Introduction to Investments

Investment involves employment of funds with the aim

of achieving additional income or growth in values.
It also involves waiting for the reward
Investments are result of savings and savings is an excess
income over expenditure, excess of profits or capital gain
Investment have to take into consideration the impact of
inflation, change in govt policies.
Specifically an investment is the current commitment of
funds for the period of time in order to derive future
payments that will compensate the investors for:
◦ The time the funds are committed
◦ The expected rate of inflation
◦ The uncertainty of the future payments
Types of Investors
• Individual Investors
• Institutional Investors
• All the investors are trading a fund today for some
expected future stream of payments that will be
greater than the current outlay.
Characteristics of Investment
Return
Risk
Safety
Liquidity
OBJECTIVES OF INVESTMENT
Maximization of return
Minimization of risk
Hedge against inflation
Types of Investment
• Financial Assets
• Physical Assets

 Investment v/s Speculation

◦ Risk
◦ Capital Gain
◦ Time period
Real Vs Financial Asset
Security Vs Non Security
Investment Alternatives
Investment Process
Set Investment Policy
Security Analysis
Valuation
Portfolio Construction
Portfolio Evaluation and Revision
Investment Policy
Investible Funds:
◦ The entire inv. Procedure revolves around availability of funds.
◦ Generating through savings and borrowings.
◦ Extra careful in the case of selection of investment alternatives,
if funds are borrowed.
◦ Return> interest pays
 Objectives
◦ They should be framed on the premises of required rate of
return, need for liquidity, safety of principal and regular
income.
◦ Risk takers objective should be high rate of return in the form
of cap appreciation.
◦ Where as Primary objective of risk averse is the safety of
principal.
 Knowledge
◦ Knowledge about investment alternatives and market plays an
important role.
◦ Inv alt ranges from security to real estate.
◦ Risk and return associated with inv alt differ from each other.
◦ E.g. inv in equity is high yielding but more risk than fixed income
securities.
◦ Tax sheltered schemes offer tax benefits to investors.
◦ Awareness of stock market structure and broker charges.
◦ Mode of operation varies among BSE, NSE and OTCEI.
◦ Brokerage charges also changes.
Security Analysis
▶ Market Analysis
◦ The growth in GDP and inflation are reflected in stock prices.
◦ The recession in the economy results in a bear market.
◦ The stock prices may be fluctuating in the short run but in the
long run they move in trends i.e. either upwards or downwards.
 Industry Analysis
◦ The industries that contribute to the output of the major segments of
the economy vary in their growth rates and overall contribution to
eco activity.
◦ Some industry grow faster than the GDP and are expected to
continue in their growth.

 Company Analysis
◦ CA is to help to investor for better analysis.
◦ Company’s earnings, profitability, operating efficiency, capital
structure and mgmt have to be screened.
◦ These factors have direct bearing on the stock prices and return of
the investors.
◦ Company with a high product market share is able to create
wealth to the investors in the form of cap app.
Construction of Portfolio
Its combination of securities and to meet investor’s goals
and objectives.
Max return and min risk.
Diversification:
Obj-> reducing a risk
Portfolio revision
• Portfolio revision includes the active and passive
revision strategies for maximising the returns and
minimising the risk in the constructed portfolio.
Portfolio Evaluation
• The return and risk performance of the security vary
time to time.
• It should be measured and compared.
• Steps should be taken to avoid loss.
Risk and Return
• The uncertainty associated with any of the
investments is called risk
• Expected return is the uncertain future return that an
investor expects to get from his Investment.
• The realized return on the contrary is the certain
returns that an investor has actually obtained from his
investment.
• The possibility variation of the actual return from the
expected returns is termed as risk
Different Types of Risks
 External Risk
◦ Uncontrollable in nature and affect large number of securities
 Internal Risk
◦ Controllable in nature and affect only that particular co.

External risk is also termed as systematic risk

Internal risk is termed as unsystematic risk
Total risk = Systematic Risk + Unsystematic Risk
Interest Rate Risk
• Interest rate risk is the variation in the single period
rate of return caused by the fluctuations in market
interest rate
• These rates affect debentures, bonds and stocks at the
most
• A bond is normally issued at a coupon rate which is
equal to the interest rate prevailing in the market.
• The fluctuations in the interest rate are caused by the
changes in the govt monetary policy.
Example_Interest rate risk
Let's assume you purchase a bond from Company XYZ.
Because bond prices typically fall when interest rates
rise, an unexpected increase in interest rates means that
your investment could suddenly lose value.
If you expect to sell the bond before it matures, this
could mean you end up selling the bond for less than
you paid for it (a capital loss).
Of course, the magnitude of change in the bond price is
also affected by the maturity, coupon rate, its ability to
be called, and other characteristics of the bond.
Market Risk
 Market risk is associated with consistent fluctuations
seen in the trading price of any particular shares or
securities.
 That is, it arises due to rise or fall in the trading price
of listed shares or securities in the stock market.
Purchasing Power & Inflation Risk
 Purchasing power risk is also known as inflation risk.
It is so, since it emanates (originates) from the fact
that it affects a purchasing power adversely.
 It is not desirable to invest in securities during an
inflationary period.
Business Risk
 Business risk is also known as liquidity risk. It is so,
since it emanates (originates) from the sale and
purchase of securities affected by business cycles,
technological changes, etc.
Financial or credit risk
 Financial risk is also known as credit risk. It arises
due to change in the capital structure of the
organization.
 The capital structure mainly comprises of three ways
by which funds are sourced for the projects.
Operational risk
 Operational risks are the business process risks failing

due to human errors. This risk will change from

industry to industry.
 It occurs due to breakdowns in the internal

procedures, people, policies and systems.

 MINIMIZING RISK EXPOSURE
◦ Protection against market risk
◦ Protection against interest rate risk
Holding the investment till maturity
Buying T bill or bond of short maturity
Investing in bonds with different maturity dates
◦ Protection against inflation
Identify real rate of return
Investment diversification
◦ Protection against business and financial risk
Swot analysis
Business life cycle and trend of profitability
Capital structure
Beta – A systematic Risk
 Systematic risk, or market risk, is the volatility that
affects many industries, stocks and assets. Systematic
risk affects the overall market and is difficult to
predict.

 Unlike unsystematic risk, diversification cannot help

to smooth systematic risk, because it affects a wide
range of assets and securities. For example, the Great
Recession was a form of systematic risk; the
economic downturn affected the market as a whole.
 Beta is a measure of a stock's volatility in relation to the
market. It measures the exposure of risk a particular stock or
sector has in relation to the market. If you want to know the
systematic risk of your portfolio, you can calculate its beta.
 A beta of 0 indicates that the portfolio is uncorrelated with
the market.

 A beta less than 0 indicates that it moves in the opposite

direction of the market.

 A beta between 0 and 1 signifies that it moves in the same

direction as the market, with less volatility.
 A beta of 1 indicates that the portfolio will move in
the same direction, have the same volatility and is
sensitive to systematic risk.

 A beta greater than 1 indicates that the portfolio will

move in the same direction as the market, with a
higher magnitude, and is very sensitive to systematic
risk.

 Assume that the beta of an investor's portfolio is 2 in

relation to a broad market index, such as the S&P
500. If the market increases by 2%, then the portfolio
will generally increase by 4%. Likewise, if the market
decreases by 2%, the portfolio generally decreases by
4%. This portfolio is sensitive to systematic risk, but
the risk can be reduced by hedging.
 Diversification is a risk management technique that mixes a wide
variety of investments within a portfolio.

 The rationale behind this technique contends that a portfolio of

different kinds of investments will, on average, yield higher
returns and pose a lower risk than any individual investment found
within the portfolio.

 Diversification strives to smooth out unsystematic risk events in a

portfolio so that the positive performance of some investments will
neutralize the negative performance of others.

 Therefore, the benefits of diversification will hold only if

the securities in the portfolio are not perfectly correlated.
Expected rate of return
 Probability value to all possible returns is assigned, based on
their past historical returns and future expectation about the
returns, which again depends upon the economic conditions.
 Expected returns, E(Ri) = PiRi
 Risk can be defined in terms of variability of returns.
 An investment whose returns are fairly stable is considered to
be a low risk investment, whereas an investment with
fluctuate returns is considered to be a high risk investment.
Measuring the risk of expected rate of
return
 2 possible measures of risk have received support in
theoretical work on portfolio theory
◦ Variance
Variance = Pi(Ri –Eri)2
The larger the variance for an expected rate of return, the greater the
dispersion of expected returns and the greater the uncertainty, or risk
of investments.
◦ Standard Deviation

◦ A relative measure of risk:

 In some cases, an unadjusted variance or standard deviation can
be misleading.
If conditions for two or more investment alternatives are not
similar; i.e if there are major differences in the expected rates of
return, it is necessary to use a measure of variability, which is
coefficient of variation.
Determinants of required rates of return
 Factors to be considered while selecting securities for
an investment portfolio
◦ The time value of money during the period of investment
◦ The expected rate of inflation during the period
◦ The risk involved
 The summarization of the above components is called
the required rate of return.
 This is the minimum rate of return that one should
expect from an investment to compensate for
deferring consumption.
Factors affecting recent investment
trends
• Increase in working population, large family income.
• Provision of tax incentive in respect of investment
• Increase in tendency of people to hedge against inflation.
• Attractive investment alternative
• Increase in investments related publicity
• Ability of investments to provide income and capital
INTRODUCTION TO STOCK MARKET

OPERATIONS OF INDIAN STOCK MARKET

Stock Exchange means any body of individuals,
whether incorporated or not, constituted for the
purpose of regulating or controlling the business of
buying, selling or dealing in securities.
These securities includes:

1.Shares, bonds, debenture or other marketable

securities.
2.Government Securities.
 NATURE AND FUNCTION OF STOCK EXCHANGE

 The scope for acquisition an  Provide information promptly

ownership of capital by private and widely
individuals also
 The opportunity for stock market to
render the service of stimulating  To secure the working capital
private saving and channeling such from the banks, individuals,
saving in to productive investment businessmen, partnership and
exits on vastly great scale. corporation provide the stock and
 Market that mobilizes and distributes shares of companies
the nation’s savings
 The stock exchange ensures the flow
of saving is utilized
 REGULATORY FRAMEWORK FOR SECURITIES
MARKET
 Legislations  Depositories Act 1996
 Capital issues Act 1947 making securities of public limited
 Securities contract Act 1956 company's freely transferable
provide direct and indirect control of dematerialized the securities
virtually, all aspects of securities maintain the record of ownership
trading
 Companies Act 1956
 SEBI Act 1992

protect the interest of investor in

securities
promoting the development of securities.
regulating the securities market
 BOMBAY STOCK EXCHANGE (BSE)

 History ● TRADING SYSTEM OF BSE

 The origin of the BSE dates back to 1875.  In March 1995, BSE introduced screen
 It was organized under the name of “The Native based trading called BOLT ( BSE On Line
Stock & Share Brokers Association” as a Trading).
voluntary & non-profit making association.  BOLT has a nation wide network.
 It was recognized on a permanent basis in 1957.  Trading Work Stations are connected with
the main computer at Mumbai through
● OBJECTIVES OF BSE WAN.
1. To safeguard the interest of investing public
having dealings on the exchange.
2. To establish & promote honorable & just practices
in securities’ transactions.
3. To promote, develop & maintain well regulated
market for dealing in securities.
4. To promote industrial development in the country
through efficient sources.
 NATIONAL STOCK EXCHANGE (NSE)
 The NSE of India became operational in capital
market segment on 3rd November 1994 in
Mumbai.
 The genesis of the NSE lies in the
recommendations of the Pherwani Committee
(1991).
 Committee pointed out five major defects in the
Indian Stock market.
● THE MAIN DEFECTS ARE -
1. Lack of liquidity in most of the markets in terms
of depth & breadth.
2. Lack of ability to develop market for debt.
3. Lack of infrastructure facilities & outdated
trading system.
4. Lack of transparency in the operations that
affects investors’ confidence.
5. Outdated settlement systems that are inadequate
to cater to the growing volume, leading delays.
● RECENT DEVELOPMENTS
 Regulation of Intermediaries
 Insistence of quality securities
 Prohibition of insider trading
 Transparency of accounting practices
 Strict supervision of stock market operations
 Prevention of price rigging
 Protection of investors’ interest
 Free pricing of securities
 Setting up of credit rating agencies
 Introduction of electronic trading
 Establishment of NSE
 Introduction of depository system
 Buy back of shares
 Disinvestment of shares of public sector units
 Stock watch system
 Trading in derivatives
 Stock Lending Mechanism
 International Listing
 Rolling Settlement
 PROCESS OF TRADING
 Choice of a broker
 Placement of order
 At best order
 Limit order
 Discretionary order
 Immediate or cancel order
 Limited discretionary order
 Open order
 Stop loss order
 Execution of orders
 Preparation of contract notes
 Settlement of transactions
 Spot delivery settlement
 Hand delivery settlement
 Clearing settlement
 Limit orders
 Anyone placing a limit order
specifies the buy or sell price.
 Suppose you submit a order at
50 per share when the current
market price is 60/60.10, with
the expectation that the stock
will decline to 50 in the near
future.
 Time till order will be
outstanding should be
specified.
 It can be fill or kill, , part of
the day, full day, several days,
week, month etc.
 Short sales
 Sell overpriced stock that you
don’t own and purchase it back
later (at a lower price)
 Borrow the stock from another
investor (through your broker)
 Can only be made on an uptick
trade, means the price of the short
sale must be higher than the last
trade price.
 This is because, the exchanges do
not want trades to force a profit
on short sale by pushing the price
down through continually selling
short.
 Margin requirements apply
 Special Orders
 Stop loss
 Conditional order to sell stock
if it drops to a given price
 Does not guarantee price you
will get upon sale
 Market disruptions can cancel
such orders
 Stop buy order
 Investor who sold short may
want to limit loss if stock
increases in price
 MARGIN TRANSACTIONS
 When investors buy stock, they can pay for the
stock with cash or borrow part of the cost,
leveraging the transaction.
 On any type order, instead of paying 100% cash,
borrow a portion of the transaction, using the stock
as collateral
 Interest rate on margin credit may be below prime
rate
 Regulations limit proportion borrowed
 Margin requirements are from 50% up
 Changes in price affect investor’s equity, which is
equal to the market value of the collateral stock
minus the amount borrowed.
 Maintenance margin
 Requirement proportion of equity to stock
 Protects broker if stock price declines
 Minimum requirement is 25%
 Margin call on under margined account to
meet margin requirement
 If margin call not met, stock will be sold to
pay off the loan
● TYPES OF ORDERS
 Market orders
 This is the most frequent type of order
to buy or sell a stock at the best current
price.
 An investor who enters a market sell
order indicates a willingness to sell
immediately at the highest bid available
and buy order indicates the investor is
willing to pay the lowest offering price
available at the time on the exchange.
 Eg: Suppose the price of BPCL is 360
– 361; first one is the bid price that any
one has offered to pay for BPCL and
second is the ask price which is the
lowest any one is willing to accept to
sell the stock.
 There fore an order can be placed and
purchased at the lowest ask price i.e;
361 and can be sold at 360.
 Efficient Capital Markets
● In an efficient capital market, security
prices adjust rapidly to the arrival of new
information. Therefore, the current
prices of securities reflect all information
about the security
● Whether markets are efficient has been
extensively researched and remains
controversial
● There are deviations in market, but they
are random, hence it is not possible to
identify over or under valued security.
● The concept of efficient capital market
has been one of the dominant themes
since 60s
● According to Elton and Gruber:
● When someone refers to efficient capital
market they mean that security prices
fully reflect all available information
comparison between FA, TA and EMT
●Why Should Capital Markets
Be Efficient?
The premises of an efficient market
○ A large number of competing profit-
maximizing participants analyze and
value securities, each independently
of the others
○ New information regarding securities
comes to the market in a random
fashion
○ Profit-maximizing investors adjust
security prices rapidly to reflect the
effect of new information
● As security prices adjust to all new
information, these security prices should
reflect all information that is publicly
available at any point in time.
● Therefore, these security prices should be
an unbiased reflection of all currently
available information, including the risk
involved in owing the security.
● In efficient markets, the expected returns
implicit in the current price of the security
should reflect its risk.
Conclusion: In an efficient market, the
expected returns implicit in the current
price of a security should reflect its risk
EFFICIENT MARKET HYPOTHESIS
(EMH):-
Weak-Form EMH
●Current prices reflect all security-market
information, including the historical
sequence of prices, rates of return, trading
volume data, and other market-generated
information
●This implies that past rates of return and
other market data should have no
relationship with future rates of return
Semi strong-Form EMH
●Current security prices reflect all public
information, including market and non-
market information
●This implies that decisions made on new
information after it is public should not
lead to above-average risk-adjusted profits
from those transactions
Strong-Form EMH
● Stock prices fully reflect all information
from public and private sources
●This implies that no group of investors
should be able to consistently derive
above-average risk-adjusted rates of
return
●This assumes perfect markets in which
all information is cost-free and available to
everyone at the same time
●Tests and Results of Weak-Form EMH
This is formulated in 2 groups
Statistical Tests of Independence: which is
the independence between rates of return
○ Autocorrelation tests
○ Runs tests
Tests of Trading Rules: this is the
comparison of risk-return results for
trading rules that make investment
decisions based on past market
information
● Autocorrelation tests
The independence or randomness between price
movements can be tested by calculation the
correlation between price changes in one period
and changes for the same stock in other period.
● Does the rate of return on day t correlate with the
rate of return on day t-1, t-2 or t-3.
● Positive value indicates a direct relation and
negative value implies an inverse relationship
● Thus if r is close to 0, the price changes can be
considered to be serially independent.
Run tests
● In this test, the absolute value of price changes are
ignored, only the direction of change is considered.
● An increase in represented by (+) sign and
decrease in value is represented by (-) sign and
when there is no change in price, it is represented
by 0.
● A consecutive sequence of the same sign is
considered as a run, for eg. +++---000++-- = 5
runs.
● In a run test, the actual number of runs observed in
a series of stock price movements is compared
with the number of runs in a randomly generated
series.
● If no significant difference is found, then the
security price changes are considered to be
random in nature.
Filter tests
●Filter tests have been developed as direct
tests of specific mechanical trading strategies
to examine their validity and usefulness.
●When new information comes in the market,
a new equilibrium price will be determined.
●If the news is favorable, then the price
should move up to a new equilibrium above
the old price.
●If the investors purchase at this point, they
will be benefited from the price increase to
the new equilibrium level.
●Same goes when the news received is
unfavorable.
●Technicians set up trading strategies based
on such patterns to earn excess returns. The
strategy is called filter rule.
●The rule is usually stated in the foll way:
 Purchase the stock when it rise by X
% from the previous low and sell it
when it declines by X% from the
subsequent high.
 The filer may range from 1% to 50%
or even more.trt

Tests and Results of Weak-Form EMH
●Testing constraints
○ Use only publicly available data
○ Include all transactions costs
○ Adjust the results for risk
●Only better-known technical trading rules have
been examined
○ Too much subjective interpretation of data
○ Almost infinite number of trading rules
Tests of the Semi strong Form of Market
Efficiency
Two sets of studies
●Time series analysis of returns or the cross
section distribution of returns for individual stocks
●Event studies that examine how fast stock prices
adjust to specific significant economic events
Adjustment for Market Effects
○ Test results should adjust a security’s rate
of return for the rates of return of the
overall market during the period
considered
Abnormal rate of return
ARit = Rit - Rmt
where:
ARit = abnormal rate of return on security i during
period t
Rit = rate of return on security i during period t
Rmt =rate of return on a market index during period t
Quarterly Earnings Reports
○ Large Standardized Unexpected Earnings
(SUEs) result in abnormal stock price
changes, with over 50% of the change
happening after the announcement
○ Unexpected earnings can explain up to 80%
of stock drift over a time period
●These results suggest that the earnings surprise is
not instantaneously reflected in security prices
The January Anomaly
○ Stocks with negative returns during the prior
year had higher returns right after the first of
the year
○ Tax selling toward the end of the year has
been mentioned as the reason for this
phenomenon
○ Such a seasonal pattern is inconsistent with
the EMH
Other calendar effects
○ All the market’s cumulative advance
occurs during the first half of trading
months
○ Monday/weekend returns were
significantly negative
○ For large firms, the negative Monday
effect occurred before the market opened
(it was a weekend effect), whereas for
smaller firms, most of the negative
Monday effect occurred during the day on
Monday (it was a Monday trading effect)
Price-earnings ratios and returns
○ Low P/E stocks experienced superior risk-
adjusted results relative to the market,
whereas high P/E stocks had significantly
inferior risk-adjusted results
○ Publicly available P/E ratios possess valuable
information regarding future returns
○ This is inconsistent with semistrong efficiency
Tests and Results of Strong-Form EMH
●Strong-form EMH contends that stock prices fully
reflect all information, both public and private
●This implies that no group of investors has access to
private information that will allow them to consistently
earn above-average profits
Testing Groups of Investors
●Corporate insiders
●Stock exchange specialists
●Security analysts
●Professional money managers
Corporate Insider Trading
Insiders include major corporate officers, directors, and
owners of 10% or more of any equity class of securities
Corporate insiders include major corporate officers,
directors, and owners of 10% or more of any equity
class of securities
● Insiders must report to the SEC each
month on their transactions in the stock of
the firm for which they are insiders
● These insider trades are made public
about six weeks later and allowed to be
studied
● Corporate insiders generally experience
above-average profits especially on
purchase transactions
● This implies that many insiders had private
information from which they derived
above-average returns on their company
stock
● Studies showed that public investors who
traded with the insiders based on
announced transactions would have
enjoyed excess risk-adjusted returns (after
commissions), but the markets now seems
to have eliminated this inefficiency (soon
after it was discovered)
● Other studies indicate that you can
increase returns from using insider trading
information by combining it with key
financial ratios and considering what group
of insiders is doing the buying and selling
● Stock Exchange Specialists
● Specialists have monopolistic access to
information about unfilled limit orders
● You would expect specialists to derive above-
average returns from this information
● The data generally supports this expectation
● Security Analysts
● Tests have considered whether it is possible
to identify a set of analysts who have the
ability to select undervalued stocks
● The analysis involves determining whether,
after a stock selection by an analyst is made
known, a significant abnormal return is
available to those who follow their
recommendations
● Analysts Recommendations
● There is evidence in favor of existence of
superior analysts who apparently possess
private information
● Professional Money Managers
● Trained professionals, working full time at
investment management
● If any investor can achieve above-
average returns, it should be this group
● If any non-insider can obtain inside
information, it would be this group due to
the extensive management interviews that
they conduct
● Individual analyst recommendations seem
to contain significant information
● Performance of professional money
managers seem to provide support for
strong-form EMH
 Fundamental Analysis
● A fundamental analyst believes that analyzing
the economy, strategy, management, product,
financial status and other related information will
help choose shares that will outperform the
market and provide consistent gains to the
investors.
● FA is the examination of the underlying forces
that effect the interests of the economy, industry
sectors, and companies.
● FA requires an examination of the market from a
broader perspective.
● FA focuses on the economic data to evaluate
the present and future growth of the nation.
● It usually compares one economy with similar or
superior national economies.
● At industry level, there is an examination of the
supply and demand forces for the products
offered, substitute product/industry, industry
cycles and so on.
● At the company level, FA examines financial
data, mgmt policies, business vision,
competitive strength and so on.
● Thus to forecast future share prices, FA
combines economic, industry, and company
analysis to derive a share’s current fair value
and forecast its future value from this info.
 FA tend to look first into the national
economy before analyzing industry
performance and then individual
companies within an industry.
 This method is called a top-down
approach to fundamental analysis.
 The problem in FA is the evaluation of
economic indicators as they need to be
compared over a period of time to assess
the favourable climate.
The ACTUAL value of an equity share
depends on a multitude of factors. The
earning of the company, the growth rate
and the risk exposure of the company
have a direct bearing on the price of the
share.
Fundamental analysis consist of the
following analysis.
 Economic analysis
 Industry analysis
 Company analysis
The level of economic activity has an impact on
investment in many ways. if the economy
grows rapidly, the industry can also be
expected to show rapid growth.
when the level of economic activity is low ,stock
price are low, and the vice versa. the analysis
of macro economic environments is essential to
understand the behavior of the stock prices.
● Hence, an investor has to spend some time
exploring the forces operating in the overall
economy.
● A macro economy has 2 components
○ The national economy
○ The international economy on the national
economy
● The growth of national economy is mainly
determined by the domestic consumption
pattern.
The economic analysis factors
Gross Domestic Product
● GDP is the total amount of goods and services
produced in a country in a year.
● It is calculated by adding all the market values
of all the final goods and services produced in a
year.
● GDP has several components. A component is
helpful to investors
● Major components of GDP are:
● Consumption Spending
● Investment Spending
● Govt Expenditure
● Goods and Services produced
domestically for export
● The production of goods and services
consumed in the process of distributing
imports to the domestic consumer.
Consumption Spending:
● It classified into:
● Durable Goods. Car, Furniture and
house hold appliances which are used
for several yrs.
● Non durable Goods. Food, clothing
and disposable products which are
used for a short time.
● Services include the rent paid on
premises air plane tickets, legal advice
and medical treatment.
● An increase in consumption spending
leads to an immediate increase in
capacity utilization, in turn increasing
the profitability of companies.
● Investment Spending
● Non Residential fixed invt
It is the creation of tools and equipment to use
in the production of other goods and services.
E.g., the establishment of factories, installation
of new machines and computers for business
use are non – residential fixed invt.
Residential invt is the building of a new house or
apartment
● Inventory changes consist of changes in the
level of stocks of goods necessary for
production, and finished goods ready to be
sold.
● Investment spending does not necessarily
lead to an immediate release of productive
goods and services. There is a time lag before
which investment spending results in
increased profitability for companies
● Govt Expenditure:
● It consist of spending by the Central, state and
local govt on goods and services such as
infrastructure, research, roads, defense,
school and police and fire dept.
● Govt expenditure as a % of GDP will be more
in regulated mkt and less in a liberalized
economy.
● Exports:
● Exports are items produced in a country and
purchased by foreigners. It lead to an
exchange of productive goods and services
for an equivalent foreign currency.
● Consumption in the process of Import
Distribution
● It also lead to the local productivity.
● Imports are the items produces by foreigners
and purchased by the local consumers.
● For the purpose of computing GDP,
expenditures involving localization or
internalizations of the imported goods are
considered.
Monetary Policy
● If the monetary policy is very tight & banks
have little excess reserves to lend, the
sources of capital become scarce and
economic activity may slow down or decline.
● Although a good monetary policy and
liquidity is essential for the economy, excess
liquidity can be harmful. Excess money
supply growth can lead to inflation, higher
interest rates and higher risk premiums
leading to costly sources of capital and slow
growth
Inflation International Influence:
●It can be defined as a trend of rising prices caused ●One imp measure of influence of international
by demand exceeding supply. economies is the exchange rate – the rate at
●In other words, if prices rise steadily, after a no. of which one currency may be converted into
yrs, consumers will be able to buy only fewer goods another.
and services assuming income level does not change ●Rapid growth in overseas market can create
with inflation. surges in demand for exports, leading to growth
●It increases the uncertainty of future business and in export sensitive industries and overall GDP.
●Erection of trade barriers can hinder the free
invt decisions, which in turn , increase risk premiums.
flow of currency, goods and services and can
●It also affects the investment, as reduces the value harm the export sector of an economy
of fixed income securities.
●A constant inflationary situation in an economy will Consumer Sentiments
be foreseen as a positive influence on the investors ●It usually expressed in terms of future
and hence market prices are likely to go up under expenditures planned and the feeling about the
such circumstances. future economy.
●CS can affect both cash flow i.e. higher or
Interest Rates: lower sales and operating incomes.
●It is the price of credit. It is the percentage fee
received or paid by individuals or organizations when
they lend or borrow money.
●In general IR caused by inflation, govt policy, rising
risk premiums or other factors will lead to reduced
borrowing and an economic slowdown.
●Rising IR lead to a decline in bond prices and
typically lead to a fall in share price
●When interest rates rise, investors required rate of
return on shares rise as well, causing the price of
securities to fall.
●Bank prime lending rate influences business
demand for loans.
● Industry analysis
● Standard Industry Classification:
● It’s a common method of classifying business or
industries by type is the Standard Industry
Classification System, commonly referred to as
the SIC Code.
● It divides virtually all economic activity into
divisions that are further broken up into
numbered, major groups.
● SIC codes get progressively more specific as the
no. of digits increases.
● A 2 digit SIC code indicates the broad industry
category (e.g., Furniture)
● Adding 3rd digit might further specify a type of
furniture (e.g., home furniture or office furniture)
● Adding 4th digit might further specify wooden
household furniture or metal household furniture)
● A full listing of SIC codes is an imp tool in industry
analysis.
Factors to be considered in industry life cycle
analysis
● Growth of industry
● Cost structure and profitability
● Nature of the product
● Nature of the competition
● Government policy
● Labor
● Research and development
● Tools For Industry analysis
● Cross-sectional Industry Performance
● Industry Performance over time
● Differences in industry risk
● Prediction about market behavior
● Competition over the industry life cycle
Cross-sectional Industry Performance
● It aimed at finding out if the rates or return
among different industries varied during a
given period of time.
● Analysts usually compare the performance
measured in terms of growth in sales, profits,
market capitalization and the dividend of
various industries.
Industry Performance over Time
● Analysts also perform a detailed exploration
of industry performance over time, to identify
the stage of product life cycle that the industry
is expected to face.
● Usually a time duration of 3 to 5 yrs is
considered to determine whether industries
that perform well in one time period would
continue to perform well in subsequent time
periods.
● In many economies, the forecast of industrial
performance has been the most difficult task.
 ● Analysis of Industry Competition
Difference in Industry Risk
Competition and Expected Industry Returns
●Industry risk specifically investigates 2 questions: ○ Porter’s concept of competitive strategy
1. Does risk differ across industries in a given time is described as the search by a firm for a
period? favorable competitive position in an
2. Are industry risk measures stable over time? industry
Risk is measured in terms of variability in return/ ○ To create a profitable competitive
productive value. strategy, a firm must first examine the
basic competitive structure of its industry
○ The potential profitability of a firm is
Prediction about Market Behavior
heavily influenced by the profitability of its
●Prediction about Market Behavior industry
●Predicting Market behavior can be through a ● Competitive Structure of an Industry
qualitative assessment of strengths and weaknesses of ● Porter’s Competitive Forces
the industry on the whole. ○ Rivalry among existing competitors
●SWOT Analysis ○ Threat of new entrants
●SWOT Analysis can also applied in industrial analysis ○ Threat of substitute products
as well as in evaluating individual organisations ○ Bargaining power of buyers
○ Bargaining power of suppliers
Structural Economic Changes and Alternative Estimating the Required Rate of Return
Industries ● Influenced by the risk-free rate
●Social Influences ● Expected inflation rate
○ Demographics ● Risk premium for the industry versus the
○ Lifestyles market
●Technology ○ business risk (BR)
●Politics and regulations ○ financial risk (FR)
○ Economic reasoning ○ liquidity risk (LR)
○ Fairness ○ exchange rate risk (ERR)
○ Regulatory changes affect numerous ○ country political risk (CR)
industries ● Or compare systematic risk (beta) for the
○ Regulations affect international commerce industry to the market beta of 1.0
● Industry Valuation Using the Free Cash Flow Qualitative Factors
to Equity (FCFE) Model ●Business Model
FCFE is defined as follows: ●Management
Net income
○ Sources of Management Analysis
+ Depreciation
- Capital expenditures ■ Conference Calls
-  in working capital ■ Management Discussions
- Principal debt repayments ■ Management Ownership of
+ New debt issues equity

Industry Profit Margin Forecast ●Corporate Governance

● Industry’s operating profit margin
○ Areas of CG
(EBITDA / Sales)
○ Depreciation expense ■ Structure of BOD
○ interest expense ■ Financial and information
○ tax rate transparency
■ Stakeholder rights
Company analysis ■ Corporate culture
In the company analysis the investor assimilate
the several bits of information related to the
company and evaluates the present and
future value of the stock.
The risk and return associated with the
purchase of the stock is analyzed to take
better investment decisions.
Quantitative Factors
Earnings of the company (EAT)
●The key element all investors look after is earnings.
Before investing in a company you want to know how
much the company is making in profits. Future
earnings are a key factor as the future prospects of
the company's business and potential growth
opportunities are determinants of the stock price.
●Factors determining earnings of the company are
such as sales, costs, assets and liabilities. A simplified
view of the earnings is earnings per share (EPS).
This is a figure of the earnings which denotes the
amount of earnings for each outstanding share.
●EPS = PAT / No of shares outstanding
Profit Margins
○ The profit margin measures how much the
company keeps in earnings out of every
rupee of their revenues. This measure is
therefore very useful for comparing similar
companies, within the same industry.
○ Higher profit margin indicates that the
company has better control over its costs
than its competitors. Profit margin is
displayed in percentages and a 10 percent
profit margin denotes that the company has
a net income of 10 cents for each rupee of
their revenues.
○ Net profit margin = Net profit / Revnue
Return on Equity (ROE)
○ This ratio is a measure of how efficient
a company is in generating its profits.
It is a ratio of revenue and profits to
owners' equity (shareholders are the
owners). Specifically it is:  ROI = Net
income / Shareholder’s equity
Price-to-Earnings (P/E)
●When taking the current market price into
consideration, the most popular ratio is the
Price-to-Earnings (P/E) ratio. As the name
suggest it is the current market price divided by
its earnings per share (EPS). It is an easy way
to get a quick look of a stock's value.
●A high P/E indicates that the stock is priced
relatively high to its earnings, and companies
with higher P/E therefore seem more expensive.
However, this measure, as well as other
financial ratios, needs to be compared to similar
companies within the same sector or to its own
historical P/E. This is due to different
characteristics in different sectors and changing
markets conditions.
 BALANCED SCORECARD
Financial analysis
The best source of financial information about a The balanced scorecard is a framework for
company is its own financial statements. this is tracking important aspects of company strategy
primary source of information for evaluating the and for facilitating organizational improvement
investment prospects in the particular company's or change.
stock. ●Revenues
●Earnings
●The balance sheet
●Profit and loss account ●Market share
●Comparative financial statement ●Quality
●Trend analysis ●Employee morale
●Common size statement ●Customer satisfaction metrics
●Fund flow analysis THE BCG GROWTH-SHARE MATRIX
●Cash flow analysis This quadrant matrix, developed by Boston
●Ratio analysis Consulting Group (BCG), is a tool companies
use to assess the relative strength of product
BENCHMARKING lines within their portfolios.
●Benchmarking is the process of comparing your ●Product lines are assigned to one of four
company metrics to the metrics of your industry quadrants:
competitors or to those of innovative companies ●Cash cows
outside the industry. ●Stars
●Common metrics for benchmarking include: ●Question marks
●Revenues ●Dogs
●Production costs
●Employee turnover
●Process cycle time
● THE GE-MCKINSEY NINE-BOX MATRIX
● This matrix was developed by McKinsey &
Company in the 1970s to help General Electric
prioritize its investments in its numerous business
units. It’s widely used to help companies assess the
relative merits of various opportunities.
● Business units or opportunities are categorized as
“high,” “medium,” or “low” within the two axes of the
matrix, which are “industry attractiveness” and
“competitive strength of the business unit.”
● CORE COMPETENCIES
● The process of identifying your company’s core
competencies helps you define your company’s
positioning and competitive advantage.
TECHNICAL ANALYSIS
Price is determined solely by the interaction of
supply & demand
(2) Supply and demand are governed by
numerous factors both rational and
irrational. The market continually and
automatically weighs all these factors. (A
random walker would have no qualms about
this assumption either. He would point out that
any irrational factors are just as likely to be one
side of the market as on the other.)
(3) Disregarding minor fluctuations in the
market, stock prices tend to move in trends
which persist for an appreciable length of
time. ( Random walker would disagree with
this statement. For any trend to persist there
has to be some collective 'irrationality')
(4) Changes in trend are caused by shifts in
demand and supply. These shifts no matter
why they occur, can be detected sooner or
later in the action of the market itself. (In the
financial economist's view the market (through
the price) will instantaneously reflect any shifts
in the demand and
Dow Theory
●Introduction
○ Charles Dow and his partner Edward Jones
founded Dow Jones & Company in 1882
○ Dow published his ideas in a series of
editorials he wrote for the Wall Street
Journal.
○ On July 3, 1884, Dow published the first
stock market average
○ By 1928 the industrial index had grown to
include 30 stocks, the number at which it
stands today
●Basic Tenets
1. The Averages Discount Everything
2. The Market Has Three Trends
■ Primary – More than a year and
possibly for several years
■ Secondary – 3 weeks to 3 months
■ Minor – Less than 3 weeks
3. Major Trends Have Three Phases
■ An accumulation phase
■ A public participation phase
■ A distribution phase
● Candlestick Chart
Another kind of chart used in the technical analysis
is the candlestick chart, so-called because the main
component of the chart which represents prices
looks like a candlestick, with a thick ‘body’ and
usually, a line extending above and below it, called
the upper shadow and lower shadow, respectively.
● The closing price of the security
being traded determines whether
the candlestick is bullish or bearish.
The real body is usually white if the
candlestick closes at a higher price
than it opened. In such a case,
the closing price is located at the
top of the real body and the opening price is located at
the bottom.
● If the security being traded closed at a lower price
than it opened for the time period, the body is
usually filled up or black in color. The closing price
is located at the bottom of the body and the opening
price is located at the top. Modern candlesticks now
replace the white and black colors of the body with
more colors, such as red, green, and blue. Traders
can choose among the colors when using electronic
trading platforms.
● Candlestick Patterns
● Japanese Candlesticks form patterns that
traders use to analyze price movement. Some
examples of candlestick patterns include:
● Doji: This is a candlestick formed when the
opening and closing prices are the same, or
very close to each other. The shadows may
have different lengths.
● Gravestone Doji: This pattern resembles a
gravestone, hence the name. It is formed
when the open and the close occur at the low
of the period.
● Dragonfly Doji: This pattern is formed when
the opening and the closing prices of a
security are at the high of the period. It
includes a long lower shadow and signals a
reversal of an uptrend.
● Bearish Engulfing Pattern: This pattern
indicates bears in control of the market. It
consists of a large body that completely
engulfs the body of the previous candlestick.
It is a “down” candlestick, one where the
closing price is below the opening price.
When it appears, it signals a bearish reversal.
● Bullish Engulfing Pattern: The pattern is
often formed at the end of a downtrend. It is
comprised of a smaller down candlestick
whose body is engulfed by a larger up
candlestick.
● The key to P&F charts is the establishment of
the unit of price, which is the unit measurement
of a price movement plotted on the graph. On
P&F charts, there is no time axis, only a price
axis. Rising stock prices are shown with X's and
falling prices are shown with O's. These points
appear on the chart only if the price moved at
least one unit of price in either direction.
● So say the closing prices of a stock moved up
one price unit three times. This would appear as
a column of three X's. If the price
movement reverses direction, the chart shows a
new column of O's, wherein an O is plotted for
each unit of price movement. X's and O's never
appear in the same column. The chartist,
however, must establish how many price units
make up a box, which is how much the price
must move in the opposite direction for the
chart to begin a new column.

● If the issue is rising in price and we have

an uptrend in place with at least three X's, we
believe that demand has overcome supply.
● The reverse, when that chart gives us three O's,
indicates supply has overcome demand. P&F
charts show us the establishment of trends,
trend reversals and the supply and demand of
charted issues.

● Support & Resistance
● The support and resistance (S&R) are specific
price points on a chart which are expected to
attract maximum amount of either buying or
selling. The support price is a price at which one
can expect more buyers than sellers. Likewise
the resistance price is a price at which one can
expect more sellers than buyers.
● On a standalone basis traders can use S&R to
identify trade entry points as well.
● 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.  and subsequently declines to form a trough.
● Market psychology plays a major role as traders
and investors remember the past and react to
changing conditions to anticipate future market
movement.
● Support and resistance areas can be identified
on charts using trendlines and moving averages.
● Head & Shoulders
● A head and shoulders pattern is a technical
indicator with a chart pattern described by three
peaks, the outside two are close in height and the
middle is highest.
● A head and shoulders pattern describes a specific
chart formation that predicts a bullish-to-bearish
trend reversal.
● The head and shoulders pattern is believed to be
one of the most reliable trend reversal patterns.
● What Does A Head And Shoulders Pattern Tell
You?
● A head and shoulders pattern is comprised of three
component parts:
● After long bullish trends, the price rises to a peak
● The price rises again to form a second high
substantially above the initial peak and declines
again.
● The price rises a third time, but only to the level of
the first peak, before declining once more.
● The first and third peaks are shoulders, and the
second peak forms the head. The line connecting
the first and second troughs is called the neckline.
● The opposite of a head and shoulders chart is
the inverse head and shoulders, also called a head
and shoulders bottom, is inverted with the head
and shoulders top used to predict reversals in
downtrends.
● Double top and bottom
● A double bottom occurs when the price of a stock
hits a particular low price level and rebounds back
with a quick recovery. Following the price recovery
the stock trades at a higher level, after which the
stock attempts to hit back to the low price previously
made. If the stock holds up once again and
rebounds, then a double bottom is formed.
● A double bottom formation is considered bullish,
and hence one should look at buying opportunities
● Breadth of the market
Measure: This is a measure of the number of stocks
in the market which have advanced relative to
those that have declined. The broader the
market, the stronger the demand.
Related measures:
(1) Divergence between different market indices
(BSE 30 Vs NSE 50)
(2) Advance/Decline lines
● Market breadth is a technique used in technical
analysis that attempts to gauge the direction of
the overall market by analyzing the number of
companies advancing relative to the number
declining.
● Positive market breadth occurs when more
companies are moving higher than are moving
lower, and it is used to suggest that the bulls are
in control of the momentum. Conversely, a
disproportional number of declining securities is
used to confirm bearish momentum.
● A large number of advancing issues is a sign of
bullish market sentiment and is used to confirm
a broad market uptrend. Traders will specifically
look at the number of companies that have
created a 52-week high relative to the number
that created a 52-week low because this data
can provide longer term information about
whether the bullish or bearish trend will
continue.
● Moving Average and Exponential Moving
Average
● A moving average (MA) is a trend-following
or lagging indicator because it is based on past
prices. The two basic and commonly used MAs are
the simple moving average (SMA), which is the
simple average of a security over a defined number
of time periods, and the exponential moving
average (EMA), which gives bigger weight to more
recent prices.
● As it is evident, the moving average changes as
and when the closing price changes. A moving
average as calculated above is called a ‘Simple
Moving Average’ (SMA). Since we are calculating it
as per the latest 5 days of data it is called referred
to as 5 Day SMA.
● The averages for the 5 day (or it could be anything
like 5, 10, 50, 100, 200 days) are then joined to
form a smooth curving line known as the moving
average line, and it continues to move as the time
progresses.
● An exponential moving average (EMA) is a type
of moving average that is similar to a simple
moving average, except that more weight is
given to the latest data. It's also known as the
exponentially weighted moving average. This
type of moving average reacts faster to
recent price changes than a simple moving
average.
● Application of averages
● The moving average can be used to identify
buying and selling opportunities with its own
merit. When the stock price trades above its
average price, it means the traders are willing
to buy the stock at a price higher than its
average price. This means the traders are
optimistic about the stock price going higher.
Therefore one should look at buying
opportunities.
● Likewise, when the stock price trades below
its average price, it means the traders are
willing to sell the stock at a price lesser than
its average price.
● Rule 1) Buy (go long) when the current
market price turns greater than the 50 day
EMA. Once you go long, you should stay
invested till the necessary sell condition is
satisfied
● Rule 2) Exit the long position (square off)
when the current market price turns lesser
than the 50 day EMA
● The primary difference between an EMA and
an SMA is the sensitivity each one shows to
changes in the data used in its calculation.
● SMA calculates the average of price data,
while EMA gives more weight to current data.
The newest price data will impact the moving
average more, with older price data having a
lesser impact

● Moving average
convergence divergence (MACD) is a trend-
following momentum indicator that shows the
relationship between two moving averages of
prices. The MACD is calculated by subtracting
the 26-day exponential moving average (EMA)
from the 12-day EMA. A nine-day EMA of the
MACD, called the "signal line", is then plotted
on top of the MACD, functioning as a trigger for
buy and sell signals
● The relative strength index is calculated
using the following formula:
● RSI = 100 - 100 / (1 + RS)
● Where RS = Average gain of up periods
during the specified time frame / Average
loss of down periods during the specified
time frame/
● The RSI provides a relative evaluation of the
strength of a security's recent price
performance, thus making it a momentum
indicator. RSI values range from 0 to 100.
The default time frame for comparing up
periods to down periods is 14, as in 14
trading days.
Markowitz Portfolio Theory
●Quantifies risk
●Derives the expected rate of return for a
portfolio of assets and an expected risk measure
●Shows that the variance of the rate of return is a
meaningful measure of portfolio risk
●Derives the formula for computing the variance
of a portfolio, showing how to effectively diversify
a portfolio
Assumptions of Markowitz Portfolio Theory
1.Investors consider each investment alternative as
being presented by a probability distribution of expected
returns over some holding period.
2.Investors maximize one-period expected utility, and
their utility curves demonstrate diminishing marginal
utility of wealth.
3.Investors estimate the risk of the portfolio on the basis
of the variability of expected returns.
4.Investors base decisions solely on expected return
and risk, so their utility curves are a function of expected
return and the expected variance (or standard deviation)
of returns only.
5.For a given risk level, investors prefer higher returns to
lower returns. Similarly, for a given level of expected
returns, investors prefer less risk to more risk.
● Using these five assumptions, a single
asset or portfolio of assets is considered to
be efficient if no other asset or portfolio of
assets offers higher expected return with
the same (or lower) risk, or lower risk with
the same (or higher) expected return.
Alternative Measures of Risk
● Variance or standard deviation of expected
return
● Range of returns
● Returns below expectations
○ Semivariance – a measure that only
considers deviations below the mean
○ These measures of risk implicitly
assume that investors want to
minimize the damage from returns
less than some target rate
Expected Rates of Return
● For an individual asset - sum of the
potential returns multiplied with the
corresponding probability of the returns
● For a portfolio of assets - weighted
average of the expected rates of return for
the individual investments in the portfolio
Variance (Standard Deviation) of Returns for
an Individual Investment
Standard deviation is the square root of the
variance
Variance is a measure of the variation
of possible rates of return R i, from the expected
rate of return [E(Ri)]
Covariance of Returns
A measure of the degree to which two variables
“move together” relative to their individual mean
values over time
Covariance and Correlation
The correlation coefficient is obtained by
standardizing (dividing) the covariance by the
product of the individual standard deviations
Correlation Coefficient
It can vary only in the range +1 to -1. A value of
+1 would indicate perfect positive correlation.
This means that returns for the two assets move
together in a completely linear manner. A value of
–1 would indicate perfect correlation. This means
that the returns for two assets have the same
percentage movement, but in opposite directions
Portfolio Standard Deviation
Calculation
●Any asset of a portfolio may be
described by two characteristics:
○ The expected rate of return
○ The expected standard deviations
of returns
●The correlation, measured by
covariance, affects the portfolio standard
deviation
●Low correlation reduces portfolio risk
while not affecting the expected return
Combining Stocks with Different
Returns and Risk
●Assets may differ in expected rates of
return and individual standard deviations
●Negative correlation reduces portfolio
risk
●Combining two assets with -1.0
correlation reduces the portfolio standard
deviation to zero only when individual
standard deviations are equal
● Estimation Issues ● If all the securities are similarly related to the
● Results of portfolio allocation depend on accurate market and a bi derived for each one, it can
statistical inputs be shown that the correlation coefficient
● Estimates of between two securities i and j is given as:
○ Expected returns
○ Standard deviation
 m2
○ Correlation coefficient rij  b i b j
■ Among entire set of assets  i j
■ With 100 assets, 4,950 correlation

●
estimates
Estimation risk refers to potential errors
where  m2  the variance of returns for the
● With assumption that stock returns can be aggregate stock market
described by a single market model, the number of
correlations required reduces to the number of
assets
● Single index market model:

R i  a i  biR m   i
● bi = the slope coefficient that relates the returns for
security i to the returns for the aggregate stock
market
● Rm = the returns for the aggregate stock market
The Efficient Frontier
●The efficient frontier represents that set of
portfolios with the maximum rate of return for
every given level of risk, or the minimum risk for
every level of return
●Frontier will be portfolios of investments rather
than individual securities
○ Exceptions being the asset with the
highest return and the asset with the
lowest risk.

The Efficient Frontier and Investor Utility

●An individual investor’s utility curve specifies the
trade-offs he is willing to make between expected
return and risk
●The slope of the efficient frontier curve
decreases steadily as you move upward
●These two interactions will determine the
particular portfolio selected by an individual
investor
●The optimal portfolio has the highest utility for a
given investor
●It lies at the point of tangency between the
efficient frontier and the utility curve with the
highest possible utility