Security Analysis & Portfolio Management/SMS LUCKNOW

UNIT 1: INTRODUCTION TO SECURITIES

CONCEPT OF INVESTMENT
Investment is the employment of funds on assets with the aim of achieving additional income or growth in value.
The essential quality of an investment is that it involves “waiting” for a reward. It is the sacrifice of certain present
value for the uncertain future reward.

OBJECTIVES OF INVESTMENT
The main investment objective are “increasing the rate of return and reducing risk”. The other objectives are:
1. Risk
Any kind of investment involves a certain risk. Risk refers to the probability of an actual return becoming less
than the expected return. Many at times people use risk and uncertainty as synonyms but there is a fundamental
difference between the two. Risk is something that can be measured or assessed whereas uncertainty is generally
used where the probability of happenings cannot be measured.

2. Return
Return refers to expected rate of return from an investment. It is the value the investor receives at the end of the
period. Return is the major factor which influences the pattern of investment that is made by the investor. Investor
always prefers to high rate of return for his investment. We can simply understand it by the given formula:

Return = End Period Value – Beginning period value X 100

Beginning period Value

3. Safety
Safety is also one of the essential and crucial elements of investment. Safety refers to the protection of investor
principal amount and expected rate of return. Investor prefers safety about his capital. The selected investment
should be within the legal and regulatory framework to make it safe.

4. Liquidity
Liquidity refers to an investment ready to convert into cash position. In other words, it is available immediately
in cash form. Liquidity means that investment is easily realizable, saleable or marketable. When the liquidity is
high, then the return may be low.

5. Capital Growth
Capital Growth is the appreciation of investment. An investor would always prefer that the investment made show
grow in future, taking in consideration the opportunity cost of resources.

6. Hedge against Inflation

Hedging means a transaction designed to minimize the risk. As we all know the investments are influenced by
the inflationary conditions. So, the investment should be such that the rate of return should be higher than the rate
of inflation; else the investor will have loss in real terms.

SPECULATION
Speculation means taking business risk in the hope of getting short term gain. Speculation essentially involves
buying and selling activities with the expectation of getting profit from the price fluctuations.

Difference between Speculation and Investment

1 | PGDM IV Sem-S M S ( 2 0 1 7 )
Security Analysis & Portfolio Management/SMS LUCKNOW

Basis Speculation Investment

Meaning A message expressing an opinion The investing of money

based on incomplete evidence

Time Plans for a very short period. Plans are longer time horizon
Holding period varies from few days
to months.
Risk Willing to undertake high risk Assumes moderate risk
Return Like to have returns for assuming Likes to have moderate rate of
high risk return associated with limited
risk
Decision Considers inside information, in Considers Fundamental factors
relation to market behavior. and evaluates the performance
of company regularly.
Funds Uses borrowed funds to supplement Investor uses his own funds and
his personal resources avoids borrowed funds.

GAMBLING

A gamble is usually a very short term investment in a game or chance. The time horizon involved in gambling is
shorter than speculation and investment. Gambling is usually played by people to entertain themselves and earning
is a secondary factor. Gambling involves higher artificial risk than investment risk.

Distinguish between Gambling & Investment

Basis Gambling Investment

Meaning Gambling is a typical, chronic and Employment of money with an
repetitive experience expectation of higher returns
Time Horizon Usually plans are for a very short term
Plans for a longer term
Risk High degree of Risk Moderate amount of risk
involved
Analysis Generally it is a game of luck It requires a proper knowledge
and study for investment
Purpose Gambling is done for excitement and Investment is made for security
enjoyment of future

IMPORTANCE OF INVESTMENT

1) Longer life expectancy or planning for retirement

Investments are made with a belief that a person has a Long life and would need funds after retirement.

2) Increasing rates of taxation

When tax rate is increased, it will focus for generating saving by tax payer.

2 | PGDM IV Sem-S M S ( 2 0 1 7 )
Security Analysis & Portfolio Management/SMS LUCKNOW

3) High interest rates

Interest rate is one of the most important aspects of a sound investment plan. The interest rate differs from one
investment to another. There may be changes between degree of risk and safe investments.

4) High rate of inflation

Inflation affects in terms of rising prices coupled with a falling standard of living. Investor ensures to check up
safety of the principal amount, security of the investment.

5) Larger incomes
More incomes and more avenues of investment have led to the ability and willingness of working people to save
and invest their funds

6) Availability of a complex number of investment outlets.

The growth and development of the country leading to greater economic prosperity has led to the introduction of
vast areas of investment outlets.

INVESTMENT PROCESS

The investment process involves a series of activities leading to the purchase of securities or other investment
alternatives.

INVESTMENT POLICY
STAGE 1

STAGE 2 INVESTMENT ANALYSIS

STAGE 3 VALUATION OF SECURITY

STAGE 4 PORTFOLIO CONSTRUCTION

STAGE 5 PORTFOLIO EVALUATION

Investment Policy
Investment policy is the first stage of the investment process. It determines the following aspects of the investor:

§ Determination of Investable Wealth

§ Determination of Portfolio Objectives
3 | PGDM IV Sem-S M S ( 2 0 1 7 )
Security Analysis & Portfolio Management/SMS LUCKNOW

§ Identification of Potential Investment Assets

§ Consideration of Attributes of Investment Assets
§ Allocation of Wealth to Asset Categories.

Investment Analysis
Investment analysis is the second stage of the investment process. Investor analysis of the investment is made on
the following grounds:

§ Equity Stock Analysis § Analysis of Yield Structure

§ Screening of Industries § Consideration of Debentures
§ Analysis of Industries § Quantitative Analysis of Debentures
§ Quantitative Analysis of Stocks § Other Asset Analysis
§ Analysis of the Economy § Qualitative Analysis
§ Debentures and Bond Analysis § Quantitative Analysis

Valuation of Securities
Valuation of the securities is the third stages of the investment process. This stage involves
§ Valuation of Stocks
§ Valuation of Debentures and Bonds
§ Valuation of Other Assets

Portfolio Construction
Portfolio construction is the last stage of the investment process. It involves the following areas as outlined below
that:
§ Determination of Diversification Level
§ Consideration of Investment Timing
§ Selection of Investment Assets

Evaluation
The portfolio has to be managed efficiently. This process consists of portfolio appraisal and revision.

TYPES OF INVESTORS
1. Active investors (Enterprising Investors):
When you say active investors, it doesn’t mean you buy the stock today and sell it tomorrow. Active
investors are the types of investors who spend a lot of time researching individual stocks. They study the
companies that they have purchased or are planning to purchase. They can be deep value investors, growth
value investors or a combination of both.

2. Passive investors (Defensive Investors):

Passive investors are the types of stock market investors who are keen on investing their money but do
not want to spend a lot of time researching individual stocks. They give their money to fund managers
who invests it for them.

3. Speculators:

4 | PGDM IV Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

Speculators are people who are interested in making a quick buck based on rumors or prospects. They
don’t want to hold a stock for a long period of time and returns are largely based on hope that someone
will pay up the stock that he has bought.

Apart from these the few other types of Investors are:

a. Window shoppers: They will be the first to read or get information over an investment but they will
never participate in markets.
b. Only Savers: Majority investors in India are from this category. They never invested a single penny
in equities. Their answer to equity is – equity is risky so why take the risk. They are happy with what
they are getting but not greatly thrilled, all the same.
c. Regular Investor: They have a long term view over equity. They invest when they have a surplus and
withdraw when in need. They are convinced over the fact that equity will beat all other investments in
long run.
d. Scapegoats: He is basically a friend of financial product sellers. Agents complete majority of their
targets form these investors. He takes advice from all… from colleagues, fellow bus travelers etc.

TYPES OF MARKETS
Financial markets are mechanism enabling participants to deal in financial claims. The markets also provide a
facility in which their demands and requirements interact to set a price for such claims.

FINANCIAL MARKET

Capital Market Money Market

Equity Market Debt Market

Primary/NIM Secondary Derivative

Capital Market
A Capital Market is a market for long term securities (equity/Debt). The purpose of capital market is to mobilize
long term savings to finance long term investments.

Money Market
A money market is a market for short term debt instruments (maturity below one year). It is highly liquid market
where in securities are bought and sold in large denominations to reduce transaction cost. Call money market,
certificate of deposits, commercial paper, and treasury bills are major instruments of money market.

Primary Market
A primary market is a market for new issues, but the volume, pricing and timing of new issues are influenced by
the returns in the stock market. It is also called the New Issue market (NIM) New Issues means the shares floated
for the first time in the market. The participants of NIM are banks, brokers, etc.

5 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

Secondary Market
Secondary market is meant for trading in outstanding or existing securities. There are two components of
secondary market: (i) Over the counter market (OTC) and (ii) Stock Exchanges

Over The Counter Exchange of India

A market developed for small and medium companies an access to the capital market for raising finance. It a first
ring-less, electronic screen based trading system listing entirely a new set of companies of small size.

Derivatives Market
The Derivatives Market is meant as the market where exchange of derivatives takes place. Derivatives are one
type of securities whose price is derived from the underlying assets. And value of these derivatives is
determined by the fluctuations in the underlying assets. These underlying assets are most commonly stocks,
bonds, currencies, interest rates, commodities and market indices.

PRIMARY MARKET/ NEW ISSUE MARKET

The Primary Market is the market that provides a channel for the issuance of new securities by issuers
(Government companies or corporate) to raise capital. The securities (financial instruments) may be issued at face
value, or at a discount / premium in various forms such as equity, debt etc. They may be issued in the domestic
and / or international market.
The companies that issue their shares are called issuers and the process of issuing shares to public is known as
public issue. This entire process involves various intermediaries like Merchant Banker, Bankers to the Issue,
Underwriters, and Registrars to the Issue etc. All these intermediaries are registered with SEBI and are required
to abide by the prescribed norms to protect the investor.

Features of primary markets include:

Ø The securities are issued by the company directly to the investors.
Ø The company receives the money and issues new securities to the investors.
Ø The primary markets are used by companies for the purpose of setting up new ventures/ business or for
expanding or modernizing the existing business
Ø Primary market performs the crucial function of facilitating capital formation in the economy

TYPES OF ISSUES
i. Public issue: When a company raises funds by selling (issuing) its shares (or debenture / bonds) to the public
through issue of offer document (prospectus), it is called a public issue.

a. Initial Public Offer: When a (unlisted) company makes a public issue for the first time and gets its shares
listed on stock exchange, the public issue is called as initial public offer (IPO).
b. Further public offer: When a listed company makes another public issue to raise capital, it is called
further public / follow-on offer (FPO).

ii. Offer for sale: Institutional investors like venture funds, private equity funds etc., invest in unlisted company
when it is very small or at an early stage. Subsequently, when the company becomes large, these investors sell
their shares to the public, through issue of offer document and the company’s shares are listed in stock exchange.
This is called as offer for sale. The proceeds of this issue go the existing investors and not to the company.

6 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

iii. Issue of Indian Depository Receipts (IDR): A foreign company which is listed in stock exchange abroad
can raise money from Indian investors by selling (issuing) shares. These shares are held in trust by a foreign
custodian bank against which a domestic custodian bank issues an instrument called Indian depository receipts
(IDR), denominated in `. IDR can be traded in stock exchange like any other shares and the holder is entitled to
rights of ownership including receiving dividend.

iv. Others:
1) Rights issue (RI): When a company raises funds from its existing shareholders by selling (issuing) those new
shares / debentures, it is called as rights issue. The offer document for a rights issue is called as the Letter of
Offer and the issue is kept open for 30-60 days.
Existing shareholders are entitled to apply for new shares in proportion to the number of shares already held.

2) In a Bonus Issue, the company issues new shares to its existing shareholders. As the new shares are issued out
of the company’s reserves (accumulated profits), shareholders need not pay any money to the company for
receiving the new shares.

METHODS OF ISSUING CAPITAL

There are various methods of issuing fresh capital:
1. Issue through Prospectus: According to Companies (Amendment) Act 1985, application forms for shares
of a company should be accompanied by a Memorandum (abridged prospectus). In simple terms a
prospectus document gives details regarding the company and invites offers for subscription or purchase
of any shares or debentures from the public. The draft prospectus has to be sent to the Regional Stock
Exchange where the shares of the company are to be listed and also to all other stock exchanges where
the shares are proposed to be listed. The stock exchange scrutinizes the draft prospectus. After scrutiny if
there is any clarification needed, the stock exchange writes to the company and also suggests modification
if any. The prospectus should contain details regarding the statutory provisions for the issue, program of
public issue-opening, closing and earliest closing date of the issue, issue to be listed at, highlights and risk
factors, capital structure, board of directions, registered office of the company, brokers to the issue, brief
description of the issue, cost of the project, projected earnings and other such details.
2. Offer for sale
3. Private placement: Direct sale of newly issued securities by the issuer to a small number of investors.
Private placement of issues is arranged through merchant bankers, where a selective client which may be
FII’s, high net worth individuals etc.
4. Rights issues

PRICING OF (PUBLIC) ISSUES

On the basis of pricing, issues can be classified into Book Built issues and Fixed Price issues.

Book Building issue

Here the issuer company mentions the minimum and maximum price (price band) at which it will sell (issue) its
shares. Thus the offer document (in this case, called the Red Herring Prospectus) contains only the price band
instead of the price at which its shares are offered to the public.
Within this price band the investor can choose the price at which the investors are willing to buy the shares and
also the quantity. As this process is similar to bidding in an auction, the application form for book built issue is
also known as the bid form.

7 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

At times the issuer may revise the price band (revision of price band) which has to be accompanied with news
paper advertisement.
Bids by various investors are entered into the stock exchange system through the broker’s (also called syndicate
member) terminal. The list of the bid received from investors at various price bands is known as the ‘book’ and
can be seen in the website(s) of the stock exchange for each investor category. Based on the total demand in the
‘book’, the cut off price is then decided by the issuer and merchant banker. The cut off price is the price at which
the cumulative demand for shares, equals or exceeds the offer size.

Fixed Price Issue

Here the company raising funds decides the price at which it will sell (issue) its shares to the public and the same
is printed in the Offer Document. This issue is kept open for 3-10 working days.

FUNCTIONS of NIM
The main function of NIM is to facilitate the “transfer of Resources’ from savers to users. This can be divided
into a triple-service function:
a. Origination
b. Underwriting
c. Distribution

Origination
It refers to the work of investigation and analysis and processing of new proposals. It is the stage where initial
‘spade work’ is conducted to be sure of the issue floated and whether it will be subscribed by public. There are
factors to be carefully analyzed before the issue like:
a. The time of floating an issue
b. Type of issue: (Equity, preference or convertible securities)
c. Price of an issue
d. Method of floatation

Underwriting
Underwriting entails an agreement where a person/organization agrees to take a specified number of shares or
debentures on a specified amount of stock offered to the public in the event of public not subscribing to it, in
consideration of a commission called underwriting commission. In India we have Institutional Underwriters and
Non Institutional Underwriters.

Distribution
The sale of securities to the ultimate investors is referred to as distribution which is performed by brokers and
dealers who maintain regular and direct contact with ultimate investors.

PARTIES INVOLVED IN NIM

1. Managers to the Issue
Lead managers are appointed by the company to manage the public issue. Their main duties are
(a) Drafting of prospectus
(b) Preparing the budget of expenses related to the issue
(c) Suggesting the appropriate timings of the public issue
(d) Assisting in marketing the public issue successfully
(e) Advising the company in the appointment of registrars to the issue, underwriters, brokers, bankers to the
issue, advertising agents etc.
8 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

(f) Directing the various agencies involved in the public issue.

Sometimes the banks or financial institutions impose a condition while sanctioning term loan or underwriting
assistance to be appointed as one of the lead managers to the issue. The fee payable to the lead managers is
negotiable between the company and the lead manager. The fee agreed upon is revealed in the memorandum of
the understanding filed along with the offer document.

2. Registrar to the Issue

After the appointment of the lead managers to the issue, in consultation with them, the Registrar to the issue is
appointed. Quotations containing the details of the various functions they would be performing and charges for
them are called for selection. Among them the most suitable one is selected. It is always ensured that the registrar
to the issue has the necessary infrastructure like computer, Internet and telephone.
The Registrars normally receive the share application from various collection centers. They recommend the basis
of allotment in consultation with the Regional Stock Exchange for approval. They arrange for the dispatching of
the share certificates. They hand over the details of the share allocation and other related registers to the company.
Usually registrars to the issue retain the issuer records at least for a period of six months from the last date of
dispatch of letters of allotment to enable the investors to approach the registrars for redressal of their complaints

3. Underwriters
Underwriting is a contract by means of which a person gives an assurance to the issuer to the effect that the former
would subscribe to the securities offered in the event of non subscription by the person to whom they were offered.
The person who assures is called an underwriter. The underwriters do not buy and sell securities. They stand as
back-up supporters and underwriting is done for a commission. Underwriting provides an insurance against the
possibility of inadequate subscription. Underwriters are divided into two categories (i) financial institutions and
banks (ii) brokers and approved investment companies. Some of the underwriters are financial institutions,
commercial banks, merchant bankers, members of the stock exchange, Export and Import Bank of India etc. The
underwriters are exposed to the risk of non-subscription and for such risk exposure they are paid an underwriting
commission.

4. Bankers to the Issue

Bankers to the issue have the responsibility of collecting the application money along with the application form.
The bankers to the issue generally charge commission besides the brokerage, if any. Depending upon the size of
the public issue more than one banker to the issue is appointed. When the size of the issue is large, 3 to 4 banks
are appointed as bankers to the issue. The number of collection centers is specified by the central government.
The bankers to the issue should have branches in the specified collection centers. In big or metropolitan cities
more than one branch of the various bankers to the issue are designated as collecting branches are designated in
the different towns of the state where the project is being set up.

5. Advertising Agents
Advertising plays a key role in promoting the public issue. Hence, the past track record of the advertising agency
is studied carefully. Tentative programs of each advertising agency along with the estimated cost are called for.
The effectiveness and cost of each program is compared with the other & a suitable advertising agency if selected
in consultation with the lead managers. The advertising agencies take the responsibility of giving publicity to the
issue on the suitable media. The media may be newspapers/magazines/hoardings/ press release or a combination
of all.

6. The Financial Institutions

9 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

Financial institutions generally underwrite the issue and lend term loans to the companies. Hence, normally they
go through the draft of prospectus, study the proposed program for public issue and approve them. IDBI, IFCI
& ICICI, LIC, GIC & UTI are the some of the financial institutions that underwrite and give financial
assistance.
Government and Statutory Agencies
The various regulatory bodies related with the public issue are:
1. Securities Exchange Board of India
2. Registrar of companies
3. Reserve Bank of India (if the project involves foreign investment)
4. Stock Exchange where the issue is going to be listed
5. Industrial licensing authorities
6. Pollution control authorities (clearance for the project has to be stated in the prospectus)

SECONDARY MARKET
The market for long term securities like bonds, equity stocks and preferred stocks is divided into primary market
and secondary market. The primary market deals with the new issues of securities. Outstanding securities are
traded in the secondary market, which is commonly known as stock market predominantly deals in the equity
shares. Debt instruments like bonds and debentures are also traded in the stock market. Well regulated and active
stock market promotes capital formation.

FUNCTIONS OF STOCK EXCHANGE

1. Maintains Active Trading

Shares are traded on the stock exchanges, enabling the investors to buy and sell securities. The prices may vary
from transaction to transaction. A continuous trading increases the liquidity or marketability of the shares traded
on the stock exchanges.

2. Fixation of Prices
Price is determined by the transactions that flow from investors’ demand and supplier’s preferences. Usually the
traded prices are made known to the public. This helps the investors to make better decisions.

3. Ensures Safe and Fair Dealing

The rules, regulations and by-laws of the stock exchanges’ provide a measure of safety to the investors.
Transactions are conducted under competitive conditions enabling the investors to get a fair deal.

4. Aids in Financing the Industry

A continuous market for shares provides a favorable climate for raising capital. The negotiability and
transferability of the securities helps the companies to raise long-term funds. When it is easy to trade the securities,
investors are willing to subscribe to the initial public offerings. This stimulates the capital formation.

5. Dissemination of Information
Stock exchanges provide information through their various publications. Stock exchanges publish the share prices
traded on daily basis along with the volume traded. Directory of Corporate information is useful for the investors’
assessment regarding the corporate. Handouts, handbooks and pamphlets provide information regarding the
functioning of the stock exchanges.

6. Performance Inducer
10 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

The prices of stock reflect the performance of the traded companies. This makes the corporate more concerned
with its public image and tries to maintain good performance.

7. Self-regulating Organization
The stock exchanges monitor the integrity of the members, brokers, listed companies and clients. Continuous
internal audit safeguards the investors against unfair trade practices. It settles the disputes between member
brokers, investors and brokers.

PARTICIPANTS OF STOCK EXCHANGE

1.The innumerable, but not organized investors.

2.Those seeking capital from the capital market--big corporations, small and medium sized business, etc.

3.Regulatory Body: SEBI (the Securities & Exchange Board of India) an autonomous and statutory body
acts as the market regulator and market developer. SEBI also looks into investor complaints against
companies. It is quasi-judicial and can try cases and pass judgments against any market participant

4.The Stock Exchanges: A stock exchange is the marketplace where companies are listed and where the
trading happens. They provide a transparent and safe (risk-free) forum of a market for investors to
transact and invest their funds.
There are 23 Stock Exchanges registered with SEBI and under its regulation. National Stock Exchange
(NSE) and the Bombay Stock Exchange (BSE) are the pre-dominant ones

5.The Depositories and their Participants: The depositories are institutions that have rendered the
market paperless by holding stocks of investors in an electronic form through a registered depository
participant (DP) and can be compared to a bank. Depositories hold securities in an account, transfer
securities between accounts on the instruction of the account holder and facilitate the transfer of
ownership without the account holder needing to handle securities. They provide ease and speed for
those transacting in the market.
There are two depositories in India--the National Securities Depository Ltd (NSDL) and the Central
Depository Services Ltd (CDSL), while there are over a 100 DPs

6.The Registered Intermediaries: They consist of brokers, sub-brokers, Trading and Clearing Members,
portfolio managers, Bankers to Issue, merchant bankers, registrars, underwriters and credit rating
agencies. They provide a range of services to the investors and are registered with SEBI and act under
the regulation of SEBI abiding by the Code of Conduct prescribed for each of the roles.

MEMBER OF THE STOCK EXCHANGE

The Securities Contract Regulation Act of 1956 has provided uniform regulation for the admission of members
in the stock exchanges. The qualifications for becoming a member of a recognized stock exchange are given
below
1. The minimum age prescribed for the members is 21 years.
2. He/she should be an Indian Citizen.
3. He should be neither a bankrupt nor compounded with the creditors.
4. He should not be convicted for fraud or dishonesty.
5. He should not be engaged in any other business connected with a company.
6. He should not be a defaulter of any other stock exchange.
11 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

7. The minimum required educational qualification is a pass in 12th examination.

The Mumbai and Calcutta stock exchanges have set up training institutes to enable the members to understand
the complexities of the stock trading. In recent day’s highly qualified persons such as Company secretaries,
charted accountants and MBA’s are becoming members. Corporate membership is also permitted now. The
members can transact business through their appointed members.

TYPES OF ORDERS
Buy and sell orders are placed with the members of the stock exchanges by the investors. The orders are of
different types.
Limit Orders
Orders are limited by a fixed price. ‘Buy Reliance Petroleum at Rs 50. Here, the order has clearly indicated the
price at which it has to be bought and the investor is not willing to give more than Rs 50.

Best Rate Order

Here, the buyer or seller gives the freedom to the broker to execute the order at the best possible rate quoted on
that particular date for buying. It may be the lowest rate for buying and the highest rate for selling.

Discretionary Order
The investor gives the range of price for purchase and sale. The broker can use his discretion to buy within the
specified limit. Generally the approximate price is fixed. The order stands as this ‘Buy HDFC 100 shares
around Rs 40’.

Stop Loss Order

The orders are given to limit the loss due to unfavorable price movements in the market. A particular limit is
given for waiting. If the price falls below the limit, the broker is authorized to sell the shares to prevent further
loss. Ex. Sell SAIL at Rs 25, stop loss at Rs 22.

REGULATORS OF CAPITAL MARKET

The securities market is regulated by various agencies such as Department of Economics Affairs (DEA), the
Department of Company Affairs (DCA), the Reserve Bank of India (RBI) and the Securities Exchange Board of
India (SEBI). The capital market i.e the market for equity & Debt securities is regulated by the SEBI. The SEBI
has full autonomy and authority to regulate and develop the capital market.
The SEBI has framed regulations under the SEBI Act and the Depositories Act for registration and regulation of
all market intermediaries, for prevention of unfair practices, and insider trading.

SECURITIES EXCHANGE BOARD OF INDIA

The Government has set up the Securities & Exchange Board of India (SEBI) in April, 1988. For more than three
years, it has no statutory powers. Its interim functions during the period were:
(i) To collect information and advice the Government on matters relating to Stock and Capital Markets
(ii) Licensing and regulation of merchant banks, mutual funds etc.
(iii) To prepare the legal drafts for regulatory and development role of SEBI and
(iv) To perform any other functions as may be entrusted to it by the Government.

12 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

Earlier the stock exchanges were managed by the Capital Issues Act. The Capital Issues (control) Act was
repealed and the Controller of Capital Issues abolished & SEBI got legal teeth through an ordinance issued on
January 30th, 1992. The ordinance conferred a wide range of powers.

Objectives of SEBI
1. To protect the interest of the investor in securities.
2. To promote the development of securities market.
3. Another major function performed by SEBI is regulating the securities market.

Functions of SEBI
Its regulatory jurisdiction extends over corporate in the issuance of capital and transfer of securities, in addition
to all intermediaries and persons associated with securities market. SEBI has been obligated to perform the
aforesaid functions by such measures as it thinks fit. In particular, it has powers for:
1. Regulating the business in stock exchanges and any other securities markets
2. Registering and regulating the working of stock brokers, sub–brokers etc.
3. Promoting and regulating self-regulatory organizations
4. Prohibiting fraudulent and unfair trade practices
5. Calling for information from, undertaking inspection, conducting inquiries and audits of the stock
exchanges, intermediaries, self – regulatory organizations, mutual funds and other persons associated with
the securities market.
6. Levying fees or other charges for carrying out the purpose of the act.
7. Conducting research

Stock Markets
Stock Market is a market where the trading of company stock, both listed securities and unlisted takes place. It is
different from stock exchange because it includes all the national stock exchanges of the country. For example,
we use the term, "the stock market was up today" or "the stock market bubble."

Stock Exchanges
Stock Exchanges are an organized marketplace, either corporation or mutual organization, where members of the
organization gather to trade company stocks or other securities. The members may act either as agents for their
customers, or as principals for their own accounts. Stock exchanges also facilitates for the issue and redemption
of securities and other financial instruments including the payment of income and dividends. The record keeping
is central but trade is linked to such physical place because modern markets are computerized. The trade on an
exchange is only by members and stock broker do have a seat on the exchange.

Following are the key functions of Stock Exchange;

a) By providing a market place and by providing quotation for securities the stock exchange facilitates buying
and selling the securities of listed corporate.
b) The trading facility offered by stock exchange creates liquidity for the instruments. The liquidity
(marketability) created for the securities benefits both the issuing company as well as the investors.
c) Through its rules, regulations and by-laws the stock exchange regulates the trading activities and it ensures
investors protection. The investors are able to get a fair deal.
The securities listed in Stock Exchange are bought and sold by investors. The demand and supply forces
determine the price of the securities. Thus the Stock Exchange facilitates price fixation.
13 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

e) By issuing shares and securities and listing the same in Stock Exchanges the corporate are able to mobilize
long-term capital. The liquidity created and the regulated trading increases the investor’s confidence. Thus the
Stock Exchanges facilitate capital formation. The scattered savings of vast majority of investors are transferred
to the needy corporate.
f) There is high demand for the shares of companies which are reporting good results, transparent and offering
good returns to shareholders. Thus the increased demand for the share increases the price and the market value
of the firm. Therefore the stock market quotations are acting as the real performance inducer.

Stock Exchanges
The Securities Contract (Regulation) Act, 1956 [SCRA] defines ‘Stock Exchange’ as any body of individuals,
whether incorporated or not, constituted for the purpose of assisting, regulating or controlling the business of
buying, selling or dealing in securities. Stock exchange could be a regional stock exchange whose area of
operation/jurisdiction is specified at the time of its recognition or national exchanges, which are permitted to have
nationwide trading since inception. NSE was incorporated as a national stock exchange.

The stock exchange performs the following functions:

1. Provide trading platform to investors and provide liquidity
2. Facilitate Listing of securities
3. Registers members - Stock Brokers, sub brokers
4. Make and enforce by-laws
5. Manage risk in securities transactions
6. Provides Indices

In India, there are 22 stock exchanges as of now in 2013, some having a permanent membership or some with a
temporary membership.
1. Ahmedabad Stock Exchange Ltd.
2. BSE Ltd.
3. Bangalore Stock Exchange Ltd.
4. Bhubaneswar Stock Exchange Ltd
5. Calcutta Stock Exchange Ltd.
6. Cochin Stock Exchange Ltd
7. Delhi Stock Exchange Ltd.,
8. The Gauhati Stock Exchange Ltd.,
9. The Inter-Connected Stock Exchange of India Limited
10. Jaipur Stock Exchange Ltd
11. Ludhiana Stock Exchange Ltd.,
12. The MCX SX Exchange Limited
13. Madhya Pradesh Stock Exchange Ltd
14. Madras Stock Exchange Ltd.
15. Magadh Stock Exchange Ltd. ("SEBI vide order dated September 3, 2007 refused to renew the recognition
granted to Magadh Stock Exchange Ltd.")
16. Mangalore Stock Exchange (As per Securities Appellete Tribunal order dated October 4, 2006, the
Mangalore Stock Exchange is a de-recognized Stock Exchange under Section 4 (4) of SCRA)
17. National Stock Exchange of India Ltd.
18. OTC Exchange of India
19. Pune Stock Exchange Ltd.
20. The Vadodara Stock Exchange Ltd.
14 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

21. U.P. Stock Exchange Limited

22. United Stock Exchange of India Limited

There are two leading stock exchanges in India which help us trade are:
i. National Stock Exchange: National Stock Exchange incorporated in the year 1992 provides trading in the
equity as well as debt market. Maximum volumes take place on NSE and hence enjoy leadership position in the
country today

ii. Bombay Stock Exchange: BSE on the other hand was set up in the year 1875 and is the oldest stock
exchange in Asia. It has evolved in to its present status as the premier stock exchange. In 1956, the
Government of India recognized the Bombay Stock Exchange as the first stock exchange in the country under
the Securities Contracts (Regulation) Act.
At BSE you will find some scripts listed that are not available on NSE. Also BSE has the largest number of
scripts which are listed.

NATIONAL STOCK EXCHANGE

National Stock Exchange was set up in 1993 to encourage stock exchange reform through system modernization
and competition. NSE is India's leading stock exchange covering 364 cities and towns across the country. It was
set up by leading institutions to provide a modern, fully automated screen-based trading system with national
reach. The Exchange has brought about unparalleled transparency, speed & efficiency, safety and market
integrity. It has set up facilities that serve as a model for the securities industry in terms of systems, practices and
procedures.
NSE's mission is setting the agenda for change in the securities markets in India. The NSE was set-up with the
following objectives:
a. establishing a nation-wide trading facility for equities, debt instruments and hybrids,
b. ensuring equal access to investors all over the country through an appropriate communication
network,
c. providing a fair, efficient and transparent securities market to investors using electronic trading
systems,
d. enabling shorter settlement cycles and book entry settlements systems, and
e. meeting the current international standards of securities markets

Importance of NSE in Indian Stock Market

1. NSE has played a catalytic role in reforming the Indian securities market in terms of microstructure,
market practices and trading volumes.
2. The National Stock Exchange of India Limited has genesis in the report of the High Powered Study Group
on Establishment of New Stock Exchanges, which recommended promotion of a National Stock Exchange
by financial institutions (FIs) to provide access to investors from all across the country on an equal footing.
3. Based on the recommendations, NSE was promoted by leading Financial Institutions at the behest of the
Government of India and was incorporated in November 1992 as a tax-paying company unlike other stock
exchanges in the country. On its recognition as a stock exchange under the Securities Contracts
(Regulation) Act, 1956 in April 1993, NSE commenced operations in the Wholesale Debt Market (WDM)
segment in June 1994. The Capital Market (Equities) segment commenced operations in November 1994
and operations in Derivatives segment commenced in June 2000.
4. The standards set by NSE in terms of market practices and technologies have become industry benchmarks
and are being emulated by other market participants.
15 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

5. NSE is more than a mere market facilitator. Till the advent of NSE, an investor wanting to transact in a
security not traded on the nearest exchange had to route orders through a series of correspondent brokers
to the appropriate exchange which leaded to uncertainty and high transaction costs. One of the objectives
of NSE was to provide a nationwide trading facility and to enable investors spread all over the country to
have an equal access to NSE.
6. NSE has made it possible for an investor to access the same market and order book, irrespective of
location, at the same price and at the same cost. NSE uses sophisticated telecommunication technology
through which members can trade remotely from their offices located in any part of the country. NSE
trading terminals are present in 363 cities and towns all over India.
7. NSE has been promoted by leading financial institutions, banks, insurance companies and other financial
intermediaries NSE is one of the first demutualised stock exchanges in the country, where the ownership
and management of the Exchange is completely divorced from the right to trade on it. From day one, NSE
has adopted the form of a demutualised exchange - the ownership, management and trading is in the hands
of three different sets of people. N
8. While the Board deals with broad policy issues, decisions relating to market operations are delegated by
the Board to various committees constituted by it. Such committees include representatives from trading
members, professionals, the public and the management. The day-to-day management of the Exchange is
delegated to the Managing Director who is supported by a team of professional staff.

Nifty
NIFTY is an Index computed from performance of top stocks from different sectors listed on NSE (National stock
exchange). NIFTY consists of 50 companies from 24 different sectors. NIFTY stands for National Stock
Exchange’s fifty. The companies which form index of NIFTY may vary from time to time based on many factors
considered by NSE. NIFTY is for NSE similarly SENSEX is for BSE

BOMBAY STOCK EXCHANGE

Mumbai stock exchange is popularly "BSE". BSE was established in 1875 as "The Native Share and Stock
Brokers Association". It is the oldest one in Asia, even older than the Tokyo Stock Exchange, which was
established in 1878. It is the first Stock Exchange in the Country to have obtained permanent recognition in 1956
from the Govt. of India under the Securities Contracts (Regulation) Act, 1956. The Exchange, while providing an
efficient and transparent market for trading in securities, debt and derivatives upholds the interests of the investors
and ensures redressal of their grievances whether against the companies or its own member-brokers.
It also strives to educate and enlighten the investors by conducting investor education program and making
available to them necessary informative inputs. A Governing Board having 20 directors is the apex body, which
decides the policies and regulates the affairs of the Exchange. The Governing Board consists of 9 elected directors,
who are from the broking community (one third of them retire every year by rotation), three SEBI nominees, six
public representatives and an Executive Director & Chief Executive Officer and a Chief Operating Officer.
On March 14th 1995 the BSE turned to electronic trading where the brokers trade using computers. This system
is known as the BSE On-line Trading system (BOLT). It is a screen based system which helped in improving
trading volumes, significantly reducing the spread between buy and sell orders, better trading in odd lot shares,
fixed income instruments and dealing in remuneration of right shares.

Carry forward Deals or Badla

It is a unique selling proposition of the BSE. Badla is the postponement of the delivery of or payment for the
purchase of securities from one settlement period to another. Badla was allowed in the specified group of shares

16 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

of the BSE. This group is known as the forward group as one could buy or sell shares in it without physical
delivery.

BSE Indices
BSE launched the BSE Sensitivity Index (SENSEX) in 1986. It is a "Market Capitalization-Weighted" index of
30 stocks representing a sample of large, well-established and financially sound companies. Earlier, this index
comprised of 100 scrips. It is the oldest index in India and has acquired a unique place in the collective
consciousness of investors. The index is widely used to measure the performance of the Indian stock markets.
SENSEX is considered to be the pulse of the Indian stock markets as it represents the underlying universe of
listed stocks at The Stock Exchange, Mumbai. Further, as the oldest index of the Indian Stock market, it provides
time series data over a fairly long period of time (since 1978-79).

OVER THE COUNTER EXCHANGE OF INDIA (OTCEI)

The traditional trading mechanism prevailed in the Indian stock markets gave way to many functional
inefficiencies, such as, absence of liquidity, lack of transparency, unduly long settlement periods and benami
transactions, which affected the small investors to a great extent. To provide improved services to investors, the
country’s first floorless, ring-less, scrip-less, electronic stock exchange - OTCEI - was created in 1992 by
country’s premier financial institutions - Unit Trust of India, Industrial Credit and Investment Corporation of
India,
Industrial Development Bank of India, SBI Capital Markets, Industrial Finance Corporation of India, General
Insurance Corporation and its subsidiaries and CanBank Financial Services. The objective of OTCEI is to provide
an alternate market for the securities of smaller companies, public-sector companies, closely held companies
desirous of listing etc. Smaller industries that are not listed in any other SE and those which have a minimum paid
up capital of Rs 30 lakhs can be listed on OTCEI

Trading at OTCEI is done over the centers spread across the country. Securities traded on the OTCEI are classified
into:
Listed Securities - The shares and debentures of the companies listed on the OTC can be bought or sold at any
OTC counter all over the country and they should not be listed anywhere else
Permitted Securities - Certain shares and debentures listed on other exchanges and units of mutual funds are
allowed to be traded
Initiated debentures - Any equity holding at least one lakh debentures of particular scrip can offer them for
trading on the OTC. OTC has a unique feature of trading compared to other traditional exchanges. That is,
certificates of listed securities and initiated debentures are not traded at OTC. The original certificate will be
safely with the custodian. But, a counter receipt is generated out at the counter which substitutes the share
certificate and is used for all transactions.
In the case of permitted securities, the system is similar to a traditional stock exchange.
The difference is that the delivery and payment procedure will be completed within 14 days.

ADVANTAGES
OTCEI has widely dispersed trading mechanism across the country which provides greater liquidity and lesser
risk of intermediary charges.
Greater transparency and accuracy of prices is obtained due to the screen-based scripless trading.

17 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

Since the exact price of the transaction is shown on the computer screen, the investor gets to know the exact
price at which s/he is trading.
Faster settlement and transfer process compared to other exchanges.
In the case of an OTC issue (new issue), the allotment procedure is completed in a month and trading
commences after a month of the issue closure, whereas it takes a longer period for the same with respect to other
exchanges. Thus, with the superior trading mechanism coupled with information transparency investors are
gradually becoming aware of the manifold advantages of the OTCEI.

The Depository Act

The Depositories Act, 1996, ushered in an era of efficient
capital market infrastructure, improved investor protection, reduced risks and increased transparency of
transactions in the securities market. It also immensely benefited the issuer companies, in terms of reduced costs
and the effort expended in managing their shareholder populace. Perhaps, no other single act other than the
Depositories Act has had such profound all round impact on every single stakeholder in the Indian capital
markets. This legislation envisaged multiple depositories in India to ensure benefits of competition for the users
of the depository system.

The Depositories Act which facilitated establishment of depositories (like CDSL) in India sought
to effectively curb irregularities in the capital market, and protect the interests of the investors, and paved a way
for an orderly conduct of the financial markets through free transferability of securities with speed,
accuracy, transparency etc. Due to the introduction of the depository system, the investors are able to enjoy many
benefits like free and instant transferability in a secured manner at
lowercosts, free from the problems like bad deliveries, odd-lots etc.

Today the tradable lot is reduced to “one unit” hence even a common man is able to invest money in one equity
share or bond or debenture. The investor is able to save a lot on account of stamp duty as government has
exempted stamp duty on transfer of securities at present. Investors are also spared from theproblems of
preserving the securities held in physical form

What is a Depository?
The Depositories Act defines a depository as “a company formed and registered under the Companies Act, 1956
and which has been granted a certificate of registration under subsection (1A) of section 12 of Securities and
Exchange Board of India Act,1992.”
The main function of a depository is to dematerialize securities and to enable their transactions in book entry
form.
As per The Bank for International Settlements (BIS),depository is “a facility for holding securities which enable
s securities transactions to be processed by book entry. Physical securities may be immobilized by the depository
or securities maybe dematerialized (so that they exist only as electronic records)”.In simple terms depository is
an organization where securities of an investor are held in electronic form.

Depository Participant

18 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

A Depository Participant (DP) is an agent of the depository through which it interfaces with the investor and
provides depository services. Public financial institutions, scheduled commercial banks, foreign banks operating
in India with the approval of the Reserve Bank of India, state financial corporations, custodians, stock-brokers,
clearing corporations /clearing houses, NBFCs and Registrar to an Issue or Share Transfer Agent complying with
the requirements prescribed by SEBI can be registered as DP. Banking services can be availed through a branch
whereas depository services can be availed through a DP.As on September 30, 2008, a total of 711 DPs (266
NSDL, 445CDSL) are registered with SEBI.

Number of Depositories in India

At present two Depositories:

National Securities Depository Limited (NSDL)

NSDL is a public limited company incorporated under the Companies Act, 1956. Four renowned institutions
participate in it.Unit Trust of India (UTI), Industrial Development Bank of India (IDBI), National Stock
Exchange of India (NSE), State Bank of India(SBI).UTI is the largest mutual fund of India and IDBI is the largest
development bank, NSE is the largest stock exchange of India and SBI is the largest commercial bank of India
having clearing facility. HDFC and Citibank also share in this system.
NSDL is managed by Board of directors headed by a managing director. It is governedby its bye-
laws and its business operations are regulated bybusiness rules. NSDL interfaces with the investors through
playersor business partners.
Constituents of depository compromise of clearing corporation, brokers, clearing member, registrar andtransfer
agents, company or issuer, stock exchange, bankdepository participant and investors. All are electronically
linked to the main depository for the settlement of trades and to perform a daily reconciliation of all accounts held
with NSDL.

Central Depository Services (India) Limited(CDSL)

Second agency is CDSL - Central Depository Service (India) Limited. Main functions of this agency are
centralized data base and accounting. Major participant in CDSL are LIC, GIC and BSE.
This agency is set up with the object to keep in mind to
accelerategrowth of scripless trading, with major thrust of individualparticipation and creating competitive
environment, responsible to the user’s interests and demands to enhance liquidity. CDSL aims to retain the entire
data of the investors in the central database of CDSL.

NSDL and CDSL essentially perform the following functions through their various participants
1. Enable surrender and withdrawal of securities to and from the depository.
2. Maintain investor holdings in the electronic form.
3. Effect settlement of securities traded on the Exchanges.
4. Carry out settlement of trades not done on the Stock Exchanges i.e. Off Market Trades.
5. Coordination of benefits accruing on the depository accounts of investors.

Meaning of Dematerialization
Dematerialization is a process by which physical certificates of an investor are converted into electronic form and
credited to the account of the depository participant. Dematted securities do not have any certificate numbers or
distinctive numbers and are dealt only in quantity, i.e., the securities are replaceable. Investors can dematerialize
only those certificates that are already registered in their names and are in the list of securities admitted for
dematerialization. These are: shares, scrip’s, stocks, bonds, debentures, stock or other marketable securities of a
like nature in or of any incorporated company or other body corporate, units of mutual funds, rights
19 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

under collective investment schemes and venture capital funds, commercial paper, certificate of deposit,
securities debt, money market instruments and unlisted securities, underlying sharing of American Depository
Receipts andGlobal Depository Receipts issued to non-resident holders. Dematerialization is the process of
converting physical holdings into electronic form with the depository where in the share certificates are shredded
and corresponding entry of the number of shares is done in the opened with the depository.
The securities held in dematerialized form are fungible; that is, they do not bear any notable feature like distinctive
number, folio number or certificate number. Once shares get dematerialized, they lose their identity in terms of
share certificate distinctive numbers and folio numbers.

Following requisites are necessary for dematerialization of securities:

1. Investors should have a depository account.
2. Securities should be from the eligible list of securities issued by the depository
3. Securities must be in the name of the account holders and owned by
him.Separate demat requisition form is required for each issuer company.
4. Dematerialization Request Form (DRF) should be signed by all the holders so as to match specimen
signature.

Object Of Demat System

India has adopted this system in which book entry is done electronically. It is the system where no paper is
involved. Physical form is extinguished and shares or securities are held in electronic mode. Before the
introduction of the depository system by the Depository Act, 1996, the process of sale, purchase and transfer
of shares was a huge problem and the safety perspective was zero.

Securities that can be dematerialized

The entire depository system in India is governed by the
rulesmade by the market regulator - SEBI. According to the SEBI
(Depositories and Participants) Regulations, 1996, the following securities are eligible for holding in
dematerialized form
1. Shares, scrips, stocks, bonds, debentures, debenture stock
orother marketable securities of similar nature of anyincorporated company or other body corporate, incl
udingunderlying shares of ADRs and GDRs.
2. Units of mutual funds, rights under collective investmentschemes and venture capital funds, commercial
paper,certificate of deposit, securitised debt, money marketinstruments, government securities, national
saving certificates, kisan vikas patra and unlisted securities.

Process of Dematerialization
A holder of eligible securities in the depository system may get his physical holdings converted into electronic
form by makinga request through the DP with whom he has his beneficiaryaccount.

Prerequisites for Dematerialization Request

1. The registered holder of the securities should make the request.
2. Securities to be dematerialized must be recognised byNSDL/CDSL as eligible. In other words, only t
hose securitieswhose ISIN has been activated by NSDL/CDSL, can bedematerialized in the
NSDL/CDSL system.

20 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

3. The company/Issuer should have established connectivity

withNSDL/CDSL. Only after such connectivity is established, thesecurities of that company/Issuer
are recognised to be "available for dematerialization" in the NSDL/CDSL system.
4. The holder of securities should have a beneficiary account in the
same name as it appears on the security certificates to be dematerialized.
5. The request should be made in the prescribed dematerialization request form.

Listing of Securities

Listing means admission of securities to dealings on a recognised stock exchange. The securities may be of any
public limited company, Central or State Government, quasi governmental and other financial
institutions/corporations, municipalities, etc.

The objectives of listing are mainly to :

• provide liquidity to securities;

• mobilize savings for economic development;
• protect interest of investors by ensuring full disclosures.

The BSE Limited has a dedicated Listing Department to grant approval for listing of securities of companies in
accordance with the provisions of the Securities Contracts (Regulation) Act, 1956, Securities Contracts
(Regulation) Rules, 1957, Companies Act, 1956, Guidelines issued by SEBI and Rules, Bye-laws and
Regulations of BSE.

BSE has set various guidelines and forms that need to be adhered to and submitted by the companies. These
guidelines will help companies to expedite the fulfillment of the various formalities and disclosure requirements
that are required at various stages of

Public Issues
o Initial Public Offering
o Further Public Offering
o Preferential Issues
o Indian Depository Receipts
o Amalgamation
o Qualified Institutions Placements

1. Minimum Listing Requirements for New Companies

The following eligibility criteria have been prescribed for listing of companies on BSE, through Initial Public
Offerings (IPOs) & Follow-on Public Offerings (FPOs):

• The minimum post-issue paid-up capital of the applicant company (hereinafter referred to as "the
Company") shall be Rs. 10 crore for IPOs & Rs.3 crore for FPOs; and
• The minimum issue size shall be Rs. 10 crore; and

21 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

• The minimum market capitalization of the Company shall be Rs. 25 crore (market capitalization shall be
calculated by multiplying the post-issue paid-up number of equity shares with the issue price).
Further :

• In respect of the requirement of paid-up capital and market capitalization, the issuers shall be required to
include in the disclaimer clause forming a part of the offer document that in the event of the market
capitalization (product of issue price and the post issue number of shares) requirement of BSE not being
met, the securities of the issuer would not be listed on BSE.
• The applicant, promoters and/or group companies, shall not be in default in compliance of the listing
agreement.
• The above eligibility criteria would be in addition to the conditions prescribed under SEBI (Issue of Capital
& Disclosure Requirements) Regulations, 2009.
• The Issuer shall comply to the guidance/ regulations applicable to listing as bidding inter alia from
o Securities Contracts (Regulations) Act 1956
o Securities Contracts (Regulation) Rules 1957
o Securities and Exchange Board of India Act 1992
o And any other circular, clarifications, guidelines issued by the appropriate authority.
o Companies Act 1956

2. Minimum Requirements for Companies Delisted by BSE seeking Relisting on BSE

Companies delisted by BSE and seeking relisting at BSE are required to make a fresh public offer and comply
with the existing guidelines of SEBI and BSE regarding initial public offerings.

3. Permission to Use the Name of BSE in an Issuer Company's Prospectus

Companies desiring to list their securities offered through a public issue are required to obtain prior permission
of BSE to use the name of BSE in their prospectus or offer for sale documents before filing the same with the
concerned office of the Registrar of Companies.

BSE has a Listing Committee , comprising of market experts, which decides upon the matter of granting
permission to companies to use the name of BSE in their prospectus/offer documents. This Committee evaluates
the promoters, company, project , financials, risk factors and several other aspects before taking a decision in
this regard.

Decision with regard to some types/sizes of companies has been delegated to the Internal Committee of BSE.

4. Submission of Letter of Application

As per Section 73 of the Companies Act, 1956, a company seeking listing of its securities on BSE is required to
submit a Letter of Application to all the stock exchanges where it proposes to have its securities listed before
filing the prospectus with the Registrar of Companies.

5. Allotment of Securities
As per the Listing Agreement, a company is required to complete the allotment of securities offered to the
public within 30 days of the date of closure of the subscription list and approach the Designated Stock
Exchange for approval of the basis of allotment.
In case of Book Building issues, allotment shall be made not later than 15 days from the closure of the issue,
failing which interest at the rate of 15% shall be paid to the investors.

22 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

6. Trading Permission
As per SEBI Guidelines, an issuer company should complete the formalities for trading at all the stock
exchanges where the securities are to be listed within 7 working days of finalization of the basis of allotment.
A company should scrupulously adhere to the time limit specified in SEBI (Disclosure and Investor Protection)
Guidelines 2000 for allotment of all securities and dispatch of allotment letters/share certificates/credit in
depository accounts and refund orders and for obtaining the listing permissions of all the exchanges whose
names are stated in its prospectus or offer document. In the event of listing permission to a company being
denied by any stock exchange where it had applied for listing of its securities, the company cannot proceed with
the allotment of shares. However, the company may file an appeal before SEBI under Section 22 of the
Securities Contracts (Regulation) Act, 1956.

7. Requirement of 1% Security
Companies making public/rights issues are required to deposit 1% of the issue amount with the Designated
Stock Exchange before the issue opens. This amount is liable to be forfeited in the event of the company not
resolving the complaints of investors regarding delay in sending refund orders/share certificates, non-payment
of commission to underwriters, brokers, etc.

8. Payment of Listing Fees

All companies listed on BSE are required to pay to BSE the Annual Listing Fees by 30th April of every
financial year as per the Schedule of Listing Fees prescribed from time to time.
The schedule of Listing Fees for the year 2011-12, is given here under:

Securities *other than Privately Placed Debt Securities and Mutual Funds

Sr.No. Particulars Norms

1 Initial Listing Fees Rs. 20,000/-
2 Annual Listing Fees
(i) Upto Rs. 5 Crs. Rs. 15,000/-
(ii) Rs.5 Crs. To Rs.10 Crs. Rs. 25,000/-
(iii) Rs.10 Crs. To Rs.20 Crs. Rs. 40,000/-
(iv) Rs.20 Crs. To Rs.30 Crs. Rs. 60,000/-
Rs. 70,000/-
plus Rs. 2,500/-
for every
(v) Rs.30 Crs. To Rs.100 Crs. increase of Rs. 5
crs or part
thereof above
Rs. 30 crs.
Rs. 125,000/-
plus Rs. 2,500/-
for every
(vi) Rs.100 Crs. to Rs.500 Crs. increase of Rs. 5
crs or part
thereof above
Rs. 100 crs.
23 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

Rs. 375,000/-
plus Rs. 2,500/-
for every
(vii) Rs.500 Crs. to Rs.1000 Crs. increase of Rs. 5
crs or part
thereof above
Rs. 500 crs.
Rs. 625,000/-
plus Rs. 2,750/-
for every
(vi) Above Rs. 1000 Crs. increase of Rs. 5
crs or part
thereof above
Rs. 1000 crs.
Note: In case of debenture capital (not convertible into
equity shares), the fees will be 75% of the above fees.
* includes equity shares, preference shares, indian depository
receipts, fully convertible debentures, partly convertible
debentures and any other security convertible into equity shares.

Placed Debt Securities

Sr.No. Particulars Norms

1 Initial Listing Fees NIL
2 Annual Listing Fees
(i) Issue size up to Rs.5 Crs. Rs. 2,500/-
(ii) Above Rs.5 Crs. and up to Rs.10 Crs. Rs. 3,750/-
(iii) Above Rs.10 Crs. and up to Rs.20 Crs. Rs. 7,500/-
Rs. 7,500/- plus
Rs. 200/- for
every increase
Rs.1 Cr. or part
thereof above
(iv) Above Rs.20 Crs.
Rs.20 crs.
Subject to a
maximum of
Rs.30,000/- per
instrument.
Note: Cap on the annual listing fee of debt instruments per issuer
is Rs.5,00,000/- per annum.

Mutual Funds

Sr.No. Particulars Norms

1 Initial Listing Fees NIL
24 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

Payable
Annual Listing Fee for tenure of the per 'month
2
scheme or part
thereof'
(i) Issue size up to Rs.50 Crs. Rs.1,000/-
(ii) Above Rs.50 Crs.and up to Rs.100 Crs. Rs.2,000/-
(iii) Above Rs.100 Crs.and up to Rs.300 Crs. Rs.3,600/-
(iv) Above Rs.300 Crs.and up to Rs.500 Crs. Rs.5,900/-
(v) Above Rs.500 Crs.and up to Rs. 1000 Crs. Rs.9,800/-
(vi) Above 1000 Crs. Rs.15,600/-
Note:
1. For tenure beyond One month, fees are payable for one
month or any part thereof.

2. Asset Under Management (AUM) of all such listed schemes

of the Fund House exceed Rs. 10,000 crs, discount of 10%
will be offered on future annual listing fees for all listed
schemes of that Fund House. For eligibility of 10% discount
on listing fees, the corpus of AUM will be taken as on March
31st of every year.

Applicability
The above schedule of Listing Fee is uniformly applicable for all companies irrespective of whether BSE is
the designated stock exchange or not.

PAYMENT DATE
The last date for payment of Listing Fee for the year 2011-12 is April 30, 2011. Failure to pay the Listing
Fee (for equity debt segment and/or Mutual Fund) by the due date will attract interest @ 12% per annum
w.e.f. May 1, 2011.
SERVICE TAX
Service Tax is payable on the listing fee at the applicable rates.

9. Compliance with the Listing Agreement

Companies desirous of getting their securities listed at BSE are required to enter into an agreement with BSE
called the Listing Agreement, under which they are required to make certain disclosures and perform certain
acts, failing which the company may face some disciplinary action, including suspension/delisting of securities.
As such, the Listing Agreement is of great importance and is executed under the common seal of a company.
Under the Listing Agreement, a company undertakes, amongst other things, to provide facilities for prompt
transfer, registration, sub-division and consolidation of securities; to give proper notice of closure of transfer
books and record dates, to forward 6 copies of unabridged Annual Reports, Balance Sheets and Profit and Loss
Accounts to BSE, to file shareholding patterns and financial results on a quarterly basis; to intimate promptly to
the Exchange the happenings which are likely to materially affect the financial performance of the Company
and its stock prices, to comply with the conditions of Corporate Governance, etc.
The Listing Department of BSE monitors the compliance by the companies with the provisions of the Listing
25 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

Agreement, especially with regard to timely payment of annual listing fees, submission of results, shareholding
patterns and corporate governance reports on a quarterly basis . Penal action is taken against the defaulting
companies.

10. Cash Management Services (CMS) - Collection of Listing Fees

In order to simplify the system of payment of listing fees, BSE has entered into an arrangement with HDFC
Bank for collection of listing fees from 141 locations all over the country.Details of the HDFC Bank branches
are available on our website site www.bseindia.com as well as on the HDFC Bank website www.hdfcbank.com
This facility is being provided free of cost.
Companies intending to utilize this facility for payment of listing fee should furnish the information (as
mentioned below) in the Cash Management Cash Deposit Slip. These slips are available at all the HDFC Bank
branches.

Sr.No. Head Information to be Provided

1 Client Name BSE Limited
2 Client Code BSELIST
3 Cheque No. mention the cheque No & date
date on which payment is being
4 Date
deposited with the bank.
state the name of the company
and the company code No.The
last digits mentioned in the Ref.
No. on the Bill is the company
5 Drawer code No.e.g If the Ref. No in
the Bill is mentioned as :
Listing/Alf- Bill/2004-
2005/4488, then the code No of
that company is 4488
state the bank on which cheque
6 Drawee Bank
is drawn
Mention the location of the
7 Drawn on Location
drawee bank.
8 Pickup Location Not applicable
9 No. of Insts Not applicable

26 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

UNIT 2
FUNDAMENTAL ANALYSIS
The investors’ ultimate aim is to get a reasonable return on his investment. The investor who wants to get a
reasonable return should analyze various fundamental factors before committing his hard earned funds and should
hold his investment for a reasonable period. Fundamental Analysis helps the investor to identify the right
investment outlet and the right entry and exit timings and thus it helps in enhancing the return and reduces the
risk of investing. The fundamental analysis mainly focuses on the analysis of economy, industry and the company
performance. The general economic conditions affect the performance of companies and resultantly influence the
returns available for the equity investors. Therefore, analyzing economy becomes pertinent before investing in
shares and securities. A study on the economic conditions would certainly give an idea about the future earning
prospectus of companies and the dividends, capital gain and interest available for investors.

1.ECONOMIC FORECASTING
The growth of economy is influenced by a large number of factors. The growth rate may be fluctuating from
period to period and in turn influences the stock price movements.
The investor has to analyze and predict the growth of economy so that he can take right investment decisions.
The economic forecasting should be done both for short term and long term for taking stock investment decisions.
Forecasting for a period above three years can be treated as long term and below three years can be treated as
short term.

STOCK INVESTMENT DECISIONS

a) Population of the country
Analyzing the population of the country gives a complete picture about the kind of labour force. Increase in
population results in increase in demand for many goods and services and at the same time the availability of
manpower also increases. If the population explosion is strategically used by the country certainly it is an asset.
b) Research and Development facilities
The economic growth mainly depends on the emphasis given on research and development and the infrastructure
development. The investor should select the industry based on the above issue. For example the Government is
focusing on the development of infrastructure, telecommunication and power sector. These sectors future growth
rate is very high.
c) Capital Formation
The capital formation in the country influences the growth of various industries. Mobilization of scattered savings
and passing the same to the needy industries require efficient financial system.
d) Resources
Natural resources are very much important for the economic growth of the country. Water, oil, mines resources
are the backbone of any economy. Technological discoveries in recycling of materials, nuclear and solar energy
and new synthetics offers lot of potential for growth of economy.
e) Gross Domestic Product (GDP)
The GDP indicates the growth rate of the economy and it represents the total value economy and it represents the
total value of goods and services produced in the country. The growth of GDP reflects the growth of various
sectors, companies and per capita income. If the GDP growth rate increases certainly the return available for
investors also will increase.

27 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

f) Savings and Investments.

The savings made by the large number of people and various sectors determine the growth of economy. If the
people save a part of their earnings and make investments in various shares and securities then corporate can
easily make investments in expansion and modernization program and this will fuel their earning capacity.
g) Rate of Inflation
The rate of inflation prevailing in the country determines the real economic growth. If money supply increases
without increase in production of goods and services then inflation rises. During inflationary conditions more
money chasing few goods. When inflation is high the cost of living and cost of business operations are increasing.
The returns available from stock market investments will be declining.
h) Budget Proposals
The annual budget proposals submitted by the State and Central Governments affects the economic growth. When
budget deficit increases the economic growth will slow-down and inflation starts rising.
i) The taxation policy
The various taxes imposed by the Central and State Government on individuals and corporate affects their
purchasing ability. High corporate tax leaves the companies with fewer surpluses which will be inadequate to pay
dividend to shareholders and to meet business development expenditures.
j) Balance of Payment of Currency value
The balance of payment position determines the currency value against overseas currencies and in turn the
currency value determines the profitability of exports and importers. When the currency value appreciates against
overseas currencies then it benefit the importers but affect the exporters.
k) Monsoon and Agriculture
In India around 79% of the people lives in rural areas and engaged in agriculture and allied activities. The
agriculture mainly depends on monsoon. Moreover many sectors get raw materials from agriculture. Therefore
the monsoon and agricultural output influences the stock market.

TECHNIQUES OF ECONOMIC FORECASTING

a) Surveys
The Survey method of economic forecasting involves getting the concerned peoples opinion about the current
development and outlook of the economy and specific sector. It is very difficult to meet all the concerned people
and a sample can be taken and a questionnaire or interview schedule can be administered with the selected sample.
Thus survey involves the collection of first hand information from the concerned respondents and this method is
more reliable. However the survey method is a time consuming and costly method.
b) Indicators
The economic forecasting can be done with the help of analyzing the economic indicators. The factors like GDP,
capital investments, corporate profits, liquidity, rate of interest, FOREX level, currency value, unemployment
rate, per capita income etc, gives lot of insight and indicate the direction of the economic growth.
The economic indicators may be classified as Leading Indicator, Coincidental Indicator and Lagging Indicator.
The Leading Indicators give a hint about what would happen to economy. This indicates the future direction of
the economy. The examples of Leading Indicator are fiscal policy, Monitory Policy, Productivity, Monsoon and
Stock market indices.
The coincidental indicator indicates the current condition of the economy. For example GNP, GDP, Industrial
production and interest rate etc. shows the current developments of economy. The charges that are taking place

28 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

in leading and coincidental indicators are reflected in the lagging indicators. For example unemployment rate,
inflation, and FOREX level are the outcome of leading and coincidental indicators.

c) Diffusion Index
The Diffusion Index is considered as a composite index and consensus index. The diffusion index includes the
futures of leading indicators, coincidental indicator, and lagging indicator. Under diffusion index both micro as
well as macro factors are analyzed. However this complex statistical method is very difficult to understand and
apply.

d) Economic Model Building

Under Economic Model Building technique of economic forecasting relationship between two variables are found
to draw some conclusions so as to predict the future direction of the economy. One independent variable and
dependent variable are taken and their relationship is measured. Like this many variables are compared to draw
some meaningful inferences and to know to the future direction of the economy. However, to apply this model
one has to have the computer, necessary software and accurate data.

e) Opportunistic Model Building

The Opportunistic Model Building is also known as Sectoral analysis of Gross National Product Model Building
and this is widely used economic forecasting technique. This method is based on the national accounting data and
helps to find out the total income and total demand for various goods and services. The forecast is made for the
Central Government Sectors, State Government Sectors, Private Sectors, and the Consumption Sector. The
expenses and income of all the above sectors are carefully analyzed. This method is very reliable and highly
flexible in forecasting the economic conditions and future directions.

2. INDUSTRY ANALYSIS
Under fundamental analysis the next focus area is Industry Analysis. When the investor is ensured about the
growth of economy he has to evaluate various industries and select the most promising industry for identifying
investment opportunities. Therefore it becomes pertinent to carefully select the growth oriented industries for
investment.

THE MEANING OF INDUSTRY

An industry means a group of firms doing similar business. The companies in a particular industry are almost
using similar materials, technology manpower skill and distribution system. They target the same customer
segment. Following are the examples of Industries;
(i) Banking Industry v) Steel Industry
ii) Software Industry vi) Paper Industry
iii) Automobile Industry vii) Aluminum Industry
iv) Cement Industry viii) Textiles Industry
CLASSIFICATION OF INDUSTRY
a) Growth Industry
The industry which is growing at faster rate is termed as growth industry. This industry is growing at high rate
when compared to other industry and to certain extent independent of the economy life cycle. In other words the
growth industry growth rate is high when compared to the growth rate of economy and other sectors. For instance
the Indian Software and Information technology enabled services industry and Infrastructure industry is
considered as growth industry.
29 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

b) Cyclical Industry
The Cyclical Industries’ growth depends on the growth of economy. For example the consumer goods industry
such as consumer white goods industry (colour television, washing machine, fridge etc.,) growth rate depends on
the growth of general economic conditions.

c) Defensive Industry
The Defensive industry to certain extend is independent from the ups and downs of the other sectors. For example
the growth of industry which is producing consumer essential goods such as food, cloth and basic requirements
of the consumer are steady always.

d) Cyclical Growth Industry

The industry is basically cyclical and at the same time it is growing. For example the demand for passengers cars
increases when the economy is in sound shape and facing down trend when they economy started facing trouble.
The technological innovation and effective marketing strategy results in growth of the demand at high rate.
However, when there is a slowdown in economical conditions, the growth rate of cyclical growth industry comes
down.

INDUSTRY LIFE CYCLE

Every industry has to undergo various stages due to changes in technology, consumer behaviour and innovations.
The length of each and every stage may be different from industry to industry. The cost, profitability and demand
are influenced mainly by the stages of the industry life cycle.
Life cycle models are not just a phenomenon of the life sciences. Industries experience a similar cycle of life. Just
as a person is born, grows, matures, and eventually experiences decline and ultimately death, so too do industries.
The stages are the same for all industries, yet industries cycle through the stages in various lengths of time. Even
within the same industry, various firms may be at different life cycle stages. Strategies of a firm as well as of
competitors vary depending on the stage of the life cycle. Some industries even find new uses for declining
products, thus extending the life cycle. Others send products abroad in hopes of extending their life.
The growth of an industry’s sales over period is used to chart the life cycle. The distinct stages of an industry life
cycle are: introduction, growth, maturity, and decline.
Sales typically begin slowly at the introduction phase, and then take off rapidly during the growth phase. After
leveling out at maturity, sales then begin a gradual decline. In contrast, profits generally continue to increase
throughout the life cycle, as companies in an industry take advantage of expertise and economies of scale and
scope to reduce unit costs over time.

STAGES OF INDUSTRY LIFE CYCLE.

a) Pioneering Stage
This is the first stage of the industry life cycle and at this stage a new product is introduced and the demand is
created by educating the consumers about the product. The number of players at the stage is less and the sales are
also less. No company can operate at its full capacity. The cost of production, marketing and distribution are very
high. In the introduction stage of the life cycle, an industry is in its infancy. Perhaps a new, unique product offering
has been developed and patented, thus beginning a new industry.
At the introduction stage, the firm may be alone in the industry. It may be a small entrepreneurial company or a
proven company which used research and development funds and expertise to develop something new. Marketing
refers to new product offerings in a new industry as “question marks” because the success of the product and the
life of the industry are unproven and unknown.

30 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

A firm will use a focus strategy at this stage to stress the uniqueness of the new product or service to a small
group of customers. These customers are typically referred to in the marketing literature as the “innovators” and
“early adopters.” Marketing tactics during this stage are intended to explain the product and its uses to consumers
and thus create awareness for the product and the industry.
Introduction requires a significant cash outlay to continue to promote and differentiate the offering and expand
the production flow from a job shop to possibly a batch flow. Market demand will grow from the introduction,
and as the life cycle curve experiences growth at an increasing rate, the industry is said to be entering the growth
stage. Firms may also cluster together in close proximity during the early stages of the industry life cycle to have
access to key materials or technological expertise.

b) Expansion Stage
Under Expansion stage the companies in the industry are seeing growth rate of sales and profits. The demand for
the product is consistently increasing since the consumer has accepted the product. To meet increased demand
the companies expand their capacity. Thus the companies enjoy the economics of large scale activities. In other
words the increased capacity utilization helps the company to reduce over head cost. .
Like the introduction stage, this stage also requires a significant amount of capital for the firm. The goal of
marketing efforts at this stage is to differentiate a firm’s offerings from other competitors within the industry.
The duration of the growth stage, as all the other stages, depends on the particular industry under study. Some
items—like food, clothing, for example may experience a very short growth stage and move almost immediately
into the next stages of maturity and decline
In this Stage of the industry the companies are achieving robust growth in sales and profit. By seeing the
profitability many companies jump in to the industry and make it more competitive. The demand for the products
will increase at very high rate. The profitability of all companies is very high. Introduction of new technologies,
research and development and various collaborations enhances quality of the product and customer satisfactions.

d) Stagnation Stage
The next stage is called Maturity stage. At this stage the market is stabilizing and the growth rate is very less. At
the far end of the stage the symptoms of obsolesces of the technology and product will appear. To continue the
business the companies have to take a lot of efforts to increase quality and customer satisfaction.
Firms may compete on quality to separate their product from other lower-cost offerings, or conversely the firm
may try a low-cost/low price strategy to increase the volume of sales and make profits from inventory turnover.
A firm at this stage may have excess cash to pay dividends to shareholders. But in mature industries, there are
usually fewer firms, and those that survive will be larger and more dominant. While innovations continue they
are not as radical as before and may be only a change in color or formulation to stress “new” or “improved” to
consumers. Laundry detergents are examples of mature products.

This is last life cycle of the industry and at this stage the demand for the product starts declining. Beyond this the
declining stage begins for an industry. Thus causes of declining stage may be changes in raw material, technology,
consumer behavior or Government policy. Under declining stage the companies’ production is declining whereas
the cost is high and above all the profitability is severely affected and ultimately it results in loss. Declines are
almost inevitable in an industry. If product innovation has not kept pace with other competitors, or if new
innovations or technological changes have caused the industry to become obsolete, sales suffer and the life cycle
experiences a decline.
In this phase, sales are decreasing at an accelerating rate, causing the plotted curve to trend downward. Profits
may continue to rise, however. There is usually another, larger shake-out in the industry as competitors who did
not leave during the maturity stage now exit the industry. Yet some firms will remain to compete in the smaller

31 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

market. Mergers and consolidations will also be the norm as firms try other strategies to continue to be competitive
or grow through acquisition and/or diversification.

SALES

Stagnation

Growth

Pioneering

TIME

INDUSTRY ANALYSIS – ISSUES

To analyze an industry for taking investment decisions the various factors which affect the prospects should be
studied. Following are the key issues to be analyzed.

a. Growth of the Industry

The rate of growth in terms of sales and profitability is very important factor to be analyzed. The growth rate of
industry has a significant impact on the profitability and growth rate of the companies in the industry.

b. Profitability of the Industry

The profit margin of the industry determines the return available for investors. The asset structures (fixed and
current assets) and the operating expenses influence the profitability.

c. Nature of the Industry

The nature of the industry suggests what kinds of goods are produced: consumer goods, industrial goods, or
service sector influences the profitability. If the particular industry directly depends on other industry then that
industry also should be analyzed.

d. Degree of competition
The level of competition is an important factor to be analyzed for sound investment decision. If the competition
level is very high the profit margin of this company will be very low. The growth prospects also will be very less.

e. Government policy
The Government policy over a particular industry determines the profitability. The taxation policy, price control,
environmental norms etc., affects directly the performance of the companies.

32 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

f. Manpower
The availability of skilled manpower and its cost structure are very important issues to be analyzed. When the
required skilled manpower is available at reasonable cost then the cost of recruitment, training and development
will be low. Otherwise the employee cost will be very high and in turn it will affect the profitability of the industry.

g. Research and development

The investment on Research and Development and the facilities available will help the industry to achieve high
growth rate.

COMPANY ANALYSIS
This type of looking at the problem consists of selecting the stocks based on information regarding the financial
situations of the company, its area of activity, and also on comparing the price with other similar ones from the
market. The fundamental analysis is useful when investing in stocks for a long period of time (at least a year).
Those who use this type of analysis have themselves different objectives of evaluation and profit, using mostly
certain criteria.
The company analysis is the major part in fundamental analysis. For taking prudent investment decision, the
investor has to analyze economic conditions and select the most promising industry. However it doesn’t mean
that all the companies in the selected industry will be really growth oriented. Therefore it becomes necessary to
identify the best company from the selected industry for investment. For this purpose the investor has to carefully
analyze various important fundamental factors which influence the valuation and growth prospects of the
company.

FACTORS TO BE CONSIDERED
a) The Core strength of the Company: Each and every company has its own competitive edge when compare to
others.

b) Market Share: The market share enjoyed by a company facilitates strong earnings growth.

c) Growth of Sales: The Growth of the sales of the company should be steadily increasing, so that its financial
results really improve. The growth of sale indicates the increasing market share, increasing number of loyal
customers. Such growth results in optimum utilization of the resources of the company.

d) Profitability The profitability is the result of the efficiency of various functional areas of the company.
The increase in cash profit and operating margin really improves the liquidity conditions of the company. Besides
paying a reasonable dividend to share holder the company can use the surplus for expansion program and reduce
its debts burden, so as to reduce the cost of capital. All these will certainly increase the financial position of the
company.
MEASURING EARNINGS
The investor has to go through the financial statements and analyze the profitability and financial position of the
company. The various accounting policies and accounting standards adopted by the company for preparation of
the financial statement should be understood so that the real financial health of the company is known. In this
regards the following areas should be carefully analyzed:
Analysis of Financial Statement
The Trading, Profit and Loss account and Balance sheet are the basic financial statement of a company. The
Trading, Profit and Loss account shows the results of one year business operation that is loss profit or loss. The
Balance sheet shows the financial position of the company. Following are the techniques of financial statement
analysis:
33 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

a) Comparative Financial Statement

The figures of financial statement for more than one period are presented in a table for analysis. The increase or
decrease of various items such as expenses, income, liabilities and assets over two years period are calculated and
shown in terms of actual amounts and percentage. Such analysis helps the investor which items is increasing or
decreasing and the percentage of increase or decrease.

b) Common Size Statement

The common items in the financial statements are taken as hundreds and the rest of the items are converted as a
percentage of the common item. For example in common size income statement the sale figure is taken as hundred
and all the expenses are converted as a percentage of sales. Similarly in common size balance sheet the total
liabilities are taken as hundred and all the liabilities are shown as a percentage of the total liabilities. When come
to assets side of the balance sheet the total asset is taken as hundred and all the assets are converted as percentage
of total assets. This exercise simplifies lengthy accounting figures and facilitates easy and quick understanding of
the importance of each and every accounting figure.

c) Trend Analysis
The Trend analysis considers more than two years figures. For example a company’s five years balance sheet can
be shown in the form of table by taking the first year figure as base data. The base data is taken as hundred and
the subsequent years figures are converted as a percentage of the based data. This Trend Analysis helps to
understand the movement of the trend of the profitability and the financial position of the company.

d) Funds Flow and Cash Flow Analysis

The funds flow and cash flow analysis shows the various sources of funds and applications of funds of a company.
It shows changes in the financial condition of the company over two years period. This statement also shows
funds earned from core business or funds lost in the core business. The Cash flow statement shows the root causes
of changes in cash position over two years period.

e) Ratio Analysis
Ratio is a relationship between two accounting figures expressed mathematically. Calculating ratio and analyzing
the same will give a better picture about the turn over efficiency, profitability and financial position of a company.
There are many ratios but the ratios under the following classifications will be immense useful to the investor (i)
Profitability ratios, (ii) Turnover ratio, (iii) Leverage ratios (iv) Valuation ratios.
1. Profitability Ratios
Profitability ratios relate the firms profit with factors that generate profit.
a. Net profit Margin ratio:
Profit after tax
Sales

b. Return on Assets:
Net Income
Total Assets

c. Return on Equity (ROE)

Net profit
Net Worth

34 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

(Net worth= Equity share capital + preference share capital+ Securities premium+ General reserve+ capital
reserve+ other reserves+ credit balance of Profit and loss – accumulated losses and fictitious assets)

2. Turnover ratios
Turnover ratios show how well the assets are used. These are also known as activity ratios.
a. Inventory turnover ratio: Net sales/ Average inventory
b. Debtors turnover ratio: Credit sales/ Average debtors + Average B/R
c. Creditors turnover ratio: Credit purchase/ average creditors + Average B/P
d. Fixed assets turnover ratio: Net sales/ Net fixed assets

3. Leverage ratios
Leverage ratios show the financial liability of a company. It depicts the capital structure decisions.
a. Debt Equity Ratio
Total Debt
Total equity (Net worth)

b. Debt to assets ratio

Total Debt
Total Assets

c. Interest coverage ratio

EBIT
Interest

4. Valuation Ratios
The valuation ratios provide a comprehensive measure of the performance of the firm.

a. Book Value per share

Equity share capital
Number of equity shares outstanding
Implication: when the book value is high the company can issue bonus shares higher than par value.

b. Dividend yield
Dividend per share x 100
Market price per share

c. Earnings per share

Profit after tax
Number of outstanding shares

FORECASTING EARNINGS
The investor has to predict the future earnings of the company, so as to know the returns on his investment. The
cost structure changes in sale and provisions etc. will influence the profitability. To predict earnings in the
following factors should be carefully analyzed
a) The cost and sales

35 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

The cost structure that is the proposition of variable cost and fixed cost and the pattern of sales affects the
profitability of the company. When the fixed cost proportion is very high the company can earn more profit by
increasing volume. Therefore growth in sale under the circumstances will yield maximum benefit to the company.

b) Depreciation
The provision for depreciation and other reserve determine the profitability of the company. If the company
follows a conservative approach then the amount of depreciation and other reserve will be very high and leaves
share holders with very less cash dividend.
From such companies the shareholders can get only less immediate return. However the book value of the share
may increase and in turn the market value of the equity shares gets increased. If the company changes the method
depreciation it will have an impact on the profitability.

c) Depletion of resources
If the company is in oil, mining, gas and forest based business the depletion of such natural resources will pull
down the profitability of the company. Therefore the resources available and the rate of depletion will give a hint
about the future profitability of the company.

d) Employee cost
If the company is in manpower intensive industry and if the manpower cost is increasing then the future
profitability of the business is doubtful. For example there is a consistent increasing employees cost in Indian IT
Sectors and the profit margin is affected.

e) Currency Value
If the company is in export or import business the currency value against overseas currencies determine the
profitability.

f) Capital Structure
The capital structure that is the source of long term capital employed by a company influences the ultimate profit
available for the equity share holders. By employing debt capital the company can reduce the cost of capital since
the payment of interest is made before payment of corporate tax and results in tax savings. Above all the company
promises to pay interest to the debenture holders irrespective of the profitability of the company Thus the
debenture holders are on safer side and they expects only a reasonable interest.
Thus the after tax cost of debt capital is always less. So the capital structure indicates in future returns available
for the equity share holders.

g) Efficiency of management
If the board of directors consists of highly experienced, efficient and dedicated people then the company can be
really successful. The efficiency of the management will be reflected in terms of; introduction of new products,
financial discipline, good corporate governance and taking strategic decision.

GROWTH IN EARNINGS
The growth in earnings depends on the earnings retained and reinvested in a firm. The rate of return on equity
also influences the growth rate
Growth rate= Retention rate x ROE

36 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

(Retention ratio= 1-payout ratio)

Price Earnings ratio (P/E Ratio)

It relates the share price with earning per share. The P/E ratio is the multiplying factor that the market is willing
to offer to the company’s future earnings.
P/E Ratio= Market price per share
Earning per share
Implications:
High P/E Ratio indicates high expectations of the market regarding the growth of future earnings of the company.
The investor generally compares the company P/E ratio with industry P/E ratio. A P/E lower than the industry
means the stock is under priced.
Through the P/E ratio we can draw conclusions like:
1. If the current P/E ratio is larger than Expected (P/E) the stock is overpriced and should be disposed off
immediately. Before fall in price.
2. If the current P/E is smaller than E(P/E) it means the stock is underpriced and should be purchased.

Intrinsic Value
The true economic value of a share is the intrinsic value. The fundamental analysts find out intrinsic value by:
Current EPS x E(P/E)

Expected P/E= Dividend /E(EPS)

k-g

TECHNICAL ANALYSIS

Technical analysis is frequently used as a supplement to fundamental analysis rather than a substitute for it. Thus,
technical analysis confirms findings based on fundamental analysis. It is useful in timing a buy or sells order- an
order that may be implied by the forecasts of return and risk.
The technician must (a) identify the trend, and (2) Recognize when one trend comes to an end and prices start in
the opposite direction. He has to distinguish between trend and real changes. The technician views price changes
and their significance mainly through price and volume statistics.

DOW THEORY
Charles H Dow formulated a hypothesis that the stock market does not perform on a random basis but is influenced
by three distinct cyclical trends: Primary, Secondary and Minor Trends. The primary trend is the long-range trend
that carries the entire market up and down. The secondary trend acts as a restraining force on the primary trend,
tending to correct deviations from its general boundaries. It usually lasts from several weeks to several months in
length. The last are the minor trends that are the day-to-day fluctuations in the market. They have very short
duration and shorter variation in aptitude. He formulated three hypotheses to develop the theory. They are;
(i) No individual investor can influence the market trend. However he can influence the price movement of
particular scrip by buying or selling significant volume of the particular scrip.
(ii) Market digests and discount every good news as well as bad news
(iii) Dow theory is not a tool to beat the market but the theory can be used to understand the market in a better
way.
Dows theory is based on the proposition that “ A bull market is in process when successive highs are reached
after secondary corrections and when secondary upswings advance beyond previous secondary downswings”
37 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

ELLIOTT WAVE THEORY

Elliott Wave analysis is a collection of complex techniques. The theory of Elliott Wave can be classified into
two parts:

1. Impulsive pattern
2. Corrective pattern

Elliott Wave Basics — Impulse Patterns

The impulse pattern consists of five waves. The five waves can be in
either direction, up or down. Some examples are shown to the right
and below. The first wave is usually a weak rally with only a small
percentage of the traders participating. Once Wave 1 is over, they sell
the market on Wave 2. The sell-off in Wave 2 is very vicious. Wave 2
will finally end without making new lows and the market will start to
turn around for another rally.

The initial stages of the

Wave 3 rally are slow, and it
finally makes it to the top of the previous rally (the top of Wave 1).
At this time, there are a lot of stops above the top of Wave 1.

Traders are not convinced of the upward trend and are using this rally to add more shorts. For their analysis to
be correct, the market should not take the top of the previous rally.
Therefore, many stops are placed above the top of Wave 1.

38 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

The Wave 3 rally picks up steam and takes the top of

Wave 1. As soon as the Wave 1 high is exceeded, the stops
are taken out. Depending on the number of stops, gaps are
left open. Gaps are a good indication of a Wave 3 in
progress. After taking the stops out, the Wave 3 rally has
caught the attention of traders.

The next sequence of events are as follows: Traders who

were initially long from the bottom finally have something
to cheer about. They might even decide to add positions.

The traders who

were stopped out
(after being upset for a while) decide the trend is up, and they decide to
buy into the rally. All this sudden interest fuels the Wave 3 rally.

This is the time when the majority of the traders have decided that the
trend is up.
Finally, all the buying frenzy dies down; Wave 3 comes to a halt.
Profit taking now begins to set in. Traders who were long from the lows
decide to take profits. They have a good trade and start to protect
profits.This causes a pullback in the prices that is called Wave 4.
Wave 2 was a vicious sell-off; Wave 4 is an orderly profit-taking
decline.
While profit-taking is in progress, the majority of traders are still convinced the trend is up. They were either
late in getting in on this rally, or they have been on the sideline.
They consider this profit-taking decline an excellent place to buy in and get even.

39 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

On the end of Wave 4, more buying sets in and the prices start to rally again.
The Wave 5 rally lacks the huge enthusiasm and strength found in the Wave 3 rally. The Wave 5 advance is
caused by a small group of traders.
Although the prices make a new high above the top of Wave 3, the rate of power, or strength, inside the Wave
5 advance is very small when compared to the Wave 3 advance.
Finally, when this lackluster buying interest dies out, the market tops out and enters a new phase.

Elliott Wave Basics — Corrective Patterns

Corrections are very hard to master. Most Elliott traders make money during an impulse pattern and then lose it
back during the corrective phase.
An impulse pattern consists of five waves. With the exception of the triangle, corrective patterns consist of 3
waves. An impulse pattern is always followed by a corrective pattern. Corrective patterns can be grouped into
two different categories:

1. Simple correction (Zig-Zag)

2. Complex Corrections (Flats, Irregular, Triangle)

40 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

Simple Correction (Zig-Zag)

There is only one pattern in a simple correction. This pattern is called a Zig-
Zag correction. A Zig-Zag correction is a three-wave pattern where the
Wave B does not retrace more than 75 percent of Wave A. Wave C will
make new lows below the end of Wave A. The Wave A of a Zig-Zag
correction always has a five-wave pattern. In the other two types of
corrections (Flat and Irregular), Wave A has a three-wave pattern. Thus, we
can identify a five-wave pattern inside Wave A of any correction, you can
then expect the correction to turn out as a Zig-Zag formation.

Price Indicators
The technicians watch the two variables concerning a group of stocks or
individual stocks:
1. Behaviour of prices
2. Volume of trading
These two variables contribute to affect the price of the stock and trading. In examining the influence of market
on stock prices, the technicians particularly note certain:
1. Advances & Declines
Comparing the advances and declines is a means of measuring the dispersion, or breadth, of a general
price rise or decline. This is often known as the “breadth of the market”

2. New High & New Lows

It is the high low differential index. The theory is that a rising market will generally be accompanied by
an expanding number of stocks attaining new highs and some lows. The reverse may be for a declining
market. The market index would be the stocks making new highs for the year minus number of stocks
making new lows averaged out. This would show the movement of the market.

3. Most Active List

Every day in the newspapers we see the twenty most active stocks. The number of issues shows a net gain
or a net loss. These stocks show the upper limit and the lower limit of the stock market and act as a
stabilizer.

Volume Indicators
Volume is a function of the demand and supply of stocks and can signal turning points for the market as well as
individual stocks. The Dows theory states that the volume increases with the advancement of price and decreases
with price decline. The volume will fall in advance of major decline in the stock price averages and rises sharply
during market bottoms.

SUPPORT & RESISTANCE

Technical analysis stock trading is based on two major indicators:
SUPPORT
It is a term used to describe the price level where the market prices can’t break through. It is also the level
where the sellers are selling short to take profits and avoid the selling pressure.

RESISTANCE
This is where the rising prices seem to stick and just cant break through a particular price level.
41 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

ODD-LOT THEORY
Odd-lot is a method of trading shares in groups which are less than 100 shares. Such investments are usually not
made by professional investors but mostly by retail investors. When the odd-lot trading is very high then the
market is said to be dominated by retail investors. The presence dominance of retail investors or professional
investors gives a hint about the next direction of market.

Short Sales
The bear operator expects a down trend in the market and he thinks that the current market price is overpriced.
Therefore he will sell the shares at current level and later when market faces down trend he will buy the same
stocks at lower level. The bear operators are known as short sellers and their initial sales are known as short sales.
When the short sales positions are increasing day by day then the next direction will be bull trend because what
are sold by bear operators should be covered (bought). Therefore when bear operator start covering the short sales
(by place buying orders) the market will start rise.
The short sales positions indicate whether the market is oversold or over bought.
.
OSCILLATORS
Oscillators are widely used by technical analyst to know the overbought and oversold positions of a particular
scrip or market. The oscillators show the trend reversal and the rise or decline in the momentum. The Oscillators
shows the share price movements across a reference point from one extreme to another extreme.
The Oscillators are indicators that we use when viewing charts that are non-trending.
Moving averages and trends are paramount when studying the direction of an issue. A technician will use
oscillators when the charts are not showing a definite trend in either direction. Oscillators are thus most beneficial
when a company’s stock either is in a horizontal or sideways trading pattern, or has not been able to establish a
definite trend in a choppy market.
When the stock is in either an overbought or oversold situation, the true value of the oscillator is exposed. With
oscillators a chartist can see when the stock is running out of steam on the upside, the point at which the stock
moves into an overbought situation. This simply means that the buying volume has been diminishing for a number
of trading days; traders will then start to think about selling their shares. Conversely, when an issue has been sold
by a greater number of investors for a period of time (from one to two weeks to three to six months or longer),
the stock will enter an oversold situation

TREND
The trend is the direction of movement. The stock price can have three trends. The price trend may either rising
or falling or flat. The share price cannot steadily increase. The uptrend is subject to minor corrections. Similarly
during flat trend the stock price cannot steadily face down but it is subject to minor corrections.

TREND REVERSAL
The increase or decrease in share price cannot go on forever. The trend may take its reverse directions at any time
due to shift in demand and supply forces. If a share price cuts the rising trend line from above, it is a violation of
trend line and signals the possibility of decline in price. Similarly if the share price pierces the trend line from
below, it indicates the rise in price.

PATTERNS
The price volume charts can be used to analyze the patterns of price behaviour. The pattern analysis emphasizes
the tendency of the price movements in a particular direction or to repeat the same formation over and over
again. The technical analyst strongly believes that stock prices move in patterns which can be identified and
42 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

standardized. Based on a particular formation of price movements or price patterns the likely behaviour of
prices in future can be predicted.

RATE OF CHANGE (ROC)

The Rate of Change (ROC) indicates the rate of change in price of a stock between two periods. The ROC shows
the change between the current price and the price “n” number of days in the past. The ROC indicates the
overbought and oversold positions of a stock. The ROC also shows the trend reversals. ROC can be calculated
by considering the closing price and it can be prepared weeks or months. ROC can be calculated by using the
following formula
Today’s price
ROC = —————————————— X 100
Price ‘n’ days back
The ROC can be calculated and shown in a chart form.

CONFIDENCE INDEX
The confidence index basically analyzes the shift in investments between high grade bonds and low grade bonds.
The high grade bonds are with high credit rating and low returns. Thus the returns are low but safety is very high.
The low grade bonds are with low credit rating but with high returns. Thus here the risk is high but returns also
high. The investment shifts between high grade bond and low grade bond shows the confidence of investors and
the future directions of the market. If investors are shifting their investments from low grade securities to high
grade securities so as to reduce their risk level then the next direction of the market would be down trend. But if
the investors shift their investment from high grade securities to low grade securities such movements shows the
investors’ confidence in the market and the next direction would be bull trend.

RELATIVE STRENGTH INDEX (RSI)

The Relative Strength Index was developed by ells wilder. The RSI is used to find out the relative strength of a
stock. RSI is calculated with the help of the following formula;
100
RSI = 100 – ———
1 + Rs
Average Gain per day
Rs = ————————————————
Average loss per day
The RSI can be calculated for one week or two weeks. If it is calculated for two weeks period the probability of
getting wrong indications is minimum.

MOVING AVERAGES
Technical Analysts are using indicators like; Volume of trade, Breadth of the market, Moving averages, Short
sales position, Odd lot trading, Relative strength and Cash reserve ratio of Mutual funds. These indicators are
used to predict the direction of the price movements of scrip and the direction of the market and of these
indicators the Moving averages is considered as most reliable and better indicator of the future direction. Most
of the Technical analysts use the Moving average since it is very simple and gives reliable signal about the forth
coming bull / bear trend.
The word moving means that the body of data moves ahead to include the recent observation. If it is 10 days
Moving averages, on the 11th day the body of data moves to include the 11th day observation eliminating the first
day’s observation likewise it continues.

43 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

For the Moving average calculation the closing price of the stock is considered, because the day’s closing price
gives better indication about the next day’s movements than the intra day’s high low price. The Moving average
can be calculated for the individual scrip and for the Index and it indicates the underlying trend in the scrip (or)
the market as the case may be. To predict short-term trend 10 – 30 days, to predict medium term, 50 – 125 days
and to predict the long – term 200 days Moving averages can be applied.

USES OF MOVING AVERAGES

There are many advantages of Moving averages. It is possible to identify the trend and confirm the trend. There
are three ways to identify the direction of the trend with Moving averages; i) direction, ii) location and iii)
crossovers.
The first trend identification techniques use the direction of the moving average to determine the trend. If the
Moving averages are rising, the trend is considered up. If the Moving average is declining, the trend is considered
down.
The location of the price relative to the Moving average can be used to determine the basic trend; if the price is
above the Moving average the trend is considered up if the price is below the Moving average the trend is
considered down.
The third technique for trend identification is based on the location of the Short-term Moving average relative to
the Long term Moving average and if it is above the Long-term Moving average the trend is considered up. If the
Short term Moving average is below the
Long-term Moving average then the Long term Moving average trend is considered down. Another important use
of Moving average is the identification of support and resistance levels. It helps the investor to find out the Support
and Resistance Level for the market as well as for individual stock. Support and resistance level identification
through Moving averages works best in trending market.

INDEX MOVING AVERAGE AND STOCK PRICE

The individual stock price can be compared with the moving average of the Stock Market Index say Nifty 50.
The Moving average of the Index and the stock price are plotted in the same sheet and trends are compared. If the
closing price of the stock is above the Moving average of the Index then the stock is said to be in bullish mode.
When the closing price of the stock crosses and falls below the Moving average of the Index the stock is said to
be bearish. The Moving averages follow the trend and works well when the stock is trending but the same Moving
average fails as an indicator when the stock is in trading range. Therefore the investor who tries to apply the
Moving averages should see whether the particular stock is trending. This process does not have to be a scientific
examination. Usually, a simple visual assessment of the price chart can determine if a stock exhibits characteristics
of trend. In its simplest form a stock’s price can be of three forms; trending up, trending downward or trading in
a range an upward trend is established when a stock reaches higher highs and higher lows. A down trend is
established when a stock a touches lower lows and lower highs. A trading range is established if a stock cannot
establish neither up trend nor down tend.
Once a stock has been with enough features of trend then the next important task is to select the number of moving
average periods. The factors such as stock’s volatility, trendiness and personal preference should be considered
for the selection moving averages period. If the stock’s volatility is high it is better to select long period so as to
smoothen the moving average. The speculators would prefer short term moving average and the investor would
prefer long-term moving averages. However the trial and error method would give best results. Price movements
should be carefully watched. If there are too many breaks, lengthen the moving average to decrease its sensitivity.
If the moving average is slow to react short – term the moving average to increase it sensitivity.

Exponential Moving Average (EMA)

44 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

A type of moving average that is similar to a simple moving average, except that more weight is given to the
latest data. Also known as “exponentially weighted moving average type of moving average reacts faster to recent
price changes than a simple moving average. The 12- and 26-day EMAs are the most popular short-term averages,
and they are used to create indicators like the moving average convergence divergence (MACD) and the
percentage price oscillator (PPO). In general, the 50- and 200-day EMAs are used as signals of long-term trends

CHARTING METHODS
Technical analysis uses charts as important tool to predict the future trend of share price movement. The price
movements of a stock presented in the form of charts enable investor to easily understand and predict the price
movements. The graphical presentation helps the investor to understand the past and present price movements.
The charts indicate the main support and resistance levels of the stock.

POINT AND FIGURE CHART

The Point and figure chart is useful to predict the change of price direction. The point and figure chart is drawn
on the ruled paper. The price interval of the stock is entered on the left side of the chart. For high priced scrip the
price intervals are high and for less priced scrip the price intervals are less. When the price of the scrip moves up
to the next price interval then it is marked up with “X” symbol and as long as the share price increases the “X
“symbols are plotted in the vertical column. When the share price declines by the price intervals then the chart is
plotted with “O” symbols in the next column. The price movements are analyzed and interpreted by reading the
‘X” and “ O” symbols on the chart.
The point and figure chart have the price interval of Rs.3 whenever the price rises by
Rs.3 then the chart is plotted “X” symbols vertically and when price declines by Rs.3 then the chart is plotted
with “O” symbol in the next column. The point and figure chart shows the support and resistance levels and also
indicates the buy and sells signals. However the point and figure chart fails to show the intra – day price
movements and minor fluctuations below the selected price intervals. The chart does not show the volume which
is very important aspect of technical analysis.

BAR CHART
The bar chart is based on the statistical technique. The bar chart shows the complete price movements of a stock.
It reveals the day’s opening price, low price, high price, closing price and the volume of a stock. The closing price
and opening price are marked in between the high price and low price by marking a tick on the vertical bar. The
volume of transactions is shown as separate vertical bars in the bottom portion of the bar chart.

LINE CHART
The line chart is the simple presentation of price movement of a stock over a specified period. The period is
represented by “ X” axis and the price movement is represented by “ Y” axis. The closing price of the stock for
various period are plotted in the chart with dots and then all the dots are joined by a line and the line is called
variable line. Line charts can be prepared by considering daily closing price, weekly closing price or monthly
closing price. To predict short term movement’s daily closing price can be used to prepare line charts. To predict
medium term and long term movements the weekly and monthly closing price can be considered. Traders in the
stock market prepare intra – day line charts by considering every ten minutes / 1/2 hr price movements.

CANDLE STICK CHART

The candle stick chart shows the price movements of the stock in vertical form. The top and bottom points of the
stock movements pass through the candle. A clear candle without any shading indicates increase in price and a
shaded candle indicate decrease in price. When the day’s closing price is higher than the opening price then it is
45 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

considered as increase in price and the candle is kept clear. When the day’s closing price is less than the opening
price it is considered as decrease in price and the candle is shaded. The candle stick chart shows the day’s opening
price, low price, high price and closing price and the price movements. The candle stick charts can be prepared
for weekly or monthly.

Fundamental vs Technical analysis

Fundamental Analysis Technical Analysis
1. Fundamental Analysis is based on analysis of The technical analysis is based on the analysis of
information relating to the economy, industry price movements and the volume.
& Company.
2. The fundamental analysis helps the investor to The technical analysis helps to predict the trend of
find out the intrinsic value of the stock. price movements.
3. The fundamental analysis uses the accounting The technical analysis used tools like technical
tools like ratio fund flow analysis. indications, charts, and trends to interpret data.
4. It generally focuses on long term investment The technical analysis mainly focuses on short term
plans. investment plans.
5. The fundamental analysis is mainly used by The technical analysis mainly used by speculators.
long term investors.

RANDOM WALK THEORY

Market efficiency implies that all known information immediately discounted by all investors and reflected in
share prices in the stock market. The only price changes that would occur are those which result from new
information. The stock changes in the prices are on a random basis and the summation of these random
movements is the market changes.
The random walk theory suggests that the markets are very efficient and there is a free flow of information the
market. This kind of market is called an efficient market. The requirements for a market to be efficient are:
1. Prices must be efficient so that new inventions and better products will cause firms securities prices to rise
and motivate investors to supply capital to the firm by buying stocks.
2. Information should be discussed freely so that the investors can react to new information.
3. Transactions costs such as sales commissions on securities are ignored.
4. Taxes are assumed to have no noticeable effect on investment policy
5. Investors are rational and they invest money in where it is needed.

EFFICIENT MARKET HYPOTHESIS

The test of efficiency of a market is based on the idea whether the information like past prices, insider’s
information or public information does have an influence on the prices of the stocks. On the basis of these the
market is divided in three forms:
a) Weak form and Random Walk
b) Semi Strong form
c) Strong form Weak form

Semi Strong
Stron
g

46 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

Weak form and Random Walk

This is the oldest form of the market. It holds that the present stock prices reflect all known information with
respect to past stocks, trends and volumes. Thus, it is asserted, such past data cannot be used to predict future
stock prices. This form is known as random walk as prices wander or walk more or less randomly along the charts.
Since the walk is random, a knowledge of past price changes does nothing to inform the analyst about whether
the price tomorrow, next week or next year will be higher or lower than today’s price.
Thus, if we see the prices to be changing randomly and slowly we consider the market to be a weak form as
yesterday’s price do not tell us much about tomorrow’s or at least not enough to consistently make unusual returns
based merely on price data.

Semi-Strong Form
Under this form the market prices not only reflect public information but also include:
a. Expectations of the investors.
b. The variations in the publically available data and the revision of the data.
c. Increasing politicization of economic data, particularly price inflation rate or cost of living data and
unemployment rates.

The semi strong form of market suggests the fruitlessness of efforts to earn superior rates of return. The semi
strong form of efficient market hypothesis maintains that as soon as information becomes publically available, it
is absorbed and reflected in the stock prices.

Strong form
The strong form is concerned with whether or not certain individuals or group of individuals possess inside
information which can be used to make above average profits. If the strong form of the efficient capital market
hypothesis holds, then any day is as good as any day to buy stocks.

47 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

UNIT 3
CONCEPT OF RISK & RETURN
Risk is inherent in any investment. Risk may relate to loss of capital, delay in repayment of capital, nonpayment
of return or variability of returns. The risk of an investment is determined by the investments, maturity period,
repayment capacity, nature of return commitment and so on. Risk and expected return of an investment are related.
Theoretically, the higher the risk, higher is the expected returned. The higher return is a compensation expected
by investors for their willingness to bear the higher risk. Risk is inherent in any investment. Risk may relate to
loss of capital, delay in repayment of capital, nonpayment of return or variability of returns.
The risk of an investment is determined by the investments, maturity period, repayment capacity, nature of
return commitment and so on.
Risk and expected return of an investment are related. Theoretically, the higher the risk, higher is the expected
returned. The higher return is a compensation expected by investors for their willingness to bear the higher risk
the factors affecting the risk the risk can be understood in following manners

Types of Risk
There are two basic types of Risk:
1. Unsystematic
2. Systematic

Unsystematic risk:
Variability in a security total return not related to overall market variability is called unsystematic (non market)
risk. This risk is unique to a particular security and is associated with such factors as business, and financial risk,
as well as liquidity risk. Although all securities tend to have some unsystematic risk, it is generally connected
with common stocks. This risk is also called diversifiable risk as the effect of risk can be diversified or reduced
with the proper decisions of the financial manager.
1. Business risk:
The changes that take place in an industry and the environment causes risk for the company in earning the
operational revenue creates business risk. It is sometimes called operating risks as it is associated with the
normal day-to-day operations of the firm. For example the traditional telephone industry faces major changes
today in the rapidly changing telecommunication industry and the mobile phones. When a company fails to
earn through its operations due to changes in the business situations leading to erosion of capital, there by
faces the business risk.

2. Financial risk:
The use of debt financing by the company to finance a larger proportion of assets causes larger variability in
returns to the investors in the faces of different business situation. During prosperity the investors get higher
return than the average return the company earns, but during distress investors faces possibility of vary low
return or in the worst case erosion of capital which causes the financial risk. The larger the proportion of assets
finance by debt (as opposed to equity) the larger the variability of returns thus lager the financial risk.
48 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

Systematic risk:
Variability in a securities total return that is directly associated with overall moment in the general market or
economy is called as systematic risk. This risk cannot be avoided or eliminated by diversifying the investment.
Normally diversification eliminates a part of the total risk the left over after diversification is the non-diversifiable
portion of the total risk or market risk.
Virtually all securities have some systematic risk because systematic risk directly encompasses the interest rate,
market and inflation risk. The investor cannot escape this part of the risk, because no matter how well he or she
diversifies, the risk of the overall market cannot be avoided. If the stock market declines sharply, most stock will
be adversely affected, if it rises strongly, most stocks will appreciate in value. Clearly mark risk is critical to all
investors.

1. Interest rate risk:

The variability in a security return resulting from changes in the level of interest rates is referred to as interest rate
risk. Such changes generally affect securities inversely, that is other things being equal, security price move
inversely to interest rate.

2. Market risk:
The variability in returns resulting from fluctuations in overall market that is, the agree get stock market is referred
to as market risk. Market risk includes a wide range of factors exogenous to securities themselves, like recession,
wars, structural changes in the economy, and changes in consumer preference. The risk of going down with the
market movement is known as market risk.

3. Inflation risk:
Inflation in the economy also influences the risk inherent in investment. It may also result in the return from
investment not matching the rate of increase in general price level (inflation). The change in the inflation rate also
changes the consumption pattern and hence investment return carries an additional risk. This risk is related to
interest rate risk, since interest rate generally rises as inflation increases, because lenders demands additional
inflation premium to compensate for the loss of purchasing power.

4. Liquidity risk:
An investment that can be bought or sold quickly without significant price concession is considered to be liquid.
The more uncertainty about the time element and the price concession the greater the liquidity risk.
The liquidity risk is the risk associated with the particular secondary market in which a security trades.

5. Exchange rate risk:

The change in the exchange rate causes a change in the value of foreign holdings, foreign trade, and the
profitability of the firms, there by returns to the investors. The exchange rate risk is applicable mainly to the
companies who operate oversees. The exchange rate risk is nothing but the variability in the return on security
caused by currencies fluctuation.

6. Political risk:
Political risk also referred, as country risk is the risk caused due to change in government policies that affects
business prospects there by return to the investors. Policy changes in the tax structure, concession and levy of
duty to products, relaxation or tightening of foreign trade relations etc. carry a risk component that changes the
return pattern of the business.

49 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

RETURNS
The return from the stock includes both current income and capital gain caused by the appreciation of the price.
The income and capital gain are expressed as a percentage of money invested in the bargaining. Return is the
outcome of an investment.

Total Return
A correct returns measure must incorporate the two components of return, yield and price changes. Returns
across time or from different securities can be measured and compared using the total return concept. Formally,
the total return (TR) for a given holding period is a decimal (or percentage) number relating all the cash flows
received by an investor during any desired time period to the purchase price of the asset. Total return is defined
as TR = any cash payments received + Price changes over the period- Price at which the asset is purchased
All the items are measured in rupees. The price change over the period, defined as the difference between the
beginning (and purchase) price and the ending (or sale) price, can be either positive (sales price exceeds
purchase price), negative (purchase price exceeds sales price), or zero. The cash payments can be either positive
or zero. Netting the two items in the numerator together and dividing by the purchase price results in a decimal
return figure that can easily be converted into percentage form.

SECURITY VALUATION

Fixed Income securities

A debenture is a legal document containing an acknowledgement of indebtness by a company. It contains a
promise to pay a stated rate of interest for a defined period and then to repay the principal at a given date of
maturity. The bond interest rates are affected with the market fluctuations. When in times of inflationary
conditions the interest rates of bonds tend to rise whereas in recession the rates go down. The maximum
permissible rates of interest on debentures are notified from government from time to time.

Bond Features
• Indenture:
Indenture is a long, complicated legal instrument containing the restrictions pledges and promises of the contract.

• Maturity
Bonds are usually grouped in maturity classe4s. Short term bonds usually mature within 5 yrs, medium term in
5-10 yes and long term may run for 20 years or more. Bonds may be secured or unsecured. Usually, long term
bonds are secured with real estate mortgage.

• Interest Payments:
Bond interest is usually paid semi-annually, though annual payments are also popular. The method of payment
depends upon whether the bond is a coupon bond or registered bond.

• Face Value:
Face value is called par value. A bond is generally issued at a par value of Rs 100 or Rs 1,000, and interest is paid
on face value.

TYPES OF BONDS
Convertible bonds and Non-Convertible Bonds

50 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

Convertible bonds are bonds having both the features as of equity and debt. The holder can at his point, convert
the bonds into a predetermined number of shares of common stock at a predetermined price.
Sinking fund Bonds
Sinking fund bonds arise when the company decides to retire its bonds issue systematically by setting aside a
certain amount each year for the purpose. The payment, usually fixed annual rupees amount or percentage
installment, is made to the sinking fund agent who is usually the trustee. This person then uses the money to call
the bonds annually at some call premium or to purchase them on the open market if they are selling at some
discount.

Serial Bonds
These are no special types of bonds but just names given to describe the method of repayment. Thus, any bond
can be such by merely specifying it in the indenture.

Mortgage or Secured Bonds

The term mortgage generally refers to a lien on real property or building. Mortgage bonds may be open-end,
close-end and limited open-end.

Redeemable and Irredeemable Bonds

A redeemable debenture is a bond which has been issued for certain period on the expiry of which its holder will
be repaid the amount thereof with or without premium. A bond without a redemption period is termed as
irredeemable debenture. These may be repaid at the time of winding up or happening other uncertain or contingent
events.

Participating Bonds
Companies with poor credit positions issue participating bonds. They have guaranteed rate of interest but may
also participate in earnings up to an additional specified percentage.

Bond Prices
The bond prices are affected by three prime types of risks business risk, purchasing power risks and interest rate
risk. The bonds are used to control inflationary conditions, under peak of expansion at times of boom where
central bank authorities raise the interest rates and bond prices go down where in recession the bond prices go up
and interest rates go down.
Bond Pricing Principles
1. Bond values are inversely related to the required rate of return
2. Bonds trade at a discount, par, or premium
3. The sensitivity of bond prices to a given change in the required rate of return increases with the maturity of the
bond
4- The sensitivity of bond prices to a given change in the required rate of return decreases the higher the coupon
rate.

51 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

Current yield
The current yield on a bond is the annual interest due on it dividend by the bonds market price. The current yield
is a reliable measure of returns earned by perpetual bonds or bonds with a long time maturity.

Current Yield= Annual Interest

Market Price

Yield to Maturity: Rate of return earned on a bond held until maturity. It also can be called the required rate of
return by the lender.
When a coupon bond is issued, the coupon rate is usually set to equal the required market rate of return (kd). A
bond’s coupon rate never changes. However, the market rate can fluctuate over time, and this can greatly affect
the bond price
§ If coupon rate = yield to maturity then bond is sold at par
§ If coupon rate > yield to maturity then bond is sold at premium (bond price> par value).
§ If coupon rate < yield to maturity then bond is sold at discount (bond price < par value).

Yield to Maturity
YTM is the percentage yield that will be earned on the bonds from the purchase date to maturity date.
It is the single discount factor that makes present value of future cash flows from a bond equal to the current price
of the bond. In simple words, YTM is the internal rate of return of the bond given the current market price, interest
changes and the maturity value.

Duration
The problem with YTM is that it fails to take into account the effects of reinvestment risk or price risk. Duration
is a yardstick which captures in a single measure the extent to which the price of the bond will react to different
interest rates. Duration measures the time structure of a bond and the bonds interest rate risk. It is the average
life of a security. It is the weighted average term to maturity of security cash flows. Duration is a single number
measured in units of time e.g months, years. For securities that make only one payment at maturity like zero
coupon bond, duration equals term to maturity.
Bond duration possesses the following properties:
• Higher coupon result in shorter duration.
• A longer maturity means longer durations.
• Higher yields lead to shorter durations.
A bonds duration and volatility are directly related: the shorter the duration, the less volatile is the bond.

Immunization
Immunization allows an investor to derive specified rate of return from bond investments over a given period of
time regardless of what happens to market interest rates over the course of the holding period. It is a technique
that makes the bond portfolio holder to be relatively certain about the promised stream of cash flows. The bond
interest rate arises from the changes in the market interest rate. The market rate affects the coupon rate and the
price of the bonds. In the immunization process, the coupon rate risk and the price risk can be made to offset each
other. Whenever there is an increase in the market interest rate, the prices of bonds fall. The coupon can be
reinvested in the bonds offering higher interest rates and losses that occur due to fall in price of the bond can be
balanced by the profit of the other, this is called immunization.

Equity Valuation & Analysis

52 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

Most equity valuation models are based upon present value theory, by John B.Williams. The investment analyst
must turn first to the present value estimation to know the intrinsic value of equities.

Present value Estimation

Present value means to know the estimated value of a sum to be received in future at the present. We can
calculate it by:
PV= Future Value
(1+i)n

If the present value of the share which we can also call it as the intrinsic value (V) of the share is higher than the
market value of the share we should not purchase it as the net present value would be negative (V-P<0). On the
other hand if the shares market price (P) is below its intrinsic value (V) the investor should purchase the share,
since the net present value is positive (V-P>0)

Models of valuation of Equity share

The dividend discount model defines the intrinsic value of a share as the present value of a future dividend.

Zero Growth Model

This model assumes that the dividend will remain constant and there will be zero growth in the future and so
will the investors require rate of return is also constant.

V= D
K

Constant Growth Model

In this model, the cash dividends are expected to increase at constant (percentage) rate each year. In order to
find the discounted present value of the stream of constant rising dividends:
V= D1
(k-g)

Variable Growth Rate of Dividends

Firms often grow at a faster rate for a few years and then revert to a constant or no growth situation. This a form
of growth rate where the dividend growth varies.

Vo= ∑ D0(1+gx)t + ∑ Dn(1+gy)t-n

(1+k)t (1+k)t

Models Based on Price-Earnings Ratio

The price earnings ratio indicates the price being paid for each rupee of a firm’s earnings. The ratio of equity is
equal to its current market price divided by some measure of earnings per share.

P/E Ratio= Market Price

Earning Per Share
The P/E ratio is used for valuation and is influenced by many factors:
1. The higher the growth rate of earnings expected, higher the P/E ratio. The investor will be willing to pay
a higher price for the current earnings if earnings are expected to grow at a much higher rate in the future.
2. Inflationary expectations tend to reduce P/E ratio.
53 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

3. P/E ratio for a group of companies, tend to change little from one period to the next. Therefore an
investor cannot expect a dramatic change in future P/E ratios.
4. P/E ratios vary by industry.

Preference share Valuation

Preference share is a hybrid security having the characteristics of both equity as well as debt. Legally a preference
share represents a position of the ownership of the company, and thus in the balance sheet with the equity shares
as making up the capital stock or equity interest.

Features
1. Dividends
Preference shares have dividend provisions which are either cumulative or non cumulative. Most shares
have cumulative provisions, which mean that any dividends not paid by the company accumulate.
Normally, the preference shares have a preference of dividend to be paid prior to the payments of common
stock. These unpaid dividends are known as dividends in arrears.

2. Participating Preference shares

Most preference shares are non participating meaning that the preference shareholder receives only his
stated dividend no more. The participating preference shareholder receives a stipulated dividend and
shares additional earnings with the common shareholders.

3. Voting Rights
Preference shares do not normally confer voting rights. But in case where there are cumulative preferences
shares can vote if their dividend is in arrears for 2 years. The voting right of each preference shareholder
is to be in the proportion which the paid up share capital on his shares bears to the total equity share capital
of the company.

4. Convertible
Convertible preference share means that the owner has the right to exchange a preference share for a share
of equity of the same company. The holder of a convertible preference share usually has a stronger claim
than the holder of an equity share to earnings and assets. In addition, if a company earnings increase, the
convertible preference share will rise in value. A company might wish to call preference shares. Then the
preference shareholder must be given the required number of days notice. This will enable him to either
convert into equity or sell the stock.

5. Preemptive Right
Common law statute gives shareholders, equity or preference, the right to subscribe to additional issues to
maintain their proportionate share of ownership. However, the existence of the preemptive right depends
on the law and the provisions of the company’s articles in corporation.

54 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

UNIT 4
PORTFOLIO ANALYSIS WITH RISK & RETURN
CAPITAL ASSET PRICING MODEL
The capital asset pricing model (CAPM) is used in finance to determine a theoretically appropriate rate of return
of an asset, if that asset is to be added to an already well-diversified portfolio, given that assets non-diversifiable
risk.
The CAPM formula takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic
risk or market risk), referred to as beta (β) in the financial industry, as well as the expected return of the market
and the expected return of a theoretical risk-free asset.
The model was introduced by Jack Treynor, William Sharpe, John Lintner and Jan Mossin independently,
building on the earlier work of Harry

William Sharpe (1964) published the capital asset pricing model (CAPM). Parallel work was also performed by
Treynor (1961) and Lintner (1965). CAPM extended Harry Markowitz portfolio theory to introduce the notions
of systematic and specific risk. For his work on CAPM, Sharpe shared the 1990 Nobel Prize in Economics with
Harry Markowitz and Merton Miller.
CAPM considers a simplified world where:
there are no taxes or transaction costs.
All investors have identical investment horizons.
All investors have identical opinions about expected returns, volatilities and correlations of available
investments.

Risk and diversification

The risk of a portfolio comprises systematic risk and specific risk. Systematic risk refers to the risk common to
all securities - i.e. market risk. Specific risk is the risk associated with individual assets. Specific risk can be
diversified away (Specific risks "average out"); systematic risk (within one market) cannot.
Depending on the market, a portfolio of approximately 15 (or more) well selected shares might be sufficiently
diversified to leave the portfolio exposed to systematic risk only.
A rational investor should take only non-diversifiable risks, which are rewarded. Therefore, the return that
compensates for risk taken must be linked to its riskiness in a portfolio context - i.e. its contribution to overall
portfolio risk - as opposed to its "stand alone risk." In the CAPM context, portfolio risk is represented by higher
variance i.e. less predictability.

The efficient (Markowitz) frontier

The CAPM assumes that the risk-return profile of a portfolio can be optimized - an optimal portfolio displays the
lowest possible level of risk for its level of return. Additionally, since each additional asset introduced into a
portfolio further diversifies the portfolio, the optimal portfolio must comprise every asset, (assuming no trading
costs) with each asset value-weighted to achieve the above (assuming that any asset is infinitely divisible). All
such optimal portfolios, i.e., one for each level of return, comprise the efficient

55 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

(Markowitz) frontier. Because the unsystematic risk is diversifiable, the total risk of a portfolio can be viewed as
beta...

An investor might choose to invest a proportion of his or her wealth in a portfolio of risky assets with the
remainder in cash - earning interest at the risk free rate Here, the ratio of risky assets to risk free asset determines
overall return - this relationship is clearly linear. It is thus possible to achieve a particular return in one of two
ways:
By investing all of one’s wealth in a risky portfolio, or by investing a proportion in a risky portfolio and the
remainder in cash (either borrowed or invested). For a given level of return, however, only one of these portfolios
will be optimal (In the sense of lowest risk). Since the risk free asset is, by definition, uncorrelated with any other
asset, option 2) will generally have the lower variance and hence be the more efficient of the two.
This relationship also holds for portfolios along the efficient frontier: a higher return portfolio plus cash is more
efficient than a lower return portfolio alone for that lower level of return. For a given risk free rate, there is only
one optimal portfolio which can be combined with cash to achieve the lowest level of risk for any possible return.
This is the market portfolio.

Model: The CAP model (CAPM)

The CAPM is a ceteris paribus model. It is only valid within a special set of assumptions. They are:
• Investors are risk averse individuals who maximize the expected utility of their end of period wealth.
Implication: The model is a one period model.
• Investors have homogenous expectations (beliefs) about asset returns. Implication: all investors perceive
identical opportunity sets. This is, everyone have the same information at the same time.
• Asset returns are distributed by the normal distribution.
• There exists a risk free asset and investors may borrow or lend unlimited amounts of this asset at a constant rate:
the risk free rate (kf).
• There is a definite number of assets and their quantities are fixed within the one period world. All assets are
perfectly divisible and priced in a perfectly competitive marked. Implication: e.g. human capital is non-existing
(it is not divisible and it can’t be owned as an asset).
• Asset markets are frictionless and information is costless and simultaneously available to all investors.
Implication: the borrowing rate equals the lending rate.
• There are no market imperfections such as taxes, regulations, or restrictions on short selling.

56 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

The derivation of the CAPM starts by assuming that all assets are stochastic and follow a normal distribution.
This distribution is described completely by its two parameters: mean value (µ) and variance (s2). The mean value
is a measure of location among many such as median and mode.
In the hypothetical world of the CAPM theory all that the investor bothers about is the values of the normal
distribution. In the real world asset return are not normally distributed and investors do find other measures of
location and dispersion relevant.
However, the assumption may be seen as a reasonable approximation and it is needed in order to simplify matters.
The diversification property implies that the minimum variance opportunity set will be convex, and this is a
necessary condition for the existence of unique and efficient portfolio equilibrium. As will be seen this property
is used for the derivation of the CAPM.
The minimum variance opportunity set is the locus of mean and variance combinations offered by portfolios of
risky assets that yield the minimum variance for a given return.
The convexity property holds for two risky assets or more. The area on and behind the locus (the oval) is
sometimes referred to as the portfolio production possibility area. Each point in this region represent the return
and risk from some single asset available in the market, or some portfolio made on those assets.

The next assumption is that investors are risk averse and maximize expected utility. They perceive variance as a
bad and mean as a good.

CAPM decomposes a portfolio’s risk into systematic and specific risk. Systematic risk is the risk of holding the
market portfolio. As the market moves, each individual asset is more or less affected. To the extent that any asset
participates in such general market moves, that asset entails systematic risk. Specific risk is the risk which is
unique to an individual asset. It represents the component of an asset’s return which is uncorrelated with general
market moves.
According to CAPM, the marketplace compensates investors for taking systematic risk but not for taking specific
risk. This is because specific risk can be diversified away. When an investor holds the market portfolio, each
individual asset in that portfolio entails specific risk, but through diversification, the investor’s net exposure is
just the systematic risk of the market portfolio.
Systematic risk can be measured using beta. According to CAPM, the expected return of a stock equals the risk-
free rate plus the portfolio’s beta multiplied by the expected excess return of the market portfolio.

There is an old saying: Be more concerned about return of your investment than return on your investment.

CAPITAL MARKET LINE

James Tobin (1958) added the notion of leverage to portfolio theory by incorporating into the analysis an asset
which pays a risk-free rate. By combining a risk-free asset with a portfolio on the efficient frontier, it is possible
to construct portfolios whose risk-return profiles are superior to those of portfolios on the efficient frontier. The
capital market line is the tangent line to the efficient frontier that passes through the risk-free rate on the expected
return axis. 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.
Using the risk-free asset, investors who hold the super-efficient portfolio may:
a) Leverage their position by shorting the risk-free asset and investing the proceeds in additional holdings in the
super-efficient portfolio, or
b) De-leverage their position by selling some of their holdings in the super-efficient portfolio and investing the
proceeds in the risk-free asset.

57 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

The resulting portfolios have risk-reward profiles which all fall on the capital market line. Accordingly, portfolios
which combine the risk free asset with the super-efficient portfolio are superior from a risk-reward standpoint to
the portfolios on the efficient frontier.

EFFICIENT FRONTIER
The efficient frontier was first defined by Harry Markowitz in his groundbreaking (1952) paper that launched
portfolio theory. That theory considers a universe of risky investments and explores what might be an optimal
portfolio based upon those possible investments.
Consider an interval of time. It starts today. It can be any length, but a one-year interval is typically assumed.
Today’s values for all the risky investments in the universe are known. Their accumulated values (reflecting price
changes, coupon payments, dividends, stock splits, etc.) at the end of the horizon are random. As random
quantities, we may assign them expected return and volatilities. We may also assign a correlation to each pair of
returns. We can use these inputs to calculate the expected return and volatility of any portfolio that can be
constructed using the instruments that comprise the universe.
The notion of “optimal” portfolio can be defined in one of two ways:
a) For any level of volatility, consider all the portfolios which have that volatility. From among them all, select
the one which has the highest expected return.
b) For any expected return, consider all the portfolios which have that expected return. From among them all,
select the one which has the lowest volatility. Each definition produces a set of optimal portfolios. Definition (1)
produces an optimal portfolio for each possible level of risk. Definition (2) produces an optimal portfolio for each
expected return. Actually, the two definitions are equivalent. The set of optimal portfolios obtained using one
definition is exactly the same set which is obtained from the other. That set of optimal portfolios is called the
efficient frontier. The dark region corresponds to the achievable risk-return space. For every point in that region,
there will be at least one portfolio that can be constructed and has the risk and return corresponding to that point.
The efficient frontier is the gold curve that runs along the top of the achievable region. Portfolios on the efficient
frontier are optimal in both the sense that they offer maximal expected return for some given level of risk and
minimal risk for some given level of expected return.
The portfolios that correspond to points on that curve are optimal according to both definitions (1) and (2) above.
Typically, the portfolios which comprise the efficient frontier are the ones which are most highly diversified. Less
diversified portfolios tend to be closer to the middle of the achievable region.

SHARPE SINGLE INDEX MODEL

Sharpe W.E. (1964) justified that portfolio risk is to be identified with respect to their return co-movement with
the market and not necessarily with respect to within the security co-movement in a portfolio. He therefore
concluded that the desirability of a security for its inclusion is directly related to its excess return to beta ratio,
R (i) – R (f)/ β (i)
Where
R (i) = expected return on security i R (f) = return on a riskless securityΒ (i) = beta of security
This ranking order gives the best securities that are to be selected for the portfolio.
Cut-off Rate:
The number of securities that are to be selected depends on the cut-off rate. The cut-off rate is determined such
that all securities with higher ratios are included into the portfolio. The cut-off rate for the selection of a security
into a portfolio is determined as:
58 | PGDM 3rd Sem-S M S ( 2 0 1 7 )
Security Analysis & Investment Management; Lecture Notes

Where σm2 = market variance Ri = security return Rf = risk free return βi = security betaσei2 = security error
variance
ARBITRAGING PRICING THEORY
It holds that the expected return of a financial asset can be modeled as a linear function of various macro-
economic factors, where sensitivity to changes in each factor is represented by a factor specific beta coefficient.
The model derived rate of return will then be used to price the asset correctly - the asset price should equal the
expected end of period price discounted at the rate implied by model. If the price diverges, arbitrage should bring
it back into line. The theory was initiated by the economist Stephen Ross in 1976.

Based on the law of one price. Two items that are the same cannot sell at different prices. If they sell at a different
price, arbitrage will take place in which arbitrageurs buy the good which is cheap and sell the one which is higher
priced till all prices for the goods are equal.

ADVANTAGES & LIMITATIONS OF ARBITRAGE PRICING THEORY

The APT has a number of benefits. First, it is not as a restrictive as the CAPM in its requirement about individual
portfolios. It is also less restrictive with respect to the information structure it allows. The APT is a world of
arbitrageurs and vendors of information. It also allows multiple sources of risk, indeed these provide an
explanation of what moves stock returns. The benefits also come with drawbacks. The APT demands that
investors perceive the risk sources, and that they can reasonably estimate factor sensitivities.

ASSUMPTIONS OF ARBITRAGE PRICING THEORY

The Major Assumptions:

• Capital markets are perfectly competitive.
• Investors always prefer more to less wealth.
• Price-generating process is a K factor model.
• In APT, the assumption of investors utilizing a mean-variance framework is replaced by anassumption
of the process of generating security returns
• APT requires that the returns on any stock be linearly related to a set of indices.
• In APT, multiple factors have an impact on the returns of an asset in contrast with CAPM model that
suggests that return is related to only one factor, i.e., systematic risk

MULTIPLE-FACTOR MODELS –
FORMULA
r i = ai + bi1 F1 + bi2 F2 +. . . + biKF K+ ei

where r is the return on security i b is the coefficient of the factor F is the factor e is the error term

59 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

SECURITY PRICING FORMULA:

r i = λ0 + λ1 b1 + λ2 b2 +. . .+ λKbK
where r i = rRF +(δ1−rRF )bi1 + (δ2− rRF)bi2+ . . . +(δ−rRF)biK

• where r is the return on security i λ0 is the risk free rate b is the factor e is the error term
• hence – a stock’s expected return is equal to the risk free rate plus k risk premiums based on the stock’s
sensitivities to the k factor

60 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

UNIT 5
PERFORMANCE EVALUATION
In order to determine the risk-adjusted returns of investment portfolios, several eminent authors have worked
since 1960s to develop composite performance indices to evaluate a portfolio by comparing alternative
portfolios within a particular risk class. The most important and widely used measures of performance are:
1. The Treynor Measure
2. The Sharpe Measure
3. Jenson Model

The Treynor Measure

Developed by Jack Treynor, this performance measure evaluates funds on the basis of Treynor's Index. This Index
is a ratio of return generated by the fund over and above risk free rate of return (generally taken to be the return
on securities backed by the government, as there is no credit risk associated), during a given period and systematic
risk associated with it (beta). Symbolically, it can be represented as:

Treynor's Index (Ti) = (Ri - Rf)/Bi.

Where, Ri represents return on fund, Rf is risk free rate of return and Bi is beta of the fund. All risk-averse
investors would like to maximize this value. While a high and positive Treynor's Index shows a superior risk-
adjusted performance of a fund, a low and negative Treynor's Index is an indication of unfavorable performance.

The Sharpe Measure

In this model, performance of a fund is evaluated on the basis of Sharpe Ratio, which is a ratio of returns generated
by the fund over and above risk free rate of return and the total risk associated with it. According to Sharpe, it is
the total risk of the fund that the investors are concerned about. So, the model evaluates funds on the basis of
reward per unit of total risk. Symbolically, it can be written as:
Sharpe Index (Si) = (Ri - Rf)/Si

Where, Si is standard deviation of the fund. While a high and positive Sharpe Ratio shows a superior risk-adjusted
performance of a fund, a low and negative Sharpe Ratio is an indication of unfavorable performance.

Comparison of Sharpe and Treynor

Sharpe and Treynor measures are similar in a way, since they both divide the risk premium by a numerical risk
measure. The total risk is appropriate when we are evaluating the risk return relationship for well-diversified
portfolios. On the other hand, the systematic risk is the relevant measure of risk when we are evaluating less than
fully diversified portfolios or individual stocks. For a well diversified portfolio the total risk is equal to systematic
risk. Rankings based on total risk (Sharpe measure) and systematic risk (Treynor measure) should be identical for
a well-diversified portfolio, as the total risk is reduced to systematic risk. Therefore, a poorly diversified fund that
ranks higher on Treynor measure, compared with another fund that is highly diversified, will rank lower on Sharpe
Measure.

Jenson Model
Jenson's model proposes another risk adjusted performance measure. This measure was developed by Michael
Jenson and is sometimes referred to as the Differential Return Method. This measure involves evaluation of the
returns that the fund has generated vs. the returns actually expected out of the fund given the level of its systematic

61 | PGDM 3rd Sem-S M S ( 2 0 1 7 )

Security Analysis & Investment Management; Lecture Notes

risk. The surplus between the two returns is called Alpha, which measures the performance of a fund compared
with the actual returns over the period. Required return of a fund at a given level of risk
(Bi) can be calculated as:

Ri = Rf + Bi (Rm - Rf)

Where, Rm is average market return during the given period. After calculating it, alpha can be obtained by
subtracting required return from the actual return of the fund. Higher alpha represents superior performance of
the fund and vice versa.
Limitation of this model is that it considers only systematic risk not the entire risk associated with the fund and
an ordinary investor cannot mitigate unsystematic risk, as his knowledge of market is primitive.

62 | PGDM 3rd Sem-S M S ( 2 0 1 7 )