Investment Analysis and Management This document is only for reference and for practical problems refer the class notes hapter 1 BASICS OF INVESTMENTS Investment Investment refers to the allocation of funds or resources with the expectation of generating a financial return. It involves committing capital to various financial instruments, assets, or projects in the hopes of earning profits or increasing wealth over time Difference between Investment, Trading and Speculation: Investment: Investment involves allocating funds with a long-term perspective and the intention of generating returns over an extended period. Investors typically aim to build ‘wealth steadily over time through the appreciation of assets or the generation of income. Investments are often made in assets such as stocks, bonds, real estate, or mutual funds, with a focus on fundamental analysis and evaluating the intrinsic value of the asset. Investors typically have a diversified portfolio and tend to take a more passive approach, holding their investments for the long term ‘Trading: Trading involves buying and selling financial instruments (such as stocks, currencies, commodities, or derivatives) with the objective of generating short-term profits from market fluctuations. Traders typically analyse technical indicators, market trends, and price patterns to make short-term trading decisions. The holding period for trades can range from seconds to days, weeks, or months. Traders may use various strategies, such as day trading, swing trading, or momentum trading, and often employ leverage to amplify potential ‘gains (and losses). Unlike investors, traders are more active in the market, seeking to exploit short-term price movements. Speculation: Speculation involves taking calculated risks in the financial markets with the aim of profiting from anticipated price changes. Speculators typically rely on market trends, news, or rumours to predict short-term price movements, rather than fundamental analysis or long-term value. Speculation is often associated with higher risk and can involve complex trading strategies. Speculators may engage in derivative trading, such as options or futures contracts, to leverage their positions and potentially amplify returns, Unlike investors and traders, speculators often have a shorter time horizon and are willing to take on greater risk for the potential of higher rewards.Investment Analysis and Management This document is only for reference and for practical problems refer the class notes Process of making and Managing Investments. 1 Set Financial Goals: Start by defining your financial goals. Determine what you want to achieve through your investments, such as retirement planning, funding education, buying a house, or generating additional income Assess Risk Tolerance: Evaluate your risk tolerance, which refers to your ability and willingness to withstand fluctuations in the value of your investments. Consider factors such as your age, financial situation, investment knowledge, and comfort level with market volatility Develop an Investment Plan: Create a well-defined investment plan based on your financial goals and risk tolerance. Consider factors like asset allocation, diversification, investment horizon, and the types of investments that align with your objectives Research and Analysis: Conduct thorough research on different investment options available, such as stocks, bonds, real estate, mutual funds, or other financial instruments. Analyse the performance, historical data, and potential risks and rewards associated with each investment option. Select Investments: Based on your research and analysis, choose investments that align with your investment plan and goals. Consider factors like asset class, expected returns, liquidity, investment fees, and the overall fit with your risk profile, Execute the Investment: Open brokerage or investment accounts to facilitate the purchase of your chosen investments. Follow the necessary procedures and provide the required information to complete the investment transactions. Monitor and Review: Regularly monitor the performance of your investments, Stay informed about market trends, economic indicators, and news that may impact your investments. Review your portfolio periodically and make adjustments if needed, considering factors like changing market conditions or shifis in your financial goals Risk Management: Implement risk management strategies to protect your investments, ‘This may include diversifying your portfolio, setting stop-loss orders, or using hedging techniques to mitigate potential losses. Stay Informed and Educated: Continuously educate yourself about investment strategies, market dynamics, and financial trends. Stay updated with changes in regulations or tax laws that may impact your investments, Seek Professional Advice: Consider consulting with a financial advisor or investment professional who can provide personalised guidance and help you make informed investment decisions.Investment Analysis and Management This document is only for reference and for practical problems refer the class notes Investment goals and Constraints Investment Goals: ‘They can be classified into ‘Wealth Accumulation: This goal focuses on growing capital over the long term to achieve financial independence, retirement, or funding specific financial goals suc buying a home or paying for education. Income Generation: The objective is to generate a regular stream of income to meet ‘ongoing expenses or supplement existing income sources, Capital Preservation: This goal emphasises protecting the initial investment and avoiding significant losses, making it suitable for conservative investors with a low tolerance for risk. Capital Appreciation: This goal aims to achieve substantial growth in investment capital by targeting higher-risk, higher-reward opportunities. Constraints: a ‘Time Horizon: The time frame within which you expect to achieve your investment goals is an essential consideration, It can range from short-term (less than one year) to intermediate-term (1-5 years) to long-term (more than 5 years). Longer time horizons generally allow for a greater tolerance of risk and potentially higher returns Risk Tolerance: risk tolerance refers to your comfort level with market fluctuations and the potential for investment losses. It is influenced by factors such as your financial situation, investment knowledge, time horizon, and emotional resilience Regulatory and Legal Constraints: Certain investment activities may be subject to legal restrictions or regulatory requirements. For example, institutional investors like pension funds may have restrictions on the types of assets they can invest in or limitations on the maximum allocation to a particular asset class Ethical or Social Constraints: Some individuals or institutions may have specific ethical, moral, or social considerations that guide th involve avoiding investments in industries such as tobacco, firearms, or fossil fuels, or actively seeking out socially responsible investment opportunities. wvestment choices. This could Tax Considerations: Tax implications can significantly impact investment decisions Factors such as the tax efficiency of different investment vehicles, capital gains taxes, and tax benefits associated with specific investments should be taken into account,Investment Analysis and Management This document is only for reference and for practical problems refer the class notes hapter 2 ESTMENT ALTERNATIVES Non-marketable securities Non-marketable securities are financial instruments that cannot be easily bought or sold in the secondary market, Unlike marketable securities, which are traded on organized exchanges or over-the-counter markets, non-marketable securities have limited liquidity and are generally held until maturity. 1. Savings Bonds: These are debt securities issued by the government to individual inyestors. They typically have a fixed interest rate and a specific term to maturity. Savings bonds cannot be traded on the open market but can be redeemed with the government issuer, 2. Certificates of Deposit (CDs): CDs are time deposits offered by banks and financial institutions. They have a fixed term and pay a predetermined interest rate. While some CDs may be traded in the secondary market, most are non-marketable, meaning they cannot be easily bought or sold before maturity. 3. Private Placements: Private placements are offerings of securities that are not registered with regulatory authorities for public sale. These securities are typically sold directly to a limited number of institutional or accredited investors and are not freely tradable in public markets. 4, Employee Stock Ownership Plans (ESOPs): ESOPs are retirement plans that provide employees with an ownership stake in the company they work for. The shares issued through ESOP are often non-marketable, meaning they cannot be freely bought or sold on public exchanges Money market instruments Money market instruments are short-term debt securities issued by governments, financial institutions, and corporations. These instruments are highly liquid and typically have a maturity of one year or less. They are often considered low-risk investments and serve as a ‘way for institutions and individuals to park their cash or earn a modest return while preserving capital. Here are some common types of money market instruments: 1. Treasury Bills (T-Bills): T-Bills are short-term debt obligations issued by governments, usually with maturities ranging from a few days to one year. They are considered one of the safest money market instruments because they are backed by the government's credit. T-Bills are typically sold at a discount to their face value and mature at par, providing investors with the difference as their returnInvestment Analysis and Management This document is only for reference and for practical problems refer the class notes Certificates of Deposit (CDs): CDs are time deposits offered by banks and financial institutions. They have a fixed term, which can range from a few weeks to several years. CDs pay a fixed interest rate and are insured by the Federal Deposit Insurance Corporation (FDIC) in the United States up to certain limits, making them relatively low-risk investments Commercial Paper: Commercial paper represents short-term unsecured promissory notes issued by corporations and financial institutions to raise funds for their short-term financing needs. It typically has a maturity ranging from a few days to nine months, Commercial paper is considered a relatively safe money market instrument but carries a slightly higher level of risk compared to government-backed securities, Repurchase Agreements (Repo): Repos involve the sale of securities, typically government bonds, with an agreement to repurchase them at a later date and a slightly higher price. Repos serve asa short-term borrowing tool for financial institutions and are commonly used in money market operations to manage liquidity Banker's Acceptances: Banker's acceptances are short-term time drafts or bills of exchange issued by a bank, representing a guarantee of payment to a seller of goods or services. They are commonly used in international trade transactions and are often regarded as low-risk money market instruments. Fixed income securities Fixed income securities are investment instruments that provide a fixed or predictable stream of income to investors over a specific period. These securities represent debt obligations issued by governments, municipalities, corporations, or financial institutions to raise capital They are called "fixed income" because they typically pay a fixed interest rate or coupon payment to investors at regular intervals until maturity. Here are some common types of fixed income securities: 1 Government Securities (G-Secs): G-Secs are fixed income securities issued by the Government of India to fund its fiscal requirements. These securities have tenures ranging from short-term (Treasury Bills) to long-term (bonds). G-Secs are considered to have low credit risk as they are backed by the government. ifferent Treasury Bills (T-Rills): T-Bills are short-term debt instruments issued by the Reserve Bank of India (RBI) on behalf of the government. They have maturities of 91 days, 182 days, or 364 days and are issued at a discount to their face value. The difference between the issue price and the face value represents the investor's return State Development Loans (SDLs): SDLs are debt securities issued by state governments in India to raise funds for their development activities. These securitiesInvestment Analysis and Management This document is only for reference and for practical problems refer the class notes have different tenures and coupon payments, and their interest income is generally exempt from federal taxes. 4, Corporate Bonds: Corporate bonds are debt instruments issued by companies to raise capital. They offer fixed interest payments (coupons) to investors until maturity when the principal amount is repaid. Corporate bonds in India have varying credit ratings, reflecting the creditworthiness of the issuer. 5, Debentures: Debentures are similar to corporate bonds but are typically unsecured debt instruments issued by companies. They pay fixed interest to investors and have specified maturity dates. Debentures may have different features such as convertible debentures that can be converted into equity shares of the issuing company. 6. Public Provident Fund (PPE): PPF is a long-term fixed income investment option offered by the Government of India. It is a popular savings scheme that provides tax benefits and offers a fixed interest rate. The maturity period of a PPF account is 15 years, and it can be extended in blocks of five years 7. Fixed Deposit (FD) Fixed deposits are offered by banks and non-banking financial institutions (NBFCs) in India. They involve depositing a specific amount for a fixed term, and the depositor receives interest on the deposit. Fixed deposits offer various tenures and interest rate options 8. Non-Convertible Debentures (NCDs): NCDs are debt instruments issued by ‘companies that cannot be converted into equity shares. They offer a fixed interest rate and have a specific maturity period Equity Shares Itisa financial instrument issued for raising capital for a company. It is a long term instrument issued to investors(private and public) which has voting rights, rights to profit, claim on assets but with no maturity or redeemable ability but transferable. Holder of an equity share is the fraction or full owner of the company depending on the percentage of shareholdings. It generally provides greater return but also carries a greater level of risk. Returns can be in the form of capital appreciation and divided. Risk is based on the company performance and its stability Mutual Fund ‘A mutual fund is an investment vehicle that pools money from multiple investors to invest in a diversified portfolio of securities such as stocks, bonds, and other assets. It is managed by professional fund managers who make investment decisions on behalf of the investorsInvestment Analysis and Management This document is only for reference and for practical problems refer the class notes Features of Mutual Fund: 1. Diversification: Mutual funds offer diversification by investing in a wide range of securities across different sectors, industries, and asset classes. This diversification helps to spread risk and can potentially enhance returns 2. Professional Management: Mutual funds are managed by experienced investment professionals who analyze markets, conduct research, and make investment decisions. Fund managers aim to achieve the fund's stated investment objective and maximize returns for investors. 3. Investment Objectives. Mutual funds can haye various investment ebjectives, such as capital appreciation, income generation, or a combination of both. These objectives determine the types of securities the fund invests in and the level of risk it takes, 4, Types of Mutual Funds: There are different types of mutual funds catering to various investment preferences, including equity funds (investing primarily in stocks), bond funds (investing in fixed income securities), money market funds (investing in short-term, low-risk instruments), and balanced funds (holding a mix of stocks and bonds) 5. Net Asset Value (NAV): The NAV is the price at which mutual fund shares are bought or sold. It is calculated by dividing the total value of the fund's assets minus liabilities by the number of outstanding shares. The NAV per share fluctuates based on the performance of the underlying securities. 6, Fees and Expenses: Mutual funds charge fees and expenses to cover operating costs and management fees. These fees are typically expressed as an expense ratio, which represents the percentage of the fund's assets deducted annually to cover expenses. Investors should be aware of the fees associated with a mutual fund before investing. 7. Liquidity: Mutual funds offer liquidity as investors can buy or sell shares on any business day at the NAV. However, the ease of selling depends on the type of fund and the market conditions. 8. Regulation: Mutual funds are regulated by government authorities to protect investors! interests. In many countries, mutual funds are subject to regulatory oversight and disclosure requirements to ensure transpareney and accountabi 9, Investment Risks: Mutual funds carry investment risks, including market risk, credit risk, interest rate risk, and liquidity risk. Investors should carefully consider their risk tolerance and investment objectives before investing in mutual funds.Investment Analysis and Management This document is only for reference and for practical problems refer the class notes Derivatives Derivatives are financial instruments that derive their value from an underlying asset or reference rate. They are contracts between two parties, known as counterparties, and their value is determined by the price fluctuations of the underlying asset or benchmark Derivatives are used for various purposes, including hedging against risks, speculation, and arbitrage. Here are some common types of derivatives 1. Futures Contracts: Futures contracts are agreements to buy or sell an underlying asset ata predetermined price (the futures price) on a specified future date. They are standardized contracts traded on exchanges, and they provide investors with exposure to assets such as commodities, currencies, stock indices, and interest rates, Options Contracts: Options contracts give the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price (the strike price) within a specified period. Options provide flexibility and can be used for hedging or speculative purposes Swaps: Swaps are agreements between two parties to exchange cash flows or other financial instruments based on predetermined terms. The most common types of swaps include interest rate swaps, currency swaps, and commodity swaps. Swaps are often used to manage interest rate risks, currency exposures, of to achieve specific investment strategies. 4, Forwards Contracts: Forwards are customized contracts between two parties to buy or sell an asset at a specified price on a future date. Unlike futures contracts, forwards are not traded on exchanges and are typically used in over-the-counter (OTC) markets, Forwards can be tailored to meet specific needs but come with counterparty risk. Life insurance policies Life insurance policies are contractual agreements between an individual (the policyholder) and an insurance company. These policies provide financial protection and a lump sum payment, known as the death benefit, to the designated beneficiaries upon the death of the insured person. Policyholders pay premiums, which are regular payments, to the insurance company in exchange for the life insurance coverage. Premium amounts are determined based on various factors such as the insured person's age, health condition, occupation, and the type andInvesiment Analysis and Management This document i only for reference and for practical problems refer the class notes amount of coverage chosen. Premiums can be paid monthly, quarterly, annually, or in other agreed-upon intervals, Real Estate: Real estate is a tangible asset class that can serve as an investment for individuals and institutions. Investing in real estate involves purchasing, owning, and managing properties with the expectation of generating income and/or capital appreciation. Factors to be considered while investing in Real Estate 1. Diversification; Real estate can provide diversification benefits to an investment portfolio. It has historically shown a low correlation with other asset classes such as stocks and bonds, which means that real estate returns may not move in tandem with those of traditional financial instruments. 2. Cash Flow: Rental properties can provide a steady stream of income, which can be especially attractive for long-term investors seeking regular cash flow to supplement their finances. 3. Tangible Asset: Real estate investments provide the advantage of being tangible assets. Unlike stocks or bonds, which are paper assets, real estate properties have inherent value in physical land and structures. This can provide a sense of security and control for investors who value having a physical asset. 4. Leverage: Real estate investments often allow for the use of leverage, which means borrowing money to finance a property purchase 5. Market Risks: Real estate investments are subject to market risks, including changes in property values, rental demand, and economic conditions. Real estate markets can be cyclical, experiencing periods of growth and downtums.Investment Analysis and Management This document is only for reference and for practical problems refer the class notes Chapter 3 STOCK SELECTION AND PORTFOLIO CONSTRUCTION Fundamental Analysis: Fundamental analysis refers to the process of studying any security’s intrinsic value with the object of making profits while trading in it. The primary purpose of fundamental analysis is to determine whether the security or stock is undervalued or overvalued and thereby make an informed decision to buy, hold, or sell it in order to maximise the potential for gains A. Economy Analysis: ‘The performance of a company depends on the performance of the economy. If the economy is booming, incomes rise, demand for goods increases, and hence the industries and companies in general tend to the prosperous. On the other hand, if the economy is in recession, the performance of companies will be generally bad. This is the study of the economy in detail and analysis whether economic conditions are favourable for the companies to prosper or not. Economic condition can be classified as 1. International See! hey include Geo- political scenario, World Supply and trade, Trade restriction, Exchange rate and Interest rate foreign countries (Especially USA- Federal Reserve Bank) 2. Domestic Scenario: they include Government policies and regulation, Political, Inflation , Interest rates, Industrial scenario, Agriculture and Monsoon, Tax structure, Infrastructure facilities and Market sentiment. B. Industry Analysis An industry is a group of firms that have similar technological structure of production and produce similar products. It is undertaken to understand and assess the Growth and competitive dynamics of the industry as a whole. It helps to understand the position of the industry and the factors that influence it Understanding the industry is a key component of understanding a company. So it helps investors and other stakeholders to position a company against other peers from the same industry. It gives investors a picture of roadblocks and opportunities that come in the way of the company and its industry Industry analysis can be performed with the help of Porter’s Five Forces Model and SWOTInvestment Analysis and Management This document is only for reference and for practical problems refer the class notes Porter's Five Force Model; 1. Rivalry with Peers Itis important to know about the position of a company wrt peers from the same industry. You cannot rank a manufacturing company against a pharmaceutical company for comparison. For the same, one needs to look at the competition levels, Competition and the fear of losing out on business to a peer company keep companies on their toes and helps them, innovate 2. Threat of New Competition The second competitive force that Porter emphasises is the ability of new companies to enter the industry and intensify the competition. Industries, where itis difficult for new competitors to enter, benefit from extended periods profitability and very limited rivalry 3. Threat of Substitutes Substitutes are products that can be used in place of the other For example, Domino’s Pizza and Pizza Hut pizza are substitutes for each other. Ifthe price of one rises, the demand for the other one will increase. Since it is so easy to switch to the substitute on account of any change such as a price rise or quality drop, the threat remains and the pressure to continuously perform better and in a cost-efficient way is essential, ¢ Power of Buyers This power refers to the power buyers have where they can force the sellers to give them better quality products and at lower prices. ‘The bargaining power is high when the number of buyer are less than suppliers and when the market have a lot of similar products and vice versa. 5. Bargaining Power of Suppliers Many small and mid-sized companies face a threat from an industry where the suppliers hold bargaining powers. Or when there are a limited number of suppliers in the market SWOT Analysis SWOT analysis is one of the most common analytical tools. It can be used to assess the situation of an Industry. Strengths: Factors that give the industry an edge over the others Weaknesses: Factors that keep businesses at a disadvantage Opportunities: Factors present in the economy and external environment that positively impact the performance and profitability 4. Threats: Factors present in the economy and external environment that negatively impact the performance and profitabilityInvestment Analysis and Management This document is only for reference and for practical problems refer the class notes Company Analysis Itis a method of analysing the company’s profile, management, performance, profitability and its products and services offered to make a decision on whether to make an investment in it ornot Analysis can be classified as into 1. Non Financial Analysis: a Internal Management- assessing the management and leaders of the company in terms of experience, qualification, expertises and also to check if there is conflict, division, mismanagement and so on Corporate Governance: laws, bylaws and policies must be assessed to ensure that illegal and unethical activities can be prevent Projects undertaken or partnership or Joint ventures: these show that the company is looking for growth and strategic alliance to develope the company in the future 2. Financial Analysis: a Income Statement Analysis: it is a financial statement that shows you the company's income and expenditures, It also shows whether a company is making profit or loss for a given period. financial operation for a particular year, Profit and Loss and comparison with the previous years/quarter using ratio can be performed. Balance Sheet Analysis:A balance sheet is a statement of a business's assets, liabilities, and owner's equity as of any given date. It is primarily analysed by ‘comparing with the previous years to check the progress of the company Cash Flow statement: it displays the total cash inflows from various operations. This shows the liquidity and revenue generation ability of the company Efficient market hypothesis Itis an investment theory which suggests that the prices of financial instruments reflect all available market information, Hence, investors cannot have an edge over each other by analysing the stocks and adopting different market timing strategies. According to this theory developed by Eugene Fama, investors can only earn high returns by taking more significant risks in the marketInvestment Analysis and Management This document is only for reference and for practical problems refer the class notes Assumptions of the Efficient Market Hypothesis Also referred to as an efficient market theory, EMH is based on the following assumptions ~ * Stocks are traded on exchanges at their fair market values. + This theory assumes that the market value of stocks represents all the relevant information. «+ Italso assumes that investors are not capable of outperforming the market since they have to ‘make decisions based on the same available information. ‘Three forms of efficient market hypothesis: 1. Weak form- This is based on the assumption that the market prices of all financial instruments represent all public information related to the market. It does not reflect any information that is not yet disclosed publicly. it provides the opportunity for fundamental analysis. This helps all market participants to find out more information and earn an above-average return on investment. 2. Semi - strong This version of EMH elaborates on the assumptions of the weak form and accepts that the market prices make quick adjustments in response to any new public information that is disclosed. Hence, there is no scope for fundamental analysis. all public information fully reflecting the security- fundamental analysis of no use 3. Strong: all the information is fully reflected in the security including insider trading information- no use for fundamental and technical analysis ‘This form of EMH states that the market prices of securities represent both historical and current information. This includes insider information as well as publicly disclosed information ‘Technical Analysi Itis the study of charts, graphs and diagrams patterns on past data to make predictions of the future.It is a process of forecasting future prices based on proven techniques and identifying trend and reversals at an earlier stage to formulate the buying and selling strategy. With the help of several indicators they analysed the relationship between price - volume and supply-demand for the overall market and the individual stock.Investment Analysis and Management This document is only for reference and for practical problems refer the class notes & Finance FUNDAMENTAL vs TECHNICAL ANALYSIS Fenteet tented ‘Technical Anal bre te For long term investment. For short term investment. reer Useful for trading & investing. | Useful for trading, [olsen To find out fair value of Determine correct time to security center & exit trade. porte] Use both past & present data. | Use past data only. ROEM Uses annual reports, news, Relies on chart analysis only. economy's statistic, ete SiC Long tem position trader. Swing & short term trader. oom Retum on equity & on assets. | Dow theory & price data. Sinn) Identify undervalued or Determines right time to buy overvalued stocks or sell stock. Portfolio Construction Theories 1. Markowitz Theory Itis a practical method for selecting investments in order to maximise their overall returns within an acceptable level of risk Most investments are either high risk and high return or low risk and low retum. Markowitz argued that investors could achieve their best results by choosing an optimal mix of the two based on an assessment of their individual tolerance to risk, Essence of Markowitz model 1, An investor's has a certain amount of capital he wants to invest over a single time horizon 2. He has option to choose between stocks, bonds, options, currency or portfolio 3. Thy can decide either to maximise yield or minimise risk 4, This model help in selecting the most efficient portfolio 5. The best course of investment is to diversify into various types of securities,Investment Analysis and Management This document is only for reference and for practical problems refer the class notes Assumptions under Markowitz model 1. The model assumes that investors are rational and will always behave in a certain manner. 2. The model assumes that there are only two different types of assets—low returns and high returns 3. Harry Markowitz argues that markets will always work in a certain direction and will always be efficient. But this is not always the case. 4, Diversification is important. But the theory assumes diversification is the only way to minimise investment risks 5. The Markowitz, model of portfolio assumes that every investor has unlimited access to information about market changes. In reality, investors often lack the time and expertise to gather relevant data 6. Markowitz assumes that all investors are risk-averse, but that is not universally true. The Markowitz formula is as follows: Rp = Ine + (Ra ~ Insop/om Here, + Rp = Expected Portfolio Return © Ry = Market Portfolio Return = Ige = Risk-free Rate of Interest © Oy = Market's Standard Deviation * op = Standard Deviation of Portfolio Advantages of Markowitz model: ‘The portfolio becomes resistant to systematic risk Diversification helps investors understand different sectors, Such portfolios suit both long-term wealth creation and short-term profits A variety of financial instruments fit this investment strategy. Repo Disadvantages of Markowitz model: 1. It does not guarantee good returns and is only based on historical data 2. The model does not account for associated costs like broker commissions, taxes, and other chargesInvestment Analysis and Management This document is only for reference and for practical problems refer the class notes 3. The whole model is based on irrelevant stock market assumptions. In reality, stock markets are as unpredictable as they are volatile. 2. Capital Asset Pricing Model: It describes the relationship between risk and expected return that is used in pricing of risky securities. The investors need to consider two things: time value of money and risk. CAPM is a framework for determining the equilibrium of expected retum for risky assets. ‘The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital Assumption of CAPM Investors are rational and risk averse Investors seek to maximise the expected return Investors base their decision onthe basis of risk and return Investors assumes homogeneous expectations with respect to holding period, risk and return Investors can lend and borrow any amount freely at risk less rate of return Assumes market is perfect There is no transaction cost Assumes all information is available to all There is no personal income tax aepe Capital Asset Pricing Model Formula R,= Ret BS (Ria Rie) 3. Arbitrage Pricing Theory (APT) Itis a theory of asset pricing that holds that an asset’s returns can be forecasted with the linear relationship of an asset’s expected returns and the macroeconomic factors that affect the asset’s risk. Unlike the Capital Asset Pricing Model (CAPM), which only takes into account the single factor of the risk level of the overall market, the APT model looks at severalInvesiment Analysis and Management This document is ont for reference and for practical problems refer the class notes macroeconomic factors like inflation risk, business cycle risk, market timing risk, confidence risk, ete ‘The Assumptions 1. The investors have homogeneous expectations. 2. The investors are risk averse and utility maximisers, 3. Perfect competition prevails in the market and there is no trans: 4. Investors will diversify their investments ERO) = Rf + BRP, + B2RP2+...+B,RP, * — ER() - Expected return on asset = B, (Beta) - The asset's price sensitivity to factor + AP,- The risk premium associated with factor CHAPTER 4 BONDS Bonds: Bonds refer to high-security debt instruments that enable an entity to raise funds and fulfil capital requirements. It is a category of debt that borrowers avail fiom individual investors for a specified tenure. Organisations, including companies, governments, municipalities and other entities, issue bonds for investors in primary markets. The corpus thus collected is used to fund business operations and infrastructural development by companies and governments alike. Investors purchase bonds at face value or principal, which is returned at the end of a fixed tenure. Issuers extend a percentage of the principal amount as periodical interest at fixed or adjustable rates.Investment Analysis and Management This document is only for reference and for practical problems refer the class notes ‘Characteristics of Bonds 1. Face Value Face value implies the price of a single unit of a bond issued by an enterprise. Princi nominal, or par value is used alternatively to refer to the price of bonds. Issuers are under a legal obligation to return this value to the investor after a stipulated period. 2. Interest or Coupon Rate Bonds accrue fixed or floating rates of interest across their tenure, payable periodically to creditors. Bond interest rates are also called coupon rates as per the tradition of claiming interests on paper bonds in the form of coupons, Interest eared on a bond depends on various aspects such as tenure, the issuer’s repute in the public debt market. 3. Tenure of Bonds Tenure or term refers to the period after which bonds mature. These are financial debt contracts between issuers and investors. Financial and legal obligations of an issuer to the investor or creditor are valid only until the tenure’s end. Bonds Valuation: 1- Bond prices vary inversely with market interest rates. Because the stream of promised payments usually is fixed no matter what subsequently happens to interest rates, higher rates reduce the present value of these promised payments, and thus the bond price 2- The value of bonds falls when people come to expect higher inflation. The reason is that higher expected inflation raises market interest rates, and therefore reduces the present value of the fixed stream of promised payments. 3- The greater the uncertainty about whether the promised payments will be made (the risk that the issuer will default on the promised payments), the lower the expected payments to bondholders and the lower the value of the bond 4- Bonds whose payments are subjected to lower taxation provide investors with higher expected after-tax payments. Because investors are interested in after-tax income, such bonds sell for higher prices.Investment Analysis and Management This document is only for reference and for practical problems refer the class notes Bond Portfolio A bond portfolio is a group of investments predominantly composed of bonds Bond portfolios are also known as fixed income portfolios as the bonds provide income in the form of coupons. Bonds are a better option when compared to savings bank accounts as they provide higher returns, and the risk can be minimised with a well-balanced and diversified bond portfolio. Bond Portfolio - Immunization Strategy Bond immunisation strategy is a combination of both active as well as passive investment strategies. It helps eliminate the risk of interest rate fluctuations, The investment horizon of the investor is matched with the duration of the portfolio to make the investments immune to any interest rates risk In simple terms, to immunize a portfolio, we have to match the duration of portfolio assets With the duration of future liabilities. To understand, let us look into the tradeoff between price risk and reinvestment risk in the context of a fixed-income portfolio, There is an inverse relationship between price risk (return) and reinvestment risk (return) When interest rates increase, the price of a coupon bond falls, whereas the reinvestment retum on the coupon rises. The aim of immunization is to establish a portfolio in which these ‘two components of total return—price return and reinvestment return (coupons being constant) —exactly offset each other in case of a parallel interest rate shift once the portfolio is set up. CHAPTERS Mutual Fund Defi According to SEBI: “Mutual fund is a mechanism for pooling the resources by issuing units to the investors and investing funds in securities in accordance with objectives as disclosed in the offer document. Investments in securities are spread across a wide cross-section of industries and sectors and thus the risk is reduced.” Mutual fund refers to an investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets.Investment Analysis and Management Unit holders: Investors of mutual funds are known as unitholders. The profits or losses are shared by investors in proportion to their investments. Trustee: The Board of Trustees is appointed by the AMC and is subject to the approval of SEBI.they provide a holding service who has administrative power for managing the money, property or assets used in mutual funds. There must be a ‘minimum of 4 trustee or a trustee company with 4 directors. Asset Management company: they pool funds from various individual and institutional investors and invest in various securities. They have professionals called fund managers who manage the investment and the research team selects the right securities. They manage the funds of investors Sponsor: is any person or any entity that can set up a mutual fund to earn money by fund management. A sponsor can be seen as the promoter of the associate companyInvestment Analysis and Management ‘This document is only for reference and for practical problems refer the class notes, 5. Custodian: the custodians protects the portfolio securities. Mostly qualified bank custodians are used for mutual funds. The custodian settles securities transactions for the fund, collects interest and dividend paid for securities and records information on stocks and other corporate actions 6. Transfer agent: purpose of maintaining records such asThey maintain shareholders account, calculate the dividend and share information to the shareholders about their investment ( accounting statement, notices and income tax information) Net Asset Value Net Asset Value represents the market value per share for a particular mutual fund. It is calculated by deducting the liabilities from total asset value divided by the number of shares. One needs to gather the market value of a portfolio and divide it by the total current fund unit number to determine the price of each fund unit. Most of the time, the unit cost of mutual funds begin with Rs. 10 and increase as the assets under the funds grow. Selection Criteria 1. Sharpe’s Measure: Developed by William Sharpe is referred to as the Sharpe ratio also, It is a ratio which, indicates a return generated by a fund aver and above the risk free rate of return and the total risk associated with it. It examines the performance of an investment by adjusting for its risk and risk free rate of return, Interpretation: Ratio is the final calculated value @ Ratio < 1.0 = the fund is sub par and not recommended for investment @ Ratio | to 2 = Acceptable as an investment © Ratio > 2 = Expectation investmentInvestment Analysis and Management ‘This document is only for reference and for practical problems refer the class notes, 2. Treynor Measure: ‘This index is a ratio of return generated by the fund over and above risk free rate of return during a given period and systematic risk(beta) associated with it Interpretation: The calculated value must be positive and higher in value, then we can accept the fund. 3. Jensen’s Measure: the index is a ratio of returns generated by the fund over and above the market retum, this return above market is also called as alpha. + Jensen’s Alpha = ro — Ire + BX (hm - ral = Portfolio Return + = Risk-Free Rate * tm = Expected Market Return + 6 = Portfolio Beta Interpretation: Positive value(Answer after calculation) - a positive value indicates that the fund has outperformed the market (Accept the fund) Negative value- the fund has performed or has generated returns less than the market (Reject the fund)Investment Analysis and Management This document is only for reference and for practical problems refer the class notes CHAPTER 6 PORTFOLIO EVALUATION AND REVISION Performance evaluation: Performance evaluation in investment refers to the assessment of the performance and effectiveness of investment portfolios, funds, or individual investments. It involves measuring investment returns, risk-adjusted performance, and comparing the results against benchmarks or objectives. Performance of Portfolio or mutual fund are performed with the help of 1, Sharpe's Performance Index, 2. Jensen’s Performance Index 3. Treynor’s Performance Index They have been explained in the previous chapter Evaluation of Mutual Fund using NAV method ‘The NAV is calculated by dividing the net assets of the mutual fund by the total number of outstanding shares. Net assets are the total value of the fund's investments minus its liabilities, The NAV per share represents the fund's underlying value 1 Tracking NAV Changes: Investors track the NAV of @ mutual fund over time to assess its performance. An increasing NAV suggests positive performance, while a decreasing NAV indicates negative performance. However, it's important to consider that NAV changes can be iniluenced by factors such as market movements, fund expenses, and investment returns, ‘Comparing NAV: Investors compare the NAV ofa mutual fund to other funds in the same category or toa benchmark index. This comparison helps determine whether the fund has outperformed or underperformed its peers or the market. It's important to consider the time period over which the comparison is made to gain meaningful insights. NAV Growth Rate: By comparing NAVs at different points in time, investors can calculate the NAV growth rate, which indicates the fund's performance over a specificInvesiment Analysis and Maragement This document is only fr reference and for practical problems reer the class notes period, The NAV growth rate can be calculated as (Ending NAV - Beginning NAV) / Beginning NAV. A higher growth rate signifies better performance. Historical NAV Performance: Evaluating a mutual fund's NAV performance over a longer time horizon provides a more comprehensive assessment. Investors may consider annual or cumulative NAV returns over multiple years to understand the fund's consistency and potential for delivering long-term returns. Expense Ratio Impact: The expense ratio, representing the fund's annual expenses as a percentage of its assets, affects the NAV. Higher expense ratios can erode the fund's NAV over time, Evaluating the expense ratio alongside the NAV performance helps inyestors assess the impact of expenses on their investment returns. Portfolio Revision Method: Rebalancing: Rebalancing involves adjusting the portfolio's asset allocation back to its target weights. Over time, the performance of different asset classes can cause deviations from the desired allocation. It typically involves selling overperforming assets and buying underperforming assets to restore the desired allocation Tactical Asset Allocation: Tactical asset allocation involves making strategic shifts in the portfolio's asset allocation based on short-term market conditions or economic outlook. It aims to take advantage of perceived opportunities or to mitigate risks. Tactical asset allocation may involve overweighting or underweighting certain asset classes or sectors for a specific period, with the intention of capitalising on potential market movements. Strategic Asset Allocation: Strategic asset allocation refers to establishing a long-term target asset allocation based on the investor's risk profile and investment objectives. It considers factors such as the investor's time horizon, risk tolerance, and return expectations. Once the strategic asset allocation is set, periodic reviews and adjustments may be made to ensure it remains aligned with the investor's goals. Risk-Based Rebalancing: Risk-based rebalancing focuses on adjusting the portfolio based on changes in the investor's risk tolerance. Ifthe investor's risk tolerance changes, the portfolio may need to be adjusted accordingly. For example, as an inyestor approaches retirement, their risk tolerance may decrease, leading to a shift towards more conservative investments Performance-Based Rebalancing: Performance-based rebalancing involves adjusting the portfolio based on the performance of individual investments or asset classes. It typically involves selling investments that have significantlyInvestment Analysis and Management This document is only for reference and for practical problems refer the class notes underperformed and reallocating the funds to investments with better performance prospects. This method aims to capture potential retums by focusing on the most promising investments. Formula Plan Formula Plan is a portfolio revision method that involves making systematic adjustments to the portfolio based on a predetermined formula or set of rules. The formula specifies how the portfolio allocation should be adjusted based on certain market indicators or performance metrics Strategies using Formula Plan 1, Constant Dollar Value Plan ‘The Constant Dollar Value Plan, also known as the Constant Dollar Plan or Dollar-Cost Averaging, is an investment strategy that involves investing a fixed amount of money at regular intervals regardless of the security's price. The goal of this plan is to accumulate more Units or shares when prices are low and fewer units or shares when prices are high. 2. Constant ratio plan A constant ratio plan (also known as "constant mix" or "constant weighting” investing) is a strategic asset allocation strategy, or investment formula, which keeps the aggressive and conservative portions of a portfolio set at a fixed ratio. To maintain the target asset weights typically, between that of stocks and bonds the portfolio is periodically rebalanced by selling outperforming assets and buying underperforming ones, Thus, stocks are sold if they rise faster than other investments and bought if they fall in value more than the other investments in the portfolio. Variable Ratio Plan ‘The variable-ratio plan builds on where the constant ratio plans stop by providing higher flexibility than the latter does. The plan allows the ratio between the aggressive and defensive portions of a portfolio to change either based on market movement or some pre-set factors For instance, a variable ratio plan can allow for a higher ratio of the aggressive portion vis-d-vis the conservative portion when equities are doing well to benefit from the bull run. ‘The plan can also allow for a higher ratio in favor of the defensive portion as an investor grows old and his life cycle demands @ more conservative approach to investments