). (2020). Available at 7 https://www.rbi.org.in/Scripts/BS_ViewMasCircular-
details.aspx?id=8171, Accessed on May 2, 2020.
Reserve Bank of India Website (d). (2020). Available at 7 https://www.rbi.org.in/Scripts/BS_NSDP-
Display.aspx?param=4, Accessed on March 18, 2020.
Reserve Bank of India Website (e). (2020). Available at 7 https://www.rbi.org.in/scripts/BS_ViewBul-
letin.aspx?Id=17819, Accessed on January 16, 2020.
Reserve Bank of India Website (f). (2020). Available at 7 https://m.rbi.org.in/Scripts/AnnualReport-
Publications.aspx?Id=1278, Accessed on April 22, 2020.
Securities and Exchange Board of India. (2020). Available at 7 https://www.sebi.gov.in/legal/acts/feb-
1957/the-securities-contracts-regulation-act-1956-as-amended-by-finance-act-2017-_4.html, Ac-
cessed on April 30, 2020.
51 2
Behavioural Finance
Contents
2.1 Introduction to Behavioural Finance – 52
2.2 Efficient Market Hypothesis – 52
2.3 Concept of Utility Maximization and Risk – 53
2.4 The Behavioural Critique – 54

2.4.1 Information Processing/Cognitive Errors – 55
2.4.2 Behavioural Biases – 56
2.5 Bubbles and Behavioural Economics – 62
2.6 Equity Premium Puzzle and Myopic Loss

Aversion (MLA) – 64
2.7 Equity Premium Puzzle and Corporate

Governance – 64
2.8 Common Behavioural Errors in Investing – 65
2.9 Behavioural Qualities for Successful Investing – 67
2.10 Socially Responsible Investing – 71
52 Chapter 2 · Behavioural Finance
The objective of this chapter is to provide a bird’s eye view of the concept of be-
havioural finance in the context of investments. This chapter covers the following
2 topics:
2.1 Introduction to Behavioural Finance
> Warren Buffett, Perhaps the Most Legendary Investor of Our Time, Stated
“When the price of a stock can be influenced by a “herd” on Wall Street, with
prices set at the margin by the most emotional person or the most depressed per-
son, it is hard to argue that the market always prices rationally. In fact, market
prices are frequently non-sensical” (Singh et al., 2013).
Traditional finance treats investors as rational-economic actors, which is con-

cerned with prediction of investor behaviour and stock markets. A rational-eco-
nomic actor means that every investor will try to maximize gains for a given level
of risk and/or try to minimize risk for a given level of returns. However, several
events in the financial markets coupled with the inability of traditional finance
concepts to predict investor behaviour have highlighted the significance and role
of cognitive and psychological factors in understanding investor decision mak-
ing processes. This approach to studying finance is more popularly termed as be-
havioural finance. How investors behave in financial markets has been of concern
across the world but its understanding in emerging markets like India acquires
new significance, since the investors here are relatively less sophisticated and have
relatively less information. Here, corporate governance which revolves around fi-
nancial reporting and disclosure becomes critical for the functioning of an effi-
cient capital market (Healy & Palepu, 2001).
2.2 Efficient Market Hypothesis
Traditional investment theories, primarily the Markowitz portfolio theory, are

based on the concept of efficient markets.
> An efficient market for investments is based on information and implies the
following:
5 All investors have the same (homogeneous) expectations regarding returns and
risk.
5 All investors have access to all the information about securities.
5 There are no restrictions on the amount or timing of investments.
5 Taxes do not exist.
5 Transaction costs do not exist.
5 No one investor can influence the market price.
2.3 · Concept of Utility Maximization and Risk
53 2
Basically, an efficient market in case of finance and investments is based on all
investors being rational investors and the information about the risk and return
profiles of financial instruments being complete and freely available to all. As
stated earlier, a rational investor is the one who wants to maximize returns for a gi-
ven level of risk and/or wants to minimize risk for a given level of returns. Availabil-
ity of information is the basic assumption of an efficient market; hence, presence
(or absence) of relevant information might impact the investor decision making.
This becomes even more significant for those financial markets where the availa-
ble information is less than more developed markets.
2.3 Concept of Utility Maximization and Risk
We assume that the objective of investors, as well as of other individuals, is to

maximize their utility. Utility is the satisfaction derived from present and pro-
spective future consumption. We can think of the investor as deciding, at vari-
ous discrete intervals during his lifetime, as to what portion of his wealth will be
consumed and what portion will be invested. The portion invested is expected
to increase future wealth which, in turn, will be allocated between consump-
tion and investment. Determination of an optimal consumption-investment se-
quence is complicated by the fact that we live in an uncertain world where fu-
ture wealth levels associated with various investment decisions are not known
with certainty.
> A Mean–Variance Approach to Utility Maximization and Risk

We assume that the investors select stocks according to the desire of maximizing
expected utility. Expected utility is determined on the basis of the average expected
returns from an investment. This will determine the return expected.
In principle, an individual adjusts his asset holdings (both real and financial)
and consumption such that the marginal utility derived from each asset and con-
sumption is the same, as is the absolute magnitude of negative marginal utility as-
sociated with the occurrence of financial liabilities.
The greater the standard deviation of the distribution in relation to its expected
value, of course, the greater the dispersion of the distribution and the greater the
risk, i.e. the spread of the distribution of value reflects the degree of uncertainty or
risk for the investor.
Determinants of Utility Maximization

Utility maximization and risk can be ascertained from the following parameters:
5 Skewness of the distribution;
5 Kurtosis of the distribution; and
5 State of nature (circumstance).
In investing, individuals attempt to maximize their expected utility, which is a
function of expected return and risk. That is,
where,
E(U) = expected utility,
2 f = function of,
R = return,
Ϭ = risk (standard deviation).
On the basis of the expected risk and return, investors determine the expected uti-
lity from an investment.
2.4 The Behavioural Critique
The basic premise behind behavioural finance is that in real life, people make de-
cisions differently than what conventional financial theory suggests. Investors are
the people governed by sentiments and that is reflected in the decisions they make.
► Example
. Figure 2.1 presents the investment process as a roller coaster ride of emotions. ◄
► Example
. Figure 2.1 exhibits the investment process undertaken by an emotional person and it is
an ideal example of how people lose money in the stock market. Initially, investors watch
the trend and imagine that this trend will continue for some time, without proper research
to find out the actual reason(s) behind the trend. They don’t even consider the fundamen-
tals of the company. The investor, here, is exhibiting what is called the confirmation bias.
However, the behavioural critique in investments is not simply restricted to individu-
als. Even investment communities like that of a nation exhibit biases in terms of invest-
. Fig. 2.1 Investment process—roller coaster of emotions. Source Credit Suisse (2016)

2.4 · The Behavioural Critique
55 2
ment choices. Consider . Fig. 2.2 which presents the home bias, revealed by countries
in international equity portfolios.
From . Fig. 2.2, it is clear that Japan has the highest percentage of equities held by
domestic investors (92%). This means that Japanese investors are biased towards their
domestic equities. In the USA, 80% of the American equities are held by domestic
(American) investors while 40% of the securities in the world equity market are held by
Americans. ◄
These apparent irrationalities fall into two broad categories: first, information
processing errors, under which the investors are not able to process information
correctly, and second, they often make inconsistent or emotional decisions (be-
havioural biases).
2.4.1 Information Processing/Cognitive Errors
Even though there are many information processing/cognitive errors which inves-
tors make, the prominent ones amongst them are:
i. Forecasting errors—also termed a “memory bias”, under this type of error, in-
vestors provide higher weightage to recent experiences compared to the past
occurrences. For example, price-earning (P/E) ratios: if the market sentiment
is bullish (investors are optimistic and expect price levels to rise in future due
. Fig. 2.2 Home bias in international equity portfolio. Source Cooper et al., (2012). Note The shorter
green line indicates the contribution of the country’s investors in the world equity market and the
longer brown line indicates the contribution of the country’s investors in the domestic equity market
to underlying economic factors doing well), investors increase the demand for
securities, thus, pushing up their prices beyond reasonable levels, leading to
inflated P/E ratios. The reverse is true when the market sentiment is bearish
2 (investors are pessimistic and expect price levels to fall in future due to un-
derlying economic factors not performing well), and there is a decrease in the
demand for securities, thus, pushing their prices down beyond reasonable lev-
els.
ii. Overconfidence—under this type of error, human beings become overconfident
about their abilities. It was reported in a study (Barber & Odean, 2001) that
in the stock market, single men trade far more actively than women. It is well
documented in psychology that men have greater overconfidence compared to
women. The authors conclude for male traders: “trading (and by implication,
overconfidence) is hazardous to your wealth”.
iii. Conservatism—investors are too slow (too conservative) in relearning in the
light of new information. This becomes the basis of momentum in the stock
market. Momentum refers to the temporary stagnation in price levels due to a
stagnant phase in trading before an increase or decrease sets in due to trading
activity.
iv. Sample size neglect and representativeness—in this type of error, investors in-
correctly believe that their chosen sample is a fair representation of the entire
population. Further, a short-term success makes them believe that the success-
ful run will continue forever, and hence, they resort to investing more in the
same securities, thereby, exaggerating the price increase.
2.4.2 Behavioural Biases
Investors are not always rational, as the efficient market hypothesis assumes.
Hence, the field of behavioural finance explores the effect of human psychology
on investing decisions and its subsequent effects on the financial markets.
Definition
In the words of George Dvorsky: “The human brain is capable of 1016 processes
per second, which makes it far more powerful than any computer currently in ex-
istence. However, that doesn’t mean our brains don’t have major limitations. The
lowly calculator can do math thousands of times better than we can, and our mem-
ories are often less than useless—plus, we’re subject to cognitive biases, those an-
noying glitches in our thinking that cause us to make questionable decisions and
reach erroneous conclusions” (Seeking Alpha, 2017).
Some of the prominent behavioural biases are:

i. Confirmation bias—where investors believe and consider only that informa-
tion which is in line with their own thinking and neglect the other information
available in market.
57 2
As humans, we tend to seek and process only that information which conforms to
our beliefs; we tend to ignore the other information as we dislike being told that
we are wrong. As investors too, we seek answers to only those questions which
support our beliefs. It is essential to be aware of this bias, weigh both sides of any
aspect equally and keep an open mind while evaluating an investment.
► Example 2.1: Confirmation Bias

The rule is: “If the card has a vowel on one side, then it must have an even number on
the other side”. Given a choice, which are the two cards that you would turn over to ex-
amine this rule?
Most people are likely to pick A and 4 as these tend to confirm the statement. How-
ever, confirming the evidence doesn’t prove much; if you consider it carefully, the card 4
has no ability to invalidate the hypothesis. In fact, turning over the card with the value
7 could provide a valuable negating evidence if it has a vowel on the other side; it would
mean that not every card with vowels has an even number on the opposite face. ◄
Even the legendary investor, Warren Buffet, acknowledges the existence of this
bias. To negate this bias, he invited a hedge fund trader Doug Kass, a hard core
critic of Buffet’s investment style, to Berkshire Hathaway’s annual meeting, being
attended by its 35,000 stockholders. His aim was to have Doug Kass voice out his
criticisms and play devil’s advocate, so that the company could avoid any confir-
mation bias and look at its investment from all aspects.
Under this bias, an investor who has bought a stock which has not performed
well and is sitting on huge losses will tend to just search for favourable news
about the company, to validate his decision to cling to the investment.
ii. Hindsight Bias—hindsight bias is the belief that past events would repeat them-
selves (are predictable) and should have been acted on, at the time. The feeling
that history will repeat itself may make investors fearful of repeating unsuc-
cessful strategies of the past. For example, an investor who has lost money in
the stock market in the past may not want to invest in equity stocks again.
iii. Loss Aversion Bias—this bias forces investors to hold investments in cash even
if they have lost substantial value.
iv. Optimism Bias—this happens when investors are too positive/optimistic about
share market even if the market situation seems bearish.
v. Framing bias—how one frames the choices one has, affects decision making.
2 For example, an individual may reject a proposal when it is presented in a
way which highlights the risk around possible gains but may decide otherwise
when the same proposal is presented in a way which highlights the risk around
possible losses. It depends largely on the investor’s attitude, and for example,
is the same as a person stating that a glass is half-full whereas another person
states that the glass is half-empty.
vi. Mental accounting—a specific form of framing bias, under mental accounting,
investors create mental accounts segregating their investment portfolio into
accounts that can incur greater risk vis-a-vis those that cannot. For example,
an investor may take a conservative position with an account dedicated to the
education of his/her children. Similarly, investments pertaining to retirement
savings may be accorded more importance than other investments.
However, it should be borne in mind that all of these are investments and
should be treated equally. That is, all money is fungible and should be treated
accordingly.
vii. Regret avoidance—psychologists have established that most individuals who
make decisions that turn out unsound/unsuccessful blame themselves and ex-
press regret. This regret gets exacerbated when the unsuccessful decision is linked
to a mental account that was accorded greater importance vis-à-vis others.
Concept in Practice 2.1: The Significance of Muhurat Trading During Diwali

Muhurat or Mahurat trading is the trading activity that takes place for an hour on
the evening of Diwali in India. A ritual that has been performed for years, it is be-
lieved that Muhurat trading on Diwali (the Festival of Lights) leads to wealth and
prosperity throughout the year.
Muhurat means “an auspicious hour”. It is believed that planets align themselves
favourably during the Muhurat, destroying the influence of evil forces. Evidently,
Muhurat trading indicates the bias in the minds of Indian traders and investors. It
is believed that investing in the stock markets during Diwali or during the specific
Muhurat would bring good fortune to the investor and, for the broker, the coming
year shall augur well.
Indian investors have some specific emotional biases associated with their pattern
of investing. This case of Diwali/Muhurat trading can be said to fall in the cate-
gories of both regret avoidance and optimism bias. Regret avoidance because in-
vestors believe that the Muhurat period is divine and investments should be made
for future prosperity. In case an investor did not participate in the Diwali/Muhurat
trading, and later his fortunes dipped, there would definitely be a sense of regret
of not having invested during the Muhurat and the belief that not investing at the
Muhurat led to the adverse situation.
This behaviour can also be partially classified, under optimism bias as the investor
is highly optimistic about the future of his stocks when an investment is made dur-
59 2
ing Diwali/Muhurat trading. Investors believe that due to divine intervention, the
returns shall be maximum on their portfolio.
In addition to the emotional biases, a specific cognitive bias can also be attributed
to such investing behaviour: the self-attribution bias. In the event that an investor’s
stock performs poorly, the same is generally attributed to luck; on the contrary,
gains accruing from the investments are usually attributed to their own choices,
hard work and dedication.
(Source India Infoline, 2017).
viii. Anchoring/Disposition/Adjustment bias—investors stick to their original tar-

gets, even though, the actual results are deviating from their original predic-
tions. Investors get attached to their past experiences and decisions and refuse
to change, regardless of any new information or new situation in the market.
ix. Affect—this bias is related to the attribution of “good” or “bad” by investors
to an investment.
Concept in Practice 2.2: Name-Based Behavioural Biases: Are Expert Inves-

tors Immune?
Most of the investors in the market are mostly irrational in nature and lack the in-
formation and skills required to make the most of the markets in an efficient man-
ner. This creates room/opportunities for experts who possess the necessary skills
and knowledge and have access to information to make better and more informed
decisions as compared to irrational investors.
The irrational investors are not only impacted by information asymmetry, lack of
knowledge and skills required, but are also bogged down by their own behavioural
biases, risk taking tendencies and investment horizons. One such bias is name-
based behavioural bias where investors invest in securities based on their names by
using name-based securities, or in securities which come in alphabetical order, us-
ing name-based shortcuts, name fluency and name recall-ability, etc. as they think
of it as a method wherein they can keep a track of their securities or portfolio,
rather than focusing on several different securities at a time, as it may become too
large and complex for them to handle and follow.
However, this may not be the most efficient way to make the most of the markets
and may even lead to financial losses as the investor may lose out on good oppor-
tunities owing to his behavioural patterns and biases. This bias generally doesn’t
seem to impact the experts who have vast knowledge of the markets and make in-
formed and rational decisions.
(Source Taylor and Francis Online, 2017).
x. Survivorship bias—this bias makes investors believe that they will emerge as
the greatest investors in the stock market (much like the superstars of Holly-
wood/Bollywood film industry). They ignore many traders whose losses drove
them out of the market.
z Prospect Theory
Perhaps, the most popular theory in behavioural finance, prospect theory, states
that higher wealth provides higher satisfaction or “utility” but at a diminishing
2 rate. Developed by Daniel Kahneman and Amos Tversky in 1979, it earned Kah-
neman the 2002 Nobel Prize in Economics.
. Figure 2.3 represents the utility/value of wealth function under prospect
theory. Note that the individual’s utility for wealth increases at a decreasing rate.
The outcome (gain) is plotted on the X-axis, and the psychological value is
plotted on the Y-axis. The graph is S-shaped and asymmetrical. Further, to the
left of the origin (origin denotes no change from current wealth), the curve is con-
vex rather than concave. The value function is steeper on losses side as compared
to gains indicating that risk of losses outweigh gains. Hence, the graph signifies
that for the same value of dollar gain or loss, the value of psychological losses
would be much higher than value of psychological gains.
The prospect theory assumes that losses and gains are valued differently; thus,
individuals’ decision is based on perceived gain instead of perceived loss. Gener-
ally speaking, if two choices (gain and loss) are given to an individual, one pre-
sented in terms of potential gains and other in terms of potential losses, the first
choice will be taken.
This utility function is consistent with the law of diminishing marginal util-
ity and risk aversion. Moreover, the convex curvature to the left of the origin typ-
ically induces investors to be risk seeking rather than risk averse when it comes
to gains. What it means is that for lower income level people, the marginal utility
. Fig. 2.3 Prospect theory. Source Behavioral Economics.com

61 2
that they derive from moving from low to high returns is much higher than their
wealthier counterparts who derive diminishing marginal utility from higher re-
turns. It is for this reason that the lower income investors get lured by higher risk
investment avenues like chit funds, lotteries, etc.
z Limits to Arbitrage and the Law of One Price Under Behavioural Biases
Behavioural biases would not be of any consequence if rational arbitrageurs (inves-
tors who buy from one market where the price level is lower and sell in another where
the price level is higher in order to make gains) could fully exploit the mistakes of be-
havioural investors. Arbitrageurs would eventually ensure that the prices coalesce to
one price by exploiting the price differentials in different markets. This is referred to
as the law of one price. However, there are limitations to the process of arbitrage:
i. Fundamental risk—suppose that a share of ABC is underpriced. Buying it
may be profitable but that does not mean that the security has no risk asso-
ciated with it. This underpricing could get worse and any corrections towards
the intrinsic (inherent, underlying) value may not even happen within the in-
vestor’s investment horizon.
ii. Implementation costs—implementation or transaction costs vary across mar-
kets and investment levels thereby ensuring that the concept of one price re-
mains an approximation at best.
iii. Model risk—investors base their portfolio selections on rather sophisticated
mathematical models designed by investment banks and analysts that predict
optimal portfolios from time to time. Howsoever fancy, these models are sus-
ceptible to faulty calculations and human errors leading to erroneous judg-
ments and decisions.
iv. ‘Siamese Twin’ companies—Royal Dutch and Shell are two independent com-
panies, incorporated in the Netherlands and England, respectively. In 1907,
the two companies agreed to merge their interests through an alliance while
remaining separate and distinct entities. The two companies agreed to share
profits from this alliance on a 60/40 basis. Shareholders of Royal Dutch were
to receive 60% of the cash flows and those of Shell were to receive 40%. It
was, therefore, expected that Royal Dutch would sell for exactly 60/40 = 1.5
times the price of Shell. However, this was not the case. The relative value of
the two firms was very different from this “parity” ratio for a long time. This
is an example in behavioural finance of sentiments ensuring that market prices
remain different from the rational one price.
v. Equity carve-outs—as demonstrated below, several equity carve-outs have vio-
lated the law of one price.
► Example 2.3: Equity Carve-Outs

A company called, 3Com, in 1999, decided to spin off its Palm division. Initially, 5%
of stake in Palm was sold in an initial public offering (IPO), and 95% of the remain-
ing shares of 3Com shareholders were to be sold 6 months later in a spinoff (starting a
new business entity). Each 3Com shareholder was to receive 1.5 shares of Palm. Inves-
tors could, thus, buy Palm shares directly or get them through the embedded option in
3Com shares. 3Com had other profitable businesses as well, and so, when trading be-
gan, it was expected that the share price of 3Com would be at least 1.5 times that of
Palm. However, this was not the case. In fact, Palm shares sold for a price greater than
the 3Com shares (Chandra, 2009).
2 vi. Closed-ended funds—closed-ended funds which are mutual fund schemes with a
definite maturity date, often sell for discounts or premiums, that is, their net asset
value (NAV) is different from the value indicated by the sum total of the underlying
shares. Typically, though, the value of the fund should be equal to the value of the
underlying shares. This, then, presents a violation of the law of one price. ◄
2.5 Bubbles and Behavioural Economics
In a six-year period beginning in 1995, the National Association of Securities

Dealers Automated Quotations (NASDAQ) index of the American stock mar-
ket increased by a factor of more than 6. Former Federal Reserve Bank (the cen-
tral bank of USA) Chairman Alan Greenspan characterized the dot-com boom
as an example of “irrational exuberance” and, in October 2002, the index fell to
less than one-fourth the peak value it had reached only 2½ years earlier. Similar
bubbles were reported in the Indian stock markets in 2014 and the Chinese stock
markets in 2015 (Singh et al., 2016).
Definition
Bubbles can be defined as “self-fulfilling expectations that push stock prices to-
wards a level which is unrelated to the change in the market fundamentals”
(Singh et al., 2016). They are usually characterized by a rapid increase in prices
followed by a drastic fall, after which the prices return back to their mean level.
Also called an economic bubble or asset bubble (sometimes also referred to as a
speculative bubble, a market bubble, a price bubble, a financial bubble, a spec-
ulative mania, or a balloon), it reflects an asset or even a sector or a market at a
price that strongly exceeds the underlying intrinsic value.
Concept in Practice 2.3: Market Bubbles—The Tulip-Bulb Craze

“Bubble” is perhaps one of the most dreaded word in the financial world. Bubbles
are a perfect example of the irrationality/madness of the crowd and deviations
from market efficiency. Bubbles mostly occur when the prices of stocks soar much
higher than the underlying value of the asset due to overreaction by market par-
ticipants. Bubbles are not a recent phenomenon but date as early as the 1600s. The
tulip-bulb craze was perhaps one of the most spectacular get-rich-quick schemes
in history. It is generally considered the first ever speculative bubble.
Some stories suggest that is all started when a professor brought to Leyden, some
unusual/unique plants that had originated in Turkey. The Dutch were quite fasci-
2.5 · Bubbles and Behavioural Economics
63 2
nated with this new addition to their gardens and over the next decade the tulip
became a popular and expensive item.
The most bizarre incident then took place. Many of the tulip bulbs got infected
with a virus that caused tulip petals to develop contrasting coloured strips. These
bulbs were valued at a much greater price and soon a trend developed that the
more bizarre a bulb, the more valuable it is.
Slowly, the tulip mania set in. Merchants tried to predict what the next trend
would be and started buying stocks of those tulips and prices soared to exorbi-
tant levels. Some who thought that prices could not possibly rise further and chose
not to buy were only disappointed by the further price rise. Soon people started
exchanging their jewels and furniture for the tulip stocks because they hoped to
profit from price increases and wanted to ride the market as it moved upwards.
The markets made it even easier for speculative activities through various instru-
ments like call and put options. People enjoyed the several fold increases to their
investment but just when everybody started believing that tulip-bulb prices could
not go down, they crashed!
Charles Mackay describes the events in his book “Extraordinary Popular Delu-
sions and the Madness of Crowds” as a phenomenon when “from the richest no-
bles to the poorest maid-servants traded in tulips. However, after the fantastic rise
in prices, the prices continued to plummet downwards until most bulbs were al-
most invaluable and sold for a price no more than a common onion’s.
(Source Mackay, 2001).
Concept in Practice 2.4: Bitcoin Bubbles

Bitcoin is the new digital currency, and it is attracting a lot of investment from
the public. This digital currency touched an all-time high of $2420 in May, 2017.
Looking back, in 2010, the price stood at $0.05. So anyone who would have in-
vested $1000 in bitcoin in 2010 would have made $48.4 million by 2017. This artifi-
cially created value is attracting new investors.
There is a lot of speculation that bitcoin is going to be the gold of the future. On
the other hand, regulators like the Reserve Bank of India (RBI) have come for-
ward with a warning for trading in bitcoin. If governments disapprove of such

digital currencies in the future, the investment made by investors, at the high per-
2 ceived prices, could burst as a bubble.
(Source The Economist, 2017)
2.6 Equity Premium Puzzle and Myopic Loss Aversion (MLA)
Stock markets exhibit a puzzling phenomenon called “equity premium puzzle”

which indicates that investors tend to make conservative choices when investing in
equity and debt instruments. Though equity shares provide much higher returns,
investors choose short-term debt instruments, which defies the rational-eco-
nomic assumptions about investor behaviour. Researchers in the field of cogni-
tion termed this behaviour as myopic loss aversion (MLA), a cognitive explana-
tion of the phenomenon. Essentially, this is based on the experiential findings
that investors are less likely to invest in risky assets within a shorter investment
horizon than in a longer investment horizon. This is further explained through
loss aversion in financial decision making. It means that the investors’ perception
of disutility is much higher than the perceived utility of the same return. In other
words, a loss of 50% is viewed far more negatively than the positive assessment of
a 50% gain.
Definition
One of the early proponents of MLA was Richard Thaler who was awarded the
Nobel Prize for his research in 2017. In his opinion, MLA is the expression of a
greater sensitivity to losses than to gains (Thaler et al., 1997).
Some researchers have hinted at a connection of cognitive reactions to loss aver-

sion with emotions. Though researchers, on one hand, have reported the negative
impact of emotional dysfunction, others have reported the opposite, i.e. lack of
emotions might actually lead to better decisions. The jury is still out on this.
Availability of information is the basic assumption of an efficient market,
hence presence (or absence) of relevant information might impact the investor de-
cision making and the process of MLA. This becomes more significant for finan-
cial markets where the information availability is less than that of developed mar-
kets. Hence, it would be important to see if the availability of information im-
pacts MLA.
2.7 Equity Premium Puzzle and Corporate Governance
The corporate sector of an economy requires equity finance to promote growth

and development. This sector becomes the engine that pulls the economic devel-
opment of a nation forward.
2.8 · Common Behavioural Errors in Investing
65 2
Typically, MLA is due to the perceived higher risk that equity carries vis-à-vis
debt, in the minds of the investors. The disclosure of financial and non-financial
information by companies is imperative for an efficient capital market. Studies by
Singh et al. (2013) and Black and Khanna (2007) stated that companies that need
external equity financing benefit more from corporate governance rules and their
compliance. The Securities and Exchange Board of India (SEBI) has mandated
corporate governance compliance for all listed companies through the revised
Clause 49 [Listing Obligations and Disclosure Requirements (LODR)]. A better
governed company (with risk management frameworks and disclosures in place)
would essentially mean lower perceived risk for the investors, and they may be en-
couraged to invest in the equity of a company rated high on the corporate gov-
ernance compliance.
Further, the setting up of mutual funds as a financial intermediary was also
aimed at helping risk-averse investors participate in the equity market through
professional institutions which would optimise the risk–return trade-off for the
investors.
2.8 Common Behavioural Errors in Investing
Some of the common behavioural errors in investing are:

1. Limited understanding of risk and return—most investors have very little idea
about the returns and risk emanating from an investment choice. They have
unrealistic and exaggerated expectations from certain securities. One can al-
ways find an investor expecting high return from the market which is generally
the result of being misled by extraordinary claims made by people who stand
to gain from such gullible investors. This is only a reflection of the investor’s
gullibility and, more often than not, such investors are cheated out of their
savings and left with a permanent scar from their investment “experience”.
2. Unclear investment policy—investors get into the arena of investments with a
faint idea of their risk disposition and returns’ expectations. This leads to a lot
of confusion during their investment journey. As a result, one finds conserva-
tive investors turning aggressive when the market is bullish and aggressive in-
vestors turning conservative when the market is bearish. This change in atti-
tude is the reason for incurring losses. One must know what his/her risk ap-
petite is and why he/she is investing. If one loses sight of these fundamentals,
one can often get lost in the investment jungle. The fear of losing everything
when the markets are down and the greed for more gains when the markets
are doing well, are probably, more responsible for the poor outcome than the
stocks themselves.
Every investor should have a well-articulated investment policy which must be ad-
hered to diligently. Any changes in the risk–return profile should be made after
careful deliberations and adequate considerations given to changing market and/
or investor situations.
3. Too much reliance on the past—investors almost naively believe the past to be
an indication of how the future would shape up. They ignore the changes tak-
ing place in the micro and macro-economic environment around them into
2 their calculations.
> In the words of Zeikel (1975): “Most investors tend to cling to the course to
which they are currently committed, especially at turning points”. Empha-
sized further by Peter Bernstein: “Momentum causes things to run farther
and longer than we anticipate. The very familiarity of a force in motion re-
duces our ability to see when it is losing its momentum. Indeed, that is why
extrapolating the present into the future so frequently turns out to be the gen-
esis of an embarrassing forecast”.
4. Careless decision making—investors do not make their choices through careful

deliberations. Most of the times, they base their decisions on half-baked evi-
dence, tips by brokers and friends and general hearsay.
Their comprehension and estimation of the risks emanating from investments

are disappointing at best. The market risk, business risk, price level risk, interest
rate risk and other risks are often brushed off due to overconfidence and/or igno-
rance.
5. Buying and selling at the same time—when investors sell a stock, they almost
always buy another one simultaneously. While it may be the right time to sell
a particular one, it may not be the right time to buy the other one and vice-
versa. It is important to remember that when contemplating switching, the in-
vestor should first sell or buy when it is the right time to sell or buy the particu-
lar stock and make the other deal (buy or sell) when the time is right to do so.
6. Attraction for cheap or “bargain” stocks—investors like any other custom-
ers love a good bargain. The same is evident in their buying behaviour, for
example:
– Buying a stock which is on its way down as it seems like a good bargain;
– Buying more of the stock which is going down in order to lower their aver-
age acquisition costs;
– Prefer buying a stock that is low as it makes them feel better as they get
more quantity for the same price.
7. Over or underdiversification—the balance between overdiversification and un-
derdiversification is the one not many investors can manage well. Either their
portfolios would be so unwieldy with more than 50–60 stocks that the impact
of a good return generating security would be missed in the melee or the port-
folio would hardly have any diversification against the risk exposure faced in
investing in a particular security. Both are undesirable choices and often have
catastrophic consequences.
8. Investing in stock of familiar companies—familiarity brings comfort. Believ-
ing in the adage “a known devil is better than an unknown god”, investors
draw comfort from investing in companies they are familiar with or companies
which are popular. For example, a software engineer would feel more comfort-
2.9 · Behavioural Qualities for Successful Investing
67 2
able in investing in a software company than any other business. However, the
fame of a company has little correlation with the returns of its equity stock.
Investors would do well to keep this fact in mind.
9. Wrong attitudes towards losses—most investors have an aversion to admit-
ting their mistakes in stock selections. They hold on to stocks which are going
down because they do not want to admit they made a wrong choice and some-
times even buy more of the stock as the price lowers. The pain of regret along
with the pain of the realization of losses seems too much to bear. However,
when the prices recover, the investors tend to exit the investment around the
original price simply so that they can recover their losses. This misplaced sense
of relief of recovering losses prevents them from making better returns.
2.9 Behavioural Qualities for Successful Investing
There is no sure shot way to success in investments. Based on research, however,

there are certain traits which are common in successful investors. These traits, in
no way, guarantee success; they simply improve the odds.
1. Contrariness in thinking—investors typically exhibit the herd mentality, that is,
they follow a group or trend. There are two reasons behind this: one, human
beings are social animals and like to belong to a group and, second, most in-
vestors do not have confidence in their independent investment choices and
they feel mollified when they mirror the actions of a group.
Following this investment pattern, however, does not provide great investment
results. For example, if everyone starts investing in a particular share and buys
it, the extended demand tends to lead to overpricing of the share. As a result
of this bandwagon psychology, the share remains bullish for a longer period
than what is rationally justifiable. This unnatural price hike is ultimately cor-
rected by the market forces as people start selling to book this abnormal price
hike. This may lead to abrupt and sharp falls in prices leading to abnormal
and avoidable losses to the investors who could not exit in time.
Instead of joining the crowd, if an investor can adopt a contrarian approach
and go against the market or herd behaviour and/or sentiment, it is likely to
lead to higher returns than what the conventional route would have provided.
This may be a difficult attitude to adopt as it is more comfortable and conven-
ient to imitate others. If one can let go of this fear of going against the flow,
one can make significant returns in the stock market.
► Example
During the financial crisis which originated in the USA in 2008, markets across the
world dipped and the economic scenario appeared bleak. While most investors did not
initiate new ventures due to the low sentiment prevailing, contrarian investors under-
stood that it presented a great opportunity to buy or start a new venture, as prices of
even prized resources were low due to the prevalent sentiment and overall it was a good
time to buy.
At the time of writing this text, the ongoing COVID-19 pandemic and the resultant
economic downturn also presents a good time to invest for contrarian investors. ◄
2 > In the words of Gipson (1986): “being a joiner is fine when it comes to team
sports, fashionable clothes and trendy restaurants. When it comes to invest-
ing, however, the investor must remain aloof and suppress social tendencies.
When it comes to making money and keeping it, the majority is generally
wrong”.
This, in no way, suggests that an investor must always adopt the contrarian ap-
proach and go against the majority at all times. By doing this, he/she may miss
out on market swings and the opportunities they present. The more prudent
course to follow would be to stay with the market during intermittent phases of
bullishness or bearishness but be contrarian when the market is going through ex-
treme fluctuations, say a recession or boom.
► Example
. Figure 2.4 presents the point of maximum financial risk and maximum financial op-
portunity for the contrarian investor. These are the times when the rest of the investors
are exhibiting contrasting emotions and behaving in the exact opposite manner. Hence,
a contrarian investor would sell at the point of maximum financial risk and buy at the
point of maximum financial opportunity. ◄
2. Patience—It is said that patience is a virtue. However, this virtue exhibits it-
self differently in different people. There are some investors like young persons
who may be willing to wait patiently for long-term returns in the stock market
through the “buy and hold” strategy while there are others who want instanta-
neous returns and check prices on a daily basis.
The field of investments favours people who have this virtue. Making
money in the short run could be a factor of luck and market forces as the
market behaves randomly in the short run but there is a trend which is distinct
over the long term. Hence, people who invest with patience and diligence are
generally assured of favourable returns.
3. Being calm and composed—in the words of Rudyard Kipling, you become
a mature adult “if you can keep your head when all around you are losing
theirs”. The ability to stay calm and composed during times of turbulence and
volatility is again a virtue that is favoured in the field of investments.
An investor would do well to understand one’s own psyche and how he/
she deals with greed and/or fear, work on overcoming these emotions that
warp judgement and capitalize on others’ greed and fear. Basically, if an inves-
tor can detach himself/herself from the general market sentiment and behave
like an outsider, he/she can reap benefits out of opportunities provided due to
the sentiment of others.
Even though it seems easy to do so, it is very difficult in practice since hu-
man beings react to emotions like greed and fear and are very seldom able to
detach themselves from the way the market and other investors are behaving.
2.9 · Behavioural Qualities for Successful Investing
69 2
. Fig. 2.4 Maximum financial risk and maximum financial opportunity for the contrarian inves-
tor. Source The ETF Bully website (2020). Available at 7 https://theetfbully.com/2007/05/have-we-re-
ached-the-point-of-maximum-financial-risk/, Accessed on April 1, 2020
Benjamin Graham (Graham & Dodd, 2009), considered the father of se-
curity analysis, suggests that an investor should maintain a certain distance
from the market place so as to reduce any vulnerabilities arising from the con-
tagious influences of greed and fear. He/she should rely on hard numbers and
less on emotions (as emotions can be biased).
4. Adaptability to change—change is the only constant in life and nothing is
more certain than change in the field of investments. The macro-environment
surrounding not just the stock market but the general economic conditions of
the world may have an influence on the domestic markets in this era of glo-
balization. Technologies, whether information or communication, are enabling
capital to flow from one part of the world to another with alarming ease. At
the same time, the ever-changing political, technological, economic and mar-
ket dynamics across the world influence the prices, returns and risk in the in-
vestment spectrum.
Despite change being the only constant, most of us adjust to it poorly.
In the words of Zeikel (1975): “We tend to develop a ‘defensive’ interpretation
of new developments, and this cripples our capacity to make good judgements
about the future”.
Having an open mind is critical for success in investing. An investor should
make a conscious effort to bin his/her thinking, assimilate new information and
be open to reexamine old premises, cultivate mental agility and willingness to
change. However, this ability is not very common and investors often fail to
learn from their mistakes due to egoism, overconfidence or basic stubbornness.
In the words of John Train (Chandra, 1998): “Their temperament does

not change, so they go on repeating the same patterns, in this as in all matters.
And the extraordinary thing is that they have more confidence not less, as they
2 repeat the same mistakes, because they think they have learned from their pre-
vious misfortunes”.
5. Decision making in imperfect situations—the information in the investment

market is never complete due to the ever-changing dynamics and, hence, the
art of investment calls for making decisions in the light of inadequate prem-
ises. Instead of waiting for the complete picture to emerge (which may never
happen and the opportunity may be lost), the investor needs to have the cour-
age to be decisive and take chances.
However, being decisive does not mean being rash. It refers to the ability
to quickly weigh a range of factors, evaluate them and act; in other words, it
refers to the ability to “act on one’s feet”. Procrastination and half-hearted in-
vestments, often, produce lacklustre investment results.
> Normative Framework for Investors

Here are some investment mantras/tips/aspects that can help any investor reach a
successful end in the journey of investment.
1. Avoid stocks with very high price-earnings (P/E) ratios—a stock with a very high
P/E ratio indicates that it is very popular amongst the investors and, hence, is
generally overpriced. Similarly, evaluate stocks with low P/E ratios to understand
whether they are undervalued or not, as they may indicate good buys.
2. Recognize the fact that behaviour, and not fundamentals, motivates most inves-
tors.
3. Sell to the investors who are bullish (optimist about future rise in prices) and buy
from the investors who are bearish (convinced about downturn in future prices).
This can be judged by evaluating the buy and sell orders/quotations available
with dealers/brokers/stock exchanges. Bullish investors are ready to buy at higher
prices and provide higher buy quotes and vice-versa.
4. Not everyone can be Warren Buffet (the legendary investor) of the stock market.
Keep expectations reasonable. Similarly, no portfolio manager or investor can
“win” every time.
5. There is nothing like a good or bad security, the price levels make it appear that
way.
6. Invest long-term but ride the short-term wave.
7. Never put hard-earned money after bad/risky investments.
8. To achieve success, think independently, not like most people.
9. Investigate, then invest.
10. Having an open mind will help reap large benefits in the stock market.
11. The market follows a cycle and prices rise and fall continually. The only way to
beat the market is to read these cycles and strategize accordingly.
12. One of the greatest gifts is the ability to realize the true worth of anything. An
economist’s guess is likely to be as good as anyone else’s. Do your independent
thinking.
2.10 · Socially Responsible Investing
71 2
Concept in Practice 2.5: Price Multiples

The authors of this book conducted a study on equity returns in India for the period
1994–2014 (Singh et al., 2016). These findings are taken from the same to illustrate
the scenario of price multiples in India.
India began to open up its stock market gradually to foreign portfolio investment
in the 1980s. This had the effect of raising the Indian P/E ratios to international
levels. Further, the Indian government provided fiscal incentives to domestic savers
for investing in equities. This pushed up the domestic demand for equities and led
to the popularization of equity investment amongst the investing community (par-
ticularly the middle class).
Further, over the past two decades, Indian investors have come to accept a sub-
stantially reduced dividend yield, i.e. dividend as per cent of market price; it is, to
a marked extent, also a reflection of the rise in the P/E ratios, especially because
the dividend pay-out ratio has remained largely unchanged. Hence, in India, the
use of the P/E ratio was not very common till as late as 1990.
Interpreting the P/E Ratio: A Word of Caution

The P/E ratios should, however, be used with caution as the published P/E ratios
are normally based on the published financial statements of corporate enterprises.
Earnings are not adjusted for extraordinary items and, therefore, to that extent,
may be distorted. Besides, all financial fundamentals are often ignored in pub-
lished data. Finally, they reflect market sentiments, moods and perceptions. As-
suming retail stocks have been overvalued/undervalued, this error could, in all
probability, be built into the valuation as well.
2.10 Socially Responsible Investing
A major contribution of behavioural finance is the advent of socially responsible

investing. Socially responsible investors or social investors are the ones who seek
to consider both the financial and social returns, i.e. to bring about good changes
in society.
The socially responsible investors encourage organizations that have clear vi-
sion and mission strategies for social impact. These would be corporates which
practice environmental responsibility, consumer safety, human rights, etc. Such
investors exclude ethically questionable companies whose businesses include liq-
uor, cigarettes, gambling, weapons, etc. from their investment portfolios.
Socially responsible investing in India is in a nascent stage right now but it is
evolving. According to the data provided by Morningstar, as of July 2017, the asset
size of funds dedicated to an environmental, social and corporate governance (ESG)
strategy was $193.19 billion in Europe and $80 billion in the USA, while it was
$28.54 billion in emerging markets, with an annualized growth rate of 6.60%, 45.40%
and 27.60%, respectively, over the three years (2014–2017). The only India-specific
fund focused on governance as a part of the ESG strategy is Robeco Indian Equities,
with a fund size of $42.24 million as of July 2017 (Morningstar, 2020).
2.11 Conclusion
The objective of this chapter is to provide a bird’s eye view of the concept of be-
2 havioural finance in the context of investments. Behavioural finance is the study
of how human psychology affects investments. A brief on the efficient market
hypothesis (the ideal market scenario) is presented followed by the fundamental
concepts of utility maximization and risk. The behavioural critique is then elabo-
rated in terms of information processing errors and behavioural biases. Emerging
research areas like the study of bubbles in relation to behavioural economics, the
equity premium puzzle and its relationships with myopic loss aversion and corpo-
rate governance are discussed. The common behavioural errors, found in invest-
ing, are highlighted, and based on them, certain behavioural qualities for success-
ful investing are suggested. Finally, a normative framework for investors is pre-
sented. Towards the end, the emerging practice of socially responsible investing is
introduced. The learning from this chapter should help the reader in recognizing
certain traits of investor behaviour and also help in anticipating future prices and
returns based on such behaviour.
Summary
5 An efficient market, in the context of investments, is based on information and
states that all investors have the same (homogeneous) expectations regarding re-
turns and risk.
5 Traditional finance assumes that all investors are rational. The study of behav-
ioural finance, however, suggests that investors are often irrational and suffer
from information processing errors and biases.
5 A rational investor is the one who seeks to maximize returns for a given level of
risk and/or minimize risk for a given level of returns.
5 Some important information processing/cognitive errors are forecasting, overcon-
fidence, conservatism, sample size neglect and representativeness.
5 In forecasting errors, investors provide higher weightage to recent experiences
compared to past experiences when making forecasts.
5 Sample size neglect and representativeness error states that investors believe that
a small sample is representative of the entire population.
5 Some prominent behavioural biases are confirmation, hindsight, loss aversion, op-
timism, framing, mental accounting, regret avoidance, anchoring/disposition/ad-
justment, affect and survivorship.
5 Confirmation bias is when investors believe and consider only that information
which is in line with their own thinking and neglect the other information availa-
ble in market.
5 Hindsight bias is the belief that past events would repeat themselves (are predict-
able) and should have been acted on, at the time.
5 Loss aversion bias forces investors to hold investments in cash even if they have
lost substantial value.
5 Optimism bias occurs when investors are too positive/optimistic about share
markets even if the market situation indicates otherwise.
Summary
73 2
5 Framing bias happens when how one frames the choices one has, affects decision
making. For example, an individual may reject a proposal when it is presented in
a way which highlights the risk around possible gains but may decide otherwise
when the same proposal is presented in a way which highlights the risk around
possible losses.
5 Mental accounting is an example of framing bias in which investors create distinct
investment segregations mentally and treat them separately in terms of taking risk.
5 In regret avoidance bias, psychologists have discovered that those investors who
make decisions that are unsuccessful, regret the same and blame themselves.
5 In anchoring/disposition/adjustment bias, investors stick to their original tar-
gets, even though the actual results are deviating from their original predictions.
Hence, investors get attached to their past experiences and decisions and refuse
to change, regardless of any new information or new situation in the market.
5 Affect bias is related to the attribution of “good” or “bad” by investors to an in-
vestment.
5 The survivorship bias makes investors believe that they will emerge as the great-
est investors in the stock market (much like the superstars of Hollywood/Bol-
lywood). They ignore the many traders whose losses drove them out of the
market.
5 Probably one of the most popular theories in behavioural finance, Prospect The-
ory, states that higher wealth generates higher satisfaction or “utility” but this
utility increases at a diminishing rate.
5 Some aspects that present limits to arbitrage and the law of one price are fun-
damental risk, implementation costs, model risk, equity carve-outs, closed-end
funds, etc.
5 Bubbles can be defined as “self-fulfilling expectations that push stock prices to-
wards a level which is unrelated to the change in the market fundamentals”.
They are usually characterized by a rapid increase in prices followed by a drastic
fall.
5 Stock markets exhibit a puzzling phenomenon called “equity premium puzzle”
which indicates that investors tend to make conservative choices when invest-
ing in equity and debt instruments. Though equity shares provide much higher
returns, investors choose short-term debt instruments, which defies the ration-
al-economic assumptions about investor behaviour. Researchers in the field of
cognition termed this behaviour as myopic loss aversion (MLA).
5 Common behavioural errors in investment management are limited understan-
ding of risk and return, unclear investment policy, too much reliance on the past,
careless decision making, buying and selling at the same time, attraction for cheap
or “bargain” stocks, over or underdiversification, investing in stock of familiar
companies and wrong attitudes towards losses.
5 Some behavioural qualities for successful investing are contrariness in thinking,
patience, being calm and composed, adaptability to change and decision making in
imperfect situations.
5 Socially responsible investors or social investors are the ones who seek to con-
sider both the financial and social returns, i.e. to bring about positive changes in
society.
2.12 Exercises
2 2.12.1 Objective (Quiz) Type Questions
? 1. Fill in the Blanks:

(i) ________________ states that all investors have the same (homogeneous) ex-
pectations regarding returns and risk.
(ii) A ___________ investor is the one who seeks to maximize returns for a given
level of risk and/or minimize risk for a given level of returns.
(iii) In _____________, investors provide higher weightage to recent experiences
compared to past experiences when making forecasts.
(iv) ___________ is the belief that past events would repeat themselves (are pre-
dictable) and should have been acted on, at the time.
(v) __________ occurs when investors are too positive/optimistic about share
market even if the market situation indicates otherwise.
(vi) _____________ is an example of framing bias in which people create separate
mental accounts for certain investments, in terms of the risk they are willing
to take.
(vii) In ______________, psychologists have discovered that individuals who make
unsuccessful decisions regret the same and blame themselves.
(viii) The __________ makes investors believe that they will emerge as the greatest
investors in the stock market.
(ix) One of the most popular theories in behavioural finance, ___________, states
that higher wealth provides higher satisfaction or “utility”, but at a diminish-
ing rate.
(x) _________ can be defined as “self-fulfilling expectations that push stock
prices towards a level which is unrelated to the change in the market funda-
mentals”.
v
(Answers: (i) Efficient market hypothesis (ii) rational (iii) forecasting errors
(iv) Hindsight bias (v) Optimism bias, (vi) Mental accounting (vii) regret
avoidance bias (viii) survivorship bias (ix) Prospect Theory (x) Bubbles).
? 2. True/False
(i) A
n efficient market implies that all investors have different expectations re-
garding the expected returns and risk.
(ii) A rational investor is the one who seeks to maximize returns for a given level
of risk and/or minimize risk for a given level of returns.
(iii) Optimism bias is the belief that past events would repeat themselves (are pre-
dictable) and should have been acted on, at the time.
(iv) In hindsight bias, psychologists have found that individuals who make deci-
sions that turn out unsound/unsuccessful have more regret (blame themselves
more) especially when that decision was unconventional.
2.12 · Exercises
75 2
(v) In mental accounting, investors stick to their original targets, even though,
the actual results are deviating from their original predictions.
(vi) In survivorship bias, investors ignore the many traders whose losses drove
them out of the market.
(vii) One of the most popular theories in behavioural finance is Prospect Theory.
(viii) In mental accounting, an investor may take risk with one type of investment
and may not want to take any risk with another.
(ix) Bubbles typically exhibit a rapid increase in prices followed by a drastic fall.
(x) A socially responsible investor or social investors are the ones who seek to
consider both the financial and social returns, i.e. to bring about positive
changes in society.
v
(Answers: (i) False (ii) True (iii) False (iv) False (v) False (vi) True (vii)
True (viii) True (ix) True (x) True).
? 1. What is the basic premise of behavioural finance? Discuss with an example.

2. What are the basic assumptions under the efficient market hypothesis?
3. What role does the prospect theory play in understanding the concept of utility
and risk? Elaborate.
4. What are rational bubbles? Cite real-life examples to illustrate your answer.
5. What do you understand by the equity premium puzzle and myopic loss
aversion?
6. What are some aspects that present limits to arbitrage and the law of one price?
7. List some common behavioural errors in investing? Can you list some qualities
that can lead to successful investing?
8. Write a note on socially responsible investing?
9. What are information processing errors? How do they affect investments?
10. What are the prominent behavioural biases? Illustrate with examples.
? 1. Is it possible to separate the psychology of human behaviour from investing?

(Hint: Human behaviour is prone to information processing/cognitive errors and
biases.)
2. Is it possible to invest only on the basis of the merits of the investment?
(Hint: There are certain behavioural qualities that can be imbibed for a success-
ful investment journey.)
3. Would socially responsible investing be the trend of the future?
(Hint: Consider the problems facing the world today and link the same to inves-
tments)
? This can be used as a class exercise

2 Conduct a role play in class. One student will play an investor and another student,
an investment advisor. Let the class build up the profile of the investor in terms of
his income, circumstances in terms of liabilities and assets, risk perception, knowl-
edge level, etc. A similar exercise can be conducted to provide a portfolio of differ-
ent investment avenues to the investment advisor. Questions can be suggested to the
investment advisor that can be used to elicit responses from the investor. Such re-
sponses can be used to deduce the information processing/cognitive errors and be-
havioural biases the investor exhibits.
Indicative questions (more questions should be generated on these lines):
(i) From March 2020 through July 2020 (due to the COVID-19 pandemic), some
shares lost more than 40% of their value. If I owned shares which lost 40%, I
would:
a. Sell all of them
b. Sell some of them
c. Do nothing
d. Buy more
(Hint: Answer (a) above may indicate framing)
(ii) In the event of the markets going down, I sell some of my risky investments
and invest in safer securities.
a. Yes
b. No
c. May be
(Hint: Answer (b) above may indicate conservatism)
(iii) Based only on the suggestions made by a friend or relative, I would invest in a
particular security. I don’t need more information.
a. Yes
b. No
c. May be
(Hint: Answer (a) above may indicate overconfidence)

Additional Readings
Bodie, Z., Kane, A., Marcus, A. J., & Mohanty, P. (2005). Investments (6th ed.). Tata McGraw-Hill.
Chandra, P. (2009). Investment analysis and portfolio management (3rd ed.). Tata McGraw-Hill.
Fisher D. E., & Jordan R. J. (1995). Security analysis and portfolio management, 4th edn. Pren-
tice-Hall.
son Education.
Graham, B., & Dodd, D. L. (2009). Security analysis (6th ed.). McGraw Hill.
Jones, C. P. (2010). Investment analysis and management (9th ed.). Wiley.
South-Western.
77 2
References
Black, B. S., & Khanna, V. S. (2007). Can corporate governance reforms increase firm market values?
Event study evidence from India. Journal of Empirical Legal Studies, 4(4), 749–796.
Business Insider Website. (2017). Available at 7 https://www.businessinsider.in/GOLDMAN-SACHS-
Chinas-7-year-debt-boom-is-one-of-the-biggest-and-fastest-in-history/articleshow/52838635.cms,
Accessed on November 1, 2017.
Chandra, P. (1998). Managing investments. Tata McGraw-Hill Publishing Company Limited.
Cooper, I., Sercu, P., & Vanp´ee, R. (2012). The equity home bias puzzle: A survey. Foundations and
Trends in Finance 7(4), 289–416.
Gipson, J. (1986). Winning the investment game (pp. 153–154). McGraw Hill Book Company.
Graham, B., & Dodd, D. L. (2009). Security analysis (3rd ed.). McGraw Hill.
Healy, P. M., & Palepu, K. G. (2001). Information asymmetry, corporate disclosure, and the capital
markets: A review of the empirical disclosure literature. Journal of Accounting and Economics,
31(1–3), 405–440.
India Infoline Website. (2017). Available at 7 http://www.indiainfoline.com/article/research-articles/
the-significance-of-muhurat-trading-during-diwali-47330822_1.html, Accessed on 16th Sept 2017.
Mackay, C. (2001). Extraordinary popular delusions and the madness of crowds. Litrix Reading Room,
France.
Morningstar. (2020). Available at 7 https://www.morningstar.in/posts/58587/esg-stocks-outper-
form-wider-market.aspx, Accessed on July 11, 2020.
Singh, S., Jain, P. K., & Yadav, S. S. (2016). Equity markets in India: Risk, return and price multiples.
Springer.
The Economist Website. (2017). Available at 7 http://www.economist.com/topics/bitcoins, Accessed
on September 25, 2017.
Zeikel, A. (1975). On the threat of change. Financial Analysts Journal, 31(6), 17–20.
Seeking Alpha Website. (2017). Available at 7 https://seekingalpha.com/article/3740026-brain-kil-
ling-returns, Accessed on October 4, 2018.
Taylor and Francis Website. (2017). Available at 7 http://www.tandfonline.com/doi/abs/ 7 https://doi.
org/10.1080/15427560.2017.1308940, Accessed on October 15, 2018.
Thaler, R. H., Tversky, A., Kahneman, D., & Schwartz, A. (1997). The effect of myopia and loss aver-
sion on risk taking: An experimental test. Available at 7 https://Academic.Oup.Com/Qje/Article-
Pdf/112/2/647/5291785/112-2-647.Pdf, Accessed on December 1, 2017.
79 3
Concept of Risk
and Return
Contents
3.1 Introduction to Risk and Return – 80
3.2 Concept and Measurement of Return

and Risk – 81
3.2.1 Measuring Return – 81
3.2.2 Measuring Risk – 84
80 Chapter 3 · Concept of Risk and Return
The objective of this chapter is to provide an insight into the concept of risk and
return. It covers the following topics.
3.1 Introduction to Risk and Return

3
Risk and return are two sides of the same coin. They always go hand in hand.
Human beings, like other animals, are designed to be risk-averse (it is a survival
instinct). Our brains are programmed to flee or fight any potential risk or threat.
All rational investors, thus, aim to minimize risk. In operational and technical
terms, risk is defined as the deviation from the expected value or expected hap-
pening. However, higher risk carries higher return and vice-versa. Have you ever
wondered why it is so?
> Return is the reward earned for bearing risk; hence, the higher the risk, the higher
the return. Consider a manufacturer who is developing a product or service that
has never been introduced in the market. For example, some years ago, the com-
pany Sony® came up with an innovation—the Walkman! It was a product that
was the first of its kind—portable music! Sony® would have faced a lot of risk fac-
tors at the introduction of such a product, for example, the cost of innovation that
would have been a waste in case the product was not accepted in the market, in ad-
dition to the cost of manufacturing and selling the product, the tastes and prefer-
ences of consumers, the availability of finance for a new product, etc. However, due
to the same risk considerations, perhaps, there were no other players in the mar-
ket selling a similar product. As all of you would be aware, the product became an
instant hit with the public, and Walkman became a household name. Due to the
fact that there was no competition, the returns emanating out of the sales of this
product were huge/substantial for Sony®. Similarly, wherever risk factors are sig-
nificant, you would find very few companies/players in that segment. Since a small
number of companies now cater to the overall demand, they reap greater benefits.
Now, consider a product which has an established market with a large number
of suppliers, all contributing towards a small part of the market share. The risk
factors are much less now as the product is already established, there is very lit-
tle cost of innovation, the tastes and preferences of consumers are already known
and catered to, and finance is relatively easier to obtain for an established prod-
uct, etc. Here, the risk is low, and therefore, the returns are also low.
Ninety five per cent of new businesses fail due to risk factors. It is for this rea-
son that monopolies earn substantial rewards (extraordinary profits) for bearing
and beating the risks associated with a product and emerging as the only supplier
in the market for that product.
3.2 · Concept and Measurement of Return and Risk
81 3
3.2 Concept and Measurement of Return and Risk
This section presents the measurement techniques used for estimating return and
risk of a security and also that of a collection of securities, called a portfolio.
3.2.1 Measuring Return
Let us start by measuring the return for a security through an example.

i. Rate of Return (RoR) on a Security
Definition
The per annum rate of return of a security or an asset is the annual income gener-
ated by the security and the capital gains derived out of selling the security at the
end of the year, at a typically higher price (than what it was purchased at) as a per-
centage of the price at which it was purchased (investment).
Remember that if the price at which a security is sold is less than its purchase
price, the investor makes a capital loss. Further, the returns can be daily, monthly,
quarterly, etc. Suitable pro rata modifications can be made to provide a per an-
num figure.
The return on any security can be subdivided into the current yield and capital
gains yield which indicate the following:
5 Current yield = annual income/beginning price;
5 Capital gains yield = (ending price-beginning price)/(beginning price).
i Rate of return (RoR) on a security

= (Annual Income + Ending price (3.1)
−Beginning price)/Beginning price
? * You can take the help of a normal calculator or a scientific calculator for the calcu-
lations.
? Numerical Example 3.1: Security Return

The price of a share at the beginning of the year is INR 20. The dividend paid at
the end of the year as an annual income on holding the share is INR 2.40. The
price of the share at the end of the year is INR 25. Calculate the rate of return.
v As per Eq. 3.1,
Rate of return (RoR) on a security = (Annual Income + Ending price − Beginning
price)/Beginning price.
Substituting values, the RoR can be calculated as
(2.40 + 5)/20 = 7.40/20 = 37% .

Hence, RoR = 37%.
> Please note that the annual income can take different forms, it can be dividend in
the case of shares or it can be interest payments in the case of debt instruments.
ii. Rate of Return on a Portfolio
Definition
3 The return on a portfolio is the weighted average of the returns on the securities
comprising the portfolio.
i Portfolio rate of return = (weight of first asset in portfolio*return of first asset in

portfolio) + (weight of second asset in portfolio*return of second asset in portfolio)
and so on…
► Example
In a portfolio comprising two securities (1 and 2), the return of the portfolio is given as
Rp = w 1 R1 + w 2 R2 (3.2)
where
Rp is the return on the portfolio,
R1 is the return on the security 1,
w1 is the proportion or weight of portfolio invested in security 1, and
w2 is the proportion or weight of portfolio invested in security 2.
In general, when a portfolio consists of n securities, the expected return on the portfo-
lio is
n

Rp = Wi R i (3.3)
1
where
Ri is the return on the security i,
wi is the proportion of portfolio invested in security i. ◄
> 5 Please note that in the equations/formulae provided throughout the text, the
numbers 1, 2, 3…. or the alphabets i, j, k…, etc., are used interchangeably. They
all denote the number of securities under consideration or the number of ob-
servations. This has been consciously followed to make the reader comfortable
with the different notations used in other texts on the subject.
5 Further, all the equations we are using are also provided as functions in Micro-
soft Excel®. Readers may use them with ease, once they are conversant with the
concepts and methodologies behind the same.
83 3
. Table 3.1 Growth of $1 investment: 1926–2019
Index Compounded return

US small company stocks 11.90
US large company stocks 10.20
US LT government bonds 5.60
US 30 day treasury bills 3.40
Source Skloff.com
? Numerical Example 3.2: Portfolio Return

If a portfolio contains four equally weighted assets (i.e. one-fourth or 25% invested
in each asset) with expected returns of 4%, 6%, 10% and 14%, respectively, what is
the portfolio's expected return?
v As per Eq. 3.3,
Rp = w1 R1 + w2 R2 + w3 R3 + w4 R4
The portfolio return can be calculated as
(4% ∗ 25%) + (6% ∗ 25%) + (10% ∗ 25%)
+ (14% ∗ 25%) = 8.50%
> To illustrate the concept further, consider the following return of various securities/
portfolios. . Table 3.1 depicts the growth of $1 in 2019 which was invested in 1926
in the USA. As is evident, the stocks in the small capitalization (cap) segment pro-
vided the highest returns. It is to be noted here that the small cap segment, large
cap segment, long-term (LT) government bonds and treasury bills (the debt instru-
ment issued by the central government) are all portfolios consisting of underlying
securities.
Similarly, . Fig. 3.1 depicts the rates of return for common stocks, long-term
treasury bonds and treasury bills in the USA over 1926–2000. Can you notice the
. Fig. 3.1 Rates of Return 1926–2000: US Economy. Source Skloff.com

fluctuations (crests and troughs), especially in the common stocks denoted by the
red line? These fluctuations (going up and down) from the calculated average, also
called the mean, are what depict the “risk”.
3.2.2 Measuring Risk
3
To measure risk, one must first understand the concept of uncertainty. The state-
ment “it may rain tomorrow” indicates an uncertain event; it may rain or it may
not. However, the statement “as per the satellites images of the low pressure area
built over the city and the monsoon winds closing in at high speeds, there is a
80% chance that the city might experience heavy rain showers through this week”
sounds more plausible as there is a probability or likelihood of occurrence as-
signed to an uncertain event based on substantiated information. The assigning
of a probability to an uncertain event leads to the estimation of risk. Basically,
risk indicates the variability or distance from the expected event/return.
Now, based on the stated prediction, a shopkeeper decides to order some um-
brellas and raincoats from his supplier. This is a very simple example of a busi-
ness decision, made based on the information regarding the chances of the occur-
rence of an event. This is how households, businesses and governments across the
world function, based on forecasting. It is, therefore, crucial that the information
that forms the basis of such forecasts be as accurate and substantiated as possible.
Definition
The variables used to measure risk are variance and standard deviation. Variance
is calculated as the average value of squared deviations from the mean. Statisti-
cally, variance is calculated as the square of standard deviation. Both parameters
are measures of volatility. Another important measure used to determine volatil-
ity is the coefficient of variation that is calculated as the standard deviation divided
by mean.
3.2.2.1 Probability Distribution and Risk and Return

The probability of an event represents the likelihood of its occurrence. It plays an
important role in the estimation of return and risk. In case of return, the average
return can be calculated by summing up the products of probability and corre-
sponding return. Thus,
n

Rc = pi Ri (3.4)
i=1
where
Rc is the average return of the company,
pi is the probability of the ith state, and
Ri is the return of the ith state.
85 3
? Numerical Example 3.3: Probability and Return
The returns along with their corresponding probabilities for Company ABC and
Company XYZ are given in . Table 3.2. Calculate the average or expected return
of each company.
v As per Eq. 3.4
n

Rc = pi Ri
i=1
Substituting values, the average return for Company ABC Limited would be calcu-
lated as follows:

= p∗1 R1 + p2∗ R2 + p∗3 R3
(where 1, 2 and 3 represent boom, normal and recession states of the economy, re-
spectively)

= 0.30∗ 16 + 0.50∗ 11 + 0.20∗ 6
= 4.80 + 5.50 + 1.20 = 11.50% .
Similarly, the average return for Company XYZ Limited is

= 0.30∗ 40 + 0.50∗ 10 + 0.20∗ − 20
= 12 + 5 − 4 = 13% .
As is evident from . Table 3.2, even though the average returns of the two com-
panies appear to be not much different from each other, the variations in the re-
turns of Company XYZ Limited in the event of an economic boom or recession
are much more than those of Company ABC Limited. Hence, through this prob-
ability distribution, intuitively, Company XYZ Limited is more risky than Com-
pany ABC Limited.
As mentioned earlier the risk is measured by variance or standard deviation of
the return.
Equations 3.5 and 3.6 express the value of variance and standard deviation (σ,
pronounced as sigma):

2
Ri − R
i Variance = σ = 2 (3.5)
n−1
. Table 3.2 Returns and their probabilities
State of the Probability of Company ABC Company XYZ

economy occurrence Limited (RoR %) Limited (RoR %)
Boom 0.30 16 40
Normal 0.50 11 10
Recession 0.20 6 −20
Source Authors’ compilation


2
Ri − R (3.6)
Standard Deviation = σ =
n−1
where
Ri is the return of security in the nth period, and
3 R is the average return of the security over n periods.
One period can be a year, a month, a week or a day, etc.
> Please note that “n” can also denote the number of observations.
2
Please note that Ri − R is divided by “n – 1” and not n. This is because our

observations belong to a sample and not the entire population. Statistically, “n – 1”
is used to correct for the loss of one degree of freedom in sample observations. To
read about this in detail, you may consult a book on statistics.
Further, in case of a probability distribution accompanying returns, the standard

deviation formula can be modified as per Eq. 3.7.
i

2
σ = pi Ri − R (3.7)
where
Ri is the return of security with a probability of pi,
R is the average return of the security, and
pi is the probability of the ith state.
R is calculated as already provided as Eq. 3.4 as
n

R= pi Ri
i=1
> Please note that this equation does not include (n − 1) as denominator. This is be-
cause this method is used to determine expected (ex-ante) returns based on future
probable results, unlike the previous method which was based on an ex-post facto
measurement based on “n” observations.
Let us further understand the measurement of risk through another numerical

example.
? Numerical Example 3.4: Calculating the Risk of a Security

—————————————————————
Column 1 contains the percentage rate of return provided by a security over the
past 4 years. How would you measure the risk of the security?
Percent rate of return Ri
+40
+10
87 3
Percent rate of return Ri
+10
−20
v As per Eqs. 3.5 and 3.6:
2
Ri − R
Variance = σ = 2 (3.5)
n−1

2
Ri − R (3.6)
n−1
where
Ri is the return of security in the nth period, and
R is the average return of the security over n periods.
The stepwise calculation of the risk of the security is

Step 1: Calculate the average rate of return.
R = (40 + 10 + 10 − 20)/4 = 10%

Step 2: Calculate the deviations from the mean or R (presented in Column 2)
Deviations from the mean
= Ri − R = 40 − 10 = 30; 10 − 10 = 0;
10 − 10 = 0; −20 − 10 = −30.
Step 3: Square the deviations (presented in Column 3).
2
Squared deviations = Ri − R = 900; 0; 0; 900.
Percent rate of return Ri Deviation

from mean Squared 2deviations
Ri − R Ri − R
+40 +30 900
+10 0 0
+10 0 0
−20 −30 900
Step 4: Calculate the variance as the average of the total of squared deviations
Variance = average of squared deviations
= 1800/(n − 1) = 1800/3 = 600
Step 5: Calculate the standard deviation as the square root of the variance
√
Standard Deviation = (Variance)1/2 = 600 = 24.49%
> Another popular measure of risk in the investment landscape is “coefficient of var-
iation (CoV)”, and it is calculated as per Eq. 3.8.
i Coefficient of variation = (standard deviation/mean returns) * 100
Or, CoV = (σ/R)∗ 100 (3.8)

3 It is denoted as a percentage.
> In the previous numerical example, the coefficient of variation would be calculated as
(24.49/10)∗ 100 = 244.90%
► Example
. Figure 3.2 presents the daily percentage price change of the shares of Microsoft
from 1990–2001. The shape of the curve is a normal distribution, indicating that Mi-
crosoft’s share prices fluctuate by nearly the same degree in both directions, that is,
both increase and decrease in share prices are of the same deviation from the average
share price for the period. ◄
The features of such a distribution can also be explained via skewness and kurtosis.
Definition
Skewness is the measure of the extent to which a curve is non-symmetrical.
Non-symmetrical distributions may either be positively or negatively skewed. If
most of the values lie to the right of the mean value (greater than the mean), the
distribution is positively skewed and vice-versa.
Definition
Kurtosis is the property that informs about the shape of any distribution, in terms
of whether the curve is more peaked (the dispersion around the mean is narrow) or
less peaked (the dispersion around the mean is wide) than a normal distribution.
. Fig. 3.2 Microsoft—daily percentage change, 1990–2001. Source Authors’ compilation

89 3
In line with the scope of this text, we would not be calculating skewness and/or kur-
tosis; rather, our focus would be on what they imply.
Concept Check 3.1

Consider Investment A and Investment B with respect to their distributions.
What can you deduce from them?
(. Fig. 3.3).
Investment A
Investment B
. Fig. 3.3 a Pattern of returns of Investment A, b pattern of returns of Investment B. Source

Authors’ compilation
As you may have noticed, the distribution of Investment A has a lower peak,
while the distribution of Investment B has a higher peak. Statistically, Invest-
ment A has a lower kurtosis (peak of the curve) than Investment B. Both distri-
butions appear to have a normal distribution (similar deviations from the mean)
and hence a neutral (neither positive nor negative) skew. However, peak returns
in Investment B are 20% compared to Investment A’s 12%. Based on this, Invest-
ment B appears more attractive in terms of assuring higher positive returns when
compared to Investment A. As is to be expected, however, the risk in terms of the
magnitude of variations is also higher in Investment B.
Concept in Practice 3.1: Volatility Characteristics of Indian Equity Returns

the concept of risk (volatility) in practice, in the Indian equity returns. The study un-
dertook an examination, perhaps for the first time, in the Indian context, of the beha-
3 viour of equity returns and their volatility patterns (if any) for the NSE 500 index.
Also, the analysis presented the behaviour of volatility of returns in the Indian stock
market in a comprehensive manner bringing forth evidences of “volatility clustering”,
“stationarity” and the “leverage effect” in the volatility exhibited in the return series.
NSE 500 is a broad-based index of the National Stock Exchange in India.
Put simply, the NSE 500 index returns were volatile (during the study period) and
showed the following characteristics:
i. Volatility clustering—Whenever volatility was observed, it appeared in a clus-
ter, that is, the variations appeared together, indicating that the market went th-
rough a volatile “phase”. Therefore, technical (short-term) investors could use
this “phase” to book returns, and fundamental (long-term) investors could wait
out this volatile cluster, in order to book returns; they could even exit the market if
the prices exhibited a relatively upward trend.
ii. Stationarity—There was evidence of “stationarity” (referring to a sort of lag in
the volatility cluster) indicating that the volatility cluster provided a window for
aggressive trading and an opportunity to be able to book returns, especially for
technical investors.
iii. Leverage effect—The “leverage effect” indicated that investors reacted more
strongly to negative information or news. Hence, investor behaviour was pessimis-
tic, and they brought prices down, sometimes by a larger extent than what was ex-
pected. On the other hand, when compared to positive or good news, the optimism
reflected in increasing prices was of a lower degree.
*For more details, please refer to 7 Chap. 7 of Singh et al. (2016).
3.2.2.2 Portfolio Risk
Just as the risk of an individual security is measured by the variance (or standard
deviation) of its return, the risk of a portfolio is measured by the variance of the
portfolio’s returns.
i For a portfolio containing two securities,
Var Rp = σ12 W12 + σ22 W22 + 2W1 W2 σ1 σ2 ρ12

(3.9)
where
Var (Rp) is variance of the portfolio returns or portfolio risk,
σ12 is the variance of the return of security 1,
w1 is the weight of portfolio invested in security 1,
91 3
w2 is the weight of portfolio invested in security 2,
σ1 is the standard deviation of the return of security 1,
σ2 is the standard deviation of the return of security 2,
ρ12 is the correlation between the returns on securities 1 and 2, and
ρ 12σ1σ2 is the covariance between the returns on securities 1 and 2.
This equation can be extended for “n” number of securities in the similar manner.
Point to Ponder: Analysing the Above Equation, How Can You Minimize the Portfolio
Risk?
(Hint: correlation).
i Since the covariance between two variables is the product of their standard devia-
tions multiplied by their coefficient of correlation, it can also be written as

Cov Ri , Rj = ρij σi σj (3.10)
where
ρij is the coefficient of correlation between Ri and Rj,
αi is the standard deviation of Ri, and
αj is the standard deviation of Rj.
Hence, the portfolio risk equation for n securities can be written as per Eq. 3.11.
n
n
n
σp2 = wi2 σi2 + ρij σi σj (i �= j) (3.11)
i=1 i=1 j=1
In line with the scope of this text, we would not be calculating correlations be-
tween securities; the values would typically be provided in the numericals.
? Numerical Example 3.5: Portfolio Return and Risk

A portfolio consists of four securities, viz. R1, R2, R3 and R4. The expected returns,
variances and covariances are as follows:
R1 = 8% R2 = 10% R3 = 12% R4 = 15%
Var (R1) = 100 Var (R2) = 160 Var (R3) = 200 Var (R4) = 240
Cov (R1, R2) = 85 Cov (R1, R3) = 94 Cov (R1, R4) = 100
What is the expected portfolio return and portfolio variance when the weights are
w1 = 0.2, w2 = 0.4, w3 = 0.2 and w4 = 0.2?
v The expected portfolio return is

n

RP = wi Ri
i=1
= 0.2(8) + 0.4(10) + 0.2(12) + 0.2(15)
= 11%
The portfolio variance is

n
n
n
σp2 = wi2 σi2 + ρij σi σj (i �= j)
i=1 i=1 j=1
= w12 Var(R1 ) + w22 Var(R2 ) + w32 Var(R3 ) + w42 Var(R4 )

3 + 2w1 w2 Cov(R1 , R2 ) + 2w1 w3 Cov(R1 , R3 ) + 2w1 w4 Cov(R1 , R4 )
+ 2w2 w3 Cov(R2 , R3 ) + 2w2 w4 Cov(R2 , R4 ) + 2w3 w4 Cov(R3 , R4 )
= (0.20)2 100 + (0.40)2 160 + (0.20)2 200 + (0.20)2 240

+ 2(0.20)(0.40)85 + 2(0.20)(0.20)94 + 2(0.20)(0.20)100
+ 2(0.40)(0.20)120 + 2(0.40)(0.20)130 + 2(0.20)(0.20)160
= 0.04∗ 100 + 0.16∗ 160 + 0.04∗ 200 + 0.04∗ 240 + 0.16∗ 85 + 0.08∗ 94
+ 0.08∗ 100 + 0.16∗ 120 + 0.16∗ 1300.08∗ 160
= 4 + 25.60 + 8 + 9.60 + 13.60 + 7.52 + 8 + 19.20 + 20.80 + 12.80
= 129.12
The portfolio standard deviation is

σp = Var Rp
= (129.12)1/2 = 11.36%
Concept in Practice 3.2: Risk and Return in the Indian Stock Market
As stated earlier, the authors of this book conducted a study on equity returns in In-
dia for the period 1994–2014 (Singh et al., 2016). Findings from the same are stated
here to illustrate the concept of risk and return in practice, in the Indian equity mar-
ket.
The Indian equity market, represented by the NSE 500 companies (constituting
96.27% of the market capitalization), appears to be an attractive investment destina-
tion for long-term investors as well as short-term investors. Mean annual returns are
over 20% (22.27%) for 1 year holding period, 17.33% for the 5 years holding period,
19.62% for the 10 years holding period and 18.41% for the 15 years holding period.
Although there does not exist substantial difference in RoR for holding periods of 5,
10 and 15 years, yet the markets appear to favour the long-term investor as the vola-
tility, measured through the coefficient of variation, falls substantially as the invest-
ment horizon (holding period) increases.
Equity returns have been extremely volatile in the short run with a coefficient of va-
riation of 213.43% for the 1 year holding period which decreased significantly to
15.64% for the 15 year holding period.
In sum, it is reasonable and safe to contend that Indian equity markets provide ro-
bust and stable returns over the long-term investment horizon, say, 5, 10 or 15 year
3.3 · Conclusion
93 3
holding periods. In the short run too (one year), the average returns of 22.27% (in
absolute terms) are attractive. However, the speculative market lends volatility to the
short-term returns, making it a less safe option vis-à-vis the long-term returns. The
same is also corroborated by the minimum and maximum value of returns over diffe-
rent time horizons. Hence, it appears advisable to adopt a long-term investment ho-
rizon while investing in the Indian equity market to earn better/higher/safer returns.
Hence, overall, it appears safe to assume that the success story of the Indian eq-
uity market continues, both in terms of the returns and in their increasing market
breadth and coverage.
*For more details, please refer to 7 Chap. 9 of Singh et al. (2016).
3.3 Conclusion
The objective of this chapter is to provide an insight into the concept and meas-
urement of risk and return. The rate of return on a single security as well as a
portfolio has been discussed through discussions and solved numericals. Similarly,
the risk of a security as well as a portfolio has been elaborated upon. Real-life ex-
amples based on empirical evidence have also been presented to provide the read-
ers the crucial link between concept and practice. Sufficient numbers of solved
and unsolved numericals have been provided to help the reader become conver-
sant with the measurement of risk and return, both for a security and a portfolio.
Summary
5 Risk and return are two sides of the same coin. Returns are the rewards earned
for bearing the risk; hence, higher the risk, higher the return.
5 Rate of return on a single asset = (Annual Income + Ending price − Beginning
price)/Beginning price.
5 The expected return on a portfolio is the weighted average of the returns on the
securities comprising the portfolio.
5 Portfolio rate of return = (weight of first asset in portfolio * return of first as-
set in portfolio) + (weight of second asset in portfolio * return of second asset
in portfolio) and so on.
5 Rp = w1 R1 + w2 R2
where
Rp is the return on the portfolio,
w1 is the proportion of portfolio invested in security 1, and
w2 is the proportion of portfolio invested in security 2.
5 The assigning of a probability to an uncertain event leads to the estimation of
n
risk. In that case, Rp = i̇=1 pi Ri
where
Rp is the return on the portfolio, and
Ri is the return on the security i
5 The variables used to measure risk are variance and standard deviation. Vari-
ance, denoted by σ2 (sigma), is calculated as the average value of squared devi-
ations from the mean. Statistically, standard deviation, denoted by σ, is calcu-
lated as the square root of variance.
2
3 Variance = σ = 2Ri − R
n−1
and

2
Ri − R
n−1
where
Ri is the return of security in the nth year, and
R is the average return of the security over n years.
(“n” can also denote the number of observations)
Similarly, in case of a probability distribution,

2
σ = pi Ri − R
where
Ri is the return of security in the ith year/period,
R is the average return of the security over n years, and
pi is the probability of the ith return.
5 Another important measure used to determine volatility is the coefficient of
variation, that is, the standard deviation divided by mean.
Coefficient
of variation = (standard deviation/mean returns)*100
or α/R ∗ 100
5 Skewness is the measure of the symmetry of the distribution curve. Non-sym-
metrical distributions may either be positively or negatively skewed.
5 Kurtosis represents the shape of any probability distribution, in terms of
whether the curve is more peaked (the dispersion around the mean is narrow) or
less peaked (the dispersion around the mean is wide) than a normal distribution.
5 The covariance between two variables is the product of their standard devia-
tions multiplied by their coefficient of correlation.

Cov Ri , Rj = ρij σi σj
where
ρij is the coefficient of correlation between Ri and Rj,
σi is the standard deviation of Ri, and
σj is the standard deviation of Rj.
5 The risk of a portfolio is measured by the variance of the portfolio’s returns.
3.4 · Exercises
95 3
The portfolio risk equation for n securities can be written as
n
n
n
i=1 i=1 j=1
where
σp2 is the variance of the portfolio returns or portfolio risk,
σi2 is the variance of the return of security i,
σj2 is the variance of the return of security j,
wi is the proportion of portfolio invested in security i,
wj is the proportion of portfolio invested in security j, and
ρij σiσj is the covariance between the returns on securities i and j.
5 For a portfolio of two securities,
Standard deviation (Rp) =

σp = w12 σ12 + w22 σ22 + 2w1 w2 ρ12 σ1 σ2
Or

σp = w12 σ12 + w22 σ22 + 2w1 w2 Cov12
where
Var (Rp) is the variance of the portfolio returns or portfolio risk,
w1 is the proportion of portfolio invested in security 1,
ρ12 is the correlation between the returns on securities 1 and 2, and
ρ12 σ1σ2 is the covariance between the returns on securities 1 and 2
3.4 Exercises

1. (i)
___________ and ___________ are two sides of the same coin.
(ii) Rate of return on a single asset = (_____________ + Ending price −
Beginning price)/Beginning price.
(iii) The expected return on a portfolio is the __________ average of the
expected returns on the securities comprising the portfolio.
(iv) _________________is calculated as the average value of squared devia-
tions from the mean.
(v) ______________ is calculated as the square of standard deviation.

(vi) Coefficient of variation is the standard deviation divided by________.
(vii) __________ is the measure of extent to which a curve is non-symmetrical.
(viii) __________ represents the shape of any probability distribution.
(ix) The _________ between two variables is the product of their standard
deviations multiplied by their coefficient of correlation.
3 (x) The risk of a portfolio is measured by the _________ of the portfolio’s
returns.
v (Answers: (i) Risk, return (ii) Annual income (iii) Weighted (iv) Variance (v) Vari-
ance (vi) Mean (vii) Skewness (viii) Kurtosis (ix) Covariance (x) Variance).
? 2. True/False
(i) Return is the reward earned for bearing the risk; hence, the higher the risk,
the higher the return.
(ii) Rate of return on a single asset = (Annual Income + Ending price − Begin-
ning price)/Annual income.
(iii) The expected return on a portfolio is the average of the expected returns on
the securities comprising the portfolio.
(iv) Portfolio rate of return = (weight of first asset in portfolio*return of first
asset in portfolio) + (weight of second asset in portfolio*return of second
asset in portfolio) and so on.
(v) The variables used to measure risk are variance and standard deviation.
(vi) Non-symmetrical distributions may either be positively or negatively

skewed.
( vii) Kurtosis denotes the shape of the distribution.
(viii) The risk of a portfolio is measured by the variance of the portfolio’s re-
turns.
(ix) The portfolio risk equation for n securities can be written as
n n n

i=1 i=1 j=1
where
wj is the proportion of portfolio invested in security j,
ρij σiσj is the covariance between the returns on securities i and j.
(x) Variance is calculated as the square root of standard deviation.
v (Answers: (i) True (ii) False (iii) False (iv) True (v) True (vi) True (vii) True
(viii) True (ix) True (x) False)
3.4 · Exercises
97 3
? SQ1. A bond bought at face value of INR 100 pays an annual interest of 10% and
can be sold at INR 105 after 1 year. Calculate the rate of return (RoR) for the in-
vestor.
v AQ1. Rate of return on a security/asset = (Annual Income + Ending price − Begin-

ning price)/Beginning price.
Therefore, RoR of the bond = [10 + (105–100)] / 100 = 15/100 = 15%.
? SQ2. A share bought at INR 30 pays a dividend of INR 3 and can be sold at INR
35 after 1 year. Calculate the RoR for the investor.
v AQ2. Rate of return on a security/asset = (Annual Income + Ending price − Begin-

ning price)/Beginning price.
Therefore, RoR of the bond = [3 + (35–30)] / 30 = 8/30 = 26.67%.
? SQ3. Given below are the rates of return on equity of ABC Limited for the last five
years:
Assessment year RoR (in %)

2012 8
2013 12
2014 13
2015 5
2016 2
Calculate the following:
a. Average rate of return;

b. Standard deviation;
c. Variance;
d. Coefficient of variation
v AQ3. The stepwise calculation of the average return and risk is as follows:
a. Average rate of return (R)

R = (8 + 12 + 13 + 5 + 2)/5 = 8%
b. Standard deviation
Step 1: Calculate the deviations from the mean (already calculated in “a”)

Deviations from the mean = Ri − R
= 8 − 8 = 0; 12 − 8 = 4; 13 − 8
3 = 5; 5 − 8 = −3; 2 − 8 = −6.
Step 2: Square the deviations
2
Squared deviations = Ri − R = 0; 16; 25; 9; 36
The calculations are depicted in the table.
Assessment year RoR (R%) 2

Ri − R

Ri − R
2012 8 0 0
2013 12 4 16
2014 13 5 25
2015 5 −3 9
2016 2 −6 36

Ri − R
2 86
Variance = average of squared deviations = 86/(n  − 1) = 86/4 = 21.50%.

Step 4: Calculate the standard deviation
√as the square root of the variance
Standard Deviation = (Variance)½ = 21.5 = 4.64%.
c. Variance
Variance has already been calculated in (b) as 21.50%.
Coefficient of variation = (σ/Mean) * 100 = (4.64/8) * 100 = 58%.
? SQ4. XYZ Limited’s debentures provided the following returns for the last five
years:
Year Rate of return

2011 10
2012 12
2013 11
2014 9
2015 10
3.4 · Exercises
99 3
a. Average rate of return;

b. Standard deviation;
c. Variance;
v AQ4. The stepwise calculation of the average return and risk is as follows:
a. Average rate of return (R).

R = (10 + 12 + 11 + 9 + 10)/5 = 52/5 = 10.40%
b. Standard deviation

Deviations from the mean = Ri − R = 10 − 10.40
= −0.40; 12 − 10.40 = 1.60; 11 − 10.40 = 0.60; 9 − 10.40
= −1.40; 10 − 10.40 = −0.40.
2
Squared deviations = Ri − R = 0.16; 2.56; 0.36; 1.96; 0.16.
The calculations are depicted in the table.
Assessment year RoR (R%) 2

Ri − R

Ri − R
2011 10 −0.40 0.16
2012 12 1.60 2.56
2013 11 0.60 0.36
2014 9 −1.40 1.96
2015 10 −0.40 0.16
Sum 52 5.20
Mean 10.40
Variance = average of squared deviations
= 5.20/(n − 1) = 5.20/4 = 1.30%
√
Standard Deviation = (Variance)1/2 = 1.30 = 1.14%
c. Variance
Variance has already been calculated in (b) as 1.30%.
Coefficient of variation = (σ/Mean) * 100 = (1.30/10.40) * 100 = 12.50%.
? SQ5. An investor has invested in the equity shares of ABC Limited and XYZ Lim-
ited. The risk and return profiles of the two securities are as follows:
3 Security Mean return Standard deviation

ABC 12 3
XYZ 16 3.50
The correlation coefficient between the two securities is −0.80.
(i) Calculate the return and risk of the investor’s portfolio given that he has in-
vested in the two securities in the ratio of 6:4.
(ii) Is it possible that the risk of the portfolio is less than the risk of individual se-
curities?
v AQ5.
(i) Average return of the portfolio can be calculated as

Rp = w1 R1 + w2 R2
where
Rp is the expected return on the portfolio,
R1 is the expected return on the security 1,
R2 is the expected return on the security 2,
w2 is the proportion of portfolio invested in security 2.
Substituting,
W1 = 0.6; W2 = 0.4; R1 = 12%; R2 = 16%

Hence, return of the portfolio, Rp = 0.6 * 12 + 0.4 * 16
= 7.20 + 6.40
= 13.60%
Risk of a portfolio can be measured through its standard deviation, variance
and coefficient of variation. Let us calculate them.
Standard deviation for a portfolio consisting of two securities can be calculated
as follows:

σp = w12 σ12 + w22 σ22 + 2w1 w2 ρ12 σ1 σ2
where
σp is the standard deviation of the portfolio returns or portfolio risk,
3.4 · Exercises
101 3
ρ12 is the correlation between the returns on securities 1 and 2.
Substituting,
2
σp = (0.6) ∗ 32 + (0.4)2 ∗ (3.5)2
+ 2 ∗ 0.6 ∗ 0.4 ∗ (−0.80) ∗ 3 ∗ 3.5

= (0.36)∗ 9 + (0.16)∗ 12.25 − 4.032
√ √
= 3.24 + 1.96 − 4.032 = 1.168
= 1.08%
Variance is the square of standard deviation. Hence,
Variance = σp2 = (1.08)2 = 1.168%
Similarly, coefficient of variation = (σp/Mean) * 100 = (1.08/13.60) * 100 = 7.94
%.
(ii) As is evident, the overall risk level of the portfolio has declined significantly
since the correlation coefficient between the return of two securities is negative.
It is much lower than the risk of the individual securities.
? SQ6. ABC Company is evaluating an investment that is sensitive to changes in the

national economy. If the economy is expanding rapidly, the investment will gen-
erate earnings (returns) of INR 7,50,000 per year; if there is mild growth, returns
would be INR 5,00,000 and if there is a recession, INR 250,000. The company's
staff economists estimate there is a 20% chance that there will be rapid expansion,
a 60% chance of mild growth and a 20% chance of recession. Given this informa-
tion, calculate the expected returns for ABC. Bear in mind that the figures convey
absolute returns and not rates of return.
v AQ6. The average or expected absolute return is given by the equation:

n

Rc = pi Ri
i=1
where
pi is the probability of the ith state,

Ri is the expected return of the ith state, and
Rc is the average return of the company.
Substituting,

Rc = p∗1 R1 + p∗2 R2 + p∗3 R3
where p1 = 0.2, p2 = 0.6, p3 = 0.2 and R1 = 7,50,000, R2 = 5,00,000 and R3 = 2,50,000.
Rc = (0.2 * 7,50,000) + (0.6 * 5,00,000) + (0.2 * 2,50,000) = 1,50,000 + 3,00,000 + 50,000.
Hence, expected return, Rc = INR 5,00,000.
? SQ7. Assume the data contained in SQ6, and calculate the standard deviation of
the returns from the proposed investment. Further, what is the coefficient of varia-
tion (CoV) of the returns from this proposed investment?
v AQ7. The formula for calculating standard deviation with a probability distribu-
tion of returns is
3
2
σ = pi Ri − R
where
Ri is the expected return of security in the nth year,

The stepwise calculation of the standard deviation of the investment return is
Step 1: Calculate the average expected rate of return (R).
R has already been calculated as INR 5,00,000.
Step 2: Calculate the deviations from the mean or R
Deviations from the mean =
Ri − R = 5,00,000 − 7,50,000 = −2,50,000; 5,00,000 − 5,00,000 = 0; 5,00,000 −
2,50,000 = 2,50,000.
Step 3: Square the deviations and multiply with probability.
2
Squared deviations = Ri − R
pi

= (0.20)(−2, 50, 000)2 + (0.60)(0)2 + (0.20)(2, 50, 000)2
= [0.20 ∗ 62, 500, 000, 000 + 0 + 0.20 ∗ 62, 500, 000, 000]
= 25, 000, 000, 000

Standard Deviation = (Variance)1/2 = 25, 000, 000, 000 = 1, 58, 113.88
Further, coefficient of variation (CoV) can be computed as
CoV = σ/R = (1, 58, 114/5, 00, 000)∗ 100 = 31.60%

? SQ8. An investor is planning to invest in the stock market. She is considering two
stocks: stock S1 and stock S2. As we know, the economy can move any way (up or
down). India, being a growing economy, the likelihood of the economy moving up
(boom) is twice its likelihood of moving down (recession). Few other facts about
the two stocks are as follows:
State of the economy Probability of occurrence S1 (RoR %) S2 (RoR %)

Boom 2/3 10 40
Recession 1/3 6 −2
3.4 · Exercises
103 3
Given the situation,
a. Calculate the expected returns for stocks S1 and S2.

b. Calculate the total risk (variance and standard deviation) for stocks S1 and S2.
c. Calculate the expected return of a portfolio that consists of both stocks in
equal proportions.
d. Calculate the expected return of a portfolio that consists of both stocks in the
following proportion: 10% of stock S1 and the rest in stock S2.
v AQ8. a. Average or expected returns of the securities S1 and S2

n

Rs = pi Ri
i=1
where
pi is the probability of the ith state,

Ri is the expected return of the ith state, and
Rs is the average return of the stock.
If the probability of the economy moving up (boom), pup = 2/3, and probability of
economy moving down (recession), pdown=1/3, then
Expected return E(RS1 ) = p∗up RS1.up + pdown ∗ RS1.down

= 2/3 × 0.10 + 1/3 × 0.06
= 0.26/3
= 0.0867
= 8.67%
Expected return E(RS2 ) = pup ∗ RS2.up + p∗down RS2.down

= 2/3 × 0.40 + 1/3 × −0.02
= 0.78/3
= 0.26
= 26%
b. Total risk (variance and standard deviation) for S1 and S2.
The standard deviation in this case can be calculated as

2
σ = pi Ri − R
where
Ri is the expected return of security in the nth year,
Standard deviation for S1: SD(RS1).

= 10 − 8.67 = 1.33; 6 − 8.67 = −2.67

3
2
Squared deviations = Ri − R = 1.77; 7.13
Standard Deviation SD(RS1 ) = [2/3 × 1.77 + 1/3 × 7.13]1/2

= [1.18 + 2.38]1/2
= 1.89%
Variance = SD(RS1 )2 = 3.57%

Standard deviation for S2: SD(RS2).

= 40 − 26.10 = 13.9; −2 − 26.10 = −28.10

2
Squared deviations = Ri R = 193.21; 789.61
Standard deviation,SD(RS2 ) = [2/3 × 193.21 + 1/3 × 789.61]1/2

= [128.81 + 263.20]1/2
= 19.80%
Variance = SD(RS2 )2 = 392.04%

c. Expected returns of a portfolio that consists of both stocks in equal propor-
tions
Portfolio weights:
Weight of security S1, WS1 = 0.5


Expected return on portfolio, E Rp = 0.5 × 8.67 + 0.5 × 26.10
= 4.34 + 13.05
= 17.39%
3.4 · Exercises
105 3
d. Expected return of a portfolio that consists of both stocks in the following pro-
portion: 10% of stock S1 and the rest in stock S2.
Portfolio weights:

Expected return on Portfolio,E Rp = 0.1 × 8.67 + 0.9 × 26.10
= 0.87 + 23.49
= 24.36%
? SQ9. An investor is considering investing in a portfolio which would consist of four
securities. He has data on five securities, viz. 1, 2, 3, 4 and 5. The expected returns,
variances and covariances are provided as follows:
R 1 = 8% R 2 = 12% R 3 = 12% R 4 = 15% R 5 = 17%

Var (R1) = 100 Var (R2) = 160 Var (R3) = 200 Var (R4) = 240 Var (R5) = 250
Cov (R1, Cov (R1, Cov (R1, Cov (R1, Cov (R2,
R2) = 85 R3) = 94 R4) = 100 R5) = 110 R3) = 120
Cov (R2, Cov (R2, Cov (R3, Cov (R3, Cov (R4,
R4) = 130 R5) = 145 R4) = 160 R5) = 180 R5) = 200
Help the investor choose the four best securities from the options available in order
to generate a portfolio that provides the maximum returns as well as minimum risk.
The expected portfolio will have equal proportions invested in each security, that is,
25% in each.
v AQ9. The investor can have the following combinations of portfolios:
P1 = [R1 , R2 , R3 and R4 ].
P2 = [R1 , R2 , R3 and R5 ].
P3 = [R1 , R2 , R4 and R5 ].
P4 = [R1 , R3 , R4 and R5 ].
P5 = [R2 , R3 , R4 and R5 ].
We would need to calculate the returns and risks of all these five portfolios to de-
termine the best one for him/her.
We know that the expected portfolio return is given as
n

Rp = Wi Ri
1
where
Ri is the expected return on the security i, and
wi is the proportion of portfolio invested in security i.

Considering the weightage provided to each security is 25% or 0.25, let us cal-
culate the expected returns and risk for each portfolio:
(i) P1 = [R1, R2, R3 and R4]
E(P1 ) = [0.25(8) + 0.25(12) + 0.25(12) + 0.25(15)]
3 = [2 + 3 + 3 + 3.75] = 11.75%
Further, the portfolio variance is given as per the following equation:
n
n
n
i=1 i=1 j=1

wj is the proportion of portfolio invested in security j, and
ρij σi σj is the covariance between the returns on securities i and j.
Substituting the values from the table:
Var(P1 ) = w12 Var(R1 ) + w22 Var(R2 ) + w22 Var(R3 ) + w42 Var(R4 )

= (0.25)2∗ 100 + (0.25)2∗ 160 + (0.25)2∗ 200 + (0.25)2∗ 240

+ 2(0.25)(0.25)85 + 2(0.25)(0.25)94 + 2(0.25)(0.25)100
+ 2(0.25)(0.25)120 + 2(0.25)(0.25)130 + 2(0.25)(0.25)160
= 6.25 + 10 + 12.50 + 15 + 10.625 + 11.75

+ 12.50 + 15 + 16.25 + 20 = 129.875%

Var Rp = (129.875)1/2 = 11.39%

σp =
Similarly,
(ii) P2 = [R1, R2, R3 and R5]
E(P2 ) = [0.25(8) + 0.25(12) + 0.25(12) + 0.25(17)]
= [2 + 3 + 3 + 4.25] = 12.25%

+ 2w1 w2 Cov(R1 , R2 ) + 2w1 w3 Cov(R1 R3 ) + 2w1 w5 Cov(R1 R5 )
+ 2w2 w3 Cov(R2 R3 ) + 2w2 w5 Cov(R2 R5 ) + 2w3 w5 Cov(R3 , R5 )
3.4 · Exercises
107 3
= (0.25)2∗ 100 + (0.25)2∗ 160 + (0.25)2∗ 200
+ (0.25)2∗ 250 + 2(0.25)(0.25)85 + 2(0.25)(0.25)94
+ 2(0.25)(0.25)110 + 2(0.25)(0.25)120 + 2(0.25)(0.25)145
+ 2(0.25)(0.25)180
= 6.25 + 10 + 12.50 + 15.625 + 10.625 + 11.75

+ 13.75 + 15 + 18.125 + 22.50
= 136.125%

Var Rp = (136.125)1/2 = 11.67%

σp =
(iii) P3 = [R1, R2, R4 and R5]

E(P3 ) = [0.25(8) + 0.25(12) + 0.25(15) + 0.25(17)]
= [2 + 3 + 3.75 + 4.25] = 13%

= (0.25)2∗ 100 + (0.25)2∗ 160 + (0.25)2∗ 240 + (0.25)2∗ 250

+ 2(0.25)(0.25)85 + 2(0.25)(0.25)100 + 2(0.25)(0.25)110
+ 2(0.25)(0.25)130 + 2(0.25)(0.25)145 + 2(0.25)(0.25)200
= 6.25 + 10 + 15 + 15.625 + 10.625 + 12.50

+ 13.75 + 16.25 + 18.125 + 25
= 143.25%
(iv) P4 = [R1, R3, R4 and R5]
E(P4 ) = [0.25(8) + 0.25(12) + 0.25(15) + 0.25(17)]
= [2 + 3 + 3.75 + 4.25] = 13%

+ 2w1 w3 Cov(R1 , R3 ) + 2w1 w4 Cov(R1 , R4 ) + 2w1 w5 Cov(R1 , R5)
= (0.25)2∗ 100 + (0.25)2∗ 200 + (0.25)2∗ 240 + (0.25)2∗ 250

+ 2(0.25)(0.25)94 + 2(0.25)(0.25)100 + 2(0.25)(0.25)110
+ 2(0.25)(0.25)160 + 2(0.25)(0.25)180 + 2(0.25)(0.25)200
3 = 6.25 + 12.50 + 15 + 15.625 + 11.75

+ 12.50 + 13.75 + 20 + 22.50 + 25
= 154.875%

Var Rp = (154.875)1/2 = 12.44%

σp =
(v) P5 = [R2, R3, R4 and R5]

E(P5 ) = [0.25(12) + 0.25(12) + 0.25(15) + 0.25(17)]
= [3 + 3 + 3.75 + 4.25] = 14%

+ 2w2 w3 Cov(R2 , R3 ) + 2w2 w4 Cov(R2 R4 ) + 2w2 w5 Cov(R2 , R5 )
= (0.25)2∗ 160 + (0.25)2∗ 200 + (0.25)2∗ 240 + (0.25)2∗ 250

+ 2(0.25)(0.25)120 + 2(0.25)(0.25)130 + 2(0.25)(0.25)145
+ 2(0.25)(0.25)160 + 2(0.25)(0.25)180 + 2(0.25)(0.25)200
= 10 + 12.50 + 15 + 15.625 + 15 + 16.25

+ 18.125 + 20 + 22.50 + 25 = 170%

Var Rp = (170)1/2 = 13.04%

σp =
Hence, the returns and risk available in the different portfolio combinations are as
follows:
Portfolio Return Standard deviation Variance
P1 11.75 11.39 129.875
P2 12.25 11.67 136.13
P3 13 11.97 143.25
P4 13 12.44 154.88
P5 14 13.04 170
3.4 · Exercises
109 3
As is evident from the tabulated results, both P3 and P4 provide the same returns,
but P3 provides a lower risk. Why do you think this is?
(Hint: Look at the risk–return profile of R2 and R3; what do you notice?).
Hence, the investor may choose P3. However, if he desires the highest returns avail-
able (risk notwithstanding), he can choose P5. If you compare the portfolio risk
and return with those of the individual securities, you can appreciate the fact that
the investor would enjoy returns of 13–14% with much lower accompanying risk.
Only security 1 has lower risk than any of the five portfolios suggested above. How-
ever, in that case, return is only 8%. This is the beauty and benefit of diversification.
* You can take the help of a normal calculator or a scientific calculator for the cal-
culations.
? UQ1. A debenture bought at face value of INR 200 pays an annual interest of 10%
and can be sold at INR 220 after 1 year. Calculate the ROR for the investor.
[Answer: 20%].
? UQ2. A share bought at INR 50 pays a dividend of INR 6 and can be sold at INR
60 after 1 year. Calculate the ROR for the investor.
[Answer: 32%].
? UQ3. An investor has invested in four securities, A, B, C and D in equal propor-

tions (weightage of 25% each). A and B are shares providing 15% and 16% returns,
respectively. Similarly, C and D are bank fixed deposits providing interest of 7%
and 8%, respectively. Calculate the RoR for his portfolio. Remember that bank
fixed deposits do not provide capital appreciation.
[Answer: 11.50%].
? UQ4. Given below are the rates of return on equity of ABC Limited for the last
five years:
Assessment year RoR (in %)

Year 1 10
Year 2 12
Year 3 14
Year 4 8
Year 5 8

e. Average rate of return;
f. Standard deviation;
g. Variance;
h. Coefficient of variation.
[Answer: a. 10.40%; b. 2.61%; c. 6.80%; d. 25.07%].
? UQ5. XYZ Limited’ debentures provided the following returns for the last five years:
Year Rate of return

Year 1 15
Year 2 14
3 Year 3 15
Year 4 13
Year 5 14

e. Average rate of return;
f. Standard deviation;
g. Variance;
h. Coefficient of variation.
[Answer: a. 14.20%; b. 0.84%; c. 0.70%; d. 5.89%]
? UQ6. An investor has invested in equity shares of ABC Limited and XYZ Limited.
The risk and return profiles of the two securities are as follows:
Security Mean return Standard deviation

ABC 15 5
XYZ 12 6
The correlation coefficient between the two securities is −0.50.

(iii) Calculate the return and risk of the investor’s portfolio given that he has in-
vested in the two securities in the ratio of 1:1 (50% each).
(iv) Comment on the resultant return and risk of the portfolio. What do you ob-
serve?
[Answer: i. Return = 13.50%; Variance = 7.75%; Standard deviation = 2.78%]
? UQ7. ABC Company is evaluating an investment that is sensitive to changes in the

national economy. If the economy is expanding rapidly, the investment will generate
returns of 15% per year; if there is mild growth, returns would be 8% and if there is
a recession, 5%. The company's staff economists estimate that there is a 20% chance
that there will be rapid expansion, a 60% chance of mild growth and a 20% chance
of recession. Given this information, calculate the expected returns for ABC.
[Answer: 8.8%].
? UQ8. Assume the data contained in UQ7, and calculate the standard deviation of
the returns from the proposed investment. Further, what is the coefficient of varia-
tion (CoV) of the returns from this proposed investment?
[Answer: Standard deviation = 2.78; Coefficient of variation = 31.59].
? UQ9. An investor is planning to invest money in the stock market. She is consid-
ering two stocks: stock S1 and stock S2. As we know, the economy can move any
way (up or down). India being a growing economy, the likelihood of the economy
3.4 · Exercises
111 3
moving up (boom) is equal to its likelihood of moving down (recession). Few other
facts about the two stocks are as follows:
State of the economy Probability of occurrence S1 (RoR %) S2 (RoR %)

Boom 1/2 14 40
Recession 1/2 7 10
a. Calculate the expected returns for stocks S1 and S2.

b. Calculate the total risk (variance and standard deviation) for stocks S1 and S2.
c. Calculate the expected return of a portfolio that consists of both stocks in
equal proportions.
d. Calculate the expected return of a portfolio that consists of both stocks in the
following proportion: 60% of stock S1 and the rest in stock S2.
[Answer: a. S1 = 10.5%, S2 = 25%; b. Variance = S1 = 12.25; S2 = 225; Standard de-
viation = S1 = 3.5%, S2 = 15% c. 17.75% d. 16.30%].
? UQ10. An investor is considering investing in a portfolio which would consist of

two securities. He has data on three securities, viz. 1, 2 and 3. The expected returns,
variances and covariances are provided as follows:
R 1 = 10% R 2 = 12% R 3 = 15%

Var (R1) = 100 Var (R2) = 120 Var (R3) = 130
Help the investor choose the two best securities from the options available in order
to generate a portfolio that provides the maximum returns as well as minimum risk.
The expected portfolio will have equal proportions invested in each security, that is,
50% in each. Discuss your choice.
[Answer: [R1R2] returns = 11%, variance = 85%; P[R1R3] returns = 12.50%, variance
= 97.50%; P[R2R3] returns = 13.50%, variance = 112.50%].
* All the equations we have been using are also provided as functions in Microsoft
Excel®. Readers may use them with ease, once they are conversant with the con-
cepts and methodologies behind the same.
? 1. What is “return”? How can one compute the returns on a security?

2. What is “portfolio return”? How can one compute the returns on a portfolio?
3. What is “risk”? What are the various measures used for estimating risk?
4. What is “portfolio risk”? How can one compute the risk on a portfolio?
5. What is implied by “skewness” and “kurtosis” in the context of a returns’ distri-
bution?
6. What is standard deviation? How is it calculated? Illustrate with an example.
7. What is variance? How is it calculated? Illustrate with an example.
8. What is coefficient of variation? How is it calculated? Illustrate with an example.

9. Do you expect a difference between the returns of a debt instrument and an eq-
uity share? Why? Provide justification.
10. Comment on the returns and risk characteristics of the Indian stock market.
3 3.4.5 Discussion Questions (Points to Ponder)
*These questions can take the form of a class exercise and/or assignment.
? 1. What are the factors that can affect the returns and risk of any company? Enu-
merate with a brief justification for each factor.
(Hint: A company’s returns may be affected by its own performance and the com-
petitive environment under which it functions. Its returns can also be impacted by
the prevailing stock market conditions and investor behaviour.)
The answers to this question will set you thinking and make you appreciate the le-
arning of the chapters on fundamental analysis and technical analysis.
2. Compare the returns of the treasury bills of a developed economy and a devel-
oping economy. Enumerate the differences with possible justifications.
*These questions can take the form of a class exercise and/or assignment.
? 1. Track the returns and risk of your favourite company. Comment on the same.
Compare its returns and risk with that of the underlying industry/sector. Enu-
merate your findings. Provide justifications, if possible.
2. Track the returns and risk of the treasury bills issued by the central govern-
ment. Comment on the same. Compare their returns and risk with that of a
popular stock index. Enumerate your findings. Provide justifications, if possible.
Additional Readings
Bodie, Z., Kane, A., Marcus, A. J., and Mohanty, P. (2005), “Investments”, 6th Edition, Tata McGraw-Hill.
Chandra, P. (2009), “Investment Analysis and Portfolio Management”, 3rd Edition, Tata McGraw-Hill.
Fisher D. E. and Jordan R. J. (1995), “Security Analysis and Portfolio Management”, 4th Edition.,
Prentice-Hall.
Gordon, A., Sharpe, J., William, F. and Bailey, J. V. (2009), “Fundamentals of Investment, 3rd Edi-
tion, Pearson Education.
Graham, B. and Dodd, D. L. (2009), Security Analysis, 6th Edition, McGraw Hill, New York.
Jones, C. P. (2010), “Investment Analysis and Management”, 9th Edition, John Wiley and Sons.
Reilly, F. and Brown, K. (2003), “Investment Analysis & Portfolio Management”, 7th Edition, Thom-
son South-Western.
Reference
Singh, S., Jain, P. K., & Yadav, S. S. (2016). Equity markets in India: Risk, return and price multiples.
Springer.
113 4
Fundamental Analysis
Contents
4.1 Introduction – 114
4.2 Fundamental Analysis – 114

4.2.1 Economy Analysis – 115
4.2.2 Industry Analysis – 123
4.2.3 Company Analysis – 133
4.3 Classification of Companies’ Stock from an

Investment Perspective – 137
4.4 Examples of Different Aspects of Fundamental

Analysis – 139
4.5 Why Might Fundamental Analysis

Fail to Work? – 143

4.7.4 Activity Based Question/Tutorial – 149
114 Chapter 4 · Fundamental Analysis
The objective of this chapter is to provide an overview of the activities undertaken
as a part of fundamental analysis in the context of investments. This chapter covers
the following topics.
4.1 Introduction
4 A successful investment strategy would be based on the ability of the analyst to

identify a security that can generate desired returns at an acceptable level of risk.
It would also allow you to buy or invest in such a security when it is available at a
lower/cheaper (than usual) price (in a market) and sell the same security when it is
trading at a higher price (in the same or another market). This chapter focuses on
the former of these aspects: the identification of a security which is intrinsically
sound and can generate returns. The analysis so deployed is called fundamental
analysis. The analysis undertaken for the estimation of the appropriate time to
buy or sell such a security is termed technical analysis and will form the subject
matter of the next chapter. Both these analyses are conducted to select appropri-
ate financial instruments, whether debt or equity, based on the risk–return profile
of the investor.
Debt instruments typically carry a fixed rate of return and also a fixed time
period for investment purposes. The returns on a debt instrument are dependent
on the earnings of the underlying company/organization issuing it, i.e. a debt in-
strument is as good/bad as the entity issuing it. As a result, more than the debt in-
strument, it becomes important to conduct a fundamental analysis of the organ-
ization/assets backing it. Hence, fundamental analysis plays a role in debt instru-
ments as well. Generally, central government debt securities are considered less
risky, than say, corporate debt securities. Even though debt instruments are also
traded, and their yields vary with time, the variations are more pronounced for
the equity instruments due to the higher level of risk associated with them.
4.2 Fundamental Analysis
Definition
Fundamental analysis is the method of evaluating a security by measuring its in-
trinsic value. This is achieved by examining related economic, industry and com-
pany factors. These factors can be both qualitative and quantitative in nature. The
objective of fundamental analysis is to produce an intrinsic value that an investor
can compare with the security's current price with the objective of ascertaining the
position to take with that security (buy if it is underpriced, sell or short if it is over-
priced).
4.2 · Fundamental Analysis
115 4
As stated earlier, fundamental analysis of any security is the way in which an in-
vestor can measure its intrinsic/underlying value. It deals with the analysis of its
economic and financial environment and other qualitative and quantitative fac-
tors. As a part of this analysis, the E-I-C (economy, industry, company) model is
followed and various factors are examined to determine the current value of the
security. It also incorporates aspects that can affect the security's value in the fu-
ture; this can include macro-economic factors such as the overall economy and
industry conditions, and/or microeconomic factors such as the financial condition
of the company and/or the quality of its management.
Fundamental analysis is generally undertaken by long-term investors who are
willing to hold the shares of the company for long periods.
As a part of fundamental analysis, an investor, typically, examines the finan-
cial statements of a company. Along with this, he/she also enquires into the eco-
nomic factors of the domestic economy like gross domestic product (GDP) as
well as the state of the industry the company in question is a part of. Also to be
considered are other factors and events; some known (like the Olympic Games)
and others, relatively unknown and unpredictable (like the COVID-19 pandemic)
that can directly or indirectly affect the company of interest. The ultimate goal of
fundamental analysis for an investor is to ascertain whether a particular share is
overvalued or undervalued with respect to the prevalent market price. It bears men-
tion that overvaluation or undervaluation stems from an investor’s perception on
whether the present share prices are fair or not as per the information he/she has
about the company and its future.
Obviously, the decision to invest will be based on the past performance, pres-
ent conditions and the future projections of the company’s performance, both op-
erationally and financially.
Ironically though, sometimes investment decisions may also depend on the in-
vestor’s preferences, moods or fancies (behavioural finance).
> The E-I-C analysis involves a three-step examination:

5 Analysing the macro-economic environment and developments;
5 Estimating the prospects of the industry/sector to which the company belongs;
and
5 Determining the future (prospective) performance of the company.
Economy-Industry-Company (E-I-C) Analysis
4.2.1 Economy Analysis
Investors typically are and should be concerned with those features of the econ-
omy that affect the performance of organizations.
4.2.1.1 Economic Features Which Impact Investments

Some of the broad economic forces that impact investments are:
1 Population—generally, the population of any country is an indication of the
market its economy can offer. Of course, the demographics available in the
population, the income levels and consumer tastes and preferences would pro-
vide a better idea of the kinds of products and services that would sell well in
that country.
4 ► Example
India with its large high-income, middle-class population is an attractive destina-
tion for the fast moving consumer goods (FMCG) sector. This means that FMCG
companies, in India, would typically be highly profitable and hence, good investment
choices. ◄
2. Research and technological developments—economies that focus on and incen-

tivize research and technological developments and initiatives become home
to companies looking for such an environment. Such economies typically lead
the rest of the economies in terms of new innovations in products and ser-
vices.
► Example
Economies of the USA, Germany and Japan are home to companies that invest heavily
into research and development, and, as a result, they are often considered market lead-
ers in many products/services. ◄
3. Capital formation—this refers to the net capital formed or accumulated dur-

ing a period. In layman terms, it refers to the addition/modernization in the
assets (equipment, machinery, technology, etc.) made by the entities residing
in the economy. Naturally, larger the capital formation, more the economy
grows.
4. Natural resources and raw materials—certain countries and their economies
are blessed with natural resources which provides them a competitive advan-
tage over other economies.
► Example
The natural beauty of Switzerland makes it an ideal tourist destination; and, the petro-
leum and natural gas reserves available in the Gulf nations help them become one of
the largest suppliers of crude oil to the rest of the world. ◄
An investor should consider these and other such aspects in understanding a

particular economy and conducting a strengths, weaknesses, opportunities and
threats (SWOT) analysis for the same. This would enable him/her to get a broad
perspective on the kind of investment (in that particular economy) that would
generate significant returns with low risk. For example, it would be a good idea
117 4
to invest in the shares of a company, which mines and exports minerals to other
economies, if the underlying economy has the largest deposits (in the world), of
such a mineral.
4.2.1.2 Types of Information Sources

There are various kinds of information sources available for any investor. So
much so that it becomes an overwhelming experience to wade through the enor-
mous amount of information available (unfortunately a large portion of this in-
formation, especially on the Internet, may be inaccurate and unreliable). It is very
important that an investor learns how to navigate this ocean of information and
focus only on the real and reliable information sources. Presented here are some
reliable information sources/indicators. Kindly note that this is just an indicative
list to help get you started; there are many more sources of information available
which the reader is encouraged to explore. Further, some examples provided here
are focused on India, and so, international students are encouraged to explore the
websites of their country’s counterparts to the Indian organizations mentioned.
1. World affairs—the World Trade Organization (WTO), a multinational organ-
ization that oversees international trade, releases well-researched reports on
world affairs. Further, the World Bank and its constituents also release exten-
sive material on world affairs. All this information is available on their web-
sites. For example, the WTO website is 7 https://www.wto.org/ and the World
Bank website is 7 https://www.worldbank.org/.
Further, newspapers and journals like the Financial Times, The Economist, the
Harvard Business Review and The Wall Street Journal are also good sources of
international news and world affairs, especially from a business perspective. In-
dian newspapers like the Economic Times provide information about the econ-
omy and the market, as well.
2. Domestic economic and political factors—the Economic Surveys released every
year by the Government of India), ahead of the fiscal budget presentations by
the Ministry of Finance, is a rich source of understanding the domestic eco-
nomic situation. Apart from leading newspapers, journals like the Economic
and Political Weekly are also good sources of information on the economic
and political environments of the country.
3. Industry information—industry associations, across the world, share their per-
spectives on the sector through well-researched reports and documents. In In-
dia, associations like the Federation of Indian Chambers of Commerce and
Industry (FICCI) or the Associated Chambers of Commerce and Industry
(ASSOCHAM) release reports and data on various industries and sectors op-
erating in the economy. Further, from the government’s side, the Ministry of
Corporate Affairs (MCA) also has databases with information about sectors
as well as companies within the sector.
4. Company information—generally, companies provide substantial amount of
information on their own registered websites. Typically, the annual report pub-
lished by a listed company, every year as a part of their mandatory disclo-
sures, is a rich source of information. However, one can also find their infor-
mation on the websites of the stock exchanges where they are listed. Apart
from these, international proprietary databases like Bloomberg® and Thom-
son Reuters® and also Indian databases like Prowess® from the Centre for
Monitoring Indian Economy (CMIE) and AceEquity® also contain informa-
tion on companies.
5. Security market information—stock exchanges, around the world, are the best
sources of security market information. Daily, monthly and even yearly se-
curity price quotations and their trends, etc., are all readily available on their
4 (stock exchanges’) websites. Further, brokerage firms and market consultants
also share security market information and their analysis on the same. Corpo-
rate databases also carry security market information.
6. Data on related markets—international databases like Bloomberg® provide in-
formation on related markets. Further, large consultant giants like Ernst and
Young (E&Y), McKinsey, Deloitte and PricewaterhouseCoopers (PwC) also
provide information and comparative analysis of related markets, sometimes
for free, to students. International trade organization, WTO and the World
Bank also provide such information.
7. Data on mutual funds—in India, the Association of Mutual Funds of India
(AMFI) is the registered body that governs mutual funds. It is a rich source of
information on all mutual funds registered in India. Further, all mutual funds
also have to abide with the disclosure guidelines set by SEBI and their details
can also be sought from its website. International corporate databases like
Bloomberg® and domestic databases like Prowess® also carry information on
mutual funds.
8. Data on primary and new issues—SEBI, being the regulator of all stock mar-
ket dealings in India, carries all information about primary and new issues on
its website, in the form of repositories. Further, stock market brokerage firms
also are good sources of such information. RBI, the central bank of India,
has its own research divisions and provides useful information on its website.
4.2.1.3 Indicators of Economic Situation

An analysis of some major indicators will help capture and forecast the long-term
implications of any economic change.
Some of the economic indicators are:
(i) GDP/GNP
Definition
GDP stands for gross domestic product, that is the sum of all products and ser-
vices produced in the domestic economy, by the domestic factors of production, in
a particular year. GDP can be reported in the actual quantity of products and ser-
vices produced. It can also be reported in terms of the monetary value of the prod-
ucts and services produced, called the nominal GDP.
GDP is an indicator of the size of the economy and its growth and is an accepted
measure of economic growth, across the world.
119 4
(ii) CPI/WPI
Definition
CPI stands for the consumer price index and is a measure of the rise in retail price
levels (inflation) of a basket of commodities consumed by the average populace of
an economy/country. It is an index created with a predetermined base year (prices)
and tracks the rise in those prices over time. WPI or wholesale price index, on the
other hand, is a measure of the rise in wholesale price levels (inflation) of a basket
of commodities consumed by typically wholesale consumers like companies. WPI
is generally used as a proxy for inflation for any economy.
Both CPI and WPI are indicators of inflation levels in any economy and generally
form the basis of interest rates determination.
(iii) Corruption index
Definition
Published annually since 1995, by Transparency International, an organization that
receives funding from international donors and governments, the Corruption Per-
ceptions Index s(CPI) ranks countries “by their perceived levels of corruption”, as
determined by expert assessments and opinion surveys.
In 2018, India ranked 79 in a list of 176 nations, where the first rank stands for
the least corrupt. Such indices provide an indication of the level of corruption
prevalent in any economy and can be a cause of concern for potential investors.
(iv) Foreign exchange reserves—maintained by the central bank of any country
(RBI in the case of India), the foreign exchange reserves of the country pro-
vide an indication of the international trade of the economy. Naturally, the
higher the foreign exchange reserves, greater the capacity to meet the exter-
nal obligations.
(v) Consumer spending—data on consumer spending provides an indication of
the disposable/consumable income available in the hands of the populace.
For example, the middle-class population of India has seen, increasing levels
of disposable income over recent times, making the Indian market an attrac-
tive destination for investment from FMCG and consumer durable goods
sectors.
(vi) Industrial growth rate—the industrial/sector growth rate is an indication of
the growth as well as the investment attracted by a particular sector.
► Example
The growth rate of the manufacturing sector, that forms the backbone of the real econ-
omy, is an indication of capital formation in the economy. Growth in industries like
software and services, has been contributing to India’s overall economic growth, as
well. ◄
(vii) Inflationary trends—the inflationary trends in any economy are an indica-

tion, not simply of the inflation levels and its progression, but also of the
interest rates that would prevail as a result of the same.
> A moderate level of inflation is considered desirable for a growing economy.

Inflation can be caused due to demand-pull (aspects that increase demand)
or cost-push (aspects that push/increase costs) factors. An investor would do
well to analyse the factors affecting the prevalent inflationary trends before
4 forming a judgement on the inflation levels.
(viii) Savings and investment—this is that portion of the GDP which is saved and
then invested. The savings rate in India is about 25% of the income. Need-
less to say, the higher the level of savings and investment (other things being
equal), the more favourable it is for the economy as well as the stock mar-
ket.
(ix) Agriculture and monsoons—agriculture still accounts for a major chunk of
the Indian economy and has both direct and indirect linkages with the in-
dustry. Companies using agricultural raw materials as inputs or compa-
nies which supply inputs to the agriculture sector are directly affected by the
state of agricultural production.
Agriculture in India, on the other hand, is still heavily dependent on the mon-
soons. As a result, a spell of good monsoon indicates good agricultural produc-
tion, which in turn, provides impetus to the industrial sector. Similarly, a bad
monsoon is an indication of poor agricultural and even poor hydel power pro-
duction, which further dampens the industrial sector production.
(x) Infrastructure—an economy’s growth is directly related to the state of the
infrastructural facilities available to its industries and citizens. For exam-
ple, adequate and regular supply of electric power, well-developed trans-
portation and communication systems, stable and assured supply of in-
puts, responsive and assured supply of financial support, etc. are helpful in
growth.
(xi) Fiscal and monetary frameworks—the key aspects of the fiscal and mone-
tary frameworks adopted by the government and impacting the economic
scenario are:
– The size of the budget and its key components;
– The size of the budgetary surplus or deficit;
– The level of internal and external debt;
– The balance of payments position;
– The tax structure;
– The money supply;
– The interest rate structure and credit policy.
121 4
Though it may be difficult to assess how each of these aspects impacts different
industries in one go, investment analysts may consider certain aspects favourable
and unfavourable.
► Example
Analysts may consider a reasonably balanced budget favourable over one with a very
high surplus/deficit; a comfortable level of debt (in terms of serviceability) favourable
over one which is very high/low; a satisfactory balance of payments situation favour-
able over an unsatisfactory one; a tax structure which encourages savings and invest-
ments favourable over one which discourages savings and investments; a money supply
which ensures inflation stays within permissable limits favourable over one which re-
sults in high inflation; a stable and balanced interest rate structure favourable over one
which is volatile; a credit policy which accommodates and responds to reasonable busi-
ness demands favourable over one which is unresponsive. ◄
4.2.1.4 Economic Forecasting
Definition
Economic forecasting is the process of predicting the future demand/supply pattern
of any economic event and/or investment.
Since it is based on the future, time becomes a relevant consideration.

Based on the same, forecasting is generally of three kinds:
(i) Short term (1–3 years)—this kind of forecasting is aimed at the short term,
viz., the next 1–3 years. Typically, this kind of forecasting would incorporate
any short-term aspects that would impact the future of the business, like raw
material prices, labour shortage, a downturn in the industry, a legal dispute,
etc. Such events would generally be resolved within the short-term and not
impact the long-term prospects of the company. The forecaster, based on
such aspects, predicts the performance of the company’s stock over the next
few years.
(ii) Medium-term (3–5 years)—aimed at the medium-term, this kind of forecast-
ing incorporates any changes/events that may impact the company over the
next 3–5 years; for example, a change in government policy, a new competi-
tive product available in the market, change in consumer tastes and prefer-
ences, innovations in technology, etc. The forecaster, based on these events,
predicts how the company’s future would shape up over 3–5 years.
(iii) Long term (5–30 years)—this kind of forecasting takes a long-term perspec-
tive of more than five years and can go up to 30 years depending on the in-
dustry.
► Example
In the aircrafts manufacturing sector, Boeing and Airbus would be interested in know-
ing how the transportation sector would shape up over the next few decades, so that
they can plan their production accordingly. Products like aircrafts and ships take many
years to manufacture and also entail substantial costs. Forecasting the consumer pro-
pensity (across the world) for air travel, over the next 20–30 years, would be crucial
for their future plans. This would also depend on various economies and their com-
mitment towards the infrastructure required to enable efficient air travel. Hence, here,
4 the forecaster would consider all these aspects to predict the future of the aviation sec-
tor over the long term. Further, the COVID-19 pandemic that has disrupted air travel
across the world would affect such long-term forecasts drastically and should be kept
in mind. ◄
> It is important to note here that in today’s turbulent world, especially in the
light of the recent and still ongoing COVID-19 pandemic, taking a very long-
term perspective may not be the best idea as the situation may not remain the
same as predicted earlier. Economies and countries face countless changes
and challenges, and therefore, it may be prudent to adopt a short-term per-
spective and maintain flexibility/agility in one’s approach towards the future
and also towards one’s investments.
Forecasting Techniques
There are broadly five forecasting techniques:
(i) Surveys—carried out through various methods and channels, a survey is ba-
sically an investigation into consumer preferences and opinions, in order to
predict future demand or even to incorporate improvements in the existing
product and/or practices. Common surveys often conducted around us in-
clude census, opinion polls, customer feedback, online questionnaires, mar-
ket research surveys, etc.
(ii) Economic indicators—an economic indicator is a statistic reflecting an eco-
nomic activity. Taken together, economic indicators like, GDP, CPI, unem-
ployment rate, Internet penetration, etc. may help an analyst piece together
a scenario for the future of a product/sector/economy. Such indicators also
help in predicting and understanding business cycles in any economy.
(iii) Diffusion indices—used typically by technical analysts (analysts who study
markets and price movements) diffusion indices help in ascertaining a posi-
tive or negative incline/decline in price levels. Though helpful in all markets,
diffusion indices acquire special meaning and utility in stock markets. Such
indices can be validated by the state of the underlying economy and its busi-
ness cycle, in the form of upswing or downswing or boom and slump.
(iv) Economic model building—an economic model is a theoretical construct rep-
resenting economic variables and processes.
123 4
► Example
A model indicating the measurement of inflation would include the variables affecting
inflation and examine how the changes in those variables would impact inflation. Since,
the underlying economic variables keep changing, economic models are typically dy-
namic models reflecting such changes. A deeper study into the field of economic mod-
elling is called econometrics. ◄
(v) Opportunities model building—also deployed in strategic management, this

approach builds on techniques like SWOT and PESTLE (political, eco-
nomic, social, technological, legal and environmental) to evaluate the over-
all economy’s strengths, weaknesses, opportunities and threats (SWOT) and
to examine the impact the PESTLE factors have on the SWOT; it helps in
developing a long-term perspective on the future of the economy and its un-
derling sectors.
After determining the economy’s potential opportunities and threats, it is neces-

sary to analyse the underlying industries/sectors which appear promising in the
coming years, and then, select companies from those industry groups.
> It is important to note here that there may be almost no correlation between
the growth trends of the economy and the underlying industries and between
the growth trends of the industry and its underlying companies. An investor
should never assume that if an economy is performing well, all underlying in-
dustries would perform well, and vice-versa.
After analysing the economy, an investor can analyse the underlying industry/sec-
tor in order to determine potential sectors for investments.
4.2.2 Industry Analysis
This section presents the analysis and understanding of the industry of which
the company/ies (whose securities are a potential target for investment) is/are a
part.
4.2.2.1 Industry/Sector Classifications
Any industry can be classified on various parameters like size, ownership, nature
of product/commodity, nature of inputs/raw materials, life cycle stage, etc. Some
of the classifications are presented here:
Based on Size
Definition
(i) Micro-scale: defined, from time to time, by the government, micro-scale in-
dustry would comprise of small companies with investment in plant and ma-
chinery or equipment of not more than INR 1 crore and an annual turnover
of not more than INR 5 crores (as in 2020 according to the Ministry of Mi-
cro, Small and Medium Enterprises (MSME), Government of India (GoI),
4 (MSME 2020)).
(ii) Small scale: the small-scale industry would comprise of small companies with
investment in plant and machinery or equipment of not more than INR 10
crores and an annual turnover of not more than INR 50 crores (as in 2020 ac-
cording to the Ministry of Micro, Small and Medium Enterprises (MSME),
Government of India (GoI), (MSME 2020)).
(iii) Medium scale: these industrial units would comprise of medium-sized com-
panies with an investment in plant and machinery or equipment of not more
than INR 50 crores and an annual turnover of not more than INR 250 crores
(as in 2020 according to the Ministry of Micro, Small and Medium Enter-
prises (MSME), Government of India (GoI), (MSME 2020)).
(iv) Large scale: this industry type would comprise of companies with investment
in plant and machinery or equipment of more than INR 50 crores and an an-
nual turnover of more than INR 250 crores (as in 2020 according to the Min-
istry of Micro, Small and Medium Enterprises (MSME), Government of In-
dia (GoI), (MSME 2020)).
Based on the revised definitions, a substantial chunk of Indian companies now fall
under the MSME banner.
Based on Ownership
(i) Private sector—in the private sector, the majority ownership (more than 50%
shareholding) of the underlying companies is closely held by and vested in
the hands of certain private individuals/persons, who exercise complete
control over the business of the company. Such companies can be “fami-
ly-owned” as well, where members of a family control the management of
the company.
(ii) Public sector—in the public sector, the government owns the majority stake
in the underlying companies. It is responsible for the functioning of such
companies, as well. Such companies are also called public sector undertak-
ings (PSUs).
Based on Nature of Product/Commodity

(i) Basic—examples of basic industries include infrastructure, fertilizer, coal,
oil, cement, electricity, power, etc. Typically, such industries cater to the fun-
damental and basic requirements of any economy.
125 4
(ii) Capital goods—examples of capital goods industry include machine tools,
agri-equipment, railroad equipment, etc. Typically, such industries require
substantial investments and assets.
(iii) Intermediate goods—examples of intermediate goods industry include cot-
ton, tyres, batteries, etc. Typically, such industries provide intermediate raw
material to other industries; hence, they belong to the business-to-business
(B2B) sector.
(iv) Consumer goods—examples of consumer goods industry include FMCG,
consumer durables, automobiles, etc. Typically, such industries have retail
consumers as their market and belong to the business-to-customer (B2C)
sector.
Based on Nature of Inputs/Raw Materials

(i) Agro based—this industry would utilize agricultural commodities as its in-
puts/raw materials, for example, wheat to make flour, cotton to make textiles,
cocoa beans to make coffee, etc.
(ii) Forest based—this industry would utilize raw materials available in forests as
its input, for example, trees to make paper or furniture, rubber sap to make
rubber, etc.
(iii) Marine based—this industry would utilize animals and commodities available
in water bodies like rivers and oceans as its input, for example, fisheries, sea
shells to make jewellery, oysters for pearls, minerals, oil and natural gas, etc.
(iv) Metal based—this industry would utilize metals mined from the earth as its
input, for example, gold and silver to make jewellery, uranium to make nu-
clear weapons/power reactors, aluminium to make equipment, etc.
(v) Chemical based—this industry would utilize chemicals as its input, for exam-
ple, pharmaceuticals, cosmetics, processed foods, etc.
Based on Lifecycle Stage

(i) Pioneering stage (infant industry stage)—such industries typically exhibit
high growth trajectories accompanied by characterized by super normal
(above average expected) profits.
(ii) Expansion stage—such industries are characterized by changes/expansion in
technology and development, increase in assets and market shares, etc.
(iii) Maturity stage—such industries, mostly, have reached their maturity and are
commanding a large market share. They have few growth opportunities left
and are sitting on vast reserves of idle cash; hence, they are also character-
ized as “cash cows”.
(iv) Decline stage—such industries are in declining phase after having attained
maturity, perhaps, due to changing technology and/or better competitive
products available in the market, that are eating into the industry’s market
share.
Wherever possible, identify companies in your country or from across the world, as
examples of each industry classification. One company can be classified under more
than one classifications.
4.2.2.2 Key Factors to Be Examined

Some of the key factors to be examined (through the following indicative ques-
tions), for any industry classification, are:
5 Past sales and earnings performance—what has been the past track record of
the industry in terms of average sales and earnings? Is the industry projected
to maintain its past performance or is it capable of expanding further?
5 Stage of growth of the industry—is the industry in its nascent stage with a
small, growing market or is it a large, established industry?
4 5 Government policy towards the industry—is the present government policy fa-
vouring the industry? Is the government policy projected to remain the same
in the future or is it likely to change? How would a change in the government
policy affect the future of the industry?
5 Labour conditions—what are the labour conditions in the industry? Is it labour
intensive? Is it prone to strikes/lockouts? Are there large labour unions?
5 Competitive conditions—does the industry face stiff competition? Is the indus-
try an established one? Are there new entrants being allowed into the domes-
tic economy due to liberalized legislation (e.g. allowing 100% foreign direct in-
vestment (FDI) in the retail sector)?
5 Industry vitals—what are the industry vitals in terms of statistics regarding
average share prices and average earnings per share (EPS)? What is the rela-
tive EPS when compared to other sectors/industries in the economy? What is
the growth rate of the sector and how does it compare with the other sectors’
growth rates?
Concept in Practice 4.1: Stock Returns in India based on Disaggregate/Classi-

fications like Age, Size, Ownership Structure and Underlying Sector/Industry
The authors of this book conducted a study on equity returns, risk and price mul-
tiples in India for the period 1994–2014 (Singh et al., 2016). These findings are
taken from the same to illustrate the role firm disaggregates like age, size, owner-
ship structure and underlying sector play on stock returns, in India. Overall, the
returns vary along with various segregates, providing the investors diversification
opportunities, based on the same. A negative correlation appears between the age
of companies and returns (younger, growing companies yield higher returns). Fur-
ther, small and medium-sized companies yield higher returns compared to their
large counterparts.
The ownership structure of the Indian corporates is dominated by “family-owned”
businesses and their average returns are also the highest. Amongst the PSUs, the high
kurtosis figures indicate that the returns are high for only a small number of PSUs.
The “non-PSU/non-family” segment has the lowest returns. Therefore, they appear
unattractive, as an investment choice. The “family-owned” and “PSU” ownership
segments thus, not surprisingly, continue to be popular choices for equity investors.
Amongst the underlying sectors, the “transport” and “infrastructure” sectors re-
corded high returns. There is evidence of high volatility (standard deviation, var-
iance and coefficient of variation) amongst the sectors. However, relatively low
skewness figures indicate a near normal distribution of returns, within the sectors.
127 4
However, considering the substantial volatility present in all segregates, investors

would do well to analyse each company both fundamentally and technically, for
possible risk considerations, before investing.
* For more details, please refer 7 Chap. 5 of Singh et al. (2016).
4.2.2.3 Industrial Legislation
The Industries (Development and Regulation) Act (IDRA) of 1951 legislates the
industrial development in India. The government, from time to time, charts the
future course of industrial development in the country, through the Industrial
Policy Resolution passed by the Parliament.
The Department of Public Undertakings (DPE) presents guidelines for gov-
ernance of the public sector undertakings. The Competition Commission of In-
dia, set up under the Competition Act of 2002, monitors and regulates the level
of competition in different sectors in India.
Examples of Industry Analysis
Examine the indicative . Table 4.1 presenting the financial aggregates for the cement
industry in India, divided into two regions. The accounting terms used here would be
familiar to finance students and academics. For the readers who do not possess a back-
ground in finance, the terms used and their meanings are presented as notes to the table.
On careful examination of the variations in the financial aggregates of the sector, over
the two years, attention is drawn to the variation in interest payments (highlighted in
bold) over the period, for the north Indian region. What does it indicate? As may be
evident, this could be an indication of lowered interest costs, and hence, decrease in the
average leverage and gearing in the sector, by the underlying companies in that region.
This could be a result of efficiency in capital structuring (financial capital employed in
the company) and better sourcing and utilization of funds. And therefore, an investor
exploring investments in the cement industry may like to focus on the companies resid-
ing in the north Indian region, as they appear to be more efficient. Their net profit is
higher too.
As another example, consider the indicative . Table 4.2 presenting the financial aggre-
gates for the software industry in India.
On examination of the variations, it is evident that the operating profit for the sector
has decreased by 10% (highlighted in bold) over the two years’ period. The investor
would do well to investigate the reasons behind such a decrease for the sector, in order
to ascertain whether the causes are temporary in nature or do they indicate a long-term
decrease in profitability for the sector.
These are just some examples of how data, and variations therein can be probed/ana-
lysed to form an opinion about the company as an investment choice.
4.2.2.4 Factors Affecting the Future Performance of the Industry

Along with the factors considered in . Tables 4.1 and 4.2, a similar kind of anal-
ysis can be undertaken to study the other important aspects of the industry that
could affect its future performance, for example:
4
. Table 4.1 Financial aggregates of cement sector in India
128
Cement sector aggregates figures in INR crores

Region North India South India All India
Year 2018 2017 Variation % 2018 2017 Variation % 2018 2017 Variation
%
Sales 7199 5935 21 2056 1445 42 9255 7380 25
Operating 32.6 32.2 – 33.7 31.6 - 32.9 32.5 –
profit margin
(OPM) (%)
Operating 2349 1911 23 693 457 52 3042 2368 28
Chapter 4 · Fundamental Analysis
profit
Other incomes 144 59 144 87 58 50 231 117 97
Profit be- 2493 1970 27 780 515 51 3273 2485 32
fore deprecia-
tion, interest
and taxes (PB-
DIT)
Interest 36 111 − 68 78 72 8 114 183 -38
Profit be- 2457 1859 32 702 443 58 3159 2302 37
fore deprecia-
tion and taxes
(PBDT)
Depreciation 281 259 8 100 68 47 381 327 17
Profit before 2176 1600 36 602 375 61 2778 1975 41
taxes (PBT)
(continued)
Cement sector aggregates figures in INR crores

Region North India South India All India
Year 2018 2017 Variation % 2018 2017 Variation % 2018 2017 Variation
%
Tax 632 423 49 140 72 94 772 495 56
Cash profit 1825 1463 27 562 371 51 2387 1807 32

Net profit 1544 1177 31 462 303 52 2006 1480 36
Note
– Sales represents the sales revenue,
Operating profit margin is a ratio determined by dividing the operating profit by the sales. It is then multiplied by 100 to get a percentage. It is an indication of
the margins/returns emanating from the operations of a company vis-à-vis its sales
– Operating profit, also called earnings before interest and taxes (EBIT), can be computed as sales less cost of goods sold, administrative and marketing expen-
ses (basically all manufacturing and operating expenses)
– Profit before depreciation, interest and taxes (PBIDT) denotes the sum of operating profit and other incomes
– Other incomes may include income from other sources (not from the main operations) like interest or dividend income on investments
– Profit before depreciation, interest and taxes (PBIDT) denotes the sum of operating profit and other incomes
– Interest denotes the financing cost of debt capital employed in the company. It is allowed as a tax-deductible expenditure by the income tax authorities
– Depreciation is an accounting treatment which allows companies to write-off a portion of their assets, as a tax-deductible expenditure, each year. Please note
that it is simply an accounting treatment and no cash outflow takes place
– Profit before taxes (PBT) is PBDT less depreciation
– Tax indicates the income tax levied on the company
– Cash profit is the net profit plus depreciation
129
– Net profit is PBT less tax. This is the indication of the net income of the company
4
. Table 4.2 Financial aggregates of software sector in India
Software sector aggregates Figures in INR crores

2018 2017 Variation %
Sales 23,586 23,465 1
Operating profit margin (OPM) (%) 21.2 23.7
Operating profit 4989 5563 −10
4 Other incomes 919 623 48
Profit before interest, depreciation and taxes (PBIDT) 5903 6185 4
Interest 84 82 3
Profit before depreciation and taxes (PBDT) 5824 6103 − 5
Depreciation 706 699 1
Profit before taxes (PBT) 5117 5404 -5
Tax 586 555 6
Cash profit 5238 5548 − 6
Net profit 4531 4849 − 7
5 Growth rates of fixed assets or total assets—to ascertain growth in the sector.
5 Activity and liquidity ratios—activity ratios measure the level of activity and
efficiency of a business entity’s operations. Naturally, the more active a sec-
tor, the more likely it is to grow and be profitable. Liquidity denotes the abil-
ity of a business entity to meet its short-term financial obligations. It is use-
ful to bear in mind that a business entity/sector can legally come to an end
if it defaults on its short-term and/or long-term financial obligations. The set
of ratios that measure the ability to service long-term financial obligations is
called solvency ratios. A set of select ratios and their significance is presented
in . Table 4.3.
5 Profitability ratios and profit allocation ratios—to ascertain the profitability,
and hence, the potential returns emanating from the sector. Further, through
the profit allocation ratios, to analyse the retentions as an indication of
growth in the sector.
5 Product line—to ascertain the products sold by the industry and the margins
provided by and costs incurred for the sales of such products.
5 Raw material and inputs—to ascertain the nature of raw materials and other
inputs used in order to understand whether and how a change in the supply of
such inputs would (if at all) impact the future of the sector.
5 Capacity installed and utilized—to ascertain the level and efficiency of opera-
tions in the sector and to enable comparisons with similar sectors, across the
world.
5 Industry characteristics—to ascertain the peculiarities (if any) present in the
sector that differentiate the sector from other sectors or from similar sectors,
across the world.
131 4
. Table 4.3 Financial ratios and their significance
Profitability/return Formula Significance

ratios
Earnings per share Profit after-tax less pref- The higher the better in terms of returns
(EPS) erence dividends (if any)/
number of outstanding
equity shares
Book value per (Paid up capital + reserves Indicates the asset backing per share Higher
Share or net worth and surplus − accumu- the better
per share lated losses (if any))/num-
ber of outstanding equity
shares
Return on equity Profit after-tax less pref- This is the measure of the returns for the
(RoE) or return on erence dividends (if any)/ owners. Higher the better
shareholders’ funds (equity capital + reserves
and surplus − accumu-
lated losses (if any))
Price to book ratio Market price per share/ If the market price is higher than the book
(P/B ratio) book value per share value, it indicates overvaluation and vice-
versa
Price to earnings Market price per share/ This indicates the earnings multiple in terms
Ratio earnings per share of the prevailing price as a multiple of earn-
(P/E multiple) ings. Indicates over/under valuation
Gross profit Mar- Gross profit/Sales Both ratios indicate profitability. Hence, the
gin (GPM) & and Net profit/Sales higher, the better
net profit margin
(NPM)
Dividend/pay out Dividends paid per share/ Indicates the payment and distribution of
(D/P) ratio Earning per share dividends
Compound an- (Sales for the ending year/ Growth in sales over a period
nual growth rate sales for the beginning
(CAGR) of Sales year)1/n
CAGR of EPS (EPS for the ending year/ Growth in EPS over a period
EPS for the beginning
year)1/n
Volatility of RoE Range of RoE over a pe- Indicates the risk exposure in the returns of
riod/average RoE for the the equity owners
period
Beta Covariance of a securi- A measure indicating how sensitive the re-
ty’s returns with the mar- turn on the stock is to variations in the un-
ket returns/variance in the derlying market’s return. Indicator of sys-
market returns tematic (market) risk
(continued)
Liquidity Ratios Formula Significance

Current ratio (CR) Current assets/current li- Current assets represent the assets that can
abilities be converted into cash within an account-
ing period (typically one year), for exam-
ple, cash, and bank balance, inventory, debt-
ors, etc. Similarly, current liabilities represent
the liabilities that have to be paid off within
4 an accounting period (typically one year),
for example, creditors, salaries payable, etc.
Higher the CR, greater the liquidity
Acid-test ratio (Current assets − Invento- More rigorous than CR. It removes inven-
(ATR) ries − Prepaid expenses)/ tory and prepaid expenses from the current
current liabilities assets as they may not provide liquidity as
quickly as the other current assets
Debtors turnover Net credit sales/average Debtors are those customers who have re-
ratio (DTR) debtors ceived the products/services but are yet to pay.
A high DTR indicates efficiency in collections
Debtors collection (12 months/365 days)/ Indicates the debtors’ collection period in
period DTR days
Creditors turnover Net credit purchases/aver- Creditors are those suppliers who have sup-
ratio (CTR) age creditors plied material/services to the company but
have not been paid
Creditors payment (12 months/365 days)/ Indicates the creditors’ collection period in
period CTR days
Inventory turnover Cost of goods sold/aver- Indicates the efficiency of the operating cycle
ratio (ITR) age inventory of the company in terms of turning over in-
ventory into sales
Inventory holding (12 months/365 days)/ Indicates the holding of the inventory. A
period ITR high number indicates inefficiency
Solvency ratios Formula Significance
Interest coverage Earnings before interest Indicates the ability to pay interest charges.
ratio and taxes (EBIT)/interest Higher the better
Debt service cover- (EAT + interest + depreci- Indicates the ability to pay instalment
age ratio (DSCR) ation + amortization)/in- charges. Higher the better. Instalment = inter-
stalment est + principal
Total debt to total Total debt (including cur- Indicates the proportion of assets financed
assets ratio rent liabilities)/total assets by debt
Total equity to to- Total shareholders’ funds/ Indicates the proportion of assets financed
tal assets ratio total assets by equity
Total debt to total Total debt/total share- Indicates the proportion of debt versus eq-
equity ratio holders’ funds uity in the capital structure. A high ratio in-
dicates financial risk
Efficiency/activity Formula Significance
ratios
Fixed assets turno- Cost of goods sold/aver- Indicates the productivity of the fixed assets
ver ratio (FATR) age fixed assets deployed in generating sales
Total assets turno- Cost of goods sold/aver- Indicates the productivity of the total assets
ver ratio (TATR) age total assets deployed in generating sales
133 4
5 Demand and market—to ascertain the available demand and market for the in-
dustry and to link it to forecasted future demand, to estimate the growth po-
tential of the industry.
5 Management—to ascertain the quality of the management available in the sec-
tor and the effectiveness of the strategies they adopt for the future.
5 Future Prospects—to ascertain the level of research and development in the
sector and the innovations slated to hit the market in the future, as an indica-
tion of the future prospects available for the industry.
Based on the aforementioned analysis, once an outlook of the industry has been
obtained, the next step involves the analysis of the underlying companies (in that
sector), in order to arrive at the company which is fundamentally strong and a
potential investment choice.
4.2.3 Company Analysis
Company analysis involves the study of the vitals of a company which include:
5 Financial/profitability aspects
5 Operational aspects
5 Efficiency aspects
An analyst will try to calculate the intrinsic (inherent) value of the stock of the
company (based on the vitals) in order to come to a conclusion whether the stock
is over or undervalued (when compared to the prevalent market price). Intrinsic
value of a stock means that value which is justified by the fact of assets, earnings
and dividends of that company. To arrive at the intrinsic value, the analyst will
have to project the future earnings per share (EPS) for the company and discount
them to the present value, which provides the intrinsic value of shares. Alterna-
tively, he/she may take the expected EPS and multiply it with the industry average
price/earnings (P/E) multiple.
4.2.3.1 Financial Analysis
Financial analysis entails the scrutiny of the financials of a company to assess
its financial health and the effectiveness of its management. Financial statement
analysis (FSA) involves an analysis of the financial statements of a company to
ascertain its current position and the reasons behind the same.
Components of financial statements are the profit and loss (P&L) accounts,
balance sheet, cash and fund flow statements, etc. Under the revised Clause 49
(now the Listing Obligations and Disclosure Requirements (LODR)) on corpo-
rate governance, all listed companies have to mandatorily disclose their financial
statements for the past ten years, on their websites.
Analysis and Interpretation of Financial Statements

An investor would do well to compare the financial statements over at least
five years. Further, he/she can (i) compare one year’s financials with other years;
(ii) budgeted figures with the actual; (iii) conduct an inter-products comparison;
and (iv) conduct an inter-firms comparison.
The investor should also conduct ratio analysis for at least five years, to as-
certain the liquidity, efficiency, solvency and profitability of the company; funds
flow analysis for a shorter period, to ascertain the sources and usage of funds by
the company; and, trend analysis over a period of 5–10 years, to ascertain the
growth trajectory of the financial performance of the company. Broadly, an inves-
tor would be interested in determining the (a) earnings level, (b) growth rate and
4 (c) risk exposure, if he/she decides to invest in a share.
. Table 4.3 provides some of the ratios, which can be considered in the analy-
sis and their significance.
> Please note that the ratios contained in . Table 4.3 are just an indicative list of
ratios used in financial statement analysis. There are many more ratios that are
computed under each bucket of ratios. Databases like Bloomberg®, Prowess®,
Thomson Reuters® and even the annual reports of all listed companies pro-
vide these ratios. Hence, calculations of such ratios are not the problem in com-
pany analysis; the appropriate and meaningful interpretation of these ratios is
the key to effective analysis.
For example, a company with a high earnings level, a high growth rate and low
risk exposure can be considered favourable for investment, if all other ratios
seem satisfactory.
Concept in Practice 4.2: Price Multiples and EPS for NSE500 Companies in
India
The authors of this book conducted a study on equity returns, risk and price multip-
les in India for the period 1994–2014 (Singh et al., 2016). The Indian economy ap-
pears to be led by more than six-tenths of the sample companies, with aggressive
(high) P/E ratios of more than 10. These are the growth stocks amongst the sam-
ple companies. Nearly, 15% of the sample companies have a P/E ratio of less than
5 as in 2014. This number has, however, come down substantially from more than
50% in 2001. Further, the market response to EPS growth is evident. This can be
regarded as a testimony of fundamentals applying in the Indian economy. Fun-
damental investors are doing and are likely to do well to identify the companies
which are better than average performers in terms of EPS growth over long peri-
ods and map them against their P/E ratios. The equity research should particularly
focus on EPS growth of companies, both at individual company level and portfo-
lio level.
However, the aspect that the sample companies also represent value stocks is
brought forth by the P/B ratios. Lower P/B ratios through the period of the study
are indicative of undervalued companies.
In sum, it appears that the Indian stock market provides returns to both funda-
mental (long-term) and technical (short-term) investors. It is an indication of the
breadth of the Indian stock market, in terms of presenting opportunities of in-
135 4
vestment to both kinds of investors. This is perhaps why the Indian stock market
continues to attract domestic as well as foreign capital market investments.
*For more details, refer 7 Chap. 6 of Singh et al. (2016)
4.2.3.2 Operational Analysis
Operational analysis of a company entails the scrutiny of its operations and ac-
tivities. The sources of information for the same could be.
Factual Disclosures by the Company

This can include disclosures made by the company to SEBI and the Company
Law Board; the Director’s Report that is an integral part of the annual report of
a company; energy conservation measures undertaken, technology development
and absorption, foreign exchange earnings and outgo, etc. (typically part of an-
nual report and/or sustainability report).
SEBI directives on reporting are aimed at:
5 Transparency—specific formats are to be followed by companies for their dis-
closures to ensure consistency and clarity;
5 Investor protection—quarterly results, major decisions of the board like merg-
ers and acquisitions (M&A), joint ventures, etc. are all a part of the manda-
tory disclosures, thus, ensuring that no vital aspect of the company’s opera-
tions remain hidden from anyone;
5 Accounting and auditing improvement—full disclosures in financial statements and
explanations in footnotes of the operational strategy behind the specific variables.
The annual report (AR) of any company is a virtual treasure trove of informa-
tion. It contains everything from the chairman’s (of the board) speech to the in-
vestors, the director’s report (detailing the corporate vision and strategy), balance
sheet and profit and loss account (income expenditure statement) for the year
(along with the notes), auditor’s reports, SEBI report (detailing the disclosures re-
quired by SEBI), credit ratings by independent credit rating agencies and market
reports by independent market research agencies.
Apart from this, independent consultants also provide sectoral reports in
which they highlight the underlying companies that are contributing towards the
growth of the industry. Associations like FICCI and ASSOCHAM may also pro-
vide information on companies. Business news channels and magazines may also
provide perspectives on a company and its future.
Estimating the Future Based on Current Operations

In order to size up the company’s current operations and future prospects, the fol-
lowing aspects may be examined:
(i) Available market and future demand—does the company have a stable mar-
ket share? Is it expected to grow? Who are its top customers? Are they loyal?
What is the level of competition in the market? Is it growing? What are the
substitutes available for the product? Are they cheaper/better quality?
(ii) Availability and cost of raw materials/inputs—does the company have ac-
cess to a cheap and stable supply of good quality raw material? How does its
sourcing of inputs compare with its competitors in terms of advantages/dis-
advantages?
(iii) Tax planning and accounting practices—how efficient is the tax planning of
the company? Does it attract penalties on tax payments on a continual ba-
sis? How sound are the accounting practices? Is the company able to use
the most efficient method of inventory costing, etc. so as to add to the bot-
4 tom-line (profitability)?
(iv) Corporate governance—how is the company governed? Is there a conflict be-
tween the management and shareholders? Does it comply with the regula-
tory framework concerning corporate governance in terms of board of di-
rectors, audit committee, related party transactions, etc.?
(v) Technology and production capabilities—what is the level of technology used
by the company? Is its product a new innovation and/or does it provide a
competitive edge to the company? What is the state of production facili-
ties—is it manual or machine intensive? What does it mean for the future of
the sector?
(vi) Marketing and distribution—how robust are the company’s marketing and
distribution networks? Does its supply chain provide the company a compet-
itive advantage? How valuable is the company’s brand in the market?
(vii) Product line/range—How large and effective is the company’s product range?
Is it able to satisfy the customer requirements through its own products
(one-stop shop) or do the customers need to seek their competitors out for
the fulfilment of the product related needs?
(viii) Human Resources—how competent or skilled is the workforce? Is the com-
pany able to attract the best talent in the market? What is the attrition rate in
the company and why? What is the level of employee motivation and morale?
4.2.3.3 Efficiency Analysis
Efficiency denotes the way in which a company produces its output vis-à-vis its
inputs. The inputs could be in terms of material, time taken, cost, etc. If a com-
pany can produce higher output while using the same inputs compared to an-
other company, it is said to be more efficient. Likewise, if a company can pro-
duce the same output while using lesser inputs compared to another company, it
is considered more efficient. An investor would be interested in identifying a com-
pany which is efficient as it would indicate a better utilization of his/her invest-
ment. Efficiency can manifest itself in various ways in a company.
Aspects to Consider in Efficiency Analysis

Here are some aspects and questions an investor can seek the answers to, in order
to ascertain the level of efficiency. Of course, it is important to compare the effi-
ciency of a company vis-à-vis its competitors to identify the “best pick”.
(i) Efficiency of capital use—is the company utilizing the capital at its disposal
or is it sitting on a large amount of idle cash?
137 4
(ii) Productivity of total capital employed—even if the company is utilizing all of
its available capital, are the operations productive? Is the return on the total
assets higher than its competitors in the sector?
(iii) Growth of assets and capacity utilization—is the growth in the assets of the
company commensurate with the lifecycle stage of the company? Is the com-
pany able to utilize capacity or is its capacity lying idle?
(iv) Sales turnover and operational efficiency—how fast is the company able to
convert its finished goods into sales? Is the supply chain efficient or does it
take an abnormally long time for the product to reach the consumer once it
has left the factory?
(v) Profitability of operations—needless to say, the profitability of operations is
a key determinant of future returns. However, how does the profitability of a
company compare to, not just its competitors, but also the other sectors? If
other sectors provide the same profitability/returns compared to this sector
at a lower risk, then the investor should shift focus. Further, is there growth
in the profitability or is it stagnant? A major area of concern is, are the prof-
its sustainable?
(vi) Growth in return on capital employed (RoCE)—what are the returns recorded
by the company on the capital employed? Another aspect that is gaining cur-
rency is the economic value added (EVA) of a company; it is a measure of
its earnings after it has paid off both the cost of debt and the cost of equity.
What is the EVA? A positive EVA is an indication of a sound and profitable
business.
(vii) Expansion plans and internal reserves built up—what is the status of the re-
serves built up over the past, by the company? Are they being applied appro-
priately to fuel growth and expansion plans? If the company does not have
adequate expansion plans, is it maximizing the wealth of its shareholders by
giving dividends?
Once an investor has conducted the E-I-C analysis, he/she may be able to classify
companies on the basis of their potential for investment.
4.3 Classification of Companies’ Stock from an Investment

Perspective
(i) Growth shares—growth shares would indicate the shares/stock of a company
which is expanding its operations, has been performing well consistently, is
managed efficiently and exhibits a stable and increasing dividend trend over
years (in case the company pays dividends). Example of such stock can be
technology stocks.
(ii) Cyclical shares—such companies are fundamentally strong but their sales/
profitability is affected by business cycles. As a result, they report substan-
tial profits or poor results depending on the underlying business cycle; hence,
their share prices follow the pattern of the business cycle. Examples of such
stocks can be consumer durables, fashion accessories, etc.
(iii) Defensive shares—generally, such shares have stable prices and the issuing
companies pay regular dividends. Further, these companies are large com-
panies with stable earnings and have typically reached the maturity stage of
their lifecycle. As a result, the do not have high growth potential but provide
stable and low returns. Examples of such companies can be large PSUs.
(iv) Discount shares—the share prices of such companies may be low at present
but they have a lot of potential for growth in the future. Such companies are
usually undervalued with low P/B ratios.
4 (v) Blue-chip companies—as the name suggests, these companies belong to the
expanding and growing industries. They are typically market leaders and
have the capacity to diversify. Management outlook is dynamic and aggres-
sive and such companies exhibit a commitment to research and develop-
ment. Example of such a company is Reliance Industries, one of the largest
companies in India, in terms of market capitalization.
It is important to note that the market price formation process does not sim-
ply include the intrinsic value (fundamental value factors) but also the technical
(market) factors that affect the prices of a stock. Thus, the prevalent market price
is an indication of the fundamental factors as well as the technical factors. The
subsequent chapter will be dealing with technical analysis.
Concept in Practice 4.3: Returns and Risk for NSE500 Companies in India
The authors of this book conducted a study on equity returns, risk and price multip-
les in India for the period 1994–2014 (Singh et al., 2016).
The equity returns were computed for varying holding periods, viz., fifteen, ten,
five and one-year periods. Along with returns, other statistics, used to measure risk
or volatility, were also computed to present the overall picture of risk and return
emanating from the Indian equities. The returns for all periods average around 20%
which is encouraging. However, the volatility present in the short term (one-year
holding period) is substantially high (with a coefficient of variation of 213.43%)
indicating speculative forces at play. It is gratifying to note that such volatility de-
creases significantly as the holding period increases, the coefficient of variation de-
creases substantially to 15.64% for the fifteen-year holding period, indicating that
the market favours long-term investors.
It appears safe to assume that the Indian stock markets offer attractive returns
in the short-run as well as the long-run. However, it would be prudent to stay in-
vested for a longer period if the investor is risk-averse, as the volatility present in
the short-run may eat away into short-run returns.
Further, to get a complete perspective, equity returns were compared with long-
term and short-term debt returns (interest rates). In terms of after-tax returns and
liquidity, equity returns in India fare better than debt returns. However, in terms
of risk (volatility), debt returns provide a safer option. Further, the debt markets
provide recourse to the investor in terms of diversification when equity markets
are volatile, due to their continued stability.
4.3 · Classification of Companies’ Stock from an Investment Perspective
139 4
In sum, India appears to be an attractive investment destination for both the

risk-taking and the risk-averse investors. Indian companies are recording robust
growth in their profitability (Jain et al., 2013) and are going to be strong contribu-
tors to the overall economic growth and development of the country.
* For more details, refer Chapter 4 of Singh et al. (2016).
The following examples touch upon certain aspects considered with the funda-
mental analysis framework, in order to help the readers comprehend and get a
sense of the exercise of analysing a sector/company’s fundamentals. Examples 4.1
to 4.4 present small excerpts that help the reader analyse a sector/company based
on specific information. Example 4.5 presents a more detailed E-I-C analysis for a
specific company.
Readers should consider these simply as examples and not as recommendations
for investments.
4.4 Examples of Different Aspects of Fundamental Analysis
► Example 4.1: Analysis of Steel Sector in Hebei, China—Impact of Government

Policies (Economy)
“On Monday, August 7, 2017, the price of hot-rolled coil, a key steel product, surged
5% after the Hebei province announced new measures to limit steel production to half
of its capacity during the winter months”. Hebei accounted for nearly one-fourth of
China's total steel production in the first half of 2017 (CNBC, 2017).
China, in March 2017, announced plans to reduce steel production in the country to
tackle environmental pollution and excess supply. Accordingly, the plan was implemented
by Hebei Province of China, which is a leading producer of steel in the country. With the
reduction of supply, it was observed that there was a surge in stock prices of steel.
Apart from this, adverse effects were anticipated on allied industries like construction;
that was due to rise in their costs/expenditure on steel. This case of China’s steel in-
dustry also had global implications. The steel exports of other global players, like Tata
Steel, were on the rise. Such analysis of the conditions of an economy, industry and
company (E-I-C approach) is called “fundamental analysis”. It involves the analysis
of root causes, unlike technical analysis, where only the historic stock price trends are
used for future predictions. ◄
► Example 4.2: The Electric Vehicle (EV) Sector in India—Impact of Global Sectoral
Trends (Industry)
In the Indian economy, in recent times, companies engaged in the manufacturing of
electric vehicles are being highly valued due to the expectation that the global market
is moving towards electric vehicles (EV); hence, such companies and/or the EV sector
would do well in the coming future. For example, the share price of Ashok Leyland has
gained after announcing plans to produce EVs (Financial Express, 2018).
On the other hand, oil companies in the international markets are being treated cau-
tiously as price increases in oil (which is considered positive for an oil company) may
prove its nemesis, as higher oil prices will make EVs more economical. ◄
► Example 4.3: Analysis of Price Multiples of Microsoft.

Microsoft’s (US) stock is traded on NASDAQ and the stock price per share on Octo-
ber, 22, 2017, was $78.81. Although Microsoft’s stock has never been a hyper-growth
stock like those of Facebook, Netflix, Amazon, Google, etc., the transformation which
4 is taking place under its new CEO’s leadership, and the company’s focus on artificial
intelligence (AI) and cloud computing, appears promising. The cloud business of Mi-
crosoft grew by 97% in year on year (YoY) in the fourth quarter (Q4) of 2017, one of
the fastest growing public cloud businesses.
Credit Suisse predicts “Our outperform thesis on Microsoft shares is centered on what we
view as significant earnings power potential over the next few years” (CNBC, 2017).
Probably as a result of this positive news, the average P/E ratio of Microsoft was 27.50
(in 2017), 40% higher than the Standard and Poor’s (S&P) 500 (an index of the top 500
companies in the USA) average based on past twelve months, which indicates that the
stock was overvalued. The P/B ratio was 6.2, whereas industry average was 4.9, which
again indicates that the stock is overvalued.
Similarly, any company that has similar P/B ratios can be considered overvalued. ◄
► Example 4.4: Fundamental Analysis of Engineers India Limited (EIL)

Engineers India Ltd. (EIL) is the largest engineering consulting firm in India and one
of the leading players in south-east Asia. It provides engineering solutions and consul-
tancy services to the hydrocarbon industry throughout the value chain and has also ef-
fectively diversified into potentially high growth sectors like infrastructure, fertilizers,
nuclear power, water and sanitation, etc. EIL is a public sector firm under the adminis-
trative control of the Ministry of Petroleum & Natural Gas, with the government hold-
ing approximately 59% of the shares. From an investor’s perspective, the fundamental
analysis of EIL has been carried out with objective of determining its potential of pro-
viding good returns on investments.
Economy Analysis.
The demand for petroleum products in India has continuously been on the rise. The
gradual adoption of electric vehicles (EVs) in the mainstream market has failed to
dampen the consumption of petroleum products. While this trend may be correct for
a short term, in the long run, there is a fair chance that the demand for electric vehicles
would rise, thereby reducing dependence of petrol/diesel as the primary auto fuel.
This would lead to lesser number of refineries being built and would affect EIL at its
most profitable area. Since this effect is not perceived to happen in the near future, EIL
would continue to maintain its position and keep growing incrementally. Though we
have witnessed a decline in oil prices, experts suggest that India and other developing
countries have a horizon of at least 30–40 years before EVs and alternate energy would
drive the economy. So, EIL and similarly placed companies shall continue to do well
in the near future and, with diversification into related sectors, can enjoy success in the
long run too.
4.4 · Examples of Different Aspects of Fundamental Analysis
141 4
Industry Analysis.
EIL is a publicly owned enterprise with the Government of India as the main pro-
moter. It can be categorized as a medium-size company which operates mainly in the
basic requirements of energy, infrastructure, fertilizers, etc. This indicates that the
long-term operations and sustainability of EIL should not be a major concern as de-
mand for basic necessities shall continue to exist in case of developing countries. EIL
is a consulting and services driven company with no manufacturing operations. This
makes the company quite nimble that way, should the market demand it to shift focus
to a different sector for a limited or a prolonged period.
The company is already more than half a century old in business. It can be consid-
ered to be in the maturity stage. The growth rate has more or less saturated presently as
the petroleum refining sector is not witnessing mega investments on a continual basis.
Rather, the need for setting up value added products like petrochemicals is being rec-
ognized now. This also offers a good scope for EIL to leverage its expertise. The energy
consulting sector in India comprises of around 4–5 main players. The level of debt for
companies in the consulting domain is low as these companies do not engage much in
capital investments and are more service oriented.
Company Analysis
The financial/efficiency analysis of EIL reveals that EIL has consistently been record-
ing substantial net profits after taxes. The financial statements reveal a sound finan-
cial health of the company. The profits, though not exceptionally high as compared
to other manufacturing/production firms, are nonetheless significant since there are no
debts to be repaid. The main expenses of EIL are towards employee remuneration and
benefits and maintenance of existing assets in the four metros (Delhi, Mumbai, Cal-
cutta and Chennai) and at Vadodara. The turnover of EIL is from consultancy and
other engineering and construction assignments from a range of clients. A comparison
of the profit and loss (P&L) statements from 2000 onwards indicate a steady increase
in turnover and net profits till 2012, followed by a sharp decrease in profits in 2012 due
to poor market conditions which translated into reduced order inflows to the company.
The next couple of years also saw decreased profits as EIL was forced to cut down on
margins to bag assignments, due to increased competition and lower investments by
the clients. However, 2015 onwards, an increase in turnover and profits is again noticea-
ble and going by the order book figures, growth in profits is sustainable for the next few
years.
Operational Analysis
EIL is listed with both the Bombay Stock Exchange (BSE) and the National Stock Ex-
change (NSE) and complies with the procedures laid down by SEBI for corporate gov-
ernance. All factual and mandatory disclosures to SEBI and the Company Law Board
are provided by the company in the form of various reports, coordinated through the
company secretariat. There have been no incidents of misrepresentation/non-disclosure
of fact and the records have been clean as on date.
Profitability Analysis
The EPS, when compared for the last five years (2013–2018), indicates a decreasing
trend from 18.6 to 4.2. This is primarily because there have been two follow-on pub-
lic offerings (FPOs) issued by EIL to increase the shareholder base, which brings down
the EPS. Also, there have not been any exceptional incidents in the industry or the
company that would prop up the share prices; hence, the constant drop in EPS values.
EIL has a P/E ratio of around 29.9, which is relatively high suggesting that the shares
may be overvalued, which would make investors a bit wary (Equity Master, 2017). ◄
Points to Ponder Over 4.1: Investment Lessons from Warren Buffet

4
Warren Buffet is considered as the most successful fundamental investor of all

time. His fundamental analysis approach involves monitoring all the information
available for a company, and, taking a note of all the factors that have an influence
on them, be it at the economy, industry or company level. This helps in determin-
ing the present value of the stock and also predict its future prospects, based on the
underlying fundamentals.
Another key aspect of the fundamental analysis approach by Warren Buffet is the
“buy and hold” strategy wherein an investor needs to stay invested for the long
term to obtain any significant returns from the market. He/she shouldn’t panic
when the markets are not doing well and the prices have gone down. In fact, as per
him, such a time is the best time to invest, because if the fundamentals of a com-
pany are strong, it is bound to bounce back in the long run.
(Source: Business Insider, 2018).
4.4 · Examples of Different Aspects of Fundamental Analysis
143 4
Concept in Practice 4.1: Multi-baggers

There have been investments in stocks that have recorded multifold growth in the
last decade (2005–2015), indicating that a single stock with good fundamentals can
change your investment fortunes.
. Table 4.4 presents some stocks that turned out to be multi-baggers (stocks whose
prices have risen multiple times their initial values) in the Indian stock market over
the period 2005–2015.
. Table 4.4 Top 20 Multi-baggers in the India Stock Market (2005–2015)
Hence, as per . Table 4.4, any investor who had purchased these stocks in 2005
and held them till 2015 would have gained the above mentioned returns on his/her
investment.
4.5 Why Might Fundamental Analysis Fail to Work?
In spite of the best efforts of analysts, fundamental analysis may not yield the de-
sired expected returns. Some reasons behind the failure could be:
1. Influence of random events: Most of the important factors which would affect
the earnings in the future are essentially random projections. Even the util-
ity stocks considered stable have been victims of unpredictable events and un-
expected and unfavourable rulings by governments. The ongoing COVID-19
pandemic is a case in point.
2. Dubious reporting of earnings: “Creative accounting” procedures have caused
a lot of anguish to both security analysts and investors. Enron is a classic ex-
ample of inflated earnings reported through manipulations and creative ac-
counting. However, Enron is far from unique; there are several other compa-
nies who have constantly manipulated the market through dubious reporting.
3. Errors made by analysts: There is no simple formula to project earnings and

analysts spend days on a particular company studying past reports and future
prospects; however, sometimes, even the best of them become victims of hu-
man error and unforeseen situations, which lead to faulty projections.
4. Superficial analysis: The research may lack an in-depth analysis. Typically,
there are few reputed sources of information that everyone relies on. Very few
investors conduct their very own in-depth research from their investment’s
perspective.
4 5. Inadequate specialization: Most investment analysts claim to be experts in var-
ious domains. It is humanly impossible for a person to acquire the knowledge
and the ability to track a large number of sectors. As a result, a meaningful
depth of understanding in a sector is often not achieved.
> As a word of caution to the investor, remember that stocks of airlines, ho-
tels and tourism sectors, that were erstwhile growth sectors, became intrin-
sically weak and vulnerable during the ongoing COVID-19 pandemic. Their
fortunes would indicate a reversal only once the pandemic is over. Some com-
panies, within these sectors, may not be able to survive to see that day. An in-
vestor would do well to be agile and proactive in such turbulent times. Hence,
investment analysis is a dynamic evaluation of investment choices and may
call on a dynamic rebalancing/rejig of portfolios from time to time.
In a Nutshell
Fundamental analysis is a dynamic assessment of the intrinsic value of an eq-
uity/debt instrument. It requires an understanding of the economy, industry and
company (E-I-C) characteristics that affect the value of the stock. Ratios like the
P/E or P/B and their comparison with the current market price may prima-fa-
cie indicate over/under valuation. However, care should be taken, on the basis of
the E-I-C analysis, to validate the same (under/over valuation). It could be that a
company’s equity/debt instruments may be intrinsically strong/weak but the mar-
ket and investor conditions may be reflecting a price higher/lower than the same.
The behaviour of market prices and their trends is discussed in the chapter on
technical analysis. A prudent investor would use both the analyses to buy a stock
that is intrinsically strong but is currently undervalued in the market and sell a
stock which is overvalued by the market.
4.6 Conclusion
This chapter presents one of the two aspects of analysing a security. The funda-
mental analysis, as the name suggests examines the fundamental strengths and
weaknesses of the company and projects its future performance, based on the
overall industry and economic situation. The aspects considered under the eco-
nomic-industry-company (E-I-C) analysis are enumerated here.
Summary
145 4
Once a fundamentally strong security is identified, the next step becomes the
determination of the good time to buy/sell such a security (based on price pat-
terns and market movements). This analysis, called the technical analysis, is the
subject matter of the subsequent chapter.
Summary
5 A successful investment strategy would be based on the ability of the investor/
analyst to identify a security that can generate desired returns at an acceptable
level of risk.
5 Fundamental analysis is the process of evaluating a security by measuring its in-
trinsic value.
5 The E-I-C analysis involves a three-step examination: analysing the macro-eco-
nomic environment and developments, estimating the prospects of the indus-
try/sector to which the company belongs, and predicting the future (prospective)
performance of the company.
5 Some of the broad economic forces that impact investments are population, re-
search and technological developments, capital formation, natural resources and
raw materials.
5 The World Trade Organization (WTO), a multinational organization that over-
sees international trade, releases well-researched reports on world affairs. The
World Bank and its constituents also release extensive material on world affairs.
5 In India, associations like the Federation of Indian Chambers of Commerce
and Industry (FICCI) or the Associated Chambers of Commerce and Industry
(ASSOCHAM) or Confederation of Indian Industry (CII), release reports and
data on various industries and sectors operating in the economy.
5 Some of the economic indicators are gross domestic product (GDP), consumer
price index/wholesale price index (CPI/WPI), corruption index, foreign ex-
change reserves, consumer spending, industrial growth rate, inflationary trends,
savings and investment, agriculture and monsoons, infrastructure, and fiscal and
monetary frameworks.
5 GDP or gross domestic product is the sum of all products and services pro-
duced in the domestic economy, by the domestic factors of production, in a par-
ticular year.
5 CPI or the consumer price index is a measure of the rise in retail price levels (in-
flation) of a basket of commodities consumed by the average populace of an
economy/country.
5 There are broadly five forecasting techniques: surveys, economic indicators, dif-
fusion indices, economic model building and opportunities model building.
5 Techniques like strengths, weaknesses, opportunities and threats (SWOT) and
political, economic, social, technological, legal and environmental factors (PES-
TLE) help to evaluate the impact the PESTLE factors have on the SWOT of the
company.
5 The industry/sector classifications based on size are micro, small, medium and
large.
5 Micro-scale would comprise of very small companies with investment in plant

and machinery/equipment of not more than INR 1 crore and an annual turn-
over of not more than INR 5 crores; the small scale would comprise of small
companies with investment in plant and machinery/equipment of not more than
INR 10 crores and an annual turnover of not more than INR 50 crores; medium
scale would comprise of medium-sized companies with investment in plant and
machinery/equipment of not more than INR 50 crores and an annual turnover
of not more than INR 250 crores; and large scale would comprise of companies
4 with investment in plant and machinery/equipment of more than INR 50 crores
and an annual turnover of more than INR 250 crores (as in 2020 according to
the Ministry of Micro, Small and Medium Enterprises (MSME), Government
of India (GoI), (MSME, 2020)).
5 The industry/sector classifications based on ownership are private sector, public
sector and joint sector.
5 The industry/sector classifications based on nature of product/commodity are
basic goods, capital goods, intermediate goods and consumer goods.
5 The industry/sector classifications based on nature of inputs/raw materials are
agro based, forest based, marine based, metal based and chemical based.
5 The industry/sector classifications based on lifecycle stage are pioneering stage
(infant industry), expansion stage, maturity stage and decline stage.
5 Some of the key factors to be examined, for any industry classification, are past
sales and earnings performance, stage of growth of the industry, government
policy towards the industry, labour conditions and competitive conditions.
5 Company analysis involves the study of the vitals of a company which include
financial/profitability aspects, operational aspects and efficiency aspects.
5 Earnings per share (EPS) is calculated as profit after-tax less preference divi-
dends (if any) divided by the number of outstanding equity shares.
5 Price to earnings ratio (P/E multiple) indicates the earnings multiple in terms of
the prevailing price as a multiple of earnings. It indicates over/under valuation.
5 In order to size up the company’s current operations and future prospects, the
following aspects may be examined: available market and future demand, avail-
ability and cost of raw materials/inputs, tax planning and accounting practices,
corporate governance, technology and production capabilities, marketing and
distribution, product line/range and human resources.
5 Aspects to be considered in efficiency analysis are efficiency of capital use, pro-
ductivity of total capital employed, growth of assets and capacity utilization,
sales turnover and operational efficiency, profitability of operations, growth in re-
turn on capital employed (ROCE), expansion plans and internal reserves built up.
5 Classification of companies’ stock from an investment perspective can be growth
shares, cyclical shares, defensive shares, discount shares and blue-chip shares.
5 Fundamental analysis may fail to work due to influence of random events, dubi-
ous reporting of earnings, errors made by analysts, superficial analysis and inad-
equate specialization.
4.7 · Exercises
147 4
4.7 Exercises

(i) ______________ is the method of evaluating a security for measuring
its intrinsic value.
(ii) The __________ analysis involves a three-step examination: analysing
the macro-economic environment, understanding the prospects of the
industry/sector, and estimating the future (prospective) performance of
the company.
(iii) The ____________, a multinational organization that oversees interna-
tional trade, releases well-researched reports on world affairs.
(iv) ____________________ is the sum of all products and services pro-
duced in the domestic economy, by the domestic factors of production,
in a particular year.
(v) __________________ is a measure of the rise in retail price levels (infla-
tion) of a basket of commodities consumed by the average populace of
an economy/country.
(vi) The technique ___________ highlights the strengths, weaknesses, op-
portunities and threats for a company/sector.
(vii) The technique ___________ enumerates the political, economic, social,
technological, legal and environmental factors.
(viii) The industry/sector classifications based on _____ are micro, small,
medium and large.
(ix) _______________ is calculated as profit after-tax less preference divi-
(x) _________________ indicates the earnings multiple in terms of the pre-
vailing price as a multiple of earnings. It indicates over/under valua-
tion.
v (Answers: (i) Fundamental analysis (ii) E-I-C (iii) WTO (iv) GDP (v) CPI (vi)
SWOT (vii) PESTLE (viii) size (ix) EPS (x) P/E ratio).
? 2. True/False
(i) A successful investment strategy would be based on the ability of the in-
vestor/analyst to identify a security that can generate desired returns at an
acceptable level of risk.
(ii) Technical analysis is the method of evaluating a security by measuring its
intrinsic value.
(iii) The company analysis involves a three-step examination: analysing the mac-
ro-economic environment, understanding the prospects of the industry/sec-
tor, and estimating the future (prospective) performance of the company.
(iv) Some of the broad economic forces that impact investments are population,
research and technological developments, capital formation, natural re-
sources and raw materials.
(v) The World Trade Organization (WTO) is a multinational organization that
oversees international trade, releases well-researched reports on world af-
fairs.
(vi) GDP or gross domestic product is the sum of all products and services pro-
duced in the domestic economy, by the domestic factors of production, in a
4 particular year.
(vii) CPI or the consumer price index is a measure of the rise in wholesale price
levels (inflation) of a basket of commodities consumed by the average popu-
lace of an economy/country.
(viii) The industry/sector classifications based on size are micro, small, medium
and large.
(ix) Earnings per share (EPS) is calculated as profit after-tax less preference divi-
(x) Book value per share or net worth per share denotes the market value of the
share.
v (Answers: (i) True (ii) False (iii) True (iv) True (v) True (vi) True (vii) False
(viii) True (ix) True (x) False)
? 1. What is fundamental analysis? What are its key components?

2. Explain the key macro-economic factors considered in fundamental analysis.
3. Enumerate three forecasting techniques.
4. What is industry analysis? What is the broad framework of conducting indus-
try analysis?
5. What are industry/sector classifications? Provide two examples.
6. As an investor, what are the aspects you would consider when conducting the
financial analysis of a company?
7. As an investor, what are the aspects you would consider when conducting an
operational analysis of a company?
8. What analysis can one draw from analysing ratios like the P/E ratio and the
book value of a share. Give an example.
9. Discuss Warren Buffet’s investment strategy.
10. What are the reasons because of which fundamental analysis may fail?
? 1. Is it possible to have a fundamentally good stock which is undervalued? If yes,

under what conditions would this happen?
4.6 · Exercises
149 4
(Hint: The ongoing COVID-19 pandemic has resulted in stock markets
across the world facing a downturn, if not a recession)
? 2. Can economic policies make or break a company’s future? Cite an example to
support your answer.
(Hint: The Indian government’s decision on demonetization provided a boost
to the digital payment companies).
4.7.4 Activity Based Question/Tutorial
This can be used as a class exercise.

? 1. Conduct a PESTLE analysis for the Indian economy and suggest three sectors/
industries that you think would do well in the future.
2. Pick a company of your choice and indicate its SWOT vis-à-vis the PESTLE
exercise carried out in Q1. Support your answer with financial and operational
inputs about the company.

Additional Readings
Fisher, D. E., & Jordan R. J. (1995). Security analysis and portfolio management (4th ed.). Pren-
tice-Hall.
Gordon, A., Sharpe, J., William, F., & Bailey, J. V. (2009). Fundamentals of investment (3rd ed.). Pear-
son Education.
Reilly, F., & Brown, K. (2003). Investment analysis & portfolio management (7th ed.). Thomson
South-Western.
References
Business Insider website (2018). Available at 7 https://www.businessinsider.com/6-life-lessons-from-
warren-buffett-2017-7/?r=AU&IR=T. Accessed on August 2, 2018.
Consumer News and Business Channel (CNBC). website (2017). Available at 7 https://www.cnbc.
com/2017/08/10/chinas-steel-prices-are-rising-and-thats-worrying-beijing.html. Accessed on Octo-
ber 27, 2017.
CNBC website (2017). Available at 7 https://www.cnbc.com/2017/04/27/microsoft-earnings-pre-
view-credit-suisse-initiates-at-outperform.html. Accessed on October 22, 2017.
Equity Master website (2018). Available at 7 https://www.equitymaster.com/stock-research/financi-
al-data/ENGS/ENGINEERS-INDIA-LIMITED-Detailed-Share-Analysis. Accessed on July 18,
2018.
Financial Express website (2018). Available at 7 https://www.financialexpress.com/about/ashok-ley-
land/. Accessed on July 17, 2018.
Jain, P. K., Singh, S., & Yadav, S. S. (2013). Financial Management Practices—2013An Empirical
Study of Indian Corporates. Springer.
Ministry of Micro. (2020). Small and Medium Enterprises (MSME) website (2020). Available at 7 ht-
tps://msme.gov.in/. Accessed on July 24, 2020.
Singh, S., Jain, P. K., & Yadav, S. S. (2016). Equity market in India: Returns, risk and price multiples.
Springer. ISBN 978-981-10-0868-9.
151 5
Technical Analysis
Contents
5.2 Technical Analysis – 152

5.2.1 Economic Basis of Technical Analysis – 153
5.2.2 Assumptions of Technical Analysis – 153
5.2.3 Difference Between Fundamental and Technical
Analysis – 154
5.2.4 Market Trends/Phases Under Technical Analysis – 154
5.3 Tools Deployed in/for Technical Analysis – 156

5.3.1 Tools for Assessing Overall Market Movements – 156
5.3.2 Tools for Assessing Individual Stock’s
Movements – 163
5.4 Technical Indicators of the Witchcraft

Variety – 173
5.4.1 Super Bowl Indicator – 173
5.4.2 Sunspots – 173
5.5 Price Formation Process – 174
5.6 Critiques of Technical Analysis – 175


152 Chapter 5 · Technical Analysis
The objective of this chapter is to introduce the concept of technical analysis and
to detail the various tools/techniques deployed as a part of the same. This chapter
covers the following topics.
5.1 Introduction
Fundamental and technical analyses are the two approaches deployed in security
analysis. Technical analysis adopts a radically different approach towards security
5 analysis when compared to fundamental analysis. While fundamental analysis as-
sumes that the market prices are a representation of the fundamental characteris-
tics of the underlying company/security and are not influenced by investor behav-
iour, technical analysis assumes that market prices are simply a play between the
market forces of demand and supply (driven by investor behaviour) and are not
dependent on the underlying fundamental characteristics of the security.
5.2 Technical Analysis
In the previous chapter, various aspects of “fundamental analysis” have been con-
sidered which attempt to measure a security's intrinsic value. Technical analysis,
on the other hand, is aimed at identifying patterns in share price/return series that
can suggest/forecast future activity/levels.
Definition
Technical analysis can be defined as a method of evaluating the timing of securi-
ties (in terms of buy/sell/hold decisions) by analysing the data generated by mar-
ket activity, such as past prices and volume. Volume, which is simply the number of
shares traded over a given period, is an important factor in technical analysis. Vol-
ume is primarily used to measure the strength of any given price movement. For in-
stance, a 50 per cent rise in a stock’s price may not be relevant if it occurs over a
very low volume, for example, penny stocks (extremely volatile stocks of very small
companies).
> Technical analysis employs various charts, tools and statistical techniques to
ascertain patterns and trends in the share prices/returns data by observing the
movement of share prices/returns in the past. Under this analysis, investors
classify trends on the basis of their duration (long term, short term) and their
nature (uptrend, downtrend). After identifying their investment horizons, in-
vestors enter (buy) and exit (sell) the market, according to the trend which
suits them (according to their risk–return profile).
5.2 · Technical Analysis
153 5
5.2.1 Economic Basis of Technical Analysis
Technical analysis is that form of security analysis which relies on price and vol-
ume data.
> The logic of technical analysis is simple and is drawn from the economic funda-
mentals of demand and supply. Thus,
5 Supply and demand determine prices.
5 Supply and demand aspects are affected by many factors, both rational and ir-
rational. These may be fundamental factors as well as psychological (behav-
ioural) factors.
5 Except for minor deviations, stock prices move in fairly discernible trends.
5 Changes/shifts in supply and demand bring about changes in trends.
5 Such prices can, therefore, be projected with charts and technical tools (based
on the underlying demand and supply).
5 Finally, due to the persisting nature of trends, analysis of past market data can
be used to predict future price behaviour.
Hence, the goal of technical analysis is to take advantage of short-term price

movements (from the stock’s intrinsic value) by buying or selling (without consid-
ering the fundamentals) for gaining profit in the short term.
>
Technical analysis can also be thought of as a study of collective investor psy-
chology; the prices of a security are set by humans and humans are irrational,
so the prices never reflect the security’s intrinsic value, and hence, technical ana-
lysts always have room for profit.
5.2.2 Assumptions of Technical Analysis
Unlike fundamental analysis, technical analysis postulates that there is no way

to identify an under-valued stock as markets are efficient and they factor in
everything intrinsic to the price of the stock. Any gain to be made in the mar-
ket is due to the short-term fluctuations in prices, due to the imbalance in demand
and supply, resulting from investor irrationality. Hence, one cannot make a profit
by investing in the stock for the long term.
> Technical analysis is, thus, based on the following assumptions:

(i) The market discounts everything—Technical analysis assumes that market prices
reflect all available information about a stock’s fundamental value, that is, the
markets are efficient.
(ii) Prices always move in trends—Technical analysis assumes that prices always fol-
low a trend, and there is no “randomness” in the movement of prices as sug-
gested by the “random walk” hypothesis.
(iii) History tends to repeat itself—Technical analysis assumes that past trends are
the predictors of future movements and that a stock will continue to exhibit the
same pattern/trend in the future, which it exhibited in the past.
5.2.3 Difference Between Fundamental and Technical Analysis
Technical and fundamental analyses are both valid security analysis tools, but
they approach the market in different ways:
(i) Fundamental analysis is a much wider field and includes the complete eco-
nomic, industry and company analyses. Technical analysis, on the other
hand, is based typically on price and volume data.
(ii) Technical analysis is based on more concrete data in terms of price and vol-
ume, in order to predict the movement of the security. On the other hand,
fundamental analysis is based on not just concrete data but also on assump-
5 tions and future estimates.
(iii) Technical analysis is a short-term approach, whereas fundamental analysis is
more of a theoretical approach for long-term investment.
(iv) Technical analysis appeals to short-term traders, whereas fundamental analy-
sis is the tool used by long-term investors.
5.2.4 Market Trends/Phases Under Technical Analysis
Stock markets and their underlying price levels typically exhibit certain behav-
iours; the phase where price levels are rising (due to increased buying activity) is
termed as “bullish” and the phase in which the price levels are falling (due to in-
creased selling activity) is termed as “bearish”. The bull phase is an indication of
investor confidence in the market, and the bear phase is a sign of pessimism in the
investor’s mood or sentiment regarding the future of the market. The bull phase
is also termed as the “positive rally” and the bear phase as the “negative rally”,
indicating that the market forces impact the price levels positively/negatively, re-
spectively.
(i) Bull trend
Definition
Technically, a trend is regarded as bullish when the high point of each rally (in-
crease in price movement) is higher than the high point of the previous rally, and
the low point of each decline (downward price movement) is higher than the low
point of the previous decline.
> This phase can be characterized by three sub-phases. In bullish markets, the
stock prices may also start to grow as a response to some improvements in
the business conditions of the industry/company under consideration. This
initial growth (which is an implication of actual fundamental growth/con-
ditions) is the first sub-phase. The second sub-phase begins when the earn-
ings of the industry/company under consideration rise significantly. This at-
tracts even more investors; this is still a fact-driven investment scenario. The
5.2 · Technical Analysis
155 5
last phase is where speculation starts to dominate and the investors’ irrational
exuberance starts to govern the stock prices (rather than the actual financial
gains of the company/industry), pulling them way above their intrinsic value.
A prolonged speculative sub-phase may result in the formation of a stock
market bubble.
(ii) Bear trend
Definition
Technically, a trend is regarded as bearish when the high point of each rally (in-
crease in price movement) is lower than the high point of the previous rally, and the
low point of each decline (downward price movement) is lower than the low point
of the previous decline.
> This phase can also be characterized by three sub-phases. In bearish markets,
the stock prices start to fall in response to abandonment of positive inves-
tor expectations. The first sub-phase is where there is a significant loss in the
profitability/growth of the investment/capital for the company/industry under
consideration. This is followed by the second sub-phase, where there is sus-
tained decline in stock prices (which is an implication of the factual condi-
tions that the company’s/industry’s earnings are reducing). This is followed
by the third sub-phase, where there is abnormal fall in stock prices as a re-
sponse to the pessimism/distress of investors. In this sub-phase the value of
stock generally falls way below its intrinsic value; a prolonged speculative
sub-phase may result in a market crash.
In this way, both bull and bear trends have three sub-phases; first, the evolution
sub-phase, second, the consolidation sub-phase and third, the speculation sub-
phase. The first two sub-phases are generally implications of actual industry/com-
pany conditions. The third sub-phase, however, is a speculation sub-phase, where
the stock price is generally not a representation of its actual/intrinsic value.
Concept in Practice 5.1: The Dotcom Bubble and Crash

. Figure 5.1 depicts the rise and fall (1995–2005) of the National Association of
Securities Dealers Automated Quotations (NASDAQ) index. It is the second larg-
est stock exchange in the world after the New York Stock Exchange. It is located
in the United States of America (USA).
As is evident from . Fig. 5.1, during the dotcom bubble boom and burst (1995–
2005), investors followed the bullish trend and kept on investing without giving
heed to the intrinsic values of the stocks they were buying. Eventually, the bub-
ble burst and was followed by a strong and prolonged bearish trend, bringing the
stock market down. The figure also marks some of the main events during this
phase.
. Fig. 5.1 Rise and fall of the NASDAQ during the Dotcom Bubble and Crash. Source Wall
Street Journal (WSJ) (2018)
5.3 Tools Deployed in/for Technical Analysis
Withintechnical analysis, there are various tools and techniques which are de-
ployed for analysis; some of them have been old puzzles like the Fibonacci series
while most of them are new developments like the Dow theory, Elliott wave prin-
ciple, the moving average analysis, etc.
Some of these tools assess overall market movements, while the others are em-
ployed for assessing individual stock price behaviour. This section provides the
various tools/techniques used in technical analysis, divided into these two broad
categories:
5.3.1 Tools for Assessing Overall Market Movements
5.3.1.1 Dow Theory
Dowtheory is based on Charles H. Dow’s article published in 1900 in the Wall
Street Journal (IFC Markets.com, 2018). Based on his analysis, Dow created the
Dow Jones Industrial Index and Dow Jones Rail Index to track the business and
economic conditions in America.
5.3 · Tools Deployed in/for Technical Analysis
157 5
Dowtheory still forms an important part of technical analysis, and even today,
the Dow Jones Industrial Average (DJIA) index is tracked in the USA to check
for the state of the economy. Akin to the SENSEX of India (whose performance
is considered the barometer of the Indian economy’s performance), the perfor-
mance of the DJIA is considered the barometer of the performance of the Amer-
ican economy.
The six basic characteristics of Dow theory are:
(i) Market trend/movement—Within the Dow theory, the markets exhibit a
main/primary movement/trend and also features intermediate/medium
trends and short swings (fluctuations in prices).
(a) The primary/main trend—It represents the major trend/movement that can
last from one year to several years. It can be bullish or bearish.
(b) The intermediate/medium/secondary trend—This trend may last from around
ten days to a quarter.
(c) The short swings or daily fluctuations—This trend can vary from an hour to
a few days.
(ii) Market phases—Under the Dow theory, the market trend generally has
three phases:
(a) Accumulation phase—In the accumulation phase, a few people who have su-
perior knowledge about the stock, accumulate (buy) it.
(b) Absorption/public participation phase—In the absorption phase, this knowl-
edge is absorbed by the market and, other investors too, start aggressively
buying the stock.
(c) Distribution phase—In the distribution phase, those who had initially accu-
mulated the stock, now start distributing (selling) it, for higher returns.
(iii) Stock markets are efficient and discount all news—Stock markets absorb all
new information, and the same is translated into increase/decrease in stock
prices (based on the type of news).
(iv) Stock market sector averages must confirm each other—This is the most fun-
damental aspect of the Dow theory. All underlying sectors (in a market) and
their respective performances must confirm the complementing sector’s per-
formance.
> For example, if the manufacturing sector’s profitability is increasing, it means

that it is producing more, and thus, is supplying more goods to its customers via
a transportation channel, say, railroads. Thus, the manufacturing sector and the
railroad sector are positively correlated, that is, the profitability of the manu-
facturing sector and the railroad sector should move in the same direction; such
sectors are called complementary or secondary sectors. Hence, an investor con-
sidering the manufacturing sector for investment due to its significant growth
projections would do well to also invest in the sectors complementing it, like
transport. . Figure 5.2 presents the buy and sell signals through the Dow the-
ory, pictorially.
In other words, stock market averages confirm each other, that is if the primary
sector (e.g. manufacturing) is performing well, it will give a boost to the second-
. Fig. 5.2 Buy and sell signal through the Dow theory. Source Authors’ compilation
ary (in this case, railroad) and tertiary (in this case, cargo insurance) sectors.
Thus, the secondary and tertiary sector indices will follow the primary sector in-
dex.
(v) Trends are confirmed by volumes—Considering that there are many sell-
ers/buyers in the market for a particular security, large volumes (in terms
of trading) would accompany definite price movements in the security; this
would further confirm the trend.
(vi) Trends exist until definitive market signals/indicators prove that they have en-
ded—Trends exhibit inertia. Hence, a trend will continue to exist until an
event/signal takes place which carries information of a contrary nature to
the direction of the current trend, thus, disrupting it and ending it.
5.3.1.2 Elliott Wave Principle

Proposed by Ralph Nelson Elliott in 1938, the Elliott wave principle posits
that investor psychology and the resultant optimism/pessimism moves in waves
(Stockcharts.com, 2018). It works on the principle that each major trend can be
broken down into five smaller waves. In an upward trend, three out of five waves
would be higher than the other two waves and the reverse will take place in case
of a downturn; three of the five waves would be lower than the others.
► Example
Panels (A) and (B) in . Fig. 5.3 present the Elliott wave indicating uptrend, pictorially. ◄
159 5
. Fig. 5.3 Elliott wave. Source Authors’ compilation
5.3.1.3 Kondratiev Wave Theory

Propounded by Soviet economist Nikolai Kondratiev (also written as Kondratieff
or Kondratyev) in 1925, the Kondratiev wave theory posits super market cycles
that range over 50–60 years (Kondratieff.net, 2018). They represent cycles of high
sectoral growth (upturn) or low sectoral growth (downturn) in the economy. Kon-
dratiev identified three sub-phases in the overall market cycle: expansion, stagna-
tion, and recession. Kondratiev theory gained some credence after the crash of
1987, which happened after 58 years from the crash of 1929.
However, due to the large period of time considered, most financial analysts
tend to ignore this theory, as it is difficult to determine the causes of such waves
(as multiple events could have taken place over the long period).
5.3.1.4 Chaos Theory
Chaostheory is an emerging field of study in Physics, which postulates that ap-
parently random behaviour, in instances, is quite systematic or even determinis-
tic. The theory was summarized by Edward Lorenz. Scientists also apply this the-
ory to population growth estimates, prediction of weather and fisheries biology,
amongst others. The movement of people in the Maha Kumbh Mela, the largest
congregation of humans on the planet, has also been studied under Chaos theory.
On the same lines, some of the patterns in the stock market may be explained
by the Chaos theory while some patterns remain unknown. This theory, however,
needs much more work and revision if the apparent randomness of the change in
the stock price can be shown to be non-random.
► Example
. Figure 5.4 presents a pictorial representation of the Chaos theory. ◄
5.3.1.5 Neural Networks and Genetic Algorithms

Neural networks, a branch of computer science and artificial intelligence, basi-
cally refers to a system in which an anticipating model is trained to ascertain a de-
sired output from the past data. The neural network eventually learns the pattern
that generates the required output by repeatedly cycling through the data. There
is also a feedback mechanism in the neural network by which the network gains
experience from the past errors. Hence, a neural network learns and evolves over
time and becomes more accurate.
. Fig. 5.4 Chaos theory—a pictorial representation. Source Forbes (2018)
Building of a genetic algorithm into the neural network is a more sophisticated

way of predicting future security prices. In a genetic algorithm, sub-algorithms
called baby newts are spawned. Each newt is allowed to swim against the alter-
ing flow of data, learn from it, and assume the role of mother by defeating all the
other newts in terms of accuracy and endurance (survival of the fittest). This al-
lows the network to learn and arrive at the best prediction model and follow it.
5.3.1.6 Breadth of Market Analysis

In order to ascertain the state of the market, one may also analyse the breadth of
the market. While several methods exist to measure the breadth of the market,
some of the popular ones are:
Advance/Decline Ratio
“Advance” denotes the number of shares whose share prices have increased (ad-
vanced) on a particular day, and “decline” denotes number of shares whose share
prices have decreased (declined) on a particular day.
> The estimation of market breadth through this methods involves the following
steps:
5 Calculate the number of net advances/declines on a daily basis. This can be cal-
culated by subtracting the number of shares which have declined from the num-
ber of shares which have advanced on a particular day.
5 Estimate the market breadth by cumulating the daily net advances/declines, for
a particular period.
Ordinarily, the market breadth is expected to move in tandem with the market
averages (measured through indices). However, if the market average is mov-
ing upwards, whereas the market breadth is moving downwards (more declines
161 5
than advances), it indicates that the market may be turning bearish. Similarly, if
the market average is moving downwards but the market breadth is moving up-
wards, it indicates that the stock market may be turning bullish.
? Suppose on March 1, 2020, the number of stocks on the Bombay stock ex-
change (BSE) that advanced (closed at a price higher than the opening price) was
1,500, and the number of stocks that declined (closed at a price lower than the
opening price) was 1,000. Calculate the advance–decline ratio for the BSE.
v The advance–decline ratio for the BSE can be computed as:

Number of stocks that advanced/Number of stocks that declined = 1500/1000 = 1.50
Short Interest Ratio Theory

The short interest theory suggests that shares sold first at higher prices and
bought later at lower prices (short selling) may be prime candidates for significant
price rise in the near future. This is because short sellers buy such shares later to
cover their positions (termed short squeeze). This creates a price hike that may
encourage more short sales. Overall, this is a bearish indicator as speculators ex-
pect prices to fall in the future.
? Suppose in August, 2020, the number of shares that were sold short on the Bombay
stock exchange (BSE) was 10 million and the average daily volume of shares traded
on BSE was 4 million. Calculate the short interest ratio for the BSE for the period.
v The short interest ratio for the BSE can be computed as:
Number of stocks sold short/Average daily volume of shares = 10 million/2.5 million = 4
Confidence Index
The investor confidence index, for any economy, is an indicator designed to meas-
ure investor confidence that can be taken to be the degree of optimism regarding
the state of economy (that consumers are expressing through activities of savings
and spending). Country-wise analysis of confidence indices indicates huge vari-
ance amongst countries. In India, there are many private organizations that re-
lease confidence indices on the stock markets, from time to time, for example, Eq-
uitymaster.com.
► Example
If sophisticated investors, for example, institutional investors, start apportioning a
higher weight of their portfolio to riskier as opposed to safer investments, it indicates
a stronger risk appetite or confidence. This may occur in times of economic boom and
even when there’s an economic downturn. Hence, the risk appetite of institutional inves-
tors is a separate and distinct behaviour when compared with the behaviour of prices. ◄
Odd Lot Ratio

The most successful investors are the ones who are rational and who do not let
emotion sway their decision-making. However, smaller irrational investors have
acquired a reputation for doing just the opposite.
When the market goes down, for instance, professional investors see it as an op-
portunity to buy at a favourable price. Emotional and irrational investors, on the
other hand, are more likely to sell off their stock especially when it’s at a low point.
Unfair or not, this behaviour forms the basis for ‘odd lot theory’. In the stock
markets, shares are traded in lots (typically, a lot represents 100 shares). When a
large institutional investor makes a purchase or sale, it’s usually in lots. On the
5 other hand, retail investors may not be able to purchase a lot at a time, and may
resort to buying odd numbers of shares, for example, 15 shares. These smaller
amounts—anywhere from one to 99 shares—are referred to as “odd lots”.
Since odd lots are, by definition, smaller orders, one can see them as a way to
gauge the sentiment of retail investors.
Relative Strength Analysis (RSA)

RSA is based on the assumption that the prices of securities rise quickly during
the bull phase but fall at a much slower pace during the bear phase, when com-
pared with the market as a whole. Hence, these securities possess greater rela-
tive strength, and typically, outperform the market. A simple way to calculate the
relative strength is to calculate rates of return on various securities and classify
the securities with superior returns (vis-à-vis the market) as those having relative
strength.
Relative strength is calculated by dividing the average gains of a security (for
a given time period) by the average losses for that security over the same time pe-
riod. A minimum period of 14 days is advisable for the computation.
> . Table 5.1 presents the daily prices of Security X over a 14-day period. Compute
the relative strength for X.
v From the data provided in . Table 5.1, the relative strength can be computed
through the following steps:
(i) For each day, compile price increases in the security into a column titled
“gains” and decreases into a column titled “losses”. The difference between
closing price and opening price will be termed as “gain” if it is positive and
“loss” if it is negative.
(ii) Compute the averages of both the gains and losses for the stock by dividing it
by the number of days in the period.
(iii) Divide the average of gains by the average of losses. If the ratio is greater than
one, the security has relative strength.
163 5
The process is shown here:
. Table 5.1 Daily prices of security X
Period Opening price Closing price Gains Losses

Day 1 200 210 10
Day 2 210 215 5
Day 3 215 200 15
Day 4 200 205 5
Day 5 205 215 10
Day 6 215 225 10
Day 7 225 210 15
Day 8 210 190 20
Day 9 190 200 10
Day 10 200 180 20
Day 11 180 190 10
Day 12 190 200 10
Day 13 200 205 5
Day 14 205 210 5
Total 80 70
Average (Total/14) 5.71 5
Hence, relative strength = 5.71 / 5 = 1.14.
5.3.2 Tools for Assessing Individual Stock’s Movements
5.3.2.1 Chart Analysis
The underlying concepts in chart analysis are:
(a) Persistence of trends—The key belief of technical analysts deploying charts
(chartists) is that stock prices tend to move in fairly discernible trends. Stock
prices have inertia (the movement continues along a certain path which could
be up, down, or in a straight line) until an opposing force (arising out of the
altered demand–supply situation) changes it.
(b) Relationship between volumes and trends—Typically, volumes and trends go
hand-in-hand, as believed by chartists. In the case of a major upturn, the vol-
ume of trading increases as the price advances and decreases as the price de-
creases. The reverse happens in the case of a downturn; the volume of trading
increases as the price declines and decreases as the price increases.
(c) Support and Resistance levels—Chartists believe that it is difficult for the price
of a particular share to rise above a certain level, called the resistance level,
and fall below a certain level, called the support level. The rationale behind the
same lies in the fundamentals of demand and supply and consumer behav-
iour, that is, demand is price elastic; demand increases as the prices fall and
decreases as the prices rise. Hence, in terms of consumer behaviour, even pur-
chasing stocks (a financial product) follows the law of demand; the demand is
elastic to price, and beyond the resistance level, the demand is non-existent.
Further, according to behavioural finance, if investors find that the share prices fall
after their purchase, they tend to hold on to their investment in the hope of a recov-
ery. They sell once the prices reach back and then break-even. Similarly, at the sup-
port level, due to the lower prices, there is a surge in demand by investors who could
not afford the shares earlier or those who had “missed the bus” (not bought the share)
5 earlier. Short sellers, having sold short at higher levels, also book profits at this level.
For example, an investor who had sold a security at the resistance level of say, INR 50
can now buy the same security at the support level of say, INR 30, and book a profit.
There are various kinds of charts, like bar and line charts, head and shoulders
pattern, support and resistance levels, triangle patterns, point and figure charts, etc.
Bar and Line Charts

One of the simplest and most popularly used tools of technical analysis, bar and
line charts, depicts the daily price range of a stock, along with the closing price.
Technical analysts believe that certain patterns and formations observed in the
bar/line charts have predictive value. For instance, a line chart shows the line con-
necting the prices (for a period).
► Example
. Figure 5.5 presents the line chart of the Indian Oil Corporation (IOCL), a Fortune
500 company (which also is a part of the Nifty 50 and the BSE 100 indices) for a pe-
riod from July–October, 2017. ◄
Head and Shoulders (HS) Pattern

As the name suggests, the HS pattern has a line/chart pattern depicting a left
shoulder, a head, and a right shoulder. This pattern depicts a bearish development
. Fig. 5.5 Line chart of the Indian Oil Corporation (IOCL), July–October, 2017
165 5
. Fig. 5.6 Head and shoulders and inverse head and shoulders (reversal patterns). Source Authors’
compilation
in the market. If the price falls below the neckline (the line drawn tangentially to
the left and right shoulders), a price decline is expected, providing a signal to sell.
Inverse Head and Shoulders (IHS) Pattern

As the name suggests, this is the reverse of the HS pattern. It reflects a bullish de-
velopment in the market. If the price rises above the neckline, a price increase is
expected, providing a signal to buy.
Both HS and IHS patterns are the most commonly used reversal patterns. As
the name suggests, reversal patterns are used to analyse when the trend/pattern
will be reversed. . Figure 5.6 presents both the HS and the IHS patterns.
► Example
Note: The breakout and trend reversal point in the HS pattern indicates a sell signal. On the
other hand, the breakout and trend reversal point in the IHS pattern indicates a buy signal. ◄
Pennant and Flag
Pennant and flag are the two most commonly used continuation patterns. As the
name suggests, continuation patterns are charts which indicate whether the pat-
tern will continue or not. . Figure 5.7 presents the pennant and flag patterns. As
is evident, both patterns are named on the shape they represent.
Resistance and Support Levels

As stated earlier, resistance level is the price level after which the prices of a particular
stock do not rise further (under normal circumstances). This level is always above the
average market price. At the resistance level, there will be pressure to sell. Hence, it is
advised to buy below the resistance level and sell around the resistance level.
Similarly, support level is the price level at which there will be maximum de-
mand of the stock (due to the low prices).
> In order to draw these levels, the following steps can be undertaken:
5 Collect the price data of the stock for at least 3–6 months (for short-term anal-
ysis) and/or 6–12 months (for long-term analysis).
5 Identify the price action zones (zones where prices have shown an increase/decrease).
5 Align the price action zones (to indicate rising/falling prices’ trends).
5 Fit a straight line (to indicate the higher/resistance and lower/support levels).
Concept in Practice 5.2: Lehman Brothers’ Support/Resistance Levels

During the 2008 financial crisis in the USA, when the stock price of Lehman
Brothers came crashing down (due to its bankruptcy), technical analysis, and
5 more specifically, resistance and support level analysis indicated that even when
the prices were falling, there were intermediate support and resistance levels.
As is evident from . Fig. 5.7, the following support and resistance levels were re-
corded:
Level 1—August 2007 to March 2008.
5 Resistance level: 70
5 Support level: 50
Level 2—March 2008 to June 2008.

5 Support level: 35
Level 3—July 2008 to September 2008.

5 Support level: 12
Hence, levels 1, 2 and 3 highlight the support and resistance levels, which provided
opportunities for the discerning investor to exit the market and contain his/her
losses. On the other hand, it also provided opportunities for day traders (technical
traders) to enter the market closer to the support prices and exit the market closer
to the resistance prices, and record significant capital gains. Thus, as one can see,
technical analysis enables investors to earn returns in the stock markets, even at
the cost of a fundamentally weak/unsound company (. Fig. 5.8).
. Fig. 5.7 Pennant and flag (continuation patterns). Source Authors’ compilation

167 5
. Fig. 5.8 Lehman Brothers Bankruptcy and support/resistance level in stock prices. Source
Stocktrader.com (2018)
Triangle Formation
This pattern, which exists in the form of a triangle, represents a pattern of uncer-
tainty. Hence, it is difficult to predict which way the price will move. . Figure 5.9
presents the evidence of a triangle pattern in Google’s stock prices.
Concept in Practice 5.3: Evidence of Triangle Pattern in Google’s Stock Prices

. Figure 5.9 depicts the daily movement in prices of the share of Google Inc.
(GOOG), traded on NASDAQ, from September 2007 to April 2008. As is evident
from the portion marked under trend lines 1 and 2, the movements in the share
prices provide evidence of a technical analysis indicator called a triangle. In this
indicator, stock prices move up and down between two converging trend lines (1
and 2). The stock prices break up or down from the trend line, depending upon
the direction of movement of stock price, just after it moves out of any one trend
line. If the stock price moves up from the upper trend line, the stock will start an
upward trend. If the stock price breaks out from the lower trend line, the stock
will start a downward trend. This process is called breakout.
. Fig. 5.9 Triangle pattern in Google’s stock prices. Source Stockcharts.com (2018)
In this example, the stock of Google Inc. is moving up and down between the
trend lines, and then breaks out from the below trend line, which leads to a down-
ward movement of the stock prices. These trends and indicators can be used for
the investors’ advantage, through monitoring the stock prices and trading at pre-
cise points for recording maximum benefits from the trade.
Point and Figure Charts (PFC)

Slightly more complex than bar and line charts, this form of chart analysis re-
cords every increase and decrease in stock prices. When the direction of price
change reverses (a decline after previous increase or an increase after previous de-
cline), the price is recorded. This helps in identifying patterns and changes more
easily. Candlestick charts are the most popular PFC pattern.
► Example
. Figure 5.10 presents the candlestick chart of IOCL, for the period July–October,
2017. The candlestick representation indicates the weekly movement of the share prices
169 5
. Fig. 5.10 Candlestick chart of IOCL (July–October, 2017). Source Authors’ compilation
of IOCL. It can be seen that during August, there was good demand for the stock as
there was strong buying/selling activity in the IOCL shares. The stock price hovered
around INR 390–405 around that time. ◄
5.3.2.2 Moving Average Analysis

A moving average is calculated by taking into account the most recent n observa-
tions. For instance, a 10-day moving average will present the average of the past
10-day security prices. These averages are used to predict trends. For example, a
300-day moving average of daily prices may be used to identify a long-term trend,
a 75-day moving average of daily prices may be used to discern a medium-term
trend and a 15-day moving average may be used to detect a short-term trend.
► Example
. Figure 5.11 presents a 200-day simple moving average pictorially. ◄
5.3.2.3 Bollinger Band
A Bollinger band is an indicator under technical analysis which was developed
by John Bollinger in 1980. It is used to determine the market movement around
average asset prices. It helps in finding the direction of the prices and in moni-
toring the price volatilities. It employs a combination of simple moving average
and standard deviation and presents them through bands. These bands contain
three envelopes which help intra-day traders make investment decisions. The up-
per, middle and lower bands provide a measure of deviation. The gap between
the middle and upper bands represents a positive deviation, and the gap between
. Fig. 5.11 Simple moving average. Source Commodity.com
the middle and lower bands is representative of a negative deviation. It is owing

to this feature that these bands become a good way to ascertain whether the mar-
kets are in excess-buy or excess-sell stage. The excess-buy stage is when prices have
moved up and are at the greatest deviation from the middle band and in the ex-
cess-sell stage, the prices have moved down and are at the utmost deviation from
the middle band.
In statistical parlance,
Upper Band = Middleband + 2SD
Milldel Band = 20 - period moving average
Lower Band = Middle band − 2SD
► Example
. Figure 5.12 presents an example of the Bollinger band, indicating the upper, middle
and lower bands. ◄
The applications of these bands are evident in various spheres of financial mar-
kets like equities, foreign exchange, commodities and futures. They help in com-
prehending upward/downward trends (bullish/bearish markets).
However, Bollinger bands suffer from certain weaknesses, as well. Some of
them are highlighted here:
5 There can be a potential affinity to give false signals.
5 When the markets are volatile, these band envelopes can shrink and get
skewed.
5 Information might not always be totally reliable and can provide false signals.
171 5
. Fig. 5.12 Bollinger band. Source Authors’ compilation
► Example
. Figure 5.13 presents some of the weaknesses inherent in the Bollinger bands. As is
evident, points 3, 4 and 6 are false reverse signals which only become apparent when
point 7 is reached. However, such false signals may be natural in the event of incom-
plete information about the security and the market. ◄
5.3.2.4 Fibonacci Series
For many centuries, the Fibonacci series has intrigued mathematicians and re-
searchers. The series was provided by a medieval mathematician named Leonard
Fibonacci (1170–1240). The Fibonacci series is as follows:
. Fig. 5.13 Weaknesses of Bollinger bands. Source Authors’ compilation

1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233........

The first two numbers in the series are 1 and 2, and the third number is the
sum of the first two numbers, the fourth number is the sum of the second and
third number, and so on. Basically, the sum of the two adjacent numbers provides
the next following number.
> The frequency with which the Fibonacci numbers appear in the environment is
significant. For example, sunflowers have seeds spirals. Some spirals have seeds
with counterclockwise arrangements while some have spirals that have clock-
wise arrangements. Most sunflowers contain adjacent Fibonacci numbers of
the numbers of counterclockwise spirals vis-à-vis the number of clockwise spi-
5 rals. For instance, there might be 34 counterclockwise spirals and 55 clockwise
spirals in a flower.
The ratio 1.618 (the ratio between the adjacent numbers in the series, after the
first ten numbers, e.g., 144/89 = 1.618, 233/144 = 1.618, and so on) is generally
used by the technical analysts who follow Fibonacci numbers. This number ap-
pears in ancient writings as well as architecture and is called the golden mean.
Further, support and resistance levels are computed by the use of first two ra-
tios, 0.382 and 0.618, as well, by investors. For example, a 30 per cent decline in
the stock price from $50 to $35 will encounter resistance to further advances af-
ter stock price rises to $40.7 (or after regaining of 38.20 per cent of its loss).
Hence, analysts deploy key Fibonacci ratios of 38.20 per cent and 61.80 per
cent to produce a grid and map it with existing price level data. These grid lines
are used to identify possible price reversal points.
Concept in Practice 5.4: Fibonacci Series Evident in EUR/USD Daily Charts

In the Euro versus US Dollar (EUR/USD) forex daily chart, a major downward
trend started in May 2014. The price then bottomed out in June and retraced up-
ward to approximately the 38.20 per cent Fibonacci retracement level from the
down/lowest level.
For investors, in this case, the 38.20 per cent level would have been an excellent
place to enter a short position in order to capitalize on the continuation of the
downtrend that started in May. There is no doubt that many traders were also an-
ticipating the 61.80 per cent retracement level, but in this case, the market was not
bullish enough to reach that level. Instead, EUR/USD turned even lower.
(Source: Fxempire.com 2020).
As a word of caution, however, technical analysis has its own limitations in terms
of a trend/pattern being evident only over a certain time period and hence, investors
cannot overly rely on this single pattern (in isolation) to make a sell/buy decision.
5.3.2.5 Spreads
A spread is the difference between the bid (buying) and ask (selling) price of a
security or asset. The spread for a security is influenced by the supply (the total
5.4 · Technical Indicators of the Witchcraft Variety
173 5
number of shares outstanding that are available to trade), demand in the security
and the volume of trade.
The bid-ask spread is one of the measures to estimate the liquidity of
the stock in the market. Greater the liquidity, lower the spread and vice versa.
Spreads are more relevant in the context of derivatives like futures and options.
5.3.2.6 Insider Transactions
Insider trading/transaction is the buying or selling of a security by an insider
(someone who has access to material and non-public information). Insider trad-
ing can be illegal or legal depending on the country and also when the insider
makes the trade. It is typically considered illegal, when the material information is
still non-public. On the other hand, legal insider trading happens when the direc-
tors/top executives of the company purchase or sell shares, but they disclose their
transactions in the prescribed legal manner.
Legal insider trading can provide useful information about the way the insid-
ers are treating the future prospects of the company and can infuse confidence (if
the insiders are buying) in the small investors.
5.4 Technical Indicators of the Witchcraft Variety
This genre of indicators is clubbed under the infamous nomenclature of “indica-

tors of witchcraft variety” as it appears to be completely divorced from logic and
rational expectations of risk and return of a security. More like witchcraft, it ap-
pears to exist and magically affect stock behaviour and returns.
5.4.1 Super Bowl Indicator
The “super bowl” indicator is an unlikely American market barometer based on a

supposition that a “super bowl” win for a team from the original National Foot-
ball League (America’s most popular football league) foretells a rise in the stock
market in the coming year.
The indicator, at one point in time, boasted of a more than 90 per cent success
rate in predicting the rise/fall outcome of the S&P500 (the US stock index) for the
following year. However, the old maxim and caution applies here as well—corre-
lation does not imply causation.
5.4.2 Sunspots
Sunspots and their impact on business cycles were first studied by the English
economist William Stanley Jevons (1835–1882). Sunspots are defined as areas
on the sun’s surface, which record lower temperatures relative to the rest of the
surface. More sunspot activity may impact weather, which could affect crop pro-
duction. Changes in crop production could, in turn, cause changes in the overall
economy. Though the connection between sunspots and business cycles has been
proven to be statistically insignificant (in recent research), the term “sunspot” has
also endured as a less technical way to refer to an extrinsic random variable (a
variable which has no direct impact on the outcome).
5.5 Price Formation Process
After learning about both fundamental and technical analysis, an investor has to
5 appreciate that the price formation process, for any security, entails aspects/varia-
bles from both approaches.
. Figure 5.14 presents the price formation process through the factors which
affect market trading. Market trading is composed of both pure investment activ-
ity (long-term fundamental investment) and speculative activity (short-term tech-
nical investment based on price trends, etc.). Further, both speculative and invest-
Market Trading
Speculative Activity Investment Activity
Market factors Future Value Factors Intrinsic Value Factors
Technical Manipulative Psychological
Management and Competition Changes in Costs

Reputation and Prospects and Prices
Earning and Assets Others

Sales Capital Structure
Dividends
PRICE FORMATION PROCESS
. Fig. 5.14 Price formation process. Source Authors’ compilation

5.6 · Critiques of Technical Analysis
175 5
ment activities are affected by market factors prevalent at the time of the trade,
that is, the factors affecting the future value of the security and the factors which
affect the current/intrinsic value of the security.
The future value of the security can depend on many factors like the underly-
ing company’s management and reputation, the level of competition and future
prospects, the changes in costs and prices, etc. The intrinsic value of the security
depends upon its sales, earnings and dividends, assets, capital structure and other
aspects. Market factors can be technical (analysts relying on charts and other
technical analysis tools), manipulative (buyers/sellers affecting prices through
large volumes of trading) and/or psychological (investor behaviour and emotions).
Investors try to estimate the future value of the security and make a buy/sell
decision depending on the current price of the security and its actual intrinsic
value.
5.6 Critiques of Technical Analysis
Technical analysis is often criticized due to certain inherent limitations:

(i) Most technical analysts are unable to provide convincing rationale behind
the tools employed by them.
(ii) By the time technical analysts signal an uptrend/downtrend, it may have al-
ready taken place.
(iii) There exists some degree of confusion in the identification and/or configu-
ration of trend lines/chart patterns, each of which can be interpreted differ-
ently by different analysts.
(iv) Under the influence of herd mentality, trends may persist for quite some
time.
5.7 Conclusion
Ultimately, as more and more investors deploy technical analysis, it would be-
come a self-defeating proposition. The markets would become increasingly effi-
cient as prices would reach an equilibrium (as technical analysts continue to gain
from any deviations thereby reducing the said deviations). However, today, in
spite of its inherent limitations, technical analysis is very popular. The basic rea-
son is that markets are inefficient and price movements do offer opportunities to
make abnormal returns in the short run, without getting into the detailed and ex-
haustive fundamental analysis. Once the markets become efficient, technical anal-
ysis would be a worthless exercise.
While investors are encouraged to reap the benefits accorded by inefficient
markets, through technical analysis, their attention is again drawn towards the
fact that the prevalent market price of any security is an amalgamation of both
fundamental and market factors (as indicated in . Fig. 5.14). Hence, it is always
advisable to keep the fundamental factors in mind, when making an investment
decision, especially a medium- to long-term one.
Summary
5 While fundamental analysis assumes that the market prices are a representa-
tion of the fundamental characteristics of the underlying company/security and
are not influenced by investor behaviour, technical analysis assumes that mar-
ket prices are simply a play between the market forces of demand and supply
(driven by investor behaviour) and are not dependent, entirely, on the underly-
ing fundamental characteristics of the security.
5 Technical analysis is aimed at identifying patterns in share price/return series
that can suggest/forecast future activity/levels.
5 Technical analysis can be defined as a method of evaluating the timing of se-
5 curities (in terms of buy/sell/hold decisions) by analysing the data generated by
market activity, such as past prices and volume.
5 Technical analysis employs various charts, tools and statistical techniques to ascer-
tain patterns and trends in the share prices/returns data by observing the movement
of share prices/returns in the past. Under this analysis, investors classify trends on
the basis of their duration (long-term, short-term) and their nature (uptrend, down-
trend). After identifying their investment horizons, investors enter (buy) and exit
(sell) the market, according to the trend which suits them (their risk–return profile).
5 Technical analysis is based on the following assumptions: the market discounts
everything, prices always move in trends and history tends to repeat itself.
5 Technically, a trend is regarded as bullish when the high point of each rally (in-
crease in price movement) is higher than the high point of the previous rally,
and the low point of each decline (downward price movement) is higher than
the low point of the previous decline.
5 Technically, a trend is regarded as bearish when the high point of each rally (in-
crease in price movement) is lower than the high point of the previous rally, and
the low point of each decline (downward price movement) is lower than the low
point of the previous decline.
5 Both bull and bear trends have three sub-phases; first, the evolution sub-phase,
second, the consolidation sub-phase and third, the speculation sub-phase. The
first two sub-phases are generally implications of actual industry/company con-
ditions. The third sub-phase, however, is a speculation sub-phase, where the
stock price is generally not a representation of its actual/intrinsic value.
5 Tools for assessing overall market movements are Dow theory, Elliott wave prin-
ciple, Kondratiev wave theory, Chaos theory, neural networks and genetic algo-
rithms.
5 Breadth of market can be ascertained by the advance/decline ratio, short inter-
est ratio theory, confidence index, odd lot ratio and relative strength analysis
(RSA).
5 Tools for assessing individual stock’s movements are chart analysis, moving av-
erages, Bollinger bands, Fibonacci series, spreads, etc.
5 There are various kinds of charts, like bar and line charts, head and shoulders pat-
tern, support and resistance levels, triangle patterns, point and figure charts, etc.
5 A moving average is calculated by taking into account the most recent n obser-
vations. For instance, a 10-day moving average will present the average of the
past 10-day security prices. These averages are used to predict trends.
5.8 · Exercises
177 5
5 Bollinger bands employ a combination of simple moving average and standard
deviation and present them through bands.
5 A spread is the difference between the bid (buying) and ask (selling) price of a
security or asset. The spread for a security is influenced by the supply (the total
number of shares outstanding that are available to trade), demand of the secu-
rity and the volume of trade.
5 Insider trading/transaction is the buying or selling of a security by an insider
(someone who has access to material non-public information). Insider trading
can be illegal or legal depending on the country and also when the insider makes
the trade.
5 Technical indicators of the witchcraft variety include the super bowl indicator,
sunspots, etc.
5.8 Exercises

(i) While ______________ analysis assumes that the market prices are a rep-
resentation of the fundamental characteristics of the underlying company/se-
curity, __________ analysis assumes that market prices are simply a play be-
tween the market forces of demand and supply (driven by investor behavior).
(ii) Technically, a trend is regarded as __________ when the high point of each
rally (price movement) is higher than the high point of the previous rally,
and the low point of each decline is higher than the low point of the previous
decline.
(iii) Technically, a trend is regarded as __________ when the high point of each
rally (price movement) is lower than the high point of the previous rally, and
the low point of each decline is lower than the low point of the previous de-
cline.
(iv) Both bull and bear trends have ________ sub-phases.
(v) Tools for assessing ___________ movements are Dow theory, Elliott wave
principle, Kondratiev wave theory, Chaos theory, neural networks and ge-
netic algorithms.
(vi) ___________ of market can be ascertained by the advance/decline ra-
tio, short interest ratio theory, confidence index, odd lot ratio and relative
strength analysis (RSA).
(vii) A ___________ is calculated by taking into account the most recent n obser-
vations.
(viii) _____________ employ a combination of simple moving average and stand-
ard deviation and presents them through bands.
(ix) A _________ is the difference between the bid (buying) and ask (selling) price
of a security or asset.
(x) Technical indicators of the ___________ variety include the super bowl indi-
cator, sunspots, etc.
v (Answer: (i) fundamental, technical (ii) bullish (iii) bearish (iv) three (v) market
(vi) Breadth (vii) moving average (viii) Bollinger bands (ix) spread (x) witchcraft).
? 2. True/False
(i) Technical analysis assumes that the market prices are a representation
of the fundamental characteristics of the underlying company/security.
(ii) Technical analysis is aimed at identifying patterns in share price/return
series that can suggest/forecast future price levels.
(iii) Fundamental analysis is based on the following assumptions: the mar-
5 ket discounts everything, prices always move in trends and history tends
to repeat itself.
(iv) A trend is regarded as bullish when the high point of each rally (price
movement) is higher than the high point of the preceding rally, and the
low point of each decline is higher than the low point of the preceding
decline.
(v) Both bull and bear trends have three sub-phases.
(vi) Tools for assessing overall market movements are Dow theory, Elliott
wave principle, Kondratiev wave theory, Chaos theory, neural networks
and genetic algorithms.
(vii) A 10-day moving average will present the average of the past 10-days’
security prices.
(viii) Fibonacci series employ a combination of simple moving average and
standard deviation and presents them through bands.
(ix) Insider trading/transaction is the buying or selling of a security by an
insider (someone who has access to material non-public information
about the security).
(x) Technical indicators of the witchcraft variety include the super bowl in-
dicator, sunspots, etc.
v (Answers: (i) False (ii) True (iii) False (iv) True (v) True (vi) True (vii) True (viii)
False (ix) True (x) True)
? 1. What are the basic assumptions behind technical analysis?

2. What are the differences between fundamental and technical analysis?
3. Distinguish between a bullish and a bearish trend. Cite real-life examples.
4. Explain the Dow theory.
5. Explain the Fibonacci numbers and its application in technical analysis.
6. Explain the basic concepts underlying chart analysis.
7. Explain the moving average technique with the help of an example.
8. Explain the Bollinger band technique with the help of an example.
5.8 · Exercises
179 5
9. What are some of the indicators of the witchcraft variety?
10. Illustrate briefly some of the latest tools and techniques (like neural networks
and genetic algorithms) used in technical analysis.
? 1. Examine the impact of the COVID-19 pandemic on the Indian stock market.
Comment on the overall trend and any patterns that are visible.
(Hint: You may track the market since the beginning of the pandemic till now).
2. Track the prices and trends of the pharmaceutical companies that promised
the COVID-19 vaccine. What do you observe?
(Hint: There have been substantial gains in the stock of such companies, possibly
indicating a bubble).
?
This can be used as a class exercise. Each student may be asked to choose a se-
parate company.
? Track the price movement of a company of your choice, over more than past
one year. Indicate the support and resistance levels for the company’s share
prices as well as any other patterns that emerge. Indicate possible timings for
entering and exiting the market for this particular stock. What are the returns
emanating from your choice of buying and selling? Present the same in class
and discuss the experiences of other students, as well.

Additional Readings
Chandra, P. (2009). investment analysis and portfolio management (3rd ed.). Tata McGraw-Hill.
Fisher D. E., & Jordan R. J. (1995). Security analysis and portfolio management (4th ed.). Pren-
tice-Hall.
Gordon, A., Sharpe, J., William, F., & Bailey, J. V. (2009). Fundamentals of investment 3rd ed.). Pear-
son Education.
South-Western.
References
Forbes website (2018), Available at 7 https://www.forbes.com/sites/startswithabang/2018/02/13/chaos-
theory-the-butterfly-effect-and-the-computer-glitch-that-started-it-all/#7d9400c669f6, Accessed
Fxempire website (2020), Available at 7 https://www.fxempire.com/news/article/eurusd-fo-
recast-using-fibonacci-retracement-levels-in-forex-graph-82091, Accessed on September 2, 2020.
IFC Markets.com website (2018). Available at 7 https://www.ifcmarkets.co.in/en/ntx-indicators/

dow-theory. Accessed on September 9, 2018.
Kondratieff.net website (2018). Available at 7 https://www.kondratieff.net/kondratieffcycles, Accessed
Stockcharts.com website (2018). Available at 7 https://stockcharts.com/school/doku.php?id=chart_
school:market_analysis:introduction_to_elliott_wave_theory, Accessed on September 2, 2018.
Stocktrader.com website (2018). Available at 7 https://www.stocktrader.com/2008/09/18/sup-
port-and-resistance-example-5-lehman-brothers-bankruptcy/, Accessed on October 1, 2017.
The Wall Street Journal website (2018). Available at 7 https://www.wsj.com/articles/
SB963527415634796028. Accessed on September 25, 2017.
5
181 6
Bond and Equity:
Valuation
and Investment
Strategies
Contents
6.2 Bonds/Debt Instruments – 183

6.2.1 Reasons for Issuing Debt – 184
6.2.2 Features/Nomenclatures of a Debt Instrument – 185
6.2.3 Concept of Time Value of Money – 187
6.2.4 Bond Valuation – 190
6.2.5 Risk in Debt Instruments – 194
6.2.6 Factors Affecting Interest Rates – 200
6.2.7 Effect of Interest Rate Changes on Bond Prices – 201
6.2.8 Yield Curve (or Term Structure of Interest Rates) – 201
6.2.9 Bond Portfolio Management Strategies – 206
6.3 Equity (Shares) Instruments – 211

6.3.1 Equity Valuation – 211
6.3.2 Equity Investment Strategies – 219
6.4 Difference Between Bond and Equity

Valuation – 221

6.2 · Bonds/Debt Instruments
183 6
The objective of this chapter is to provide the features of debt instruments and discuss
their valuation and risk. It also provides the concept of yield curves and debt port-
folio investment strategies. Further, the chapter also contains equity valuation and
investment strategies followed for the same. Finally, it provides the differences in the
valuation of debt and equity. This chapter covers the following topics.
6.1 Introduction
Prior to the liberalization of the Indian economy in 1991, debt instruments con-
stituted a substantial chunk of corporate financing. The average debt–equity
ratio used to be around 4:1 (Jain et al., 2013), which has come down significantly
(to nearly 1:1) after the equity markets gained impetus, postliberalization.
However, this does not mean that the debt instruments have receded in impor-
tance (from the investors’ point of view), in anyway. Even today, a significant por-
tion of domestic savings are parked in debt instruments making it the preferred
investment of choice for the Indian investors (Singh et al., 2016).
As is to be perhaps expected, due to the large number of investors and the
eased regulations (post-1991), over the years, both debt and equity instruments
have become more complex and volatile. However, on the positive side, liquidity
in both debt and equity markets has increased significantly postliberalization, and
sophisticated analytical tools and active investment strategies are now being de-
ployed. A lot more, though, needs to be done to move both debt and equity mar-
kets towards relatively greater efficiency.
Bond is the generic term used to denote all debt instruments, throughout this
chapter.
Since most of fundamental and technical analysis used equity investment
analysis as the focus, this chapter would first provide basic details about bond and
then proceed towards its valuation.
This chapter is divided into two parts. Part I contains basic features of bonds,
their valuation and investment strategies. Part II presents equity valuation and
strategies.
Part I
6.2 Bonds/Debt Instruments
Debt instruments, or fixed income securities, have always been an inherent part of
an investor’s portfolio, whether the investor is an individual or an organization.
A debt instrument, whether a bond or debenture, is a promissory note, issued by
184 Chapter 6 · Bond and Equity: Valuation and Investment Strategies
a business or government unit. Examples of such instruments range from fixed

deposits in banks, treasury bills, corporate debentures and money market instru-
ments like commercial papers and commercial deposits. They carry a fixed rate
of return (interest) to be paid over a fixed period of time. Debt instruments vary
widely in terms of coupon rates, maturities, tax benefits, etc.
6.2.1 Reasons for Issuing Debt
Equity shares, issued by companies, provide a share in the ownership of the com-
pany without any fixed/promised returns. In the presence of such an instrument
of financing, any organization would issue debt instruments (carrying the liabil-
ity of a fixed rate of return which has to be paid over a fixed time period) only if
6 it carried certain relative advantages. The following can be the reasons behind is-
suing debt:
i. To reduce the overall cost of capital
Debt is the cheapest source of finance. Unlike equity, debt instruments form
a contractual obligation for the company carrying a fixed rate of return (in-
terest) and a fixed payment period. For the lender, this contractual obligation
lends safety to the debt instrument. Further, debt instruments carry a collat-
eral that can be sold to meet the payment obligation in case of the company’s
failure to meet such obligations. These aspects lower the risk associated with a
debt instrument substantially, and hence, lenders are also expected to charge
a lower rate of return when compared to say, an equity instrument, which has
none of these features.
ii. To gain the benefit of leverage
As the company increases leverage on its balance sheet, it results in increasing
the returns on its shareholders’ funds (since the shareholders’ investment gets
reduced). Since the aim of the company is to maximize the wealth of its share-
holders, leverage enables the company to achieve this objective.
iii. To effect tax savings
Due to the tax advantage provided on interest payments (interest is treated as
a tax-deductible expenditure), the company saves on taxable cash flows, thus
making it even more advantageous to raise debt.
iv. To widen the sources of funds
It is important for a company to widen its sources of finance to take advan-
tage of such diversification. Debt is the cheapest source of finance.
v. To preserve control
As stated earlier, the promoters of a company have to dilute their o wnership
stake in the company when they issue shares to the public. As a result, they
have to share the control that they exert over the affairs of the company with
the new shareholders. A promoter who desires control would do well to seek
finance through debt instruments, as in that case, his ownership remains
intact.
185 6
6.2.2 Features/Nomenclatures of a Debt Instrument
Each debt instrument has the following features/nomenclatures:

i. Par value/Face value/Principal value
Definition
The par value of a bond is also called its face value or its principal value. This is
the principal amount borrowed and which is to be paid at the time of maturity (in
case of bullet maturity) or through instalments. Most commonly used face values
are in denominations like 100, 1000, 10,000, etc.
Normally, the face value and maturity date (when it is to be repaid) are printed
on the bond and typically do not change during the life of the bond.
ii. Interest rate/coupon rate
Definition
The interest rate (rate of return) carried by the bond is called its coupon rate. It is
the return promised on the face value and is expressed as a percentage. The annual
interest payment, also called the coupon, is calculated as the product of coupon
rate and face value.
Hence, coupon = coupon rate*par value of the bond.
The coupon payments can be made either quarterly, semi-annually or annually,
depending on the indenture (legal contract).
iii. Schedule/type of payment

The schedule/type of payment for a debt instrument may be either through a bul-
let maturity model or through instalment.
> a. Bullet maturity—in this case, interest payments are made regularly over the
entire time period of the debt instrument, and the principal payment is made at
the end of the maturity time period.
b. Instalment—in this case, both interest and a part of the principal are paid at
the end of every year, over the life of the debt instrument, in such a way that to-
wards the end of the maturity period, no balance payment remains.
iv. Yield to maturity (YTM)
Definition
YTM is the discount rate that equates the present value (PV) of all the bond’s ex-
pected cash flows with the current market price of the bond (it can be considered as
the internal rate of return (IRR) in capital budgeting parlance).
v. Premium bond
Definition
A premium bond is one that attracts a price that is higher than its face value, for
example, when a bond with a face value of INR 1000 commands a price of INR
1100.
vi. Discount bond
Definition
A discount bond is one that attracts a price that is lower than its face value, for ex-
6 ample, when a bond with a face value of INR 1000 commands a price of INR 900
(less than INR 1000).
vii. Par bond
Definition
A par bond is one that attracts a price that is equal to its face value, for example,
when a bond with a face value of INR 1000 commands a price of INR 1000.
viii. Indenture
> An indenture is a legal document containing the promises, pledges and re-
strictions of the contract. It involves three parties, viz.
a. Debt-issuing corporate—the company/organization which offers the debt instru-

ment,
b. Debt holder—the person/organization which buys the debt instrument and
c. Trustee—a third-party person/organization who holds the debt instruments
and their resultant obligations in trust to ensure that timely and adequate pay-
ments are forthcoming and also the safety of the instrument is assured.
ix. Maturities associated with debt instruments
Typically, a debt instrument may have three kinds of maturity periods:
a. Short term—This could extend from overnight lending and borrowing
(money markets) to a period of less than one year (e.g. 364 days’ treasury
bills).
b. Medium term—This could extend from one year to around five years.
c. Long term—As the name suggests, this debt instrument would have a ma-
turity of more than five years.
x. Call option
Even though it is not related to a maturity term, a call option on a bond en-
titles the issuer to call back/redeem the bond at a time before the actual
187 6
maturity. This feature is based on certain conditions, for example, when inter-
est rates decline. In such a situation, the issuer of debt may want to exit the
more expensive debt and substitute it with cheaper debt.
6.2.3 Concept of Time Value of Money
Since returns occur in the form of cash flows, typically spread over a long time
period, the methods/techniques of calculating returns are based on the time value
of money. Before embarking on valuation techniques for bonds and/or equity, it
would be useful to visit the concept of time value of money as it forms the basis
for valuation of both debt and equity instruments.
> “A rupee today is more valuable than a rupee tomorrow”. This statement indicates
that money carries a time value. This could be due to the following reasons:
i. Individuals and organizations prefer present consumption over future con-
sumption as they and their wants are alive today, and also, the product/service
they want to consume may not be available in the future.
ii. In the case of all investors and particularly in the case of a company (busi-
ness organization), money can be invested/employed productively to gener-
ate returns in the future. The return, thus generated, would be (1 + r) times the
amount invested today, where r is the rate of return, for the period invested.
iii. In the presence of positive inflation, the purchasing power of money reduces
(by the rate of inflation) over time. Hence, one rupee would be able to purchase
more today compared to one rupee later (say, after a year).
The two techniques used in time value of money are as follows.
6.2.3.1 Compounding Technique
Money, once invested, earns interest on a daily basis. Hence, if one stays invested
for a longer period, one can earn “interest on interest”. This aspect is called com-
pounding.
i The future value (FV) of a single cash flow under the compounding technique is
provided by Eq. 6.1
FV = PV(1 + I)n (6.1)

where FV is the future value after n years, PV or present value is the amount in-
vested today, I is the annual interest rate and n is the period of investment.
> The factor (1 + I) n is called the compounding factor and is dependent on the interest
rate I and the life of the investment, n. Values for various interest rates and periods
are already calculated and provided as future value tables, for the ease of the readers.
Annexure 1 presents the FV tables (Tables A-1 and A-2) at the end of this book.
? Numerical Example 6.1

If an investor deposits INR 20,000 in a bank that pays 10% compound interest,
how much will the deposit grow to after (a) 8 years, (b) 12 years?
v Substituting the values in Eq. 6.1,
a. FV after 8 years:
FV = PV(1 + I)n ,
FV = 20, 000(1.10)8 = 20, 000(2.144) = INR 42, 880
* The value 2.144 is the compounding factor value for 10% and 8 years, as per An-
6 nexure 1 (Tables A-1 and A-2). Alternatively, the same can also be calculated
using a financial calculator.
b. FV after 12 years:
FV = 20, 000(1.10)12 = 20, 000(3.138) = INR 62, 760

* The value 3.138 is the compounding factor value for 10% and 12 years, as per
Annexure 1 (Tables A-1 and A-2). Alternatively, the same can also be calculated
using a financial calculator. Further, online present value and future value calcula-
tors are also available.
6.2.3.2 Discounting Technique
Returns always occur in the future in FV terms. In order to compare these returns
with the price of the security/investment today, one needs to discount this future
value into present value terms.
i The technique so deployed is called the discounting technique and is given by

Eq. 6.2:
PV = FV/(1 + I)n (6.2)

where PV or present value is the equivalent value today, FV is the future value after
n years, I is the annual discount rate, and n is the period of cash flow.
> The factor 1/(1 + I)n is called the discounting factor (DF) and is dependent on the
discount rate I and the life of the investment, n. Values for various interest rates
and periods are already calculated and provided as present value tables, for the ease
of the readers. Annexure 1 presents the PV tables (Tables A-3 and A-4) at the end
of this book.
Investors, whether investing in equity or debt, may get a stream of cash flows
from their investment (in terms of dividends or interest, respectively). They would
then be interested in calculating the present value of these streams of cash flows.
189 6
An investor expects the following cash inflows from an investment: INR 400 at the
end of year 1, INR 500 at the end of year 2 and INR 600 at the end of year 3. If
the rate of return expected (discount rate) is 15%, what is the present value of this
investment?
v As per Eq. 6.2
PV = FV/(1 + I)n
Substituting values,
PV = 400(15%, 1 year) + 500(15%, 2 years) + 600(15%, 3 years)

= 400(0.870) + 500(0.756) + 600(0.658)
= 348 + 378 + 394.8 = INR 1120.80
> Sometimes investments may yield a constant stream of cash flows, such as, in the
case of interest payments. Such cash flows are called an annuity. In order to ease
calculations, the present values of an annuity factor (PVAF) for varying values of
I and n are also calculated and presented in the PVAF tables (Annexure 1—Table
A.4) towards the end of this book. Similarly, future values of an annuity fac-
tor (FVAF) for varying values of I and n are also calculated and presented in the
FVAF tables (Annexure 1—Table A.2).
i Equation 6.3 presents the PVAF:
When an annuity occurs perpetually (forever), it is called a perpetuity. In Eq. 6.3,

PVAF = [1 − 1/(1 + I)n ]/I (6.3)
as n tends to infinity, the second term in the numerator becomes zero. Hence, the
present value of INR 1 received as a perpetuity is simply 1/I, where I is the dis-
count rate.

Mr. X deposited INR 20,000 in a perpetual bond. The rate of interest is 10% per
annum. What is the present value of the returns generated from this investment?
v As per Eq. 6.3 (modified in the case of perpetuity), the annual interest is

0.10*20,000 = INR 2000.
So, the present value of return is PV = 2000/0.10 = INR 20,000.

6.2.4 Bond Valuation
The return on a debt instrument is composed of the current yield (interest) and
the capital gains (returns at the end of holding period/maturity). Together, it is
called the holding period yield.
► Example
If one owns a debenture of face value of INR 100 that carries a coupon rate of 10%
and is redeemable after 5 years, the payment stream would be:
Year 1 2 3 4 5
Interest 10 10 10 10 10
6 Principal – – – – 100
This stream of cash flows can be divided into different components (in terms of re-
turns). ◄
6.2.4.1 Current Yield
i The current yield on a bond is the annual interest due on it divided by the bond’s
market price (Eq. 6.4):
Current yield = Annual interest/Market price (6.4)
6.2.4.2 Holding Period Yield (HPY)
Definition
The holding period yield (HPY) on a bond is the interest due on it (current yield)
as well as the capital gains (taken as the difference between the price at which the
debt instrument is sold over the price at which it was bought) divided by the bond’s
original market price at which it was bought.
i HPY can be calculated as per Eq. 6.5
HPY = (It + �P)/P0 (6.5)
where
t denotes the time and refers to a holding period,
It denotes the bond’s coupon interest rate payment during the holding period t,
P0 denotes the bond’s price at the beginning of the holding period t, and
ΔP denotes the change in bond price over the period,
191 6
A bond is purchased at INR 900. During the holding period of one year, it earned
a coupon of INR 100. It was sold at INR 950 at the end of the period. Compute
the HPY.
v Applying Eq. 6.5,
HPY = (It + �P)/P0

HPY = [(100 + (950 − 900))]/900 = 150/900 = 16.67%
In the case of HPY, the assumption is that the investor holds the debt instrument
from the initiation of the instrument to its maturity. However, in the world of in-
vestment, one may have a scenario where investors own a debt instrument at dif-
ferent stages of its duration. In this case, the appropriate return measure is called
“yield to maturity” or YTM (Eq. 6.6).
Definition
YTM measures the yield available to an investor for the period for which he/she
holds the debt instrument. It is calculated as the discount rate which equates the
current price of the bond with the interest payments due and the terminal price of
the bond.
i The relationship between YTM and price can be stated as per Eq. 6.6
n

P0 = It /(1 + r)t + Pn /(1 + r)n (6.6)
t=1
where
P0 denotes the current price of the bond,
Pn denotes the terminal price/value,
It denotes the annual interest,
r denotes the discount rate (which is also called YTM),
t denotes the interim time periods, and
n denotes the terminal time period.

The coupon rate of a bond is 8%, the maturity is 3 years, the face value is INR
1000, and the discount rate (YTM) is 10%. Calculate the current price of the bond.
v Applying formula 6.6,
n

P0 = It /(1 + r)t + Pn /(1 + r)n
t=1
3

P0 = 80/(1.1)t + 1000/(1.1)3
t=1
= 2.487 ∗ 80 + 0.751 ∗ 1000
= 198.96 + 751 = INR 949.96
6 The calculation of YTM itself follows a trial and error process.

A bond is valued at INR 1000 (par) and carries a coupon rate of 8% per annum.
It matures in 8 years. The current market price of the bond is INR 900. What is its
YTM?
v As per Eq. 6.6, the YTM is the discount rate “r” used in the formula:
n

P0 = It /(1 + r)t + Pn /(1 + r)n
t=1
8

900 = 80/(1 + r)t + 1000/(1 + r)8
t=1
Through the method of hit and trial, we can choose an interest rate (YTM) to start
with, say 12% for the right-hand side of the equation. Hence, deploying the present
value of interest factors,
= INR 80(PVIFA12%,8 years ) + INR 1000(PVIF12%,8 years )
(*Please note that we have used PVIFA as the coupon payments form an annuity.)
Taking values from the present value tables provided as Annexures or by using a fi-
nancial calculator,
= INR 80(4.968) + INR 1000(0.404) = INR 801.44

193 6
Since this value is lower than the market price of INR 900, we would need to
choose a lower rate, say 9%:
= INR 80(5.5348) + INR 1000(0.502) = INR 442.78 + INR 502 = INR 944.78
As this value is above the required value of INR 900, it is evident that the YTM lies
between 9 and 12%. Using interpolation, one can arrive at the approximate YTM
as follows:
YTM = Lower rate + [(Value at lower rate−Desired value)/(Value at lower rate

−Value at higher rate) ∗ Difference between rates
= 9% + [(943.784 − 900)/(943.784 − 801.44)]
∗ (12 − 9) = 9% + 0.92% = 9.92%
approximately. (The approximation is due to the rounding off errors).

To cross check, one can substitute the YTM in the equation:
= INR 80(PVIFA9.92%,8 years ) + INR 1000(PVIF9.92%,8 years )
= INR 80(5.305) + INR 1000(0.4692) = INR 897.24,
which is quite close to INR 900.
(*There are online web calculators available for PVIFA, FVIFA, PVIF and FVIF as
well. That should make the calculations easier for the readers.)
> Prof. Hawawini and Prof. Vora, in the 1982 issue of Journal of Finance, have sug-
gested a simpler formula for readers/students not inclined towards the cumbersome
trial and error method suggested earlier, for the calculation of an approximate
YTM (Hawawini & Vora, 1982). The suggested formula is provided in Eq. 6.7.
YTM = [C + (M − P)/n]/[0.4M + 0.6P] (6.7)

where
YTM denotes yield to maturity,
C denotes the annual interest payment (coupon),
M denotes the maturity value of the bond,
P denotes the present price of the bond, and.
n denotes the years to maturity (period).
Substituting values from our previous example in Eq. 6.7,
YTM = [80 + (1000 − 900)/8]/[0.4 ∗ 1000 + 0.6 ∗ 900]
= 92.5/940 = 9.80%.
As is evident, this value is quite close to our estimated YTM of 9.92%.

Or, alternatively, we can use (0.5 M + 0.5 P) in the denominator which is just the
average of present price and the maturity price. In that case, the YTM will be appro-
ximately 9.74%.
6.2.4.3 Yield on a Perpetual Bond

A perpetual bond is a bond on which the coupon is paid perpetually and the prin-
cipal in never paid back. Perpetual bonds are not in practice anymore.
i For perpetual bonds, the YTM formula can be rewritten as given in Eqs. 6.8 and
6.9:
P0 = I1 /(1 + YTM) + I2 /(1 + YTM)2 . . . + In /(1 + YTM)n (6.8)
where n tends to infinity and I1 = I2 = I3 = I4 = … = I0, Eq. 6.7 can be simplified to
P0 = I0 /(YTM) (6.9)
(This is similar to the perpetuity equation).
6
A bond has a face value of INR 100 with a 15% coupon rate. The coupon is paid
perpetually, and the face value is never paid back. The yield to maturity is 10%.
Calculate the price of the bond.
v On substituting the values given in the example in Eq. 6.9,

P0 = I0 /(YTM)
P0 = 15/0.10 = INR 150
6.2.5 Risk in Debt Instruments
Bonds are considered to be less risky than equity instruments as they carry a fixed
rate of return (coupon interest) and a fixed payment period. Further, secured debt
obligations carry asset(s) as collateral/mortgage which secures payment in case of
inability of the borrower to pay. All of this is mentioned in the contract drawn
between the borrower and lender (indenture) and is legally binding. However, a
debt instrument is not devoid of risk. There are many factors which can contrib-
ute towards the risk of a debt instrument.
> As in case of equity instruments, such risk can be broadly divided into unsystem-
atic and systematic risk. Unsystematic risk comprises the unique risk factors that
affect the specific bond and can lead to a potential default. Systematic risk on
bonds, on the other hand, is the risk that emanates from market and/or macroeco-
nomic factors and is applicable on all debt instruments participating in that mar-
ket. Examples of such risk are purchasing power risk, interest rate risk and rein-
vestment rate risk.
195 6
6.2.5.1 Unsystematic Risk in Bonds
Definition
Unsystematic risk, also called the default risk, is a combination of business risk
and financial risk factors, facing the borrower organization.
In investment terms, a default refers to the possibility that the return realized
would be less than the promised one.
This risk emanates from the underlying business that the debt-issuing com-
pany conducts. It indicates that a decline in earning power may impair the com-
pany’s ability to service debts.
A lender may default on the payment of interest and/or principal due to in-
adequate earnings or even wilfully. The rising non-performing assets (NPAs) of
banks are an example of the default risk which plagues financial institutions.
► Example
A bond has a face value of INR 1000, a maturity period of 10 years and a coupon rate
of 10% per annum. The yield (YTM) expected is 10%.
However, due to some reason, if the coupon payments are delayed up to the end of
10 years, then the yield will obviously be less than 10%.
Hence, the revised yield would be 1000 = (1000 + 10 * 100)/(1 + YTM)10.
or YTM = (2000/1000)1/10 – 1 = 7.17% which is less than 10% ◄
Since businesses are assumed to be a riskier entity than say, the government, the
default risk of corporates is higher than the government. Hence, in order to at-
tract investors, corporate bonds sell at higher yields than government. Central
government bonds, typically, have the lowest business and financial risk because
of its sovereign status as well as the fact that it is the only entity in the economy
that owns the largest pool of assets.
> Default can be of different degrees:

5 Extension of time to make payments
5 Rescheduling of amount/timing
5 Legal liquidation of debtors.
Default typically results from inadequate liquidity (weak cash flow management) or
inadequate earnings due to inadequate revenues.
At the time of writing this text, rising defaults in the wake of the COVID-19
pandemic and the resultant moratoriums announced by the RBI are a real-life sce-
nario, playing out around us.
Analytical thrust of high-grade bond selection is different from common stock se-
lection, although earning power is the fundamental basis of value for both. There
are specialized organizations called credit rating agencies that provide comparative
ratings to debt instruments, based on various underlying parameters. These ratings

are fluid and change to reflect changes in the parameters.
► Example
A high-grade bond selection emphasizes continuity of income and protection against
loss of principal. However, such high-grade bonds may undergo an impairment in
their quality due to decrease in earning potential or similar fluctuations. Similarly, sec-
ond-rate bonds may improve in quality over time due to increased earnings and asset
protection.
Various credit rating agencies assess and subsequently provide grades to debt instru-
ments issued by various companies and organizations. Examples of credit ratings pro-
vided by some well-known agencies are as follows:
6 Agency Ratings
Moodys AaaAa1 Aa2Aa3 A1 A2 A3 Baa1 Baa2 Baa3
S&Ps AAAAA+AA AA– A+ A A– BBB+ BBB BBB–
CRISIL AAAAA A BBBBBB C D
ICRA AAAAA A BBB BBB B C D
*Both CRISIL and ICRA prefix their ratings with their names, like CRISIL AAA,
ICRA AAA and so on. ◄
Major Factors in Bond Rating Process

A range of factors is considered when evaluating the credit rating of a bond.
Some of them are as follows:
i. Indenture provisions
These are the aspects that are a part of the indenture (the legal contract be-
tween the lender and the borrower) such as liquidation, creation of additional
debt, limitation on sale and lease back of assets. These features are basically
aimed at securing the lender’s interests.
ii. Earnings power and leverage
In order to determine the borrowing organization’s earnings (and its sustaina-
bility) and its solvency (for it to be able to service its debt obligations), various
ratios are deployed. Some of the important ones are as follows:
a. Interest coverage ratio (ICR)—This ratio is calculated as earnings before in-

terest and taxes (EBIT) or operating profit divided by the interest charge. The
higher the ratio, the better in terms of paying capacity.
i Hence, ICR can be denoted by Eq. 6.10:
ICR = EBIT/I (6.10)

where
ICR = interest coverage ratio,
197 6
EBIT = earnings before interest and taxes, and
I = interest.
b. Debt service coverage ratio (DSCR)—Typical indenture provisions carry the
creation of a sinking fund (putting money aside as a deposit to meet a future
obligation) to meet the debt (principal) payments from the net earnings (earn-
ings after taxes or EAT). This is done at the stage of profit appropriation,
and such a sinking fund can also be called the “loan/debt repayment reserve”.
This is to ensure that debt (interest and principal payments) is serviced even if
earnings fluctuate or are inadequate.
i The DSCR can be denoted by Eq. 6.11:
DSCR = EBIT/Installment (6.11)

where
DSCR = debt service coverage ratio,
EBIT = earnings before interest and taxes, and
Instalment = interest and principal payments.
Further, in terms of sinking fund payments, the same equation can also be writ-
ten as follows:
DSCR = EBIT/(I + [SF/(1 − T )]) (6.12)

where
DSCR = debt service coverage ratio,
EBIT = earnings before interest and taxes,
I = interest payment,
SF = sinking fund created to meet principal payments, and
T = company’s income tax rate.
iii. Liquidity
Liquidity is a measure of the ability of a company to meet its short-term ob-
ligations. It refers to the extent of internal cash generation through the net
earnings after adding back non-cash outflows like depreciation and amortiza-
tion (net income plus depreciation plus amortization), sale of equity (external
financing) and/or sale of fixed assets.
iv. Management
The quality of the management at the helm of affairs is an important param-
eter in the credit rating process. The credit worthiness of the company and its
credit history under the specific management is an indication of the profes-
sionalism exhibited by the company in servicing its debt obligations.
How the management handles the company when the company is in a state of un-
certainty, the company is involved in an acquisition programme, the company is a
small player in the market, etc., can provide an insight into the professional acu-
men of the management.
Caselet 6.1: McDonald

McDonald’s is an American company that sells fast food (burgers) through outlets
across the world. The following data is available for the company:
a. 2/3rd of McDonald’s capital comes from equity financing.
b. Cash flows can pay at least 45% of long-term debt (LTD) in a year. Hence, the
ratio of cash flows/LTD = 45%.
c. Negative working capital (where current liabilities are greater than current assets)
is area of concern (as current ratio (CR) < 1) but not an area of anxiety since cur-
rent assets are highly liquid (the nature of business being cash transactions).
* Current ratio = current assets/current liabilities.

Further, for this example and for a particular year, revenues = $200 million.
6 Operating expenses:
5 Variable = $40 million;
5 Fixed = $100 million (including depreciation of $25 million).
Hence,
EBIT = (revenues–operating expenses) = 200–140 = $60 million.
On examining the balance sheet, McDonald’s carries debt obligations in the form of:
5 6% first mortgage bond worth $75 million
5 10% subordinate debt worth $50 million
Hence, the interest obligations emanating out of the above two debt obligations
would be:
Interest = 4.5 (calculated as 6%*75) + 5 (calculated as 10%*50) = 9.5 million.
Finally, the company is financed by common equity worth $600 million and has
created a combined sinking fund for principal payment (for both debt instru-
ments) worth $6 million. The income tax rate is 40%.
You are required to calculate a. interest coverage ratio; b. debt service coverage ra-
tio and c. which ratio would you like to see to know whether the bonds (debt) can
be safely serviced by the company or not?
Solution:
a. Interest coverage ratio;
Applying Eq. 6.10,
ICR = EBIT/I = 60/9.5 = 6.32.
b. Debt service coverage ratio;
DSCR = EBIT/(I + [SF/(1-T)]) = 60/(9.5 + [6/0.6]) = 60/(9.5 + 10) = 3.08.
c. Which ratio would you like to see to know whether the bonds (debt) can be
safely serviced by the company?
We would like to see both interest coverage and debt service coverage ratios as
simply looking at one ratio may not provide the complete picture.
199 6
6.2.5.2 Systematic Risk in Bonds
The systematic risk in bonds is the risk arising from the “system” or market the
bond is a part of. Hence, this risk is also called “market” risk. Systematic/market
risk can be divided into four kinds, viz. purchasing power/inflation risk, interest
rate risk, reinvestment rate risk and liquidity risk.
i. Purchasing power/inflation risk
This risk emanates from the prospect that high/severe inflation may impair the
purchasing power of the interest received on debt as well as of the principal
amount itself.
The return expected by the lender in the form of interest includes the rate
of inflation. According to the Fisher equation (Eq. 6.13),
i =r+π (6.13)
where
i is the nominal interest rate,
r is the real interest rate, and.
π denotes the rate of inflation.
Thus, if the inflation rate rises, it eats into (diminishes/reduces) the real interest
rate which is available to the lender. This risk is termed as inflation risk.
> Generally, commodity price levels are positively correlated with interest rates.
Hence, the following relationships are evident:
a. When commodity prices rise, investors require higher interest rates to protect
purchasing power of the debt income, and
b. Rising commodity prices increase credit demands, leading to increase in interest
rates.
Hence, the lender expects a “premium plus cover” for expected rise in inflation.

Consider the current price of the bond to be INR 100, expected inflation to be 6%,
and the rate of interest to be 4%. What is the resultant value of the bond after one
year?
v In this case, next year, the value of the bond would be
= 100(1.04)/1.06 = 98.11 (which is a capital loss).

Thus, the investor would expect to earn at least 6% plus a premium. Hence, in-
terest rates would be greater than 6%. Further, if the expected inflation is uncer-
tain, a little higher premium may be required.
ii. Interest rate risk

This kind of risk exists due to the volatility in prices and interest payments
because of changing interest rates. As interest rates rise, it may become un-
tenable for the borrower to service debt. Correspondingly, a lowering of in-
terest rates may adversely impact the returns accruing to the borrower. At the
time of writing this text, we are witnessing the impact of interest rate risk in
the Indian economy due to the COVID-19 pandemic. Non-performing assets
(NPAs) are expected to rise in most banks due to increased levels of default.
iii. Reinvestment risk
Coupon income should earn the same interest as at the time of reinvestment;
otherwise the yield will be different. However, the interest rates do fluctuate,
and hence, the rates of reinvestment vary.
An investor in a debt instrument could plan to reinvest the interest accruing
6 from one investment into another one. This planning can only be possible if the
intermittent interest receipts remain constant and known. However, if interest
rates keep fluctuating, such a reinvestment would be nearly impossible to make.
Unstable underlying economic conditions are the primary cause for this.
iv. Liquidity risk
The market for debt instruments continues to be illiquid when compared to
the equity markets. This leads to liquidity risk as traders may not be able to
find adequate volumes at desired prices, in order to conclude a trade.
6.2.6 Factors Affecting Interest Rates
Bond prices depend on and are affected by both external factors (economic ex-
pansion, economic slowdown, government deficit, central bank) and internal fac-
tors (default rate).
6.2.6.1 External Factors
i. Economic expansion
During an expansionary phase, the unemployment rate decreases, and the
business activity gathers pace. Businesses, thus, borrow money for plant and
equipment, inventory, etc. Hence, the demand for credit increases, thus push-
ing the interest rates up.
ii. Economic slowdown (recession)
The reverse of (i) happens during an economic slowdown. As is to be ex-
pected, the unemployment rate rises, and manufacturing/business activity re-
duces. Thereby, demand for credit falls, bringing down interest rates.
iii. Government deficit
Heavy borrowings by the government to finance its deficit push up interest
rates and the government becomes the major borrower. This phenomenon is
also called “crowding out of business borrowings”.
For example, during the tenure of President Ronald Reagan of the USA,
government deficit increased due to tax cuts but there was no corresponding cut
in government spending, leading to heavy borrowings by the US government.
201 6
iv. Central Bank
Central banks actively control the money supply and increase/decrease rates.
As a result, bond prices and yields (interest rates) keep on changing continu-
ously.
6.2.6.2 Internal Factors
Internal factors are generally related to default risk which has been discussed in
the previous section. Typically, if the risk of default is high, the lender will de-
mand a higher interest payment. Further, if the credit rating assigned to the debt
instrument is below investment grade, the company may find no takers for its se-
curity.
6.2.7 Effect of Interest Rate Changes on Bond Prices
Bond prices vary inversely with interest rates. The resultant effect of interest rate
changes on the price of a bond is a function of three variables: the maturity pe-
riod of the bond, the coupon rate and the current yield of the bond.
> These relationships can also be studied under the following bond price theorems
(BPTs):
BPT1—Holding coupon and yield constant, a bond with longer maturity is more
price sensitive to interest rate changes.
BPT2—Holding maturity and yield constant, a bond with lower coupon is more
BPT3—Holding coupon and maturity constant, a bond with higher yield is more
The relationship between the bond’s prices and the interest rates (yields) is pre-
sented in yield curves.
6.2.8 Yield Curve (or Term Structure of Interest Rates)
Definition
Yield curves are the graphical representation of the term structure of interest rates.
It indicates how the YTM is related to the time remaining for maturity for bonds
of similar nature but with varying terms to maturity.
The level of interest goes up or down due to various factors. However, the level of
interest is different from the term structure of interest rates. For a given bond is-
suer, the structure of nominal interest rates for a set of bonds that differ only with
respect to the length of time till maturity is called the term structure of interest
rates or yield curve.
. Fig. 6.1 Yield curve. Source Authors’ compilation
Normally, the yield curve rises with longer maturity because of increase in
risk. However, it is not necessary; short-term interest rates may be greater than
long-term interest rates.
► Example
. Figure 6.1 illustrates the normal yield curve.
In . Fig. 6.1, the horizontal axis measures the maturity period and the vertical axis
measures the returns (yield). When the maturity time period is lower, the return on the
investment is low. When/if the maturity time period increases, the return from the in-
vestment starts to increase. ◄
The interest rate levels are determined by the availability and demand of loanable
funds as well as liquidity preferences.
The classical shape of the curve is shown in . Fig. 6.1. However, typically, the
short-term rates fluctuate more than long-term ones. For example, it could hap-
pen that short-term rates move from 6 to 9% while long-term (over 20 years) rates
move from 8.50 to 8.90% only.
> If the yield on long-term instruments is lower than that of the short term, it implies
that investors expect a fall in interest rates for three reasons:
a. They expect inflation to come down substantially in the future reducing infla-
tion premium.
203 6
b. They expect government to reduce its deficit, and
c. They expect a recession or slowdown in the economy, reducing the potential de-
mand for capital.
► Example
The phenomenon discussed is depicted through the inverted yield curve (. Fig. 6.2).
Inverted yield curves indicate that the returns on the short-term maturity bonds are
higher vis-à-vis the long-term bonds. The inverted yield curve highlights the negative
relationship between the maturity time period and return on the investment. ◄
Hence, in continuation with the earlier bond price theorems, based on the yield
curves, further bond price relationships can be established:
> Bond Price Theorems (BPTs)

BPT4—Bond’s prices move inversely to bond’s yield.
BPT5—If everything else remains the same, a bond’s interest rate risk (price
volatility) increases with the length of time remaining for its maturity.
BPT6—A bond’s price (price volatility) increases or decreases at a slower rate
as the time remaining to maturity increases.
BPT7—The price change resulting from an equal increase or decrease in a
bond’s yield is not symmetrical. That is, for any given maturity, a decrease in
yield results in price rise which is higher than the price loss that is caused from
an equal increase in yields.
. Fig. 6.2 Inverted yield curve. Source Authors’ compilation

BPT8—The price volatility increases as the yields level (from which change is
made) increases.
BPT9—Price volatility increases as the coupon declines, for the same change
in yield.
6.2.8.1 Causes of Term Structure (Yield Curve)

There are four theories that can provide an explanation for the term structure:
5 Expectations theory;
5 Liquidity premium theory;
5 Preferred habitat theory;
5 Market segment theory.
i. Expectations theory
6 The current structure of interest rates is determined by the combined forecast
on future interest rates (yields). The theory posits that the shape of the yield
curve is dependent on the interest rate expectations of market participants.
i In other words, the expectations theory suggests that a long-term interest rate can
be calculated as the geometric mean of the present and future one-year rates fore-
casted by market participants.
√
1 + rtoday for 2 years = (1 + r1 ) (1 + r2 )
where r1 and r2 are one-year rates in year 1 and year 2.

√
1 + rtoday for 3 years =3 (1 + r1 ) (1 + r2 ) (1 + r3 );

where r1, r2 and r3 are one-year rates in years 1, 2 and 3.

Hence, the relationship can be surmised in Eq. 6.14:
√
1 + rtoday for n years =n (1 + r1 )(1 + r2 ) . . . (1 + rn )

(6.14)
where r1, r2 and rn are one-year rates in years 1, 2 and n.

A one-year bond has a yield of 6%. An investor expects 8% yield for a one-year
instrument to be bought next year. What can be the expected yield of a two-year
bond bought today?
v Applying the values in Eq. 6.14,

√
1 + rtoday for 2 years = (1.06) · (1.08) = 1.07 = 7%
205 6
So, as per this hypothesis:
5 An upward sloping curve is an indication of investor expectations of a rise in
interest rates.
5 A flat yield curve is an indication of investor expectations of interest rates re-
maining the same (stagnant).
5 A downward sloping curve is an indication of investor expectations of a fall in
interest rates.
ii. Liquidity premium theory

The expectations theory is criticized due to its assumption that investors know
the future. What lies ahead, however, can never be known with certainty.
There is always an uncertainty associated with one-period returns which in-
creases along with the bond maturities.
The liquidity premium theory recognizes that investors are sensitive to risk.
Long-term maturity bonds have greater liquidity risk and the investors like to
be compensated for that. Hence, since investors are risk-averse, they require an
incentive to hold on to long-term bonds. Such investors demand a long-term
rate that is higher than the average expected future rate to compensate for re-
duced liquidity due to the long-term nature of the bond.
This theory may make a yield curve to slope upward even when investors
expect the rates to fall or decline.
iii. Preferred habitat theory
As per the preferred habitat theory, investors prefer to match the maturity of
their investments to their overall investment goal as well as consumption re-
quirements. Investors with longer investment horizons invest in long-term se-
curities. Similarly, investors with shorter investment horizons invest in short-
term securities. The same can be said of borrowers as well; they match the ma-
turity of their borrowings with the duration for which they require funds.
In the preferred habitat theory, the shape of the yield curve is not fixed. It
can be upward sloping, downward sloping, flat or humped, depending on the
future expectations of interest rates and the risk premium associated with the
movement of the market participants of the preferred habitat. Such a move-
ment may be necessitated in case of a mismatch in demand and supply situa-
tions for funds for a certain maturity period.
iv. Market segment theory
Market segment theory can be considered an extension of the preferred hab-
itat theory. Built on the premise that investors/borrowers are not willing to
shift from their preferred maturity range in any case, this theory suggests that
the shape of the yield curve is determined purely by the supply and demand
forces for each maturity range.
Typically, groups of investors regularly prefer bonds with certain maturity
ranges in order to hedge their liabilities. For example, insurance companies
buy long-term bonds while commercial banks buy short-term instruments.
Due to the assumption of absolute risk aversion, the market segment theory
appears unrealistic. It is observed that market participants do rebalance their
portfolios and move away from their preferred habitats in case of significant
differences between current and expected rates. The ongoing COVID-19 pan-
demic has forced almost all market participants to move out of their preferred
habitats and rejig their portfolios.
6.2.8.2 Investment Strategy Related to Yield Curves

The investment strategy related to yield curves is typically called “riding the yield
curve”. This strategy is a buy and hold strategy in which the bond investor pur-
chases a long-term bond when the yield curve is sloped upward and is expected to
maintain the same level and slope.
The bond purchased is simply held in order to obtain capital gains that occur
in the years remaining.
6 6.2.9 Bond Portfolio Management Strategies
The bond portfolio management strategies can broadly be classified into seven
groups.
6.2.9.1 Passive Strategy
This strategy is preferred primarily by income maximizing investors who are in-
terested in the highest steady coupon income over a desired horizon. They include
retired persons, endowment funds, bond mutual funds (debt mutual funds), in-
surance companies, etc., seeking the maximum yield over an extended period of
time.
> A passive investor is typically a long-term investor and indulges in three kinds of
investment practices/strategies:
i. Buy and hold
In this case, an investor buys and holds the bond for the entire life of the bond.
ii. Indexing
In this case, an investor mirrors his debt portfolio on an existing index and fol-
lows it.
iii. Laddering
Within the passive strategy, the strategy of laddering involves building a bond
ladder, that is, buying bonds scheduled to come due at several different dates in
the future rather than in the same year.
Obviously, laddering will not produce as much income currently as buying the
highest yielding long-term bonds, but the diversification makes it safer. Such a
strategy is good for conservative investors who are not sure of interest rate move-
ments.
6.2.9.2 Active Strategy
On the other hand, an active investor is typically a short-term investor and tries
to gain abnormal returns by playing around the underlying volatile factors.
207 6
> He/she may focus on:
i. Interest rate anticipation

In this case, an investor anticipates changes in interest rates and buys and
sells, based on the same. Due to the inverse relationship between interest rates
(YTM) and prices, normally, higher interest rates mean lower prices and hence
a good time to buy. Similarly, lower interest rates mean higher prices and a
good time to sell (to record capital gains).
ii. Valuation analysis
Just like equity investment, an investor may conduct a valuation exercise for a
debt instrument and buy when it is undervalued in the market and sell when it
is overvalued in the market. Naturally, a high coupon paying bond would be
preferred over a low coupon paying bond in terms of current yield.
iii. Credit analysis
A bond with a high credit rating is a safer instrument to buy and would gen-
erally command a premium. An investor may try to record abnormal gains
by trading in bonds with different credit ratings and, hence, attracting differ-
ent prices. Generally, junk bonds (so-called due to their poor credit rating) are
highly risky and promise high returns to attract investors.
iv. Yield spread analysis
Active investors can conduct a yield spread analysis for the short to medium
term and buy and hold based on the movement of yield curves. Typically, an in-
vestor will buy and hold when he/she expects the yield curve to increase (posi-
tive slope) and short sell (sell and then buy subsequently) when he expects the
yield curve to fall.
v. Hedging risk through bond swaps
Consider two firms—one holding a fixed rate debt instrument and the other
holding a floating rate (where the interest rate fluctuates within a band) debt
instrument. The floating rate debt instrument company expects the interest
rates to rise in the future and, is thus, apprehensive about increased cash out-
flows. Bond swaps are derivative instruments in which an entity looking for say,
a fixed rate of debt payment may swap its debt instrument cash flows with an-
other entity which is looking for say, a floating rate instrument. Even though
bond swaps are derivatives and not bond management strategies, per se, they
are a popular way to hedge the risk of the debt portfolio.
6.2.9.3 Core Plus Satellite Management

In this strategy, elements of both passive and active strategies are factored in.
Here, there is a core portfolio that is invested in, in a passive (buy and hold) man-
ner and there is a satellite portfolio, in which the securities are actively managed,
through frequent buying and selling based on active/changing indicators.
6.2.9.4 Horizon Matching
In this strategy, the portfolio consists of various instruments whose repayment
time periods coincide with the investors’ inflow requirements (for future con-
sumption). This is done both for current yields and capital gains.
6.2.9.5 Classical Immunization Strategy

Interest fluctuations result into changes in prices of bonds and the reinvestment
rates of coupon income. The situations can be
5 If interest rates rise, since the time of purchase of the bond, the price received
for the bond in the market would be below expectation (price risk).
5 If interest rates fall, reinvestment at YTM would not be possible (reinvestment
rate risk).
Thus, price risk and reinvestment rate risk resulting from interest rate variations
have an opposite effect on the investors’ wealth. The strategy of immunization is
adopted to eliminate these opposite effects.
A bond portfolio is considered immunized if the realized return on a bond in-
vestment is as large as the yield initially envisaged. Such an investor would build
6 a portfolio that immunizes him/her against such price and/or reinvestment risks.
The most popular immunization strategy is duration. Immunization provides a
compound rate of return over the immunized period that equals the YTM, re-
gardless of the fluctuations in market interest rates during this period.
Duration
► Example
Consider a bond bought with a face value of INR 1000 and a coupon rate of 10%.
This means that the end of the period wealth should be 1000(1 + 0.1)n. This can hap-
pen only if the coupon payments received are reinvested at the same rate as YTM (i.e.
10%). However, if the interest rates fluctuate, the coupon payments will not earn the
same rate as YTM, and as a result the end wealth will not be the same after n years as
expected or initially envisaged (i.e. 1000(1 + 0.1)n).
If the interest rate rises, it can have two consequences: (i) the capital value of the bond
reduces, and (ii) the return on reinvestment of interest income rises. Conversely, if the
interest rate falls, it can have two consequences: (i) the capital value of the bond in-
creases, and (ii) the return on reinvestment of interest income falls. Hence, the change
in interest rate results in two effects in the opposite directions. Is it possible for an inves-
tor to ensure that these two opposite effects remain equal, and he/she is unaffected by
interest rate risk? Yes. This is possible if the investor invests in a bond which has a dura-
tion equal to his/her investment horizon. Duration is the period for which if the bond is
held, the end wealth remains unaffected despite the changes in reinvestment rates.
Therefore, an investor whose investment horizon is 10 years should invest in a bond
with a duration of 10 years. ◄
Thus, as an immunization strategy aimed at targeting price and reinvestment

risks, duration is the computation of the average maturity of the cash flows gen-
erated by a financial asset. Statistically, duration can be computed as the weighted
average of the lengths of time left till the asset’s remaining payments are made. The
proportions of the present value of the remaining cash flows (that represent the
value of the asset) are taken as the weights.
209 6
> The most popular immunization strategy is given by Prof. Macaulay and is called
the Macaulay duration (MD). MD is the weighted average term to maturity of the
cash flows from a bond (in terms of present value). It is the time for which the
bond must be held in order to get the required return. The weight of each cash flow
is calculated by taking the fraction of present value of the cash flow.
i The formula for MD is given by Eq. 6.15:
n

t n
Macaulay Duration(MD) = tC/(1 + r) + nM/(1 + r) /P0 (6.15)
t=1
where
t = period in which the coupon is received
C = periodic (usually semi-annual) coupon payment
r = the periodic yield to maturity or required yield
n = number periods
M = maturity value (in $)
P0 = market price of bond.

A bond has a face value of INR 700 and a coupon rate of 10%. The time to matu-
rity is 7 years. Find the Macaulay’s Duration of the bond such that it results in an
YTM of 10%.
v Applying Eq. 6.15, step by step,
n

Macaulay Duration(MD) = tC/(1 + r)t + nM/(1 + r)n /P0
t=1
Year Coupon Present value Present value PV as Macaulay’s

(1) (10%) interest factor (PV) of coupon percentage of duration (MD)
(2) (PVIF) @10% paid total (1*5)
(3) (4) (5)
1 70 0.909 63.63 0.091 0.091
2 70 0.826 57.82 0.083 0.165
3 70 0.751 52.57 0.075 0.225
4 70 0.683 47.81 0.068 0.273
5 70 0.621 43.47 0.062 0.311
6 70 0.565 39.55 0.057 0.342
7 770 0.513 395.01 0.564 3.948
Total 699.92 5.355
Hence, the MD of the bond is 5.355 years
Let us consider another example.

A bond has a coupon value of INR 200 with 6 years remaining for its maturity and
an YTM of 10%. The maturity principal value is 3000. Calculate Macaulay’s Dura-
tion (MD).
n

6
t n
Macaulay Duration(MD) = tC/(1 + r) + nM/(1 + r) /P0
t=1
Year Coupon Present value Present value PV as % Macaulay’s

(1) (10%) interest factor (PV) of of total duration
(2) (PVIF) @10% coupon paid (5) (MD)
(3) (4) (1*5)
1 200 0.909 181.80 0.071 0.071
2 200 0.826 165.20 0.064 0.129
3 200 0.751 150.20 0.059 0.176
4 200 0.683 136.60 0.053 0.213
5 200 0.621 124.20 0.048 0.242
6 3200 0.565 1808 0.704 4.225
Total 2566 5.057
Hence, the MD is approximately 5.06 years.
Properties of Macaulay’s Duration (MD)

MD exhibits the following properties:
1. A coupon paying bond’s MD is less than or equal to maturity or MD < = n
(where n stands for the maturity term).
2. For a zero-coupon bond or discount bond (i.e. the principal and interest pay-
ment are made at the end), MD = n.
3. For a coupon paying bond, the limiting value of MD (LVMD) is defined as
LVMD = 1 + YTM/YTM.
4. Duration of a perpetual bond is LVMD.
MD is considered to be a better measure of its time structure than its years to

maturity as MD reflects the amount and timing of each cash flow. MD has an im-
portant application in immunizing interest rate risk.
6.3 · Equity (Shares) Instruments
211 6
6.2.9.6 Contingent Procedures (Structured Active Management)
In this case, immunization strategy would be adopted only when there is an emer-
gence of price risk and/or reinvestment rate risk.
6.2.9.7 Global Fixed Income Investment Strategy

Nowadays, in the global economy, investors need not constrain themselves to one
market. In fact, large institutional investors now have the option of trading in
debt instruments across world markets. This arbitrage helps them gain returns by
buying debt instruments from a market where they are cheaply available (due to
low demand/high supply) and swapping/selling them in markets where they are
able to attract higher prices (due to high demand/low supply).
Part II
6.3 Equity (Shares) Instruments
Equity (shares) have been discussed extensively through the other chapters, as
well. This chapter focuses on methods of equity valuation and equity investment
strategies.
6.3.1 Equity Valuation
There are many methods which can be deployed to carry out equity valuation.
6.3.1.1 Capital Asset Pricing Model (CAPM)

The capital asset pricing model (CAPM) is a model which presents how risk and
return are related. It was the first formal theory on how risky assets are priced.
Professor William Sharpe, the proponent of this theory, was honoured with the
Nobel Prize for his contribution. The CAPM has been discussed in detail in
7 Chapter 8 titled “Diversification of Risk”.
i According to CAPM, the expected return can be calculated as per Eq. 6.16:

E Rj = Rf + ßj E(Rm ) − Rf (6.16)
where
E(Rj) = expected return on security j,
Rf = risk-free return,
ßj = beta of security j,
E(Rm) = expected return on market portfolio,
E(Rm)−Rf is called the market risk premium.

If E(Rm)–Rf = 8% and Rf = 3%, βx = 1.25 and βy = 0.6, calculate the expected return
as per CAPM.
v Applying Eq. 6.16, for βx = 1.25, E(Rx) = 3% + 1.25 × (8%) = 13% and for βy = 0.60,

E(Ry) = 3% + 0.60 × (8%) = 7.80%.
Concept in Practice 6.1: Equity Returns (measure through CAPM) in India

The authors of this book conducted a study on equity returns in India for the pe-
riod 1994–2014 (Singh et al., 2016). The expected equity returns were measured
through the CAPM approach, for the Indian stock market, represented by the
6 NSE 500 companies.
The CAPM appears to be an appropriate model to calculate expected returns ema-
nating from the Indian stock market. The average expected returns are 13.47% and
the average market index returns are 16.46%, indicative of the market being able
to perform better than the expected returns by the technical investors.
The average cost of equity (ke) for the sample companies based on the CAPM ap-
proach, over the period of the study, is around 14% (13.75%). The average return
on equity (RoE) computed is 19.20%, indicative of the fundamental strength of
the sample companies in earning returns which are above the expectations.
Hence, prima facie, the sample companies, constituting 96.27% of the total market
capitalization at NSE, continue to be an attractive investment destination for both
fundamental (long-term) and technical (short-term traders) investors. However, in
the presence of volatility in the short run which increases the risk, it would per-
haps be prudent to invest in the long run in the Indian stock market. Such a strat-
egy should result in relatively less risky and more stable returns vis-à-vis the short-
run returns.
6.3.1.2 Present Value Estimation

Present value estimation is simply the estimation of the future value of the invest-
ment in today’s term. This is an application of the time value of money where the
present value of an investment/security is the discounted value of the promised/
forecasted future/terminal value. The discount rate, ke, is the required rate of re-
turn (cost of equity).
i The formula for present value estimation is given as Eq. 6.17:
PV = FV/(1 + ke )n (6.17)
where
PV denotes the present value,
213 6
FV denotes the future value,
ke denotes the required rate of return (cost of equity), and
n denotes the time period.
This method is useful when returns occur in the form of both dividends and cap-
ital gains in the future. This is similar to the PV technique introduced earlier. The
only difference is that the discount rate used in this case is the cost of equity.
6.3.1.3 Dividend Discount Models

Dividend discount models are based on the concept that the value of an equity
share is equal to the present value of dividends the investor expects from its own-
ership.
i Since equity shares have an indefinite maturity, the value of an equity share is given
as per Eq. 6.18:
P0 = D1 /(1 + ke )1 + D2 /(1 + ke )2 + . . . + D∞ /(1 + ke )∞ (6.18)

where
P0 denotes the price/value of share at time 0 (today),
D1, D2, … D∞ denote the dividends paid in time periods 1, 2…. till infinity, and
ke denotes the required rate of return (cost of equity).
> In order to deploy the infinite dividend stream model, it becomes necessary to spec-
ify the dividend growth expected each year up to infinity. Obviously, this is an im-
practical proposition. Hence, users of the dividend discount model resort to sim-
plistic assumptions about the dividend growth patterns. The most popular ones are
as follows:
5 Dividend per share remains constant forever, and the growth rate is zero (zero
growth model).
5 Dividend per share grows at a constant rate per year (constant growth model).
Zero Growth Models

This model assumes a constant dividend policy where the actual dividend paid re-
mains constant/stagnant over time. In this case, the price of a share today would
be the dividend paid discounted by the cost of equity.
i The formula for zero growth model is provided in Eqs. 6.19 and 6.20:
P0 = D1 /(1 + ke )1 + D2 /(1 + ke )2 + . . . + Dn /(1 + ke )n (6.19)

where
D1, D2, … Dn denotes the dividends paid at year 1, 2…. n,
Equation 6.19 is similar to Eq. 6.18.

Further, since the dividend is not expected to grow at all (zero growth) and re-
main constant forever, the formula can be simplified (as in case of a perpetuity) to
Eq. 6.20:
P0 = D/ke (6.20)
Constant Growth Model
In this model, the dividend paid continues to grow at a constant rate “g”. Hence,
the price of a share today would be the dividend paid (after factoring a constant
growth) discounted by the cost of equity.
i The formula for constant growth model is provided in Eq. 6.21:
6
∞

P0 = D0 (1 + g)n /(1 + ke )n (6.21)
t=1
where
D0 denotes the dividends paid at time 0,
g denotes the rate of growth,
In case of a perpetuity, the equation can be stated as follows:
P0 = D1 /(ke − g) (6.22)
Company A intends to pay a dividend of INR 1 per share next year and investors
expect it to grow at 10% per annum, thereafter. The required rate of return (ke) of
the company’s stock is 16%, and currently the company is trading at INR 15 per
share. Ascertain whether the share is undervalued or overvalued.
Given ke = 16%, g = 10%, D1 = 1.

P0 = D1 /(ke − g)
Substituting values in Eq. 6.22,

Po = 1/(0.16 − 0.10) = INR 16.67.
Since the actual value (INR 16.67) of the stock is more than market value (INR
15), it means the stock is undervalued.
215 6
An investor requires a 10% rate of return (RoR) in the equity shares of a company.
What will be the market price of the share if the previous dividend was INR 2 and
the investor expects the dividend to grow at a constant rate of:
a. 5%
b. 0%
v As per Eq. 6.22,
P0 = D1 /(ke − g)
a. 2 (1 + 0.05)/(0.1 -0.05)
2*1.05/.05
= INR 42
b. 2 (1 + 0)/(0.1 – 0)
2*1/.1
= INR 20
Variable Growth Model

In a more realistic manner, this model assumes a variable growth rate in the divi-
dend paid.
i If g1 is taken as the initial growth rate (for the initial growth period, n1) and g2 is
taken as the subsequent growth rate (for the subsequent growth period, n+1 onwards),
then the value of the share can be calculated by following these steps:
Step 1: Calculate the value of dividends received at the end of each year during the
initial growth period (1 to n) as follows:
Dn =D0 (1 + g1 )n = D0 ∗ PVIFg1,n
Step 2:Determine the present value of the dividends expected during the initial
growth period, n:
n

P0 = D0 (1 + g1 )n/(1 + ke )n = (Dt ∗ PVIFke,n )
t=1
Step 3: Compute the value of the share at the end of the initial growth period (n).
Symbolically, it would become
Pn = (Dn + 1)/(ke − g2 )
This will then become the present value of the dividend expected from the period
n + 1 onwards at the rate g2. This would continue till infinity.
Symbolically, it would become
[1/(1 + ke )n ] ∗ [(Dn + 1)/(ke − g2 )]

Step 4: Add the present values obtained in steps 2 and 3, to find the value of the
share.
6.3.1.4 Book Value Method

The book value per share (BVPS) also called the net worth per share can be com-
puted in two ways (Eqs. 6.23 and 6.24).
i Book value per share is the value per share of the assets of the company (at their
value in the balance sheet) minus all liabilities (including preference shares).
BVPS = (Assets−Liabilities)/Number of outstanding equity shares (6.23)

or
6
Net worth per share(NWPS)
= Net worth of the company
× (equity capital plus reserves and surplus−accumulated losses, if any)
/number of outstanding equity shares
(6.24)

A company has total assets of INR 60 crores and total liabilities of INR 45 crores.
It has 1,00,000 equity shares. Calculate the book value per share (BVPS).
BVPS = (assets−liabilities)/number of outstanding equity shares

BVPS = (INR 60 crores–INR 45 crores)/1,00,000 = INR 1500.
6.3.1.5 Liquidation Value Method

Generally applied in the case of liquidation, the liquidation value per share
(LVPS) is computed as the value realized from liquidating all assets of a company
less all the liabilities (including preference shares) divided by the number of eq-
uity shares outstanding.
i LVPS = (Value realised from liquidation of assets − Liabilities)

(6.25)
/Number of outstanding equity shares

A company has total assets of INR 60 crores which can be liquidated for INR 50
crores. It has a total liabilities of INR 45 crores. It has 1,00,000 equity shares. Cal-
culate the liquidation value per share (LVPS).
217 6
LVPS = (Value realised from liquidation of assets − Liabilities)

LVPS = (INR 50 crores – INR 45 crores)/1,00,000 = INR 500.
LVPS is more realistic (in terms of the value of assets) compared to BVPS. How-
ever, it may not be possible to estimate the liquidation value of assets when a
company is performing well.
As a downside, it should be noted that both BVPS and LVPS do not take into
consideration the earnings potential of the company.
6.3.1.6 Price/Earnings (P/E) Multiple/Ratio

The price/earnings (P/E) multiple/ratio indicates the amount investors are willing
to pay for each rupee of earnings.
i Based on the P/E ratio, the market price of the share (MPS) can be provided as per
Eq. 6.26:
MPS = Earnings per share(EPS) ∗ P/E ratio (6.26)

A company expects to earn INR 15 per share in the coming year and the average
P/E ratio for all the companies in the sector is 10. Compute the market price of the
share.
MPS = earnings per share(EPS) ∗ P/E ratio.

MPS = INR 15*10 = INR 150.
Concept in Practice 6.2: Impact of Growth on Price, Returns and P/E Ratio
P/E ratios are amongst the most practical ways of determining whether the pre-
vailing share prices are rational or not. P/E ratios, or price/earnings ratio, are
calculated as “market price per share/earnings per share”. The P/E ratio signi-
fies the price being paid by the buyer of equities for each rupee of annual earn-
ings, whether distributed as dividends or retained in the company. The P/E ratio is
also a useful indicator of the investors’ (market’s) mood and state. It measures the
overall reasonableness or otherwise, of the market’s valuation.
Theoretically, the P/E ratio is not a perfect measure. The reason is, while the price
that an investor pays for a share is really for buying the future stream of earnings,
the P/E ratios are actually computed from the past (latest available) earnings per
share (EPS). Further, the EPS is calculated as the net profit of the last year divided
by the number of equity shares. It does not take into account the reserves and sur-
plus of the company which is also shareholders’ funds. Despite its imperfect nature,
the practical usefulness of P/E ratios is widely recognized in the world of invest-
ments in stock markets. In fact, analysis of equity investment and returns is incom-
plete without taking note of the P/E ratio.
P/E Ratios in India.
6 India began to open up its stock market gradually to foreign portfolio investment
in the 1980s. Further, the Indian government provided fiscal incentives to domes-
tic savers for investing in equities. This pushed up the domestic demand for equi-
ties and led to the popularization of equity investment amongst the investing com-
munity (in particular the middle class). As a result of all these developments, India
experienced a strong and extended bullish market for a decade and a half from the
early 1980s to the first half of the 1990s.
Further, over the past two decades, Indian investors have come to accept a substan-
tially reduced dividend yield, i.e. dividend as a per cent of market price; it is, to a
marked extent, also a reflection of the rise in the P/E ratios, especially because the
dividend payout ratio has remained largely unchanged (Jain et al., 2013).
As a logical corollary of this, it follows that capital gains constitute relatively more
important component of equity returns (and dividends less important). Investors
cannot, therefore, expect a regular annual return from equity investments in most
cases because capital gains (or losses) due to equity price appreciation (or deprecia-
tion), will always be uncertain in a volatile market like India.
Interpreting the P/E Ratio: A Word of Caution.
A high P/E ratio indicates that the investors are confident about the company’s fu-
ture performance/prospects and have expectations of high future returns; high P/E
ratios reflect optimism. On the contrary, a low P/E ratio indicates those firms in
which investors have low confidence as well as expectations of low returns in future
years; low P/E ratios reflect pessimism (Khan and Jain, 2014).
The Indian economy appears to be led by more than six-tenths of the sample com-
panies, in terms of aggressive (high) P/E ratios of more than 10. These are the
growth stocks amongst the sample companies. Nearly, 15% of the sample compa-
nies have a P/E ratio of less than 5 as in 2014. This number has, however, come
down substantially from more than 50% in 2001. Further, the market response to
EPS growth is evident. This can be regarded as a testimony of fundamentals apply-
ing in the Indian economy.
219 6
> Firm Valuation.
It is to be noted that the value of the entire firm can be calculated by adding the
value of its debt and equity components. Further, to compute the value of own-
ership of the company, i.e. the value of its equity portion, one simply needs to
multiply the per share value computed earlier by the number of shares.
Several texts on firm valuation deploy the methods discussed earlier. Another
method that is widely used is the free cash flow (FCF) method. FCF denotes
the “free” cash flow available to the investors of the business (both debt and eq-
uity providers). On the same lines, FCF to equity owners (FCFE) denotes the
cash flow left for the equity shareholders (owners) of the business, after paying
off the debt financiers.
The calculation of “free” cash flow to equity requires an understanding of ac-
counting and core financial management concepts and, as such, is beyond
the scope of this text. The typical equation used for the same is provided as
Eq. 6.27.
Free Cash Flow to Equity(FCFE) = Net Income − (Capital Expenditures − Depreciation)
− (Change in Non - cash Working Capital) + (New Debt Issued − Debt Repayments)
(6.27)
Readers who have a background in accounting/finance can read more about the
same.
6.3.2 Equity Investment Strategies
In the case of equity investment, broadly, an investor can follow either an active
or a passive strategy of investment.
6.3.2.1 Active Strategy
An active strategy is based on the premise that stock markets are not totally ef-
ficient, and all historical and current information is not correctly reflected in the
current price of every stock. Hence, there exist stocks that are undervalued, fairly
valued and/or overvalued, and returns can be earned by trading in such stocks.
> Active strategies can draw from the following analyses/aspects:
(i) Fundamental analysis—Through this, an investor may consider investing in sec-

tors that are doing well under the current economic scenario (top-down ap-
proach) or may invest in specific securities that are undervalued (bottom-up ap-
proach).
(ii) Technical analysis—Through this analysis, an investor may adopt a contrarian
approach to investing and buying when others are selling and vice versa; he/she
may even identify technical patterns and follow the price momentum (buy when
prices are low and sell when prices are high).
(iii) Anomalies—Some investors take advantage of market anomalies like the cal-
endar anomaly, value anomaly, size anomaly, etc., and plan their purchase de-
cisions when the share is cheap or undervalued and their selling decisions when
the shares are overvalued. Anomalies are discussed in greater detail in the chap-
ter on market efficiency.
6.3.2.2 Passive Strategy
By contrast, an investor/equity manager who believes the market is efficient tends
to favour a passive strategy, with indexing being the most common form of pas-
sive strategy. In this strategy, an investor buys a stock and holds it for an invest-
ment period as he/she expects to earn a return that would correspond with the
long-term growth/returns of the stock.
6 6.3.2.3 Difference Between Active and Passive Strategy

. Table 6.1 presents the differences in the active versus passive strategies followed
by equity investors in terms of the activities of portfolio construction, trading of
securities and portfolio monitoring.
. Table 6.1 Differences between the active and passive strategy
Portfolio construction
Active Passive
i. Subjective depends on investor behaviour i. Objective depends on fundamentals of the
ii. Complex rules as values of underlying varia- company
bles keep fluctuating ii. Simple rules easier to implement
iii. Few names—it is difficult to actively monitor iii. M any names can mirror an index consist-
many stocks at one time ing of many companies
iv. Appropriate weightings—it is important to iv. P recise weightings which can mirror a
provide appropriate weightings as the risk–re- market/sector index
turn complexion keeps changing
Trading of securities
Active Passive
v. Worked transactions require personal monitor- v. P
rogrammed transactions can be handled
ing and intervention by a programmed software
vi. Fewer names—it is difficult to actively trade in vi. Many names—it is easier to trade espe-
many stocks at one time cially in the case of indexing as an index
vii. Cash reserves—an active investor may need to can be traded in as a single security
keep cash reserves in order to fulfil frequent vii. F ully vested—a passive investor can stay
buy/sell transactions, as the case may be fully invested over a long term through
the buy and hold strategy
Portfolio monitoring
Active Passive
viii. I nfrequent—an active investor may not be viii. C
onstant—through the tactic of index-
able to monitor all his/her securities con- ing, a passive strategy can be constantly
stantly monitored by monitoring the index
ix. Approximate—under changing circumstances, ix. Detailed—again, through the tactic of in-
an active strategy is, at best, an approximate dexing, a passive strategy can be moni-
strategy as it is nearly impossible to monitor tored in greater detail by monitoring the
all aspects, of all securities, at all times index
6.4 · Difference Between Bond and Equity Valuation
221 6
Portfolio management processes and strategies are discussed in greater detail in
the chapter on “Portfolio Management: Process and Evaluation”.
6.4 Difference Between Bond and Equity Valuation
Even though similar in terms of having time value of money as the basis, bond
and equity valuations differ in the following respects:
i. Level of complexity
Bond valuation is relatively easier as the interest rate and the period are
known parameters, whereas equity valuation is a more complex process as the
returns are uncertain and can change from time to time.
ii. Parameters used to arrive at price
The parameters used to arrive at price in the case of bond valuation are typi-
cally interest and the capital gains (difference between terminal price and price
at origin of the investment). However, in case of equity valuation, it is the size
of the return and the degree of fluctuation (risk) that together determines the
value of a share to the investor.
iii. Role of forecasting
The role of forecasting is relatively low in the case of bond valuation, as pa-
rameters are generally known. It is, on the other hand, far more crucial in the
case of equity valuation as parameters may vary substantially over time.
Concept in Practice 6.3: Equity Returns in India and its Comparison with Re-
turns on Debt Instruments
The authors of this book conducted a study on equity returns in India for the pe-
riod 1994–2014 (Singh et al., 2016). The expected equity returns were measured
through the CAPM and the risk premium approach, for the Indian stock market,
represented by the NSE 500 companies.
The equity returns have been computed for varying holding periods, viz. fifteen,
ten, five and one-year periods. Along with returns, other statistics, used to meas-
ure risk or volatility, have also been computed to present the overall picture of risk
and return emanating from the Indian equities. The returns for all periods aver-
age around 20% which is encouraging. However, the volatility present in the short
term (one-year holding period) is substantially high indicating speculative forces at
play. It is gratifying to note that such volatility decreases significantly as the hold-
ing period increases, indicating that the market favours long-term investors.
Further, to get a complete perspective, equity returns were compared with long-
term and short-term debt returns (interest rates). In terms of after-tax returns and
liquidity, equity returns in India fare better than debt returns. However, in terms
of risk (volatility), debt returns provide a safer option. Further, the debt markets
provide recourse to the investor in terms of diversification when equity markets
are volatile, due to their continued stability.
Comparison with Debt Instruments.
a. Comparisons of Long-Term Returns
The best annual interest rates available on 15-years, 10-years and 5-years fixed
deposits (to compare with the 15-years, 10-years and 5-years equity holding pe-
riods) have been 10% on an average over the study period (Source: Moneycon-
trol website, 2014). The average returns for the equity portfolios of these dura-
tions were 18.41, 19.62 and 17.33% for 15, 10 and 5-years holding periods, re-
spectively.
6 It is to be noted that interest earned on deposits is taxed in the hands of the in-
vestor in India, as are capital gains. At the time of writing this text, the interest
income (taxed at the personal income tax slab of the individual) could attract
a maximum tax rate of 30%, whereas the long-term capital gains tax is 20%.
It is evident from the tax rates that the after-tax computation of equity returns
would be greater than the after-tax computation of interest income (assuming
the highest tax slab rate of 30%). The other advantage that accrues to equity in-
vestment is the liquidity (in terms of transaction and the entry/exit into/from
the market). On both counts of taxes and liquidity, equity investment appears
a better alternative than debt. However, it is important to consider the volatil-
ity present in equity investment. For the risk-averse investor, debt instruments
provide attractive return with low risk. Assuming debt instruments to be nearly
risk-free, the “risk premium” on equity, prima facie, appears to be approxi-
mately 8% in India (from the statistics computed). This finds support in the fig-
ures mentioned in the surveys conducted by PricewaterhouseCoopers and Er-
nst and Young to determine the equity risk premium in India (Pricewaterhouse
Coopers website (2015) and Ernst and Young website (2015)).
Overall, it appears that India continues to be an attractive investment destina-
tion for both equity and debt instruments as it caters to the requirements of
both the risk-taking and risk-averse investor.
b. Comparison of Short-Term Returns
The one-year bank interest rates have been relatively stable (fluctuations rang-
ing from 8 to 12% over 25 years). The call money market rates, comparatively,
have shown wider fluctuations with rates rising to nearly 20%, showing the vol-
atility in short-term debt returns. However, debt instrument returns (interest
rates) provide safer (as is expected) returns when compared to one-year equity
returns. Hence, it appears that India provides debt markets as a safer option in
times of volatility in equity returns, thus providing the investors with the much
required alternative to counter such volatility, present in one market. However,
in 2008, both equity returns and interest rates fell due to the financial crisis,
6.5 · Conclusion
223 6
which is perhaps to be expected, indicating that certain fundamental and sys-

tematic factors may affect both markets adversely, leaving the investor with no
choice but to diversify into international financial markets or into commodities
like gold and silver.
The ongoing COVID-19 pandemic has affected both debt and equity markets around
the world. Investors are thus, parking their funds in gold and silver, resulting in their
prices touching all time “highs”.
6.5 Conclusion
This chapter introduced the basic features of debt instruments and further delved
into interest rates and yield curves. It also detailed the hypotheses/reasons be-
hind the yield curves. After highlighting the type of risks which debt instruments
face, it provided methods to value debt instruments. Further, it explored the bond
portfolio management strategies deployed in the investment world. It introduced
“duration” as a classical immunization strategy. The chapter then presented eq-
uity valuation techniques, followed by the broad strategies deployed in equity in-
vestment, viz. active and passive. It also provided the differences between bond
and equity valuation. Further, it provided empirical evidence from the authors’
own research to substantiate and validate the content presented.
Summary
5 A debt instrument, whether a bond or debenture, is a promissory note, issued by
a business or government unit. Examples of such instruments range from fixed
deposits in banks, treasury bills, corporate debentures and money market instru-
ments like commercial papers and commercial deposits.
5 The reasons for issuing debt can be to reduce the overall cost of capital, to gain
the benefit of leverage, to effect tax savings, to widen the sources of funds and/
or to preserve control.
5 The par value of a bond is also called its face value or its principal value. This is
the principal amount borrowed and which is to be paid at the time of maturity.
5 The interest rate (rate of return) carried by the bond is called its coupon rate. It
is the return promised on the face value and is expressed as a percentage.
5 The annual interest payment, also called the coupon, is calculated as the prod-
uct of coupon rate and face value. Hence, coupon = coupon rate*par value of
the bond.
5 In case of bullet maturity, interest payments are made regularly over the entire
time period of the debt instrument, and the principal payment is made at the
end of the time period.
5 In case of instalment, both interest and a part of the principal are paid at the
end of every year, over the life of the debt instrument, in such a way that to-
5 A premium bond is one that attracts a price that is higher than its face value. A
discount bond is one that attracts a price that is lower than its face value. A par
bond is one that attracts a price that is equal to its face value.
5 An indenture is a legal document containing the promises, pledges and restric-
tions of the contract. It involves three parties, viz. debt-issuing corporate, bond
holder and trustee.
5 The current yield on a bond is the annual interest due on it divided by the
bond’s market price. Hence, current yield = annual interest/market price.
5 Holding period yield or HPY denotes the return emanating over the holding pe-
riod.
HPY = (It + �P)/P0

where
6 t denotes the time and refers to a holding period,
It denotes the bond’s interest rate payment during the holding period t,
P0 denotes the bond’s price at the beginning of the holding period t, and
ΔP denotes the change in bond price over the holding period.
5 Yield to maturity or YTM measures the yield available to an investor for the pe-
riod for which he/she holds the debt instrument. It is calculated as the discount
rate which equates the current price of the bond with the interest payments due
and the terminal price of the bond.
The relationship between YTM and price can be stated as follows:
n

P0 = It /(1 + r)t + Pn /(1 + r)n
t=1
where
P0 denotes the current price of the bond,
Pn denotes the terminal price/value,
It denotes the annual interest,
t denotes the year,
r denotes the discount rate (YTM), and
5 Risk in bonds/debt instruments can be broadly divided into unsystematic and
systematic risk.
5 Unsystematic risk comprises the unique risk factors that affect the specific bond
and can lead to a potential default. Systematic risk is the risk that emanates
from market and/or macroeconomic factors and is applicable on all debt instru-
ments participating in that market.
5 Unsystematic risk, also called the default risk, is a combination of business risk
and financial risk factors, facing the borrower organization.
5 Default can be of different degrees: extension of time to make payments, re-
scheduling of amount/timing and/or legal liquidation of debtors.
5 The major factors considered in the bond rating process include indenture pro-
visions, earnings power and leverage, liquidity and/or management.
6.5 · Conclusion
225 6
5 Systematic/market risk can be divided into four kinds, viz. purchasing power/in-
flation risk, interest rate risk, reinvestment rate risk and liquidity risk.
5 Bond prices depend on and are affected by both external factors (economic ex-
pansion, economic slowdown, government deficit, central bank) and internal
factors (default rate).
5 Bond prices vary inversely with interest rates. The resultant effect of interest rate
changes on the price of a bond is a function of three variables: the maturity pe-
riod of the bond, the coupon rate and the current yield of the bond.
5 The term structure of interest rates, popularly known as the yield curve, indi-
cates how yield to maturity is related to term to maturity for bonds that are simi-
lar in all respects, except maturity.
5 The four hypotheses that provide an explanation for the term structure are as
follows: expectations hypothesis, liquidity premium hypothesis, preferred habitat
hypothesis and/or market segment hypothesis.
5 The bond portfolio management strategies can broadly be classified into seven
groups: passive strategy, active strategy, core plus satellite management, horizon
matching, classical immunization strategy, contingent procedures (structured ac-
tive management) and global fixed income investment strategy.
5 A bond portfolio is considered immunized if the realized return on an invest-
ment in bonds is sure to be at least as large as the yield initially envisaged.
5 The most popular immunization strategy is given by Prof. Macaulay and is
called the Macaulay Duration (MD). MD is the weighted average term to matu-
rity of the cash flows from a bond (in terms of present value). It is the time for
which the bond must be held in order to get the required return.
The formula for MD is given as follows:
n

t n
Macaulay Duration(MD) = tC/(1 + r) + nM/(1 + r) /P0
t=1
where
t = period in which the coupon is received,
C = periodic (usually semi-annual) coupon payment,
r = the periodic yield to maturity or required yield,
n = number periods,
M = maturity value (in $), and
P0 = market price of bond
5 Expected equity returns based on the capital asset pricing model (CAPM) can
be calculated as follows:
E(Rj) = Rf +ßj [E(Rm) - Rf]
where
E(Rj) = expected return on security j,
Rf = risk-free return,
ßj = beta of security j, and
E(Rm) = expected return on market portfolio.
E(Rm) − Rf is called the market risk premium
5 The present value of future cash flows in case of equity returns can be calcu-
lated as follows:
PV = FV/(1 + ke) n
where
PV denotes the present value,
FV denotes the future value,
n denotes the time period
5 Dividend discount models are based on the notion that the value of an equity
share is equal to the present value of dividends the investor expects from its
ownership.
Since equity shares have an indefinite maturity, the value of an equity share is
given as follows:
6 P0 = D1/(1 + ke) 1 + D2/(1 + ke)2 + ….. + D∞/(1 + ke)∞
where
D1, D2, … D∞ denote the dividends paid in time periods 1, 2… till infinity, and
ke denotes the required rate of return (cost of equity).
5 In case the dividend is not expected to grow at all (zero growth) and remain con-
stant forever, the formula can be simplified (as in case of a perpetuity) as fol-
lows:
P0 = D/ke
5 In case the dividend is expected to grow at a constant rate, the formula is as fol-
lows:
P0 = D0 (1 + g) n/(1 + ke) n.
where
D0 denotes the dividends paid at time 0,
g denotes the rate of growth,
5 On simplifying the constant growth equation in case of a perpetuity, it becomes
P0 = D1/( ke − g)
5 Book value per share (BVPS) is the amount per share on the sale of assets of
the company (at their value in the balance sheet) minus all liabilities (including
preference shares).
BVPS = (assets–liabilities)/number of outstanding equity shares
5 Net worth per share (NWPS) = net worth of the company (equity capital plus
reserves and surplus–accumulated losses, if any)/number of outstanding equity
shares
5 Liquidation value per share (LVPS) is computed as the value realized from liqui-
dating all assets of a company less all the liabilities (including preference shares)
divided by the number of equity shares outstanding.
6.6 · Exercises
227 6
5 Based on the P/E ratio, the market price of the share (MPS) can be calculated as
follows: MPS = earnings per share (EPS) * P/E ratio.
5 Bond and equity valuations differ in the following respects: level of complexity,
parameters used to arrive at price and role of forecasting.
6.6 Exercises
? 1. Fill in the Blanks

(i) A _________ instrument, whether a bond or debenture, is a promissory note, is-
sued by a business or government unit.
(ii) The _______ value of a bond is also called its face value or its principal value.
This is the principal amount borrowed and which is to be paid at the time of
maturity.
(iii) The interest rate (rate of return) carried by the bond is called its _________
rate. It is the return promised on the face value and is expressed as a percentage.
(iv) In case of _________ maturity, interest payments are made regularly over the
entire time period of the debt instrument, and the principal payment is made at
the end of the time period.
(v) A __________ bond is one that attracts a price that is higher than its face value.
(vi) An __________ is a legal document containing the promises, pledges and re-
strictions of the contract.
(vii) The __________ on a bond is the annual interest due on it divided by the
bond’s market price.
(viii) ______________ risk comprises the unique risk factors that affect the specific
bond and can lead to a potential default.
(ix) Bond prices vary ___________ with interest rates. The resultant effect of inter-
est rate changes on the price of a bond is a function of three variables: the ma-
turity period of the bond, the coupon rate and the current yield of the bond.
(x) __________________ is computed as the value realized from liquidating all as-
sets of a company less all the liabilities (including preference shares) divided by
the number of equity shares outstanding.
v (Answers: (i) debt (ii) par (iii) coupon (iv) bullet (v) premium (vi) indenture (vii)
current yield (viii) unsystematic risk (ix) inversely (x) liquidity value per share
(LVPS)).
? 2. True/False
(i) The annual interest payment also called the coupon is calculated as the product
of coupon rate and face value.
(ii) In case of bullet maturity, both interest and a part of the principal are paid at
the end of every year, over the life of the debt instrument, in such a way that to-
(iii) A discount bond is one that attracts a price that is lower than its face value.
(iv) An indenture involves three parties, viz. debt-issuing corporate, bond holder
and trustee.
(v) Holding period yield or HPY denotes the return, consisting of coupon and
capital gains, for the holding period.
(vi) A bond portfolio is considered immunized if the realized return on an invest-
ment in bonds is sure to be equal to the yield initially envisaged.
6 (vii) CAPM is based on the notion that the value of an equity share is equal to the
present value of dividends the investor expects from its ownership.
(viii) Liquidation value per share (LVPS) = net worth of the company (equity cap-
ital plus reserves and surplus–accumulated losses, if any)/number of outstand-
ing equity shares
(ix) Based on the P/E ratio, the market price of the share (MPS) can be calculated
as follows: MPS = earnings per share (EPS) * P/E ratio.
(x) Bond and equity valuations differ in the following respects: level of complexity,
parameters used to arrive at price and role of forecasting.
v (Answers: (i) True (ii) False (iii) True (iv) True (v) True (vi) True (vii) False
(viii) False (ix) True (x) True)
? SQ1. A bond is purchased at INR 800. During the holding period of one year, it
earned a coupon of INR 50. It was sold at INR 900 at the end of the period. Com-
pute the HPY.
HPY = (It + �P)/P0
HPY = [(50 + (900 – 800)]/800 = 150/800 = 18.75%
? SQ2. A bond has a face value of INR 1000. The coupon rate is 10%, and the matu-
rity period of the bond is 10 years. Assuming interest is paid annually, calculate the
price of the bond. Assume YTM is the same as coupon rate.
6.6 · Exercises
229 6
v Applying the YTM formula (Eq. 6.6),
n

P0 = It /(1 + r)t + Pt /(1 + r)n
t=1
Hence,
10

P0 = 100/(1.1)t + 1000/(1.1)10 ,
t=1
The same can also be written as follows:
P0 = [INR 100 ∗ (PVIPA1 0, 10) + INR 1000(PVIF1 0, 10)]

= (100 ∗ 6.145) + (1000 ∗ 0.386)
= 614.5 + 386 = INR 1000.
Thus, the bond value is the same as its par value.
? SQ3. Given the other facts remain the same as in Question 1, except that the re-
quired rate of return (yield) changes to (i) 12% and (ii) 8%, find the value of the
bond.
v (i) Applying the YTM formula (Eq. 6.6),

n

P0 = It /(1 + r)t + Pn /(1 + r)n
t=1
10

P0 = 100/(1.12)t + 1000/(1.12)10 ,
t=1

P0 = [INR 100*(PVIFA12,10) + INR 1000(PVIF12,10).
= (100*5.650) + (1000*0.322) = 565 + 322 = INR 887.
Thus, the bond will be sold at a discount to its par value.
(ii) Applying the YTM formula (Eq. 6.6),
n

P0 = It /(1 + r)t + Pn /(1 + r)n
t=1
10

P0 = 100/(1.08)t + 1000/(1.08)10 ,
t=1

P0 = [INR 100*(PVIFA8,10) + INR 1000(PVIF8,10)

= (100*6.710) + (1000*0.463) = 671 + 463 = INR 1134.
Thus, the bond will be sold at a premium to its par value.
? SQ4. A bond’s face value is INR 500 (par) and carries a coupon rate of 5% per an-
num. It matures in 5 years. The current market price of the bond is INR 550. What
is its YTM?
v As per Eq. 6.6, the YTM is the discount rate “r” used in the formula:
n

P0 = It /(1 + r)t + Pn /(1 + r)n
6 t=1
5

550 = 25/(1 + r)t + 500/(1 + r)5 .
t=1
Through the method of hit and trial, we can choose an interest rate (YTM) to start
with, say 5% for the right-hand side of the equation. Hence, deploying the present
value of interest factors,
= INR 25 (PVIFA5%,5 years) + INR 500 (PVIF5%,5 years).
Taking values from the present value tables provided as Annexures or by using a fi-
nancial calculator,
= INR 25(4.3295) + INR 500(0.7835) = 108.2375 + 391.75 = 499.9875.
Since this value is lower than the market price of INR 550, we would need to
choose a lower rate, say 2%:
= INR 25(4.7135) + INR 500(0.9057) = 117.8375 + 452.85 = 570.6875.
As this value is above the required value of INR 550, it is evident that the YTM
lies between 5 and 2%. Using interpolation, one can arrive at the approximate
YTM as follows:
YTM = lower rate + [(value at lower rate–desired value)/(value at lower rate-value at
higher rate)] * difference between rates.
= 2% + [(570.6875–550)/(570.6875–499.9875)] * (5–2) = 2% + 0.88% = 2.88% ap-
proximately. (The approximation is due to the rounding off errors).
To cross check, one can substitute the YTM in the equation:
= INR 25 (PVIFA2.88%,5 years) + INR 500 (PVIF2.88%,5 years).
= INR 25(4.5954) + INR 500(0.8677) = INR 548.735, which is quite close to INR
550.
? SQ5. Calculate the Macaulay’s Duration of a 3-year semi-annual coupon bond

with 6% coupon per annum and yield to maturity of 8%. The face value of the
bond is INR 100.
6.6 · Exercises
231 6
v In this case, the cash flows occur on a semi-annual basis. So there would be a to-
tal of six cash flows for the three-year period and the interest rate for each half-year
would be 4% (half of 8%). The calculation of the Macaulay’s Duration is as below:
Applying Eq. 6.13, step by step,

n

t n
Macaulay Duration(MD) = tC/(1 + r) + nM/(1 + r) /P0 .
t=1
Half- Coupon (3% Present Value Present PV as % of Macaulay’s

year semi-annual) Interest Value (PV) Total Duration
(1) (2) F a c t o r of Coupon (5) (MD)
(PVIF) @4% Paid (1*5)
(3) (4)
1 3 0.962 2.886 0.030 0.030
2 3 0.925 2.775 0.029 0.058
3 3 0.889 2.667 0.028 0.084
4 3 0.855 2.565 0.027 0.108
5 3 0.822 2.466 0.026 0.130
6 103 0.790 81.37 0.859 5.154
Total 94.73 5.564
Hence, Macaulay Duration = 5.564 years
? SQ6. Calculate the Macaulay duration of a 10 year, 8% annual payment bond with
yield to maturity at 10%. The face value of the bond is INR 100.
n

t n
Macaulay Duration(MD) = tC/(1 + r) + nM/(1 + r) /P0 .
t=1
Year Coupon Present Value Present Value PV as % Macaulay’s

(1) (2) Interest Factor (PV) of of Total Duration
(PVIF) @10% Coupon Paid (5) (MD)
(3) (4) (1*5)
1 8 0.909 7.272 0.08 0.08
2 8 0.826 6.608 0.075 0.15
3 8 0.751 6.008 0.068 0.20
4 8 0.683 5.464 0.062 0.25
Year Coupon Present Value Present Value PV as % Macaulay’s

(1) (2) Interest Factor (PV) of of Total Duration
(PVIF) @10% Coupon Paid (5) (MD)
(3) (4) (1*5)
5 8 0.621 4.968 0.056 0.28
6 8 0.564 4.512 0.051 0.31
7 8 0.513 4.104 0.046 0.32
8 8 0.467 3.736 0.042 0.34
9 8 0.424 3.392 0.038 0.34
10 108 0.386 41.688 0.475 4.75
87.752 7.018
6 Hence, Macaulay’s Duration = 7.018  years.
? SQ7. An investor expects a share to pay dividends of INR 3 and INR 3.15 at the
end of years 1 and 2, respectively. At the end of the second year, the investor ex-
pects the shares to trade at INR 40. The required rate of return on the shares is
8%. If the investor’s forecasts are accurate and the market price of the shares is cur-
rently INR 30, is the stock overvalued?
v As per Eq. 6.15,
PV = FV/(1 + ke)n.
PV = 3/1.08 + 3.15/(1.08)2 + 40/(1.08) 2 = 2.77 + 2.69 + 34.29 = INR 39.75.
Since the current market price of the share is INR 30, the stock is undervalued.
? SQ8. Calculate the current value of Company A’s shares using the dividend dis-
count model. Based on current market prices, comment if the share is overvalued
or undervalued, given the stock price on the given day is INR 78.81. It is expected
that the share would sell for at least INR 90 after 5 years.
It’s given that beta for Company A’s share is 1.5 and risk-free rate of return is 3%,
expected market rate of return is 11% based on BSE 500, the dividend paid by
Company A for the year is INR 1.53, and dividend growth rates are expected to be
as follows:
Year Dividend growth rate (%)
1 11.72
2 11.51
3 11.30
4 11.09
5 10.88
6.6 · Exercises
233 6
v Calculating expected rate of return using CAPM and applying Eq. 6.14,
E(Rj) = Rf + ßj [E(Rm) − Rf].

Expected rate of return = 3 + 1.5(11–3) = 3 + 12 = 15%
This will be the discount rate for all future dividends and capital gains.
Year Dividend value Dividend PVIF@15% PV of
growth rate % dividends
0 1.53 11.72 1 1.53
1 1.71 11.51 0.870 1.49
2 1.91 11.30 0.756 1.44
3 2.13 11.09 0.658 1.40
4 2.37 10.88 0.572 1.35
5 2.63 0.497 1.31
5 Terminal value 90 0.497 44.73
Total INR 53.25
*Please note that here we have assumed the present value of the dividend paid in the
current year as it is and have not discounted it.
Since the current stock price is much higher than calculated using the dividend dis-
count model, the stock is highly overvalued.
? SQ9. In the last financial year, Company XYZ paid a dividend of INR 3.50 per
share. Given that the risk-free rate of return is 7%, risk premium is 6%, the beta of
XYZ is 0.70 and the company’s expected growth in dividends is 10%, calculate the
price per share of XYZ.
v Calculating expected rate of return using CAPM and applying Eq. 6.14,
E(Rj) = Rf + ßj [E(Rm) − Rf].

Substituting values = 7 + 0.7 (6) = 11.20%
P0 = D1/(ke − g).
Price per share = 3.5 *1.1/(0.112–0.1) = 3.85/(0.112-0.1) = INR 320.83.
? SQ10. A company has total assets of INR 100 crores and total liabilities of INR 50
crores. It has 10,00,000 equity shares. Calculate the book value per share (BVPS).
BVPS = (assets–liabilities)/number of outstanding equity shares.

BVPS = (INR 100 crores–INR 50 crores)/10,00,000 = INR 500.
? SQ11. A company has total assets of INR 100 crores which can be liquidated for
INR 60 crores. It has a total liabilities of INR 45 crores. It has 10,00,000 equity
shares. Calculate the liquidation value per share (LVPS).

LVPS = (INR 60 crores–INR 45 crores)/10,00,000 = INR 150.
? SQ12. A company expects to earn INR 35 per share in the coming year and the av-
6 erage P/E ratio for all the companies in the sector is 15. Compute the price of the
share.
Market price per share = earnings per share (EPS) * P/E ratio.

MPS = INR 35*15 = INR 525.
? UQ1. A bond is purchased at INR 500. During the holding period of one year,
it earned a coupon of INR 50. It was sold at INR 550 at the end of the period.
Compute the HPY.
[Answer: 20%].
? UQ2. A bond is valued at INR 1000 (par) and carries a coupon rate of 5% per
annum. It matures in 5 years. The current market price of the bond is INR 950.
What is its YTM?
[Answer: 6.22%].
? UQ3.Calculate the Macaulay’s Duration for bond priced at INR 1000 that pays
a 10% coupon and matures in six years. Interest rates (yields) are 8%. The bond
pays the coupon annually and pays the principal on the final payment.
[Answer: 4.83 years].
? UQ4. For the next three years, the annual dividends of a stock are expected to
be INR 2, INR 2.10 and INR 2.20. The stock price is expected to be INR 20 at
the end of three years. If the required rate of return on the shares is 10%, what
is the estimated value of the share today?
[Answer: INR 20.24].
? UQ5. Company XYZ paid a dividend of INR 3 in 2020. A constant growth
rate of 10% has been forecast for the future. An investor’s required rate of re-
turn is estimated to be 15%. The current market price of the share is INR 50.
Should the investor buy the share?
[Answer: Yes, as the value of the share is INR 66.]
6.6 · Exercises
235 6
? UQ6. A company declared a dividend of INR 4 per share today. The dividend
is expected to grow at a rate of 12% for the next three years and then at 10% for
the subsequent two years. The growth will stabilize at a constant rate of 8%.
The discount rate (cost of equity is 15%). Estimate the price per share.
[Answer: INR 70.46].
? UQ7.A company declared a dividend of INR 7 per share. It’s beta 0.90. The
market rate of return and risk-free rate of return are 14% and 7%, respectively.
(a) If the dividend is expected to remain constant, what is the value of the
share?
(b) If the dividend is expected to grow at a constant rate of 5% per annum,
what is the value of the share?
[Answer: a) INR 52.63; b) INR 88.55].
? UQ8. A company has total assets of INR 50 crores and total liabilities of INR 40
crores. It has 1,00,000 equity shares. Calculate the book value per share (BVPS).
[Answer: INR 1000].
? UQ9. A company has total assets of INR 10 crores which can be liquidated for
INR 5 crores. It has a total liabilities of INR 2 crores. It has 1,00,000 equity
shares. Calculate the liquidation value per share (LVPS).
[Answer: INR 300].
? UQ10. A company expects to earn INR 50 per share in the coming year, and
the average P/E ratio for all the companies in the sector is 10. Compute the
price of the share.
[Answer: INR 500].
? 1. What are debt instruments? What are the salient features of a debt instrument?
2. How do you define risk in the context of debt instruments?
3. What are the factors which affect interest rates? What is the impact of interest
rate changes on bond prices?
4. What are different bond investment strategies?
5. What is duration and how is it calculated? What are the important characteris-
tics of duration?
6. What is a yield curve? What are different types of yield curves?
7. Discuss the following hypotheses: expectations hypothesis, liquidity premium
hypothesis and preferred habitat hypothesis.
8. How do you compute the value of an equity share that pays a constant divi-
dend per share? What is the value of an equity share as per the CAPM?
9. How is bond valuation different from equity valuation?
10. What are the differences between active and passive investment strategies?
? 1. Compare the interest rates (yields) in India with those of a country of your
choice. What are the differences (if any)? Justify the same.
(Hint: The difference in valuations can be due to the underlying risk factors dis-
cussed earlier.)
2. Compare the P/E ratios in India with those of a country of your choice. What
are the differences (if any)? Justify the same.
(Hint: The differences (if any) can be due to underlying fundamental and techni-
cal indicators.)
? This can be used as a class exercise.

Select a company of your choice that has both equity and debenture issues. Calcu-
late the value of its shares using the methods provided. Calculate the yield of the
6 debenture by taking into account its current market price. What do you observe?
Compare your findings with the equity and debt valuations of its main competitor.
Discuss the same.

Additional Readings
Bodie, Z., Kane, A., Marcus, A. J., & Mohanty, P. (2005). Investments, 6th edn. Tata McGraw-Hill.
Chandra, P. (2009). Investment analysis and portfolio management, 3rd edn. Tata McGraw-Hill.
Fisher, D. E., & Jordan R. J. (1995). Security analysis and portfolio management, 4th edn, Pren-
tice-Hall.
son Education.
Graham, B. & Dodd, D. L. (2009). Security analysis, 6th edn. McGraw Hill, New York.
Jones, C. P. (2010). Investment analysis and management, 9th edn. Wiley.
Reilly, F., & Brown, K. (2003). Investment analysis & portfolio management. 7th edn. Thomson
South-Western.
References
Ernst and Young Website. (2015). 7 http://www.ey.com/Publication/vwLUAssets/EY-india-cost-of-ca-
pital-a-survey/$FILE/EY-india-cost-of-capital-a-survey.pdf. Accessed on February 3, 2015.
Hawawini, G. A., & Vora, A. (1982). Yield approximations: A historical perspective. The Journal of
Finance, 37(1), 145–156.
Jain, P. K., Singh, S., & Yadav, S. S. (2013). Financial management practices: An empirical study of In-
dian corporates. Springer (ISBN 978–81–322–0989–8).
Pricewaterhouse Coopers website (2015), 7 http://www.pwc.in/en_IN/in/assets/pdfs/publications/2013/
dissecting-indias-risk-equity-premium.pdf. Accessed on February 3, 2015.
Springer (ISBN 978–981–10–0868–9).
237 7
Market Efficiency
Contents
7.2 Efficient Market Hypothesis – 238
7.3 Degrees of Market Efficiency – 239

7.3.1 Strong Form Efficiency – 240
7.3.2 Semi-strong Form Efficiency – 241
7.3.3 Weak Form Efficiency – 242
7.4 Stock Market Anomalies – 242

7.4.1 Size Effect Anomaly – 243
7.4.2 Calendar Anomaly – 243
7.4.3 Value Effect Anomaly – 244
7.4.4 Liquidity Effect Anomaly – 244
7.4.5 Postearnings-Announcement Drift (PEAD)
Anomaly – 245
7.5 Critique of the Efficient Market Hypothesis – 245
7.6 Merits of the Efficient Market Hypothesis – 246
7.7 Normative Framework for Investors – 247
7.9 Objective (Quiz) Type Questions – 250

238 Chapter 7 · Market Efficiency
The objective of this chapter is to provide a bird’s eye view of the concept of mar-
ket efficiency through the efficient market hypothesis. This chapter covers the fol-
lowing topics.
7.1 Introduction
Let us begin this chapter, with an example, to understand the difference between
real assets markets and financial markets. Let us say that the renewable energy
sector is projected to do well over the next few years. Real markets would react by
innovating in fields of renewable sources of energy like hydro, wind and solar. If
everything works fine, these firms would be profitable in the market.
On the other hand, in financial markets, if an investor buys energy stocks on
the same pretext, he/she is most probably not going to make huge profits. The
7 reason being that the prices may have already incorporated the information that
the renewable energy sector is projected to do well in the next few years (Kwak,
2017).
Thus, it can be said that financial markets would be efficient when the prices
of stocks and other derivatives incorporate all the relevant information. Eugene
Fama (1970), the pioneer of the efficient market hypothesis (EMH), stated that
the price of a financial asset reflects all available information relevant to its value
(The Economist, 2017).
7.2 Efficient Market Hypothesis
While investing money in financial markets, the motive is not only to get good re-
turns but also outperform the market. In 1970, Eugene Fama gave the hypothe-
sis for market efficiency, popularly called the efficient market hypothesis (EMH),
which suggests that, at any given time, prices fully reflect all available information
for a particular stock.
The asset prices act as the determinant of the financial stability of the firm’s
position as well as the securities in which the investor is intending to invest. The
market efficiency theory acts as an umbrella for the investors where a sustained
investment can be predicted on the basis of the prevailing securities/assets prices.
EMH studies the information processing efficiency of the stock markets, i.e. the
ability of the market to price stocks fairly and quickly.
Definition
Market efficiency states that the price of the product/stock is the true representa-
tion of its value because it incorporates and reflects all the relevant information.
Hence, it is not possible for an investor to outperform the market because all avail-
able information is already incorporated in stock prices.
7.3 · Degrees of Market Efficiency
239 7
Information that is provided may be financial, political, economic and/or social in
nature. It may be correct or incorrect but it will reflect in the stock prices. Further,
according to the EMH, all this information is available to all the investors, at the
same time, so that no one can outperform anyone else or the market as a whole.
However, there are investors like Warren Buffett who have outperformed the
market. So the question is: how do these investors profit with the same informa-
tion available to all investors (as per the EMH)? Well, the EMH doesn’t recom-
mend that stock prices will be at fair value all the time—they might be underval-
ued or overvalued at random points of time; gradually, however, prices will come
back to the fair/mean values. Hence, there are degrees of efficiency in the market,
at any given time.
7.3 Degrees of Market Efficiency
Efficient market hypothesis states that markets are efficient in processing infor-
mation. Only that information which is available, will be reflected in the market
prices. Thus, without any new information, one can’t beat the market. So, in order
to beat the market, one should possess new/extra information.
Markets may be categorized as weak, semi-strong or strong depending upon
the level of information incorporated in stock prices, that is, based on the in-
formation symmetry or the information asymmetry shared amongst the inves-
tors, who may either be rational or irrational, affected by their behavioural bi-
ases. When there is information asymmetry, then the markets are generally con-
sidered weak in nature and offer a chance to investors who have the necessary
skills, knowledge and information to make substantial returns in the market, and
thereby, use the concept of arbitrage to their benefit. This form of market effi-
ciency is diametrically opposite to the concept of efficient market hypothesis. As
the market efficiency increases, the level of information asymmetry tends to re-
duce, thereby lowering the arbitrage gains for skilled investors, as well. Such mar-
kets tend to offer a level playing field for all, as all the investors have the same in-
formation that is required to make rational and informed choices in the market.
This leads to the concept of different levels of market efficiency.
Definition
Strong form efficiency is where all public and confidential (insider) information is
reflected in share prices. Semi-strong efficiency means that only publicly available
information is reflected in share prices. Weak form efficiency claims that the present
price reflects only the previous (historic) price.
► Example
. Figure 7.1 presents the three forms of efficiency. ◄
. Fig. 7.1 Three forms of market efficiency. Source Authors’ compilation
7.3.1 Strong Form Efficiency
Strong form of market efficiency indicates that the stock prices reflect both pub-
licly available information as well as insider information. Strong form efficiency
states that no information, public or insider, will be of use to an investor or ana-
lyst because it is already reflected in the prevailing stock price.
Strong form efficiency can be based upon price changes close to an event.
► Example 7.1: Level of Market Efficiency

Consider a merger between two firms. Normally, information regarding a merger or an
acquisition is known by an “inner circle” of lawyers, investment bankers and firm man-
agers, before the information is released to the public. If there is no change in stock
prices after the public announcement, it implies that the information was already in
the market and had been incorporated in the price. . Figure 7.2 depicts the case pic-
torially. As is evident, this market was efficient, as there was a distinct rise in the prices
leading to the announcement. ◄
7.3 · Degrees of Market Efficiency
241 7
7.3.2 Semi-strong Form Efficiency
This form of EMH implies that all public information is incorporated into a
stock's current share price. No kind of analysis (whether fundamental or techni-
cal) can be deployed to record gains. It reflects all publicly available information
such as corporate earnings, share splits, etc.
The presence of semi-strong form of efficiency indicates that the individual in-
vestor will not be able to perform prolonged arbitrage, as the market will quickly
adapt to the available information and incorporate it into the stock prices. Thus,
the stock prices would quickly reflect the recent information. In such a scenario,
the investors may secure their investment by adopting various means to make
their portfolios react in real time, like by having access to brokerage firms which
trade in real time.
► Example 7.2: Semi-strong Form of Efficiency

Warren Buffett believes in a semi-strong form of market efficiency. Before investing, he
undertakes the fundamental analysis of the firm and has dedicated analysts to study a
firm’s financial statements, visit their factories to get a sense of their operations, talk to
their suppliers and other stakeholders, etc. and get an inside line to the business from
their competitors. ◄
. Fig. 7.2 Movement of stock prices after public announcement. Source Authors’ compilation
7.3.3 Weak Form Efficiency
This type of EMH claims that only past prices of a stock are reflected in today’s
stock price. Therefore, technical analysis cannot be deployed to predict prices and
outperform the market.
► Example 7.3: Weak Form Efficiency

Suppose a company’s share prices went down over the past four weeks, and based on
this information, the investor sold his/her shares, to avoid further losses. However, with
the start of the fifth week, the prices start to increase. In this market, the technical
analysis failed and there was an indication that some fundamental analysis may have
helped; the market is weak form efficient. ◄
Points to Ponder Over 7.1: How the Quest for Efficiency Corroded the
7 Market
(Can be used to encourage a class debate on the concept).
As per an article in the Harvard Business Review—“Regulatory changes destroyed
the economics of investment analysis and discouraged professional investors from
relying on their own rational judgment”.
Due to increased measures taken by the regulatory authorities, like enhanced cor-
porate governance regulations (Clause 49) and disclosures, many investment man-
agers have adopted the passive indexing strategy which is detrimental to finding
the right risk and return mix for the investors. This will reduce the overall market
productivity and limit the best use of available capital.
(Source Healy & Palepu, 2003).
7.4 Stock Market Anomalies
Stock market anomalies are deviations from the semi-strong form of market effi-
ciency. In layman terms, stock market anomalies refer to deviations from stand-
ard, normal or expected returns. Anomalies are patterns/behaviours identified in
stock market prices, based on publicly available company fundamentals.
The implications of such anomalies are:
5 Stock prices do not fully reflect all the publicly available information in the
form of company’s fundamentals.
5 Such information can be tapped to predict stock price movements.
. Figure 7.3 depicts some popular stock market anomalies.

7.4 · Stock Market Anomalies
243 7
. Fig. 7.3 Popular stock market anomalies. Source Authors’ compilation
7.4.1 Size Effect Anomaly
It is observed that firms of smaller size give higher risk adjusted returns than the
larger sized firms. This anomaly is also called the “small firm effect”. This can be
due to the fact that small firms are growing firms with new technology and equip-
ment; they record higher returns as they gain market share. Larger firms have typ-
ically exploited/exhausted their high growth opportunities and record stagnant
growth rates.
7.4.2 Calendar Anomaly
It is observed that anomalous calendar patterns are found in returns persistently.

This anomaly was initially identified as the “small firm in January effect”.
► Example
In America, the January effect has been observed, i.e. returns in January are higher
than other months. This can be due to markets being buoyant and investors being
more bullish/aggressive, post the Christmas holidays. Such investors typically are cash
rich after receiving Christmas/year-end bonuses, as well.
In India, the April effect has been observed, i.e. returns in April are higher than other
months. The justification behind this can be the tax-loss selling hypothesis which
states that investors avoid capital gains tax by selling loss-making securities in March,
thereby, increasing net portfolio returns in April. Please note that the financial year in
India starts on April 1 and ends on March 31 of the subsequent year (Harshita et al.,
2019). ◄
7.4.3 Value Effect Anomaly
The value effect was initially identified as the “book-to-market” ratio effect.
Book-to-market ratio indicates the book value of a company’s assets over their
corresponding market value. It has been observed that firms with higher book-
to-market ratios provide higher returns than the firms with lower book-to-mar-
ket ratios. A high book-to-market ratio indicates that the firm is undervalued in
the market despite having a strong asset base. Such firms can be considered good
“buys”. Warren Buffet, the legendary investor, relies heavily on the value effect.
7.4.4 Liquidity Effect Anomaly
The liquidity effect denotes that less liquid stocks provide higher returns than
more liquid stocks. Such firms are less sought after by institutional investors, and
7 hence, they provide higher returns to attract investors. Further, due to less liquid-
ity the price differentials in buy and sell orders are also high, leading to higher
capital gains. This effect is considered an extension to the small firm effect as
small firms are less liquid and often neglected by investors.
Concept in Practice 7.1: Stock Market Anomalies in India

The authors of this book conducted a study on “Stock Market Anomalies: An Em-
pirical Study in Indian Context” for the period 1995–2017 (Harshita et al., 2018).
These findings are taken from the same to illustrate the scenario of stock market
anomalies in India.
(i) Size effect anomaly: Indian stock market exhibits negative relation between re-
turns and size, and there is evidence of significant size effect. The findings per-
sist over the study period.
(ii) Value effect anomaly: Indian stock market exhibits negative relation between
returns and value and a significant value effect during the whole study period.
(iii) Liquidity effect anomaly: Indian stock market exhibits negative relation be-
tween returns and liquidity, and there is evidence of significant liquidity effect.
The findings persist over the study period.
In the primary survey conducted, 70% of the respondents considered market

anomalies while taking decisions to buy, hold or sell stocks in the Indian stock
market. Among the anomalies studied, the value effect anomaly is the most sought
after (employed by 26.51% respondents), whereas calendar effect anomaly is the
least sought after (employed by 13.86% of the respondents).
7.5 · Critique of the Efficient Market Hypothesis
245 7
7.4.5 Postearnings-Announcement Drift (PEAD) Anomaly
This anomaly posits that stocks with positive “earnings surprise”, yield excess re-
turns in the post announcement period. “Earnings surprise” indicates the differ-
ence between actual earnings announced by the firms and the earnings that they
were expected to announce. Further, announcements such as share repurchases
and cash dividend increase, etc. also provide for abnormal returns through the
PEAD anomaly.
Concept in Practice 7.2: PEAD Anomaly in India

One of the authors of this book conducted a study on “Cash Dividend and Shares
Repurchase Announcements: Impact on Returns, Liquidity and Risk in the Indian
Context” for the period 2003–2016 (Anwar et al., 2017). These findings are taken
from the same to illustrate the scenario of PEAD in India in terms of dividend in-
crease and shares repurchase announcements.
In terms of dividend increase announcements, on the basis of the size, “small”
firms have been better providers of significant gains to the investors. Perhaps, for
these firms, dividend announcements resolve the information asymmetry between
the managers and the shareholders. According to the age of the firm, “middle-age”
firms and “young” firms have reported higher returns. Perhaps, the investors per-
ceive middle-age firms to be affiliated with the emerging/growing and important
sectors of the economy.
In terms of shares repurchase announcements, on the basis of firm size, “large”
firms are better in terms of providing higher returns around shares repurchase an-
nouncements. According to the firm age, “young and middle-age” firms have regis-
tered higher returns compared to “old and established firms”. Perhaps, these firms
are the emerging/growing firms enjoying investors’ confidence in the management
regarding positive growth/earnings. Further, by trading in their own stocks, these
firms reduce price fluctuations, thereby smoothening price discovery.
7.5 Critique of the Efficient Market Hypothesis
The EMH is controversial and disputed and has been a topic of debate among
stock market investors for years.
EMH states that all stocks are priced according to their fundamental invest-
ment characteristics, and, they get traded at fair value. It states that it is impossi-
ble to outperform the market because prices already reflect all value-relevant in-
formation. EMH supporters believe that it is futile to look for undervalued stocks
or aim to forecast trends in the market.
However, while the EMH is popular in financial research, critics believe that it
falls short when applied in practice. The financial crisis of 2008 challenged several
existing financial theories including the EMH. Had the markets been perfectly ef-
ficient, then the housing bubble and the subsequent crash of the market wouldn’t
have occurred.
Here are some criticisms levelled on EMH, based on its assumptions:
1. EMH claims that there can’t be any investor who can outperform the market,
but still, there are a few investors who do.
2. EMH claims that financial analysis (fundamental and technical analysis) is fu-
tile. Yet, financial analysis exists.
3. EMH claims that any new information is completely incorporated and re-
flected in market prices. Yet, prices change continually.
4. EMH presumes that all investors are informed, skilled, and are able to analyse
information. Still many investors are not skilled.
7.6 Merits of the Efficient Market Hypothesis
7 In spite of the criticisms levied on the EMH, the hypothesis is still very relevant
to the stock markets. Here are certain justifications against each criticism stated
earlier.
1. EMH claims that there can’t be any investor who can outperform the market,
Justification—EMH considers the long-term horizon and an investor should
not rely on a single incident. Occasionally, investors can outperform the mar-
ket, but they can’t do it predictably or consistently.
2. EMH claims that financial analysis (fundamental and technical analysis) is fu-
Justification—There are various factors that affect financial analysis, such as
the quality of information, gathering of information, processing of informa-
tion, etc. These processes cost a substantial amount of money, and hence, may
not be available to all investors. Also, investors need to pay transaction costs.
Only some investors would be able to bear this overall cost and this would
translate into higher returns for them. In fact, this is the reason why mutual
funds were created; they help low income investors gain access to valuable in-
formation (regarding securities in the markets) and its processing, which such
investors would not have been able to afford on their own.
3. EMH claims that any new information is completely incorporated and re-
flected in market prices. Yet, prices change continually.
Justification—It is correct that prices change every now and then. This can be
attributed to the market absorbing the newly available information.
4. EMH presumes that all investors are informed, skilled and are able to analyse
information; still, many investors are not skilled.
Justification—It is not necessary to have all investors to be skilled, for an ef-
ficient market. Through financial intermediation and institutions like mutual
funds, it is also possible that only a few are skilled and follow the stock market
regularly; they help the other unskilled investors.
7.7 · Normative Framework for Investors
247 7
Points to Ponder Over 7.2: Are Markets Really and Always Efficient?
If the EMH is true, then the 2008 financial crisis (or earlier crashes/swings) would
never have happened. Markets are competitive in nature and one strategy does not
fit all. Investors tend to make errors even though all the information is available. In
an efficient market, the prices of the financial assets are accurately determined and
deviations from equilibrium values do not last for long, due to rational and wise
investors.
If the price of a share was too low, informed investors would buy it. If it was per-
ceived to be too high, they could sell it and record gains. In a way, if the informa-
tion was out there, it was already incorporated in the price. Many people, there-
fore, view the financial crisis as a blow to the credibility of the academic discipline
of financial economics.
In that case, market efficiency failed to explain market anomalies, including the
speculative housing bubble. Investors poured funds into subprime mortgages and
irrational investor behaviour overtook markets. An efficient market should have
adjusted prices to rational levels, which did not happen. As a result of the same,
behavioural finance started to gain respect as a discipline.
It is important to note, further, that if prices do reflect all information, then, there
is no gain from the act of gathering more information. A little inefficiency in the
market is necessary to provide investors an incentive to analyse and trade based
on information, thereby driving prices towards their intrinsic values. Through ar-
bitrage, prices eventually do return to their intrinsic equilibrium; this provides the
EMH its continuing relevance.
7.7 Normative Framework for Investors
The following tenets put forth by Warren Buffet shall augur well for any investor
trying to pick stocks in a semi-strong/weak form market:
5 Invest in companies that one thoroughly understands.
5 Invest in a company only if one is convinced it is good. Don’t arrive at a con-
clusion based on what others say.
5 Invest in companies that lie in one’s circle of competence.
The above principles, at least ensure, that a person invests in the companies he/she
is confident and knowledgeable about. This way, he/she will be able to predict, to
a good extent, the expected behaviour of the stock and his investment horizon.
(Source Financial Post, 2017).
Concept in Practice 7.3: State of Market Efficiency in India

the scenario of market efficiency in India.
There are two notable findings that emerge as a result of the analysis. First, “ra-
tional bubbles” do not exist in the Indian stock market. Second, a cointegrating re-
lationship between the prices and the dividends, with an asymmetric adjustment
characterized by sharp movements, is established.
The above discussion could make the case for a semi-strong form of efficiency,
considering the price-adjusting nature of the stock market. However, the analy-
sis on price multiples indicates that most stocks in the market are either overval-
ued or undervalued; this indicates inefficiency in pricing. The findings of the dis-
aggregative analysis of returns also contain indications of “age” and “size” anom-
alies existing in the Indian stock market returns. Finally, the substantial volatility
present in the Indian stock market weakens the case for “semi-strong” level of ef-
ficiency. Hence, to conclude, the status of market efficiency for the Indian stock
market, based on the findings, not only from the deployment of the “rational bub-
bles” methodology but also from the other aspects studied (as a part of this re-
7 search effort) appears to be of the “weak” form.
7.8 Conclusion
Corporate governance measures, across the world, are aimed at minimizing the
information asymmetry between the management and the investors and also
amongst the investors. This would lead to the markets becoming more efficient.
The Sarbanes–Oxley Act of 2002 (SOX), an Act passed by U.S. Congress in
2002, protects investors against fraudulent accounting activities by corporations
and improves corporate governance. These reforms, as one would expect, brought
about more informational efficiency in the stock market and, hence, increased the
efficiency of the market.
The Indian counterpart to the SOX is the Clause 49 of the Listing Agreement
(Listing Obligations and Disclosure Requirements (LODR)), which is mandatory for
all companies listed on Indian stock exchanges, to adhere to. Further, the Compa-
nies Act of 2013 also provides for corporate governance measures which are aimed at
greater transparency and sharing of information. Over time, such corporate govern-
ance measures would ensure that we move towards more efficient markets.
Summary
5 Market efficiency states that the price of the product/stock is the true rep-
resentation of its value because it incorporates and reflects all the value-rele-
vant information. Hence, it is not possible for an investor to beat the market be-
cause all value-related information is already incorporated in stock prices.
5 Markets may be categorized as weak, semi-strong or strong depending upon
the level of information incorporated in stock prices.
5 Strong form efficiency is where all public and confidential (insider) information
is reflected in share prices. Semi-strong efficiency means that only publicly avail-
able information is reflected in share prices. Weak form efficiency claims that
the present price reflects only the previous (historic) price.
Summary
249 7
5 Stock market anomalies are deviations from the semi-strong form of market
efficiency. In layman terms, stock market anomalies refer to deviations from
standard, normal or expected returns.
5 It is observed that firms of smaller size give higher risk adjusted returns than
the larger sized firms. This anomaly is called the “size” or “small firm effect”.
This can be due to the fact that small firms are growing firms with new technol-
ogy and equipment; they record higher returns as they gain market share.
5 It is observed that anomalous calendar patterns are found in returns persis-
tently. This anomaly is called the calendar anomaly.
5 The value effect anomaly posits that firms with higher book-to-market ratios
provide higher returns than the firms with lower book-to-market ratios. A high
book-to-market ratio indicates that the firm is undervalued in the market de-
spite having a strong asset base. Hence, such firms can be considered good
“buys”.
5 The liquidity effect anomaly denotes that less liquid stocks provide higher re-
turns than more liquid stocks. Such firms are less sought after by institutional
investors and hence, they provide higher returns to attract investors. Further,
due to less liquidity, the price differentials in buy and sell orders are also high,
leading to higher capital gains.
5 The postearnings-announcement drift (PEAD) anomaly posits that stocks with
positive “earnings surprise” yield excess returns in the post announcement pe-
riod. Earnings surprise indicates the difference between actual earnings an-
nounced by the firms and the earnings that they were expected to announce.
Further, announcements such as shares repurchases and cash dividend increase,
etc. also provide for abnormal returns through the PEAD anomaly.
5 Some criticisms levied on EMH based on its assumptions are:
– EMH claims that there can’t be any investor who can outperform the market,
– EMH claims that financial analysis (fundamental and technical analysis) is fu-
– EMH claims that new information is fully reflected in market prices. Yet,
prices change continually.
– EMH presumes that all investors are informed, skilled and are able to analyse
information. Still many investors are not skilled.
5 In spite of the criticisms levelled on the EMH, it is still very relevant to the
stock markets. Certain justifications against each criticism are:
– EMH claims that there can’t be any investor who can outperform the market,
– Justification—EMH considers the long-term horizon, and an investor should
not rely on a single incident. Occasionally, investors can outperform the mar-
ket, but they can’t do it consistently.
– EMH claims that financial analysis (fundamental and technical analysis) is fu-
– Justification—There are various factors that affect financial analysis, such as
the quality of information, gathering of information, processing of informa-
tion. These processes cost a substantial amount of money, and hence, may
not be available to all investors.
– EMH claims that new information is fully reflected in market prices. Yet,
prices change continually.
– Justification—It is correct that prices change every now and then. This can be
attributed to the market absorbing the newly available information.
– EMH presumes that all investors are informed, skilled and are able to analyse
information; still, many investors are not skilled.
– Justification—It is not necessary to have all investors to be skilled, for an effi-
cient market. Through financial intermediation and institutions like mutual
funds, it is also possible that only a few are skilled and follow the stock mar-
ket regularly; they help the other unskilled investors.
5 The Sarbanes–Oxley Act of 2002 (SOX) of USA, mandated reforms aimed at
improving financial disclosures and preventing accounting fraud. Its Indian
counterpart, the Clause 49 of the Listing Agreement (Listing Obligations and
7 Disclosure Requirements (LODR)), is mandatory for all companies listed on
Indian stock exchanges, to adhere to. Over time, such corporate governance
measures would ensure that we move towards more efficient markets.
7.9 Objective (Quiz) Type Questions
? 1. Fill in the Blanks

(i) _______________ states that the price of the product/stock is the true rep-
resentation of its value because it incorporates and reflects all the value-rel-
evant information.
(ii) ____________________ is where all public and confidential (insider) infor-
mation is incorporated in share prices.
(iii) __________________ means that only publicly available information is in-
corporated in share prices.
(iv) __________________ claims that the present price reflects only the previous
(historic) price.
(v) ____________________ are deviations from the semi-strong form of market
efficiency.
(vi) The _____________ anomaly posits that firms with higher book to market
ratios provide higher returns than the firms with lower book to market ra-
tios.
(vii) The _____________ anomaly denotes that less liquid stocks provide higher
returns than more liquid stocks.
( viiii) The ____________________ anomaly posits that stocks with positive ‘earn-
ings surprise’ yield excess returns in the post announcement period.
(ix) The ______________ of USA, mandated reforms aimed at improving finan-
cial disclosures and preventing accounting fraud.
(x) Over time, ___________ measures would ensure that we move towards more
efficient markets.
7.9 · Objective (Quiz) Type Questions
251 7
v
(Answers: (i) Market efficiency (ii) Strong form efficiency (iii) Semi-strong ef-
ficiency (iv) Weak form efficiency (v) Stock market anomalies (vi) value effect
(vii) liquidity effect (viii) post earnings announcement drift (PEAD) (ix) Sarba-
nes-Oxley Act of 2002 (SOX) (x) corporate governance)
? 2. True/False
(i) Market efficiency states that it is not possible for an investor to beat the
market because all value-related information is completely incorporated
in stock prices.
(ii) Markets may be categorized as weak, semi-strong or strong depending
upon the level of information incorporated in stock prices.
(iii) Weak form efficiency is where all public and confidential (insider) infor-
mation is incorporated in share prices.
(iv) Weak form efficiency claims that the present price reflects only the previ-
ous (historic) price.
(v) Stock market anomalies are deviations from the semi-strong form of mar-
ket efficiency.
(vi) It is observed that firms of smaller size give higher risk adjusted returns
than the larger sized firms.
(vii) A high book to market ratio indicates that the firm is undervalued in the
market despite having a strong asset base.
(viii) The liquidity effect anomaly denotes that less liquid stocks provide higher
returns than more liquid stocks.
(ix) EMH claims that there can’t be any investor who can outperform the
market, but still, there are a few investors who do.
(x) Clause 49 of the Listing Agreement (Listing Obligations and Disclosure
Requirements (LODR)) is mandatory for all companies listed on Indian
stock exchanges, to adhere to.
v
(Answers: (i) True (ii) True (iii) False (iv) True (v) True (vi) True (vii) True
(viii) True (ix) True (x) True)
? 1. What is the efficient market hypothesis (EMH)?

2. What are the degrees of efficient market hypothesis? Illustrate with examples.
3. Can you suggest a suitable investment strategy based on the three levels of
market efficiency?
s4. What are stock market anomalies?
5. What is the “size effect” anomaly? Illustrate your answer with an example.
6. What is the “calendar effect” anomaly? Illustrate your answer with an example.
7. What is the “value effect” anomaly? Illustrate your answer with an example.
8. What are the criticisms levelled against the EMH?
9. Provide justifications on how EMH is still relevant in the stock markets.
10. Write a note on corporate governance measures and their link to market effi-
ciency.
? 1. Is the stock market of your country efficient? Provide justifications for your
answer
(Hint: The stock market may indicate different levels of efficiency at diffe-
rent times. Check with investment analyst reports and other publications.)
? 2. Is it necessary for stock markets to be efficient? What are the pros and cons of
an efficient market?
(Hint: An efficient market means that there would be no scope of fundamen-

tal and/or technical analysis leading to extra returns.)
7 ? This can be used as a class exercise
1. Conduct a study on the methodologies deployed to test market efficiency levels.
Discuss them in class.
2. Track the returns of small-cap companies and compare them with those of
large-cap companies. Do the same for low-value versus high-value stocks. Do
you notice any significant differences? Justify the same.

Additional Readings
Chandra, P. (2009). Investment analysis and portfolio Management (3rd ed.). Tata McGraw-Hill.
Fisher D. E., & Jordan, R. J. (1995). Security analysis and portfolio management (4th ed.). Pren-
tice-Hall.
son Education.
South-Western.
References
Anwar, S., Singh, S., & Jain, P. K. (2017). Impact of cash dividend announcements: Evidence from the
Indian manufacturing companies. Journal of Emerging Market Finance, 16(1), 29–60. ISSN 0972-
6527.
Financial Post Website (2017). Available at 7 http://business.financialpost.com/investing/global-inves-
tor/its-fundamental-why-warren-buffett-beats-the-stock-market-how-have-investors-missed-it-for-
so-long. Accessed on September 16, 2017.
Harshita, S. S., & Yadav, S. S. (2018). Calendar anomaly: Unique evidence from the Indian stock mar-
ket. Journal of Advances in Management Research, 15(1), 87–108.
253 7
Harshita, S. S., & Yadav, S. S. (2019). Size effect in Indian stock market: An anomaly or a methodo-
logical artifact. Journal of Financial Management and Analysis, 31(2018–2019 Composite Issue),
71–81.
Healy, P. M., & Palepu, K. G. (2003). How the quest for efficiency corroded the market. Harvard Busi-
ness Review, July 2003 Issue.
Kwak, J. (2017). Efficient markets and innovation. The baseline scenario. Available at 7 https://base-
linescenario.com/2009/06/22/efficient-markets-and-innovation. Accessed on September 16, 2017.
Singh, S., Jain, P. K., & Yadav, S. S. (2016). Equity markets in india: Risk, return and price multiples.
Springer.
The Economist Website (2017). Available at 7 http://www.economist.com/node/14030296. Accessed
on October 8, 2017.
255 8
Diversification of Risk
Contents
8.2 Markowitz’s Modern Portfolio Theory – 256

8.2.1 Concept of Efficient Markets – 256
8.2.2 Portfolio Construction Under Markowitz Portfolio
Theory (MPT) – 259
8.2.3 Critiques of Markowitz Portfolio Theory (MPT) – 263
8.3 Sharpe’s Single-Index Model and the Capital

Asset Pricing Model (CAPM) – 265
8.3.1 Sharpe’s Single-Index Model – 265
8.3.2 Capital Asset Pricing Model (CAPM) – 265
8.4 Advent of the Multi-factor Models – 276

8.4.1 Two-Factor CAPM – 276
8.4.2 Fama and French Three-Factor Model – 277
8.4.3 Arbitrage Pricing Theory – 278
8.5 Normative Framework for Investors – 280

8.7.1 Objective (Quiz)-Type Questions – 285
256 Chapter 8 · Diversification of Risk
The objective of this chapter is to explore the various theories available in under-
standing the diversification of risk and portfolio optimization.
8.1 Introduction
This chapter presents the various theories and models that are deployed in port-
folio optimization: the quest for a portfolio that maximizes returns and mini-
mizes risk. Let us begin with the seminal work in portfolio theory—the Markow-
itz portfolio theory.
8.2 Markowitz’s Modern Portfolio Theory
As far back as the late eighteenth century, Bernoulli and Cramer (1713) con-
cluded that returns could not be calculated simply on the basis of the average
8 (mean) or rule of thumb or intuition, especially in the event of any uncertainty. It
was much later that through Markowitz portfolio theory (MPT) that a level of so-
phistication was introduced in the world of investments and portfolio construc-
tion. Prof. Harry Markowitz propounded a mean-variance (return–risk) model
and provided, perhaps for the first time, a structured understanding of the con-
cept and measurement of risk and return, in the investment landscape.
In 1952, he published his seminal paper titled “Portfolio Selection” in the Jour-
nal of Finance, which presented the basic principles behind portfolio construc-
tion (Markowitz, 1952). This laid the foundation for understanding the concepts
of risk and return in terms of investments. The portfolio theory is a normative
theory as it prescribes what a rational investor should do.
8.2.1 Concept of Efficient Markets
> The modern portfolio theory is based on the assumption of efficient markets and
rational investors. The characteristics of an efficient market are:
5 All investors have the same expectations regarding the returns and risk of all
securities.
5 All investors have access to the same information.
5 Investments can be freely made; there are no restrictions.
5 There are no taxes.
5 Transaction costs are nil.
5 The market price is not affected by any large buyer/seller.
8.2 · Markowitz’s Modern Portfolio Theory
257 8
. Fig. 8.1 Efficient frontier. Source Investing Answers (2017)
The Markowitz portfolio theory (MPT) was the first formal attempt at classifying
and quantifying the risk and return of a portfolio and developing a methodology
for determining the optimal portfolio. It is based on the basic premise/assumption
that the utility (satisfaction) derived by an investor is a function of two factors:
mean or expected return and risk measured by variance (or standard deviation)
of return. Any rational investor would prefer a higher return to a lower one and a
lower risk to a higher one. In other words, if an investor has an option, he would
want to move to a portfolio that provides him higher returns for the same level of
risk or lower risk for the same level of returns.
► Example
The modern portfolio theory can be best understood through the concept of efficient
frontier. The eggshell-shaped curve given in . Fig. 8.1 depicts the efficient frontier.
The efficient frontier, as depicted in . Fig. 8.1, depicts the optimal portfolios that offer
the highest return for a given level of risk or the lowest risk for a given level of return.
Portfolios that lie below the efficient frontier are inefficient. ◄
The various weighted combinations of stocks that create this return–standard de-
viation mix constitute the set of efficient portfolios. However, expected returns
and standard deviations vary given the different weighted combinations of the
stocks.
Expected Goal is to move up and left.

Return (%)
WHY?
Standard
Deviation
. Fig. 8.2 Goal of the investor within the efficient frontier. Source Authors’ compilation
► Example
8 For example, consider two portfolios: A and B. Portfolio A has an expected return of
8.5% and a standard deviation of 8%, and Portfolio B has an expected return of 8.5%
and a standard deviation of 9.5%. Portfolio A would be deemed more “efficient” be-
cause it has the same expected return but a lower risk.
. Figure 8.2 presents the goal of the rational investor vis-à-vis the efficient frontier—
to move up and left. Why is this so?
Justification: According to the concept of the efficient frontier within the modern port-
folio theory, the investors need not worry about the overwhelming range of permuta-
tions and combinations of securities, as what matters mainly, is to reduce the level of
risk for the same rate of return, or, to increase the rate of return for the same level of
risk. That is, the ultimate goal is to move up and left or in the northwest direction on the
eggshell-shaped boundary of the feasible range. This eggshell-shaped boundary is called
the efficient frontier. It contains all the feasible options available to the investor. ◄
> . Figure 8.3 intersperses the efficient frontier with the indifference (utility) curves
of investors. Curves C1, C2 and C3 denote the indifference in terms of utility or sat-
isfaction that the investors experience from a set of products (in this case, an invest-
ment portfolio). Generally, higher income levels correspond to better quality prod-
ucts (here, a better product would be in terms of higher returns and lower risk),
and hence, the utility curves also move up and left corresponding with the efficient
frontier.
For example, a portfolio like Y is inefficient as portfolios like R and X dom-
inate it in terms of higher returns (R) and lower risk (X). The efficient frontier
is the same for all investors because portfolio theory is based on the assumption
that all investors have the same information and expectations. Further, portfolio R
259 8
. Fig. 8.3 Efficient frontier interspersed with indifference (utility) curves. Source Authors’ compilation
provides the highest utility for the investors in terms of their indifference curves,
and, probably being much in demand, corresponds to the highest utility curve, C3.
8.2.2 Portfolio Construction Under Markowitz Portfolio Theory

(MPT)
The basis of portfolio construction under MPT is that combining stocks into a
portfolio can reduce standard deviation (risk). This is because of correlation coef-
ficients.
► Example
Justification: Imagine an island where the weather is either sunny or rainy. The indi-
vidual weather conditions last for six months each, in a year (i.e. they are evenly dis-
tributed) and are mutually exclusive (i.e. it doesn’t rain when it’s sunny and vice-versa).
Further, imagine that there are only two companies on the island selling competing
products—sunscreens and umbrellas. Both companies make the same return and have
been in business for the same duration. Obviously, given the market conditions, when
one company’s product sells, the other’s doesn’t. Therefore, the correlation between
their returns is −1 (they are perfectly negatively correlated).
In this hypothetical example, if an investor would consider any one company for in-
vesting, the return would be available but only for half the time (risk); the rest of the
days, it will be zero. However, if he were to split his portfolio and invest equally in the
two companies, the return would continue to be the same, but guess what, it would be
available all through the year! Hence, through this simple diversification strategy, the
risk is reduced to zero. ◄
Under MPT, the portfolio return and risk can be calculated using the following
formulae:
i 1. Portfolio return
In a portfolio comprising of two securities (1 and 2), the return of the portfolio is
given as:
Rp = w1 R1 + w2 R2 (8.1)
where
Rp – is the return on the portfolio,
R1 – is the return on the security 1,
w1 – is the weight of portfolio invested in security 1 and.
w2 – is the weight of portfolio invested in security 2.
When a portfolio consists of n securities, the expected return on the portfolio is:
8 n

Rp = wi R (8.2)
i=1
where
Ri – is the return on the security i,
wi – is the proportion of portfolio invested in security i.
Further, the risk (variance) of the portfolio with two securities is calculated as
Var Rp = σ12 w12 + σ22 w22 + 2w1 w2 σ1 σ2 ρ12

(8.3)
where
Var (Rp) – is variance of the portfolio returns or portfolio risk,
σ12 – is the variance of the return of security 1,
w1 – is the weight of portfolio invested in security 1,
σ1 – is the standard deviation of the return of security 1,
ρ12 – is the correlation between the returns on securities 1 and 2 and
ρ12σ1σ2 – is the covariance between the returns on securities 1 and 2.
The same formula can be extended to n securities as follows:

n
n

Var Rp = wiWi σi σj ρij (8.4.1)
i=1 j=1
261 8
n
n
n
= w2i σi2 + wi wj σi σj ρij (i �= j)
i=1 i=1 j=1 (8.4.2)
It can be noted here that standard deviation is simply the square root of variance.
? Numerical Example 8.1: Portfolio Construction under MPT

Consider two companies ABC and XYZ with a correlation coefficient of 0.4. Cal-
culate the portfolio return and risk.
Stocks Standard deviation Weight in portfolio (%) Average return (%)

ABC 28 60 15
XYZ 42 40 21
v Applying Eqs. 8.2 and 8.3:

n

Portfolio return = Rp = wi Ri
i=1
= 0.60 ∗ 15 + 0.40 ∗ 21
= 17.40%
Portfolio risk (variance) = σ12 w21 + σ22 w22 + 2w1 w2 σ1 σ2 ρ12

= (0.60)2 (28)2 + (0.40)2 (42)2 + 2 ∗ 0.60 ∗ 0.40 ∗ 28 ∗ 42 ∗ 0.40
= 0.36 ∗ 784 + 0.16 ∗ 1764 + 225.792
= 282.24 + 282.24 + 225.792
= 790.272%
√
Similarly, standard deviation = 790.272
= 28.10%
Now, let us see what happens, when we add a new stock PQR to the portfolio. PQR
has a return of 19% and standard deviation of 30. The correlation coefficient of
PQR with the existing portfolio is 0.30.
Stocks Stocks Weight in portfolio (%) Average return
(%)
Old portfolio 28.10 50 17.40
PQR 30 50 19
n

The revised portfolio return = Rp = wi Ri
i=1
= 0.50 ∗ 17.40 + 0.50 ∗ 19
= 18.20%

= (0.50)2 (28.10)2 + (0.50)2 (30)2 + 2 ∗ 0.50 ∗ 0.50
∗ 28.10 ∗ 30 ∗ 0.30
= 0.25 ∗ 789.61 + 0.25 ∗ 900 + 126.45
= 197.40 + 225 + 126.45
= 548.85%
√
= 23.43%
Hence, the revised return and standard deviation of the new portfolio become
18.20% and 23.43%, respectively.
What do you notice here?
Yes: Through this simple diversification exercise, not only have we reduced the
8 risk of the portfolio but we have even increased the return!
► Example
. Figure 8.4 presents the return versus risk profile of portfolios of stocks and bonds
from 1970 to 2009, in the USA. The image links stocks and bonds to the risk and re-
turn graph very aptly, and the efficient frontier curve is visible. ◄
. Fig. 8.4 Risk versus return of portfolios of stocks and bonds, 1970–2009 (USA). Source Morning-
star (2017)
263 8
8.2.3 Critiques of Markowitz Portfolio Theory (MPT)
Amongst the critiques of the MPT, the most important ones pertain to its suffer-
ing from the lack of certain important aspects, which were not covered in the the-
ory, primarily, the practices of short selling or leveraged portfolios.
8.2.3.1 Short Selling
Definition
Short selling is the practice of selling a stock first (one which is showing indications
of a fall in price) and then buying it later, at the lower price. The effect of short sell-
ing is that a security sold short yields a positive return when the security records a
large decline in price and vice versa.
Hence, if it pays to short sell, the efficient frontier shifts up and to the left as it
allows disinvestment in poor investments (hence, investors gain if stocks do
poorly). At the same time, however, excessive/inaccurate short selling may cause
the extension of the efficient frontier to the right, which arises as short selling in-
creases the risk on the portfolio; the practice of short selling can involve huge
losses if the prices increase.
8.2.3.2 Borrowing and Lending or Leveraged Portfolios

Markowitz did not allow for borrowing and lending opportunities and rates in
his theory. However, in practice, investors do have access to both risk-free assets
and risky assets to invest in and can even borrow and invest (leveraged portfolio).
Hence, both lending and borrowing portfolios are possible.
1. Investing in risk-free asset—investment in a risk-free asset is referred to as risk-
free lending. As the name suggests, the standard deviation (risk) of the returns
on risk-free asset is zero. Hence, the covariance is also zero. Proxies for risk-
free assets are generally the treasury bills issued by the central government of
any country/economy.
2. Investing in both risk-free and risky asset—when an investor invests in a portfo-
lio with both risk-free and risky assets, he/she earns a return premium for the
extra risk undertaken over the risk-free investment.
i As per MPT, the reward-to-risk ratio for evaluating portfolio performance can be
given by Eq. 8.4.
Reward − to − riskratio = (return on risky asset − risk-free return)/standard deviation (8.4)
. Fig. 8.5 Efficient frontier with real-life borrowing and lending curves. Source Authors’ compilation
8
► Example
. Figure 8.5 presents the efficient frontier with real-life borrowing and lending curves.
As per . Fig. 8.5, RFR depicts the risk-free lending rate and Rb depicts the borrowing
rate. As is evident, the lending rate (RFR) is not the same as the borrowing rate (Rb).
There is a kink in the rates, with the lending rates for an investor, being lower than the
borrowing rates. This is common in financial markets, as the difference in the borrow-
ing rates and the lending rates for the investors allows the banks and other financial in-
stitutions to earn (through the rate differential, Rb-RFR). Also, an individual is consid-
ered riskier than the central government (in terms of default risk), and hence, there is a
higher premium attached to lending to an individual by the bank.
F denotes a lending portfolio, and K denotes a borrowing portfolio. Both are efficient
portfolios. ◄
> Apart from these practical aspects not covered in the theory, there are other limita-
tions to the MPT as well, in terms of certain unrealistic assumptions, for example:
5 Assumption that all rational investors are risk averse: Why should one as-
sume that all rational investors are risk averse? In fact, most entrepreneurs are
risk-takers, and economies would fail if people did not take risk.
5 Assumption that variance is the most appropriate measure of risk: Why is vari-
ance considered the most appropriate measure of risk? In fact, for a long-term
investor, price volatility is not a real risk.
Further, in practice, investment managers are vary of mathematics and are

more comfortable with individual returns rather than covariances. Most impor-
tantly, in case of MPT, the entire portfolio needs to be re-evaluated even if one un-
derlying security changes.
8.3 · Sharpe’s Single-Index Model and the Capital Asset Pricing Model (CAPM)
265 8
8.3 Sharpe’s Single-Index Model and the Capital Asset Pricing
Model (CAPM)
8.3.1 Sharpe’s Single-Index Model
A major drawback with the Markowitz model is that it is very information-inten-

sive. So, if there are n securities, the Markowitz model would require n expected
returns, n variance terms and n(n − 1)/2 covariance terms. As is evident, so many
calculations become rather cumbersome, especially for large institutional inves-
tors, who may have hundreds of securities in their portfolios. Hence, it was re-
quired to simplify the Markowitz model, especially with respect to the covariance
terms required. Markowitz, himself, in his seminal work, suggested the use of an
index to which the securities are connected (or are a part of), to reduce the covar-
iance terms.
Drawing from his postulate, Prof. William Sharpe developed the single-index
model in which the return of a security was expressed as a function of the return
of a broad-based market index.
i The relationship was expressed as:

Ri = αi + bi Rm + ei (8.5)
where
5 Ri measures return on security I,
5 αi (alpha) is the constant return,
5 Rm measures the market index return, and
5 bi is the measure of the sensitivity of the return of a security i to the return of
the market index
5 ei denotes the error term.
8.3.2 Capital Asset Pricing Model (CAPM)
8.3.2.1 Expected Return–Beta Relationship Under CAPM

The capital asset pricing model (CAPM) is a model which presents how risk and
return are related. It was the first formal theory on how risky assets are priced.
Professor William Sharpe shared the Nobel Prize for economic sciences with Pro-
fessor Harry Markowitz in 1990. The CAPM proposed by Sharpe was first pub-
lished in Journal of Finance in 1964 (Sharpe, 1964).
Elaborating on the single-index model, the CAPM is an economic theory
which focuses on the relationship between the risk and return. The CAPM model
is a centrepiece of modern financial economics.
8.3.2.2 Assumptions of the CAPM

The CAPM assumptions draw from the efficient market hypothesis (as used in the
Markowitz portfolio theory). It assumes:
5 A single-period investment horizon;
5 Investors can invest in the universal set of publicly traded financial assets;
5 Investors can borrow or lend at the risk-free rate without limit;
5 No taxes, inflation and transaction costs;
5 Information is free and available to all;
5 Investors are price takers (there is no sufficiently wealthy investor, such that,
his will or behaviour can influence the market and security prices);
5 All investors have the same expectations about the expected return and risk of
a security;
5 All investors are rational and try to construct efficient;
5 Capital markets are in equilibrium; and
5 Investors are all similar except in their initial wealth and in their degree of risk
aversion.
8 8.3.2.3 Unique Risk and Market Risk: Basis of Diversification

According to Sharpe, the risk of a security can be divided into two components:
unique risk and market risk.
Definition
Unique risk, as the name suggests, denotes the risk factors affecting only that par-
ticular company or entity. Examples of these can be the labour situation in a com-
pany, the leadership, the technology that it employs, the competition it faces, the
bargaining power with suppliers, etc. Unique risk is also called “diversifiable risk/
unsystematic risk” as it can be diversified by investing in another company which
does not face the same risk factors.
Definition
On the other hand, market risk includes all sources of risk that affect the overall
market. For example, political risk, cultural risk, legal risk, socio-economic factors,
natural calamities, and so on. Since it arises from the general system and is com-
mon to all players in that system/market, it is also called “systematic risk or non-di-
versifiable risk”.
► Example
. Figure 8.6 presents the aspect of diversification. As stated earlier, one may reduce
the unique risk by investing in other securities which do not face the same risk fac-
tors which a particular security faces, but eventually, even after you diversify against
all unique risk factors, the market risk component still remains and it cannot be diver-
267 8
. Fig. 8.6 Unique risk and market risk. Source Madfientist.com (2021)
sified (within the same market/economy1). Thus, the overall risk of the diversified port-
folio becomes parallel or nearly equal to the market risk line. Hence, there is a limit
to diversification and an investor will do well, to not add on additional securities to
the portfolio, once the diversification limit has been reached. Doing that will only add
to the monitoring and management expenses (in terms of brokerage and transaction
costs) and provide no extra benefits in terms of reduced risk. ◄
8.3.2.4 Market Portfolio Under CAPM

The most important implication of the CAPM is the concept of the market port-
folio which assumes that:
5 All investors invest in the same optimal portfolio;
5 The optimal portfolio lies at the tangent between RF and the efficient frontier;
and
5 The optimal portfolio consisting of all risky assets is called the market portfo-
lio.
Characteristics of the Market Portfolio

The concept of market portfolio assumes that all risky assets must be in the port-
folio, so that it is completely diversified as far as the unique risk component is con-
cerned, and hence, the portfolio only faces systematic risk.
1 Technically, one can diversify against market risk, as well, by diversifying into other markets
which do not feature the risk characteristics of a particular market. The globalized market pro-
vides this opportunity to both capital and investors.
. Fig. 8.7 Security market line (SML). Source Authors’ compilation
8
Theoretically, a market portfolio contains economy-wide assets and includes all fi-
nancial and real assets. Further, all securities are included in the market portfolio
in proportion to their market value (capitalization). Such portfolios are, obviously,
impossible to create and are thus generally unobservable. However, for practical
purposes, they are proxied by broad market indices like the S&P 500 and Nifty 50,
etc.
8.3.2.5 Security Market Line and Capital Market Line
> Every security, thus, earns a return premium due to its unique risk factors and
also due to the market risk factors prevalent in the market of which the security
is a part.
Hence, total risk = unique risk + market risk.
The relationship between the returns of a security and its risk is called the security
market line (SML) (. Fig. 8.7).
The difference between the security’s return, RS, and the risk-free return, Rf, is
called the “risk premium” of the security. Similarly, the difference between market
return, Rm, and the risk-free return Rf is called the “risk premium” of the market.
A security’s risk premium is denoted as β(Rm – Rf).
According to CAPM, alpha (α) in the long run has a value of zero, which means
that the returns investors get (through a diversified portfolio) are only due to their
exposure to the “market”. This is justified by some reasoning like “other risks can
be diversified away, so they will not be rewarded in equilibrium, only ‘systematic
risk’ will be rewarded”.
269 8
. Fig. 8.8 Capital market line. Source Authors’ compilation
In other words, since the non-systematic risk can be diversified, investors do

not require a risk premium as compensation for bearing unique/non-systematic
risk; investors need to be compensated only for bearing systematic/market risk.
The risk premium, defined as the expected return in excess of RF, reflects the
compensation for security holders.
As you may have gathered by now, the market portfolio is, of course, on the
efficient frontier, and the line from the risk-free rate through the market portfolio
is called the capital market line (CML).
► Example
. Figure 8.8 denotes the capital market line under the CAPM. ◄
8.3.2.6 Estimating Returns Through CAPM

Expected returns can be estimated through the CAPM by deploying Eq. 8.6.
i As per the CAPM,
E(Ri ) = Rf + βi [E(Rm ) − Rf ] (8.6)

where
E(Ri) = – expected return on security i,
Rf = – risk-free return,
ßi = – beta of security i,
E(Rm) = – expected return on market portfolio.
Risk premium = ßi [E(Rm) – Rf]
Therefore, the greater the systematic risk, the greater the required return.
? Numerical Example 8.2: CAPM

If [E(Rm) – Rf] = 8% and Rf = 3%, what are the expected returns of securities X and
Y, with betas of 1.25 and 0.60, respectively?
v Applying Eqs. 8.6,
For βx = 1.25,
E(Rx ) = 3% + 1.25 × (8%) = 13%

For βY = 0.60,
E(RY ) = 3% + 0.60 × (8%) = 7.80%

Hence, as is evident, a stock with a higher beta needs to offer a higher expected
return to attract investors, due to its higher systematic risk.
8.3.2.7 Estimating Beta
Estimating individual security betas is a difficult exercise. Since we can only use
company-specific factors in CAPM, it requires an asset-specific forecast. Beta is
8 a measure of the covariance of the security’s returns with the market returns di-
vided by the variance in the market returns.
Hence, beta (β)measures systematic risk. It measures the relative risk of a se-
curity compared to the market portfolio of all stocks. It, thus, presents that the
volatility of the stock is different from that of the market.
> Beta(β) = Covariance(R1 , Rm )/Variance of Rm (8.7)
The same can also be written as per Eq. 8.8:
Beta(βi ) = σim /σm2 (8.8)

? Numerical Example 8.3: Beta
You are provided the following information on market returns and the returns of a
company:
Returns in % Year 1 Year 2 Year 3 Year 4 Year 5
Market index (Rm) 10 12 14 12 10
ABC Ltd. (RABC) 15 18 20 18 15
Calculate beta coefficient of the company.
v 1. Beta calculation for ABC Ltd.:

Applying Eq. 8.7,
Beta(βi ) = Covariance(Ri , Rm )/Variance of Rm

271 8
Year RABC Market (Rm) (A) (B) A*B B*B
RABC − RABC Rm − Rm
Year 1 15 10 −2.20 −1.60 3.52 2.56
Year 2 18 12 0.80 0.40 0.32 0.16
Year 3 20 14 2.80 2.40 6.72 5.76
Year 4 18 12 0.80 0.40 0.32 0.16
Year 5 15 10 −2.20 −1.60 3.52 2.56
Mean 17.20 11.60 14.40 11.20
Hence, Beta (βi) = 14.40/11.20 = 1.29.
> A beta of one implies the security is as risky as the underlying market. Typically,
an index-based mutual fund scheme would have a beta of 1. Companies with betas
greater than 1 are considered aggressive stocks, and typically, belong to the growth
sectors, like technology, renewable energy, etc. Companies with betas less than 1 are
considered defensive stocks. Such companies can be mature companies with lower
growth opportunities, for example large PSUs. Their returns may be lower, but they
are considered more stable/safe.
The underlying market index chosen for the proxy of market returns should be
chosen carefully. For instance, if one is considering a diversified portfolio, a broad-
based market index, like the BSE200 or BSE500, can be chosen. Similarly, if one
is interested in investing in a particular sector, a sectoral index would be a good
choice.
? Numerical Example 8.4: Risk, Return and Beta

Provided here are the hypothetical returns of the banking sector and of two banks,
for three years. Determine the beta and comment on the risk and return profile of
the two banks.
Year 1 Year 2 Year 3

Return of Banking Sector 15 18 15
Return of ABC Bank 20 25 21
Return of XYZ Bank 14 16 15
2. Beta calculation for ABC Bank:

Applying Eq. 8.7,


Year 1 20 15 −2 −1 2 1
Year 2 25 18 3 2 6 4
Year 3 21 15 −1 −1 1 1
Mean 22 16 9 6
Hence, Beta (βi) = 9/6 = 1.5

Similarly,
2. Beta calculation for XYZ Bank:
Applying Eq. 8.7,

Year 1 14 15 −1 −1 1 1
8 Year 2 16 18 1 2 2 4
Year 3 15 15 0 −1 0 1
Mean 15 16 3 6
Hence, Beta (βi) = 3/6 = 0.50.

As is evident from the beta values, Bank ABC with a beta of 1.5 is more aggres-
sive than the sectoral average in terms of providing higher returns. However, the
downside is that the returns would fall at a higher rate (compared to the sectoral
index) during a downturn/recession. Bank XYZ is a defensive stock when com-
pared to the index; however, it would be more stable in case of a sectoral downturn.
Hence, ABC can be a good investment choice for the aggressive/ambitious investor
desiring high returns and XYZ would be favoured by conservative investors who
desire stable albeit lower returns.
It is to be noted here that three data points may be fine for illustrating a concept;
however, investors would do well to consider a larger data set in order to make more
informed decisions.
Beta of a Portfolio

Since the expected return–beta relationship according to the CAPM is linear,
and holds not only for all individual assets/securities but also for any portfolio,
the beta of a portfolio is simply the weighted average of the betas of the individ-
ual securities in the portfolio. The return of the portfolio (as in the Markowitz
model) is the weighted average return of the underlying securities.
i n
(8.9)

βp = βi wi
1
273 8
where
βp – is the beta of the portfolio,
wi – is the weight of the security i in the portfolio and
βi – is the beta of the security i in the portfolio.
? Numerical Example 8.5: Portfolio Beta

You have the following information on two securities in which you have invested:
Expected return (%) SD (σ) Security beta (β) Percent invested
ABC 20 8 1.50 40
XYZ 15 6 0.80 60
What is the expected return and risk on the portfolio? What is the beta of the
portfolio? The correlation coefficient between the returns of ABC and XYZ is 0.30.
Expected return = 0.40 ∗ (20%) + 0.60 ∗ (15%) = 17%
1/2
Standard deviation = (0.40)2 ∗ (8)2 + (0.60)2 ∗ (6)2 + 2 ∗ (0.40) ∗ (0.60)∗ (8) ∗ (6) ∗ (0.30)
= [10.24 + 12.96 + 6.91]1/2

= 5.49%
Variance, being the square of standard deviation, is 30.11%.
Betaof portfolio = 0.40 ∗ (1.5) + 0.60 ∗ (0.80) = 0.60 + 0.48 = 1.08

How Accurate Are Beta Estimates?
The beta values are at best estimates due to the following reasons:
5 Betas change real-time reflecting a company’s and the market’s dynamic situa-
tions;
5 Estimating a future beta is important because it may differ from the historical
beta;
5 RM represents the total weighted returns of all marketable securities in the
economy. Since, this is unobservable and nearly impossible to compute, it is
proxied through a stock market index which, in turn, approximates returns on
all common stocks;
5 There are no accurate/correct number of observations and/or durations for
computing beta; and
5 Portfolio betas are considered relatively more reliable than individual security
betas.
8.3.2.8 Constructing the Optimal Portfolio Under CAPM
> To determine which securities are to be included in the optimum portfolio, the
following steps are necessary:
1. Calculate the excess return to beta ratio for each security under review and rank them.
2. The optimum portfolio consists of investing in all securities for which
(Ri − Rf)/βi is greater than a particular cut-off point.
Points to Ponder 8.1: The Case of a Negative BETA

The values of beta are considered to be the measure of the systematic risk of a parti-
cular stock. We know that when beta equals one, it reflects that the stock or the port-
folio mirrors the underlying market index (proxy for market) movement in terms of
volatility. Similarly, for stocks with higher beta values (mostly greater than 2), the
risks associated are higher, as are also, the corresponding returns. When the market
is bullish, the gains derived from higher beta stocks will be higher than the index re-
turns. Conversely, during a fall/recession, these stocks book larger losses than the un-
derlying market.
The case of a negative beta denotes a negative correlation between the security and
the underlying market. A typical example of a negative beta instrument is gold, which
acts as a hedge against higher inflation (which eats into the gains of other financial
investments such as stocks and bonds). This means that while the market is growing,
gold exhibits a stagnant or even negative growth rate. This is because most of the in-
vestments are channelized into the stock market and the demand for bullion (gold
and silver) declines, hence pulling the price down. Similarly, when markets are bea-
rish, people fall back upon gold and bullion for their investments as they are conside-
8 red safer and all-weather investments.
Gold and silver, by themselves, are considered to have negative beta values. It has,
however, been observed that when securitized into gold ETF (exchange traded
funds), the funds show a positive beta. It is, thus said, “when securitized, real as-
sets behave more like financial assets”.
You may have observed that gold and silver prices have hit their all-time high, as a
result of the ongoing COVID-19 pandemic. It is due to the reasoning mentioned
above.
(Sources: Morningstar, 2017; Wall Street Oasis, 2017)
8.3.2.9 Disadvantages/Limitations of CAPM
The CAPM suffers from a number of disadvantages and limitations.
5 For CAPM, one needs the values for the risk-free rate of return, the return
on the market or the risk premium and the security beta. However, yields on
short-term government treasury bills (generally taken as the proxy for the risk-
free rate of return) are not fixed. They change in real-time based on underly-
ing economic situations. A short-term average value is generally used in order
to smooth out this volatility. Therefore, finding an accurate value for the risk
premium is difficult.
5 The return on a stock market is the average of the capital gains and dividend
yields of the constituent stocks. However, a market can even provide negative
rather than positive returns, especially in the short-run. This happens when
share prices fall, and this loss is higher than the dividend yields. It is, therefore,
usual to use a long-term average value for the risk premium. This value, ob-
viously, is dynamic. Hence, this volatility induces uncertainty in the calculated
value for the expected return.
275 8
5 Beta values are now estimated and published for all listed companies. Since
these beta values are dynamic, there is an underlying uncertainty/inaccuracy in
the estimation of the expected return.
5 Companies have different sources of finance. Some companies may have debt
that is not traded or have convertible securities. The simplistic assumption that
debt has a beta value of zero leads to inaccurate calculations of project-specific
discount rates.
> To sum up, in spite of the immense contribution of the CAPM, there are several
criticisms levelled at the model. Some of them are:
5 In reality, not all securities lie on the SML and under-priced (over-priced)
stocks plot above (below) the SML.
5 Unreal assumptions, e.g. homogeneous expectations of security returns and
variance, borrowing funds at the risk-free interest rate.
5 Logical inconsistency: The CAPM fails to justify why an investor would follow
an active strategy when a passive strategy is considered most efficient (under
CAPM).
5 Differences in risk tolerances can be handled by changing the asset allocation
decisions in the complete portfolio.
However, in spite of the limitations, the concepts one learns from the CAPM are
valid. Investors do gain from diversification.
Points to Ponder 8.2: Concept of Smart Beta

In recent times, the markets have seen the emergence of a new approach to investing,
which is known as smart beta—which has slowly gained momentum and become popu-
lar amongst investors. The growth of investments, based on the concept of smart beta,
has been highlighted in Fig. 8.9.
Smart beta is primarily an enhanced indexing strategy which also takes into account
certain performance criteria with the aim to surpass the benchmark index. So, smart
beta is fundamentally different from the traditional passive indexing strategy.
In an actively managed mutual fund, the fund managers select between individual
stocks/sectors in an effort to beat the benchmark index. Smart beta aims at increa-
sing returns, enhancing diversification and minimizing risk by making investments in
customized indices or exchange-traded funds (ETFs) based on other predetermined
factors. They seek to outperform and have lower risk than traditional capitalizati-
on-weighted benchmarks. They also have typically lesser operating costs when compa-
red to a traditional actively managed fund.
Traditional index funds and ETFs are weighted based on the capitalization. This
implies that the individual stocks within the index are calculated depending on the
individual stock’s collective market capitalization. This means those with higher
market capitalization are given more weight than those with a lower market capi-
talization. What happens is that due to a few highly valued stocks, the total index
value is a skewed as they comprise of a larger percentage in entirety.
. Fig. 8.9 Smart beta. Source Bloomberg
8 Smart beta is a strategy which does not only depend on the market exposure to value a
stock’s performance relative to its index, but also, smart beta looks to allocate and re-
balance portfolio securities by taking into consideration other “factors” too. A factor
is an attribute which aids in driving risks and returns, for example—quality, size, etc.
For example, stocks of companies that generate higher profits, with strong balance
sheets and stable cash flows, are considered high-quality and tend to outperform
the market over time. Similarly, small-capitalization stocks have historically out-
performed large-capitalization stocks. Most factors are not correlated with one an-
other and different factors may perform well at different times.
For strategies that blend components of active and passive investing decisions, in-
vestors are looking to invest in smart beta companies more and more.
(Source: Bloomberg, 2017)
8.4 Advent of the Multi-factor Models
Many tests for the effectiveness of CAPM were conducted following Roll’s cri-
tique in 1977. Roll argued that since the true market portfolio can never be ob-
served, and hence, the CAPM is untestable (Roll, 1977).
Multi-index models, as an alternative, draw from the full variance–covariance
method of Markowitz and the single-index model.
8.4.1 Two-Factor CAPM
In reality, the systematic risk does not occur from one source. It is obvious that
developing models that allow for several factors of systematic risk can provide
better descriptions of security returns.
8.4 · Advent of the Multi-factor Models
277 8
i Suppose that the two most important macroeconomic sources of risk are
“uncertainties surrounding the state of the business cycle” and “unanticipated
change in interest rates”. The two-factor CAPM model could be:
E(Ri ) = Rf + βi [E(Rm − Rf )] + βTB [E(RTB − Rf )] (8.10)

where apart from the first beta coefficient, the second beta coefficient measures the
sensitivity of interest rate changes. TB denotes treasury bond returns.
Hence, the overall risk premium on a security is the sum of the risk premiums
required as compensation for each source of systematic risk.
? Numerical Example 8.6: Two-factor CAPM

ABC company has a beta of 1.2, and a bond has a beta of 0.70. Suppose the risk
premium of the market index is 6% while that of the bond portfolio is 3%. Risk-
free rate is 4%. What is the expected return for the company?

E(Ri ) = Rf + βi E Rm − Rf + βTB E RTB − Rf
Hence,
E(RABC ) = 4% + 1.2 ∗ 6% + 0.70 ∗ 3% = 13.30%
8.4.2 Fama and French Three-Factor Model
How to identify meaningful factors to increase the explanatory or predictive

power of the CAPM was an unsolved problem. Motivated by two observations,
viz. the average stock returns for smaller firms and returns for firms with a high
book-value-per-share to market-value-per-share ratio (B/M), are historically
higher than the predictions according to the CAPM, Fama and French added
the firm size and book-to-market ratio into the CAPM to explain expected re-
turns which was called the Fama and French three-factor model (Fama & French,
1992).
Possible reasons for the same are that the size or the book-to-market ratio
may be proxies for other sources of systematic risk, not captured by the CAPM
beta and, thus, result in return premiums.
Hence, in addition to the market risk premium, Fama and French proposed
the size premium and the book-to-market premium. The size premium is con-
structed as the difference in returns between small and large firms and is denoted
by “small minus big” (SMB). The book-to-market premium is calculated as the
difference in returns between firms with a high versus low book-to-market ratio
and is denoted by “high minus low” (HML).
i The Fama and French three-factor model is given as follows:
E(Ri ) = Rf + βm [E(Rm − Rf )] + βiSMB E(RSMB ) + βiHML E(RHML ) (8.11)

where
5 RSMB is the return of a portfolio consisting of a buy position of $1 in a small-
size-firm portfolio and a sell position of $1 in a large-size-firm portfolio (basi-
cally the excess returns provided by a small versus large firms’ portfolio).
5 RHML is the return of a portfolio consisting of a buy position of $1 in a high-
er-B/M portfolio and a sell position of $1 in a lower-B/M portfolio (basically
the excess returns provided by a value versus growth firms’ portfolio).
The roles of RSMB and RHML are to identify the average reward compensating
holders of the security i exposed to the sources of risk for which they proxy.
8.4.3 Arbitrage Pricing Theory
Arbitrage means the creation of riskless profits by trading on the relative mispric-
8 ing amongst securities, across different markets. In layman terms, it means buying
a security from a market where its price is low and selling it in a market where the
price is high, to record profit. Since there is no risk for arbitrage, an investor will
create arbitrarily large positions to obtain large levels of profit. It is to be noted
that there are no arbitrage opportunities in efficient markets.
The arbitrage pricing theory, a multi-factor model pioneered by Stephen Ross,
is a more general asset pricing theory (Ross, 1977). The arbitrage pricing theory
(APT) is based on the “Law of One Price”. Drawing from the efficient market hy-
pothesis, it states that in an efficient market, two otherwise identical assets (prod-
ucts), cannot sell at different prices. Market forces function in such a manner that
equilibrium prices adjust to cancel all arbitrage opportunities.
Even though the basic premise remains movement towards an efficient mar-
ket, unlike the CAPM, APT does not assume a single-period investment horizon,
absence of personal taxes, riskless borrowing or lending and mean–variance deci-
sions for its investors.
i Considering a well-diversified (large enough) portfolio such that the non-systematic

risk is negligible, the model implies:
Rp = αp + βp Rm (8.12)
where
Rp = Rp – Rf and Rm = Rm – Rf are excess rates of return of the well-diversified
portfolio and the market portfolio.
The APT concludes that the only value for alpha that rules out arbitrage oppor-
tunities is zero. Hence, for all well-diversified portfolios, APT is like CAPM.
8.4 · Advent of the Multi-factor Models
279 8
8.4.3.1 The APT Return Generating Process
i The APT return generating process is given as per Eq. 8.13:

Ri = ai + bi1 i1 + bi2 i2 + · · · + bij ij + ei (8.13)
where
Rp – is return on stock i,
ai – is expected return on stock i if all factors have a value of zero,
ii – is value of jth factor which influences the return on stock i (j  =  1 to n),
bij – is sensitivity of stock i’s return to the jth factor and
ei – is random error term.
The equilibrium relationship according to the APT is as follows:
Ri = 0 + bi1 1 + bi2 2 + · · · + bij j (8.14)

where
Ri – is expected return on stock i,
λ0 – is return on a risk-free asset,
bij – is sensitivity of stock i to risk factor j and
λj – is risk premium for the type of risk associated with factor j.
8.4.3.2 Risk Factors in APT

The APT assumes that returns are generated by risk factors unique to securities.
These factors could be size, age and/or sector to which the security belongs. To
qualify as a factor, the following criteria must be met:
> Risk Factor Criteria

5 Each risk factor should be able to influence stock returns.
5 Risk factors must have non-zero prices.
5 Risk factors must not be predictable.
8.4.3.3 Challenges in APT
The factors used in APT are not well specified and are ex-ante. To implement the
APT model, we need to use the factors that result in differences amongst secu-
rity returns. Keeping things simple, CAPM identified the market portfolio as sin-
gle factor.
The APT seems to obtain the same expected return–beta relationship as
the CAPM with fewer objectionable assumptions. However, the absence of ar-
bitrage does not mean that, in equilibrium, the expected return–beta relation-
ship will hold true for all securities. In contrast, it is suggested in the CAPM
that all assets in the economy should satisfy the famous expected return–beta
relationship.
However, evidence from research shows that neither CAPM nor APT has been
proven superior to the other.
These multi-factor models/frameworks are complicated in nature, deploying
company specific as well as macroeconomic variables and several assumptions.
Further, they require an understanding of econometrics. They typically find ap-

plication in research. Therefore, keeping in mind the target audience of this text,
we are not solving numericals based on these models. Instead, a simplified norma-
tive framework is suggested.
8.5 Normative Framework for Investors
Whatever be the model that one may deploy to assess the risk and return of a
stock/portfolio of stocks, the basic point to ponder over is the estimation of an
individual investor’s risk and return profile, and this exercise does not come with
a ready-made model/equation.
Every investor, before investing, needs to understand his/her risk profile. He/
she needs to decide how comfortable he/she is with risk (volatility in returns) and
how much risk he/she is prepared to take or is capable of bearing to achieve the
returns he/she wants.
This is a very important decision, and one should make it wisely. Suppose an
8 investor wants 20% returns, is he/she equal with say 10% (in case of volatility eat-
ing into 50% of the returns) or does he/she want only constant returns?
People invest money with the desire to increase wealth and improve their
standard of living. In financial terms, increasing wealth means positive rate of re-
turn, achieved on investments. However, every stock that you buy is associated
with some risk.
High risk means high potential returns, and lower risk is generally accompa-
nied with smaller returns. This is a financial trade-off that the investor has to con-
sider every time he invests in the financial markets.
Diversification of portfolio entails the spreading/distribution of investment
around different assets so that the exposure to risk is not limited to one type of
asset. Diversification helps to reduce the volatility of the portfolio, over time. Di-
versification may also provide the potential to improve returns for the same level
of risk (as has been seen through the numerical examples in this chapter).
To build a diversified portfolio, there should be an asset mix (e.g. stocks,
bonds and short-term investments) which is aligned to the investment time frame
and risk appetite of the investor. The sample asset mixes presented in . Fig. 8.10
combine various proportions of stocks, government bonds and short-term invest-
ments to illustrate different levels of risk and return potential.
The conservative mix is suggested for risk–averse investors, as the investors
put most of their savings in government bonds which are relatively less risky. All
the investors have certain goals for their investment, for example a retirement
fund, college tuition, a down payment for a house or even a vacation. As an in-
vestor, you should focus on two important considerations: first, the number of
years until you expect to need the money—also known as your investment hori-
zon; second, your attitude towards risk—also known as your risk tolerance.
Imagine you are a 30—year-old investor. Think about a goal that’s 30 years
away, like retirement. Because the time horizon is fairly long, you may be willing
8.5 · Normative Framework for Investors
281 8
. Fig. 8.10 Sample asset (* Bonds represents government bonds only). Source Fidelity (2017a, 2017b)
to take on additional risk with the aim of long-term growth, considering the as-
sumption that you have time to recover losses in the event of a short-term mar-
ket decline. In that case, a higher risk portfolio like growth stocks can be selected.
However, here’s where the risk tolerance becomes a factor regardless of the
time horizon. Suppose the investor has his family as dependents, and his parents
need medical attention (which is costly). So, even if the investor is saving for a
long-term goal, he is more risk–averse and may want to consider a more balanced
portfolio with some fixed income investments so that a certain portion of the re-
turns is assured. Anyhow, regardless of the goal, time horizon or risk tolerance, a
diversified portfolio is the foundation of any smart investment strategy.
8.6 Conclusion
This chapter presents the theoretical framework behind portfolio management.

The Markowitz portfolio theory, by Prof. Harry Markowitz, is the seminal work
in the area and all other frameworks and models draw from it. Professor William
Sharpe’s capital asset pricing model (CAPM) is the leading model for estimating
returns based on market risk. The Fama–French three-factor model is based on
introducing specific aspects like size and value effects, within the CAPM model.
Another multi-factor model, the arbitrage pricing theory (APT), is also an exten-
sion of the CAPM in terms of considering other risk factors.
These multi-factor models/frameworks are technical in nature, and hence,
keeping in mind the target audience of this text, a simplified normative frame-
work is suggested for investors.
Summary
5 Prof. Harry Markowitz propounded a mean–variance (return–risk) theory and
provided a structured understanding of the concept and measurement of risk
and return, in the investment landscape.
5 The Markowitz portfolio theory (MPT) is based on the assumption of efficient
markets and rational investors. The characteristics of an efficient market are:
– All investors have the same expectations regarding the returns and risk of
all securities.
– All investors have access to the same information.
– Investments can be freely made; there are no restrictions.
– There are no taxes.
– Transaction costs are nil.
– The market price is not affected by any large buyer/seller.
5 According to the MPT, any rational investor, would prefer a higher return to a
lower one and a lower risk to a higher one. In other words, if an investor has
an option, he would want to move to a portfolio that provides him higher re-
turns for the same level of risk or lower risk for the same level of returns.
5 In a portfolio comprising of two securities (1 and 2), the return of the portfo-
8 lio is given as
Rp = w1 R1 + w2 R2
where
w1 – is the weight of portfolio invested in security 1 and
w2 – is the weight of portfolio invested in security 2.
5 When a portfolio consists of n securities, the expected return on the portfolio is:
n

Rp = wi Ri
i=1
where
Ri – is the return on the security i,
wi – is the proportion of portfolio invested in security i.
5 The risk (variance) of the portfolio is calculated as
Var Rp = σ12 w12 + σ22 w22 + 2w1 w2 σ1 σ2 ρ12

where
Var (Rp) – is variance of the portfolio returns or portfolio risk,
Summary
283 8
ρ12 – is the correlation between the returns on securities 1 and 2 and
ρ12σ1σ2 – is the covariance between the returns on securities 1 and 2.
The same formula can be extended to n securities.

5 Amongst the criticisms of the MPT, the most important ones, pertain to its
suffering from the lack of certain important aspects, which were not covered in
the theory, primarily, the practices of short selling or leveraged portfolios.
5 Short selling is the practice of selling a stock first (one which is showing indi-
cations of a fall in price) and then buying it later, at a lower price. The effect of
short selling is that a security sold short yields a positive return when the secu-
rity records a large decline in price and vice versa.
5 Limitations to the MPT in terms of unrealistic assumptions are that all ratio-
nal investors are risk averse and that variance is the most appropriate measure of
risk.
5 Prof. William Sharpe developed the single-index model in which the return of
a security was expressed as a function of the return of a broad-based market
index.
5 According to Sharpe, the risk of a security can be divided into two compo-
nents: unique risk and market risk.
5 Unique risk, as the name suggests, denotes the risk factors affecting only that
particular company or entity. Examples of these can be the labour situation in
a company, the leadership, the technology that it employs, the competition it
faces, the bargaining power with suppliers, etc. Unique risk is also called “di-
versifiable risk/unsystematic risk” as it can be diversified by investing in an-
other company which does not face the same risk factors.
5 Market risk includes all sources of risk that affect the overall market. For ex-
ample, political risk, cultural risk, legal risk, socio-economic factors, natural
calamities and so on. Since it arises from the general system and is common to
all players in that system/market, it is also called “systematic risk or non-diver-
sifiable risk”.
5 The difference between the security’s return, RS, and the risk-free return, Rf,
is called the “risk premium” of the security. Similarly, the difference between
market return Rm and the risk-free return Rf is called the “risk premium” of
the market. A security’s risk premium is denoted as β(Rm – Rf).
5 As per the CAPM,
E(Ri ) = Rf + βi [E(Rm ) − Rf ]
where
E(Ri) = – expected return on security i,
Rf = – risk-free return,
ßi = – beta of security i,
E(Rm) = – expected return on market portfolio.
Risk premium of security = – ßi [E(Rm) – Rf]
5 Beta is a measure of the covariance of the security’s returns with the market
returns divided by the variance in the market returns. Hence, beta (β) measures
systematic risk.

5 A beta of one implies the security is as risky as the underlying market. Typi-
cally, an index-based mutual fund scheme would have a beta of 1. Companies
with betas greater than 1 are considered aggressive stocks and, typically, be-
long to the growth sectors, like technology, renewable energy, etc. Companies
with betas less than 1 are considered defensive stocks. Such companies can be
mature companies with lower growth opportunities, for example large PSUs.
Their returns may be lower, but they are considered more stable/safe.
5 Since the expected return–beta relationship, according to the CAPM, is linear
and holds not only for all individual assets/securities but also for any portfolio,
the beta of a portfolio is simply the weighted average of the betas of the indi-
vidual securities in the portfolio.
n
8

βp = βi wi
1
where
βp – is the beta of the portfolio,
wi – is the weight of the security i in the portfolio and
βi – is the beta of the security i in the portfolio.
5 The beta values are, at best, estimates due to the following reasons:
– Betas change real-time reflecting a company’s and the market’s dynamic
situations.
– Estimating a future beta is important because it may differ from the histori-
cal beta.
– Rm represents the total weighted returns of all marketable securities in the
economy. Since this is unobservable and nearly impossible to compute, it is
proxied through a stock market index which, in turn, approximates returns
on all common stocks;
– There are no accurate/correct number of observations and/or durations for
computing beta; and
– Portfolio betas are considered relatively more reliable than individual secu-
rity betas.
5 Given that the two most important macroeconomic sources of risk are “uncer-
tainties surrounding the state of the business cycle” and “unanticipated change
in interest rates”. The two-factor CAPM model would become
E(Ri ) = Rf + βi [E(Rm − Rf )] + βTB [E(RTB − Rf )]

where, apart from the first beta coefficient, the second beta coefficient meas-
ures the sensitivity of interest rate changes. TB denotes treasury bond returns.
Summary
285 8
5 Motivated by two observations, viz. the average stock returns for smaller
firms and returns for firms with a high book-value-per-share to market-val-
ue-per-share ratio, are historically higher than the predictions according to the
CAPM, Fama and French added the firm size and book-to-market ratio into
the CAPM to explain expected returns which was called the Fama and French
three-factor model.
5 The arbitrage pricing theory (APT) is based on the “Law of One Price.” Draw-
ing from the efficient market hypothesis, it states that in an efficient market,
two otherwise identical assets (products) cannot sell at different prices. Market
forces function in such a manner that equilibrium prices adjust to cancel all ar-
bitrage opportunities.
5 Regardless of the goal, time horizon or risk tolerance, a diversified portfolio is
the foundation of any smart investment strategy.
8.7 Exercises
8.7.1 Objective (Quiz)-Type Questions
? Fill in the Blanks

(i) The Markowitz portfolio theory (MPT) is based on the assumption of
________ markets and rational investors.
(ii) A rational investor would want to move to a portfolio that provides him
______ returns for the same level of risk or _______ risk for the same level
of returns.
(iii) Amongst the criticisms of the MPT are the practices of short selling and
________________.
(iv) ______________ is the practice of selling a stock first (one which is showing
indications of a fall in price) and then buying it later, at the lower price.
(v) Limitations of the MPT in terms of unrealistic assumptions are that all ra-
tional investors are _________ and that variance is the most appropriate
measure of risk.
(vi) ____________ developed the single-index model in which the return of a se-
curity was expressed as a function of the return of a broad-based market in-
dex.
(vii) According to Sharpe, the risk of a security can be divided into two compo-
nents: ___________ risk and market risk.
(viii) ____________ risk includes all sources of risk that affect the overall market.
(ix) The difference between the security’s return, RS, and the risk-free return, RF,
is called the ___________ of the security.
(x) __________ is a measure of the covariance of the security’s returns with the
market returns divided by the variance of the market returns.
v (Answers: (i) efficient (ii) higher; lower (iii) leveraged portfolios (iv) short selling;
(v) risk averse (vi) Prof. William Sharpe (vii) unique (viii) market (ix) risk pre-
mium (x) beta).
? True/False
(i) Prof. Harry Markowitz propounded a mean–variance (return-risk) theory
and provided a structured understanding of the concept and measurement
of risk and return, in the investment landscape.
(ii) The Markowitz portfolio theory (MPT) is based on the assumption of ineffi-
cient markets.
(iii) Long selling is the practice of selling a stock first (one which is showing indi-
cations of a fall in price) and then buying it later, at the lower price.
(iv) Prof. Harry Markowitz developed the single-index model in which the re-
turn of a security was expressed as a function of the return of a broad-based
market index.
(v) Unique risk, as the name suggests, denotes the risk factors affecting only
8 (vi)
that particular company or entity.
Beta (β) measures systematic risk.
(vii) Companies with betas less than 1 are considered aggressive stocks.
(viii) Portfolio betas are considered relatively more reliable than individual secu-
rity betas.
(ix) The arbitrage pricing theory (APT) is based on the “Law of One Price”.
(x) Regardless of the goal, time horizon or risk tolerance, a diversified portfolio
is the foundation of any smart investment strategy.
v (Answers: (i) True (ii) False (iii) False (iv) False (v) True (vi) True (vii) False
(viii) True (ix) True (x) True)
? SQ1: Portfolio ConstructionUnder MPT
Consider two companies ABC and XYZ with a correlation coefficient of 0.5. Cal-
ABC 20 50 16
XYZ 40 50 20
What happens when you add another stock, PQR to the portfolio in the 50:50
ratio? PQR has a return of 19% and standard deviation of 30. The correlation co-
efficient of PQR with the existing portfolio is 0.30.
8.7 · Exercises
287 8
Applying Eqs. 8.2 and 8.3:
n

Portfolio return (ABC and XYZ) = Rp = wi Ri
1
= 0.50 ∗ 16 + 0.50 ∗ 20
= 18%
Portfolio risk (variance) (ABC and XYZ) = σ12 w12 + σ22 w22 + 2w1 w2 σ1 σ2 ρ12
= (0.50)2 (20)2 + (0.50)2 (40)2
+ 2 ∗ 0.50 ∗ 0.50 ∗ 20 ∗ 40 ∗ 0.50
= 0.25 ∗ 400 + 0.25 ∗ 1600 + 200
= 100 + 400 + 200
= 700%
√
Similarly, standard deviation = 700
= 26.46%
Further, when we add the stock PQR to the portfolio:

Stocks Standard deviation Weight in portfolio (5) Average returnn (%)
Old portfolio 26.46 50 18
PQR 30 50 19
n

The revised portfolio return = Rp = wi Ri
1
= 0.50 ∗ 18 + 0.50 ∗ 19
= 18.50%

= (0.50)2 (26.46)2 + (0.50)2 (30)2 + 2 ∗ 0.50 ∗ 0.50
∗ 26.46 ∗ 30 ∗ 0.30
= 0.25 ∗ 700 + 0.25 ∗ 900 + 119.07
= 175 + 225 + 119.07
= 519.07%
√
= 22.78%
Hence, the revised return and standard deviation of the new portfolio becomes
18.50% and 22.78%, respectively.
What do you notice here?
Yes: Through this simple diversification exercise, not only have we reduced the
risk of the portfolio but we have even increased the return!
? SQ2. CAPM
If [E(Rm) – Rf] = 10% and Rf = 5%, what are the expected returns of securities X
and Y, with betas of 1.50 and 0.80, respectively?
Applying Eq. 8.6,
For βx = 1.50,
E(RX ) = 5% + 1.50 × (10%) = 20%

For βY = 0.80,
E(RY ) = 5% + 0.80 × (10%) = 13%

? SQ3. CAPM
XYZ Ltd. has a beta of 1.45. The expected risk-free rate of return is 4%, and the
expected return on the market is 10%. What will be XYZ’s expected return?
Solution: E(Rxyz) = Rf + βxyz [E(Rm − Rf)]

E Rxyz = 4 + 1.45 ∗ (10 − 4) = 12.70%
? SQ4. Two-factor CAPM
8
ABC Company has a beta of 1.50, and the T-bond has a beta of 0.50. Suppose the
risk premium of the market index is 8% while that of the T-bond portfolio is 2%.
Risk-free rate is 3%. What is the expected return for the company?

E(Ri ) = Rf + βi E Rm − Rf + βTB [E(RTB − Rf )]
Hence,
E(RABC ) = 3% + 1.50 ∗ 8% + 0.50 ∗ 2% = 16%

? SQ5. Risk, Return and Portfolio Beta
You have the Expected return (%) SD (σ) Security beta (β) Per cent invested
following
information on
two securities in
which you have
invested
ABC 15 4.50 1.20 35
XYZ 12 3.80 0.98 65
portfolio? The correlation coefficient between the returns of ABC and XYZ is 0.60.
Expected return = 0.35 ∗ (15%) + 0.65 ∗ (12%) = 13.05%

Standard deviation = (.35)2 ∗ (4.50)2 + (0.65)2 ∗ (3.80)2
1/2
+2∗ (0.35)∗ (0.65)∗ (0.6)∗ (4.50)∗ (3.80)
= [2.48 + 6.10 + 4.67]1/2
= 3.64%
8.7 · Exercises
289 8
Variance, being the square of standard deviation, is 13.25%.
Betaof portfolio = 0.35 ∗ (1.2) + 0.65 ∗ (0.98) = 0.42 + 0.64 = 1.06

? SQ6. Beta
You are provided the following information on market returns and the returns of
three banks:
ABC Bank (RABC) 15 18 14 18 15
XYZ Bank (RXYZ) 20 24 18 25 24
PQR Bank (RPQR) 11 12 8 11 9
Calculate beta coefficient of the shares of the three banks and analyse the re-
sults.
v Beta calculation for ABC Bank:

Applying Eq. 8.7,

Year 1 15 12 −1 −0.80 0.80 0.64
Year 2 18 15 2 2.20 4.40 4.84
Year 3 14 10 −2 −2.80 5.60 7.84
Year 4 18 15 2 2.20 4.40 4.84
Year 5 15 12 −1 −0.80 0.80 0.64
Mean 16 12.80 16 18.80
Hence, beta (βABC) = 16/18.80 = 0.85.

Similarly,
beta calculation for XYZ Bank:
Applying Eq. 8.7,

Year 1 20 12 −2.20 −0.80 1.76 0.64
Year 2 24 15 1.80 2.20 3.96 4.84
Year 3 18 10 −4.20 −2.80 11.76 7.84
Year 4 25 15 2.80 2.20 6.16 4.84
Year 5 24 12 1.80 −0.80 1.44 0.64
Mean 22.20 12.80 25.08 18.80
Hence, beta (βXYZ) = 25.08/18.80 = 1.33.

Beta calculation for PQR Bank:
Applying Eq. 8.7,

Year 1 11 12 0.80 −0.80 −0.64 0.64
Year 2 12 15 1.80 2.20 3.96 4.84
Year 3 8 10 −2.20 −2.80 6.16 7.84
Year 4 11 15 0.80 2.20 1.76 4.84
Year 5 9 12 −1.20 −0.80 0.96 0.64
Mean 10.20 12.80 12.20 18.80
Hence, Beta (βPQR) = 12.20/18.80 = 0.65.
8
* You can take the help of a normal calculator or a scientific calculator for the cal-
culations.
? UQ1: Portfolio Construction under MPT
Consider two companies BCD and PQR with a correlation coefficient of 0.4. Cal-

BCD 10 40 15
PQR 20 60 18
What happens when you add another stock, MNO to the portfolio in the 60
(old portfolio): 40 (MNO) ratio? MNO has a return of 18% and standard deviation
of 25. The correlation coefficient of MNO with the existing portfolio is 0.25.
v [Answer: Portfolio return (before MNO) 16.80%; portfolio risk (before MNO): va-
riance 198.40%, standard deviation 14.09; portfolio return (after MNO) 17.28%;
portfolio risk (after MNO) variance 213.74%, standard deviation 14.62]
? UQ2. CAPM
If [E(Rm) – Rf] = 12% and Rf = 6%, what are the expected returns of securities X
and Y, with betas of 2 and 0.95, respectively?
v [Answer: X: 30%; Y: 17.40%]

8.7 · Exercises
291 8
? UQ3. CAPM
ABC Ltd. has a beta of 2. The expected risk-free rate of return is 5%, and the ex-
pected return on the market is 12%. What will be XYZ’s expected return?
v [Answer: 19%]
? UQ4. Two-factor CAPM

XYZ Ltd. has a beta of 1.8, and the T-bond has a beta of 0.60. Suppose the risk
premium of the market index is 10% while that of the T-bond portfolio is 3%.
Risk-free rate is 5%. What is the expected return for the company?
v [Answer: 24.80%]
? UQ5. Risk, Return and Portfolio Beta
Expected return (%) SD(σ) Security beta(β) Per cent invested

PQR 20 5 1.20 40
MNO 25 7 1.50 60
portfolio? The correlation coefficient between the returns of PQR and MNO is
0.50.
v [Answer: Expected return 23%; standard deviation 5.48%; variance 30.04%; portfolio
beta 1.38]
? UQ6. Beta
You are provided the following information on market returns and the returns of
two companies:

ABC Ltd. (RABC) 20 18 16 18 18
XYZ Ltd. (RXYZ) 12 10 12 11 10
Calculate beta coefficient of the shares of the two companies and analyse the
results.
v [Answer: βABC −0.71; βXYZ −0.18]

? 1. What is the basic postulate of the mean–variance theory propounded by Prof.

Harry Markowitz?
2. What are the characteristics of an efficient market?
3. How can one calculate the returns on a portfolio?
4. What are the measures used for determining the risk of a portfolio? How do we
calculate the same?
5. Enumerate the critiques of the Markowitz Portfolio Theory.
6. Distinguish between unique risk and market risk.
7. What is the concept of “risk premium”? Enumerate with examples.
8. What is beta? What do different values of beta indicate?
9. Describe the Fama–French three-factor model.
10. Write a note on the arbitrage pricing theory (APT).

8
? *These questions can take the form of a class exercise and/or assignment
1. Divide the class into groups. Each group invests in a portfolio with different
characteristics; for example, one group invests in the small-cap (capitalization)
segment, the other in mid-cap segment, another in large-cap segment and so
on. This would be a mock investment (not involving actual money) where stu-
dents would follow the movement of the investment in terms of return and risk.
Do this over a month/3 months. Note down the observations. Discuss the same
in class.
(Hint: Typically, one would witness differences in the returns/risk of these diffe-
rent portfolios).
2. Divide a set of companies (preferably from a broad-based index) on the basis
of their beta values into aggressive, defensive and market-mirroring stocks. Ob-
serve their returns and risk over a pre-decided time period. What do you ob-
serve? Justify your observations by commenting on the unique and market risks
of the constituent companies.
(Hint: Typically, one would find similar beta companies falling under similar mar-
ket conditions).

Additional Readings
Fisher, D. E., & Jordan R. J. (1995). Security analysis and portfolio management (4th ed.). Pren-
tice-Hall.
293 8
son Education.
Graham, B., & Dodd, D. L. (2009). Security analysis (6th ed.). McGraw Hill, New York.
Jones, C. P. (2010), Investment analysis and management (9th ed.). Wiley.
South-Western.
References
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not-everyone-thinks-smart-beta-s-a-smart-idea-quicktake-q-a. Accessed on October 18, 2017.
Brigham, E. F., & Ehrhardt, M. C. (2013). Financial management: Theory and practice. USA: Cengage
Learning.
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ving-a-9-trillion-change-in-investing/articleshow/59995247.cms. Accessed on October 12, 2017.
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on October 16, 2017.
Fama, E. F., & French, K. R. (1992). The Cross-section of expected stock returns. Journal of Finance,
47(2), 427.
Fidelity Website (2017a). Available at 7 https://www.fidelity.com/learning-center/investment-products/
mutual-funds/diversification. Accessed on October 10, 2017.
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advantages-anddisadvantages-capm-model.asp. Accessed on October 7, 2017.
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tion/, Accessed on October 30, 2021.
Markowitz, H. (1952). Portfolio selection. The Journal of Finance, 7(1), 77–91.
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thorityindia/charts/SAI#SAI. Accessed on October 1, 2017.
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Roll, R. (1977). A critique of the asset pricing theory’s tests part I: On past and potential testability of
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Singh, S., Jain, P. K., Yadav, S. S. (2016). Equity market in India: Returns, risk and price multiples. Pub-
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on-9043283?next_slideshow=1. Accessed on 17th September, 2017.
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vestment-products/article/2011121/more-chinese-investors-expected-jump-smart-beta. Accessed
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8
295 9
Portfolio Management:
Process and Evaluation
Contents
9.2 Basic Aspects of a Portfolio – 297
9.3 Underlying Principles in Portfolio

Management – 299
9.4 Portfolio Management Strategies – 300

9.4.1 Active Portfolio Management Strategy – 301
9.4.2 Passive Portfolio Management Strategy – 303
9.5 Portfolio Management Process – 303

9.5.1 Portfolio Planning Stage – 303
9.5.2 Portfolio Implementation Stage – 311
9.5.3 Portfolio Monitoring Stage – 313
9.6 Formula Plans – 319

9.6.1 Constant Rupee Value Plan – 320
9.6.2 Constant Ratio Plan – 321
9.6.3 Variable Ratio Plan – 322
9.6.4 Rupee Cost Averaging – 323
9.7 Mutual Funds in India – 324


9.2 · Basic Aspects of a Portfolio
297 9
The broad objective of this chapter is to provide the steps followed in the invest-
ment process. Starting with a brief summary of the basic concepts, it details the
portfolio management process and its evaluation. The chapter covers the following
topics:
9.1 Introduction
A portfolio is a set of investments/securities held by an individual or by an organ-

ization.
» Markowitz stated that “Investors are risk-averse; given a choice between two assets
with equal rates of return, the investor will always select the asset with the lowest level
of risk. This means that the investor would be willing to take higher risk only for a
higher return. Thus, risk and return are directly proportionate”.
Portfolio management refers to the art of creating an efficient portfolio with min-
imum risk and maximum returns.
This chapter forms the capstone of this book. It builds upon all the funda-
mental concepts of investment management (portfolio management) and details
the processes, followed in the daunting task of investing.
As we proceed through the chapter, certain concepts would be revisited (al-
beit briefly) to help those readers who are treating this chapter as a stand-alone
one. We begin by answering some questions regarding the basic aspects of portfo-
lio management.
9.2 Basic Aspects of a Portfolio
What is a Portfolio?
Definition
A portfolio is a set or collection of securities held by an individual or an organiza-
tional entity. Such investments can be held in the form of shares, bonds, real estate,
gold, fixed deposits, etc.
z What is the Critical Mass with Respect to a Portfolio?

A minimum critical mass is important for any financial advisor to work on a
portfolio. It refers to the appropriate number and type of securities required in
the portfolio to provide a certain risk–return profile. As each portfolio would be
tailor-made to suit the investor requirements, this may be different for various en-
tities or markets or situations. Obviously, the investment outlay (available with the
investor) will have a bearing on the choice and/or affordability of such securities.
298 Chapter 9 · Portfolio Management: Process and Evaluation
z Is It Required to Split a Large Investment Kitty into Smaller Lots?

A large portfolio is best divided into smaller sub-portfolios/funds, so that the
management can be decentralized. More importantly, in the interest of diversifi-
cation, it is important to spread the investment across a range of securities, offer-
ing different risk and return profiles.
z What is the Basic Postulate of the Markowitz Portfolio Theory?

The Markowitz portfolio theory postulates that investors are risk-averse. Given a
choice between two assets with equal rates of return, the investor will always se-
lect the asset with the lower level of risk. This means that the investor would be
willing to take higher risk only for a higher return. Also, for a given level of risk,
an investor will try to select the security that provides a higher return. Thus, risk
and return are positively correlated.
z What is the First Step Required in the Process of Investment?

The first step in the portfolio management process is to specify one’s investment
objectives (returns) and constraints (risk).
Hence, at the very outset, it is extremely important to assess and define the
9 risk–return profile of the investor and then select investments based on the de-
fined risk profile. It is important to remember here that diversification of invest-
ments mitigates risk.
> What Are Commonly Stated Investment Objectives?
The commonly stated investment objectives/goals are:
i. Income: to provide a steady stream of income through regular interest/dividend
payments. This is typically more relevant for pensioners/retired personnel/wid-
ows who are looking for a source of livelihood through their investments. These
investors are fulfilling the transaction motive of money (they want the money
to make transactions).
ii. Growth: to increase the value of the principal amount through capital apprecia-
tion. This is for investors who are fulfilling the precautionary motive of money
and are saving today for a large potential consumption in the future (e.g., son’s
marriage, daughter’s education, etc.).
iii. Stability: to protect the principal amount invested from the risk of loss/infla-
tion. Examples of such investments would be a fixed deposit, gold, etc.
> What Are Commonly Stated Investment Objectives?

The commonly stated investment objectives/goals are:
i. Income: to provide a steady stream of income through regular interest/dividend
payments. This is typically more relevant for pensioners/retired personnel/wid-
ows who are looking for a source of livelihood through their investments. These
investors are fulfilling the transaction motive of money (they want the money
to make transactions).
ii. Growth: to increase the value of the principal amount through capital apprecia-
tion. This is for investors who are fulfilling the precautionary motive of money
9.3 · Underlying Principles in Portfolio Management
299 9
and are saving today for a large potential consumption in the future (e.g., son’s
marriage, daughter’s education, etc.).
iii. Stability: to protect the principal amount invested from the risk of loss/infla-
tion. Examples of such investments would be a fixed deposit, gold, etc.
> What Are Commonly Stated Investment Constraints?

The constraints an investor faces determines the level of risk tolerance. Constraints
can arise out of the following factors:
i. Liquidity: what are the liquidity needs in the foreseeable future which need to be
built into the portfolio design? How much money is required when?
ii. Taxes: what is the tax-shelter sought? Is it possible to avoid tax through the
portfolio?
iii. Time horizon: what is the time horizon the investor is looking at? Is he/she a short-
term investor (less than 1 year) or a long-term investor (5 years, 10 years, etc.)?
iv. Unique preferences and circumstances: Does the investor have any unique circum-
stances which need to be factored into the portfolio? For example, the investor
may have a special child and/or ailing parents who need constant medical care.
> What Are Some Key Aspects/Suggestions to Remember in Investments?

Some of the key aspects/suggestions to remember include:
i. Keep the portfolio limited to some but not very few stocks
Remember that frequent turnover (buying and selling) of stocks incurs signif-
icant transaction costs. Hence, an analysis of the associated costs and benefits
of frequent transactions should be made before trading.
ii. Diversify across stocks, industries and markets, if possible
As has been established in the chapter on risk and return, diversification can
help in substantially reducing the risk of the portfolio.
iii. Select long-term investments and stay invested
As has been made evident through empirical data in the chapter on bond and
equity valuation; long-term investors, especially in the Indian stock market,
stand to make significant returns, at relatively lower risk. However, this strategy
may be adopted only by passive investors, and active investors may trade fre-
quently to earn higher returns.
iv. Identify your reasons for choosing a stock and monitor to see if the reasons remain
Exit only on change in assumptions. Frequent trading is not recommended, es-
pecially for a passive/long-term investor, as it may prove costly. This suggestion
may not be viable for an active/speculative investor, though.
9.3 Underlying Principles in Portfolio Management
Before embarking upon the portfolio management process, it is important to re-

visit the underlying principles in portfolio management.
i. It is the portfolio that matters
The return an investor earns and the risk he/she faces is the result of the port-
folio. Do not expect a return–risk profile that is not commensurate with the
risk–return profile of the individual securities of the portfolio. Simply put, do
not expect significant gains to arise out of a portfolio made out of central gov-
ernment (risk-free) securities. Similarly, do not expect low risk to emanate out
of a portfolio made up of small sector, high growth companies or junk bonds.
ii. High returns come only with high risks
Always, always, always! There is no substantial gain to be earned without sub-
stantial risk associated with it. Risk and return are two sides of the same coin.
An investor should never be fooled into believing smooth talking investment
managers/brokers who promise him/her otherwise.
iii. Risk depends on timing of liquidation
Many investors go through sleepless nights fretting over volatile markets and
imagining their fortunes being wiped out with every downturn. Please remem-
ber it is only when an investor exits the market (sells) that he/she actually real-
izes a loss/gain, and it is only the price of the security/return of the portfolio
(at that time) that determines the net gain (loss).
iv. Diversification works
Even though it seems iterative, diversification helps in significantly reducing
risk of a portfolio. The same has been made amply evident in the earlier chap-
ters on “risk and return” and “diversification of risk”.
v. Portfolios should be tailor-made
There is no “one-size-fits-all” solution in investments. Every investor is unique
9 and has his/her own risk/return profile, and the portfolio should mirror that as
accurately as possible. Further, every investor, due to his/her financial status
and the investment kitty at his/her disposal, may not be able to lie on the “effi-
cient frontier” of the Markowitz portfolio theory (for details, refer 7 Chap. 8)
and may mostly find his/her portfolio somewhere within it.
vi. Competition for abnormal returns is extensive
It appears that some investors look towards investments (especially in the stock
markets) as “get-rich-quick” schemes or some sort of a magic-wand that would
transform them into millionaires (or at least to an income level far beyond their
current situation). It is important to consider that financial markets simply mir-
ror the real economy and the gains to be made, here, are a result of the prices
that the underlying companies attract for their products and services. Yes,
there is volatility in the markets (due to various reasons) leading to abnormal
(greater than expected) returns, in the short run, but this is a fact known to all
technical investors. Never imagine that one investor will be able to reap all of
the abnormal returns for himself/herself. The competition in the stock market
for such abnormal returns is extensive and spread over a large number of trad-
ers/investors, allowing each one only a small share in the pie of total gains.
9.4 Portfolio Management Strategies
Managing a portfolio is an important and challenging task for any investment

manager. Portfolio management strategies comprise of the methods that are ap-
plied on a portfolio in order to maximize returns for the lowest possible risk.
Portfolio management strategies are broadly classified into two categories.
9.4 · Portfolio Management Strategies
301 9
9.4.1 Active Portfolio Management Strategy
This strategy relies on the fact that a portfolio can be managed in a way in which
abnormal returns can be generated. It attempts to exploit inefficiencies present in
the market. This strategy is typically followed by technical (day) traders. This ap-
proach to portfolio management involves two stock selection styles:
i. Top-down approach: Under the top-down approach, the investment/fund man-
ager considers the stocks from a macro-perspective and takes decisions based
on the prevailing and expected market conditions. In case the economy is pre-
dicted to grow, the fund manager may like to buy stocks in the sectors where
boom is expected. He/she may probably invest in specific sectors like technol-
ogy or infrastructure, if growth outlook is specifically bullish in these sectors.
ii. Bottom-up approach: In this method, investors analyse the financial data and
other fundamental factors of companies, and based on their strength, they se-
lect stocks.
An active portfolio strategy is typically followed by aggressive investors who aim

to record abnormal returns through active portfolio management. Such a strategy
is reflected in and through three aspects.
Aspects Considered in an Active Portfolio Management Strategy

5 Market timing;
5 Sector rotation;
5 Use of a specialized concept.
Market Timing
Market timing denotes the activity of creating an explicit or implicit forecast of how
the market will move in the foreseeable future and trade accordingly. Typically, de-
ployed by technical traders, this strategy uses analytical tools like econometric mod-
els, business cycle analysis, moving average analysis, advance–decline ratios, etc.
Based on these, if one expects stocks to outperform bonds in the short-run, one may
increase the stock component in the portfolio to earn extra returns (it is to be borne
in mind that such an action will also increase the portfolio beta) and vice-versa.
Such a strategy, however, must be approached with caution as not too many inves-
tors succeed in this game and in the process expose the portfolio to unnecessary risk.
Sector Rotation
Even though sector rotation typically applies to stocks, it can be used in bonds, as
well. It involves shifting of the weightages of different industries/sectors depend-
ing on their outlook. For example, if one expects the technology and renewable
energy sectors to do well in the near future, one may increase the weightage of the
stocks of these sectors (vis-à-vis other sectors) in the portfolio.
Similarly, in case of bonds, if one expects a rise in short-term interest rates, one
may shift from long-term bonds to short-term bonds. The other parameters which
could become the basis of rotation in bonds could be coupon rate, maturity, credit
rating, etc.
Concept in Practice 9.1: Sector Rotation Across Economic Cycles

Natural fluctuations in an economy including growth (expansion) and recession
(contraction) are termed as “economic cycles”. The National Bureau of Eco-
nomic Research (NBER) has been maintaining the record of economic cycles in
the USA, since 1950s. The average length of one economic cycle as recorded by
NBER is five and a half years.
It has been observed that few sectors outperform others during a given phase (ex-
pansion or contraction). As shown in . Fig. 9.1, sectors like telecom and energy
outperform the others in the expansion phase. Similarly, sectors like healthcare
and finance outperform the others in the contraction phase.
To build an optimum portfolio, one can try to predict the future state of the
economy or the economic cycle. One can then select the sectors to invest in.
This process of selecting companies from such sectors (doing well in the respec-
tive economic condition) is termed as “sector rotation”. This strategy can be used
for the design of an optimum portfolio with an aim to outperform the overall
market index.
. Fig. 9.1 Sector rotation across economic cycles. Source Seeking Alpha (2018)
9.5 · Portfolio Management Process
303 9
> Use of a Specialized Concept
In this case, an investor chooses a specialized concept based on his/her abilities/
talents/knowledge and employs that in the portfolio. Certain concepts which
have been deployed successfully in the past by many investors are investments
in “growth” stocks, “neglected” or “out-of-favour” stocks, “technology” stocks
and/or “cyclical” stocks.
The benefits of such a strategy are that it allows one to focus on a certain kind of
investment, and not be distracted by other stocks; it also helps to master the
approach through continuous practice and self-appraisal. The downside of this
approach is that the specialized concept being deployed may itself become re-
dundant (due to changes in market and/or investor conditions).
9.4.2 Passive Portfolio Management Strategy
This strategy is based on the assumption that markets are efficient and an inves-
tor cannot adopt an active strategy in order to “beat” the market. This strategy
involves creating a well-diversified portfolio at a predetermined level of risk and
then holding the portfolio relatively unchanged over time, till the time it becomes
inadequately diversified or not in line with the investor’s risk–return profile. This
strategy is typically followed by long-term fundamental investors.
The most common passive portfolio management strategy is that of “index-
ing”, in which an investor mirrors the securities (and their relative weights) in an
index into his/her portfolio. Thus, the returns mirror the index returns over time,
and no active intervention is required intermittently in the portfolio.
9.5 Portfolio Management Process
The portfolio management process includes the three crucial steps/sub-processes

of planning, implementing and monitoring (PIM).
. Figure 9.2 presents the complete portfolio management process. Each of
the aspects listed here are discussed within each sub-process.
9.5.1 Portfolio Planning Stage
This stage involves the analysis of investor conditions along with market condi-
tions. Further, based on whether the investor is a passive (long-term fundamental
investor) or an active (speculator/trader) investor, investment or speculative poli-
cies are determined. Based on this, a document is created which is known as the
statement of investment policy (SIP). This provides the roadmap for the invest-
ment process. This document acts as the guide for strategic asset allocation.
. Fig. 9.2 Portfolio management process. Source Authors’ compilation
► Example
. Figure 9.3 presents the portfolio planning stage. ◄
Let us examine each step, in detail:
9.5.1.1 Investor Conditions
Within investor conditions, the financial situation of the investor, his/her knowl-
edge levels and risk tolerance are studied and analysed.
305 9
. Fig. 9.3 Portfolio planning stage. Source Authors’ compilation
Financial Situation of the Investor

In ascertaining the financial situation of the retail investor, it should be borne in
mind that apart from the investor’s salary/monthly income, he/she may have in-
heritances and/or a spouse whose income can also be combined with that of the
investor to understand the overall financial situation and his/her and the family’s
consumption pattern. Also, his/her family size and peculiarities (in terms of other
earning members and/or dependents) should be considered. The family’s back-
ground (in terms of education and lineage) and its lifestyle are important aspects
to understand the return–risk profile of the investor.
Hence, to assess the financial situation of an investor, the following questions
can be answered: what is the current position of financial wealth? What major ex-
penses (building a house, education, marriage, medical expenses, etc.) can be an-
ticipated in the near future? What is the current and potential earning capacity?
In case of an institutional investor, the same considerations apply; the owners’
risk–return profile and the existing investments/assets and liabilities could provide
a good indication of the way the organization has been investing. The risk profile
of the organization can be deduced from the various kinds of risk (business risk,
financial risk) it faces.
Based on this background, the following financial status can be ascertained:
i. Marketable and non-marketable assets and liabilities
What is the level of marketable and non-marketable assets and liabilities that
the investor possesses? What are the returns associated with the same? How
liquid are these securities? What is the risk associated with each type of secu-
rity and what is the overall risk the existing portfolio of the investor carries?
Are these assets earmarked for a future consumption or are they meant for
current consumption? What is the nature of the liabilities the investor bears?
These are some of the questions that can help in probing/exploring the situa-
tion related to the marketable and non-marketable assets and liabilities the in-
vestor has.
ii. Financial distress
Is the investor in any kind of financial distress? Is a condition of financial dis-
9 tress imminent due to the current situation of the investor? Is there any way of
recovering from the situation of financial distress? In the case of a retail inves-
tor, a situation of financial distress can arise out of the death of the sole earn-
ing member or a permanent disability arising out of sickness/accident; it can
also be brought on by a terminal illness requiring expensive medical attention.
In the case of an organization, a situation of financial distress can arise out of
low liquidity/solvency brought on by a drastic fall in earnings or a recession,
whereby, the organization is unable to meet its financial obligations and is on
the verge of bankruptcy.
Knowledge
The educational background and/or knowledge of the investor are crucial in or-
der for him/her to evaluate the investment choices available and also assess
the prevalent market conditions. In India, generally, financial literacy is poor
amongst investors. As a result, many investors lose out on the various options
available to them. Further, this lack of knowledge inhibits their ability to compre-
hend risk in its entirety, leading them to make unwise decisions. Hence, the spec-
trum of knowledge regarding investments includes both an accurate assessment
of the investor’s own assets and liabilities and also the risk–return profile of the
financial instruments, most suited to his/her own risk–return profile.
Risk Tolerance
An accurate assessment of risk tolerance is, at best, subjective as risk is a rela-
tive term. In quantifiable terms, it means the deviation from the expected re-
turn. However, how much of deviation can an investor bear, depends on the in-
vestor’s attitude, desire to take risk and the existing and desired future financial
307 9
conditions. Further, risk is a dynamic concept as the conditions surrounding an
investor and also his/her investment keep changing, thereby changing the risk per-
ception and the resultant risk tolerance.
It is important for an investor to understand the various facets of risk (unique
risk and market risk; business risk and financial risk and also his/her own risk
factors) to appreciate his/her risk tolerance levels. For instance, for an investor
who is risk-averse, investing everything in equity stocks (the relatively risky asset
class) may not be the best idea.
How much money can one lose without it damaging the existing standard of
living? A careful appraisal of assets, expenses and earnings is basic to assessing
the risk tolerance.
This also means that there is no single ideal portfolio. A portfolio ideal for one
person may not be ideal for another. The risk-taking ability depends on various
factors, like:
Age Generally, lower the age, higher is the risk-taking capacity.
Family Background A person with a family of multiple earning members is likely

to take more risk than a family with only a single earning member.
Expense to Saving Ratio Lower the ratio, higher is the saving and risk-taking
capacity.
Operational Statement of Investment Objectives

Theoretically, each investor will attempt to maximize utility. This can be done in
one of the two ways:
5 Maximize the expected rate of return, subject to the risk exposure (the risk
tolerance level) being held within a certain limit; or
5 Minimize the risk exposure, without sacrificing a certain expected rate of re-
turn (the target rate of return).
Which of these two should the investor adopt? The risk he/she can bear depends
on two key factors: (a) financial situation; and (b) attitude/temperament.
After assessing the financial situation, as stated earlier, one must assess the at-
titude/temperament. For instance, even though the financial situation may permit
an investor to absorb losses easily, he/she may become extremely upset over small
losses. On the other hand, despite a not-so-strong financial position, an investor
may not be easily perturbed by losses.
The risk tolerance is set either by the financial situation or the temperament
whichever is lower. It is to be borne in mind that it is impossible to estimate risk
tolerance in units and/or precisely. Once a realistic level is defined for the inves-
tor, it would serve as a guideline in the investment strategy. This is particularly de-
sired, as the investor should not suffer through the investment process by poorly
gauging his/her risk tolerance and then reacting like a victim to the volatility pres-
ent in returns/markets.
9.5.1.2 Market Conditions
Market conditions reflect the prevalent state of the economy and the finan-
cial markets. This, in turn, would have a bearing on the kind of risk/return pro-
file which the existing financial instruments would carry. It is very important to
match the investor’s expectations with the securities available in the market for
a successful investment strategy. The market is also a dynamic environment, and
hence, a thorough understanding of its past, the present and the future scenarios
is imperative to be able to fulfil an investor’s short-term and long-term expecta-
tions and goals.
Short-Term Expectations
As the name suggests, short-term expectations refer to the short-term forecast of
how the overall underlying economy is expected to shape up. Which sectors are
doing or are slated to do well in the near future depending on the current eco-
nomic conditions? Apart from the economic environment, short-term expecta-
tions are also affected by the political, legal, natural, socio-economic scenarios, as
well (fundamental analysis). This, in turn, would have a bearing on the constitu-
ent organizations’ short-term returns and risk. Similarly, investors, based on their
risk–return profile, may expect a certain return accompanied by a certain level of
risk, in the short-term. Securities matching the said return–risk profile can be as-
9 certained by conducting a market analysis of past returns (technical analysis).
The portfolio would thus need to be planned in such a way as to match the two
expectations.
Long-Term Expectations
On the same lines, long-term expectations refer to the forecasting of conditions
over a longer period, say, 3–10 years. Based on the current economic, political,
socio-economic and natural conditions, a long-term scenario is developed. Simi-
larly, depending on the underlying scenario(s) and the constituent organizations’/
companies’ own analysis, a long-term forecast of expected returns and accompa-
nying risk is made.
Just like companies and economies, investors also foresee a change in their fu-
ture return/risk expectations, based on certain events like retirement, children’s
education and marriage, building of a house, etc. These aspects and the accompa-
nying changes in consumption and savings would help an investor design a port-
folio which matches his/her requirements, over the long-run.
9.5.1.3 Investor Policies
Once the investor conditions and the market conditions are analysed and ascer-
tained, investor policies can be designed by matching the two conditions and se-
lecting securities, based on the risk–return profile established.
Strategic Asset Allocation

In the overall scheme of investments, one must provide priority to a residential
house, insurance cover and liquidity. Once these aspects are covered, the strategic
309 9
asset allocation is mainly concerned with the asset mix, based on financial assets,
broadly divided into stocks and bonds.
Stocks—as has been covered earlier, stocks include equity shares and units of eq-
uity–oriented schemes of mutual funds.
Bonds—broadly cover the non-convertible debentures of private sector compa-

nies, public-sector bonds, gilt-edged (government) securities, units of debt-ori-
ented schemes of mutual funds, National Savings Certificates (NSCs), Kisan
Vikas Patras (KVPs), bank deposits, post office savings deposits, public provident
funds, etc.
Should the long-term asset mix be 50:50 (stock:bond) or 75:25 or 25:75 or any
other ratio? This allocation in terms of asset mix is referred to as the strategic as-
set mix allocation and is perhaps one of the most important decisions made by
the investor. Empirical evidence suggests that more than 75% of the variance in
the portfolio is explained by its asset mix (Ibbotson, 2009). This means that only
up to 25% of the variance of the portfolio returns is explained by other elements
like “sector rotation” and “security selection”.
z Considerations in Asset Mix

Other things being equal, an investor with greater risk tolerance should favour
more stocks in the portfolio, while an investor with lesser risk tolerance should
choose more bonds in the portfolio. This is due to the fact that stocks are more
risky than bonds.
Further, an investor with a longer investment horizon should favour more stocks
in the portfolio. This is because risk in stocks diminishes drastically over a longer
time period. The same is also evident empirically in the research carried out by
the authors wherein risk came down substantially over longer investment horizons
(Singh et al., 2016). Hence, there is a “time diversification of risk evident in stocks.
In sum, strategic asset allocation refers to the long-term choice of investing
in certain asset classes mirroring the risk–return profile of the investor. Based on
the short-term and long-term expectation of the market and of the investor con-
ditions, the portfolio can be planned to reflect the current choices available, and
then, a passive rebalancing exercise can be conducted in the future to reflect the
overall expectations.
z Current Asset Allocation

Current asset allocation indicates the initial choice of asset classes, depending on
the current availability and market conditions. Such conditions may or may not
serve/meet the investment needs completely. For example, certain securities may
be overvalued currently, and thus, it may not be the best time to buy. Investments
in such securities, thus, may be postponed to a later date.
z Passive Rebalancing
Rebalancing is a technique to revisit the original asset mix weightage allocated.
It is important to retain the asset mix so as to retain the investor’s portfolio mix
(along with its return/risk profile). For example, a portfolio mix that was created
with 60% equity and 40% government bonds, can, during a bullish market, shift
to 70:30 allocation. This exposes the investor to more risk than was intended.
Therefore, revisiting the portfolio and rebalancing the mix are important to main-
tain the return/risk profile.
Once the current strategic asset allocation is made, a passive rebalancing exer-
cise can be conducted in the near future (in case the current asset allocation does
not meet the risk–return profile completely). Also, certain securities which were
unavailable/unaffordable when the current asset allocation was made, may now
(due to their availability/affordability) be incorporated into the portfolio.
The acts of current strategic asset allocation and its passive rebalancing would
provide the investor with a long-term portfolio (with its constituent asset classes)
mirroring the risk–return complexion of the investor. This would be broadly what
the investor would hold for his/her investment horizon.
Asset allocation strategies occur in two forms: strategic and/or tactical. Stra-
tegic asset allocation takes a long-term outlook towards capital market expecta-
tions, while tactical asset allocation adds value by seeking out shorter-term op-
portunities.
Speculative Strategy
9 As stated earlier, the prevalent market conditions and the resultant prices may not
be conducive to investing in (buying) certain securities. Further, market condi-
tions may also encourage the portfolio manager to suggest a speculative strategy
(technical trading) to the investor to gain from the price fluctuations in the short
run. For instance, to meet the short-term expectations of the investor, the portfo-
lio manager may suggest a speculative strategy in which he/she buys a security ex-
pected to rise in the near future or even sell a security expected to fall in the near
future (short sell). In other words, a speculative strategy would focus on the short-
term portfolio for the investor where he/she will invest in securities which would
generate desired returns-risk in the short-run.
Tactical Asset Allocation

This activity refers to the selection of tactical (short-term) asset classes which
would generate the desired return–risk mix of the investor for his short-term re-
quirements.
Security Selection
The act of security selection refers to the actual act of picking/choosing specific
securities (like shares, debentures, fixed deposits) which match the return–risk ex-
pectation of the investor.
Internal/External Management
At the planning stage itself, the internal and external management aspects are dis-
cussed and detailed out so as to avoid any confusion in the future. Internal/exter-
nal management basically highlights the activities which would be undertaken at
the internal (investor) level and the external (portfolio manager) level. This is also
311 9
necessary to avoid duplication of efforts and to determine the commission (fee) to
be paid to the portfolio manager.
► Example
An investor may have multiple investment horizons corresponding to various invest-
ment objectives, for example:
Investment objective Investment horizon
Buy a car Two years
Build a house Ten years
Son’s marriage Fifteen years
Obviously, the appropriate asset mix for each investment goal would be different and
may also entail different internal/external management specifications. ◄
Statement of Investment Policy (SIP)

The portfolio planning stage, once completed, results in the creation of a docu-
ment detailing the complete strategy, called the “statement of investment policy
(SIP). This document acts as the bible for the investment journey of the investor.
It is also a legal document which is heavily relied upon in the case of any dispute
between the investor and the portfolio manager. It mentions the investor condi-
tions and the market conditions prevalent at the time of creation of the SIP and
also indicates the internal/external management details. Further, it also specifies
the situation(s) under which the SIP can be revised (typically due to changes in in-
vestor/market conditions).
More importantly, it will mention the investment objectives (income, growth
and stability), the constraints (liquidity, taxes, time horizon, unique preferences
and circumstances) and the strategies to be followed. All these aspects have al-
ready been discussed earlier.
9.5.2 Portfolio Implementation Stage
As the name suggests, at this stage, the planned portfolio is actually implemented
and the underlying transactions (in securities) executed. The basis of this imple-
mentation is the SIP, and the choice of securities depends on the prevalent market
conditions at the time of implementation. . Figure 9.4 presents the portfolio im-
plementation stage.
9.5.2.1 Statement of Investment Policy (SIP)

As stated, this document (a result of the portfolio planning stage) contains the
overall portfolio investment objectives, constraints and strategy and acts as the
guideline for the portfolio implementation stage. Based on the SIP, the portfolio
is implemented.
. Fig. 9.4 Portfolio implementation stage. Source Authors’ compilation
9.5.2.2 Current Market Conditions

As is obvious, no strategy can be implemented if the current market conditions
and the constituent securities do not provide/meet the investor risk–return profile.
And, even if it does, the desired security(ies)/asset classes may not be available at
that time. Hence, it may be possible to invest in certain available securities imme-
9 diately (current asset allocation) while the other securities’ investment may need
to be deferred to when conditions (price/liquidity) are more suitable (passive re-
balancing).
9.5.2.3 Rebalance Strategic Asset Allocation

This stage involves the reviewing and revising of the portfolio composition (the
stock–bond mix or the sectoral mix).
► Example
There are three basic policies used within this:
Buy and hold policy—in this case, the initial portfolio is left untouched. What this
means is that whatever was the original asset mix, say 50:50 (stocks:bonds), the same is
continued with, through the investment horizon. In spite of any changes in the under-
lying parameters, the asset mix remains unchanged.
Constant mix policy—in this case, a desired asset mix (stocks:bonds) is determined in
the beginning, and the attempt is to maintain this constant mix. Whenever the values
of the two components change (increase/decrease), it is rebalanced to come back to the
desired constant mix.
Portfolio insurance policy—as the name suggests, such a portfolio is rebalanced to en-
sure a certain basic minimum (floor) level. In this case, the exposure to stocks (more
volatile than bonds) is increased when the portfolio value increases and decreased when
the portfolio value decreases, ensuring that the portfolio value never falls below a cer-
tain level. ◄
The acts of current strategic asset allocation and its passive rebalancing would
provide the investor with a long-term portfolio (with its constituent asset classes)
313 9
mirroring the risk–return complexion of the investor. This would, broadly, be
what the investor would hold for his/her investment horizon.
As stated, the rebalancing can be done across asset classes and/or sectors/in-
dustries.
Asset Classes
Certain asset classes like equity and debt are relatively more liquid, than say, real
estate. Further, the volatility and also the returns reflected in equity (as an asset
class) may be much higher than the other asset classes. In certain locations, the re-
turns recorded by real estate (albeit over a longer time period) as an asset class,
may surpass all other asset classes. All these features play a role in the rebalanc-
ing choices.
Sectors/Industries
Different sectors exhibit different risk–return profiles dependent on the nature of
their business, their growth rate, relative market share, technology, etc. For exam-
ple, a new and growing sector, like renewable energy, may record high growth, al-
beit with high volatility. On the other hand, an old and established sector, like
manufacturing, may offer stable returns, albeit with relatively very little growth.
This diversity provided by different sectors makes them ideal targets for portfolio
diversification.
9.5.2.4 Security Selection
The basic art of security selection is based on searching for undervalued/under-
priced securities. Both fundamental and technical analyses can be deployed for
the same.
Once the asset class and/or sector is identified, the actual security of a particu-
lar entity is chosen and invested in. Each security has its own unique features and
risk–return profile. As always, the art of investing is to match the investor’s risk–
return profile with his/her portfolio’s risk–return profile. Thus, the securities are
selected in such a way that the combined return and risk of the portfolio matches
that of the investor’s.
► Example
. Figure 9.4 presents the portfolio implementation stage. ◄
9.5.3 Portfolio Monitoring Stage
Once the portfolio has been planned and implemented, all that is left, is to moni-
tor it and ensure that the implementation matches the planning. The basis of this
monitoring is the statement of investment policy (SIP). This is a continuous pro-
cess and lasts for the lifetime of the investment portfolio. Once the investment ho-
rizon is over, or even during the investment period, the performance of the invest-
ment is evaluated to assess whether the desired performance is being met or not.
9.5.3.1 Evaluation of Statement of Investment Policy (SIP)

The SIP is evaluated from time to time to ensure that the planning and imple-
mentation are in congruence. In case of any deviations that could be due to
changes in investor and/or market conditions, remedial action is taken, till such
time that the portfolio comes back in line with the SIP. Changes in investor con-
ditions could include the inclusion of new dependents, loss of employment/re-
tirement, increase in salary/inheritance, etc. Similarly, changes in market con-
ditions could include changes in the political scenario, emerging sectors and
technology, natural disasters, economic recession/boom, etc. In case of drastic
changes in investor and/or market conditions, the entire SIP may need to be re-
vised/redrafted.
9.5.3.2 Evaluation of Investment Performance

Finally, the performance of the portfolio (both in terms of return and risk) is also
evaluated to assess whether the goals laid out in the beginning have been met/
achieved. Such an evaluation can either be done at the end of the investor’s in-
vestment horizon or continually, during the life of the investment. This is a de-
cision taken mutually by the investor and the portfolio manager and is incorpo-
rated in the SIP.
The crucial test of portfolio management is the performance of the portfolio.
9 Hence, it is important to periodically monitor the performance of the portfolio,
objectively, and to provide feedback for improving the quality of the process on
a continual basis. This would help in refining the methodologies followed and im-
proving on the existing performance.
The key dimensions in measuring portfolio performance are returns and the
accompanying risk. How are such returns and risk measured?
i The rate of return on a portfolio for a given period is measured as per Eq. 9.1:
[Dividend income and/or Interest income + (Terminal value − Initial value)]/Initial value (9.1)
In order to calculate the average rate of return over a period of several years (in-
vestment horizon), one may deploy (a) the arithmetic mean of annual rates of re-
turns, (b) geometric mean of annual rates of return (compounded return) and/or
(c) internal rate of return (yield to maturity).
z Risk
As has already been covered in previous chapters, the most commonly used meas-
ures of risk are beta, standard deviation and/or variance.
Types of Portfolios
Considering the risk and return appetite, the following types of portfolios could
be created:
315 9
► Example
i. Conservative Portfolio: In this case, the risk appetite of an investor is very low
which necessarily means that the risk premium would also be low, resulting in lower
returns. This portfolio will typically have debt instruments as the asset class.
ii. Balanced Portfolio: In this case, the risk appetite of an investor is moderate. These
risks can be balanced and counterbalanced by considering different asset classes or
by building a diversified portfolio. As the name suggests, this portfolio will have a
balance of both debt and equity.
iii. Aggressive Portfolio: In this case, the main aim is to maximize returns. This results
in higher risks also. Hence, this portfolio will typically have equity instruments as
the asset class. ◄
Portfolio Performance Evaluation Measures

These risk-adjusted measures of performance have been in use only after 1960s. It
is interesting to note that prior to this, there were no sophisticated tools or formu-
lae to measure portfolio performance.
> The most commonly deployed measures of performance are:
5 Sharpe’s reward-to-variability ratio
5 Treynor’s reward-to-volatility Ratio
5 Jensen’s differential return measure
5 Arbitrage pricing theory
5 Grinblatt and Titman’s PCM model.
Sharpe’s Reward-to-Risk Ratio
i Also called the Sharpe’s Index of Desirability, the formula for measuring a portfo-
lio’s performance by the Sharpe’s reward-to-risk ratio is given as Eq. 9.2:
Sharpe’s reward-to-risk ratio = (Average return on portfolio

− average return on risk-free investment (9.2)
/Standard deviation of the portfolio returns
The same can also be written symbolically as:

Sp = Rp −Rf /σp
= Reward/Total Risk
= Risk Premium/Standard Deviation
where
Sp = Sharpe’s reward-to-risk ratio;
Rp = Return on portfolio;
Rf = Return on risk-free investment; and
σp = Standard deviation of the portfolio returns.
Treynor’s Reward-to-Volatility Ratio
i Also called the Treynor’s Index of Desirability, the formula for measuring a portfo-
lio’s performance by the Treynor’s reward-to-volatility ratio is given as Eq. 9.3:
Treynor’s reward-to-volatility ratio = (Average return on portfolio
− average return on risk-free investment) (9.3)
/Beta of the portfolio

Tp = Rp − Rf /βp
= Reward/Volatility
= Risk Premium/βp
where
Tp = Treynor’s reward-to-volatility ratio;
Rp = Return on portfolio;
Rf = Return on risk-free investment; and
ßp = Beta of the portfolio.
9
Given return, standard deviation and beta values of two portfolios, calculate the
portfolio’s Sharpe’s reward-to-risk ratio and Treynor’s reward-to-volatility ratio.
Portfolio X Portfolio Y
Portfolio return (%) 18 10
Risk-free return (%) 5 5
Standard deviation (%) 9 15
Beta 0.5 0.8
v For portfolio X:
For Sharpe’s reward-to-risk ratio, applying Eq. 9.2,
Sharpe reward-to-risk ratio = (Average return on portfolio

−average return on risk-free investment)
Sharpe’s reward-to-risk ratio = (0.18 − 0.05/0.09) = 0.13/0.09
= 1.44
317 9
For Treynor’s reward-to-volatility ratio, applying Eq. 9.3,
Treynor reward-to-volatility ratio = (Average return on portfolio

− average return on risk-free investment)
Treynor’s measure = (0.18 − 0.05/0.5) = 0.13/0.05
= 0.26
Similarly, for portfolio Y:
For Sharpe’s reward-to-risk ratio, applying Eq. 9.2,
Sharpe reward - to - risk ratio = (Average return on portfolio

− average return on risk - free investment)
Sharpe’s index = (0.10 − 0.05)/0.15
= 0.33
For Treynor’s reward-to-volatility ratio, applying Eq. 9.3,
Treynor reward-to-volatility ratio = (Average return on portfolio

Treynor’s ratio = (0.10 − 0.05)/0.8
= 0.0625
Jensen’s Differential Return Measure
Also called Jensen’s alpha, this measure is based on the capital asset pricing model
(CAPM). It reflects the difference between the return actually earned on a portfo-
lio, and the return the portfolio was expected to earn (based on the CAPM).
i It is calculated as per Eq. 9.4:
Jensen’s alpha = Actual return on portfolio − [risk-free return

+ portfolio beta(average return on market (9.4)
portfolio-risk − free return)]

αp = Rp − Rf + βp (E(Rm ) − Rf )
where
αp = Jensen’s alpha;
Rp = Return of a portfolio;
Rf = Risk-free interest rate;
E(Rm) = Expected return of market index; and
ßp = Beta of a portfolio

The actual return on a portfolio is 10%. The risk-free rate is 4%, the market return
is 8%, and the beta of the portfolio is 1.2. Calculate Jensen’s alpha.
Jensen’s alpha = Actual return on portfolio

− risk - free return + portfolio beta
(average return on market portfolio − risk-free return)
Jensen’s alpha = 10 − [4 + 1.20(8 − 4)] = 10 − [4 + 4.80]
= 10 − 8.80 = 1.20 per cent
9 Arbitrage Pricing Theory
The arbitrage pricing theory (APT) is typically used as a portfolio performance
measure by investors with portfolios that are international (or spread across mar-
kets), with varying parameters that contribute to the overall market risk. It fac-
tors in aspects like inflation and interest rates on a cross-sectional level, to de-
termine the overall expected portfolio return. This can also be understood in the
context of the APT model and the Fama-French multi-factor model (for details,
refer to chapter on portfolio theory).
i The expected portfolio performance, on the basis of APT, can be estimated as per
Eq. 9.5:
Actual portfolio return − Expected portfolio return

where
Expected portfolio return = Risk-free rate
(9.5)
+ sum of factor risk premiums

E Rp = E(Rf ) + 1 β1,p + 2 β2,p + · · · + n βn,p
where
E(Rp) = Expected portfolio return;
E(Rf) = Risk-free rate; and
λ1ß1,p = Factor risk premium.
319 9
This multi-factor measure is complicated in nature, deploying company specific as
well as macro-economic variables and several assumptions. Further, it requires an
understanding of econometrics. Therefore, keeping in mind the target audience of
this text, we are not solving numericals based on this measure.
Grinblatt and Titman’s Performance Change Measure (PCM)

This is perhaps the only measure of performance that does not use the basis of
risk and return or utilize an asset pricing model like CAPM/APT for evaluating
performance. This measure is targeted at evaluating the performance of a portfolio
that has had active intervention/management from a portfolio manager. It, thus,
assesses the performance of a portfolio that has been actively managed through as-
set allocation and subsequent rebalancing. It calculates the difference in returns af-
ter the portfolio has been rebalanced over the returns of the original portfolio.
i PCM can be estimated through Eq. 9.6:
PCM = rit (wit ) − rit−1 (wit−1 ) (9.6)

where
rit(wit) = the rate of return of the portfolio with the percentage of the manager’s
portfolio invested in stock i at the end of investment horizon, t;
rit−1(wit−1) = the rate of return of the portfolio with the percentage of the manag-
er’s portfolio invested in stock i in the beginning of investment horizon, t − 1.

A portfolio manager rebalanced the portfolio by altering the asset allocation, mid-
way through the investment horizon. The expected return on the portfolio in the
beginning was 12%. The resultant return at the end of the investment horizon was
15%. Calculate the Grinblatt and Titman’s performance change measure (PCM).
v Applying PCM through Eq. 9.6:
PCM = rit (wit ) − rit−1 (wit−1 )

Hence, PCM = 15 – 12 = 3%.
It is very important to select an appropriate benchmark that helps to assess the

skills of the portfolio manager regarding asset allocation, market timing and se-
curity selection. The PCM method helps to select and evaluate funds based on
these parameters and track errors (if any).
9.6 Formula Plans
An average investor struggles with the aspect of buying/selling in the stock mar-
ket as he/she is never sure of the price movements, in terms of the direction and
magnitude of the price change. As a result, he may sell too early or hold on to
an investment in declining prices. Emotion, lack of education/knowledge and/or

poor judgement are the reasons behind such behaviour.
Hence, investment timing or the decision when to buy/sell a security can be a
complex, difficult and emotional one. There is, however, no perfect way to deter-
mine this. It remains a decision driven by the investor risk–return profile and in-
vestment strategy. Further, the investment timing is also dependent on the market
and its behaviour. Since these are all dynamic variables, there is no single solution
that can be deployed with success. Depending on the overall strategy of the inves-
tor and the market conditions, there are certain techniques called formula plans
that can be deployed by investors to time their investments.
> There are four kinds of formula plans deployed by investors across the world:
5 Constant rupee value plan
5 Constant ratio plan
5 Variable ratio plan
5 Rupee cost averaging.Formula plans, as the name suggests, are techniques de-
veloped to help investors understand when to buy or sell, depending on a pre-
scribed proportion of stocks and bonds in the portfolio. Formula plans are ba-
sically oriented towards loss-minimization. In formula plans, the investor will:
(a) decide in advance, the asset mix (proportion of stocks and bonds) of the port-
folio;
9 (b) periodically evaluate the actual proportion (based on the market values of the
proportions); and
(c) effect whatever trade (buy/sell) is required to move the portfolio back to the
predetermined ratio.
9.6.1 Constant Rupee Value Plan
In a typical portfolio, there are generally two parts, i.e., aggressive and conserv-
ative. The aggressive part refers to the stocks in the portfolio, and the conserva-
tive part refers to the bonds. In the constant rupee value plan, the attempt is to
keep the value of the aggressive part (stocks) constant. Whenever the value of
the stocks rise, the excess (from the constant pre-decided value) is sold and in-
vested into the conservative part. Whenever the value of aggressive part falls,
more stocks are bought using the funds from the conservative portfolio in order
to match the initial (pre-agreed constant) value of the aggressive portfolio.

An investor wants to invest INR 100 lakhs and he decides to divide it equally be-
tween the aggressive portfolio (comprising of shares) and conservative portfolio
(comprising of bonds, treasury bills). For the same, the investor purchases 25,000
shares of a company A which is currently trading at INR 200 per share and invests
the rest in bonds (conservative portfolio). How would the portfolio be rebalanced
under the constant rupee value plan?
9.6 · Formula Plans
321 9
v The step-by-step rebalancing is provided as per the market price fluctuations (and
the resultant changes in the aggressive portfolio value):
Market Value of Value of Total Portfolio Number of
price of aggressive conservative portfolio rebalancing shares
share portfolio portfolio value (INR
(INR) (INR lakhs) (INR lakhs) lakhs)
200 50 50 100 25,000
240 60 50 110 Sell 4167
shares at
INR 240 and
invest in con-
servative part
240 50 60 110 20,833
190 39.58 60 99.58 Buy 5484
shares at
INR 190
190 50 49.58 99.58 26,317
200 52.63 49.58 102.21 Sell 1315
shares at
INR 200
As a result of this rebalancing, when the price touches INR 200 again, there is a
return of INR 2.21 lakhs on the investment of INR 100 lakhs, and there is also
an increase in number of shares by 1317, ready to be sold for rebalancing pur-
pose.
9.6.2 Constant Ratio Plan
This is the same as the constant rupee plan, except that in this case, an attempt
is made to keep the ratio between the values of the aggressive and conservative
parts of the portfolio constant. Whenever the value of the stocks rise, the excess
(from the constant pre-decided ratio) is sold and invested into the conservative
part. Whenever the value of aggressive part falls, more stocks are bought using
the funds from the conservative portfolio in order to match the initial (pre-agreed
constant ratio) value of the aggressive portfolio.

An investor had some savings and he decided to invest the same in the financial
market. He decides to invest a total value of INR 20,000, but he is risk-averse and
hence decides to invest INR 10,000 in stocks and INR 10,000 in risk-free securities.
He desires to follow the constant ratio plan wherein the ratio between the values in-
vested in shares and stocks remains 50:50. Indicate how the portfolio would be re-
balanced in this situation.
v
Market Value of Value of Total Portfolio Number
price of aggressive conservative portfolio rebalancing of shares
share portfolio portfolio value (INR)
(INR) (INR) (INR)
50 10,000 10,000 20,000 200
35 7000 10,000 17,000 200
35 8500 8500 17,000 Bought 242.50
42.5 shares
45 10,912.50 8500 19,412.50 242.50
45 9706.25 9706.25 19,412.50 Sold 26.80 215.70
shares
50 10,785 9706.25 20,491.25 215.70
In this example, on an initial investment of INR 20,000, after the rebalancing, the
portfolio value is INR 20,491.25, thereby providing a return of INR 491.25 and an in-
crease in the number of shares by 15.70.
9.6.3 Variable Ratio Plan

9
As the name suggests, in this case, the portfolio manager rebalances the portfolio
depending upon the variation in the stock prices (aggressive portion). This plan is
ideally suited for markets which are volatile in nature.

An investor wants to invest INR 1 lakh. He invests half the money in aggressive
stocks and the rest in defensive bonds. He would like to rebalance his portfolio
when the stock investment’s total value fluctuates 20% above or below the current
investment value. Through a table, calculate the amount he gains/loses, the total
portfolio value and the number of shares if the shares rise from the initial value of
INR 40 to INR 45 and INR 50 and then drop back to INR 40.
v
price of aggressive conservative portfolio rebalancing of
share portfolio portfolio value (INR) shares
(INR) (INR) (INR)
40 50,000 50,000 100,000 1250
45 56,250 50,000 106,250 1250
50 62,500 50,000 112,500 Sold 1250
250 shares
50 50,000 62,500 112,500 1000
40 40,000 62,500 102,500 Buy 1000
250 shares
40 50,000 52,500 102,500 1250
9.6 · Formula Plans
323 9
When the initial price is INR 40, the investor can purchase 1250 shares as INR 50,000
is to be invested in stocks. Now, as the threshold for rebalancing is 20%, the re-ad-
justment is made when the value in the stock portion becomes either INR 60,000 (or
above) or it becomes INR 40,000 (or below).
As shown in the table, at INR 45, the value of stocks is INR 56,250, which is less
than INR 60,000, and therefore, no rebalancing is done. As soon as the value increases
to INR 62,500, the equivalent number of shares are sold to bring the value back to
INR 50,000. The excess amount of INR 12,500 is then reinvested in bonds.
Similarly, when the market price of shares falls to INR 40, the total stock portfolio
value reaches the lower threshold value of INR 40,000. At this point, INR 10,000 from
the bonds portfolio is reinvested into buying 250 shares. The rebalancing results in a
gain of INR 2500 on the investment.
9.6.4 Rupee Cost Averaging
The “rupee cost averaging method is a very popular method and is the basis of
systematic investment planning. Herein, an investor, instead of investing a lump-
sum into a portfolio, breaks his capital down into smaller amounts and invests
regularly over months, six months or annually (as the case may be). This is typ-
ically useful for small investors who may not have a large amount of capital at
their disposal (to invest) and feel more comfortable investing smaller amounts at
a time.
Apart from the ease of investing that this method provides, it also provides a
financial benefit. In a volatile market where the stock prices fluctuate, by spread-
ing investment over time, an investor is able to reap the benefits of averaging, in
the sense that, at the end of the investment cycle, the average cost per share that
he/she is able to achieve is significantly lower than the price that he/she would
have paid if he/she had transacted in one go (and the prices were high at that
time).

An investor invests INR 25,000 semi-annually in a systematic investment plan (SIP)
for a period of 5 years. Calculate the total number of shares purchased at the pre-
vailing market prices, the average cost per share and the average market price using
the “rupee cost averaging plan” and the net profit/loss due to the approach.
v
Period Market Number Total Total Average Average
price of shares number amount cost per price per
purchased of shares invested share share
for INR purchased
25,000
1 100 250 250 25,000 100 100
2 90 277.78 527.78 50,000 94.74 95

price of shares number amount cost per price per
purchased of shares invested share share
for INR purchased
25,000
3 95 263.16 790.94 75,000 94.82 95
4 85 294.12 1,085.06 1,00,000 92.16 92.50
5 90 277.78 1,362.84 1,25,000 91.72 92
6 100 250 1,612.84 1,50,000 93 93.33
7 75 333.33 1,946.17 1,75,000 89.92 90.71
8 80 312.50 2,258.67 2,00,000 88.55 89.38
9 85 294.12 2,552.79 2,25,000 88.14 88.89
10 95 263.16 2,815.95 2,50,000 88.78 89.50
As is evident, the rupee cost averaging method has allowed the investor to maximize
his gains as he can purchase more shares (approximately 2816 shares) owing to the
lower average cost per share (INR 88.78) instead of the average market price (INR
89.50), wherein he could have purchased only 2793 shares. This provides him a differ-
9 ence of 23 shares at the rate of INR 95, thereby maximizing his overall gains.
9.7 Mutual Funds in India
India has an expanding financial services sector which consists of non-bank fi-
nance companies (NBFCs), commercial banks, insurance firms, mutual funds
and other such entities. Out of these, mutual funds, in particular, have the
greatest potential of mobilizing savings for investments into the equity mar-
kets. They also provide the benefits of professional management and risk mit-
igation to small retail investors who may not have the requisite knowledge or
skills.
. Figure 9.5 provides, in brief, the history of the mutual fund sector in
India in terms of important timelines (1965–2016). As is evident, the growth
in the mutual fund sector in India has been significant, auguring well for the
investment climate of the country. Investors would do well to avail of the
services of mutual funds to try and ensure a safer and lucrative investment
experience.
Concept in Practice 9.2: Promising Future of Indian Mutual Funds

The assets of India’s mutual fund industry have doubled over the past three years.
In 2017, the industry managed INR 20 lakh crores, up from INR 10 lakh crores in
2014.
9.7 · Mutual Funds in India
325 9
. Fig. 9.5 History of mutual fund sector in India (1965–2016). Source AMFI (2018)
This is due to the increased inflows into equity/balanced funds driven by participa-
tion from retail and high net worth individuals (HNIs).
Mutual funds, as a financial intermediary, offer investors flexible, low-cost
schemes which are diversified and may also provide tax benefits. This allows the
small investors to have access to the best returns available in the stock market as
well as enjoy professional management of their investments.
. Figure 9.6 presents the growth of the mutual fund sector in India over the pe-
riod 2011–2017. More specifically, . Fig. 9.7 presents the net inflows into mutual
funds in India over the past five years (2013–2017).
9.8 Conclusion
This chapter details the steps involved in the investment process: portfolio plan-
ning, portfolio implementation and portfolio evaluation. In portfolio planning,
investor and market conditions are considered, resulting in a suitable investor
policy/strategy. In portfolio implementation, the current market conditions are
ascertained, and the portfolio is rebalanced, as and when required. In portfo-
lio monitoring, the performance of the portfolio is evaluated, using the different
methods/techniques in vogue. Further, different formula plans, which form the
basis of active trading strategies, have been discussed. A brief on the Indian mu-
tual fund scenario is also provided.
. Fig. 9.6 Growth of mutual fund sector in India (2011–2017). Source AMFI, Bloomberg
. Fig. 9.7 Net inflows in mutual fund sector in India (2011–2017). Source AMFI, Bloomberg
Summary
327 9
Summary
5 A portfolio is a set of investments/securities held by an individual or by an or-
ganization.
5 Markowitz stated that “Investors are risk-averse; given a choice between
two assets with equal rates of return, the investor will always select the a sset
with the lowest level of risk. This means that the investor would be willing
to take higher risk only for a higher return. Thus, risk and return are directly
proportionate”.
5 Portfolio management refers to the art of creating an efficient portfolio with
minimum risk and maximum returns.
5 The commonly stated investment objectives/goals are income, growth and
stability.
5 The commonly stated investment constraints are liquidity, taxes, time horizon
and/or unique preferences and circumstances.
5 Some key aspects/suggestions to remember in the investment process include
i. Keep the portfolio limited to some but not very few stocks;
ii. Diversify across stocks, industries and markets, if possible;
iii. Select long-term investments and stay invested; and
iv. Identify your reasons for choosing a stock and monitor to see if the
reasons remain.
5 The underlying principles in portfolio management are
i. It is the portfolio that matters;
ii. High returns come only with high risks;
iii. Risk depends on timing of liquidation;
iv. Diversification works;
v. Portfolios should be tailor-made; and
vi. Competition for abnormal returns is extensive.
5 Portfolio management strategies are broadly classified into two categories: ac-
tive and passive.
5 Aspects considered in an active portfolio management strategy are market tim-
ing, sector rotation and use of a specialized concept.
5 The portfolio management process includes the three crucial steps/sub-pro-
cesses of planning, implementing and monitoring (PIM).
5 The “planning” stage considers the investor conditions, the market conditions,
the investment/speculative policies and leads to the preparation of the state-
ment of investment policy that states the strategic asset allocation.
5 The “implementation” stage rebalances the strategic asset allocation and moni-
tors tactical asset allocation and security selection.
5 The “monitoring” stage evaluates the adherence to the statement of investment
policy as well as the performance of the investment.
5 The most commonly deployed measures of performance are Sharpe’s re-
ward-to-variability ratio, Treynor’s reward-to-volatility ratio, Jensen’s differen-
tial return measure, arbitrage pricing theory (APT) and the Grinblatt and Tit-
man’s performance change measure (PCM).
5 Sharpe’s reward-to-risk ratio = (Average return on portfolio – average return
on risk-free investment) / Standard deviation of the portfolio returns
5 Treynor’s reward-to-volatility ratio = (Average return on portfolio – average

return on risk-free investment) / Beta of the portfolio
5 Based on the CAPM, Jensen’s alpha = Actual return on portfolio – [risk-free
return + portfolio beta (average return on market portfolio – risk-free return)]
5 The expected portfolio performance, on the basis of APT, can be estimated as:
5 Actual portfolio return - Expected portfolio return
where
Expected portfolio return = Risk-free rate + sum of factor risk premiums

E Rp = E Rf + 1 β1,p + 2 β2,p + · · · + n βn,p
where,
E(Rp) = Expected portfolio return;
E(Rf) = Risk-free rate; and
λ1ß1,p = factor risk premium.
5 Grinblatt and Titman’s performance change measure (PCM) evaluates the per-
formance of a portfolio that has had active intervention/management from a
portfolio manager. It calculates the difference in returns after the portfolio has
been rebalanced over the returns of the original portfolio.
9 PCM = rit (wit ) − rit−1 (Wit−1 )

where
rit(wit) = the rate of return of the portfolio with the percentage of the manag-
er’s portfolio invested in stock i at the end of investment horizon, t;
rit−1(wit−1) = the rate of return of the portfolio with the percentage of the
manager’s portfolio invested in stock i in the beginning of investment ho-
rizon, t − 1
5 Depending on the overall strategy of the investor and the market conditions,
there are certain techniques called formula plans that can be deployed by inves-
tors to time their investments. There are four kinds of formula plans deployed
by investors across the world: constant rupee value plan, constant ratio plan,
variable ratio plan and rupee cost averaging.
5 Formula plans are techniques developed to help investors understand when to
buy or sell, depending on a prescribed proportion of stocks and bonds in the
portfolio. Formula plans are basically oriented towards loss-minimization. In
formula plans, the investor will decide in advance, the asset mix (proportion of
stocks and bonds) of the portfolio, periodically evaluate the actual proportion
(based on the market values of the securities), and effect whatever trade (buy/
sell) is required to move the portfolio back to the predetermined ratio.
5 In the constant rupee value plan, the attempt is to keep the value of the aggres-
sive part (stocks) constant. Whenever the value of the stocks rises, the excess
(from the constant pre-decided value) is sold and invested into the conservative
part. Whenever the value of aggressive part falls, more stocks are bought us-
ing the funds from the conservative portfolio in order to match the initial (pre-
agreed constant) value of the aggressive portfolio.
Summary
329 9
5 Similar to the constant rupee plan, in the case of the constant ratio plan, an at-
tempt is made to keep the ratio between the values of the aggressive and con-
servative parts of the portfolio constant. Whenever the value of the stocks rise,
the excess (from the constant pre-decided ratio) is sold and invested into the
conservative part. Whenever the value of aggressive part falls, more stocks are
bought using the funds from the conservative portfolio in order to match the
initial (pre-agreed constant ratio) value of the aggressive portfolio.
5 As the name suggests, in the variable ratio plan, the portfolio manager rebal-
ances the portfolio depending upon the variation in the stock prices (aggressive
portion). This plan is ideally suited for markets which are volatile in nature.
5 The “rupee cost averaging method is very popular and is the basis of system-
atic investment planning. Herein, an investor, instead of investing a lump sum
into a portfolio, breaks his capital down into smaller amounts and invests reg-
ularly over months, six months or years (as the case may be). This is typically
useful for small investors who may not have a large amount of capital at their
disposal (to invest) and feel more comfortable investing smaller amounts at a
time.
5 India has an expanding financial services sector which consists of non-bank fi-
nance companies (NBFCs), commercial banks, insurance firms, mutual funds
and other entities. Out of these, mutual funds, in particular, have the greatest
potential of mobilizing savings for investments into the equity markets. The
growth in the mutual fund sector in India has been significant, auguring well
for the investment climate of the country.
9.9 Exercises

(i) A ______________ is a set of investments/securities held by an individual or
by an organization.
(ii) ____________________ refers to the art/process of creating an efficient port-
folio with minimum risk and maximum returns.
(iii) Portfolio management strategies are broadly classified into two categories:
_______ and passive.
(iv) The portfolio management process includes the three crucial steps/sub-pro-
cesses of __________, implementing and monitoring.
(v) The __________ stage rebalances the strategic asset allocation and monitors
tactical asset allocation and security selection.
(vi) The _____________ stage evaluates the adherence to the statement of invest-
ment policy as well as the performance of the investment.
(vii) ___________________ evaluates the performance of a portfolio that has had
active intervention/management from a portfolio manager.
(viii) _______________ are techniques developed to help investors understand

when to buy or sell, depending on a prescribed proportion of stocks and
bonds in the portfolio.
(ix) In the ___________________ plan, the attempt is to keep the value of the
aggressive part (stocks) constant.

(x) The _________________ method is the basis of systematic investment
planning.
v (Answers: (i) Portfolio (ii) Portfolio management (iii) Active (iv) Planning (v)
Implementation (vi) Monitoring (vii) Grinblatt and Titman’s PCM (viii) Formula
plans (ix) Constant rupee value (x) Rupee cost averaging)
? 2. True/False
(i) Markowitz stated that “Investors are risk-averse; given a choice between two
assets with equal rates of return, the investor will always select the asset with
the lower level of risk”.
(ii) Portfolio management refers to the art of creating an efficient portfolio with
maximum risk and minimum returns.
(iii) The commonly stated investment objectives/goals are income, growth and
9 stability.
(iv) Portfolio management strategies are broadly classified into two categories:
active and passive.
(v) The “planning” stage evaluates the adherence to the statement of investment
policy as well as the performance of the investment.
(vi) The most commonly deployed measures of performance are Sharpe’s re-
ward-to-variability ratio, Treynor’s reward-to-volatility ratio, Jensen’s differ-
ential return measure, arbitrage pricing theory (APT) and the Grinblatt and
Titman’s performance change measure (PCM).
(vii) Treynor’s reward-to-volatility ratio = (Average return on portfolio – average
return on risk-free investment) / Beta of the portfolio
(viii) Formula plans are techniques developed to help investors understand when
to buy or sell, depending on a prescribed proportion of stocks and bonds in
the portfolio.
(ix) In case of the constant ratio plan, an attempt is made to keep the ratio be-
tween the values of the aggressive and conservative parts of the portfolio
constant.
(x) Mutual funds have the greatest potential of mobilizing savings for invest-
ments into the equity markets.
v (Answers: (i) True (ii) False (iii) True (iv) True (v) False (vi) True (vii) True
(viii) True (ix) True (x) True).
9.9 · Exercises
331 9
? SQ1. Rank the following portfolios using Sharpe’s reward-to-risk ratio.
Portfolio Average return (%) Standard deviation (%) Risk-free return (%)
X 10 18 7
Y 15 25 7
Z 13 20 7
v For Sharpe’s reward-to-risk ratio, applying Eq. 9.2,
Sharpe reward-to-risk ratio = (Average return on portfolio

− average return on risk-free investment
X = (10 − 7)/18 = 0.167

Y = (15 − 7)/25 = 0.32
Z = (13 − 7)/20 = 0.30
Based on the above values, the rank order of the portfolios is Y, Z and X. An in-
vestor will choose Portfolio Y as it has the highest Sharpe’s reward-to-risk ratio.
? SQ2. Assume that a portfolio has a return of 18%, a beta of 1.4, and the risk-free
rate is 8%. What is its Treynor’s reward-to-volatility ratio?
v Applying Eq. 9.3:

Treynor Ratio = (18 − 8)/1.40 = 10/1.40 = 7.14

? SQ3. Rank the following portfolios using Sharpe and Treynor ratios:
Portfolio Average return Standard deviation Beta

A 10 18 1.00
B 15 25 1.15
C 13 20 1.05
Risk-free rate is 6%.
v Sharpe measure
Applying Eq. 9.2:
Sharpe’s reward-to-risk ratio = (Average return on portfolio

A: (10 − 6)/18 = 0.22 → 3

B: (15 − 6)/25 = 0.36 → 1
C: (13 − 6)/20 = 0.35 → 2
Treynor measure
Applying Eq. 9.3:

9 Substituting values,
A: (10 − 6)/1 = 4 → 3
B: (15 − 6)/1.15 = 7.83 → 1
C: (13 − 6)/1.05 = 6.67 → 2
Both measures provide the same rankings. The best portfolio is B, followed by C
and A.
? SQ4. The actual return on a portfolio is 15%. The risk-free rate is 5%, the market
return is 10%, and the beta of the portfolio is 1.5. Calculate Jensen’s alpha.
Jensen’s alpha = (Average return on portfolio

− risk-free return + portfolio beta

(average return on market portfolio−risk - free return)
Jensen’s alpha = 15−[5 + 1.5(10 − 5)] = 15−[5 + 7.50]
= 15 − 12.50 = 2.50%
9.9 · Exercises
333 9
? SQ5. An investor has savings of INR 15,000. One third of his savings is to be in-
vested in a defensive portfolio (bonds). The rest he intends to invest in a particular
stock (with a present-day value of INR 80). The strategy (formula plan) to be fol-
lowed in maintaining the portfolio is the “constant rupee plan”. The level for rebal-
ancing the portfolio is decided as the level when the aggressive component is either
20% above or below its value of INR 10,000 (INR 12,000 or INR 8000, respec-
tively). The daily prices of the stock over next 10 days are as given in Column 1 of
the table. Illustrate the actions to be taken whenever necessary.

share portfolio(INR) portfolio value (INR)
(INR) (INR)
80 10,000 5000 15,000 125
75 9375 5000 14,375 125
70 8750 5000 13,750 125
64 8000 5000 13,000 Buy 31.25 125
shares
64 10,000 3000 13,000 156.25
70 10,937.50 3000 13,937.50 156.25
75 11,718.75 3000 14,718.75 156.25
77 12,031.25 3000 15,031.25 Sell 25.97 156.25
shares
77 10,031.25 5000 15,031.25 130.28
80 10,422.40 5000 15,422.40 130.28
As is evident, at the end of the rebalancing, the investor increased the total fund
value from INR 15,000 to INR 15,422.40 even though the starting and finishing
prices were the same and the stock never rose above the starting price of INR 80.
Further, the number of shares increased from 125 to 130.28. It should be noted
here that when we sold 25.97 shares, the attempt was to bring back the debt portion
(conservative portfolio) to its original level.
? SQ6. The initial value of a portfolio is INR 50,000, with equal ratio allocation to-
wards speculative and conservative investments. Rebalancing estimate is decided to
be INR 1000 more or less (INR 26,000 or INR 24,000, respectively), in the specula-
tive allocation. Assume share values to be INR 100, 102, 105, 103, 101 and 100.50.
Illustrate the rebalancing exercise (under this constant ratio plan).

share portfolio(INR) portfolio value
(INR) (INR) (INR)
100 25,000 25,000 50,000 250
102 25,500 25,000 50,500 250
105 26,250 25,000 51,250 250
105 25,000 26,250 51,250 Sold 11.90 238.10
shares
103 24,524.30 26,250 50,774.30 238.10
101 24,048.1 26,250 50,298.10 238.10
100.50 23,929.05 26,250 50,179.05 238.10
100.50 25,000 25,179.05 50,179.05 Bought 248.76
10.66 shares
Here, the two trigger points are reached at price levels 105 and 100.50, where shares
9 were sold and bought, respectively, to keep the investment in speculative portion in-
tact. At the first trigger point of 105, when the speculative investment increased,
it was brought down to INR 25,000 by selling 11.90 shares. Similarly, when the
price touched 100.50, the speculative value dropped to INR 23,928, at which 10.66
shares were bought to push up the speculative investment to INR 25,000.
? SQ7. An investor has a total of INR 50,000 invested in the ratio of 50:50 in stocks
and defensive bonds. Illustrate the balancing using the “constant ratio plan”. Re-
balancing should be undertaken whenever the value of the aggressive portion rises
or falls by INR 5000 of the original value (INR 30,000 or INR 20,000, respec-
tively). What would the returns be at the end of the rebalancing?

share portfolio portfolio(INR) value (INR) shares
(INR) (INR)
100 25,000 25,000 50,000 250
80 20,000 25,000 45,000 250
80 25,000 20,000 45,000 Bought 312.5
62.5 shares
96 30,000 20,000 50,000 312.5
9.9 · Exercises
335 9
share portfolio portfolio(INR) value (INR) shares
(INR) (INR)
96 25,000 25,000 50,000 Sold 52.08 260.42
shares
100 26,042 25,000 51,042 260.42
As can be seen, 62.50 shares would be bought at INR 80. Similarly, 52.08 shares
would be sold at INR 96. So, against an investment of INR 50,000, the return is
INR 1042 with the number of shares increased from 250 to 260.42.
? SQ8. An investor wants to invest INR 50,000. He invests half the money in aggres-
sive stocks and the rest in defensive bonds. He would like to rebalance his portfolio
when the stock investment’s total value fluctuates 20% above or below the current in-
vestment value. Through a table, calculate the amount he gains/loses, the total portfo-
lio value and the number of shares if the shares rise from the initial value of INR 50
to INR 55 and then to INR 60 and back to INR 55 and then drop down to INR 40.

share portfolio portfolio value (INR) shares
(INR) (INR) (INR)
50 25,000 25,000 50,000 500
55 27,500 25,000 52,500 500
60 30,000 25,000 55,000 Sold 500
83.33
60 25,000 30,000 55,000 416.67
shares
55 22,916.85 30,000 52,916.85 416.67
40 16,666.80 30,000 46,666.80 Buy 416.67
208.33
40 25,000 21,666.80 46,666.80 625
shares
When the initial price is INR 50, the investor can purchase 500 shares as INR
25,000 is to be invested in stocks. Now, as the threshold for rebalancing is 20%,
the re-adjustment is made when the value in the stock portion becomes either INR
30,000 (or above) or it becomes INR 20,000 (or below).
As shown in the table, at INR 55, the value of stocks is INR 27,500, which is
less than INR 30,000, and therefore, no rebalancing is done. As soon as the value in-
creases to INR 30,000, the equivalent number of shares are sold to bring the value
back to INR 25,000. The excess amount of INR 5000 is then reinvested in bonds.
Similarly, when the market price of shares falls to INR 40, the total stock port-
folio value falls below the lower threshold value of INR 20,000. At this point, INR
8,333.20 from the bonds portfolio is reinvested into buying 208.33 shares. The re-
balancing results in a gain of 125 shares.
? SQ9. An investor decides to invest INR 50,000 every year, in a systematic invest-
ment plan (SIP) for 10 years. Calculate the number of shares purchased at the pre-
vailing market prices using the “rupee cost averaging method?

price per of shares number amount cost per price
share purchased for of shares invested share per
(INR) INR 50,000 purchased share
1 100 500 500 50,000 100 100
2 90 555.55 1,055.55 100,000 94.74 95
3 95 526.32 1,581.87 150,000 94.82 95
4 85 588.24 2,170.11 200,000 92.16 92.50
5 90 555.55 2,725.66 250,000 91.72 92
6 75 666.67 3,392.33 300,000 88.43 89.17
7 80 625 4,017.33 350,000 87.12 87.86
8 85 588.24 4,605.57 400,000 86.85 87.50
9 9 75 666.67 5,272.24 450,000 85.35 86.11
10 80 625 5,897.24 500,000 84.79 85.50
The rupee cost averaging method has allowed the investor to maximize his gains as
he could purchase extra shares (897.24 shares) owing to the lower average cost per
share (84.79) by spreading his investment through an SIP.
? UQ1. If a fund has a return of 18%, a standard deviation of 10% and the risk-
free rate is 8%, what is its Sharpe’s reward-to-risk ratio?
[Answer: 1].
? UQ2. Keeping everything else constant as in UQ1, except that the portfolio
beta equals the market beta of 1, what would be the Treynor ratio?
[Answer: 10].
? UQ3. The actual return on a portfolio is 20%. The risk-free rate is 7%, the mar-
ket return is 13%, and the beta of the portfolio is 1.4. Calculate Jensen’s alpha.
[Answer: 4.6%].
? UQ4. An investor has INR 10,000 to be invested. The investor decides to invest
in balanced proportions (INR 5000 in aggressive stocks and INR 5000 in de-
fensive bonds) and to rebalance the portfolio whenever the aggressive portion is
20% above or below INR 5000 (INR 6000 or INR 4000, respectively). He buys
100 shares of Company X having a share price of INR 50 per share and invests
INR 5000 in bonds. Illustrate how the rebalancing would be exercised under the
constant rupee value plan.
9.8 · Exercises
337 9
share portfolio portfolio(INR) value (INR)
(INR) (INR)
50 5000 5000 10,000 100
44
40
40
44
48
48
50
.
v
[Answer: Purchase 25 shares at INR 40 and sell 20.83 shares at INR 48. At the
end of the rebalancing, the investor would have increased the total fund value
from INR 10,000 to INR 10,209 even though the starting and finishing prices
were the same and the stock never rose above the starting price of INR 50.
Further, the number of shares would have increased from 100 to 104.17]
? UQ5. The initial value of the portfolio is INR 10,000, with an equal ratio (1:1)
invested in stock and defensive investments. Illustrate the rebalancing exercise
at varying market prices (as indicated in the table) as per the “constant ratio
plan”. Rebalancing has to occur at 10% (up or down) of the constant ratio of
1:1 (that is, 0.9:1 or 1.1:1, respectively).

price of aggressive conservative portfolio ratio shares
share portfolio(INR) portfolio value
(INR) (INR) (INR)
50 5000 5000 10,000 1:1 100
48
45
45
40.50
40.50
44.50
44.50
49
49
50
v
[Answer: There were four trigger points to maintain the ratio when share prices
reached INR 45, 40.50, 44.50 and 49. At prices of INR 45 and INR 40.50, 5.50
and 5.90, shares were bought, respectively, and at prices of INR 44.50 and INR
49, 5 and 4.90, shares were sold, respectively. At the end of the rebalancing
exercise, the investor was left with a total portfolio of INR 10,049 and 101.50
shares].
? UQ6. An investor wants to invest INR 2,00,000. He invests half the money in
aggressive stocks and the rest in defensive bonds. He would like to rebalance his
portfolio when the stock investment’s total value fluctuates 10% above or below
the current investment value. Through a table, calculate the amount he gains/
loses, the total portfolio value and the number of shares if the shares rise from
the initial value of INR 100 to INR 105 and then to INR 110 and back to INR
105 and then drop down to INR 95.

price of aggressive conservative portfolio rebalancing shares
share (INR) portfolio portfolio value (INR)
(INR) (INR)
100 100,000 100,000 200,000 1000
9 105
110
105
95
v
[Answer: Rebalancing will be undertaken when the stock value touches INR
110,000 or falls to INR 90,000. Hence, rebalancing will be undertaken when the
stock price touches INR 110. The rebalancing results in a gain of 52.63 shares].
? UQ7. An investor decides to invest INR 100,000 every year, in a systematic in-
vestment plan (SIP) for 5 years. Calculate the number of shares purchased at
the prevailing market prices using the “rupee cost averaging method?

price per of shares number amount cost per price per
share purchased of shares invested share share
(INR) for INR purchased
100,000
1 100 1000 1000 100,000 100 100
2 90 200,000
3 95 300,000
4 85 400,000
5 90 500,000
9.9 · Exercises
339 9
v
[Answer: The rupee cost averaging method has allowed the investor to maxi-
mize his gains as he could purchase extra shares (451.32 shares) owing to the
lower average cost per share (91.72) by spreading his investment through an
SIP].
? 1. What are the key stages in portfolio management?

2. What is active portfolio management strategy?
3. What is passive portfolio management strategy?
4. What are the basic policies used in portfolio rebalancing?
5. How can one evaluate the performance of the portfolio?
6. Enumerate the main portfolio performance measurement techniques.
7. What are “formula plans?
8. Illustrate a constant rupee value plan with appropriate data.
9. Illustrate a constant ratio plan through with appropriate data.
10. Illustrate a variable ratio plan through with appropriate data.
11. Illustrate a rupee cost averaging plan with appropriate data.
? 1. Discuss the different kinds of investment strategies adopted by different kinds

of investors. Is it necessary that each individual investor follows only one kind
of investment strategy?
(Hint: Each investor may follow different investment strategies given the ch-
anging personal and investment environments)
? 2. Compare the statement of investment policies provided by different mutual
fund schemes. What are the differences (if any)? Justify the same
(Hint: The differences (if any) can be due to their portfolio management
processes and the underlying strategies)
? This can be used as a class exercise

Make groups in the class on the basis of the two portfolio management strategies:
active and passive. Provide them similar portfolios. Ask them to monitor the re-
turns through an active strategy vis-à-vis a passive one. Encourage them to rebal-
ance the portfolio over a month (you may choose the appropriate time period).
What do you observe? Provide justifications. Discuss the same in light of other in-
vestment alternatives available, as well.

Additional Readings
Fisher, D. E., & Jordan, R. J. (1995). Security analysis and portfolio management (4th ed.). Pren-
tice-Hall.
son Education.
South-Western.
References
Association of Mutual Funds in India. (AMFI, 2018). Available at 7 https://www.amfiindia.com/rese-
arch-information/amfi-monthly. Accessed on October 15, 2018.
Bloomberg website. (2018). Available at 7 https://www.bloombergquint.com/mutual-funds/mutual-
funds-asset-base-rises-5-percent-to-rs-24-lakh-crore-in-july#gs.YikslQs. Accessed on October 30,
2018.
Ibbotson, R. (2009). The importance of asset allocation. Financial Analysts Journal, 66. 7 https://doi.
org/10.2307/27809175
Seeking Alpha website. (2018). Available at 7 https://seekingalpha.com/article/3173636-how-to-beat-
9 the-market-with-sector-rotation. Accessed on October 15, 2018.
Springer. ISBN 978-981-10-0868-9.
341 10
Derivatives
Contents
10.2 Forwards – 344
10.3 Futures – 345

10.3.1 Features of Futures – 346
10.3.2 Hedging with Futures – 348
10.3.3 Speculating with Futures – 348
10.3.4 Examples of Financial Futures – 348
10.3.5 Pricing the Future – 350
10.3.6 Benefits of Futures Contract – 351
10.4 Options – 353

10.4.1 Call Option – 354
10.4.2 Put Option – 354
10.4.3 Pay-Offs of Options – 354
10.4.4 Speculative Strategies Based on Options – 357
10.5 Swaps – 359
10.6 Advantages of Derivatives – 359
10.7 Participants in the Derivatives Market – 360
10.8 Risks in Derivatives Contracts – 361

10.1 · Introduction
343 10
The broad objective of this chapter is to provide the basics of derivatives as a risk
mitigation tool. It covers the following topics:
10.1 Introduction
Definition
Derivatives are financial contracts that obtain their value from an underlying asset.
Assets (whether financial or real) like precious metals, commodities, equity

stocks, stock indices, real estate, treasury bills, loans, exchange rates, interest rates,
etc., can form the underlying for derivatives. The name “derivative” indicates that
its value is “derived” from the change in the value of the underlying asset.
> It is important to note that while the actual underlying assets are selected based on
their return generating capacity, derivatives form risk mitigating tools, used typi-
cally to safeguard investors from the price fluctuations in the underlying assets.
Derivatives are already popular in developed countries and are gaining popularity
in the developing countries as well.
. Fig. 10.1 Some underlying assets for derivatives. Source Kotak securities.com (2020) 7 https://
www.kotaksecurities.com/ksweb/Research/Investment-Knowledge-Bank/what-is-derivative-trading
344 Chapter 10 · Derivatives
. Figure 10.1 presents some underlying assets/rates that derivatives can be

built on.
The examples of derivatives are forward contracts, futures, options and swaps.
. Figure 10.2 presents the types of derivatives.
Let us examine each type of derivative in detail.
10.2 Forwards
Definition
A forward is an agreement between two parties to buy or sell an underlying asset, in
the future, at a predetermined price.
► Example
If an organization agrees today to purchase 1 ton of steel on 1 December 2018 from
a steel manufacturer at a price of INR 50,000/ton, it has entered into a forward con-
tract with the seller/manufacturer. As per this contract, on 1 December, the buyer will
have to pay INR 50,000, and the seller will have to supply 1 ton of steel. According to
10
. Fig. 10.2 Types of derivatives. Source Kotak securities.com (2020) 7 https://www.kotaksecurities.

com/ksweb/Research/Investment-Knowledge-Bank/what-is-derivative-trading
10.2 · Forwards
345 10
this agreement, the buyer of the forward contract has bought or “long forward” steel,
whereas the seller has sold or “short forward” steel. No money or steel has exchanged
hands at the time of the signing of the contract. The exchange will happen in the fu-
ture. Hence, the name forward (looking into the future). ◄
> As you would have noted, buy and sell have different notations here:
Short position—this puts an obligation on the seller to deliver the asset at the
contracted price on maturity; and
Long position—this puts an obligation on the buyer to purchase the asset at
the contracted price on maturity.
As has been discussed earlier, a forward buyer (long position) is obliged to
purchase the underlying asset at the contract price at maturity or enter into
an offsetting transaction.
In terms of pay-offs, when the spot price in future exceeds the contract price,
the forward buyer’s gain is spot price–contract price. Similarly, if it is the
other way round, the forward buyer’s loss is contract price–spot price. Hence,
the pay-offs in a forward contract are a zero-sum game, and the buyer’s gain
is the seller’s loss and vice-versa.
The transaction in a forward contract is done over-the-counter (OTC) or
through financial intermediaries. Hence, a forward contract is a customized
agreement between two parties providing them option to buy or sell underly-
ing assets at a specified date and at a predetermined price in future. Delivery
of the underlying asset is typical in case of forwards as they are entered into
by companies and manufacturers to lock in future purchases/sales of the un-
derlying assets.
10.3 Futures
Definition
Futures, as derivatives, are similar to forwards in concept, but they are standard-
ized contracts that are traded on stock exchanges (and not OTC like forwards). In-
vestors have the option to buy or sell the underlying asset at a certain date in the
future, at a specified price and a specified quantity.
It can also be said that futures are standardized forward contracts. However, in
case of futures, actual delivery of the underlying asset is rare; most settlements
are done in cash.
10.3.1 Features of Futures
i. Spot Price
The spot price denotes the price of the underlying asset at that particular
time/spot.
ii. Contract Price
The contract price denotes the agreed upon price of the underlying asset at
the time of maturity of the contract. It is also called the exercise price.
iii. Organized Exchanges
Unlike forward contracts that are transacted on the OTC markets, futures are
traded in organized markets or stock exchanges, providing ready liquidity for
buying and selling of futures contracts.
The most important role of a futures exchange is to reconcile sales and pur-
chases and keep an account of margin requirements. The “clearing house”, as-
sociated with the exchange stands guarantor between each counterparty to en-
sure that the contract is honored. It is to be noted that clearing houses provide
guarantee to the clearing member (broker) and not to the individual operators
who have to enter into an agreement with the broker.
iv. Standardization
In futures, there is standardization evident in all aspects of the instrument.
Futures are standardized with respect to the amounts and delivery dates, de-
pending on the exchange they are being traded on. Further, only whole num-
10 bers of contracts are allowed to be traded and the minimum size of price
movement (called a “tick”) and the maximum price movement, to be allowed
during a day, are predetermined.
v. Clearing House
A “clearing house” is typically a corporate organization that evaluates the two
parties involved and acts as guarantor to the transaction, so that they do not
have to investigate the credit worthiness of each other.
It also guarantees delivery of contracts held till maturity and imposes margin
requirements on the parties.
vi. Margin
In the case of futures, only registered members of the exchange are allowed to
trade. These members can also trade on behalf of others. Every transaction is
between a “clearing member” and the exchange. A party through a “member”
deposits a margin, which is the minimum amount to be deposited to be able to
trade/transact. This margin can be in the form of cash/treasury bills.
Further, a minimum maintenance margin is required to be maintained at all
times, in order to carry on with trading.
vii. Marking-to-Market
In the marking-to-market process, all outstanding contracts are specified at
the settlement price of the day/session. The margin accounts of the loss-mak-
ers (on that particular day) are debited and of those of the gainers are cred-
ited. Thus, the time profile of gain/loss is different from that of forward con-
tracts, where the gain/loss is only determined by the price levels at the time of
maturity of the contract.
The closing/settlement price is typically used to mark the market.
10.3 · Futures
347 10
► Example
On Monday morning, an investor takes a long position in a futures contract that ma-
tures on Thursday. The contract price is INR 100. At the close of trading on Monday,
the futures price rises to INR 110. As per the marked-to-market rule:
5 the investor will receive a cash profit of INR 10,
5 the existing futures contract with a price of INR 100 will be cancelled, and
5 the investor will receive a new futures contract at INR 110.
Thus, the marked-to-market feature implies that the value of the futures contract is set
to zero at the end of each trading day. ◄
viii. Actual Delivery
In futures, actual delivery of the underlying asset is rare; it only takes place
in less than two per cent of cases. Unlike forwards, which look towards ac-
tual delivery of the underlying asset, futures are used basically for hedging
risk or speculating on prices. A futures contract gets extinguished before ma-
turity through an opposing contract.
ix. Trading Process
The trading of futures is conducted on the trading floor of the exchange
(called the trading pit). A client may specify the prices for buying/selling.
As is done in the case of shares, the broker matches the order with the best
available price. Typically, a client order would look for a higher price to sell
and a lower price to buy.
x. Participants
As has been stated earlier, the trading in futures can only be done through
registered members of the exchange (in order to ensure authenticity). The
different participants to the trade are as follows:
– Floor traders: who trade for their own accounts (like dealers in the case of
shares);
– Floor brokers: who trade on behalf of others, as agents, for a commission;
– Dual traders: who do both. They deal in their own accounts as well as act
as a broker for other traders.
If the losing party is not able to deposit the “variation margin” (the difference be-
tween the actual price and the price bid for) when called to do so, the contact is
liquidated immediately. Thus, the loss for the exchange/clearing house is limited
to one day’s price change at the most, making the trading in futures relatively safe
for the participants.
xi. Kinds of Futures based on Duration
Typically, there are three kinds of futures—one month, two months’ and
three months’, and the contract matures on the last Thursday of the respec-
tive month.
10.3.2 Hedging with Futures
Hedging refers to the activity of risk mitigation. Consider the case of a partici-
pant who has a long position (receivable in the future) and who is worried about
the possible decline in the future value of the receivable; he/she may hedge against
such decline by selling futures today.
Similarly, in the case of a participant, who has a short position (payable in the
future) and who is worried about the possible appreciation in the future value of
the payable, he/she may hedge against such appreciation by buying futures today.
It is to be borne in mind that the firm is willing to sacrifice a potential profit in
case of an appreciation in the price of receivables or a decline in the price of pay-
ables; the reason of entering into the futures trade is not to make a gain but to
hedge risk and reduce or eliminate the uncertainty.
10.3.3 Speculating with Futures
Speculators like to profit from the price movement of assets. In the case of fu-
tures as well, speculators act as active participants.
In “open price trading”, speculators bet on movements in the price of a par-
ticular futures contract. On the other hand, in “spread trading”, a speculator bets
on movements in the price differential between two futures contracts.
10
10.3.4 Examples of Financial Futures
Broadly, there are two types of futures: commodity futures (dealing in real as-
sets like metals) and financial futures (dealing in financial assets like currencies).
Hence, futures can be formed for individual stocks, currencies, stock indices, com-
modities, etc.
i. Index Futures versus Individual Stock Futures
An index future is less volatile than individual stock futures (as it is well-diver-
sified). Further, an index future is more difficult to manipulate compared to an
individual stock future. Due to lesser volatility associated with index futures,
there are lower margin requirements for the same.
a. Popular Index Futures in India
► Example
NSE Nifty
The National Stock Exchange’s (NSE) Nifty 50 is an index comprising the top 50 com-
panies listed on the NSE in terms of their market capitalization. Instead of buying/sell-
ing individual shares, one can take long/short positions on the index itself.
10.3 · Futures
349 10
BSE 30 (SENSEX)
The Bombay Stock Exchange’s (BSE) BSE 30 (SENSEX) is an index comprising the
top 30 companies listed on the BSE in terms of their market capitalization. Similarly,
instead of buying/selling individual shares, one can take long/short positions on the
SENSEX itself. ◄
b. Size of Index Futures in India
The minimum size of the index future currently is INR 200,000. The lots are de-
cided depending on the minimum size and the value of the index.
► Example
Suppose Nifty 50 is trading at 5200, then a lot of 50 would mean 5200 * 50 = INR
260,000. Hence, the lot size is likely to be 50 in case of Nifty 50. ◄
ii. Currency Futures
► Example
. Figure 10.3 presents the contract specifications on Chicago Mercantile Exchange
(CME) and Philadelphia Board of Trade (PBOT) for currency futures. ◄
. Fig. 10.3 Contract specifications on Chicago Mercantile Exchange (CME) and Philadelphia

Board of Trade (PBOT). Source 7 www.cme.com and 7 www.phlx.com
? Example 10.1: Margin Requirement

Suppose, the US$ is trading at INR 70, currently. It also appears that the dollar is
strengthening against the rupee. If an investor buys a 3-months’ futures contract
to sell US$, he/she will make money if the rupee depreciates. The contract size is
INR 2,00,000, and the margin requirement is 4% of the contract value. Calculate
the value of the margin requirement.
v The value of the margin would be

Margin requirement*contract value = 0.04 * 200,000 = INR 8000
10.3.5 Pricing the Future
10.3.5.1 Financial Futures
Derivatives provide a choice to the investor. He/she can choose to take immediate
delivery by buying a stock in the spot market, or he/she may choose deferred de-
livery in the forwards/futures market. If one buys in the spot market, one gets to
enjoy the benefits of ownership of the underlying asset, in the form of dividends
and interest. However, in the case of the futures market, the benefits of ownership
will only occur after/if delivery is made.
10.3.5.2 Commodity Futures
10 In the case of commodity futures, the investor earns an interest on his/her money
as the payment is deferred and also saves on the costs of storage, insurance and
wastage (as he/she does not need to store the commodity immediately). However,
an inconvenience to the buyer of a futures contract would be the unavailability of
the underlying commodity before the expiry of the contract.
i Given such advantages and disadvantages associated with commodity futures, the
price of futures can be given by Eq. 10.1
Futures Price = Spot Price + Cost of carry (10.1)

Symbolically, the same can be written as
ET = ST + Cost of carry
where
Spot price = is the price at spot (that particular instant),
Cost of carry = the opportunity cost of the money invested (equivalent of say, the
interest cost).
> In general, thus, the futures price is higher than the spot.
The difference between the spot price and the futures price is called the “basis”.
The basis is not constant as the spot and futures prices vary every day. The basis
decreases with time, and on the expiry/maturity date, the basis becomes zero, and
the futures price equals the spot price.
10.3 · Futures
351 10
i As per Eq. 10.2,
Before maturity, ET − ST = basis (10.2)
On maturity, ET − ST = 0
10.3.6 Benefits of Futures Contract
A futures contract may be defined as a standardized forward contract where a

buyer books a price for a particular quantity of a given commodity in the future.
This helps both the buyer and the seller to execute their operations on the ba-
sis of the contract. An obligation to execute the contract makes it more reliable.
Some of the benefits of the future contracts to the buyer (of the contract) are as
follows:
i. Benefits to Buyer
– The buyer remains unaffected by varying inflation as he/she has already
booked a price for the future transaction.
– It helps the buyer to take further orders for a finished product from his/her
customers.
The contract also brings benefits to the seller (of the contract). They are as fol-
lows:
ii. Benefits to Seller
5 It helps the seller to maintain its line of production and thus use resources
more efficiently.
5 It helps to plan material procurement better on the basis of the future orders.
Concept in Practice 10.1: Chicago Mercantile Exchange’s Bitcoin Futures

Contract
As per a recent change in policy, the world’s biggest exchange, Chicago Mercantile
Exchange (CME) has introduced Bitcoin futures trading on its platform in 2018.
By definition, this futures contract will allow the selling/buying of bitcoins (digi-
tal cryptocurrency) by trading parties at predetermined future dates. Bitcoins and
digital currencies were listed as commodities by Commodities for Futures Trading
and Commission at the end of 2015 (. Fig. 10.4).
Bitcoins are a form of “peer to peer payment networks” which do not require any
intermediary for completing the transactions. This form of currency is unique as
the network is decentralized and outside the influence of bankers/regulators. There
is no presence of a central clearing house or an authority which would validate the
end-to-end transaction; the agreements are all verified using a public ledger sys-
tem. This allows these payments to be secure, protected, transparent, cost effective
and less risky and controlled.
10
. Fig. 10.4 Chicago mercantile exchange’s bitcoin futures contract. Source Bloomberg (2018)
Bitcoin futures are a derivative form of this digital currency. The demand for such
contracts is quite substantial in the market, as conceptually, neither of the par-
ties on the contract would be consenting to settling the contract immediately. It is
mostly applicable for those aggressive traders who are willing to get a lot of lever-
age by using only a small part of their actual contract cost. Thus, leverage can po-
tentially lead to massive returns but at the same time pose a tremendous risk of
substantial losses. This form of “leveraged trading” poses a massive risk.
However, apart from the risk factor, there are several inhibiting factors which are
causing the limited acceptance of these derivatives—including huge scope of vola-
tility, limited liquidity and non-regulation which can lead to huge bubbles and po-
tential market crashes.
> Differences Between Futures and Forward Contracts

Broad differences between futures and forward contracts are presented in
. Table 10.1.
10.3 · Futures
353 10
. Table 10.1 Differences between futures and Forward contracts
Differentiating aspect Futures Forward contracts

Trading location Traded competitively on an or- Done by bank dealers via a
ganized exchange network of telephones or com-
puterized dealing systems
Structure Standardized contract Customized contract
Counterparty risk Low High
Contractual size Standardized amount of under- Tailor-made to the needs of the
lying asset participants
Regulation Stock exchange Self-regulated
Collateral Initial margin required No margin required
Settlement Daily settlement (mark- Participant buys or sells the
ing-to-market) done by the stock contractual amount of the un-
exchange through the partici- derlying security from the
pant’s margin account other party at the maturity of
the contract at the forward
(contractual) price
Expiration date Standardized expiration dates Tailor-made delivery dates that
meet the needs of the partic-
ipants
Delivery Delivery of the underlying asset Delivery of the underlying as-
is rarely made set is made regularly
Trading costs Bid-ask spread plus broker’s Bid-ask spread plus indirect
commission bank charges
10.4 Options
Options have gained currency in the derivatives market only since the 1970s. The
first exchange to offer options was the Chicago Board of Options Exchange, in
1973. Generally blamed for fuelling speculation, options do serve as an instru-
ment for reducing risk in a volatile environment.
Definition
An “option” contract gives the buyer the right but not the obligation to buy/sell
the underlying asset at a predetermined price in the future. The buyer of the option
pays a premium to buy the right from the seller, who receives the premium with an
obligation to sell the underlying assets if the buyer exercises his right. Options can
be traded in both OTC markets and exchange-traded markets.
► Example
An investor may buy an option to purchase 1000 shares of a company on or before 1
March 2021 at a price of INR 100 per share. This gives him the right but not the ob-
ligation to purchase. The agreed upon price of INR 100 (in this example) is called the
strike price or the exercise price. ◄
If the option can be exercised at any time before the expiration of the contract, it
is termed an American option; if it can be exercised only at the expiration of the
contract, it is termed a European option.
Options can further be divided into two types—call and put.
10.4.1 Call Option
The buyer of a call option expects the price to go up in the future, and hence, the
investor pre-buys a right to buy stocks at a predetermined price, on a future date.
To buy this right, the investor needs to pay a premium.
10.4.2 Put Option
On the other hand, the buyer of a put option expects the prices to fall in the fu-
10 ture, where the investor pre-buys a right to sell stocks at a predetermined price, on
a future date, for premium.
The units of trading (in options) are standardized for each exchange.
10.4.3 Pay-Offs of Options
The pay-off of options can be determined both from the buyer’s and the seller’s
perspectives. Further, it would depend on the type of option (call or put).
10.4.3.1 Buyer’s Position
Pay-Off of a Call Option
i In case of a European call option (which can only be exercised on the expiration
date), the pay-off depends on the relationship between the stock price (ST) and
the contract price/exercise price (ET) as per Eq. 10.3:
C = ST − ET (10.3)
If ST > ET, C is positive; if ST < ET, C = 0.
When ST is ≤ ET, the call is said to be “out of money” and is worthless. When
ST > ET, the call is said to be “in the money”, and the value is ST − ET.
10.4 · Options
355 10
► Example
An investor buys call option when he/she is bullish on the market and expects prices
to rise. Suppose he/she has bought an option on Nifty index at a strike price 2250 af-
ter paying a premium INR 86.60. If at expiry, Nifty is above 2250, he will exercise the
option, and the profit can be unlimited depending upon how much Nifty has moved
above 2250. If it falls below 2250, his/her loss will be limited to the premium paid as
he/she will not exercise the option and let it expire. . Figure 10.5 presents the pay-off
in this case. ◄
Pay-Off of a Put Option

The pay-off of a put option just before expiration depends on the relationship be-
tween the exercise price (ET) and the stock price (ST).
If ST < ET, the put option has a value of ET − ST and is said to be “in the
money”. In contrast, if ST is ≥ ET, the put option is said to be “out of money”
and is worthless, with zero value.
► Example
An investor buys the put option as he/she is bearish on the market and expects prices
to fall. Suppose he/she has bought an option on the Nifty index at a strike price of
2250 with a premium INR 61.70. If at expiry, Nifty is below 2250, he/she will exercise
the option, and profit can be made depending upon how much Nifty has moved below
2250. On the other hand, if it moves above 2250, loss will be limited to the premium
paid as he/she will not exercise the option and let it expire. . Figure 10.6 presents the
pay-off in this case. ◄
. Fig. 10.5 Pay-off of a call option buyer. Source Authors’ compilation

. Fig. 10.6 Pay-off of a put option buyer. Source Authors’ compilation
10.4.3.2 Seller’s Position
10 Pay-Off of a Call Option

The writer (seller) of a call option collects the premium from the buyer of the op-
tion. If the stock price (ST) is less than the exercise price
(ET) on the expiration date, the buyer will not exercise the option, and the sell-
er’s liability will be nil. However, if the stock price (ST) is more than the exercise
price
(ET), the option holder will exercise the option, and the seller is obliged to
honour the transaction. In this case, the seller will lose (ST − ET)*number of
shares.
► Example
An option writer sells the call option as he/she is bearish on the market and expects
prices to fall. Suppose he/she has sold Nifty index at a strike price of 2250 with a pre-
mium of INR 86.60. If at expiry, Nifty is below 2250, the profit is the amount of pre-
mium. If it rises above 2250, loss can be unlimited. . Figure 10.7 presents the pay-off
in this case. ◄
Pay-Off of a Put Option

As usual, the writer (seller) of a put option collects the premium from the buyer
of the option. If the stock price (ST) is greater than the exercise price
10.4 · Options
357 10
. Fig. 10.7 Pay-off of a call option seller. Source Authors’ compilation
(ET) on the expiration date, the buyer will not exercise the option, and the sell-
er’s liability will be nil. However, if the stock price (ST) is less than the exercise
price
(ET), the option holder will exercise the option, and the seller is obliged to
honour the transaction. In this case, the seller will lose (ET − ST)*number of
shares.
► Example
In selling the put option, the seller is bullish on the market and expects prices to rise.
Suppose he/she has sold an option on Nifty index at a strike price of 2250 with a pre-
mium of INR 61.70. If at expiry, Nifty is above 2250, the profit is the value of the pre-
mium. In contrast, if it falls below 2250, there will be a loss. . Figure 10.8 presents the
pay-off in this case. ◄
10.4.4 Speculative Strategies Based on Options
On the speculative front, the following two option strategies can be used to make
money in the bull/bear markets.
i. Bull Market Strategies
If an investor believes that a stock’s price is going to rise in the future (bullish
market), then there are three trades that he/she can make to profit from a ris-
ing stock price:
. Fig. 10.8 Pay-off of a put option seller. Source Authors’ compilation
5 buy the stock,

5 buy call options on the stock, or
5 write (short) put options on the stock.
ii. Bear Market Strategies

10 Similarly, if an investor believes that a stock’s price is going to fall in the fu-
ture (bearish market), then there are three trades that he/she can make to
profit from a falling stock price:
– sell the stock, and then buy (short sell) later,
– write (short) call options on the stock, or
– buy put options on the stock.
Concept in Practice 10.2: Multi Commodity Exchange (MCX) introduces Gold

Option Contracts
The Multi Commodity Exchange (MCX) in India has introduced gold option con-
tracts for the first time. This derivative instrument allows investors to enter into
contracts to either buy or sell gold sometime in the future at a predetermined price,
thus allowing investors to hedge any volatility in the price of the metal, for a pre-
mium.
Since the options usually turn out to be cheaper than the binding future agree-
ments, it would help in increasing the number of investors participating in the
agreement. The business of anticipating prices in the future is left to professional
speculators, while their clients benefit from the prospect of stable prices. In the pro-
cess, financial derivatives can facilitate the conduct of real economic activity in
higher risk segments that would not happen otherwise.
10.4 · Options
359 10
Apart from the standardized derivatives approved by SEBI for trading in ex-
changes, a framework that promotes OTC products will help improve the scope for
risk mitigation. The debut of gold options should be seen as a step towards greater
reforms.
10.5 Swaps
Definition
A swap is a contract between two parties to exchange one security for another on
or before the maturity dates. For example, in an interest rate swap, an investor can
swap a variable (floating) interest rate loan with a fixed interest rate loan.
“Currency swaps and “interest rate swaps” are the most popular swap contracts,
which are traded OTC amongst financial institutions. These contracts are typi-
cally not traded on exchanges. Therefore, retail investors, generally, do not partic-
ipate in trading of swaps.
10.6 Advantages of Derivatives
There are basically four types of advantages of using derivatives.

i. Earning Money without Physical Settlement
Through derivatives, an investor can earn money on shares which he/she does
not want to sell or trade in; instead, the investor can simply take advantage of
the fluctuations in its prices. Hence, derivatives help in the conduct of transac-
tions in which actual settlement (physical delivery) is not required.
ii. Arbitrage Trading
Investors can also gain through arbitrage trading in which they can benefit by
buying derivatives at a low price in one market and selling it in another market
at a higher price.
iii. Hedging against Price Fluctuations
In the derivatives market, one can protect his/her securities against price fluc-
tuations. It offers several products that allow an investor to hedge against a
fall in the price of the stocks under possession. On the other hand, there are
also products that protect investors from a rise in the price of stocks that they
want to purchase.
iv. Transfer of Risk
The most important use of derivatives is to transfer the risk. Derivatives can
transfer market risk from risk-averse investors to those investors who are risk
seekers or desire risk. Derivatives are used by risk-averse investors in order to
maintain safety and by risk loving investors to gain more profit by conducting
risky trades.
. Fig. 10.9 Advantages of derivatives. Source Kotak securities.com (2020) 7 https://www.kotaksecu-

rities.com/ksweb/Research/Investment-Knowledge-Bank/what-is-derivative-trading
► Example
. Figure 10.9 presents the advantages of derivatives. ◄
10
10.7 Participants in the Derivatives Market
The derivatives market consists of predominantly four types of players:

i. Hedgers
Hedgers are investors who wish to protect their investment from fluctuations
in prices by passing on their risk to those who are willing to take it.
ii. Speculators
Unlike hedgers, speculators look for opportunities to take on additional risk
in the hope of making higher returns, based on price forecasts. They could
further be classified as “day traders” or “position traders”.
iii. Margin Traders
Margin traders are more like brokers/dealers who provide margin financ-
ing and make the most of the leveraging potential of the markets to amplify
their gains. However, settlement issues need to be kept in check while being in-
volved in margin trading. Margin traders are also speculators.
iv. Arbitrageurs
Arbitrageurs exploit market imperfections and inefficiencies to their own ad-
vantage. These are generally low risk trade opportunities arising due to price
differentials of the same stock in two different markets. An arbitrageur buys
from a market where the price is low and sells in a market where the price is
high.
10.7 · Participants in the Derivatives Market
361 10
. Fig. 10.10 Derivatives trading participants. Source Kotak securities.com (2020) 7 https://www.ko-

taksecurities.com/ksweb/Research/Investment-Knowledge-Bank/what-is-derivative-trading
► Example
. Figure 10.10 presents the derivatives trading participants. ◄
10.8 Risks in Derivatives Contracts
Derivatives can create various types of risks during the process of trading. The
risks associated with derivative contracts are usually concentrated in such a way
that they cannot be readily absorbed within the financial system. Some of the
risks in derivative contracts are as follows:
i. Counterparty Risk
Also termed as default risk, legal risk and/or settlement risk, this kind of risk
arises when one of the parties to a derivative contract fails to meet the obliga-
tions stipulated. For instance, if one of the parties fails to pay up the agreed
amount as per the contract, it is said to be a default risk. Similarly, if a le-
gal contract is not framed properly for any derivative, it gives rise to legal risk.
Also, since derivatives are not traded across counters, any issue which crops
up related to settlements is called settlement risk.
Overall, the counterparty risks generally emanate from market to market ex-
posures, liquidity, operations, legal framework, collateral and settlement.
ii. Price Risk
Derivatives being traded over an exchange is a very recent phenomenon. The
derivative contracts are traded on the assumption that the exchange has ac-
cess to better information and knowledge as compared to all others involved.
However, there is an inherent risk that the exchange might misprice the deriv-
ative instruments and this could lead to a large-scale default. So, determining
the trading price of derivatives has become even more crucial now.
iii. Agency Risk
Agency risk also features in the list of probable risks associated with deriva-
tive trading. The company’s managers are primarily its agents and are likely to
enter into contracts that are more beneficial for them than for the company/
principal. For instance, if a manager finds derivative trading to be rewarding
to him personally in the short run, he/she is likely to divert more funds from
other investment avenues for derivative trading which could potentially inflict
huge losses on the principal (shareholders).
iv. Systemic/Market Risk
This pertains to the risks that are present inherently in the system. These risks
are manifested on account of movements in the interest rates, inflation and ex-
10 change rates. Swaps could be used for containing such risks.
> Value at risk (VaR) is a commonly used measure of risk. It calculates an ex-
pected loss in a given time period that may not be exceeded at a specified con-
fidence interval. Higher VaR generally indicates risky portfolio. Calculation of
VaR could be done with the following three methodologies:
Parametric: It assumes returns are normally distributed and standard deviation
of portfolio returns gives VaR.
Historical simulation: In this method, VaR is calculated from distribution of
historical returns.
Monte Carlo Simulation: In this method, VaR is calculated from distributions
constructed from random outcomes.
Concept in Practice 10.3: Risk Associated with Derivatives

Although derivatives were meant to be contracts which were to be used to hedge
risk or losses, they are now being used extensively as instruments of speculative
trade. In 2012, large investment firms like JP Morgan sat on $70 trillion invest-
ments, just in the form of derivatives. This amount was equivalent to the com-
bined GDP of the world, at that time.
The underlying assets for these derivatives were mostly home loans, car loans, etc.,
which could be a cause of concern and lead to a financial crisis, akin to the one in
2008.
10.8 · Risks in Derivatives Contracts
363 10
. Fig. 10.11 Process of creating a Mortgage Backed Obligation (MBO). Source Huffingtonpost

(2018)
Therefore, it is very important to remember and evaluate the quality of the under-
lying asset, rather than the package being offered as a derivative. Eventually, the
value of the derivative is derived from the value of the underlying asset, and if the
underlying asset is ‘garbage’, it has no value.
> Mortgage Backed Obligation (MBO)

. Figure 10.11 presents the process of creating a mortgage backed obligation
(MBO), a derivative created out of packaging home loans into securities. If the un-
derlying asset is risky (subprime), the derivative would only amplify that risk. It is
for this reason that Warren Buffet terms derivatives as “financial weapons of mass
destruction”. Hence, derivatives need to be treated with a lot of caution.
10.9 Conclusion
The biggest opportunity in derivatives trading is that investors have to pay a small
proportion of the value of the total contract (margin) to be able to trade.
If the underlying assets move in the favour of investors, the investments in deriv-
atives record very high returns. However, on the other hand, if the underlying assets
move in the opposite direction of the investor’s plan, heavy losses are also incurred.
Hence, derivative strategists and investors should be able to pick up the right stocks
and also keep track of the price movements till the expiry of the contract.
All in all, derivatives perform three very useful economic functions: risk trans-
fer, price discovery and market completion.
Risk transfer—Derivatives do not create risk; they merely allocate risk to in-
vestors who can bear the same. In distributing the risk amongst many investors,
derivatives act as a risk mitigation tool, almost like an insurance product.
Price discovery—Through derivatives, investors possessing superior informa-

tion regarding future prices feel motivated enough to participate and thus convey
this information to the rest of the market. This leads to enhanced price discovery
and better allocation of resources. Overall, the efficiency of the market also im-
proves.
Market completion—Though a theoretical concept, derivatives allow the intro-

duction of financial products which aim to target most contingencies and prof-
iting from the same. In this regard, it leads to the completion of the market, as
products are available to suit every type of investor and every investment need.
However, derivatives, due to the inherent speculation and volatility existing in
the market, should be treated with caution. If dealt with well, they can prove to
be an immensely successful risk mitigation tool.
Summary
10 5 Derivatives are financial contracts that obtain their value from an underlying as-
set. Assets (whether financial or real) like precious metals, commodities, equity
stocks, stock indices, foreign currency, real estate, treasury bills, loans or money,
etc., can form the underlying assets. The examples of derivatives are forward
contracts, futures, options, swaps, etc.
5 A forward is a trading agreement between two parties to buy or sell an underly-
ing asset, in the future, at a predetermined price.
5 A short position is one which commits the seller to deliver an item at the con-
tracted price on maturity. A long position is one which commits the buyer to
take delivery of an item at the contracted price on maturity.
5 In terms of pay-offs, when the spot price in future exceeds the contract price, the
forward buyer’s gain is spot price–contract price. Similarly, if it is the other way
round, the forward buyer’s loss is contract price–spot price. Hence, the pay-offs
in a forward contract are a zero-sum game since the buyer’s gain is the seller’s
loss and vice-versa.
5 Futures, as derivatives, are similar to forwards in concept, but they are standard-
ized contracts that are traded on stock exchanges (and not OTC like forwards).
Investors have the option to buy or sell the underlying asset at a certain date in
the future, at a specified price, and a specified quantity.
5 In the case of futures, only registered members of the exchange are allowed to
trade. These members can also trade on behalf of others. Every transaction is
between a “clearing member” and the exchange. A party through a “member”
deposits a margin, which is the minimum amount to be deposited to be able to
Summary
365 10
trade/transact. This margin can be in the form of cash/treasury bills. Further, a
minimum maintenance margin is required to be maintained at all times, in order
to carry on with trading.
5 In the marking-to-market process, all outstanding contracts are specified at the
settlement price of the day/session. The margin accounts of the loss-makers (on
that particular day) are debited and of those of the gainers are credited.
5 The different participants to the futures trade are as follows:
– Floor traders: who trade for their own accounts;
– Floor brokers: who trade on behalf of others, as agents, for a commission;
– Dual traders: who do both. They deal in their own accounts as well as act as a
broker for other traders.
5 Some of the benefits of the future contracts to the buyer (of the contract) are as
follows:
– The buyer remains unaffected by varying inflation as he/she has already
booked a price for the future transaction, and
– It helps the buyer to take further orders for a finished product from his/her cus-
tomers.
5 Some of the benefits of the future contracts to the seller (of the contract) are as
follows:
– It helps the seller to maintain its line of production and thus use resources
more efficiently.
– It helps to plan material procurement better on the basis of the future orders.
5 An “option” contract gives the buyer the right but not the obligation to buy/sell
the underlying asset at a predetermined price in the future. The buyer of the op-
tion pays a premium to buy the right from the seller of the option, who receives
the premium with an obligation to sell/buy the underlying assets if the buyer of
the option exercises his right. Options can be traded in both OTC markets and
exchanges.
5 The buyer of a call option expects the price to go up in the future, and hence, the
investor pre-buys a right to buy stocks at a predetermined price, on a future date.
5 The buyer of a put option expects the prices to fall in the future, where the in-
vestor pre-buys a right to sell stocks at a predetermined price, on a future date.
5 In case of a European call option (which can only be exercised on the expiration
date), the pay-off or cost of carry (C) depends on the relationship between the
stock price (ST) and the contract price/exercise price (ET). When ST is ≤ ET, the
call is said to be “out of money” and is worthless. When ST > ET, the call is said
to be “in money”, and the value is ST − ET.
5 The pay-off of a put option just before expiration depends on the relationship
between the exercise price (ET) and the stock price (ST). If ST < ET, the put op-
tion has a value of ET − ST and is said to be “in the money”. In contrast, if ST
is > ET, the put option is said to be “out of money” and is worthless.
5 The writer (seller) of a call option collects the premium from the buyer of the
option. If the stock price (ST) is less than the exercise price
5 (ET) on the expiration date, the buyer will not exercise the option, and the sell-
er’s liability will be nil. However, if the stock price (ST) is more than the exercise
price
5 (ET), the option holder will exercise the option, and the seller is obliged to hon-
our the transaction. In this case, the seller will lose (ST − ET)*number of shares.
5 Similarly, the writer (seller) of a put option collects the premium from the buyer
of the option. If the stock price (ST) is greater than the exercise price
5 (ET) on the expiration date, the buyer will not exercise the option, and the sell-
er’s liability will be nil. However, if the stock price (ST) is less than the exercise
price
5 (ET), the option holder will exercise the option, and the seller is obliged to hon-
our the transaction. In this case, the seller will lose (ET − ST)*number of shares.
5 If an investor believes that a stock’s price is going to rise in the future
5 (bullish market), then there are three trades that he/she can make to profit from
a rising stock price:
– buy the stock,
– buy call options on the stock, or
– write (short) put options on the stock.
5 Similarly, if an investor believes that a stock’s price is going to fall in the future
(bearish market), then there are three trades that he/she can make to profit from
a falling stock price:
– sell the stock and then buy (short sell),
– write (short) call options on the stock, or
– buy put options on the stock.
5 A swap is a contract between two parties to exchange one security for another
10 on or before the maturity dates. For example, in an interest rate swap, an inves-
tor can swap a variable (floating) interest rate loan with a fixed interest rate loan.
5 There are basically three types of advantages of using derivatives: earning
money without physical settlement, arbitrage trading and hedging against price
fluctuations (or transfer of risk).
5 The derivatives market consists of predominantly four types of players: hedgers,
speculators, margin traders and arbitrageurs.
5 Some of the risks in derivative contracts are counterparty risk, price risk,
agency risk and systemic/market risk.
5 Value at risk (VaR) is a commonly used measure of risk. It calculates an ex-
pected loss in a given time period that may not be exceeded at a specified confi-
dence interval. Higher VaR generally indicates risky portfolio.
10.10 Exercises

(i) _______________ are financial contracts that obtain their value from an un-
derlying asset.
10.10 · Exercises
367 10
(ii) A _________ is a trading agreement between two parties to buy or sell an
underlying asset, in the future, at a predetermined price.
(iii) A ________ position is one which commits the seller to deliver an item at
the contracted price on maturity.
(iv) _________ are similar to forwards in concept, but they are standardized
contracts that are traded on stock exchanges.
(v) In the ___________ process, all outstanding contracts are specified at the
settlement price of the day/session. The margin accounts of the loss-makers
(on that particular day) are debited and of those of the gainers are credited.
(vi) An _________ gives the buyer the right but not the obligation to buy/sell
the underlying asset at a predetermined price in the future.
(vii) The buyer of a call option expects the price to _________ in the future, and
hence, the investor pre-buys a right to buy stocks at a predetermined price,
on a future date.
(viii) The buyer of a put option expects the prices to ________ in the future,
where the investor pre-buys a right to sell stocks at a predetermined price,
on a future date, for a premium.
(ix) A __________ is a contract between two parties to exchange one security
for another on or before the maturity dates.
(x) _____________ is a commonly used measure of risk. It calculates an ex-
pected loss in a given time period that may not be exceeded at a specified
confidence interval.
v
(Answers: (i) Derivatives (ii) Forward (iii) Short (iv) Futures (v) Mark-to-market
(vi) Option (vii) Rise (viii) Fall (ix) Swap (x) Value at risk (VaR)).
? 2. True/False
(i) Some examples of derivatives are forward contracts, futures, options, swaps,
etc.
(ii) A short position is one which commits the buyer to purchase an item at the
contracted price on maturity.
(iii) Futures, as derivatives, are similar to forwards in concept, but they are
standardized contracts that are traded on stock exchanges.
(iv) In the case of futures, only registered members of the exchange are allowed
to trade.
(v) In the marking-to-market process, all outstanding contracts are specified at
the settlement price of the day/session.
(vi) A “swap” contract gives the buyer the right but not the obligation to buy/
sell the underlying asset at a predetermined price in the future.
(vii) A option is a contract between two parties to exchange one security for an-
other on or before the maturity dates.
(viii) The derivatives market consists of predominantly four types of players:
hedgers, speculators, margin traders and arbitrageurs.
(ix) Some of the risks in derivative contracts are counterparty risk, price risk,
agency risk and systemic/market risk.
(x) Value at risk (VaR) measures the standard deviation of prices.
v
(Answers: (i) True (ii) False (iii) True (iv) True (v) True (vi) False (vii) False
(viii) True (ix) True (x) False).
? SQ1. Margin requirement

Suppose, the Euro is trading at INR 90, currently. It also appears that the Euro is
strengthening against the rupee. If an investor enters into a 3-months’ futures con-
tract to sell Euro at INR 100, he/she will make money if the rupee depreciates fur-
ther. The contract size is INR 100,000, and the margin requirement is 3% of the
contract value. Calculate the value of the margin requirement per contract.
v The value of the margin would be

Margin requirement*contract value = 0.03*100,000 = INR 3000.
? SQ2. Buyer of call option

An investor buys call option when he/she is bullish on the market and expects
prices to rise. Suppose he/she has bought an option on Nifty index at a strike price
INR 2500 after paying a premium INR 50.
a. If at expiry, Nifty is above INR 2700, will he exercise the option? What would
the profit/loss be?
b. If Nifty falls to INR 2250, what would the profit/loss be?
10
v a. If Nifty rises to INR 2700, he/she will exercise the option. The value of the
option would be ST − ET or INR 2700–INR2500 = INR 200.
His/her net gain would be INR 200-premium paid (INR50) = INR 150.
b. If Nifty falls to 2250, his/her loss will be limited to the premium paid (INR
50) as he/she will not exercise the option and let it expire.
? SQ3. Buyer of put option

An investor buys a put option as he/she is bearish on the market and expects
prices to fall. Suppose he/she has bought an option on Nifty index at a strike price
INR 2500 after paying a premium INR 50.
a. If at expiry, Nifty is above INR 2700, will he exercise the option? What would
the profit/loss be?
v a. If at expiry, Nifty is above INR 2700, his/her loss will be limited to the pre-
mium paid (INR 50) as he/she will not exercise the option and let it expire.
b. If Nifty falls to 2250, he/she will exercise the option. The value of the put op-
tion would be ET − ST or INR 2500–INR2250 = INR 250.
His/her net gain would be INR 250-premium paid (INR50) = INR 200.

10.10 · Exercises
369 10
? SQ4. Seller of call option
An option writer sells the call option as he/she is bearish on the market and ex-
pects prices to fall. Suppose he/she has sold 50 shares at a strike price of 150 at a
premium of INR 60.
a. If at expiry, share price is INR 100 what is the profit/loss?
b. If it rises to INR 180, what is his profit/loss?
v a. If at expiry, share price is INR 100, his profit is the amount of premium
(INR 60).
b. If at expiry, share price rises to INR 180, his loss is (ST − ET)*number of
shares = (180–150)*50–60 = 30*50–60 = INR 1500–60 = INR 1440.
? SQ5. Seller of put option

In selling the put option, the seller is bullish on the market and expects prices to
rise. Suppose he/she has sold 50 shares at a strike price of 150 at a premium of
INR 60.
a. If at expiry, share price is INR 100, what is the profit/loss?
b. If at expiry, share price rises to INR 180, what is his profit/loss?
v a. If at expiry, share price is INR 100, his loss is (ET − ST)*number of

shares = (150–100)*50 -60 = 50*50–60 = INR 2500–60 = INR 2440.
b. If at expiry, share price is INR 180, his profit is the amount of premium
(INR 60).
? UQ1. Margin requirement

Suppose, the Pound is trading at INR 100, currently. It also appears that the
Pound is strengthening against the rupee. If an investor buys a 3-months’ futures
contract to sell Pound at INR 110, he/she will make money if the rupee depreci-
ates further. The contract size is INR 300,000, and the margin requirement is 4%
of the contract value. Calculate the value of the margin requirement.
[Answer: INR 12,000]
? UQ2. Buyer of call option

An investor buys call option when he/she is bullish on the market and expects
prices to rise. Suppose he/she has bought an option on Nifty index at a strike
price of INR 3000 after paying a premium INR 80.
a. If at expiry, Nifty is at INR 3500, will he exercise the option? What would the
profit/loss be?
[Answer: a. INR 500, net gain INR 420; b. INR 80]
? UQ3. Buyer of put option

An investor buys the put option as he/she is bearish on the market and expects
prices to fall. Suppose he/she has bought a put option on Nifty index at a strike
price INR 3200 after paying a premium INR 60.
a. If at expiry, Nifty is at INR 3500, will he exercise the option? What would the
profit/loss be?
[Answer: a. INR 60; b. INR 700, net gain INR 640]
? UQ4. Seller of call option

An option writer sells the call option as he/she is bearish on the market and ex-
pects prices to fall. Suppose he/she has sold 100 shares at a strike price of 100 at
a premium of INR 100.
b. If it rises to INR 120, what is his profit/loss?
[Answer: a. INR 100; b. INR 1900]
? UQ5. Seller of put option

In selling the put option, the seller is bullish on the market and expects prices to
rise. Suppose he/she has sold 100 shares at a strike price of 150 at a premium of
INR 100.
b. If at expiry, share price rises to INR 180, what is his profit/loss?
[Answer: a. INR 4900; b. INR 100]

10
? 1. What are derivatives?
2. What are the key differences between forwards and futures?
3. What is the “marking-to-market” concept? Give an example.
4. Who are the participants in the derivatives market?
5. What are the types of options?
6. What are the pay-offs from options in case of the buyer?
7. What are the pay-offs from options in case of the seller?
8. How are derivatives advantageous?
9. What are the risks associated with derivatives?
? 1. Discuss the pros and cons of using derivatives.

(Hint: Derivatives should be used in a balanced way with an eye on the fundamen-
tal strength of the underlying asset.)
2. Build a caselet (example) around the usage of three derivatives.
(Hint: For example, you can have a manufacturer who imports raw materials.)
10.10 · Exercises
371 10
? This Can Be Used As a Class Exercise

Divide the class into 3–4 groups. Each group should trace the growth of one par-
ticular derivative, with emphasis on the underlying asset(s). Discuss the findings in
class. What does this say about the derivatives market? Support your findings with
those of consultancy reports, market reports, etc.
Additional Readings
Fisher, D. E., & Jordan, R. J. (1995). Security analysis and portfolio management, 4th edn. Pren-
tice-Hall.
son Education.
South-Western.
Reading
Huffington Post Website. (2018). Available at 7 https://www.huffingtonpost.com/ron-galloway/70-tril-
lion-reasons-jp-mo_b_1527013.html. Accessed on October 1, 2018.
373
Supplementary
Information
Index – 374
© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer
Nature Singapore Pte Ltd. 2021
S. Singh and S. Yadav, Security Analysis and Portfolio Management, Classroom Companion:
Business, https://doi.org/10.1007/978-981-16-2520-6
Index
A Correlation 91, 94–96, 100, 101, 110

Corruption index 119, 145
Active strategy 303, 339 Corruption Perceptions Index (CPI) 119, 122,
Advance/decline ratio 160, 161, 176, 177 145, 147, 148
Affect bias 73 Coupon 184, 185, 190–195, 200, 201, 204,
Anchoring/disposition/adjustment bias 59, 65, 206–210, 223, 225, 227, 228, 230, 234
72, 73 Covariance 91, 94–96, 105, 106, 111
Arbitrage 61, 73, 75 Current yield 190, 201, 207, 224, 225, 227
Arbitrage Pricing Theory (APT) 278, 279, 281,
285, 286, 292, 315, 318, 319, 327, 330
Arbitrageurs 360, 366, 367 D
Debenture 183, 190, 223, 227, 236
B Default risk 195, 201, 224
Derivatives 11, 18, 20, 25, 27, 36, 42, 343–345,
Bar and line charts 164, 168, 176 350, 352, 353, 358–364, 366, 367, 370, 371
Bear trend 155, 176, 178 Diffusion indices 122, 145
Behavioral biases 55, 56, 61 Discount bond 186, 210, 224, 228
Behavioral finance 54, 60, 61, 73–75 Diversification 298–300, 309, 313, 327
Beta 265, 269–277, 279, 283, 284, 286, 288–292 Dividend discount model 213, 226, 232, 233
Bollinger bands 169–171, 176–178 Dow theory 156–158, 176–178
Bond 183, 185–187, 189–196, 198–201, 203–
210, 221, 223–225, 227–231, 234, 235
Book Value Per Share (BVPS) 216, 226, 233, E
235
Bubbles 62–64, 72–75 Earnings Per Share (EPS) 126, 131, 133, 134,
Bullet maturity 185, 223, 228 141, 142, 146–148
Bull trend 154 Economic Value Added (EVA) 137
Business sector 7–10 Efficient market 256, 266, 278, 282, 285, 286,
292
Efficient Market Hypothesis (EMH) 52, 56, 72,
C 74, 75, 238, 239, 245, 246, 251
E-I-C analysis 115, 137, 139, 144, 145
Calendar anomaly 243, 249 Elliott wave principle 156, 158, 176–178
Capital Asset Pricing Model (CAPM) 211, 212, Equity 7, 8, 14–16, 20, 22, 25, 26, 29, 30, 32,
221, 225, 228, 233, 235, 265–270, 272–279, 34–36, 38, 39, 42, 43, 45, 47, 48
281, 283–285, 288, 290, 291 Equity premium puzzle 64, 72, 73, 75
Capital market 8, 9, 14, 15, 38, 42, 49 Expectations hypothesis 225, 235
Chaos theory 159, 160, 176–178
Chart analysis 163, 168, 176, 178
Clause 49 of the Listing Agreement 248, 250, F
251
Coefficient of variation 84, 88, 92, 94, 96–102, Fama and French three-factor model 277, 278,
109, 110, 112 285
Confidence index 161, 176, 177 Fibonacci series 156, 171, 172, 176, 178
Confirmation bias 54, 56, 57, 72 Financial analysis 133, 148
Conservatism 56, 72, 76 Financial assets 11–14, 18–20, 25, 26, 36, 38,
Constant ratio plan 320, 321, 328–330, 333, 42, 48, 49
334, 337, 339 Financial engineering 36, 43
Constant rupee value plan 320, 328, 336, 339 Fiscal and monetary frameworks 120, 145
Consumer spending 119, 145 Fixed income (debt) securities 18, 21, 22,
Corporate governance 38, 43 24–26, 42
375 G–P
Index
Forecasting errors 55, 72, 74 K

Foreign exchange reserves 119, 145
Formula plans 319, 320, 325, 328, 330, 333, 339 Kondratiev wave theory 159, 176–178
Forward 344–347, 350–353, 364, 367, 370 Kurtosis 88, 89, 94, 96, 111
Framing 58, 72–74, 76
Fundamental analysis 114, 115, 139, 140,
142–148, 152–154, 175, 176, 178 L
Futures 344–354, 357, 358, 364–370
Law of one price 61, 62, 73, 75
Leveraged portfolios 263, 283, 286
Liquidation Value Per Share (LVPS) 216, 217,
G 226, 228, 234, 235
Genetic algorithms 159, 160, 176–179 Liquidity effect anomaly 244, 249, 251
Globalization 34, 43 Liquidity premium hypothesis 225, 235
Government sector 7, 9, 10, 42 Liquidity risk 199, 200, 205, 225
Grinblatt and Titman’s PCM 315, 330 Loss aversion bias 57, 72
Gross Domestic Product (GDP) 115, 118, 120,
122, 145, 147, 148
M
Macaulay Duration (MD) 209, 225, 231
H Margin traders 360, 366, 367
Head and shoulders pattern 164, 176 Market efficiency 238–242, 247–252
Hedgers 360, 366, 367 Market risk/systematic risk/non-diversifiable
Hindsight bias 57, 72, 74 risk 266–270, 274, 276–278, 281, 283–286,
Holding-Period-Yield (HPY) 224, 228 292
Household sector 7, 9, 10, 27 Market segment hypothesis 225
Markowitz Portfolio Theory (MPT) 256, 257,
259–261, 263, 264, 266, 281–283, 285, 286,
I 290, 292
Mean-variance 256, 278, 282, 286, 292
Immunization 208, 209, 211, 223, 225 Mental accounting 58, 72–75
Indenture 185, 186, 194, 196, 197, 224, 228 Money 3–6, 8, 9, 11, 12, 14, 19, 20, 27, 37, 38,
Index 16, 18, 43, 44, 48 42–44
Industrial growth rate 119, 145 Money market 8, 14, 15, 22, 23, 42
Industry/sector classifications 123, 145–148 Moving averages 156, 169, 170, 176–178
Inflationary trends 120, 145 Mutual fund 21, 25, 26, 33, 36, 38, 42, 49
Information asymmetry 239, 245, 248 Myopic loss aversion 64, 72, 73, 75
Information processing/cognitive errors 55, 72,
75, 76
Insider trading 173, 177, 178 N
Instalment 185, 197, 223
Insurance 20, 25–27, 36, 42, 49 Net Worth Per Share (NWPS) 216, 226
Interest rate 185, 187, 188, 190, 192, 199–202, Neural networks 159, 160, 176–179
204–208, 221–225, 227, 230, 231, 234, 235
Interest rate risk 194, 199, 200, 203, 208, 210,
225 O
Intrinsic value 114, 133, 138, 144, 145, 147
Odd lot ratio 162, 176, 177
Investment 3, 8, 9, 12, 15, 16, 18, 20–22, 24–30,
Optimism bias 58, 72, 74
32–40, 42–44, 47–49
Option 344, 345, 353–359, 364–370
Overconfidence 56, 66, 72, 76
J
Jensen’s differential return measure 315, 317, P
327, 330
Par value 185, 223, 229, 230
376 Index
Passive strategy 303, 339 Short selling 263, 283, 285, 286
P/E ratio 134, 140, 142, 147, 148 Single index model 265, 283, 285, 286
Political, Economic, Social, Technological, Size effect anomaly 243, 244
Legal and Environmental (PESTLE) 123, Skewness 88, 89, 94, 96, 111
145, 147, 149 Socially responsible investing 71, 72, 75
Portfolio 297–323, 325, 327–339 Speculation 28
Portfolio management 297–301, 303, 304, 314, Speculative motive 6, 42
327, 329, 330, 339 Speculators 348, 358, 360, 366, 367
Portfolio return 83, 90, 91, 95, 96, 100, 105, Spreads 172, 173, 176–178
106, 111 Standard deviation 84–88, 90–92, 94–104,
Portfolio risk 90, 91, 95, 96, 100, 106, 109, 111 106–111
Post earnings announcement drift (PEAD) Statement of investment policy 303, 311, 313,
anomaly 245, 249, 251 314, 327, 329, 330, 339
Precautionary motive 5, 42 Stock market anomalies 242–244, 249, 251
Precious objects 25, 42 Strategic asset allocation 303, 308–310, 312,
Preferred habitat hypothesis 225, 235 327, 329
Premium bond 186, 224 Strengths, Weaknesses, Opportunities and
Primary market 15, 42 Threats (SWOT) 116, 123, 145, 147, 149
Prospect theory 60, 73–75 Strong form efficiency 239, 240, 248, 251
Purchasing power risk 194 Support and resistance levels 163, 164, 166,
172, 176, 179
Survivorship bias 59, 73–75
R Swap 344, 359, 362, 364, 366, 367
Systematic risk 194, 199, 224
Real assets 11, 12, 19, 36, 38, 42
Real estate 11, 12, 20, 25, 30, 41–43
Regret avoidance 58, 72–74
Reinvestment rate risk 194, 199, 208, 211, 225
T
Relative strength analysis 162, 176, 177 Technical analysis 152–154, 156, 157, 164, 166,
Return 80–106, 108–112, 256–266, 268–292 167, 169, 172, 174–176, 178, 179
Risk 12, 13, 19–22, 25–31, 34, 35, 38, 42–45, Technical indicators of the witchcraft vari-
47, 48, 52–54, 58–61, 65, 66, 68, 69, 72–76, ety 173, 177, 178
80, 81, 84–94, 96, 97, 99–101, 103, 105, 106, Transaction motive 5, 6, 42, 44
108–112, 256–271, 273–288, 290–292 Treynor’s reward-to-volatility ratio 315–317,
Risk premium 268, 269, 274, 277, 279, 283, 327, 328, 330, 331
286, 288, 291, 292 Triangle patterns 164, 167, 168, 176
Rupee cost averaging 320, 323, 324, 328–330,
336, 338, 339
U
S Unique risk/diversifiable risk/unsystematic
risk 266–268, 283, 286, 292
Sample size neglect and representativeness 56, Unsystematic risk 194, 195, 224
72 Utility maximization 53, 72
Sarbanes-Oxley Act (SOX) 248, 250, 251
Secondary market 15, 42
Securitization 36, 37, 43 V
Security 3, 14–16, 18, 20, 21, 24–26, 29, 31–38,
Value at Risk (VaR) 362, 366, 367
42–44, 47–49
Value effect anomaly 244, 249
Security analysis and portfolio management 3,
Variable ratio plan 320, 322, 328, 329, 339
34, 38, 39
Variance 84, 85, 87, 90–92, 94–103, 105, 106,
Security return 29, 31, 34, 43
108–111
Semi-strong efficiency 239, 248, 251
Sharpe’s reward-to-variability ratio 315, 327,
330
Short interest ratio theory 161, 176, 177
377 W–Y
Index
W Y
Weak form efficiency 239, 242, 248, 251 Yield curve 183, 201–207, 223, 225, 235
World Bank 117, 118, 145 Yield-to-Maturity (YTM) 185, 191–195, 201,
World Trade Organization (WTO) 117, 118, 207–210, 224, 228–230, 234
145, 147, 148
WPI 119, 145

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Classroom Companion: Business

More information about this series at 7 http://www.springer.com/series/16374

ISSN 2662-2866 ISSN 2662-2874 (electronic)

Our Family Members

The course “Security Analysis and Portfolio Management” is typically taught as

2.12.1 Objective (Quiz) Type Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

3 Concept of Risk and Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

4 Fundamental Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

5 Technical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

6 Bond and Equity: Valuation and Investment Strategies. . . . . . . . . . . . . . . . . 181

7 Market Efficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237

7.3.3 Weak Form Efficiency. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242

8 Diversification of Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255

9 Portfolio Management: Process and Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . 295

10.10.5 Discussion Questions (Points to Ponder). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370

Supplementary Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373

About the Authors

Prof. Shveta Singh

Prof. Surendra S. Yadav

APT Arbitrage pricing theory ROEF Return on equity funds

Fig. 1.1 Two-sector economy. Source Authors’ compilation . . . . . . . . . . . . . . . . . . . 8

Fig. 5.10 Candlestick chart of IOCL (July–October, 2017). Source Authors’

Table 1.1 Consumer spending (transaction motive) in percentage for some

1.2 A Broad Map of the Territory of Investments – 3

1.3 Concept of Risk and Return – 28

1.4 Basic Criteria/Factors/Attributes

1.5 What is Security Analysis and Portfolio

1.6 Contemporary Trends in the Investment

Additional Readings and References – 49

1.2 A Broad Map of the Territory of Investments

Economics is the forerunner of finance. Hence, to understand any financial topic

However, some of the problems with the barter system were:

Illustration 1.1: Evolution of Money

Motives for Money

z Point to Ponder 1.1: Consumer Spending Pattern in India

Interest/Dividends: Reward for Sacrificing Consumption

Items Rural India Urban India

Source Reserve Bank of India (RBI) (a) (2020)

1.2.2 Sectors in an Economy

Initially, the world economy depended on physical goods or commodities—items

The extent of growth of material wealth in any economy is dependent on how

Business Savings Capital Savings

Goods and services

. Fig. 1.1 Two-sector economy. Source Authors’ compilation

Income/Goods and services

Taxes/goods and services Services/Income

. Fig. 1.2 Three-sector economy. Source Authors’ compilation

1 Consumption plus net exports Rest of Labour/Payments

Taxes/goods and services S ervices/Income

. Fig. 1.3 Four-sector economy. Source Authors’ compilation

Since we are living in a global world, it is important for us to also under-

1.2.3 Real Assets and Financial Assets

1.2.4 Importance of Financial Assets

Category FY 2018 FY 2017 Y-O-Y % Proportion % Proportion

Illustration 1.2: Holding of Financial and Physical Assets in India

1.2.5.1 Classification of Financial Markets

Anyway, as a matter of distinction, money markets would have short-term debt

Debt Instruments Preference Equity Stock

Money Capital Market

. Fig. 1.4 Classification of financial markets by maturity of claim. Source Authors’ compilation

1 Fixed Income Instruments Residual Income Instruments

Debt Preference Stock Equity Stock

Debt Market Equity Market

More information about this series at 7 http://www.springer.com/series/16374

APT Arbitrage pricing theory ROEF Return on equity funds

Fig. 1.1 Two-sector economy. Source Authors’ compilation . . . . . . . . . . . . . . . . . . . 8

Fig. 5.10 Candlestick chart of IOCL (July–October, 2017). Source Authors’

Table 1.1 Consumer spending (transaction motive) in percentage for some

1.2 A Broad Map of the Territory of Investments – 3

1.3 Concept of Risk and Return – 28

1.4 Basic Criteria/Factors/Attributes

1.5 What is Security Analysis and Portfolio

1.6 Contemporary Trends in the Investment

1.2 A Broad Map of the Territory of Investments

1.2.2 Sectors in an Economy

. Fig. 1.1 Two-sector economy. Source Authors’ compilation

. Fig. 1.2 Three-sector economy. Source Authors’ compilation

. Fig. 1.3 Four-sector economy. Source Authors’ compilation

1.2.3 Real Assets and Financial Assets

1.2.4 Importance of Financial Assets

1.2.5.1 Classification of Financial Markets

. Fig. 1.4 Classification of financial markets by maturity of claim. Source Authors’ compilation

. Fig. 1.5 Classification of financial markets by type of claim. Source Authors’ compilation

1.2.5.2 Functions of Financial Markets

1.2.5.3 Role of Financial Markets

. Fig. 1.6 Negotiable certificate of deposit (CD). Source RBI (c) (2020)

. Table 1.4 Changing pattern of asset-wise retail investor wealth in India

1.3 Concept of Risk and Return

i Beta is denoted by ß (beta) and is calculated as per Eq. 1.4:

1.5 What is Security Analysis and Portfolio Management?

1.6 Contemporary Trends in the Investment Environment

(PPF) withdrawal allowed after 6 years). offered in the govern-

. Table 1.6 Foreign direct investment flows to India: country-wise and industry-wise

1.8.1 Objective (Quiz) Type Questions

1.8.2 Solved Numericals (Solved Questions)

1.8.3 Unsolved Numericals (Unsolved Questions)

1.8.4 Short Answer Questions