Capital Mkt. SEM 3

Capital Market
Last updated on December 4th, 2019 at 11:28 pm
Capital market is a market where buyers and sellers engage in trade of financial
securities like bonds, stocks, etc. The buying/selling is undertaken by
participants such as individuals and institutions.
Description: Capital markets help channelise surplus funds from savers to

institutions which then invest them into productive use. Generally, this market
trades mostly in long-term securities.
Capital market consists of primary markets and secondary markets. Primary

markets deal with trade of new issues of stocks and other securities, whereas
secondary market deals with the exchange of existing or previously-issued
securities. Another important division in the capital market is made on the basis
of the nature of security traded, i.e. stock market and bond market.
Capital Market
1. Securities Market
• Primary Market : IPOs, Book Building, Private Placements.

• Secondary Market : Equity Market, Debt Market, Commodity
Market, Futures and Options Market. (Secondary Market can be
basically divided into two – spot market and forward market.
Forward market has two divisions – futures and
options/derivatives. Again, there are two types of options – put
option and call option.)
2. Non-Securities Market
• Mutual Funds.
• Fixed Deposits, Savings Deposits, Post Office savings.
• Insurance.
Capital Market is an institutional arrangement for borrowing medium and long-

term funds and which provides facilities for marketing and trading of securities.
So it constitutes all long-term borrowings from banks and financial institutions,
borrowings from foreign markets and raising of capital by issue
various securities such as shares, debentures, bonds, etc. The securities market
has two different segments namely primary and secondary market.
Primary Market vs Secondary Market : The primary market consists of
arrangements for procurement of long-term funds by companies by fresh issue
of shares and debentures. The secondary market or stock exchange provides a
ready market for existing long term securities. Stock exchange is the secondary
market, which provides a place for regular sale and purchase of different types of
securities like shares, debentures, bonds & government securities. It is an
organised market where all transactions are regulated by the rules and laws of
the concerned stock exchanges.
Secondary Markets or Stock Exchanges : The functions of a stock exchanges are

to provide ready and continuous market for securities, information about prices
and sales, safety to dealings and investment, helps mobilisation of savings and
capital formation. It acts as a barometer of economic and business conditions
and helps in better allocation of funds. Stock exchanges provide many benefits
to companies, investors and the society as a whole. But they also suffer from
limitations like exclusive speculation and fluctuation in prices due to rumours
and unpredictable events. There are 21 stock exchanges in India presently,
including BSE, NSE and OTCEI. Stock Exchanges are regulated by the Securities
Contracts (Regulation) Act and by SEBI. SEBI has initiated a number of reforms
in the primary and secondary market to regulate the stock market. Documentary
and procedural requirements for listing and trading have been made stricter and
foolproof to protect investors’ interest.
The secondary market has further two components. First, the spot market where
securities are traded for immediate delivery and payment. The other is forward
market where the securities are traded for future delivery and payment. This
forward market is further divided into Futures and Options Market
(Derivatives Markets). In futures Market the securities are traded for
conditional future delivery whereas in option market, two types of options are
traded. A put option gives right but not an obligation to the owner to sell a
security to the writer of the option at a predetermined price before a certain
date, while a call option gives right but not an obligation to the buyer to purchase
a security from the writer of the option at a particular price before a certain date.
Money Market and Capital Market : A comparison
Point of Distinction Money Market Capital Ma
1. Time period / Term Deals in short-term funds. Long term

Deals in sec
Deals in securities like treasury bills, commercial
shares, deb
2. Instrument Dealt In paper, bills of exchange, certificate of deposits
bonds and
etc.
governmen
Stock broke
under write
Commercial banks,
3. Participants mutual fund
NBFS, chit funds etc.
individual i
financial in
4. Regulatory body RBI SEBI
Stock Exchange and New issues Markets:

Nature, Structure, Functioning and Limitations
Last updated on November 24th, 2019 at 10:17 pm
The stock market deals in long-term securities both private and government. It
is the most important component of the capital market. The latter deals in long-
term funds of all kinds, whether raised through open-market securities or
through negotiated loans not resulting in market paper.
Open-market securities are securities (or market paper) that are bought and
sold openly in the market (like marketable goods) and can change hand any
number of times. The negotiated loans have to be negotiated directly (or
through a broker) between the borrower and the lender. They appear only in the
account books of the lenders and the borrowers’ promissory notes which are not
salable in the market. The scope and structure of the stock or securities market
are shown in Figure 3.2.
The stock market comprises several distinct markets in securities. The most
important distinction is that between the market for corporate securities and
the market for government securities.Corporate securities are instruments for
raising long- term corporate capital from the public.
The stock market organization provides separate arrangements for the new
issues of securities and for buying and selling of old securities. The former
market is known as the ‘new issues market’ and the latter market as the
‘secondary market’. Both kinds of markets are essential for servicing corporate
borrowers and investors.
The New Issues Market:
The essential function of the new issues market is to arrange for the raising of
new capital by corporate enterprises, whether new or old. This involves
attracting new investible resources into the corporate sector and their allocation
among alternative uses and users. Both ways the role is very important.
How fast the corporate industrial sector grows depends very much on the inflow
of resources into it, apart from its own internal savings. Equally important is the
movement of sufficient venture capital into new fields of manufacturing crucial
to the balanced growth of industries in the economy and in new regions for
promoting balanced regional development.
The new issues may take the form of equity shares, preference shares or
debentures. The firms raising funds may be new companies or existing
companies planning expansion. The new companies need not always be entirely
new enterprises. They may be private firms already in business, but ‘going
public’ to expand their capital bases. ‘Going public’ means becoming public
limited companies to be entitled to raise funds from the general public in the
open market.
For inducing the public to invest their savings in new issues, the services of a
network of specialised institutions (underwriters and stockbrokers) is required.
The more highly developed and efficient this network, the greater will be the
inflow of savings into organized industry. Till the establishment of the Industrial
Credit and Investment Corporation of India (ICICI) in 1955, this kind of
underwriting was sorely lacking in India. Instead, a special institutional
arrangement, known as the managing agency system had grown. Now it has
become a thing of the past.
The new institutional arrangements for new corporate issues in place of the
discredited managing agency system started, taking shape with the setting up
of the ICICI in 1955. Soon after (1956) the LIC joined hands. The new system has
already attained adulthood under the leadership of the Industrial Development
Bank of India (IDBI).
Apart from the ICICI and the other important participants in the new issues
market is the major term- lending institutions such as the UTI, the IFCI,
commercial banks. General Insurance Corporation (GIC) and its subsidiaries,
stock brokers, and investment trust. Foreign institutional funds from the World
Bank and its affiliates, International Development Association (IDA) and
International Finance Corporation, are also channeled through the all-India
term-lending institutions (IDBI, ICICI, and IFCI).
Managing successful floatation of new issues involves three distinct services:
(i) Origination,
(ii) Underwriting and
(iii) Distribution of new issues.
The origination requires careful investigation of the viability and prospectus of

new projects. This involves technical evaluation of a proposal from the
technical-manufacturing angle, the availability of technical know- how, land,
power, water and essential inputs, location, the competence of the
management, the study of market demand for the product (s), domestic and
foreign, over time, financial estimates of projected costs and returns, the
adequacy and structure of financial arrangements (promoters’ equity, equity
from the public, debt-equity ratio, short-term funds, liquidity ratios, foreign
exchange requirement and availability), gestation lags, etc., and
communication of any deficiencies in the project proposal to the promoters for
remedial measures.
All this requires well-trained and competent staff. A careful scrutiny and
approval of a new issue proposal by well-established financial institutions
known for their competence and integrity improves substantially its
acceptability by the investing public and other financial institutions. This is
especially true of issues of totally new enterprises.
Underwriting means guaranteeing, purchase of a stipulated amount of a new

issue at a fixed price. The purchase may be for sale to the public or (for one’s own
portfolio or for both the purposes. If the expected sale to the public does not
materialize, the underwriter absorbs the unsold stock in its own portfolio. The
underwriter assumes this risk for commission, known as underwriter’s
commission.
The company bringing out the new issue agrees to bear this extra cost of raising
funds, because thereby it is assured of funds and the task of sale of stock to the
public or others is passed on entirely to underwriters. Mostly, underwriting is
done by a group of underwriters, one or more of whom may act as group leaders.
The group (or consortium) underwriting distributes risks of underwriting among
several underwriters and enhances substantially the capacity of the system to
underwrite big issues.
Distribution means sale of stock to the public. The term-lending institutions,

the LIC, the UTI and several other financial institutions^ usually underwrite new
issues as direct investments for their own portfolios. For them, there is no
problem of sale of stock to the public. But, under the law, a part of the new public
issue must be offered to the general public. This is placed with stockbrokers who
have a system of inviting subscriptions to new issues from the public.
In normal times it is their distributive capacity which determines the extent of

the public participation in new issues. During periods of stock market boom the
demand for new issues from the public also goes up. New issues of well-known
houses and issues underwritten by strong institutions generally have a good
public response.
It is the placing of the issues of small companies that continues to be the Achilles’
heels of the new issues market. For loosening the grip of monopoly houses on the
industrial economy of the country, it is necessary that new entrepreneurs are
encouraged. For this, special efforts need be stepped up further for promoting
small issues.
Broadly speaking, there are three main ways of floating new issues:
(i) By the issue of a prospectus to the public,
(ii) By private placement and
(iii) By the rights issue to the existing shareholders.
What we have described above is the first method. The issue of a public
prospectus giving details about the company, issue, and the underwriters is the
last act in the drama and is an open invitation to the public to subscribe to the
issue. Private placement means that the issue is not offered to the general public
for subscription but is placed privately with a few big financiers.
This saves the company the expenses of public placement. It is also faster. Rights
issue means issue of rights (invitations) to the existing shareholders of an old
corporation to subscribe to a part or whole of the new issue in a fixed proportion
to their shareholding. Such an issue is always offered at a certain discount from
the going market price of the already-trading shares of the company.
The discount is in the nature of a bonus to the shareholders. Obviously, a rights

issue is open only to an existing public limited corporation, not to a new one. Old
corporations also increase their capitalisation (paid-up capital) by declaring
bonus to their shareholders, which means issue of new shares to them in a fixed
ratio to their shareholdings without charging any price from them. This is a way
of converting a part of accumulated reserves into companies paid- up capital.
The Secondary Market in Old Issues:
This market deals in existing securities. Its main function is to provide liquidity
to such securities. Liquidity of an asset means its easy convertibility into cash at
short notice and with minimal loss of capital value. This liquidity is provided by
providing a continuous market for securities, that is, a market where a security
cart be bought or sold at any time during business hours at small transaction cost
and at comparatively small variations from the last quoted price.
This, of course, is true of only ‘active’ securities for which there are always buyers
and sellers in the market. ‘Activeness’ is a property of individual securities, not of
the market. The function of providing liquidity to old stocks is important both for
attracting new finance and in other ways. It encourages prospective investors to
invest in securities, old or new, because they know that any time they want to get
out of them into cash, they can go to the market and sell them off.
In the absence of any organized securities market, this will not be easily feasible.
So, the investing public will keep away from securities. Then, the secondary
market provides an opportunity to all concerned to invest in securities and when
they like. This opens a way for continuous inflow of funds into the market.
This is especially important for such investors who do not want to risk their funds
by investing in new ventures, but are perfectly willing to invest in the securities
of on-going concerns. On the other end, there are venturesome investors who
invest in new issues in the hope of making capital gains later when the new
concerns have established themselves well.
In a sense, they season new issues and sell them off when the market
acceptability of these issues has improved. With their funds released from sale
of their old holdings, they can move into other new issues coming into the
market. Thus, investment into new issues is facilitated greatly by the operations
of the secondary market.
The new investment is influenced in another way too by what is happening in the
secondary market. The latter acts as an important indicator of the investment
climate in the economy. When stock prices of existing securities are rising and
the volume of trading activity in the secondary market goes up, new issues also
tend to increase as the new issues market (underwriters, stockbrokers, and
investors) is (are) better prepared and more willing to accept new issues. This is
also a good time for companies to come forward with new issues.
When the secondary market is in doldrums, the new issues market also
languishes. The underwriters are reluctant to underwrite and stockbrokers
reluctant to assume the responsibility of selling new issues to the public. Then,
firms are also advised to postpone their new issues for better times.
There are two segments of the secondary market:
(a) Organized stock exchange,
(b) Over-the-counter market.
The latter deals in such securities as are not ‘listed’ on an organized stock
exchange. These are securities of small companies and have only a limited
market. Their prices are determined through direct negotiation between stock
brokers and not through open bidding as is the case with ‘listed’ securities on a
stock exchange. The main action of the stock market is concentrated on these
exchanges. We explain briefly their organization and functioning.
9 Most Important Functions of Stock Exchange/Secondary Market

1. Economic Barometer:
A stock exchange is a reliable barometer to measure the economic condition of a

country.
Every major change in country and economy is reflected in the prices of shares.
The rise or fall in the share prices indicates the boom or recession cycle of the
economy. Stock exchange is also known as a pulse of economy or economic
mirror which reflects the economic conditions of a country.
2. Pricing of Securities:
The stock market helps to value the securities on the basis of demand and supply
factors. The securities of profitable and growth oriented companies are valued
higher as there is more demand for such securities. The valuation of securities is
useful for investors, government and creditors. The investors can know the value
of their investment, the creditors can value the creditworthiness and
government can impose taxes on value of securities.
3. Safety of Transactions:
In stock market only the listed securities are traded and stock exchange
authorities include the companies names in the trade list only after verifying the
soundness of company. The companies which are listed they also have to operate
within the strict rules and regulations. This ensures safety of dealing through
stock exchange.
4. Contributes to Economic Growth:
In stock exchange securities of various companies are bought and sold. This
process of disinvestment and reinvestment helps to invest in most productive
investment proposal and this leads to capital formation and economic growth.
5. Spreading of Equity Cult:
Stock exchange encourages people to invest in ownership securities by

regulating new issues, better trading practices and by educating public about
investment.
6. Providing Scope for Speculation:
To ensure liquidity and demand of supply of securities the stock exchange

permits healthy speculation of securities.
7. Liquidity:
The main function of stock market is to provide ready market for sale and
purchase of securities. The presence of stock exchange market gives assurance
to investors that their investment can be converted into cash whenever they
want. The investors can invest in long term investment projects without any
hesitation, as because of stock exchange they can convert long term investment
into short term and medium term.
8. Better Allocation of Capital:
The shares of profit making companies are quoted at higher prices and are
actively traded so such companies can easily raise fresh capital from stock
market. The general public hesitates to invest in securities of loss making
companies. So stock exchange facilitates allocation of investor’s fund to
profitable channels.
9. Promotes the Habits of Savings and Investment:
The stock market offers attractive opportunities of investment in various

securities. These attractive opportunities encourage people to save more and
invest in securities of corporate sector rather than investing in unproductive
assets such as gold, silver, etc.
Limitations
1. Unethical practices: Many unethical practices are rampant

in Indian stock markets. Prices of shares are artificially increased
before rights issues by circular trading. Gullible members of public
who buy such shares find the prices of such shares dropping
greatly and lose their money.
2. Misinformation: Funds are raised from investors promising
investment in projects yielding high returns. But some promoters
divert the money to speculative activities and other personal
purposes. Investors who invest their money in such companies
ultimately lose their money.
3. Absence of Genuine Investors: A very small proportion of
purchases and sales effected in a stock exchange are by genuine
investors. Speculators constitute a major portion of the market.
Many of the transactions are carried out by speculators who plan
to derive profits from short term fluctuations in prices of
securities. This is evident from the fact that majority of the
transactions are of the carry-forward type.
4. Fake shares: Frauds involving forged share certificates are quite
common. Investors who buy shares unfortunately may get such
fake certificates. They would not be able to trace the seller and
their entire investment in such fake shares would be a loss.
5. Insider trading: Insider trading is a common occurrence in many
stock exchanges. Insiders who come to know privileged
information use it either to buy or sell shares and make a quick
profit at the expense of common shareholders. Though many
rules and regulations have been formulated to curb insider
trading, it is a continuing phenomenon.
6. Unofficial transactions: Unofficial markets exist along with the
regular stock exchange. Trading takes place in these unofficial
stock exchanges after trading hours of the regular stock exchange.
Unofficial buying and selling transactions are entered into in
these unofficial stock exchanges (kerb trading and dabba trading)
even before an issue opens up for subscription. Though trading in
such unofficial stock exchanges are illegal, they continue to exist.
7. Prevalence of Price Rigging: Price rigging is a common evil
plaguing the stock markets in India. Companies which plan to
issue securities artificially try to increase the share prices, to make
their issue attractive as well as enable them to price their issue at
a high premium. Promoters enter into a secret agreement with
the brokers.
8. Thin trading: Though many companies are listed in stock
exchange, many are not traded. Trading is confined to only around
25% of the shares listed on a stock exchange. Therefore the
investors have restricted choice and many shares lack liquidity.
9. Excessive Speculation: There is excessive speculation in some
shares which artificially results in increasing or decreasing the
prices. Increase or fall in prices do not have any relationship with
the fundamental strengths or weakness of the company. Many
small investors are unaware of this fact. They buy shares based on
price movements and ultimately suffer losses.
10. Underdeveloped debt market: The debt market in India has
not been developed to the required extent. There is very little
liquidity in the debt markets.
11. Payment crisis: Market players indulge in excessive speculation
and trading to profit from the increase and decrease in prices.
When movement (increase/decrease) in the security prices is
contrary to their expectations they are not able to settle the
transaction (pay cash for securities bought).
12. Poor liquidity: The main objective of listing shares in a stock
exchange is to provide liquidity. But in India, out of over 6,400
companies which are listed, 90 percent of trading is restricted to
only 200 to 250 actively traded scrips. There is high volatility
(fluctuations) in case of actively traded scrips and low liquidity in
the others.
13.Inadequate instruments: The markets are dominated by
equity. Convertible debenture issues are very rare. Preference
shares which would be preferred by fixed return seeking investors
are almost nonexistent.
14. Influence of Financial Institutions: The equity markets are
dominated by large players such as mutual funds. pension funds
and insurance companies. Any purchase of sale by them
significantly influences the market prices as they buy and sell in
bulk quantities. The share prices, therefore do not reflect the
fundamentals.
15. Domination of FII’s: Foreign institutional investors have
come to play a major role in the Indian markets. They have
pumped in billions of dollars and buy and sell in large quantities.
Any entry (purchase) by FII’s in a particular stock significantly
pushes up its prices and any exit (sales) results in a steep fall in
prices. FII’s invest and take out their money based on global
developments. Any large scale exit by FII’s would trigger a collapse
in the Indian markets.
16. Odd lots: Odd lots suffer from poor liquidity. The number of
odd lot dealers is very less and odd lots have to be sold at a lower
price.
17. Delay in admitting securities: There is high delay in
admitting securities for trading. Sometimes it goes beyond 60 or
even 70 days. Therefore, liquidity of investments is affected.
18. Poor services: The number of brokers is less and many
brokers provide very poor service to investors, There are more
than 50,000 sub-brokers and they are totally unregulated. There
are many instances of sub brokers committing fraudulent acts
and investors losing money.
19. Broker defaults: Due to excess speculation in specific
shares, broker defaults occur. Such defaults destabilize stock
exchanges and results in payment crisis.
Preference and Equity Capital

Preference Capital
The Preference Capital is that portion of capital which is raised through the issue
of the preference shares. This is the hybrid form of financing that has certain
characteristics of equity and certain attributes of debentures.
Advantages of Preference Capital
• There is no legal obligation on the firm to pay a dividend to the

preference shareholders.
• The redemption of preference shares is not distressful for a firm
since the shares are redeemed out of the profits and through the
issue of fresh shares (preference shares and equity shares).
• The preference capital is considered as a component of net worth
and hence the creditworthiness of the firm increases.
• Preference shareholders do not enjoy the voting rights, and thus,
there is no dilution of control.
Disadvantages of Preference Capital
• It is very expensive as compared to the debt-capital because

unlike debt interest, preference dividend is not tax deductible.
• Although, there is no legal obligation to pay the preference
dividends, when the payment is made it is done along with the
arrears.
• The preference shareholder can claim prior to the equity
shareholders, in case the dividends are being paid or at the time of
winding up of the firm.
• If the company does not pay or skips the preference dividend for
some time, then the preference shareholders could acquire the
voting rights.
The preference capital is similar to the equity in the sense: the preference
dividend is paid out of the distributable profits, it is not obligatory on the part of
the firm to pay the preference dividend, these dividends are not tax-deductible.
The portion of the preference capital resembles the debentures: the rate of
dividend is fixed, preference shareholders are given priority over the equity
shareholders in case of dividend payment and at the time of winding up of the
firm, the preference shareholders do not have the right to vote and the
preference capital is repayable.
Equity Capital
Invested money that, in contrast to debt capital, is not repaid to the investors in
the normal course of business. It represents the risk capital staked by the owners
through purchase of a company’s common stock (ordinary shares).
The value of equity capital is computed by estimating the current market value
of everything owned by the company from which the total of all liabilities is
subtracted. On the balance sheet of the company, equity capital is listed as
stockholders’ equity or owners’ equity. Also called equity financing or share
capital.
Advantage of Equity Capital
(i) Fixed Costs Unchanged By Equity Capital
Equity financing has no fixed payment requirements. As a result, the

investments do not increase a company’s fixed costs or fixed payment burden. In
addition, dividends to be paid to equity investors can be deferred and cash can be
directed to business opportunities and operating requirements as needed.
(ii) Collateral-Free Financing
Equity investors do not require a pledge of collateral. Existing business assets

remain unencumbered and available to serve as security for loans. In addition,
assets purchased with equity capital can be used to secure future long-term
debt.
(iii) Long-Term Financing
Equity investors are focused on future earnings and increasing the value of a
business rather than the immediate return on their investment in the form of
interest payments or dividends. As a result, businesses can rely on equity capital
to finance projects for which the earnings or returns may not occur for some
time, if at all.
(iv) Convenant-Free Financing
A lender is concerned with the repayment of debt. The lender wants to ensure
that loan proceeds increase company assets, which generate cash to repay loans.
Therefore, lenders establish financial covenants that restrict how loan proceeds
are used. Equity investors establish no such covenants; they rely on governance
rights to protect their interests.
Disadvantage of Equity Capital
(i) Investor Expectations
Neither profits nor business growth nor dividends are guaranteed for equity
investors. The returns to equity investors are more uncertain than returns
earned by debt holders. As a result, equity investors anticipate a higher return on
their investment than that received by lenders.
(ii) Business Form Requirements
Legal restrictions govern the use of equity financing and the structure of the
financing transactions. In fact, equity investors have financial rights, including a
claim to distributed dividends and proceeds from the sale of the company in
which they invest. The equity investors also have governance rights pertaining
to the board of directors election and approval of major business decisions.
These rights dilute the ownership and control of a company and increase the
oversight of management decisions.
(iii) Financial Returns Distribution
Each investor in a company has a right to the cash flow generated by the business
after all other claims are paid. If the business is sold, the owners share cash equal
to the net proceeds of the business if a gain occurs on the sale. The investors’ net
return is equal to the net proceeds of the sale less the cash they invested in the
business. The legal restrictions that govern the use of equity financing
determine the return received by an individual.
Debentures & Bonds

Trading securities is a category of securities that includes both debt securities

and equity securities, and which an entity intends to sell in the short term for a
profit that it expects to generate from increases in the price of the securities.
This is the most common classification used for investments in securities.
Trading is usually done through an organized stock exchange, which acts as the
intermediary between a buyer and seller, though it is also possible to directly
engage in purchase and sale transactions with counterparties.
Trading securities are recorded in the balance sheet of the investor at their fair
value as of the balance sheet date. This type of marketable security is always
positioned in the balance sheet as a current asset.
If there is a change in the fair value of such an asset from period to period, this
change is recognized in the income statement as a gain or loss.
Other types of marketable securities are classified as available-for-sale and

held-to-maturity.
Debentures
Debentures are a debt instrument used by companies and government to issue

the loan. The loan is issued to corporates based on their reputation at a fixed rate
of interest. Debentures are also known as a bond which serves as an IOU between
issuers and purchaser. Companies use debentures when they need to borrow the
money at a fixed rate of interest for its expansion. Secured and Unsecured,
Registered and Bearer, Convertible and Non-Convertible, First and Second are
four types of Debentures.
Advantages of Debentures
• Investors who want fixed income at lesser risk prefer them.

• As a debenture does not carry voting rights, financing through
them does not dilute control of equity shareholders on
management.
• Financing through them is less costly as compared to the cost of
preference or equity capital as the interest payment on
debentures is tax deductible.
• The company does not involve its profits in a debenture.
• The issue of debentures is appropriate in the situation when the
sales and earnings are relatively stable.
Disadvantages of Debentures
• Each company has certain borrowing capacity. With the issue of

debentures, the capacity of a company to further borrow funds
reduces.
• With redeemable debenture, the company has to make provisions
for repayment on the specified date, even during periods of
financial strain on the company.
• Debenture put a permanent burden on the earnings of a company.
Therefore, there is a greater risk when the earnings of the
company fluctuate.
Types of Debenture
1. Secured and Unsecured:
Secured debenture creates a charge on the assets of the company, thereby

mortgaging the assets of the company. Unsecured debenture does not carry any
charge or security on the assets of the company.
2. Registered and Bearer:
A registered debenture is recorded in the register of debenture holders of the

company. A regular instrument of transfer is required for their transfer. In
contrast, the debenture which is transferable by mere delivery is called bearer
debenture.
3. Convertible and Non-Convertible:
Convertible debenture can be converted into equity shares after the expiry of a
specified period. On the other hand, a non-convertible debenture is those which
cannot be converted into equity shares.
4. First and Second:
A debenture which is repaid before the other debenture is known as the first
debenture. The second debenture is that which is paid after the first debenture
has been paid back.
Securities Trading: Types of orders, Margin

Trading
TYPES OF ORDERS
The most common types of orders are market orders, limit orders, and stop-loss
orders.
• A market orderis an order to buy or sell a security This type of

order guarantees that the order will be executed, but does not
guarantee the execution price. A market order generally will
execute at or near the current bid (for a sell order) or ask (for a buy
order) price. However, it is important for investors to remember
that the last-traded price is not necessarily the price at which a
market order will be executed.
• A limit orderis an order to buy or sell a security at a specific price or
better. A buy limit order can only be executed at the limit price or
lower, and a sell limit order can only be executed at the limit price
or higher. Example: An investor wants to purchase shares of ABC
stock for no more than $10. The investor could submit a limit
order for this amount and this order will only execute if the price
of ABC stock is $10 or lower.
• A stop order, also referred to as a stop-loss orderis an order to buy
or sell a stock once the price of the stock reaches the specified
price, known as the stop price. When the stop price is reached, a
stop order becomes a market order.
• A buy stop orderis entered at a stop price above the current
market price. Investors generally use a buy stop order to limit a
loss or protect a profit on a stock that they have sold short. A sell
stop order is entered at a stop price below the current market
price. Investors generally use a sell stop order to limit a loss or
protect a profit on a stock they own.
Margin Trading Facility (MTF)
Margin Trading Facility (MTF) is a facility offered to an investor in buying of

shares and securities from the available resources by allowing him to pay a
fraction of the total transaction value called a margin. The margin can be given
in the form of cash or shares as collateral depending upon the availability with
the respective investor. In short, it can be termed as leveraging a position in the
market with cash or collateral by the investor. In this transaction the broker
funds the balance amount.
Till last year MTF was allowed against the cash margin not against shares as
collateral. Now Securities Exchange Board of India (SEBI) has relaxed the said
criteria vide its circular no. SCIR/MRD/DP/54/2017 dated June 13, 2017.
Investors are now allowed to create a position under MTF against shares as
collateral as well.
SEBI and Exchanges monitor tightly the securities eligible under the MTF and
margin required (through cash or shares as collateral) on such securities are
prescribed by them from time to time. Currently, the securities forming part of
Group 1 securities are included in MTF.
Features of MTF:
• Investors who wish to avail the MTF need to undertake by
signing/accepting additional Terms and Conditions. It ensures
that investors are completely aware of the risk and rewards of
trading in it.
• Allows investors to create leverage position in securities which are
not part of derivatives segment.
• The positions can be created against the margin amount which
can be in the form of cash or shares as collateral.
• Position can be carried forward up to T+N days (T = means trading
day whereas N = means a number of days the said position can be
carried forward). The definition of N varies from broker to broker.
• Securities allowed under MTF are predefined by SEBI and
Exchanges from time to time.
• Only corporate brokers are allowed to offer MTF as per SEBI
regulations.
Benefits for Investors:
• MTF is ideal for investors who are looking for benefit from the
price movement in short-term but not having sufficient cash
balance.
• Utilization of securities available in portfolio/demat account
(using them as shares as collateral).
• Improve the percentage return on the capital deployed.
• Enhance the buying power of the investors.
• Prudently regulated by the regulator and exchanges.
Clearing and settlement Procedures

NSE Clearing carries out clearing and settlement functions as per the settlement
cycles provided in the settlement schedule.
The clearing function of the clearing corporation is designed to work out a) what
members are due to deliver and b) what members are due to receive on the
settlement date. Settlement is a two way process which involves transfer of
funds and securities on the settlement date.
NSE Clearing has also devised mechanism to handle various exceptional

situations like security shortages, bad delivery, company objections, auction
settlement etc.
Clearing is the process of determination of obligations, after which the
obligations are discharged by settlement.
NSE Clearing has two categories of clearing members: trading clearing members
and custodians. Trading members can trade on a proprietary basis or trade for
their clients. All proprietary trades become the member’s obligation for
settlement. Where trading members trade on behalf of their clients they could
trade for normal clients or for clients who would be settling through their
custodians. Trades which are for settlement by Custodians are indicated with a
Custodian Participant (CP) code and the same is subject to confirmation by the
respective Custodian. The custodian is required to confirm settlement of these
trades on T + 1 day by the cut-off time 1.00 p.m. Non-confirmation by custodian
devolves the trade obligation on the member who had input the trade for the
respective client.
A multilateral netting procedure is adopted to determine the net settlement

obligations (delivery/receipt positions) of the clearing members. Accordingly, a
clearing member would have either pay-in or pay-out obligations for funds and
securities separately. In the case of securities in the Trade for Trade –
Surveillance segment and auction trades, obligations are determined on a gross
basis i.e. every trade results into a deliverable and receivable obligation of funds
and securities. Members pay-in and pay-out obligations for funds and securities
are determined by 2.30 p.m. on T + 1 day and are downloaded to them so that
they can settle their obligations on the settlement day (T+2).
Auto Delivery Out facility
For pay-in through NSDL / CDSL a facility has been provided to members wherein
delivery-out instructions will be generated automatically by the Clearing
Corporation based on the net delivery obligations of its Clearing Members. These
instructions will be released on the T+1 day to NSDL / CDSL and the securities in
the Clearing Members’ pool accounts will be marked for pay-in. Clearing
members desirous of availing this facility shall send a letter in the format
provided in the Annexure.
Cleared and non-cleared deals
NSE Clearing carries out the clearing and settlement of trades executed on the
exchange except Trade for trade – physical segment of capital market. Primary
responsibility of settling these deals rests directly with the members and the
Exchange only monitors the settlement. The parties are required to report
settlement of these deals to the Exchange.
Trading and Settlement Procedure

1) Selecting a Broker or Sub-broker
When a person wishes to trade in the stock market, it cannot do so in his/her

individual capacity. The transactions can only occur through a broker or a sub-
broker. So according to one’s requirement, a broker must be appointed.
Now such a broker can be an individual or a partnership or a company or a

financial institution (like banks). They must be registered under SEBI. Once such
a broker is appointed you can buy/sell shares on the stock exchange.
2) Opening a Demat Account
Since the reforms, all securities are now in electronic format. There are no issues
of physical shares/securities anymore. So an investor must open a
dematerialized account, i.e. a demat account to hold and trade in such electronic
securities.
So you or your broker will open a demat account with the depository participant.
Currently, in India, there are two depository participants, namely Central
Depository Services Ltd. (CDSL) and National Depository Services Ltd. (NDSL).
3) Placing Orders
And then the investor will actually place an order to buy or sell shares. The order
will be placed with his broker, or the individual can transact online if the broker
provides such services. One thing of essential importance is that the order
/instructions should be very clear. Example: Buy a 100 shares of XYZ Co. for a
price of Rs. 140/- or less.
Then the broker will act according to your transactions and place an order for the
shares at the price mentioned or an even better price if available. The broker will
issue an order confirmation slip to the investor.
4) Execution of the Order
Once the broker receives the order from the investor, he executes it. Within 24
hours of this, the broker must issue a Contract Note. This document contains all
the information about the transactions, like the number of shares transacted,
the price, date and time of the transaction, brokerage amount etc.
Contract Note is an important document. In case of a legal dispute, it is evidence

of the transaction. It also contains the Unique Order Code assigned to it by the
stock exchange.
5) Settlement
Here the actual securities are transferred from the buyer to the seller. And the
funds will also be transferred. Here too the broker will deal with the transfer.
There are two types of settlements,
• On the Spot settlement: Here we exchange the funds immediately

and the settlement follows the T+2 pattern. So a transaction
occurring on Monday will be settled by Wednesday (by the second
working day)
• Forward Settlement: Simply means both parties have decided the
settlement will take place on some future date. Can be T+% or
T+9 etc.
Regulatory systems for equity Markets

Securities & Exchange Board of India (SEBI)
The Securities & Exchange Board of India (SEBI) Act, 1992 regulates the
functioning of SEBI. SEBI is the apex body governing the Indian stock exchanges.
The primary functions of SEBI are as follows:
Protective Functions
1. It checks Price rigging

2. Prohibits insider trading
3. Prohibits fraudulent and Unfair Trade Practices
Development Functions
1. SEBI promotes training of intermediaries of the securities market.

2. SEBI tries to promote activities of stock exchange by adopting a
flexible and adaptable approach
Regulatory Functions
1. SEBI has framed rules and regulations and a code of conduct to

regulate the intermediaries such as merchant bankers, brokers,
underwriters, etc.
2. These intermediaries have been brought under the regulatory
purview and private placement has been made more restrictive.
3. SEBI registers and regulates the working of stock brokers, sub-
brokers, share-transfer agents, trustees, merchant bankers and
all those who are associated with stock exchange in any manner
4. SEBI registers and regulates the working of mutual funds etc.
5. SEBI regulates takeover of the companies
6. SEBI conducts inquiries and audit of stock exchanges.
The participation in the Indian Stock Market of both the domestic or foreign
financial intermediaries are governed by the regulations framed by SEBI.
Additionally, Foreign Portfolio Investors (FPIs) can participate in Indian Stock
Market after registering them with an authorized Depository Participant.
National Stock Exchange of India (NSE)
NSE is responsible for formulating and implementing the rules pertaining to:
• Registration of Members
• Listing of Securities
• Monitoring of Transactions
• Compliance
• Other additional functions related to the above functions
NSE itself is regulated by SEBI and is under regular vigilance for all regulatory
compliances.
Stock Exchange
In simple terms, a Stock Market is a platform where people buy and sell stocks,
prices of which are set according to the prevalent demand and supply situation.
It is very similar to a marketplace where traders buy and sell goods, quoting
prices on the basis of the demand for the good and the availability or supply of it.
The term trade, in the context of the bourses, means the transfer of money from
the seller to the buyer in exchange for a security/ share. The price at which the
seller sells or the buyer buys is listed on the stock exchange. You can easily trade
through a trading member registered on a Stock Exchange.
As per National Securities Clearing Corporation Limited “A Trading Member

means any person admitted as a member in any exchange in accordance with the
Rules, Bye-laws and Regulations of that Exchange.”
The Stock Market doesn’t differentiate between any citizen of the country.
Outside investments were only permitted in the 1990s and can take place
through either Foreign Direct Investments (FDIs) or Foreign Portfolio
Investments (FPIs). Thus, the Stock Market participants range from small
individual investors to Insurance Companies, Banks, Mutual Fund companies,
Manufacturing companies etc.
However, the rules and regulations formulated by SEBI remain the same for all
types of market participants and everybody is obligated to abide by such rules
and mandates.
Types of investors
Banks
Banks are a classic source for business loans, Inc. explains. Loan-seekers will
usually be required to produce proof of collateral or a revenue stream before
their loan application is approved. Because of this, banks are often a better
option for more established businesses.
Angel investors
Angel investors are individuals with an earned income that exceeds $200,000 or
who have a net worth of more than $1 million. They are found across all
industries and are useful for entrepreneurs who are beyond the seed stages of
financing but are not yet ready to seek out venture capital.
Peer-to-peer lenders
Peer-to-peer lenders are individuals or groups that offer funding to small

business owners, Time reports. To work with these investors, entrepreneurs
must apply with companies that specialize in peer-to-peer lending, such as
Prosper or Lending Club. Once their application is approved, lenders can then
determine the businesses they wish to support.
Venture capitalists
Venture capitalists are used only after a business begins to show a significant
amount of revenue. These investors are notable, as they usually invest a
substantial amount of money (often around $10 million). They gain most of
their returns through “carried interest,” or a percentage received as
compensation from the profits of a hedge fund or private equity.
Personal investors
Business owners often rely on family, friends or close acquaintances to invest in
their companies, particularly in the beginning. However, there is a limit to how
many of these individuals can invest in startups because of legal limitations.
Aim & Approaches of Security Analysis

Aim of Security Analysis
Capital Appreciation
Capital appreciation is concerned with long-term growth. This strategy is most

familiar in retirement plans where investments work for many years inside a
qualified plan. However, investing for capital appreciation is not limited to
qualified retirement accounts. If this is your objective, you are planning to hold
the stocks for many years. You are content to let them grow within your
portfolio, reinvesting dividends to purchase more shares. A typical strategy
employs making regular purchases. You are not very concerned with day-to-day
fluctuations, but keep a close eye on the fundamentals of the company for
changes that could affect long-term growth.
Current Income
If your objective is current income, you are most likely interested in stocks that
pay a consistent and high dividend. You may also include some top-quality real
estate investment trusts (REITs) and highly-rated bonds. All of these products
produce current income on a regular basis. Many people who pursue a strategy of
current income are retired and use the income for living expenses. Other people
take advantage of a lump sum of capital to create an income stream that never
touches the principal, yet provides cash for certain current needs (college, for
example).
Capital Preservation
Capital preservation is a strategy you often associate with elderly people who
want to make sure they don’t outlive their money. Retired on nearly retired
people often use this strategy to hold on the detention has. For this investor,
safety is extremely important – even to the extent of giving up return for
security. The logic for this safety is clear. If they lose their money through foolish
investment and are retired, it is unlike they will get a chance to replace it.
Investors who use capital preservation tend to invest in bank CDs, Treasury
issues and savings accounts.
Speculation
The speculator is not a true investor, but a trader who enjoys jumping into and
out of stocks as if they were bad shoes. Speculators or traders are interested in
quick profits and used advanced trading techniques like shorting stocks, trading
on the margin, options and other special equipment. They have no love for the
companies they trade and, in fact may not know much about them at all other
than the stock is volatile and ripe for a quick profit. Speculators keep their eyes
open for a quick profit situation and hope to trade in and out without much
thought about the underlying companies. Many people try speculating in the
stock market with the misguided goal of getting rich. It doesn’t work that way. If
you want to try your hand, make sure you are using money you can afford to lose.
It’s easy to get addicted, so make sure you understand the real possibilities of
losing your investment.
The secondary objectives are tax minimization and Marketability or liquidity.
Tax Minimization:
An investor may pursue certain investments in order to adopt tax minimization

as part of his or her investment strategy. A highly-paid executive, for example,
may want to seek investments with favorable tax treatment in order to lessen his
or her overall income tax burden. Making contributions to an IRA or other tax-
sheltered retirement plan can be an effective tax minimization strategy.
Marketability/Liquidity:
Many of the investments we have discussed are reasonably illiquid, which means
they cannot be immediately sold and easily converted into cash. Achieving a
degree ofliquidity, however, requires the sacrifice of a certain level of income or
potential for capital gains.
Common stock is often considered the most liquid of investments, since it can
usually be sold within a day or two of the decision to sell. Bonds can also be fairly
marketable, but some bonds are highly illiquid, or non-tradable, possessing a
fixed term. Similarly, money market instruments may only be redeemable at the
precise date at which the fixed term ends. If an investor seeks liquidity, money
market assets and non-tradable bonds aren’t likely to be held in his or her
portfolio.
There are mainly three alternative approaches to security analysis, namely

fundamental analysis, technical analysis and efficient market theory.
1. Fundamental Analysis
The fundamental analysis allows for selection of securities of different sectors
of the economy that appear to offer profitable opportunities. The security
analysis will help to establish what type of investment should be undertaken
among various alternatives i.e. real estate, bonds, debentures, equity shares,
fixed deposit, gold, jewellery etc. Neither all industries grow at same rate nor do
all companies. The growth rates of a company depend basically on its ability to
satisfy human desires through production of goods or performance is important
to analyze nation economy. It is very important to predict the course of national
economy because economic activity substantially affects corporate profits,
investors’ attitudes, expectations and ultimately security price.
According to this approach, the share price of a company is determined by these

fundamental factors. The fundamental works out the compares this intrinsic
value of a security based on its fundamental; them compares this intrinsic value,
the share is said to be overpriced and vice versa. The mispricing security provides
an opportunity to the investor to those securities, which are under priced and sell
those securities, which are overpriced. It is believed that the market will correct
notable cases of mispricing in future. The prices of undervalued shares will
increase and those of overvalued will decline. Fundamental analysis helps to
identify fundamentally strong companies whose shares are worthy to be
included in the investor’s portfolio.
2. Technical Analysis
The second alternative of security analysis is technical analysis. The technical

analysis is the study of market action for the purpose of forecasting future price
trends. The term market action includes the three principal sources of
information available to the technician – price, value, and interest. Technical
Analysis can be frequently used to supplement the fundamental analysis. It
discards the fundamental approach to intrinsic value. Changes in price
movements represent shifts in supply and demand position. Technical Analysis
is useful in timing a buy or sells order. The technical analysis does not claim 100%
of success in predictions. It helps to improve the knowledge of the probability of
price behavior and provides for investment. The current market price is
compared with the future predicted price to determine the extent of mispricing.
Technical analysis is an approach, which concentrates on price movements and
ignores the fundamentals of the shares.
3. Efficient Market Theory
A more recent approach to security analysis is the efficient market

hypothesis/theory. According to this school of thought, the financial market is
efficient in pricing securities. The efficient market hypothesis holds that market
prices instantaneously and fully reflect all relevant available information. It
means that the market prices of securities will always equal its intrinsic value. As
a result, fundamental analysis, which tries to identify undervalued or overvalued
securities, is said to be a useless exercise.
Efficient market hypothesis is direct repudiation of both fundamental analysis

and technical analysis. An investor can’t consistently earn abnormal return by
undertaking fundamental analysis or technical analysis. According to efficient
market hypothesis it is possible for an investor to earn normal return by
randomly choosing securities of a given risk level.
Risk & Return: Concept of Risk, Component &

Measurement of Risk
So far our analysis of risk-return was confined to single assets held in isolation.
In real world, we rarely find investors putting their entire wealth into single asset
or investment. Instead they build portfolio of investments and hence risk-
return analysis is extended in context of portfolio.
A portfolio is composed of two or more securities. Each portfolio has risk-return

characteristics of its own. A portfolio comprising securities that yield a
maximum return for given level of risk or minimum risk for given level of return
is termed as ‘efficient portfolio’. In their Endeavour to strike a golden mean
between risk and return the traditional portfolio managers diversified funds
over securities of large number of companies of different industry groups.
However, this was done on intuitive basis with no knowledge of the magnitude
of risk reduction gained. Since the 1950s, however, a systematic body of
knowledge has been built up which quantifies the expected return and riskiness
of the portfolio. These studies have collectively come to be known as ‘portfolio
theory’.
A portfolio theory provides a normative approach to investors to make decisions

to invest their wealth in assets or securities under risk. The theory is based on the
assumption that investors are risk averse. Portfolio theory originally developed
by Harry Markowitz states that portfolio risk, unlike portfolio return, is more
than a simple aggregation of the risk, unlike portfolio return, is more than a
simple aggregation of the risks of individual assets.
This is dependent upon the interplay between the returns on assets comprising
the portfolio. Another assumption of the portfolio theory is that the returns of
assets are normally distributed which means that the mean (expected value) and
variance analysis is the foundation of the portfolio.
I. Portfolio Return:
The expected return of a portfolio represents weighted average of the expected

returns on the securities comprising that portfolio with weights being the
proportion of total funds invested in each security (the total of weights must be
100).
The following formula can be used to determine expected return of a

portfolio:
Applying formula (5.5) to possible returns for two securities with funds
equally invested in a portfolio, we can find the expected return of the
portfolio as below:
II. Portfolio Risk:
Unlike the expected return on a portfolio which is simply the weighted average
of the expected returns on the individual assets in the portfolio, the portfolio
risk, σp is not the simple, weighted average of the standard deviations of the
individual assets in the portfolios.
It is for this fact that consideration of a weighted average of individual security

deviations amounts to ignoring the relationship, or covariance that exists
between the returns on securities. In fact, the overall risk of the portfolio
includes the interactive risk of asset in relation to the others, measured by the
covariance of returns. Covariance is a statistical measure of the degree to which
two variables (securities’ returns) move together. Thus, covariance depends on
the correlation between returns on the securities in the portfolio.
Covariance between two securities is calculated as below:

1. Find the expected returns on securities.
2. Find the deviation of possible returns from the expected return for
each security
3. Find the sum of the product of each deviation of returns of two
securities and respective probability.
The formula for determining the covariance of returns of two securities is:
Let us explain the computation of covariance of returns on two securities with

the help of the following illustration:
So far as the nature of relationship between the returns of securities A and B is

concerned, there may be three possibilities, viz., positive covariance, negative
covariance and zero covariance. Positive covariance shows that on an average
the two variables move together.
A’s and B’s returns could be above their average returns at the same time or they
could be below their average returns at the same time. This signifies that as the
proportion of high return and high risk assets is increased, higher returns on
portfolio come with higher risk.
Negative covariance suggests that, on an average, the two variables move in

opposite direction. It means A’s returns could be above its average returns while
B’s return could be below its average returns and vice-versa. This implies that it
is possible to combine the two securities A and B in a manner that will eliminate
all risk.
Zero covariance means that the two variables do not move together either in
positive or negative direction. In other words, returns on the two securities are
not related at all. Such situation does not exist in real world. Covariance may be
non-zero due to randomness and negative and positive terms may not cancel
each other.
In the above example, covariance between returns on A and B is negative i.e., -

38.6. This suggests that the two returns are negatively related.
The above discussion leads us to conclude that the riskiness of a portfolio

depends much more on the paired security covariance than on the riskiness
(standard deviations) of the separate security holdings. This means that a
combination of individually risky securities could still comprise a moderate-to-
low-risk portfolio as long as securities do not move in lock step with each other.
In brief, low covariance’s lead to low portfolio risk.
III. Diversification:
Diversification is venerable rule of investment which suggests “Don’t put all

your eggs in one basket”, spreading risk across a number of securities.
Diversification may take the form of unit, industry, maturity, geography, type of
security and management. Through diversification of investments, an investor
can reduce investment risks.
Investment of funds, say, Rs. 1 lakh evenly among as many as 20 different

securities is more diversified than if the same amount is deployed evenly across
7 securities. This sort of security diversification is naive in the sense that it does
not factor in the covariance between security returns.
The portfolio comprising 20 securities could represent stocks of one industry

only and have returns which are positively correlated and high portfolio returns
variability. On the other hand, the 7-stock portfolio might represent a number
of different industries where returns might show low correlation and, hence, low
portfolio returns variability.
Meaningful diversification is one which involves holding of stocks of more than

one industry so that risks of losses occurring in one industry are counterbalanced
by gains from the other industry. Investing in global financial markets can
achieve greater diversification than investing in securities from a single country.
This is for the fact that the economic cycles of different countries hardly
synchronize and as such a weak economy in one country may be offset by a
strong economy in another.
Fig. 5.2 portrays meaningful diversification. It may be noted from the figure that
the returns overtime for Security X are cyclical in that they move in tandem with
the economic fluctuations. In case of Security Y returns are moderately counter
cyclical. Thus, the returns for these two securities are negatively correlated.
If equal amounts are invested in both securities, the dispersion of returns, up, on
the portfolio of investments will be less because some of each individual
security’s variability is offsetting. Thus, the gains of diversification of
investment portfolio, in the form of risk minimization, can be derived if the
securities are not perfectly and positively correlated.
IV. Systematic and Unsystematic Risk:
Thus, the variance of returns on a portfolio moving in inverse direction can

minimize portfolio risk. However, it is not possible to reduce portfolio risk to zero
by increasing the number of securities in the portfolio. According to the research
studies, when we begin with a single stock, the risk of the portfolio is the
standard deviation of that one stock.
As the number of securities selected randomly held in the portfolio increase, the
total risk of the portfolio is reduced, though at a decreasing rate. Thus, degree of
portfolio risk can be reduced to a large extent with a relatively moderate amount
of diversification, say 15-20 randomly selected securities in equal-rupee
amounts.
Portfolio risk comprises systematic risk and unsystematic risk. Systematic risk is
also known as non- diversifiable risk which arises because of the forces that
affect the overall market, such, as changes in the nation’s economy, fiscal policy
of the Government, monetary policy of the Central bank, change in the world
energy situation etc.
Such types of risks affect securities overall and hence, cannot be diversified
away. Even if an investor holds well diversified portfolio, he is exposed to this
type of risk which is affecting the overall market. This is why, non-diversifiable
or unsystematic risk is also termed as market risk which remains after
diversification.
Another risk component is unsystematic risk. It is also known as diversifiable risk

caused by such random events as law suits, strikes, successful and unsuccessful
marketing programmes, winning or losing a major contract and other events
that are unique to a particular firm.
Unsystematic risk can be eliminated through diversification because these

events are random, their effects on individual securities in a portfolio cancel out
each other. Thus, not all of the risks involved in holding a security are relevant
because part of the risk can be diversified away. What is relevant for investors is
systematic risk which is unavoidable and they would like to be compensated for
bearing it. However, they should not expect the market to provide any extra
compensation for bearing the avoidable risk, as is contended in the Capital Asset
Pricing Model.
Figure 5.3 displays two components of portfolio risk and their relationship to
portfolio size.
Covariance
Covariance is a measure of the directional relationship between the returns on

two risky assets. A positive covariance means that asset returns move together
while a negative covariance means returns move inversely. Covariance is
calculated by analyzing at-return surprises (standard deviations from expected
return) or by multiplying the correlation between the two variables by the
standard deviation of each variable.
Covariance evaluates how the mean values of two variables move together. If
stock A’s return moves higher whenever stock B’s return moves higher and the
same relationship is found when each stock’s return decreases, then these stocks
are said to have a positive covariance. In finance, covariances are calculated to
help diversify security holdings.
When an analyst has a set of data, a pair of x and y values, covariance can be
calculated using five variables from that data. They are:
xi = a given x value in the data set
xm = the mean, or average, of the x values
yi = the y value in the data set that corresponds with xi
ym = the mean, or average, of the y values
n = the number of data points
Given this information, the formula for covariance is: Cov(x,y) = SUM [(xi – xm)
* (yi – ym)] / (n – 1)
It’s important to note that while the covariance does measure the directional
relationship between two assets, it does not show the strength of the
relationship between the two assets. The coefficient of correlation is a more
appropriate indicator of this strength.
Covariance Applications
Covariances have significant applications in finance and modern portfolio

theory. For example, in the capital asset pricing model (CAPM), which is used to
calculate the expected return of an asset, the covariance between a security and
the market is used in the formula for one of the model’s key variables, beta. In
the CAPM, beta measures the volatility, or systematic risk, of a security in
comparison to the market as a whole; it’s a practical measure that draws from the
covariance to gauge an investor’s risk exposure specific to one security.
Meanwhile, portfolio theory uses covariances to statistically reduce the overall

risk of a portfolio by protecting against volatility through covariance-informed
diversification. Possessing financial assets with returns that have similar
covariances does not provide very much diversification; therefore, a diversified
portfolio would likely contain a mix of financial assets that have varying
covariances.
Correlation Coefficient, Assumptions of
Correlation Coefficient
The correlation coefficient is a statistical measure that calculates the strength

of the relationship between the relative movements of the two variables. The
range of values for the correlation coefficient bounded by 1.0 on an absolute
value basis or between -1.0 to 1.0. If the correlation coefficient is greater than 1.0
or less than -1.0, the correlation measurement is incorrect. A correlation of -1.0
shows a perfect negative correlation, while a correlation of 1.0 shows a perfect
positive correlation. A correlation of 0.0 shows zero or no relationship between
the movements of the two variables.
While the correlation coefficient measures a degree of relation between two

variables, it only measures the linear relationship between the variables. The
correlation coefficient cannot capture nonlinear relationships between two
variables.
A value of exactly 1.0 means there is a perfect positive relationship between the
two variables. For a positive increase in one variable, there is also a positive
increase in the second variable. A value of -1.0 means there is a perfect negative
relationship between the two variables. This shows the variables move in
opposite directions — for a positive increase in one variable, there is a decrease
in the second variable. If the correlation is 0, there is no relationship between the
two variables.
The strength of the relationship varies in degree based on the value of the
correlation coefficient. For example, a value of 0.2 shows there is a positive
relationship between the two variables, but it is weak and likely insignificant.
Experts do not consider correlations significant until the value surpasses at least
0.8. However, a correlation coefficient with an absolute value of 0.9 or greater
would represent a very strong relationship.
This statistic is useful in finance. For example, it can be helpful in determining

how well a mutual fund performs relative to its benchmark index, or another
fund or asset class. By adding a low or negatively correlated mutual fund to an
existing portfolio, the investor gains diversification benefits.
Correlation Coefficient Formulas

One of the most commonly used formulas in stats is Pearson’s correlation
coefficient formula. If you’re taking a basic stats class, this is the one you’ll
probably use:
Where,
r = Pearson correlation coefficient
x = Values in first set of data
y = Values in second set of data
n = Total number of values.
The assumptions of Correlation Coefficient are-
1. Normality means that the data sets to be correlated should

approximate the normal distribution. In such normally
distributed data, most data points tend to hover close to the
mean.
2. Homoscedascity comes from the Greek prefix hom, along with
the Greek word skedastikos, which means ‘able to disperse’.
Homoscedascity means ‘equal variances’. It means that the size of
the error term is the same for all values of the independent
variable. If the error term, or the variance, is smaller for a
particular range of values of independent variable and larger for
another range of values, then there is a violation of
homoscedascity. It is quite easy to check for homoscedascity
visually, by looking at a scatter plot. If the points lie equally on
both sides of the line of best fit, then the data is homoscedastic.
3. Linearity simply means that the data follows a linear
relationship. Again, this can be examined by looking at a scatter
plot. If the data points have a straight line (and not a curve)
relationship, then the data satisfies the linearity assumption.
4. Continuous variables are those that can take any value within an
interval. Ratio variables are also continuous variables. To
compute Karl Pearson’s Coefficient of Correlation, both data sets
must contain continuous variables. If even one of the data sets is
ordinal, then Spearman’s Coefficient of Rank Correlation would
be a more appropriate measure.
5. Paired observations mean that every data point must be in pairs.
That is, for every observation of the independent variable, there
must be a corresponding observation of the dependent variable.
We cannot compute correlation coefficient if one data set has 12
observations and the other has 10 observations.
6. No outliers must be present in the data. While statistically there’s
no harm if the data contains outliers, they can significantly skew
the correlation coefficient and make it inaccurate. When does a
data point become an outlier? In general, a data point thats
beyond +3.29 or -3.29 standard deviations away, it is considered
to be an outlier. Outliers are easy to spot visually from the scatter
plot.
Measurement of systematic Risk

Systematic risk can be measured using beta. Stock Beta is the measure of the
risk of an individual stock in comparison to the market as a whole. Beta is the
sensitivity of a stock’s returns to some market index returns (e.g., S&P 500).
Basically, it measures the volatility of a stock against a broader or more general
market.
It is a commonly used indicator by financial and investment analysts. The Capital

Asset Pricing Model (CAPM) also uses the Beta by defining the relationship of the
expected rate of return as a function of the risk free interest rate, the
investment’s Beta, and the expected market risk premium.
Beta is calculated using correlation or regression analysis.
Using the correlation method, beta can be calculated from the historical data
of returns by the following formula:
Where,
rim = Correlation coefficient between the returns of stock i and the returns of the
market index
σi= Standard deviation of returns of stock i
σm = Standard deviation of returns of the market index
σ2m = variance of the market returns
Using the regression analysis, beta can be calculated from the historical data
of returns by the following formula:
Y = α + βX
Where,
Y = Dependent variable
X = Independent variable
α and β are constants.
The above regression equation can also be written as follows:
Ri = α +βi Rm
Where,
Ri = Return of the individual security
Rm = Return of the market index
Βi = Beta (Systematic Risk) of individual security
α= Estimated return of security when market is stationary
The formula for calculation of CC and β are as follows:

Where,
n = number of items
X = Independent variable scores (returns of the market index)
Y = Dependent Variable scores (returns of individual security)
Interpretation of Beta:
1. A beta of 1 indicates that the security’s price will move with the
market.
2. A beta of less than 1 means that the security will be less volatile
than the market.
3. A beta of greater than 1 indicates that the security’s price will be
more volatile than the market.
For example, if a stock’s beta is 1.2, it’s theoretically 20% more volatile than the
market. The Beta of the general and broader market portfolio is always assumed
to be 1.
Fundamental Analysis: Economic, Industry,

Company Analysis
In security selection process, a traditional approach of Economic Industry

Company analysis is employed. EIC analysis is the abbreviation of economic,
industry and company. The person conducting EIC analysis examines the
conditions in the entire economy and then ascertains the most attractive
industries in the light of the economic conditions. At last the most attractive
companies within the attractive industries are pointed out by the analyst.
EIC Analysis of a Company

Below are the further details of the components of EIC analysis, which analyst
always consider before choosing or reaching any decision about any business.
• Economic Analysis
• Industry Analysis
• Company Analysis
Economic Analysis:
Every common stock is susceptible to the market risk. This feature of almost all
types of common stock indicates their combined movement with the
fluctuations in the economic conditions towards the improvement or
deterioration.
Stock prices react favorably to the low inflation, earnings growth, a better
balance of trade, increasing gross national product and other positive
macroeconomic news. Indications that unemployment is rising, inflation is
picking up or earnings estimates are being revised downward will negatively
affect the stock prices. This relationship is reasonably reliable that the US
economy is better represented by the Standard & Poor 500 stock index, which is
famous market indicator. The stock market will forecast an economic boom or
recession properly from the signs in front of average citizen. The Federal bank of
New York has conducted a research that describes that the slope of the yield
curve is the perfect indicator of the economic growth more than three months
out. Recession is indicated by negative slope while positive slope is considered as
good one.
The implications of market risk should be clear to the investor. When there is
recession in the economy, the prices of stocks moves downward. All the
companies suffer the effects of recession despite of the fact that these are high
performing companies or low performing ones. Similarly the stock prices are
positively affected by the boom period of the economy.
Industry Analysis:
It is clear there is certain level of market risk faced by every stock and the stock
price decline during recession in the economy. Another point to be remembered
is that the defensive kind of stock is affected less by the recession as compared
to the cyclical category of stock. In the industry analysis, such industries are
highlighted that can stand well in front of adverse economic conditions.
In 1980, Michael Porter proposed a standard approach to industry analysis which

is referred to as competitive analysis frame work. Threats of new entrants
evaluate the expected reaction of current competitors to new competitors and
obstacles to entry into the industry. In certain industries it is quite difficult for
new company to compete successfully.
For example new producers in the automobile industry face difficulty in

competing the established companies, like General Motors and Ford etc. There
are certain other industries where the entry of new company is easier like
financial planning industry. No extraordinary efforts are required in such kind of
industries to establish any new company. The growth in the industry is slowed
down through the rivalry among the current competitors. Profits of the company
are reduced when it tries to cover more market share because under existing
rivalry the company has to invest a large portion of its earnings in this enhancing
market share. The industry where the rivalry is friendly or modest among
competitors provides greater opportunity for product differentiation &
increased profits. The intense competition is favorable for the customer but not
good for the producer of the product. In case of airline industry there are
common fare price wars among the competitors. When one airline company
reduces its price then the other must also adjust its price accordingly in order to
retain the existing customers.
Another threat faced by company in industry is the treat of substitutes which

prevents the companies to enhance the price of their products. When there is
much increase in the price of particular product, then the consumer simply
switches to other alternative product which has lower price. For example there
are two different video games named Sega and Nintendo. These games
competes each other directly in the market. If the price of Nintendo is enhanced
then the new video game customers are switch toward the Sage which has
relatively lower price. The investor conducting industry analysis should focus the
level of risk of product substitution which seriously affects the future growth of
company.
Another aspect of the industry analysis is the bargaining power of buyers which
can greatly influence the large percentage of sales of seller. In this condition the
profit margins are lower. Concessions are necessary to be offered by the seller
because it is not affordable for him to lose customer. For example there is ship
building company and the US Navy is its main customer. Only two to three ships
are produced by the company every year and so it is very harmful for the firm to
lose the Navy contract. On the other hand in case of departmental store, there is
large number of customers and so the bargaining power of customers is low. In
this business, losing one or two customers will not much affect the sales or
profitability of the retail store.
The only capital intensive industry should not be focused. There are other
industries that are not capital intensive like consultants required in retail
computer store. There is need that is present which force the computer
technician to solve the problems of the computer systems of people. In recent
year, consumers are usually more sophisticated in area of personal computers.
So they are better guided and they try to make their own decisions in the needs
of software and hardware aspects. In fact they possess high power when they
contact the sales staff.
The bargaining power of suppliers has also substantial influence over the
profitability of the company. The supplies for manufacturing products are
required by the company and it does not have sufficient control over the costs. It
is not possible for the company to increase the price of its finished products in
order to cover the increased costs due to the presence of powerful buyer groups
in market of substitute products. So while conducing industry analysis, the
presence of powerful suppliers should be considered as negative for the
company.
The above considerations of industry structure should be analyzed by the

investor in order to make an estimate about the future trends of the industry in
the light of the economic conditions. When potential industry is identified then
comes the final step of EIC analysis which is narrower relating to companies only.
Company Analysis:
In company analysis different companies are considered and evaluated from the
selected industry so that most attractive company can be identified. Company
analysis is also referred to as security analysis in which stock picking activity is
done. Different analysts have different approaches of conducting company
analysis like
• Value Approach to Investing

• Growth Approach to Investing
Additionally in company analysis, the financial ratios of the companies are

analyzed in order to ascertain the category of stock as value stock or growth
stock. These ratios include price to book ratio and price-earnings ratio. Other
ratios like return on equity etc. can also be analyzed to ascertain the potential
company for making investment.
Portfolio Risk and Return

Construction of an optimal portfolio is an important objective for an investor.

In this reading, we will explore the process of examining the risk and return
characteristics of individual assets, creating all possible portfolios, selecting the
most efficient portfolios, and ultimately choosing the optimal portfolio tailored
to the individual in question.
During the process of constructing the optimal portfolio, several factors and
investment characteristics are considered. The most important of those factors
are risk and return of the individual assets under consideration. Correlations
among individual assets along with risk and return are important determinants
of portfolio risk. Creating a portfolio for an investor requires an understanding of
the risk profile of the investor. Although we will not discuss the process of
determining risk aversion for individuals or institutional investors, it is
necessary to obtain such information for making an informed decision. In this
reading, we will explain the broad types of investors and how their risk-return
preferences can be formalized to select the optimal portfolio from among the
infinite portfolios contained in the investment opportunity set.
Risk is uncertainty of the income/capital appreciation or loss of both. The two

major types of risk are- Systematic or market related risks and unsystematic or
company related risks. The systematic risks are the market problems, raw
material availability, tax policy or any Government policy, inflation risk, interest
rate risk and financial risk. The unsystematic risks are mismanagement,
increasing inventory, wrong financial policy, defective marketing, etc.
All investments are risky. The higher the risk taken, the higher is the return. But
proper management of risk involves the right choice of investments whose risks
are compensating. The total risk of two companies may be different and even
lower than the risk of a group of two companies if their risks are offset by each
other. Thus, if the risk of Reliance is represented by Beta of 1.90 and of Dr.
Reddy’s at 0.70 the total of these two is 1.30, on average. But the actual beta of
the group of these two may be less than that due to the fact that co-variances of
these two may be negative or independent. It may be more than that if there is a
strong positive covariance between them.
Degree of Risk and Risk Free Return:
Risk on some assets is almost zero or negligible. The examples are bank deposits,
where the maximum return is 13%. Similarly, investments in Treasury bills,
Government Securities etc., are also risk free or least risky. Their return is 13 to
14%.
Tradeoff between Risk and Return:
All investors should therefore plan their investments first to provide for their
requirements of comfortable life with a house, real estate, physical assets
necessary for comforts and insurance for life, and accident, and make a provision
for a provident fund and pension fund etc., for a future date. They have to take
all needed precautions for a comfortable life, before they enter the stock market
as it is most risky. But rarely any such plan or design is noticed among investors
as they start investment in these markets on the advice of friends, relatives and
agents or brokers, without much of premeditation or preparation.
The following chart shows the tradeoff between risk and return. If you want
more return, you take more risk and if no risk is taken, only bank deposits are
used.
At R0 risk, the reward is only M. If we take a higher risk of R1, the reward will
increase to ON. But if reward is desirable, risk is undesirable. Hence, the investor
who wants the risk taken to be only Ro, but return to be ON he has to plan his
Investments in portfolio. This is what in essence is called portfolio management.
Decomposition of Return:
The portfolio return is related to risk. There is also a risk free return, which is
secured by any investor by keeping his funds in say bank deposits or post office
deposits or certificates. Beyond the risk free rate, the excess return depends on
many factors like the risk taken, expertise in selectivity or selection, return due
to diversification and return for expertise of portfolio manager.
Fama has presented the decomposition of actual returns into its components.
Thus, there is risk free return, excess return, risk premium for taking risk, etc.
There is also a return for selecting the proper assets and extra return for the
expertise of the portfolio manager.
Concept of Beta, Classification of Beta-Geared
and Ungeared Beta
The beta (β) of an investment security (i.e. a stock) is a measurement of its

volatility of returns relative to the entire market. It is used as a measure of risk
and is an integral part of the Capital Asset Pricing Model (CAPM). A company
with a higher beta has greater risk and also greater expected returns.
The beta coefficient can be interpreted as follows:
• β =1 exactly as volatile as the market

• β >1 more volatile than the market
• β <1>0 less volatile than the market
• β =0 uncorrelated to the market
• β <0 negatively correlated to the market
Examples of beta
High β: A company with a β that’s greater than 1 is more volatile than the market.
For example, a high-risk technology company with a β of 1.75 would have
returned 175% of what the market return in a given period (typically measured
weekly).
Low β: A company with a β that’s lower than 1 is less volatile than the whole
market. As an example, consider an electric utility company with a β of 0.45,
which would have returned only 45% of what the market returned in a given
period.
Negative β: A company with a negative β is negatively correlated to the returns

of the market. For an example, a gold company with a β of -0.2, which would
have returned -2% when the market was up 10%.
Equity Beta and Asset Beta
Levered beta, also known as equity beta or stock beta, is the volatility of returns
for a stock taking into account the impact of the company’s leverage from its
capital structure. It compares the volatility (risk) of a levered company to the risk
of the market.
Levered beta includes both business risk and the risk that comes from taking on
debt. It is also commonly referred to as “equity beta” because it is the volatility
of an equity based on its capital structure.
Asset beta, or unlevered beta, on the other hand, only shows the risk of an
unlevered company relative to the market. It includes business risk but does not
include leverage risk.
Portfolio Theories: Markowitz Model

Harry M. Markowitz is credited with introducing new concepts of risk mea-

surement and their application to the selection of portfolios. He started with the
idea of risk aversion of average investors and their desire to maximise the
expected return with the least risk.
Markowitz model is thus a theoretical framework for analysis of risk and return
and their inter-relationships. He used the statistical analysis for measurement
of risk and mathematical programming for selection of assets in a portfolio in an
efficient manner. His framework led to the concept of efficient portfolios. An
efficient portfolio is expected to yield the highest return for a given level of risk
or lowest risk for a given level of return.
Markowitz generated a number of portfolios within a given amount of money or

wealth and given preferences of investors for risk and return. Individuals vary
widely in their risk tolerance and asset preferences. Their means, expenditures
and investment requirements vary from individual to individual. Given the
preferences, the portfolio selection is not a simple choice of any one security or
securities, but a right combination of securities.
Markowitz emphasized that quality of a portfolio will be different from the

quality of individual assets within it. Thus, the combined risk of two assets taken
separately is not the same risk of two assets together. Thus, two securities of
TISCO do not have the same risk as one security of TISCO and one of Reliance.
Risk and Reward are two aspects of investment considered by investors. The
expected return may vary depending on the assumptions. Risk index is measured
by the variance of the distribution around the mean, its range etc., which are in
statistical terms called variance and covariance. The qualification of risk and the
need for optimisation of return with lowest risk are the contributions of
Markowitz. This led to what is called the Modern Portfolio Theory, which
emphasizes the tradeoff between risk and return. If the investor wants a higher
return, he has to take higher risk. But he prefers a high return but a low risk and
hence the problem of a tradeoff.
A portfolio of assets involves the selection of securities. A combination of assets

or securities is called a portfolio. Each individual investor puts his wealth in a
combination of assets depending on his wealth, income and his preferences. The
traditional theory of portfolio postulates that selection of assets should be based
on lowest risk, as measured by its standard deviation from the mean of expected
returns. The greater the variability of returns, the greater is the risk.
Thus, the investor chooses assets with the lowest variability of returns. Taking
the return as the appreciation in the share price, if TELCO shares price varies from
Rs. 338 to Rs. 580 (with variability of 72%) and Colgate from Rs. 218 to Rs. 315
(with a variability of 44%) during 1998, the investor chooses the Colgate as a less
risky share.
As against this Traditional Theory that standard deviation measures the vari-
ability of return and risk is indicated by the variability, and that the choice
depends on the securities with lower variability, the modern Portfolio Theory
emphasizes the need for maximization of returns through a combination of
securities, whose total variability is lower.
The risk of each security is different from that of others and by a proper
combination of securities, called diversification one can arrive at a combination
wherein the risk of one is offset partly or fully by that of the other. In other words,
the variability of each security and covariance for their returns reflected through
their inter-relationships should be taken into account.
Thus, as per the Modern Portfolio Theory, expected returns, the variance of
these returns and covariance of the returns of the securities within the portfolio
are to be considered for the choice of a portfolio. A portfolio is said to be efficient,
if it is expected to yield the highest return possible for the lowest risk or a given
level of risk.
A set of efficient portfolios can be generated by using the above process of

combining various securities whose combined risk is lowest for a given level of
return for the same amount of investment, that the investor is capable of. The
theory of Markowitz, as stated above is based on a number of assumptions.
Assumptions of Markowitz Theory:
The Portfolio Theory of Markowitz is based on the following assumptions:

(1) Investors are rational and behave in a manner as to maximise their utility with
a given level of income or money.
(2) Investors have free access to fair and correct information on the returns and
risk.
(3) The markets are efficient and absorb the information quickly and perfectly.
(4) Investors are risk averse and try to minimise the risk and maximise return.
(5) Investors base decisions on expected returns and variance or standard

deviation of these returns from the mean.
(6) Investors choose higher returns to lower returns for a given level of risk.
A portfolio of assets under the above assumptions is considered efficient if no

other asset or portfolio of assets offers a higher expected return with the same
or lower risk or lower risk with the same or higher expected return.
Diversification of securities is one method by which the above objectives can be
secured. The unsystematic and company related risk can be reduced by
diversification into various securities and assets whose variability is different
and offsetting or put in different words which are negatively correlated or not
correlated at all.
Diversification of Markowitz Theory:
Markowitz postulated that diversification should not only aim at reducing the
risk of a security by reducing its variability or standard deviation, but by reducing
the covariance or interactive risk of two or more securities in a portfolio. As by
combination of different securities, it is theoretically possible to have a range of
risk varying from zero to infinity.
Markowitz theory of portfolio diversification attaches importance to standard

deviation, to reduce it to zero, if possible, covariance to have as much as possible
negative interactive effect among the securities within the portfolio and
coefficient of correlation to have – 1 (negative) so that the overall risk of the
portfolio as a whole is nil or negligible.
Parameters of Markowitz Diversification:
Based on his research, Markowitz has set out guidelines for diversification on the
basis of the attitude of investors towards risk and return and on a proper
quantification of risk. The investments have different types of risk
characteristics, some called systematic and market related risks and the other
called unsystematic or company related risks. Markowitz diversification
involves a proper number of securities, not too few or not too many which have
no correlation or negative correlation. The proper choice of companies,
securities, or assets whose return are not correlated and whose risks are
mutually offsetting to reduce the overall risk.
For building up the efficient set of portfolio, as laid down by Markowitz, we

need to look into these important parameters:
(1) Expected return.
(2) Variability of returns as measured by standard deviation from the mean.
(3) Covariance or variance of one asset return to other asset returns.
In general the higher the expected return, the lower is the standard deviation or
variance and lower is the correlation the better will be the security for investor
choice. Whatever is the risk of the individual securities in isolation, the total risk
of the portfolio of all securities may be lower, if the covariance of their returns is
negative or negligible.
Limitations of Markowitz model:
7. Large number of input data required for calculations: An

investor must obtain estimates of return and variance of returns
for all securities as also covariances of returns for each pair of
securities included in the portfolio. If there are N securities in the
portfolio, he would need N return estimates, N variance estimates
and N (N-1) / 2 covariance estimates, resulting in a total of 2N + [N
(N-1) / 2] estimates. For example, analysing a set of 200 securities
would require 200 return estimates, 200 variance estimates and
19,900 covariance estimates, adding upto a total of 20,300 estimates. For a set
of 500 securities, the estimates would be 1,25,750. Thus, the number of
estimates required becomes large because covariances between each pair of
securities have to be estimated.
8. Complexity of computations required: The computations

required are numerous and complex in nature. With a given set of
securities infinite number of portfolios can be constructed. The
expected returns and variances of returns for each possible
portfolio have to be computed. The identification of efficient
portfolios requires the use of quadratic programming which is a
complex procedure.
Single Index Model

To simplify analysis, the single-index model assumes that there is only 1

macroeconomic factor that causes the systematic risk affecting all stock
returns and this factor can be represented by the rate of return on a market
index, such as the S&P 500. According to this model, the return of any stock can
be decomposed into the expected excess return of the individual stock due to
firm-specific factors, commonly denoted by its alpha coefficient (α), which is the
return that exceeds the risk-free rate, the return due to macroeconomic events
that affect the market, and the unexpected microeconomic events that affect
only the firm. Specifically, the return of stock i is:
ri = αi + βirm + ei
The term βirm represents the stock’s return due to the movement of the market
modified by the stock’s beta (βi), while ei represents the unsystematic risk of
the security due to firm-specific factors.
Macroeconomic events, such as interest rates or the cost of labor, causes the
systematic risk that affects the returns of all stocks, and the firm-specific
events are the unexpected microeconomics events that affect the returns of
specific firms, such as the death of key people or the lowering of the firm’s credit
rating, that would affect the firm, but would have a negligible effect on the
economy. The unsystematic risk due to firm-specific factors of a portfolio can be
reduced to zero by diversification.
The index model is based on the following:
Most stocks have a positive covariance because they all respond similarly to
macroeconomic factors.
However, some firms are more sensitive to these factors than others, and this
firm-specific variance is typically denoted by its beta (β), which measures its
variance compared to the market for one or more economic factors.
Covariances among securities result from differing responses to macroeconomic

factors. Hence, the covariance (σ2) of each stock can be found by multiplying
their betas by the market variance:
Cov(Ri, Rk) = βiβkσ2
This last equation greatly reduces the computations, since it eliminates the need
to calculate the covariance of the securities within a portfolio using historical
returns and the covariance of each possible pair of securities in the portfolio.
With this equation, only the betas of the individual securities and the market
variance need to be estimated to calculate covariance. Hence, the index model
greatly reduces the number of calculations that would otherwise have to be
made for a large portfolio of thousands of securities.
DOW Theory
Dow Theory (Dow Jones Theory) is a trading approach developed by Charles Dow.
Dow Theory is the basis of technical analysis of financial markets. The basic idea
of Dow Theory is that market price action reflects all available information and
the market price movement is comprised of three main trends.
Dow Theory Principles
1. The Averages Discount Everything.

Every knowable factor that may possibly affect both demand and
supply is reflected in the market price.
2. The Market Has Three Trends.
According to Dow an uptrend is consistently rising peaks and
troughs. And a downtrend is consistently rising lowering peaks
and troughs.
Dow believed that laws of action and reaction apply to the
markets just as they do to the physical universe, meaning that
each significant movement is followed by a certain pullback.Dow
considered a trend to have three parts:
1. Primary (compared to tide, reaching further and further

inland until the ultimate point is reached).
2. Secondary (compared to waves and representing
corrections in the primary trend, normally retracing
between one-third and two-thirds of the previous trend
movement and most frequently about half of the
previous move)
3. Minor (ripples) (fluctuations in the secondary trend).
• Major Trends Have Three Phases.

Dow mainly paid attention to the primary (major) trends in which
he distinguished three phases:
1. Accumulation phase: The most astute investors are

entering the market feeling the change in the current
market direction.
2. Public participation phase: A majority of technicians
begin to join in as the price is rapidly advancing.
3. Distribution phase: A new direction is now commonly
recognized and well hiked; economic news are all
confirming which all ends up in increasing speculative
volume and wide public’s participation.
1. The Averages Must Confirm Each Other.

Dow used to say that unless both Industrial and Rail Averages
exceed a previous peak, there is no confirmation of inception or
continuation of a bull market. Signals did no have to occur
simultaneously, but the quicker one followed another – the
stronger the confirmation was.
2. Volume Must Confirm the Trend.
Volume increases or diminishes according to whether the price is
moving in direction of a trend or in reverse. Dow considered
volume a secondary indicator. His buy or sell signals were based
on closing prices.
3. A Trend Is Assumed to Be Contiunous Until Definite Signals of
Its Reversal.
The overall technical approach in market analysis is based upon
the idea that trends continue in motion until there is an external
force causing it to change its direction – just like any other
physical objects. And of course there are reversal signals to be
looking for.
Failure Swing.
The failure of the peak at C to overcome A, followed by the violation of the low at
B, constitutes a “sell” signal at S.
Nonfailure Swing.
Notice that C exceeds A before D falling below B. Some Dow theorists would see
a “sell” signal at S1, while others would need to see a lower high at E before
turning bearish at S2.
Dow only took in consideration closing prices. Averages had to close higher than
a previous peak or lower than a previous trough to be significant. Intraday
penetrations did not count.
Failure Swing Bottom.
The “buy” signal takes place when point B is exceeded (at Bl).
Nonfailure Swing Bottom.
“Buy” signals occur at points B1 or B2.
Support and Resistance Level

The concepts of support and resistance are undoubtedly two of the most highly
discussed attributes of technical analysis. Part of analyzing chart patterns, these
terms are used by traders to refer to price levels on charts that tend to act as
barriers, preventing the price of an asset from getting pushed in a certain
direction. At first, the explanation and idea behind identifying these levels seem
easy, but as you’ll find out, support and resistance can come in various forms, and
the concept is more difficult to master than it first appears.
Defining Support, Resistance

Support is a price level where a downtrend can be expected to pause due to a
concentration of demand. As the price of assets or securities drops, demand for
the shares increases, thus forming the support line. Meanwhile, resistance zones
arise due to a sell-off when prices increase.
Once an area or “zone” of support or resistance has been identified, it provides

valuable potential trade entry or exit points. This is because, as a price reaches a
point of support or resistance, it will do one of two things—bounce back away
from the support or resistance level, or violate the price level and continue in its
direction—until it hits the next support or resistance level.
Most forms of trades are based on the belief that support and resistance zones
will not be broken. Whether the price is halted by the support or resistance level,
or it breaks through, traders can “bet” on the direction and can quickly
determine if they are correct. If the price moves in the wrong direction, the
position can be closed at a small loss. If the price moves in the right direction,
however, the move may be substantial.
TAKEAWAYS
• Technical analysts use support and resistance levels to identify

price points on a chart where the probabilities favor a pause, or
reversal, of a prevailing trend.
• Support occurs where a downtrend is expected to pause, due to a
concentration of demand.
• Resistance occurs where an uptrend is expected to pause
temporarily, due to a concentration of supply.
• Market psychology plays a major role as traders and investors
remember the past and react to changing conditions to anticipate
future market movement.
The Basics
Most experienced traders will be able to tell many stories about how certain price
levels tend to prevent traders from pushing the price of an underlying asset in a
certain direction. For example, assume that Jim was holding a position in stock
between March and November and that he was expecting the value of the shares
to increase.
Let’s imagine that Jim notices that the price fails to get above $39 several times
over several months, even though it has gotten very close to moving above that
level. In this case, traders would call the price level near $39 a level of resistance.
As you can see from the chart below, resistance levels are also regarded as a
ceiling because these price levels prevent the market from moving prices
upward.
Figure 1
On the other side of the coin, we have price levels that are known as support. This
terminology refers to prices on a chart that tend to act as a floor by preventing
the price of an asset from being pushed downward. As you can see from the chart
below, the ability to identify a level of support can also coincide with a good
buying opportunity, because this is generally the area where market participants
see good value and start to push prices higher again.
Figure 2
Trend Lines
The examples above show a constant level prevents an asset’s price from moving
higher or lower. This static barrier is one of the most popular forms of
support/resistance, but the price of financial assets generally trends upward or
downward, so it is not uncommon to see these price barriers change over time.
This is why understanding the concepts of trending and trendlines is important
when learning about support and resistance.
When the market is trending to the upside, resistance levels are formed as the
price action slows and starts to pull back toward the trendline. This occurs as a
result of profit taking or near-term uncertainty for a particular issue or sector.
The resulting price action undergoes a “plateau” effect, or a slight drop-off in
stock price, creating a short-term top.
Many traders will pay close attention to the price of a security as it falls toward
the broader support of the trendline because historically this has been an area
that has prevented the price of the asset from moving substantially lower. For
example, as you can see from the Newmont Mining Corp (NEM) chart below, a
trendline can provide support for an asset for several years. In this case, notice
how the trendline propped up the price of Newmont’s shares for an extended
period of time.
Figure 3
On the other hand, when the market is trending to the downside, traders will
watch for a series of declining peaks and will attempt to connect these peaks
together with a trendline. When the price approaches the trendline, most traders
will watch for the asset to encounter selling pressure and may consider entering
a short position because this is an area that has pushed the price downward in the
past.
The support/resistance of an identified level, whether discovered with a

trendline or through any other method, is deemed to be stronger the more times
that the price has historically been unable to move beyond it. Many technical
traders will use their identified support and resistance levels to choose strategic
entry/exit points because these areas often represent the prices that are the
most influential to an asset’s direction. Most traders are confident at these levels
in the underlying value of the asset, so the volume generally increases more than
usual, making it much more difficult for traders to continue driving the price
higher or lower.
Unlike the rational economic actors portrayed by financial models, real human
traders and investors are emotional, make cognitive errors, and fall back on
heuristics or shortcuts. If people were rational, support and resistance levels
wouldn’t work in practice!
Round Numbers
Another common characteristic of support/resistance is that an asset’s price

may have a difficult time moving beyond a round-figure price level such as $50.
Most inexperienced traders tend to buy or sell assets when the price is at a whole
number because they are more likely to feel that a stock is fairly valued at such
levels. Most target prices or stop orders set by either retail investors or large
investment banks are placed at round price levels rather than at prices such as
$50.06. Because so many orders are placed at the same level, these round
numbers tend to act as strong price barriers. If all the clients of an investment
bank put in sell orders at a suggested target of, for example, $55, it would take
an extreme number of purchases to absorb these sales and, therefore, a level of
resistance would be created.
Moving Averages
Most technical traders incorporate the power of various technical indicators,

such as moving averages, to aid in predicting future short-term momentum, but
these traders never fully realize the ability these tools have for identifying levels
of support and resistance. As you can see from the chart below, a moving average
is a constantly changing line that smooths out past price data while also allowing
the trader to identify support and resistance. Notice how the price of the asset
finds support at the moving average when the trend is up, and how it acts as
resistance when the trend is down.
Figure 4
Traders can use moving averages in a variety of ways, such as to anticipate moves
to the upside, when price lines cross above a key moving average, or to exit
trades, when the price drops below a moving average. Regardless of how the
moving average is used, it often creates “automatic” support and resistance
levels. Most traders will experiment with different time periods in their moving
averages so that they can find the one that works best for this specific task.
Other Indicators
In technical analysis, many indicators have been developed to identify barriers

to future price action. These indicators seem complicated at first, and it often
takes practice and experience to use them effectively. Regardless of an
indicator’s complexity, however, the interpretation of the identified barrier
should be consistent to those achieved through simpler methods.
For example, the Fibonacci retracement tool is a favorite among many short-
term traders because it clearly identifies levels of potential support/resistance.
The reasoning behind how this indicator calculates the various levels of support
and resistance is beyond the scope of this article, but notice in Figure 5 how the
identified levels (dotted lines) are barriers to the short-term direction of the
price.
Figure 5
Measuring the Significance of Zones
Remember how we used the terms “floor” for support and “ceiling” for
resistance? Continuing the house analogy, the security is how a rubber ball that
bounces in a room will hit the floor (support) and then rebound off the ceiling
(resistance). A ball that continues to bounce between the floor and the ceiling is
similar to a trading instrument that is experiencing price consolidation between
support and resistance zones. Now imagine that the ball, in mid-flight, changes
to a bowling ball. This extra force, if applied on the way up, will push the ball
through the resistance level; on the way down, it will push the ball through the
support level. Either way, extra force, or enthusiasm from either the bulls or
bears, is needed to break through the support or resistance.
Often, a support level will eventually become a resistance level when the price
attempts to move back up, and conversely, a resistance level will become a
support level as the price temporarily falls back. Price charts allow traders and
investors to visually identify areas of support and resistance, and they give clues
regarding the significance of these price levels. More specifically, they look at:
Number of Touches. The more times the price tests a support or resistance area,
the more significant the level becomes. When prices keep bouncing off a support
or resistance level, more buyers and sellers notice and will base trading decisions
on these levels.
Preceding Price Move. Support and resistance zones are likely to be more
significant when they are preceded by steep advances or declines. For example,
a fast, steep advance or uptrend will be met with more competition and
enthusiasm and may be halted by a more significant resistance level than a slow,
steady advance. A slow advance may not attract as much attention. This is a good
example of how market psychology drives technical indicators.
Volume at Certain Price Levels. The more buying and selling that has occurred
at a particular price level, the stronger the support or resistance level is likely to
be. This is because traders and investors remember these price levels and are apt
to use them again. When strong activity occurs under high volume and the price
drops, a lot of selling will likely occur when price returns to that level, since
people are far more comfortable closing out a trade at the breakeven
point rather than at a loss.
Time. Support and resistance zones become more significant if the levels have
been tested regularly over an extended period of time.
The Bottom Line
Support and resistance levels are one of the key concepts used by technical
analysts and form the basis of a wide variety of technical analysis tools. The
basics of support and resistance consist of a support level, which can be thought
of as the floor under trading prices, and a resistance level, which can be thought
of as the ceiling. Prices fall and test the support level, which will either “hold,”
and the price will bounce back up, or the support level will be violated, and the
price will drop through the support and likely continue lower to the next support
level.
Determining future levels of support can drastically improve the returns of a

short-term investing strategy because it gives traders an accurate picture of
what price levels should prop up the price of a given security in the event of a
correction. Conversely, foreseeing a level of resistance can be advantageous
because this is a price level that could potentially harm a long position, signifying
an area where investors have a high willingness to sell the security. As
mentioned above, there are several different methods to choose when looking
to identify support/resistance, but regardless of the method, the interpretation
remains the same—it prevents the price of an underlying asset from moving in a
certain direction.
Trend Line
In finance, a trend line is a bounding line for the price movement of a security. It
is formed when a diagonal line can be drawn between a minimum of three or
more price pivot points. A line can be drawn between any two points, but it does
not qualify as a trend line until tested. Hence the need for the third point, the
test. Trend lines are commonly used to decide entry and exit timing when
trading securities. They can also be referred to as a Dutch line, as the concept
was first used in Holland.
A support trend line is formed when a securities price decreases and then
rebounds at a pivot point that aligns with at least two previous support pivot
points. Similarly a resistance trend line is formed when a securities price
increases and then rebounds at a pivot point that aligns with at least two
previous resistance pivot points. Stock often begin or end trending because of
a stock catalyst such as a product launch or change in management.
Trend lines are a simple and widely used technical analysis approach to judging
entry and exit investment timing. To establish a trend line historical data,
typically presented in the format of a chart such as the above price chart, is
required. Historically, trend lines have been drawn by hand on paper charts, but
it is now more common to use charting software that enables trend lines to be
drawn on computer based charts. There are some charting software that will
automatically generate trend lines, however most traders prefer to draw their
own trend lines.
When establishing trend lines it is important to choose a chart based on a price

interval period that aligns with your trading strategy. Short term traders tend to
use charts based on interval periods, such as 1 minute (i.e. the price of the
security is plotted on the chart every 1 minute), with longer term traders using
price charts based on hourly, daily, weekly and monthly interval periods.
However, time periods can also be viewed in terms of years. For example, below
is a chart of the S&P 500 since the earliest data point until April 2008. While the
Oracle example above uses a linear scale of price changes, long term data is more
often viewed as logarithmic: e.g. the changes are really an attempt to
approximate percentage changes than pure numerical value.
Trend lines are typically used with price charts, however they can also be used
with a range of technical analysis charts such as MACD and RSI. Trend lines can
be used to identify positive and negative trending charts, whereby a positive
trending chart forms an upsloping line when the support and the resistance
pivots points are aligned, and a negative trending chart forms a downsloping line
when the support and resistance pivot points are aligned.
Trend lines are used in many ways by traders. If a stock price is moving between
support and resistance trend lines, then a basic investment strategy commonly
used by traders, is to buy a stock at support and sell at resistance, then short at
resistance and cover the short at support. The logic behind this, is that when the
price returns to an existing principal trend line it may be an opportunity to open
new positions in the direction of the trend, in the belief that the trend line will
hold and the trend will continue further. A second way is that when price action
breaks through the principal trend line of an existing trend, it is evidence that the
trend may be going to fail, and a trader may consider trading in the opposite
direction to the existing trend, or exiting positions in the direction of the trend.
Gap Wave Theory

Gaps occur because of underlying fundamental or technical factors. For example,

if a company’s earnings are much higher than expected, the company’s stock
may gap up the next day. This means the stock price opened higher than it closed
the day before, thereby leaving a gap. In the forex market, it is not uncommon
for a report to generate so much buzz that it widens the bid and ask spread to a
point where a significant gap can be seen. Similarly, a stock breaking a new high
in the current session may open higher in the next session, thus gapping up for
technical reasons.
Gaps can be classified into four groups:
• Breakaway gaps occur at the end of a price pattern and signal the
beginning of a new trend.
• Exhaustion gaps occur near the end of a price pattern and signal a
final attempt to hit new highs or lows.
• Common gaps cannot be placed in a price pattern – they simply
represent an area where the price has gapped.
• Continuation gaps, also known as runaway gaps, occur in the
middle of a price pattern and signal a rush of buyers or sellers who
share a common belief in the underlying stock’s future direction.
To Fill or Not to Fill
When someone says a gap has been filled, that means the price has moved back
to the original pre-gap level. These fills are quite common and occur because of
the following:
• Irrational exuberance: The initial spike may have been overly

optimistic or pessimistic, therefore inviting a correction.
• Technical resistance: When a price moves up or down sharply, it
doesn’t leave behind any support or resistance.
• Price Pattern: Price patterns are used to classify gaps and can tell
you if a gap will be filled or not. Exhaustion gaps are typically the
most likely to be filled because they signal the end of a price
trend, while continuation and breakaway gaps are significantly
less likely to be filled since they are used to confirm the direction
of the current trend.
When gaps are filled within the same trading day on which they occur, this is
referred to as fading. For example, let’s say a company announces great earnings
per share for this quarter and it gaps up at the open (meaning it opened
significantly higher than its previous close). Now let’s say, as the day progresses,
people realize that the cash flow statement shows some weaknesses, so they
start selling. Eventually, the price hits yesterday’s close, and the gap is filled.
Many day traders use this strategy during earnings season or at other times
when irrational exuberance is at a high.
How to Play the Gaps

There are many ways to take advantage of these gaps, with a few strategies more
popular than others. Some traders will buy when fundamental or technical
factors favor a gap on the next trading day. For example, they’ll buy a stock
after hours when a positive earnings report is released, hoping for a gap up on
the following trading day. Traders might also buy or sell into highly liquid
or illiquid positions at the beginning of a price movement, hoping for a good fill
and a continued trend. For example, they may buy a currency when it is gapping
up very quickly on low liquidity and there is no significant resistance overhead.
Some traders will fade gaps in the opposite direction once a high or low point has
been determined (often through other forms of technical analysis). For example,
if a stock gaps up on some speculative report, experienced traders may fade the
gap by shorting the stock. Lastly, traders might buy when the price level reaches
the prior support after the gap has been filled. An example of this strategy is
outlined below.
Here are the key things you will want to remember when trading gaps:
• Once a stock has started to fill the gap, it will rarely stop, because
there is often no immediate support or resistance.
• Exhaustion gaps and continuation gaps predict the price moving
in two different directions – be sure you correctly classify the gap
you are going to play.
• Retail investors are the ones who usually exhibit irrational
exuberance; however, institutional investors may play along to
help their portfolios, so be careful when using this
indicator and wait for the price to start to break before taking a
position.
• Be sure to watch the volume. High volume should be present in
breakaway gaps, while low volume should occur in exhaustion
gaps.
TAKEAWAYS
• Gaps are spaces on a chart that emerge when the price of the
financial instrument significantly changes with little or no trading
in-between.
• Gaps occur unexpectedly as the perceived value of the investment
changes, due to underlying fundamental or technical factors.
• Gaps are classified as breakaway, exhaustion, common, or
continuation, based on when they occur in a price pattern and
what they signal.
Relative strength analysis
Relative strength is a measure of the price trend of a stock or other financial

instrument compared to another stock, instrument or industry. It is calculated
by taking the price of one asset and dividing it by another.
For example, if the price of Ford shares is $7 and the price of GM shares is $25,
the relative strength of Ford to GM is 0.28 ($7/25). This number is given context
when it is compared to the previous levels of relative strength. If, for example,
the relative strength of Ford to GM ranges between 0.5 and 1 historically, the
current level of 0.28 suggests that Ford is undervalued or GM is overvalued, or a
mix of both. The reason we know this is because the only way for this ratio to
increase back to its normal historical range is for the numerator (number on the
top of the ratio, in this case the price of Ford) to increase, or the denominator
(number on the bottom of the ratio, in our case the price of GM) to decrease. It
should also be noted that the ratio can also increase by combining an upward
price move of Ford with a downward price move of GM. For example, if Ford
shares rose to $14 and GM shares fell to $20, the relative strength would be 0.7,
which is near the middle of the historic trading range.
It is by comparing the relative strengths of two companies that a trading

opportunity, known as pairs trading, is realized. Pairs trading is a strategy in
which a trader matches long and short positions of two stocks that are perceived
to have a strong correlation to each other and are currently trading outside of
their historical relative strength range. For example, in the case of the Ford/GM
relative strength at 0.28, a pairs trader would enter a long position in Ford and
short GM if he or she felt the pair would move back toward its historical range.
Technical Versus Fundamental Analysis

Fundamental analysis and technical analysis, the major schools of thought

when it comes to approaching the markets, are at opposite ends of the spectrum.
Both methods are used for researching and forecasting future trends in stock
prices, and, like any investment strategy or philosophy, both have their
advocates and adversaries.
Fundamental Analysis
Fundamental analysis is a method of evaluating securities by attempting to

measure the intrinsic value of a stock. Fundamental analysts study everything
from the overall economy and industry conditions to the financial condition and
management of companies. Earnings, expenses, assets, and liabilities are all
important characteristics to fundamental analysts.
Technical Analysis
Technical analysis differs from fundamental analysis in that the stock’s price
and volume are the only inputs. The core assumption is that all known
fundamentals are factored into price, thus there is no need to pay close attention
to them. Technical analysts do not attempt to measure a security’s intrinsic
value, but, instead, use stock charts to identify patterns and trends that suggest
what a stock will do in the future.
The most popular forms of technical analysis are simple moving averages,
support and resistance, trend lines, and momentum-based indicators.
Fundamental analysis and technical analysis are the major schools of thought
when it comes to approaching the markets.
Simple Moving Averages
Simple moving averages are indicators that help assess the stock’s trend by
averaging the daily price over a fixed period. Buy and sell signals are generated
when a shorter duration moving average crosses a longer duration one.
Support and resistance utilize price history. Support is defined as areas where
buyers have stepped in before, while resistance consists of the areas where
sellers have impeded price advance. Practitioners look to buy at support and sell
at resistance.
Trend lines are similar to support and resistance, as they give defined entry and
exit points. However, they differ in that they are projections based on how the
stock has traded in the past. They are often utilized for stocks moving to new
highs or new lows where there is no price history.
There are a number of momentum-based indicators, such as Bollinger Bands®,

Chaikin Money Flow, stochastics, and moving average
convergence/divergence(MACD). These each have unique formulas and give buy
and sell signals based on varying criteria. Momentum indicators tend to be
used in range-bound or trendless markets.
9. Fundamental analysis is a method of evaluating securities by

attempting to measure the intrinsic value of a stock.
10. Technical analysis differs from fundamental analysis in that
the stock’s price and volume are the only inputs.
11. Both methods are used for researching and forecasting future
trends in stock prices.
Nature of Stock Markets

The term “stock market” refers to any institution that supports the purchase
and sale of stocks via a stock exchange. There are more than a dozen public stock
markets in the U.S., with the two most well-known being Nasdaq and the New
York Stock Exchange. Despite the differences in these markets, there are a group
of core characteristics they have in common.
Tip
The stock market is an organized body where brokers trade the stock of public
companies, who introduce their stock through initial public offerings. Stock
prices on the market reflect demand and supply, and traders try to predict stock
behavior.
An Organized Body
A stock exchange is an organized body with a management committee and rules

that control how the exchange works. Traders on the exchange are subject to the
rules of the exchange, which are enforced by the management committee. At
one time, a stock market was a physical place where traders met face-to-face to
make deals, but today most trades take place electronically.
Public Company Stock
Public companies are a key component of stock markets. Public companies are
those that have stock that is bought and sold on a public stock exchange. Before
a stock can be sold, it must first be listed on the exchange. To protect its
investors, a public company is required to disclose financial and business
information that could affect stock value.
Trading Through Brokers
Trading on a stock exchange is restricted to stock brokers and traders who are
members of the exchange. Individual investors must have a brokerage account
in order to participate in trading. For many people, brokerage services are
provided as part of an employer-sponsored retirement investment fund. For
individuals who want to trade independently, an individual account is required.
Going Public with IPOs
Initial public offerings (IPOs) are the mechanism used to introduce a company’s
stock for public sale on a stock exchange. An IPO is said to take place in the
primary market, with follow-on trading between investors occurring in the
secondary market. An IPO allows a company to raise capital for future growth by
selling shares to the public.
Supply and Demand Affect Prices
The price of a company’s stock reflects supply and demand for the stock itself
and is often independent of the company’s success. A company’s stock may be
considered desirable for a variety of reasons, from the strength of an industry
sector to the popularity of a brand.
Stock Market Prediction
In order to make a profit, stock market traders must predict whether a stock’s
value will rise. Share prices often reflect the overall economy and can be volatile
as investors react to financial news and current events, but traders who are
successful predictors can realize significant gains.
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EMH (Efficient Market Hypothesis) and its

implications for investment decision
The Efficient Market Hypothesis (EMH) is a controversial theory that states

that security prices reflect all available information, making it fruitless to
pick stocks (this is, to analyze stock in an attempt to select some that
may return more than the rest).
Stock picking takes, in the best of cases, a lot of work to be just feebly fruitful, so
there are probably better things to do with our resources
The rationale behind this is that the plentiful well-informed motivated

professionals that work in the financial markets allegedly form an efficient
system for assigning each security the most adequate price, given the available
information. Therefore, no individuals can outsmart this fabulous group
and beat the marketby regularly buying securities at prices that are lower than
what they should be.
Put in other words, the hypothesis is saying that no stock trades too cheaply or
too expensively; hence, it would be useless to select which ones to buy or sell.
According to the EMH, the reason for this perfect pricing is that, if one stock
happens to be trading even just a bit too cheaply (or too costly), then its demand
increases (or decreases), rapidly moving the price to its most reasonable value.
This sounds against ordinary wisdom, as we have all heard stories of successful
stock picking by keen traders. Sometimes, these traders justify their
accomplishments, explaining how they anticipated certain news that produced
a change of price, which was unseen for most of the other stock traders.
Nevertheless, these cases don’t necessarily contradict the EMH. When some
news triggers a change of value, the previous price may have reflected the
amount of probability of the news really happening and the price shift it would
produce. There was a probability of the news not happening, and if that had been
the case, the price would have shifted in opposite direction. If the EMH happens
to be right, those who were lucky to select the right outcome this time, may be
unlucky the next.
If we are hiring professionals to do stock picking for us, their fees shouldn’t be
too high, because the potential benefits aren’t
To decide if investors can beat the market or not, what we need to know is if their
predictions are more often right than wrong (actually, that “more often” should
be a weighted average that considers the amount of possible profits and losses).
On the one hand, people tend to remember and communicate their success
stories more than their failures, especially if they are trying to sell a service.
Moreover, among the veteran traders in the markets, there are more who won in
the past, because those who lost money were more inclined to finding
something else to do with their time and remaining assets. So you will hear a lot
of success stories about traders supposedly using their knowledge to beat the
market, but that doesn’t necessarily prove the EMH to be wrong.
Weak, Semi-Strong and Strong EMH
There is scientific evidence to support the EMH. According to some it is

conclusive (and so they talk about an Efficient Market Theory) and according to
others it is not. In part, it depends on the flavor of EMH being under study, as
there are three versions of it, which differ in their definition of available
information. We said that the hypothesis states that this fabulous team called
the market assigns the more adequate price given a certain information. It is key
to know what kind of information that is, because if we had more than that data
then the EMH wouldn’t say anything about our chances to beat the market.
The EMH version that most interests us (semi-strong) has strong factual
support, although it is arguable to say that it is conclusive
The weak version of EMH says that this information is past prices and trading
volumes. This type has the strongest support but it is the least significant, as
everyone has access to more information than past trading data. For example,
company earnings, indebtment, product profile, among other facts (that are
called fundamentals). Therefore not much is said about the possibility of
investors beating the market or not. Nevertheless, it has an interesting
consequence: it would be of no use to perform technical analysis (which is stock
price prediction based exclusively on past trading data, in contrast
to fundamental analysis, which studies the financial performance of the
corporation).
A stronger flavor of EMH, called semi-strong, says that the information in

question is all which is publicly available. This version is the most interesting for
our case because, as investors, that is exactly the information that we have
access to, so if semi-strong EMH is true, then it is useless for us to analyze stock
in an attempt to separate winners from losers.
There is a stronger version, or strong EMH, which is based on all information,

public or private. This one has evidence against. Therefore, it is illegal to use
insider information for trading, as it would mean insiders taking profits from the
general public and thus pushing them away from stock trading, something that
society doesn’t want. Corporate officers can buy their corporations’ stock, but
when they do they have to inform the government, and that information is made
public so that their purchase becomes a publicly-known fact.
Implications
The EMH version that most interests us (semi-strong) has strong factual
support, although it is arguable to say that it is conclusive. Personally I take it to
be not totally true but to a high degree, and that level of acceptance is enough for
inferring some important practical conclusions:
• Stock picking takes, in the best of cases, a lot of work to be just

feebly fruitful, so there are probably better things to do with our
resources.
• Instead of picking stocks, it makes sense to buy passively-
managed funds with low commissions, such as various ETFs, to
obtain the market’s average returns.
• If we are hiring professionals to do stock picking for us (which
happens, for example, when we purchase shares of an actively-
managed fund) their fees shouldn’t be too high, because the
potential benefits aren’t.
• Whenever we attempt to beat the market, by performing security
picking ourselves or through a professional (fund manager), lets
consider the rationale behind the EMH, to identify potential
sources of market inefficiency. For example, we better not try to
beat the market by analyzing large-cap companies, because lots
of people are doing it, with the same information that is available
to us. Instead, coming to know a small company and a niche
market could put us (or our fund manager) in an advantageous
position compared to the rest of the market. Therefore, active
management sounds like a better idea for small-cap funds than
for large.
• Don’t feel too bad if you bought a security and then its price fell,
you only were as silly (or intelligent) as that fabulous team called
the market. There are other better criteria for judging your
portfolio-building skills.
Instead of picking stocks, it makes sense to buy passively-managed funds with

low commissions, to obtain the market’s average returns
EMH shouldn’t be misinterpreted into thinking that there is no such thing

as investment-portfolio design. There are still important decisions to make in
order to obtain a portfolio with a risk that suits you; a good (expected) reward for
that risk, and the lowest possible costs, meaning commissions and other
fees. Modern Portfolio Theory is a set of theories that provide the basis for doing
it, with EMH as one of its pillars, and will be treated in subsequent articles. Just as
the Efficient-Market Hypothesis, much of the rest of Modern Portfolio Theory is
easy to grasp and has immediate practical consequences, even for small
investors.
Capital Market Theorem

Capital Market Theory tries to explain and predict the progression of

capital (and sometimes financial) markets over time on the basis of the one
or the other mathematical model. Capital market theory is a generic term
for the analysis of securities.
In terms of tradeoff between the returns sought by investors and the

inherent risks involved, the capital market theory is a model that seeks to
price assets, most commonly, shares.
In general, whenever someone tries to formulate a financial, investment,
or retirement plan, he or she (consciously or unconsciously) employs a
theory such as arbitrage pricing theory, capital asset pricing model,
coherent market hypothesis, efficient market hypothesis, fractal market
hypothesis, or modern portfolio theory.
The most talked about model in Capital Market Theory is the Capital Asset
Pricing Model.
In studying the capital market theory we deal with issues like the role of
the capital markets, the major capital markets in the US, the initial public
offerings and the role of the venture capital in capital markets, financial
innovation and markets in derivative instruments, the role of securities and
the exchange commission, the role of the federal reserve system, role of
the US Treasury and the regulatory requirements on the capital market.
Capital Market Theory sets the environment in which securities analysis is

preformed. Without a well-constructed view of modem capital markets,
securities analysis may be a futile activity. A great debate, and great divide,
separates the academics, with their efficient market hypothesis, and the
practitioners, with their views of market inefficiency. Although the debate
appears surreal and unimportant at times, its resolution is immensely
critical for conducting effective securities analysis and investing
successfully.
The CAPM is commonly confused with portfolio theory. Portfolio theory is

simply the use of statistical and mathematical programming techniques to
derive optimal tradeoffs between risk and return. Under very restrictive
assumptions (rarely found in financial markets), the CAPM is a highly
specialized subset of portfolio theory. Even so, the CAPM has become very
popular as it provides a logical, common sense tradeoff between risk and
return.
Risk-free Asset
Risk-free asset is an asset, which has a certain future return. In other

words, a risk-free asset is one for which there is no uncertainty regarding
the future returns; that is, the investor knows exactly what the value of the
asset will be at the end of the holding period. Thus, variance of returns of
a risk-free asset is equal to zero. A good example of such asset is
government bonds.
Risk-Free Lending and Borrowing
Investing in a risk-free asset is frequently referred to as `risk-free lending’,

since investment in such assets tantamount to giving loan directly to the
government. An investor does not have to depend solely on his own wealth
to decide how much to invest in assets. She/he can borrow and invest, i.e.,
the investor can use financial leverage. However, investor will have to pay
interest on borrowed funds and such borrowing is also assumed to have
same risk-free interest rate and hence deemed as “risk-free borrowing”.
Though it may not be practical for an ordinary investor to borrow at risk-
free interest rate, it is quiet possible for large funds to borrow at a rate
close to risk-free rate.
The risk-free rate is assumed to be 5%, and a tangent line-called the capital
market line-has been drawn to the efficient frontier passing through the
risk-free rate. The point of tangency corresponds to a portfolio on the
efficient frontier. That portfolio is called the “super-efficient” portfolio. The
Capital Asset Pricing Model demonstrates that, given certain simplifying
assumptions, the super-efficient portfolio must be the market portfolio.
Using the risk-free asset, investors who hold the super-efficient

portfolio may:
• Leverage their position by shorting the risk-free asset and

investing the proceeds in additional holdings in the super-
efficient portfolio.
• Deleverage their position by selling some of their holdings in
the superefficient portfolio and investing the proceeds in the
risk-free asset.
The Capital Market Theory deals with the following issues:
• Importance of venture capital in the capital market

• Initial public offerings
• Role of capital market
• Major capital markets worldwide
• Markets and financial innovations in derivative instruments
• Role of Federal Reserve System
• Role of securities
• Capital market regulatory requirements
• Role of the government treasury
Portfolio Tools: Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is a model that describes the
relationship between expected return and risk of investing in a security. It shows
that the expected return on a security is equal to the risk-free return plus a risk
premium, which is based on the beta of that security. Below is an illustration of
the CAPM concept.
CAPM Formula and Calculation
CAPM is calculated according to the following formula:
Where:
Ra = Expected return on a security

Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return of the market
Note: “Risk Premium” = (Rm – Rrf)
The CAPM formula is used to calculate the expected return on investable asset.
It is based on the premise that investors have assumptions of systematic risk
(also known as market risk or non-diversifiable risk) and need to be
compensated for it in the form of a risk premium – an amount of market return
greater than the risk-free rate. By investing in a security, investors want a higher
return for taking on additional risk.
Expected Return
The “Ra” notation above represents the expected return of a capital asset over
time, given all of the other variables in the equation. The expected return is a
long-term assumption about how an investment will play out over its entire life.
Risk-Free Rate
The “Rrf” notation is for the risk-free rate, which is typically equal to the yield
on a 10-year US government bond. The risk-free rate should correspond to the
country where the investment is being made, and the maturity of the bond
should match the time horizon of the investment. Professional convention,
however, is to typically use the 10-year rate no matter what, because it’s the
most heavily quoted and most liquid bond.
The beta (denoted as “Ba” in the CAPM formula) is a measure of a stock’s risk
(volatility of returns) reflected by measuring the fluctuation of its price changes
relative to the overall market. In other words, it is the stock’s sensitivity to
market risk. For instance, if a company’s beta is equal to 1.5 the security has 150%
of the volatility of returns of the market average. However, if the beta is equal to
1, the expected return on a security is equal to the average market return. A beta
of -1 means security has a perfect negative correlation with the market.
Market Risk Premium
From the above components of CAPM we can simplify the formula to reduce
“expected return of the market minus the risk-free rate” to be simply the
“market risk premium”. The market risk premium represents the additional
return over and above the risk-free rate, which is required to
compensate investors for investing in a riskier asset class. Put another way, the
more volatile a market or an asset class is, the higher the market risk premium
will be.
Why CAPM is Important
The CAPM formula is widely used in the finance industry by various professions
such as investment bankers, financial analysts, and accountants. It is an integral
part of the weighted average cost of capital (WACC) as CAPM calculates the cost
of equity.
WACC is used extensively in financial modeling. It can be used to find the net
present value (NPV) of the future cash flows of an investment and to further
calculate its enterprise value and finally its equity value.
Arbitrage Pricing Theory

The Arbitrage Pricing Theory (APT) is a theory of asset pricing that holds that
an asset’s returns can be forecast using the linear relationship between the
asset’s expected return and a number of macroeconomic factors that affect the
asset’s risk. This theory was created in 1976 by the economist, Stephen Ross.
Arbitrage pricing theory offers analysts and investors a multi-factor pricing
model for securities based on the relationship between a financial asset’s
expected return and its risks.
The theory aims to pinpoint the fair market price of a security that may be
temporarily mispriced. The theory assumes that market action is less than
always perfectly efficient, and therefore occasionally results in assets being
mispriced – either overvalued or undervalued – for a brief period of time.
However, market action should eventually correct the situation, moving price
back to its fair market value. To an arbitrageur, temporarily mispriced securities
represent a short-term opportunity to profit virtually risk-free.
The APT is a more flexible and complex alternative to the Capital Asset Pricing
Model (CAPM). The theory provides investors and analysts with the opportunity
to customize their research. However, it is more difficult to apply, as it takes a
considerable amount of time to determine all the various risk factors that may
influence the price of an asset.
Assumptions in the Arbitrage Pricing Theory
The Arbitrage Pricing Theory operates with a pricing model that factors in many
sources of risk and uncertainty. 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 macroeconomic factors that, according
to the theory, determine the risk and return of the specific asset.
These factors provide risk premiums for investors to consider because the
factors carry the systematic risk that cannot be eliminated by diversification of
an investment portfolio.
The APT suggests that investors will diversify their portfolios, but that they will
also choose their own individual profile of risk and returns based on the
premiums and sensitivity of the macroeconomic risk factors. Risk-taking
investors will exploit the differences in expected and real return on the asset by
using arbitrage.
Arbitrage in the APT
The APT suggests that the returns on assets follow a linear pattern. An investor
can leverage deviations in returns from the linear pattern using the arbitrage
strategy. Arbitrage is a practice of the simultaneous purchase and sale of an
asset, taking advantage of slight pricing discrepancies to lock in a risk-free profit
for the trade.
However, the APT’s concept of arbitrage is different from the classic meaning of
the term. In the APT, arbitrage is not a risk-free operation – but it does offer a
high probability of success. What the arbitrage pricing theory offers traders is a
model for determining the theoretical fair market value of an asset. Having
determined that value, traders then look for slight deviations from the fair
market price, and trade accordingly. For example, if the fair market value of stock
A is determined, using the APT pricing model, to be $13, but the market price
briefly drops to $11, then a trader would buy the stock, based on the belief that
further market price action will quickly “correct” the market price back to the
$13 a share level.
Mathematical Model of the APT
The Arbitrage Pricing Theory can be expressed as a mathematical model:

Where:
E(rj) – Expected return on asset
rf – Risk-free rate
ßn – Sensitivity of the asset price to macroeconomic factor n
RPn – Risk premium associated with factor n
The beta coefficients in the APT are estimated by using linear regression. In
general, historical securities returns are regressed on the factor to estimate its
beta.
Factors in the APT
The APT provides analysts and investors with a high degree of flexibility
regarding the factors that can be applied to the model. The factors, and how
many of them are used to analyze a given security, are subjective choices made
by the individual market analyst or investor. Therefore, two different investors
using the APT to analyze the same security may have widely varying results when
it comes to their actual trading. Even among the most devoted advocates of the
theory, there is no consensus agreement of finance professionals and academics
on which factors are best for predicting returns on securities.
However, Ross suggests that there are some specific macroeconomic factors
that have proven most reliable as price predictors. These include sudden changes
in inflation and GNP, corporate bond premiums, and shifts in the yield curve.
Some other commonly used factors in the APT are GDP, commodities prices,
market indices levels, and currency exchange rates.
Although a bit complex to work with, and something that requires time and
practice to become adept at using, the Arbitrage Pricing Theory is an analytical
tool that investors can use to evaluate their portfolio holdings from a basic value
investing perspective, looking to identify securities that may be temporarily
mispriced, well below or above their fair market value.
Valuation of Equity
Equity valuation is a blanket term and is used to refer to all tools and techniques
used by investors to find out the true value of a company’s equity. It is often seen
as the most crucial element of a successful investment decision. Investment
Banks typically have a equity research department, where research
analysts produce equity research reports of select securities in various
industries.
Who Uses Equity Valuation?
Every participant in the stock market either implicitly or explicitly makes use of
equity valuation while making investment decisions. Everyone from small
individual investors to large institutional investors use equity valuations to
make investment decisions in equity markets. The total size of the global equity
market is estimated to be around $70 trillion and every participant in the stock
market, from professional fund managers to academic researchers, is trying to
find mispriced stocks.
Inputs in the Equity Valuation Process
The true value of any financial asset is thought to be a good indicator of how that
asset will do in the long run. In equity markets, a financial asset with a relatively
high intrinsic value is expected to command a high price, and a financial asset
with a relatively low intrinsic value is expected to command a low price.
Distortions can take place in the short run, i.e., financial assets with relatively
low intrinsic value might command a high price and vice-a-versa, but such
distortions are expected to disappear over time. In the long run, the true value of
a stock (and thereby the market price of that stock) depends only on the
fundamental factors affecting the stock. The factors can be broadly classified
into four categories.
1. Macroeconomic variables
2. Management of the business
3. Financial health of the business
4. Profits of the business
Individual Investors
Individual investors make up the vast majority of stock market investors, aided
by the growing wealth of households in the 20th century and a rise in the average
education level of households.
In recent times, many developed nations in the world have moved away from a
defined benefit approach to retirement funding and towards a defined
contribution approach to retirement funding. The move has further increased
the number of individual stock market investors.
Under a defined benefit approach to pension management, employers commit

to paying their staff a set amount in retirement benefits. In order to meet these
needs, employers will invest their employees’ pension funds deposits.
Under a defined contribution approach, employers contribute a certain amount

in each period to every employee’s pension account. The employees are then
encouraged to invest the money in various financial markets (most commonly
government fixed income instruments and equity market indices).
Institutional Investors
Institutional investors are economic entities that aggregate capital and invest in
financial markets on behalf of a set of smaller economic entities. For
example, private pension funds aggregate capital from millions of individuals
and then invest the aggregated capital in financial markets.
Institutional investors can take advantage of economies of scale and lower

administrative fees compared to individual investors. Such investors include
hedge funds, pension funds, banks, and governments.
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Discounted cash-flow Techniques

Discounted cash flow (DCF) is a valuation method used to estimate the

attractiveness of an investment opportunity. DCF analyses use future free cash
flow projections and discounts them, using a required annual rate, to arrive at
present value estimates. A present value estimate is then used to evaluate the
potential for investment. If the value arrived at through DCF analysis is higher
than the current cost of the investment, the opportunity may be a good one.
Types of DCF Techniques:
There are mainly two types of DCF techniques viz… Net Present Value [NPV] and
Internal Rate of Return [IRR].
(A) Net Present Value Techniques [NPV]:
Net Present Value may be defined as the excess of present value of project cash
inflows [stream of benefits] over that of outflows [cash outlays]. The cash flows
of a project are discounted at some desired rate of return, which is mostly
equivalent to the cost of capital.
(B) Internal Rate of Return [IRR]:
The Internal Rate of Return may be defined as that rate of interest when used to
discount the cash flows of an investment, reduce its NPV to zero. Or it is the
rate of discount, which equates the aggregate discounted benefits with

aggregate discounted costs.
IRR is also called as ‘Discounted Cash Flow Method’ or ‘Yield Method’ or ‘Time
Adjusted Rate of Return Method’. This method is used when the cost of
investment and the annual cash inflows are known but the discount rate [rate of
return] is not known and is to be calculated.
Balance Sheet
The balance sheet is one of the three fundamental financial statements and is
key to both financial modeling and accounting. The balance sheet displays the
company’s total assets, and how these assets are financed, through either debt
or equity. It can also sometimes be referred to as a statement of net worth, or a
statement of financial position. The balance sheet is based on the fundamental
equation:
Assets = Liabilities + Equity.
As such, the balance sheet is divided into two sides (or sections). The left side of
the balance sheet outlines all a company’s assets. On the right side, the balance
sheet outlines the companies liabilities and shareholders’ equity. On either side,
the main line items are generally classified by liquidity. More liquid accounts like
Inventory, Cash, and Trades Payables are placed before illiquid accounts such as
Plant, Property, and Equipment (PP&E) and Long-Term Debt. The assets and
liabilities are also separated into two categories: current asset/liabilities and
non-current (long-term) assets/liabilities.
How the Balance Sheet is Structured?
Balance sheets, like all financial statements, will have minor differences
between organizations and industries. However, there are several “buckets” and
line items that are almost always included in common balance sheets. We briefly
go through commonly found line items under Current Assets, Long-Term
Assets, Current Liabilities, Long-Term Liabilities and Equity.
Learn the basics in CFI’s Free Accounting Fundamentals Course
1. Current Assets
Cash and Equivalents
The most liquid of all assets, cash, appears on the first line of the balance sheet.
Cash Equivalents are also lumped under this line item and include assets that
have short-term maturities under three months or assets that the company can
liquidate on short notice, such as marketable securities. Companies will
generally disclose what equivalents it includes in the footnotes to the balance
sheet.
Accounts Receivable
This account includes the balance of all sales revenue still on credit, net of any
allowances for doubtful accounts (which generates a bad debt expense). As
companies recover accounts receivables, this account decreases and cash
increases by the same amount.
Inventory
Inventory includes amounts for raw materials, work-in-progress goods and

finished goods. The company uses this account when it reports sales of goods,
generally under cost of goods sold in the income statement.
2. Non-Current Assets
Plant, Property and Equipment (PP&E)
Property, Plant and Equipment (also known as PP&E) capture the company’s
tangible fixed assets. This line item is noted net of depreciation. Some
companies will class out their PP&E by the different types of assets, such as Land,
Building, and various types of Equipment. All PP&E is depreciable except for
Land.
Intangible Assets
This line item will include all of the companies intangible fixed assets, which may
or may not be identifiable. Identifiable intangible assets include patents,
licenses, and secret formulas. Unidentifiable intangible assets include brand and
goodwill.
3. Current Liabilities
Accounts Payable
Accounts Payables, or AP, is the amount a company owes suppliers for items or
services purchased on credit. As the company pays off their AP, it decreases
along with an equal amount decrease to the cash account.
Current Debt/Notes Payable
Includes non-AP obligations that are due within one year time or within one
operating cycle for the company (whichever is longest). Notes payable may also
have a long-term version, which includes notes with a maturity of more than one
year.
Current Portion of Long-Term Debt
This account may or may not be lumped together with the above account,
Current Debt. While they may seem similar, the current portion of long-term
debt is specifically the portion due within this year of a piece of debt that has a
maturity of more than one year. For example, if a company takes on a bank loan
to be paid off in 5-years, this account will include the portion of that loan due in
the next year.
4. Non-Current Liabilities
Bonds Payable
This account includes the amortized amount of any bonds the company has
issued.
Long-Term Debt
This account includes the total amount of long-term debt (Excluding the current
portion, if that account is present under current liabilities). This account is
derived from the debt schedule, which outlines all the companies outstanding
debt, the interest expense and the principal repayment for every period.
5. Shareholders’ Equity
Share Capital
This is the value of funds that shareholders have invested in the company. When
a company is first formed, shareholders will typically put in cash. For example, an
investor starts a company and seeds it with $10M. Cash (an asset) rises by $10M,
and Share Capital (an equity account) rises by $10M, balancing out the balance
sheet.
Retained Earnings
This is the total amount of net income the company decides to keep. Every
period, a company may pay out dividends from its net income. Any amount
remaining (or exceeding) is added to (deducted from) retained earnings.
Dividend discount Model

The Dividend Discount Model (DDM) is a quantitative method of valuing a

company’s stock price based on the assumption that the current fair price of a
stock equals the sum of all company’s future dividends discounted back to their
present value.
The dividend discount model was developed under the assumption that
the intrinsic value of a stock reflects the present value of all future cash flows
generated by a security. At the same time, dividends are essentially the positive
cash flows generated by a company and distributed to the shareholders.
Generally, the dividend discount model provides an easy way to calculate a fair
stock price from a mathematical perspective with minimum input variables
required. However, the model relies on several assumptions that cannot be
easily forecasted.
Depending on the variation of the dividend discount model, an analyst requires

forecasting future dividend payments, the growth of dividend payments, and
the cost of equity capital. Forecasting all the variables precisely is almost
impossible. Thus, in many cases, the theoretical fair stock price is far from
reality.
Formula for the Dividend Discount Model
The dividend discount model can take several variations depending on the
stated assumptions. The variations include the following:
1. Gordon Growth Model
The Gordon Growth Model (GGM) is one of the most commonly used variations
of the dividend discount model. The model is called after American
economist Myron J. Gordon, who proposed the variation.
The GGM is based on the assumptions that the stream of future dividends will
grow at some constant rate in future for an infinite time. Mathematically, the
model is expressed in the following way:
Where:
• V0 – the current fair value of a stock

• D1 – the dividend payment in one period from now
• r – the estimated cost of equity capital (usually calculated
using CAPM)
• g – the constant growth rate of the company’s dividends for an
infinite time
2. One-period Dividend Discount Model
The one-period discount dividend model is used much less frequently than the
Gordon Growth model. The former is applied when an investor wants to
determine the intrinsic price of a stock that he or she will sell in one period from
now. The one-period dividend discount model uses the following equation:
Where:
• V0 – the current fair value of a stock

• D1 – the dividend payment in one period from now
• P1 – the stock price in one period from now
• r – the estimated cost of equity capital
3. Multi-period Dividend Discount Model
The multi-period dividend discount model is an extension of the one-period

dividend discount model wherein an investor expects to hold a stock for the
multiple periods. The main challenge of the multi-period model variation is that
forecasting dividend payments for different periods is required. The model’s
mathematical formula is below:
Intrinsic value and Market Price

Intrinsic value
Intrinsic value is also known as the fundamental price of a share. You have
number of ways to calculate it. In general, its the amount calculated based on the
money a company is expected to earn over its lifetime. This means, it’s the
estimated true value of a company regardless of the present market price of a
stock.
Investors including Warren Buffett who invest in stocks based on fundamental

analysis are constantly searching for stocks that is trading at or below intrinsic
value.
Number of factors including financial statements, management, market
analysis and company’s growth projections are considered when setting the
estimated true price of the stock. If you are lucky in getting stocks below intrinsic
value, then you will have a bit of protection if share price were to fall further,
known as margin of safety.
Market price can be significantly higher or lower than the intrinsic value of a
stock. If it’s higher than intrinsic value, then the stock is overvalued. The
opposite is undervalued, that is when the current stock price is lower than the
estimated true value. Investors always look for undervalued companies to
invest.
But, it’s not always right to avoid a stock which has lower intrinsic value than the
current market price.
You should consider other financial tools of fundamental analysis to have a

complete picture of the company before investing.
Financial tools such as P/B ratio, P/E ratio and return on equity (ROE) might help
you for taking a investment decision.
Please note, it’s difficult to determine market price and intrinsic value of a
private company as these company’s shares are not traded on the stock market.
Market Value
Market value of a stock is the amount that investors have attached to a company
at a particular point of time. In simpler terms, it’s the price you pay now to buy
stock of a publicly traded company.
When an investor sell a stock, it means there is another investor who has bought
it because to him, the selling price is attractive at that point of time.
In share market, buyers and sellers continuously pushes stock’s market prices up
and down. Price of a particular stock settle at a point where the demand equals
to the supply of a share. It measures public sentiment about the company’s
future based on number of factors. Therefore, current market price of a stock
may be significantly higher or lower than the estimated price of a stock.
Market capital of a company is calculated by multiplying a stock’s current market

price per share by the number of shares outstanding.
Earning Multiplier Approach

The market value per share is the current trading price for one share in a
company, a relatively straightforward definition. However, earnings per share
(EPS) may not be as intuitive for most investors. The more traditional and widely
used version of the EPS calculation comes from the previous four quarters of
the price-to-earnings ratio, called a trailing earnings multiplier or trailing P/E.
Another variation of the EPS can be calculated using a forward earnings
multiplier, estimating the earnings for the upcoming four quarters. Both sides
have their advantages, with the trailing earnings multiplier approach using
actual data and the forward earnings multiplier predicting possible outcomes for
the stock. Calculated as the following:
Earnings Multiplier = Market value per share / Earnings Per Share

(EPS)
Moving on from the basics, let us do a sample calculation with company XYZ that
currently trades at $100 and has an earnings per share (EPS) of $5. Using the
previously mentioned formula, you can calculate that XYZ’s earnings multiplier
is 100 / 5 = 20.
Why it Matters:
The earnings multiplier is a powerful, but limited tool. For investors, it allows a
quick snapshot of the company’s finances without getting bogged down in the
details of an accounting report.
Let us use our previous example of XYZ, and compare it to another company,
ABC. Company XYZ has an earnings multiplier of 20, while company ABC has an
earnings multiplier of 10. Company XYZ has the highest earnings multiplier of
the two; this would lead most XYZ investors to expect higher earnings in the
future than from ABC (which possesses a lower earnings multiplier ratio).
As noted earlier, the earnings multiplier is limited. It does not paint the entire
picture for the potential investor; rather it is a complementary tool in your
financial toolbox. Be wary of forward EPS measures, (remember, EPS is an
essential aspect of calculation of the earnings multiplier) as they are matters of
prediction and are only estimates of projected earnings. Further, trailing
earnings multipliers can only tell you what happened to a company in the
previous time periods.
Price Earnings Ratio (P/E Ratio)

Last updated on December 8th, 2019 at 09:58 am
The Price Earnings Ratio (P/E Ratio) is the relationship between a company’s
stock price and earnings per share (EPS). It is a popular ratio that gives investors
a better sense of the value of the company. The P/E ratio shows the expectations
of the market and is the price you must pay per unit of current earnings (or future
earnings, as the case may be).
Earnings are important when valuing a company’s stock because investors want
to know how profitable a company is and how profitable it will be in the future.
Furthermore, if the company doesn’t grow and the current level of earnings
remains constant, the P/E can be interpreted as the number of years it will take
for the company to pay back the amount paid for each share.
P/E Ratio in Use
Looking at the P/E of a stock tells you very little about it, if it’s not compared to
the company’s historical P/E or the competitor’s P/E from the same industry. It’s
not easy to conclude whether a stock with a P/E of 10x is a bargain, or a P/E of 50x
is expensive without performing any comparisons.
The beauty of the P/E ratio is that it standardizes stocks of different prices and
earnings levels.
The P/E is also called an earnings multiple. There are two types of P/E: trailing
and forward. The former is based on previous periods of earnings per share, while
a leading or forward P/E ratio is when EPS calculations are based on future
estimates, which predicted numbers (often provided by management or equity
research analysts).
Price Earnings Ratio Formula
P/E = Stock Price Per Share / Earnings Per Share

or
P/E = Market Capitalization / Total Net Earnings

or
Justified P/E = Dividend Payout Ratio / R – G

where;
R = Required Rate of Return
G = Sustainable Growth Rate

Price/Book Value
The price to book value ratio, or PBV ratio, compares the market and book value
of the company. Imagine a company is about to be liquidated. It sells of all its
assets, and pays off all its debts. Whatever is left over is the book value of the
company. The PBV ratio is the market price per share divided by the book value
per share. For example, a stock with a PBV ratio of 2 means that we pay Rs 2 for
every Rs. 1 of book value. The higher the PBV, the more expensive the stock.
Most companies have a PBV greater than one. This means that its market value
is higher than its book value. Why is this the case? There are two reasons:
First, investors will pay a premium above the book value if the company is
expected to generate enough earnings in the future. These earnings justify a
market value above the book value.
Second, the book value of the firm may not be up to date. For example, the value
of an asset on a company’s balance sheet often reflects what the firm paid for the
asset. This is not necessarily what the asset is currently worth. The best example
of this is property, which typically increases in value over time. In this case, the
true book value is higher than what the financial statements imply.
The PBV is most relevant for firms that are close to liquidation or bankruptcy. If
a firm is liquidated, shareholders receive the book value. Once caveat here is that
the bankruptcy process is costly. There is no guarantee that shareholders receive
the entire book value for a liquidated firm.
The PBV ratio is more useful for firms that hold assets of tangible value.
Manufacturing firms are a good example. They hold property, machinery, plants,
etc. For firms with few tangible assets, the book value is less relevant. For
example, companies that consists solely of employees, computers, and office
space, don’t have a meaningful book value.
The Price – Book Value Ratio Formula
The PBV ratio is the market price per share divided by the book value per share.
The market price per share is simply the stock price. The book value per share is
a firm’s assets minus its liabilities, divided by the total number of shares.
PBV ratio = market price per share / book value per share
Price/Sales Ratio
Price to sales ratio compares the price of a share to the revenue per share. This
ratio is usually used for valuation of shares. It takes into account the past
performance of a company for valuation of its shares.
Price to sales ratio is calculated for the trailing twelve months, unless stated
otherwise. A lower price/sales ratio is usually considered to be a better
investment because the investors have to pay less money for each unit of sales.
Price to sales ratio can vary substantially from industry to industry or sector to
sector. Therefore, it is better to use it for comparison with the companies
operating within the same industry or sector.
Calculation
Price to sales ratio is calculated by dividing the price per share by the revenue per
share.
Price/Sales Ratio = Price per Share / Revenue per Share

Price per share is available from the stock market sources. Revenue per share can
be calculated by dividing the revenue from income statement by the total
number of shares.
Price to sales ratio can also be calculated by the following formula:
Price to Sales Ratio = Market Capitalization / Sales Revenue

Market capitalization can be calculated by multiplying the market price per
share by the total number of equity shares. Sales revenue can be found from the
income statement.
Norms and Limits
Price to sales ratio should be used with caution. It do not present the complete
picture because it do not take into account the expenses and liabilities of a
company. Besides, a lower price/sales ratio is not always a positive indicator
because the company might be unprofitable with a lower price/sales ratio.
This ratio is usually calculated for the loss-making companies because price
earning ratio (P/E Ratio) cannot be calculated for such companies.
Economic Value Added

Economic value added (EVA) is a financial measurement of the return

earned by a firm that is in excess of the amount that the company needs
to earn to appease shareholders. In other words, it is a measure of an
organization’s economic profit that takes into account the opportunity cost
of invested capital and ultimately measures whether organizational value
was created or lost.
EVA compares the rate of return on invested capital with the opportunity
cost of investing elsewhere. This is important for businesses to keep track
of, particularly those businesses that are capital intensive. When calculating
economic value added, a positive outcome means that the company is
creating value with its capital investments.
Conversely, a negative outcome would mean that the company is

destroying value with its capital investments and the capital would be better
spent elsewhere. Businesses can use economic value added to assess
managerial performance as it serves as a measure of value creation
for shareholders.
The EVA formula is calculated using the following equation:
EVA = NOPAT – (Capital x Cost of Capital)

EVA = NOPAT – (WACC * capital invested)
Where NOPAT = Net Operating Profits After Tax
WACC = Weighted Average Cost of Capital
Capital invested = Equity + long-term debt at the

beginning of the period
and (WACC* capital invested) is also known as finance charge
Components of EVA:
These three components of EVA are described below:
(i) NOPAT:
NOPAT is defined as follows:
(Profits before interest and taxes) (1- tax rate)

(ii) Cost of capital:
Providers of capital (shareholders and lenders) want to be suitably

compensated for investing capital in the firm. The cost of capital reflects
what they expect.
The formula employed for estimating cost of capital is:
Cost of capital = (Cost of equity) (Proportion of equity in the

capital employed) + (Cost of preference) (Proportion of
preference in the capital employed) + (Pre-tax cost of debt)
(1- tax rate) (Proportion of debt in the capital employed)
(iii) Capital employed:
To obtain capital employed, we have to make adjustments to the

‘accounting’ balance sheet to derive the ‘economic book value’ balance
sheet. These adjustments are meant to reflect the economic value of assets
in place of value determined by historical cost.
Example
Paul is the CFO of an organization in Boston. In order to assess the
organization’s value creation or destruction, Paul would like to calculate
economic value added for 2015. The organization’s NOPAT is $3,500,000,
cost of capital is 5%, and the organization employed 1,000,000 in capital
in 2015.
By plugging the values into the EVA calculation above, we can compute the
value that Paul needs:
$3,500,000 – ( 1,000,000 x 5% ) = $3,450,000
Paul’s organization had a total added value amount of $3,450,000 in 2015.
Advantages of EVA:
(i) EVA is a tool which helps to focus managers’ attention on the impact of
their decisions in increasing shareholders’ wealth.
(ii) EVA is a good guide for investors; as on the bias of EVA, they can
decide whether a particular company is worth investing money in or not.
(iii) EVA can be used as a basis for valuation of goodwill and shares.
(iv) EVA is a good controlling device in a decentralised enterprise.
Management can apply EVA to find out EVA contribution of each
decentralised unit or segment of the company.
(v) EVA linked compensation schemes (for both operatives and managers)
can be developed towards protecting (or rather improving) shareholders’
wealth.
Bond Theorem, Term Structure of Interest

Rates
Bond Theorem
Bond valuation is a technique for determining the theoretical fair value of a

particular bond. Bond valuation includes calculating the present value of the
bond’s future interest payments, also known as its cash flow, and the bond’s
value upon maturity, also known as its face value or par value. Because a bond’s
par value and interest payments are fixed, an investor uses bond valuation to
determine what rate of return is required for a bond investment to be
worthwhile.
Understanding Bond Valuation
A bond is a debt instrument that provides a steady income stream to the investor
in the form of coupon payments. At the maturity date, the full face value of the
bond is repaid to the bondholder. The characteristics of a regular bond include:
Coupon rate: Some bonds have an interest rate, also known as the coupon rate,
which is paid to bondholders semi-annually. The coupon rate is the fixed return
that an investor earns periodically until it matures.
Maturity date: All bonds have maturity dates, some short-term, others long-
term. When the bond matures, the bond issuer repays the investor the full face
value of the bond. For corporate bonds, the face value of a bond is usually $1,000
and for government bonds, face value is $10,000. The face value is not
necessarily the invested principal or purchase price of the bond.
Current Price: Depending on the level of interest rate in the environment, the
investor may purchase a bond at par, below par, or above par. For example, if
interest rates increase, the value of a bond will decrease since the coupon rate
will be lower than the interest rate in the economy. When this occurs, the bond
will trade at a discount, that is, below par. However, the bondholder will be paid
the full face value of the bond at maturity even though he purchased it for less
than the par value.
Term Structure of Interest Rates
The term structure of interest rates is the variation of the yield of bonds with
similar risk profiles with the terms of those bonds. The yield curve is the
relationship of the yield to maturity (YTM) of bonds to the time to maturity, or
more accurately, to duration, which is sometimes referred to as the effective
maturity. In most cases, bonds with longer maturities have higher yields.
However, sometimes the yield curve becomes inverted, with short-term notes
and bonds having higher yields than long-term bonds. Sometimes, the yield
curve may even be flat, where the yield is the same regardless of the maturity.
The actual shape of the yield curve depends on the supply and demand for
specific bond terms, which, in turn, depends on economic conditions, fiscal
policies, expected forward rates, inflation, foreign exchange rates, foreign
capital inflows and outflows, credit ratings of the bonds, tax policies, and the
current state of the economy. The yield curve changes because a component of
the supply and demand for short-term, medium-term, and long-term bonds
varies, to some extent, independently. For instance, when interest rates rise, the
demand for short-term bonds increases faster than the demand for long-term
bonds, which causes a flattening of the yield curve. Such was the case in 2006,
when T-bills were paying the same high rate as 30-year Treasury bonds.
The term structure of interest rates has 3 characteristics:
1. The change in yields of different term bonds tends to move in the

same direction.
2. The yields on short-term bonds are more volatile than long-term
bonds.
3. The yields on long-term bonds tend to be higher than short-term
bonds.
The expectations hypothesis has been advanced to explain the 1st 2

characteristics and the premium liquidity theory have been advanced to explain
the last characteristic.
Market Segmentation Theory
Because bonds and other debt instruments have set maturities, buyers and
sellers of debt usually have preferred maturities. Bond buyers want maturities
that will coincide with their liabilities or when they want the money, while bond
issuers want maturities that will coincide with expected income
streams. Market Segmentation Theory (MST) posits that the yield curve is
determined by supply and demand for debt instruments of different maturities.
Generally, the debt market is divided into 3 major categories in regard to
maturities: short-term, intermediate-term, and long-term. The difference in
the supply and demand in each market segment causes the difference in bond
prices, and therefore, yields. There are many different factors that would cause
differences in the supply and demand for bonds of a certain maturity, but much
of that difference will depend on current interest rates and expected future
interest rates. If current interest rates are high, then future rates will be expected
to decline, thus increasing the demand for long-term bonds by investors who
want to lock in high rates while decreasing the supply, since bond issuers do not
want to be locked into high rates. Therefore, long-term interest rates will be
lower than short-term rates. On the other hand, if current interest rates are low,
then bond buyers will tend to avoid long-term bonds so that they are not locked
into low rates, especially since bond prices will decline when interest rates rise,
which will generally happen if interest rates are already low. On the other hand,
borrowers generally want to lock in low rates, so the supply for long-term bonds
will increase. Hence, a lower demand and a higher supply will cause long-term
bond prices to fall, thereby increasing their yield.
Preferred Habitat Theory
Preferred Habitat Theory (PHT) is an extension of the market segmentation

theory, in that it posits that lenders and borrowers will seek different maturities
other than their preferred or usual maturities (their usual habitat) if the yield
differential is favorable enough to them. For instance, if short-term rates are a
lot lower than long-term rates, then bond issuers will issue more short-term
bonds to take advantage of the lower rates even though they would prefer longer
maturities to match their expected income streams; likewise, lenders will tend
to buy long-term debt if the yield advantage is significant, even though carrying
long-term debt has increased risks.
Expectations Hypothesis
There are several versions of the expectations hypothesis, but essentially,

the expectations hypothesis (aka Pure Expectation Theory, Unbiased
Expectations Theory) states that different term bonds can be viewed as a series
of 1-period bonds, with yields of each period bond equal to the expected short-
term interest rate for that period. For example, compare buying a 2-year bond
with buying 2 1-year bonds sequentially. If the interest rate for the 1st year is 4%
and the expected interest rate, which is often referred to as the forward rate, for
the 2nd year is 6%, then one can be either buy a 1-year bond that yields 4%, then
buy another bond yielding 6% after the 1st one matures for an average interest
rate of 5% over the 2 years, or one can buy a 2-year bond yielding 5%—both
options are equivalent: (4%+6%) / 2 = 5%. Hence, the sequential 1-year bonds
are equivalent to the 2-year bond. (Actually, the geometric mean gives a slightly
more accurate result, but the average is simpler to calculate and the argument is
the same.)
Note that this relationship must hold in general, for if the sequential 1-year
bonds yielded more or less than the equivalent long-term bond, then bond
buyers would buy either one or the other, and there would be no market for the
lesser yielding alternative. For instance, suppose the 2-year bond paid only 4.5%
with the expected interest rates remaining the same. In the 1st year, the buyer of
the 2-year bond would make more money than the 1styear bond, but he would
lose more money in the 2nd year—earning only 4.5% in the 2ndyear instead of 6%
that he could have earned if he didn’t tie up his money in the 2-year bond.
Additionally, the price of the 2-year bond would decline in the secondary
market, since bond prices move opposite to interest rates, so selling the bond
before maturity would only decrease the bond’s return.
Note, however, that expected future interest rates are just that – expected.
There is no reason to believe that they will be the actual rates, especially for
extended forecasts, but, nonetheless, the expected rates still influence present
rates.
According to the expectations hypothesis, if future interest rates are expected to

rise, then the yield curve slopes upward, with longer term bonds paying higher
yields. However, if future interest rates are expected to decline, then this will
cause long term bonds to have lower yields than short-term bonds, resulting in
an inverted yield curve. The inverted yield curve often results when short-term
interest rates are higher than historical averages, since there is a greater
expectation that rates will decline, so long term bond issuers would be reluctant
to issue bonds with higher rates when the expectation is that lower rates will
prevail in the near future.
The expectations hypothesis helps to explain 2 of the 3 characteristics of the

term structure of interest rates:
1. The yield of bonds of different terms tend to move together.

2. Short-term yields are more volatile than long-term yields.
However, the expectations hypothesis does not explain why the yields on long-
term bonds are usually higher than short-term bonds. This could only be
explained by the expectations hypothesis if the future interest rate was expected
to continually rise, which isn’t plausible nor has it been observed, except in
certain brief periods.
Liquidity Premium Theory

The liquidity premium theory has been advanced to explain the 3rd characteristic
of the term structure of interest rates: that bonds with longer maturities tend to
have higher yields. Although illiquidity is a risk itself, subsumed under the
liquidity premium theory are the other risks associated with long-term bonds:
notably interest rate risk and inflation risk. Naturally, increased risks will lower
demand for those bonds, thus increasing their yield. This increase in yield is the
risk premium to compensate buyers of long-term bonds for their increased risk.
Liquidity is defined in terms of its marketability — the easier it is to sell a bond

at its value in the secondary marketplace, the more liquid it will be, thus reducing
liquidity risk. This explains why long-term Treasuries have such low yields,
because they are the easiest to sell. Assets may be illiquid because they are riskier
and/or because supply exceeds demand. Additionally, illiquid assets are more
difficult to price, since previous sale prices may be stale or nonexistent.
A bond’s yield can theoretically be divided into a risk-free yield and the risk
premium. The risk-free yield is simply the yield calculated by the formula for the
expectation hypothesis. The risk premium is the liquidity premium that
increases with the term of the bond. Hence, the yield curve slopes upward, even
if future interest rates are expected to remain flat or even decline a little, and so
the liquidity premium theory of the term structure of interest rates explains
the generally upward sloping yield curve for bonds of different maturities.
Liquidity Premium = Illiquid Bond YTM – Liquid Bond YTM

Besides liquidity, there are 2 other risks with holding bonds that increases with
the term of the bond: inflation risk and interest rate risk. Both the inflation rate
and the interest rate become more difficult to predict farther into the
future. Inflation risk reduces the real return of the bond. Interest rate risk is the
risk that bond prices will drop if interest rates rise, since there is an inverse
relationship between bond prices and interest rates. Of course, interest rate risk
is only a real risk if the bondholder wants to sell before maturity, but it is also an
opportunity cost, since the long-term bondholder forfeits the higher interest
that could be earned if the bondholder’s money was not tied up in the bond.
Therefore, a longer term bond must pay a higher risk premium to compensate
the bondholder for the greater risk.
Portfolio Management and Performance

Evaluation
A portfolio refers to a collection of investment tools such as stocks, shares,
mutual funds, bonds, cash and so on depending on the investor’s income, budget
and convenient time frame.
Following are the two types of Portfolio:
1. Market Portfolio
2. Zero Investment Portfolio
The art of selecting the right investment policy for the individuals in terms of
minimum risk and maximum return is called as portfolio management.
Portfolio management refers to managing an individual’s investments in the

form of bonds, shares, cash, mutual funds etc so that he earns the maximum
profits within the stipulated time frame.
Portfolio management refers to managing money of an individual under the

expert guidance of portfolio managers.
In a layman’s language, the art of managing an individual’s investment is called

as portfolio management.
Need for Portfolio Management
Portfolio management presents the best investment plan to the individuals as

per their income, budget, age and ability to undertake risks.
Portfolio management minimizes the risks involved in investing and also

increases the chance of making profits.
Portfolio managers understand the client’s financial needs and suggest the best
and unique investment policy for them with minimum risks involved.
Portfolio management enables the portfolio managers to provide customized

investment solutions to clients as per their needs and requirements.
Types of Portfolio Management
Portfolio Management is further of the following types:
• Active Portfolio Management: As the name suggests, in an

active portfolio management service, the portfolio managers are
actively involved in buying and selling of securities to ensure
maximum profits to individuals.
• Passive Portfolio Management: In a passive portfolio
management, the portfolio manager deals with a fixed portfolio
designed to match the current market scenario.
• Discretionary Portfolio management services: In Discretionary
portfolio management services, an individual authorizes a
portfolio manager to take care of his financial needs on his behalf.
The individual issues money to the portfolio manager who in turn
takes care of all his investment needs, paper work,
documentation, filing and so on. In discretionary portfolio
management, the portfolio manager has full rights to take
decisions on his client’s behalf.
• Non-Discretionary Portfolio management services: In non
discretionary portfolio management services, the portfolio
manager can merely advise the client what is good and bad for
him but the client reserves full right to take his own decisions.
An individual who understands the client’s financial needs and designs a suitable
investment plan as per his income and risk taking abilities is called a portfolio
manager. A portfolio manager is one who invests on behalf of the client.
A portfolio manager counsels the clients and advises him the best possible
investment plan which would guarantee maximum returns to the individual.
A portfolio manager must understand the client’s financial goals and objectives
and offer a tailor made investment solution to him. No two clients can have the
same financial needs.
The portfolio performance evaluation involves the determination of how a

managed portfolio has performed relative to some comparison
benchmark. Performance evaluation methods generally fall into two
categories, namely conventional and risk-adjusted methods. The most widely
used conventional methods include benchmark comparison and style
comparison. The risk-adjusted methods adjust returns in order to take account
of differences in risk levels between the managed portfolio and the benchmark
portfolio. The major methods are the Sharpe ratio, Treynor ratio, Jensen’s alpha,
Modigliani and Modigliani, and Treynor Squared. The risk-adjusted methods are
preferred to the conventional methods.
The portfolio performance evaluation primarily refers to the determination of

how a particular investment portfolio has performed relative to some
comparison benchmark. The evaluation can indicate the extent to which the
portfolio has outperformed or under-performed, or whether it has performed at
par with the benchmark.
The evaluation of portfolio performance is important for several

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

Benchmark Comparison
The most straightforward conventional method involves comparison of the

performance of an investment portfolio against a broader market index. The
most widely used market index in the United States is the S&P 500 index, which
measures the price movements of 500 U.S. stocks compiled by the Standard &
Poor’s Corporation. If the return on the portfolio exceeds that of the benchmark
index, measured during identical time periods, then the portfolio is said to have
beaten the benchmark index. While this type of comparison with a passive index
is very common in the investment world, it creates a particular problem. The
level of risk of the investment portfolio may not be the same as that of the
benchmark index portfolio. Higher risk should lead to commensurately higher
returns in the long term. This means if the investment portfolio has performed
better than the benchmark portfolio, it may be due to the investment portfolio
being more risky than the benchmark portfolio. Therefore, a simple comparison
of the return on an investment portfolio with that of a benchmark portfolio may
not produce valid results.
Style Comparison
A second conventional method of performance evaluation called ”style-

comparison” involves comparison of return of a portfolio with that having a
similar investment style. While there are many investment styles, one
commonly used approach classifies investment styles as value versus growth.
The ”value style” portfolios invest in companies that are considered
undervalued on the basis of yardsticks such as price-to-earnings and price-to-
topic value multiples. The ”growth style” portfolios invest in companies whose
revenue and earnings are expected to grow faster than those of the average
company.
In order to evaluate the performance of a value-oriented portfolio, one would

compare the return on such a portfolio with that of a benchmark portfolio that
has value-style. Similarly, a growth-style portfolio is compared with a growth-
style benchmark index. This method also suffers from the fact that while the
style of the two portfolios that are compared may look similar, the risks of the
two portfolios may be different. Also, the benchmarks chosen may not be truly
comparable in terms of the style since there can be many important ways in
which two similar style-oriented funds vary.
Reilly and Norton (2003) provide an excellent disposition of the use of

benchmark portfolios and portfolios style and the issues associated with their
selection. Sharpe (1992), and Christopherson (1995) have developed methods
for determining this style.
Sharpe, Treynor and Jensen Measures

Portfolio evaluating refers to the evaluation of the performance of the

investment portfolio. It is essentially the process of comparing the return earned
on a portfolio with the return earned on one or more other portfolio or on a
benchmark portfolio.
Portfolio performance evaluation essentially comprises of two functions,

performance measurement and performance evaluation. Performance
measurement is an accounting function which measures the return earned on a
portfolio during the holding period or investment period. Performance
evaluation, on the other hand, address such issues as whether the performance
was superior or inferior, whether the performance was due to skill or luck etc.
The ability of the investor depends upon the absorption of latest developments
which occurred in the market. The ability of expectations if any, we must able to
cope up with the wind immediately. Investment analysts continuously monitor
and evaluate the result of the portfolio performance. The expert portfolio
constructor shall show superior performance over the market and other factors.
The performance also depends upon the timing of investments and superior
investment analysts capabilities for selection. The evolution of portfolio always
followed by revision and reconstruction. The investor will have to assess the
extent to which the objectives are achieved. For evaluation of portfolio, the
investor shall keep in mind the secured average returns, average or below
average as compared to the market situation. Selection of proper securities is the
first requirement.
Portfolio Performance Evaluation Methods
The objective of modern portfolio theory is maximization of return or

minimization of risk. In this context the research studies have tried to evolve a
composite index to measure risk based return. The credit for evaluating the
systematic, unsystematic and residual risk goes to Sharpe, Treynor and Jensen.
The portfolio performance evaluation can be made based on the following

methods:
1. Sharpe’s Measure
2. Treynor’s Measure
3. Jensen’s Measure
1. Sharpe’s Measure
Sharpe’s Index measure total risk by calculating standard deviation. The method
adopted by Sharpe is to rank all portfolios on the basis of evaluation measure.
Reward is in the numerator as risk premium. Total risk is in the denominator as
standard deviation of its return. We will get a measure of portfolio’s total risk and
variability of return in relation to the risk premium. The measure of a portfolio
can be done by the following formula:
SI =(Rt – Rf)/σf
Where,
• SI = Sharpe’s Index
• Rt = Average return on portfolio
• Rf = Risk free return
• σf = Standard deviation of the portfolio return.
2. Treynor’s Measure
The Treynor’s measure related a portfolio’s excess return to non-diversifiable or

systematic risk. The Treynor’s measure employs beta. The Treynor based his
formula on the concept of characteristic line. It is the risk measure of standard
deviation, namely the total risk of the portfolio is replaced by beta. The equation
can be presented as follow:
Tn =(Rn – Rf)/βm
Where,
• Tn = Treynor’s measure of performance

• Rn = Return on the portfolio
• Rf = Risk free rate of return
• βm= Beta of the portfolio ( A measure of systematic risk)
3. Jensen’s Measure
Jensen attempts to construct a measure of absolute performance on a risk

adjusted basis. This measure is based on Capital Asset Pricing Model (CAPM)
model. It measures the portfolio manager’s predictive ability to achieve higher
return than expected for the accepted riskiness. The ability to earn returns
through successful prediction of security prices on a standard measurement. The
Jensen measure of the performance of portfolio can be calculated by applying
the following formula:
Rp = Rf + (RMI – Rf) x β
Where,
• Rp = Return on portfolio
• RMI= Return on market index
• Rf= Risk free rate of return
Finding alternatives and revision of Portfolio

A portfolio is a mix of securities selected from a vast universe of securities. Two

variables determine the composition of a portfolio; the first is the securities
included in the portfolio and the second is the proportion of total funds invested
in each security.
Portfolio revision involves changing the existing mix of securities. This may be
effected either by changing the securities currently included in the portfolio or
by altering the proportion of funds invested in the securities. New securities may
be added to the portfolio or some of the existing securities may be removed from
the portfolio. Portfolio revision thus leads to purchases and sales of securities.
The objective of portfolio revision is the same as the objective of portfolio
selection, i.e. maximizing the return for a given level of risk or minimizing the
risk for a given level of return. The ultimate aim of portfolio revision is
maximization of returns and minimization of risk.
Portfolio Revision Strategies
There are two types of Portfolio Revision Strategies.
1. Active Revision Strategy
Active Revision Strategy involves frequent changes in an existing portfolio over

a certain period of time for maximum returns and minimum risks.
Active Revision Strategy helps a portfolio manager to sell and purchase

securities on a regular basis for portfolio revision.
2. Passive Revision Strategy
Passive Revision Strategy involves rare changes in portfolio only under certain
predetermined rules. These predefined rules are known as formula plans.
According to passive revision strategy a portfolio manager can bring changes in

the portfolio as per the formula plans only.
Constraints in Portfolio Revision:
Portfolio revision is the process of adjusting the existing portfolio in accordance

with the changes in financial markets and the investor‘s position so as to ensure
maximum return from the portfolio with the minimum of risk. Portfolio revision
or adjustment necessitates purchase and sale of securities. The practice of
portfolio adjustment involving purchase and sale of securities gives rise to
certain problems which act as constraints in portfolio revision. Some of these are
as under:
1. Transaction cost: Buying and selling of securities involve

transaction costs such as commission and brokerage. Frequent
buying and selling of securities for portfolio revision may push up
transaction costs thereby reducing the gains from portfolio
revision. Hence, the transaction costs involved in portfolio
revision may act as a constraint to timely revision of portfolio.
2. Taxes: Tax is payable on the capital gains arising from sale of
securities. Usually, long-term capital gains are taxed at a lower
rate than short-term capital gains. To qualify as long-term
capital gain, a security must be held by an investor for a period of
not less than 12 months before sale. Frequent sales of securities in
the course of periodic portfolio revision or adjustment will result
in short-term capital gains which would be taxed at a higher rate
compared to long-term capital gains. The higher tax on short-
term capital gains may act as a constraint to frequent portfolio
revision.
3. Statutory stipulations: The largest portfolios in every country
are managed by investment companies and mutual funds. These
institutional investors are normally governed by certain statutory
stipulations regarding their investment activity. These
stipulations often act as constraints in timely portfolio revision.
4. Intrinsic difficulty: Portfolio revision is a difficult and time
consuming exercise. The methodology to be followed for
portfolio revision is also not clearly established. Different
approaches may be adopted for the purpose. The difficulty of
carrying out portfolio revision itself may act as a constraint to
portfolio revision.
Portfolio Revision Strategies
Two different strategies may be adopted for portfolio revision, namely an active
revision strategy and a passive revision strategy. The choice of the strategy
would depend on the investor‘s objectives, skill, resources and time.
Active revision strategy involves frequent and sometimes substantial

adjustments to the portfolio. Investors who undertake active revision strategy
believe that security markets are not continuously efficient. They believe that
securities can be mispriced at times giving an opportunity for earning excess
returns through trading in them. Moreover, they believe that different investors
have divergent or heterogeneous expectations regarding the risk and return of
securities in the market. The practitioners of active revision strategy are
confident of developing better estimates of the true risk and return of securities
than the rest of the market. They hope to use their better estimates to generate
excess returns. Thus, the objective of active revision strategy is to beat the
market.
Active portfolio revision is essentially carrying out portfolio analysis and

portfolio selection all over again. It is based on an analysis of the fundamental
factors affecting the economy, industry and company as also the technical
factors like demand and supply. Consequently, the time, skill and resources
required for implementing active revision strategy will be much higher. The
frequency of trading is likely to be much higher under active revision strategy
resulting in higher transaction costs.
Passive revision strategy, in contrast, involves only minor and infrequent

adjustment to the portfolio over time. The practitioners of passive revision
strategy believe in market efficiency and homogeneity of expectation among
investors. They find little incentive for actively trading and revising portfolios
periodically.
Under passive revision strategy, adjustment to the portfolio is carried out

according to certain predetermined rules and procedures designated as formula
plans. These formula plans help the investor to adjust his portfolio according to
changes in the securities market.
Formula Plans in Passive Revision Strategy
In the market, the prices of securities fluctuate. Ideally, investors should buy
when prices are low and sell when prices are high. If portfolio revision is done
according to this principle, investors would be able to benefit from the price
fluctuations in the securities market. But investors are hesitant to buy when
prices are low either expecting that prices will fall further lower or fearing that
prices would not move upwards again. Similarly, when prices are high, investors
hesitate to sell because they feel that prices may rise further and they may be
able to realize larger profits.
Thus, left to themselves, investors would not be acting in the way required to
benefit from price fluctuations. Hence, certain mechanical revision techniques
or procedures have been developed to enable the investors to benefit from price
fluctuations in the market by buying stocks when prices are low and selling them
when prices are high. These techniques are referred to as formula plans.
Formula plans represent an attempt to exploit the price fluctuations in the

market and make them a source of profit to the investor. They make the
decisions on timings of buying and selling securities automatic and eliminate
the emotions surrounding the timing decisions. Formula plans consist of
predetermined rules regarding when to buy or sell and how much to buy and sell.
These predetermined rules call for specified actions when there are changes in
the securities market.
The use of formula plans demands that the investor divide his investment funds
into two portfolios, one aggressive and the other conservative or defensive. The
aggressive portfolio usually consists of equity shares while the defensive
portfolio consists of bonds and debentures. The formula plans specify
predetermined rules for the transfer of funds from the aggressive portfolio to
the defensive portfolio and vice versa. These rules enable the investor to
automatically sell shares when their prices are rising and buy shares when their
prices are falling.
There are different formula plans for implementing passive portfolio revision;
some of them are as under:
1. Constant Rupee Value Plan:
This is one of the most popular or commonly used formula plans. In this plan, the
investor constructs two portfolios, one aggressive, consisting of equity shares
and the other, defensive, consisting of bonds and debentures. The purpose of
this plan is to keep the value of the aggressive portfolio constant, i.e. at the
original amount invested in the aggressive portfolio.
As share prices fluctuate, the value of the aggressive portfolio keeps changing.
When share prices are increasing, the total value of the aggressive portfolio
increases. The investor has to sell some of the shares from his portfolio to bring
down the total value of the aggressive portfolio to the level of his original
investment in it. The sale proceeds will be invested in the defensive portfolio by
buying bonds and debentures.
On the contrary, when share prices are falling, the total value of the aggressive
portfolio would also decline. To keep the total value of the aggressive portfolio
at its original level, the investor has to buy some shares from the market to be
included in his portfolio. For this purpose, a part of the defensive portfolio will be
liquidated to raise the money needed to buy additional shares.
Under this plan, the investor is effectively transferring funds from the
aggressive portfolio to the defensive portfolio and thereby booking profit when
share prices are increasing. Funds are transferred from the defensive portfolio to
the aggressive portfolio when share prices are low. Thus, the plan helps the
investor to buy shares when their prices are low and sell them when their prices
are high.
In order to implement this plan, the investor has to decide the action points, i.e.
when he should make the transfer of funds to keep the rupee value of the
aggressive portfolio constant. These action points, or revision points, should be
predetermined and should be chosen carefully. The revision points have a
significant effect on the returns of the investor. For instance, the revision points
may be predetermined as 10 per cent, 15 per cent, 20 per cent, etc. above or below
the original investment in the aggressive portfolio. If the revision points are too
close, the number of transactions would be more and the transaction costs
would increase reducing the benefits of revision. If the revision points are set too
far apart, it may not be possible to profit from the price fluctuations occurring
between these revision points.
Example: Let us consider an investor who has Rs. 1,00,000 for investment. He
decides to invest Rs. 50,000 in an aggressive portfolio of equity shares and the
remaining Rs. 50,000 in a defensive portfolio of bonds and debentures. He
purchases 1250 shares selling at Rs. 40 per share for his aggressive portfolio. The
revision points are fixed as 20 per cent above or below the original investment of
Rs. 50,000.
After the construction of the portfolios, the share price will fluctuate. If the price
of the share increases to Rs. 45, the value of the aggressive portfolio increases to
Rs. 56,250 (1250 * Rs. 45). Since the revision points are fixed to 20 per cent
above or below the original investment, the investor will act only when the value
of the aggressive portfolio increases to Rs. 60,000 or falls to Rs. 40,000. If the
price of the share increases to Rs. 48 or above, the value of the aggressive
portfolio will exceed Rs. 60,000. Let us suppose that the price of the share
increases to Rs. 50, the value of the aggressive portfolio will be Rs. 62,500. The
investor will sell shares worth Rs. 12,500 (250 * Rs. 50) and transfer the amount
to the defensive portfolio by buying bonds for Rs. 12,500. The value of the
aggressive and defensive portfolios would now be Rs. 50,000 and Rs. 62,500
respectively. The aggressive portfolio now has only 1000 shares valued at Rs. 50
per share.
Let us now suppose that the share price falls to Rs. 40 per share. The value of the
aggressive portfolio would then be Rs. 40,000 (1000 * Rs. 40) which is 20 per
cent less than the original investment. The investor now has to buy shares worth
Rs. 10,000 (250* Rs. 40) to bring the value of the aggressive portfolio to its
original level of Rs. 50,000. The money required for buying the shares will be
raised by selling bonds from the defensive portfolio. The two portfolios now will
have values of Rs. 50,000 (aggressive) and Rs. 52,500 (i.e. Rs. 62,500 – Rs.
10,000) (defensive), aggregating to Rs. 1,02,500. It may be recalled that the
investor started with Rs. 1,00,000 as investment in two portfolios.
Thus, when the ‘constant rupee value plan’ is being implemented, funds will be
transferred from one portfolio to the other, whenever the value of the aggressive
portfolio increases or declines to the predetermined levels.
2. Constant Ratio plan
This is a variation of the constant rupee value plan. Here again the investor would
construct two portfolios, one aggressive and the other defensive with his
investment funds. The ratio between the investments in aggressive portfolio
and the defensive portfolio would be predetermined such as 1:1 or 1.5:1 etc. The
purpose of this plan is to keep this ratio constant by readjusting the two
portfolios when share prices fluctuate from time to time. For this purpose, a
revision point will also have to be predetermined.
Suppose the revision points may be fixed as +/- 0.10. This means that when the
ratio between the values of the aggressive portfolio and the defensive portfolio
moves up by 0.10 points or moves down by 0.10 points, the portfolios would be
adjusted by transfer of funds from one to the other.
Let us assume that an investor starts with Rs. 20,000, investing Rs. 10,000 each
in the aggressive portfolio and the defensive portfolio. The initial ratio is then 1:1.
He has predetermined the revision points as + 0.20. As share price increases the
value of the aggressive portfolio would rise. When the value of the aggressive
portfolio rises to Rs. 12,000, the ratio becomes 1.2:1 (i.e. Rs. 12,000 : Rs. 10,000).
Shares worth Rs. 1,000 will be sold and the amount transferred to the defensive
portfolio by buying bonds.
Now, the value of both the portfolios would be Rs. 11,000 and the ratio would
become 1:1. Now let us assume that the share prices are falling. The value of the
aggressive portfolio would start declining. If, for instance, the value declines to
Rs. 8,500, the ratio becomes 0.77:1 (i.e. Rs. 8,500 : Rs, 11,000). The ratio has
declined by more than 0.20 points. The investor now has to make the value of
both portfolios equal. He has to buy shares worth Rs. 1,250 by selling bonds for
an equivalent amount from his defensive portfolio. Now the value of the
aggressive portfolio increases by Rs. 1,250 and that of the defensive portfolio
decreases by Rs. 1,250. The values of both portfolios become Rs. 9,750 and the
ratio becomes 1:1. The adjustment of portfolios is done periodically in this
manner.
3. Dollar cost averaging
This is another method of passive portfolio revision. All formula plans assume
that stock prices fluctuate up and down in cycles. Dollar cost averaging utilizes
this cyclic movement in share prices to construct a portfolio at low cost.
The plan stipulates that the investor invest a constant sum, such as Rs. 5,000,
Rs. 10,000, etc. in a specified share or portfolio of shares regularly at periodical
intervals, such as a month, two months, a quarter, etc. regardless of the price of
the shares at the time of investment. This periodic investment is to be continued
over a fairly long period to cover a complete cycle of share price movements.
If the plan is implemented over a complete cycle of stock prices, the investor will
obtain his shares at a lower average cost per share than the average price
prevailing in the market over the period. This occurs because more shares would
be purchased at lower prices than at higher prices.
The dollar cost averaging is really a technique of building up a portfolio over a

period of time. The plan does not envisage withdrawal of funds from the
portfolio in between. When a large portfolio has been built up over a complete
cycle of share price movements, the investor may switch over to one of the other
formula plans for its subsequent revision. The dollar cost averaging is specially
suited to investors who have periodic sums to invest. All formula plans have their
limitations. By their very nature they are inflexible.
Further, these plans do not indicate which securities from the portfolio are to be
sold and which securities are to be bought to be included in the portfolio. Only
active portfolio revision can provide answers to these questions.
Portfolio Management and Mutual Fund

Industry
Portfolio management services (PMS) and mutual funds (MF) are avenues to
invest in stocks or bonds. Even though both of them are indirect ways of
investing in the markets, there is a lot of difference between the two.
Let’s understand the dynamics of these investment avenues and factors to be

considered before investing in the same….
Portfolio Management Services (PMS)
PMS is a type of wealth management service that offers a range of specialized

investment strategies to benefit from the opportunities in the market, and is
managed by professional portfolio managers.
There are two types of portfolio management services (PMS):

• Discretionary PMS
• Non-discretionary PMS
In discretionary portfolio management, the portfolio manager individually and

independently manages the funds of each client. But in non-discretionary
portfolio management, the portfolio manager manages the funds in accordance
with the directions of the client. The portfolio manager cannot make buy-sell
decisions at his own discretion; he has to refer to the client for every transaction.
Mutual Funds (MF)
A mutual fund is a professionally-managed investment scheme, run by an asset

management company (AMC) that pools together a group of people and invests
their money in instruments/assets for a common investment objective.
As compared to PMS, MFs have a wider range of investment options, that an

investor can invest in based on his risk profile.
Now let us understand which investment is more suitable – PMS or Mutual
Funds?
1. Transparency and Regulations: Mutual funds are more

transparent as compared to PMS as they are tightly regulated by
SEBI whereas PMS are not very transparent in their disclosures.
2. Minimum Investments: PMS is typically a high-end product
meant for high net-worth individuals (HNIs) because the ticket
size is very high (minimum investment of Rs 25 lakh). In mutual
fund minimum investment starts from Rs 500. Hence, mutual
funds cater to a much wider investor universe.
3. Fees & Charges: As compared to mutual funds, PMS charges a
very high fee for management of portfolio. It charges various
kinds of charges and fees such as:
Entry Load: An entry load is usually charged at the time of buying the PMS.
Fund Management Charges: Every PMS scheme charges fund management

charges, which is variable in nature as per the PMS Provider.
Profit Sharing: Some PMS schemes also have profit sharing arrangements,
wherein the provider charges a certain amount of fees or profit over the
stipulated return generated in the fund. There is no profit sharing in MF. Once
the fund management charge is paid, all the appreciation is owned by investors.
Fixed Fee: Some PMS schemes might have a fixed component in the place of the
profit sharing component and charge investors a fixed monthly fee. This is not a
percentage based fee and is decided before investing in the PMS. It could depend
on the size of the portfolio.
MF on the other hand, have a minimal expense ratio and exit load (up to a certain
period). Hence, MF are more cost effective than PMS.
4. Risk: MF offer various options and diversification, suitable for

investors with different risk appetites. For instance, a risk-taking
investor can opt to invest in an aggressive equity fund whereas a
risk neutral or risk averse investor can invest in balanced or other
less risky funds. In comparison to MF, PMS investments are riskier
as these products usually hold a very concentrated portfolio of
20-30 stocks. Investing in a concentrated portfolio can be very
risky as compared to well diversified mutual funds. Generally, MF
invests in more number of stocks (varies from fund to fund)
compared to PMS.
Further, SEBI has imposed restrictions on MFs which take positions in derivative
instruments. However, PMS do not have any such restrictions, they are actively
managed and take considerably higher risky positions which could provide huge
upsides; however, if it goes wrong, the portfolio could drag down considerably.
5. Consistency: It is a common belief that PMS always generates

superlative returns as compared to mutual funds. However, if we
look at historical performance, mutual funds have given high
returns in a consistent manner, over the years.
6. Complexity: While evaluating the performance of a PMS, a retail
investor will have limited access to data and also it is much more
complex. Mutual funds, on other hand are simple to understand
and all the information about the fund is easily available on the
AMC’s website from time to time.
7. Liquidity: Since, PMS generally have a lock-in period and high exit
charges, it is illiquid compared to mutual funds. Mutual funds can
be liquidated (unless it is close ended and has a lock in) very easily
at very less exit load applicable, if any.
8. Taxability: When an individual invests in mutual funds, he is
allotted units. On redemption, units redeemed are subject to long
term/ short term capital gains tax based on the holding period. In
between, any transactions related to buy/sell of shares by the
fund manager does not attract any tax for the investor.
Whereas In PMS capital gains are computed on each underlying transaction done
by the fund manager. In the structure of PMS, all the stock holdings are directly
in the name of investor (not units of a scheme). So, every time the portfolio
manager sells a share, there is an incidence of capital gain/loss for the individual
investor. If the share is held for less than 12 months, short term capital gains will
be taxed @ 15 percent.
To conclude tax implication in mutual funds for an investor is only when he is

exiting the fund. In PMS, there may be tax implication even while you are still
invested in the same.
9. Dependency: PMS are more prone to psychological biases of the

portfolio manager. Most of the investment decisions taken in
PMS depends mainly on the portfolio manager’s judgement. This
is because the portfolio holding is more concentrated, hence
there is a lot of dependence on the fund manager’s stock picking
ability. In mutual funds, fund manager takes investment
decisions which are more process oriented and risk mitigated.
Even though some PMS do have processes is place, the one’s
followed by mutual funds are much more transparent and tightly
regulated, in comparison.
PMS v/s Mutual Funds at a glanc
Considering the underlying investment for PMS and diversified mutual funds is
similar it doesn’t make any sense to invest in PMS and structured products,
which are closed-ended, less transparent, tax inefficient and charge a higher fee.
PMS in India is still in its nascent stages and has a long way to go. Hence, we
believe that mutual funds remain one of the most suited ways of investing in the
markets.
12.

Capital Mkt. SEM 3

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Capital Market

Last updated on December 4th, 2019 at 11:28 pm

Description: Capital markets help channelise surplus funds from savers to

Capital market consists of primary markets and secondary markets. Primary

• Primary Market : IPOs, Book Building, Private Placements.

Capital Market is an institutional arrangement for borrowing medium and long-

Secondary Markets or Stock Exchanges : The functions of a stock exchanges are

Money Market and Capital Market : A comparison

Point of Distinction Money Market Capital Ma

1. Time period / Term Deals in short-term funds. Long term

4. Regulatory body RBI SEBI

Stock Exchange and New issues Markets:

The New Issues Market:

Managing successful floatation of new issues involves three distinct services:

(ii) Underwriting and

(iii) Distribution of new issues.

The origination requires careful investigation of the viability and prospectus of

Underwriting means guaranteeing, purchase of a stipulated amount of a new

Distribution means sale of stock to the public. The term-lending institutions,

In normal times it is their distributive capacity which determines the extent of

(i) By the issue of a prospectus to the public,

(ii) By private placement and

(iii) By the rights issue to the existing shareholders.

The discount is in the nature of a bonus to the shareholders. Obviously, a rights

The Secondary Market in Old Issues:

There are two segments of the secondary market:

(a) Organized stock exchange,

(b) Over-the-counter market.

9 Most Important Functions of Stock Exchange/Secondary Market

A stock exchange is a reliable barometer to measure the economic condition of a

4. Contributes to Economic Growth:

5. Spreading of Equity Cult:

Stock exchange encourages people to invest in ownership securities by

6. Providing Scope for Speculation:

To ensure liquidity and demand of supply of securities the stock exchange

8. Better Allocation of Capital:

9. Promotes the Habits of Savings and Investment:

The stock market offers attractive opportunities of investment in various

1. Unethical practices: Many unethical practices are rampant

Preference and Equity Capital

Advantages of Preference Capital

• There is no legal obligation on the firm to pay a dividend to the

Disadvantages of Preference Capital

• It is very expensive as compared to the debt-capital because

Advantage of Equity Capital

(i) Fixed Costs Unchanged By Equity Capital

Equity financing has no fixed payment requirements. As a result, the

(ii) Collateral-Free Financing

Equity investors do not require a pledge of collateral. Existing business assets

(iii) Long-Term Financing

(iv) Convenant-Free Financing

(i) Investor Expectations

(ii) Business Form Requirements

(iii) Financial Returns Distribution

Debentures & Bonds

Trading securities is a category of securities that includes both debt securities

Other types of marketable securities are classified as available-for-sale and

Debentures are a debt instrument used by companies and government to issue

• Investors who want fixed income at lesser risk prefer them.

• Each company has certain borrowing capacity. With the issue of

1. Secured and Unsecured:

Secured debenture creates a charge on the assets of the company, thereby

2. Registered and Bearer: