CU-MBA-SEM-IV-Investment Management

a. Monitoring and Re-balancing: The portfolio manager monitors and evaluates the risk of the portfolio and compares it with strategic asset allocation. This is done to ensure that investor’s objectives and constraints are achieved. b. Performance Evaluation: The performance of the portfolio must be evaluated regularly to achieve the objective and to assess the skill of the portfolio manager. Both absolute and relative returns can be used as a measure of performance while analysing the performance of the portfolio. Thus portfolio management process is a set of comprehensive steps that needs to be followed to achieve the stated objectives. Investment policy statement is a crucial part of this process in creating a portfolio and evaluating the performance of the portfolio. 9.4 ASSET ALLOCATION AND ITS IMPORTANCE Meaning of Asset Allocation: Asset Allocation is an investment strategy to divide investments among different assets such as equity, bonds, debt, fixed income securities, cash and cash equivalents, real estate e t c. The aim is to minimise the risk the portfolio is exposed to since each asset class has a different correlation to one another. Asset allocation decisions are personal in nature. It is influenced by factors such as objectives and goals, time horizon and risk appetite. (franklintempletonindia.com, n.d.)There is no fixed rule regarding asset allocation strategy used by investors and financial planners. Following are the top two strategies to influence investment decisions a. Age-based investment decisions: The investment decisions are based on the age of the investor. Most financial advisor advice their clients to invest in stock market based on a deduction of their age from 100. The figure depends on the life expectancy of the investor. Higher the life expectancy higher will be the investment in riskier assets. b. Life-cycle funds Asset Allocation: Under this investors maximise their returns based on factors such as investment goals, risk tolerance and age. This structure is complex due to standardisation issues. Each investor has different preferences over these factors. Examples of other strategies used in asset allocation are 101 CU IDOL SELF LEARNING MATERIAL (SLM)

1. Constant Weight Asset Allocation: It is based on buy and hold policy. If a stock loses in value investors buy more of it and vice versa. The aim is to ensure that proportions never deviate by more than 5% of the original mix. 2. Tactical asset allocation: This strategy aims at addressing the challenges posed by strategic asset allocation over the long run. The aim is to maximise short term investment strategies by adding market timing component to the portfolio and allowing the investor to join in conditions more favourable to one asset class 3. Insured Asset Allocation: Under this strategy base asset value is established below which the portfolio value should not drop. If the portfolio value drops below the base value the investor is advised to invest in risk free securities like treasury bills. This is suitable for risk averse investors 4. Dynamic Asset Allocation: This strategy is the most popular one. Investors constantly adjusts the mix of assets based on market highs and lows. Under this strategy investor purchases assets which shows signs of continued market gains. These asset allocation decisions are made by mutual funds to influence investment decisions. Importance of Asset Allocation: Different asset classes perform differently at same point of time. It is quite challenging to predict which asset class will move in which direction. For example when prices of stocks are high, gold prices are low. So it definitely makes sense to invest in different asset classes. If a particular asset class underperforms at a particular time the other asset class will balance it out. Investing one’s fund in one asset class or one type of fund is risky. If the investment is divided among various assets they tend to give better returns for the investor. 9.5 SUMMARY An individual invests during his life cycle depending on his age, objectives and goals to be achieved, investment amount, risks he is ready to take e t c. An individual who starts investing in the early stages of his career has the benefit to stay invested for a long time and gets the benefit of compounding over the years. An investor’s life cycle is divided into following phases  Accumulation phase  Consolidation phase 102 CU IDOL SELF LEARNING MATERIAL (SLM)

 Spending phase  Gifting phase Under each phase the objective of the investor is different and accordingly his investment strategy is different. The portfolio management management process is divided into following steps Planning which involves  Identifying objectives and constraints  Investment Policy Statement  Capital Market Expectations  Asset Allocation strategy Execution which involves  Portfolio Selection  Portfolio Implementation Feedback which involves  Monitoring and Rebalancing  Performance Evaluation Asset Allocation means deciding on the mix of asset classes to be chosen for investment. A well- diversified portfolio having different asset classes gives better returns to the investor. 9.6 KEYWORDS  Investor life cycle: The time period when the investor purchases and sells the securities  Portfolio Management: It means managing a number of financial instruments comprised in the portfolio such as equity, debt, bonds e t c  Asset Allocation: It means distributing the investment amount among different asset classes.  Strategic Asset Allocation: It means determining the long term weights of various asset classes. 103 CU IDOL SELF LEARNING MATERIAL (SLM)

 Tactical Asset Allocation: These are short term investment decisions based on market changes and change in the circumstances of the investor. 9.7 LEARNING ACTIVITY 1. What do you understand by individual investor life cycle? ___________________________________________________________________________ ___________________________________________________ 2. Define Investment Policy Statement ___________________________________________________________________________ ___________________________________________________ 9.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Explain in detail the various stages in an investor’s life cycle 2. Differentiate between Strategic and Tactical Asset allocation strategy 3. Why is the planning stage important in the process of portfolio management 4. Why is age an important factor while making decisions on investment? 5. What do you understand by the term Asset allocation? Long Questions 1. What should be the investment strategy of a person who has just started his career? 2. Why is it important to have an Investment Policy Statement in place? 3. How do you minimise risk of investment in a particular asset class? Explain 4. Explain the process of portfolio management 5. What are the different types of Asset Allocation strategies used by mutual fund? B. Multiple Choice Questions 1. _____________ asset allocation strategy should be chosen by retired persons. a. Tactical 104 CU IDOL SELF LEARNING MATERIAL (SLM)

b. Dynamic 105 c. Insured d. Constant weight 2._____________ helps in achieving investment objectives a. Financial Planner b. Investment Policy Statement c. State d. Banks 3. __________allocation strategy is very complex in nature. a. Dynamic b. Strategic c. Constant weight d. Life cycle fund investment 4. Performance of a portfolio is judged by ___________ a. management b. monitoring c. evaluation d. diversifying 5. The first step in planning is __________ a. study market conditions b. deciding amount to invest c. identifying objectives & constraints CU IDOL SELF LEARNING MATERIAL (SLM)

d. make analysis Answers 1-c, 2-b, 3-d, 4-c, 5-c 9.10 REFERENCES Textbooks  Chandra Prasanna (2009) Investment Analysis and Portfolio Management Tata McGraw Hill Website  https://ordunur.com  https://corporatefinance.com  https://efinancemanagement.com  https://www.franklintempletonindia.com 106 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 10 DEVELOPMENTS IN INVESTMENT THEORY STRUCTURE 10.0 Learning Objectives 10.1 Introduction 10.2 Efficient Market Theory 10.3 Types of efficiency 10.4 Introduction to portfolio management 10.5 Markowitz portfolio theory 10.6 Summary 10.7 Keywords 10.8 Learning Activity 10.9 Unit End Questions 10.10 References 10.0 LEARNING OBJECTIVES After studying this chapter you will be able to  Describe Efficient Market theory  Explain the different forms of efficiency in markets  Define portfolio management  Describe Markowitz portfolio theory 10.1 INTRODUCTION An individual investor invests in a basket of securities which gives him liquidity and returns for the risk determined initially. Portfolio management is deciding on the asset mix so as to minimise risk while maximising returns. From this chapter you will understand the different approaches to portfolio management. 107 CU IDOL SELF LEARNING MATERIAL (SLM)

You may think whether an individual can benefit from price fluctuations in stock market. In this context you will be understanding two theories the Efficient Market Hypothesis and Random Walk theory. You will also understand different forms of efficiency found in markets. After finishing this chapter you will understand the difference between the traditional approach and modern approach and the statistical tools used to calculate returns and risk. 10.2 EFFICIENT MARKET THEORY (corporatefinanceinstitute.com, n.d.)The efficient market theory was developed by Eugene Fama through his research in his 1970 book “Efficient Capital Markets- A Review of Theory an Empirical Work”. He put forth the idea that it is impossible to beat the market to make a return higher than market averages as reflected by stock market indices. His theory carries the same implication for investors as the Random Walk theory. It is based on a number of assumptions about the securities market and how they function. The main idea which is critical to the efficient market theory is that all information related to stock prices is readily and freely available universally shared among all investors. As there are a large number of buyers and sellers in the market, price movements always occur efficiently in a timely up-to-date manner. The stocks thus always trade at their current fair market value. The major conclusion of this theory is that since stocks always trade at their fair market value it is impossible to buy a stock at a bargain or sell overvalued stocks for extra profits. It is thus impossible to outperform the market by expert stock analysis or carefully implemented market strategies. The only way to generate superior returns is by assuming greater risks. The Random Walk Theory or The Random Walk Hypothesis is a mathematical model of the stock market. According to this theory prices of securities in the stock market evolve according to a random walk. Random Walk is a statistical phenomenon where a variable follows no discernible trend and move at random. The assumptions of the Random Walk Theory are  The price of the securities in the market move at random  The movement in the prices of a security are independent of the movement in the price of another security. 108 CU IDOL SELF LEARNING MATERIAL (SLM)

The implication of this theory is that it is impossible to outperform the overall market average other than by sheer chance. Those who subscribe to the random walk theory recommend using a “buy and hold” strategy such as investing in basket of stocks that represent the overall market i.e. Example index mutual fund or exchange traded funds can be chosen. Thus as per this theory stocks take a random and unpredictable path. There is an equal chance that stock prices will either rise or fall from current levels. As per the efficient market hypothesis (EMH) prices of stock reflect all available information and prices adjust to any new information. Information includes what is currently known about the stock but also any future expectations such as earning or dividend pay-outs. It seeks to explain the random walk theory by positing that only new information will move stock prices significantly, since new information is unknown and occurs at random future movement in prices is also unknown and thus move randomly. Hence it is impossible to outperform the market by picking undervalued stocks since there are no stocks which are undervalued or overvalued Hence we can say that as per Efficient Market Hypothesis  Information is readily and widely available to all investors  Investors use this information to analyse the economy, markets and individual securities  Most events have a major impact on stock prices.  Investors will react quickly to new information 10.3 TYPES OF EFFICIENCY There are three variations of the efficient market hypothesis – weak, semi-strong and strong which represent three different assumed levels of market efficiency a. Weak form: The weak form of efficiency assumes that prices of securities reflect all available public information but may not reflect new information that is not yet publicly available. It assumes that past information regarding price, volume and returns is independent of future prices. According to the weak form EMH technical analysis cannot provide consistent return since past information can’t predict future prices as it is based on new information. Fundamental analysis provide a means to outperform market average returns. 109 CU IDOL SELF LEARNING MATERIAL (SLM)

(vtusolutions.in, n.d.)Three types of tests have been employed to empirically verify the weak form of efficiency i. Filter rule test: According to this strategy if the price of a stock rises by at least x% investor should buy and hold back the stock until its price declines by at least x% from a subsequent high. Studies have shown that gains produced by filter rules were much below normal than gains produced by simple buy and hold strategy adopted by the investor. ii. Run Test: Given a series of stock price changes each price change is designated by + if it represents an increase and – if it represents a decrease. The resulting series nay be +,-, -, -, +, +, -. A run occurs when there is no difference between the sign of two changes. When the sign of change differs the run ends and new run begins. To test a series of price change for independence the number of runs in that series is compared with the number of runs in a purely random series of the size to determine whether it is statistically different. The result of these studies strongly supports the Random Walk Model. iii. Serial Correlation test: It measures the correlation co-efficient in a series of numbers with the lagging values of the same series. Many studies conducted on security price changes have failed to show any significant correlations. b. Semi-strong form: The semi-strong form of the theory dismisses the usefulness of both fundamental and technical analysis. As per this form security prices rapidly adjust to publicly available information. The prices not only reflects the past price data but also information regarding earnings, dividend, bonus issue, mergers & acquisitions and so on. The market has to semi-strongly efficient, timely and correct dissemination of information and assimilation of news is needed. c. Strong form: All information is fully reflected on security prices. It represents an extreme hypothesis which most observers do not expect to be literally true. Information whether it is public or inside cannot be used consistently to earn superior returns on investment in the strong form. 10.4 INTRODUCTION TO PORTFOLIO MANAGEMENT Portfolio is a combination of securities such as equity, bonds, money market instrument, mutual funds, cash and so on selected depending on the investor’s budget, time frame, 110 CU IDOL SELF LEARNING MATERIAL (SLM)

convenience e t c. The art of selecting the right investment policy for the individual in terms of minimum risk and maximum return is called as portfolio management. It refers to managing an individual’s investments in the form of shares, bonds, mutual funds e t c so that he earns maximum returns within a particular timeframe. Portfolio managers suggest best investment plan to their clients considering their budget, income, age and risk taking ability. Portfolio management enables portfolio managers to provide customised investment solutions to clients as per their needs and requirements. Portfolio managers provide active, passive, discretionary and non-discretionary portfolio management services depending upon client’s requirements. There are two approaches to portfolio construction a. Traditional Approach of portfolio construction b. Modern Approach of portfolio construction Under the traditional approach of portfolio construction the financial plan of an individual is evaluated with regard to his needs in terms of income and capital appreciation. Later appropriate securities are selected. It consists of five steps i. Analysis of constraints ii. Determination of objectives iii. Selection of portfolio iv. Assessment of risk and return v. Diversification Under the modern approach of portfolio construction also known as Markowitz Approach emphasizes on selection of securities based on risk and return analysis. We will discuss this approach in the next section. 10.5 MARKOWITZ PORTFOLIO THEORY As per the Markowitz portfolio theory the financial plan of an individual is audited in terms of risks and returns and efforts are made to maximise the expected returns for a given level of risk. Under traditional approach the investors need for income or capital appreciation as basis for selection of stocks, the modern approach takes into account the investor needs in the form of 111 CU IDOL SELF LEARNING MATERIAL (SLM)

market return or dividend and his tolerance for risk as basis for selection of stocks. Returns are measured in terms of market return and dividend. As per this theory stocks with good prospects of return are selected and funds are appropriately allocated among different stocks according to the portfolio requirement (return & risk) of the investor. Portfolio managers may adopt active or passive strategy for managing the portfolio. Under passive strategy the investor holds the securities for the holding period which is previously determined. Under active strategy a continuous assessment of risk and securities of securities is done and low performing securities are replaced with high performing securities over time. Following are the assumptions of Markowitz Model 1. The individual investor estimates risk on the basis of variability of returns. 2. The decision of the investor depends on the expected return and variance of returns only. 3. For a given level of risk investors prefer higher returns to lower returns. 4. Likewise for a given level of return investors prefer lower risk than higher risk. Portfolio Return Rp = = WaRa +WbRb + …… Wa = Weight of first security Ra = Return of first security Wb= Weight of second security Rb= Return of second security Standard deviation of portfolio σp =√������2������������������2 + ������2������������������2 + 2������������������������ × ������������������ × ������������ × ������������ Where (WA)2 = Square of Weight of first security ( σA)2 = Square of Standard deviation of first security (WB)2 = Square of Weight of second security (σB)2 = Square of Standard deviation of second security ρAB = Correlation between first security and second security 112 CU IDOL SELF LEARNING MATERIAL (SLM)

10.6 SUMMARY  An investor is interested in purchasing low value stocks and selling them when highly priced. However as per the Efficient Market Hypothesis (EMH) prices of securities reflect all information which is freely and readily available. As there are a large number of buyers and sellers in the market the current price of securities reflect the fair market value. Hence there is no opportunity for the investor to buy low priced securities and gain by selling high priced stocks. Such opportunities come by sheer chance. There are three forms of EMH Weak Form Semi-strong form Strong form  A portfolio manager constructs the mix of different assets in such a way that it maximises returns for the investor taking into account his budget, income and risk taking capacity. There are two approaches in portfolio construction  Traditional Approach: It takes into account the investor’s need for income or capital appreciation while selecting stocks  Modern Approach/Markowitz theory: It takes into account market return or income and tolerance for risk by investor as the basis for selecting stocks.  The modern approach uses a statistical method of calculating portfolio expected return and risk. It is more scientific in its approach. 10.7 KEYWORDS  Efficient market: It means since a large number of buyers and sellers are present in the market information is readily available for all. Hence the prices of securities reflect the current fair market value. Investors thus cannot benefit except by chance.  Random Walk theory: Prices of stocks move randomly in market, movements in prices are independent.  Portfolio Management: Selecting the right investment policy for the investor.  Weak form of efficiency: Prices of securities reflect all available information but may not reflect new information. 113 CU IDOL SELF LEARNING MATERIAL (SLM)

 Semi-strong form of efficiency: Prices of securities change rapidly to publicly available information.  Strong form of efficiency: Prices of securities reflect all information. It is the extreme hypothesis of the EMH theory which cannot be true. 10.8 LEARNING ACTIVITY 1. What is Random Walk theory? ___________________________________________________________________________ ___________________________________________________ 2. What is the meaning of portfolio management? ___________________________________________________________________________ ___________________________________________________ 10.9 UNIT END QUESTIONS A. Descriptive questions Short Questions 1. What do you understand by Efficient Market Hypothesis? 2. Explain the relation between EMH and Random Walk theory 3. Why is portfolio management important for an individual? 4. What is filter rule test? 5. List the steps in traditional approach of portfolio management Long Questions 1. Differentiate between traditional approach and modern approach of portfolio management 2. Explain the different tests employed to check weak form of efficiency. 3. Differentiate between weak form of efficiency and strong form of efficiency 4. Do you think Markowitz theory is more scientific in nature? Explain 114 CU IDOL SELF LEARNING MATERIAL (SLM)

5. Do you agree that portfolio risk is weighted average of risks of individual securities? Why? B. Multiple Choice Questions 1. Prices of securities are ________ valued as per EMH a. average b. fairly c. correctly d. not properly 2. As per the random walk theory price of one security is _________ of price of another security a. partially dependent b. independent c. partially independent d. not determined 3. _________ helps in minimising risk a. Treasury bills b. Bonds c. Portfolio diversification d. Fixed income securities 4. ____________ is used to measure risk in modern portfolio theory 115 a. Beta b. Variance c. Standard deviation d. Alpha CU IDOL SELF LEARNING MATERIAL (SLM)

5. As per the modern portfolio theory for a given level of risk investors prefer _________returns a. market b. higher c. lower d. average Answers 1–b, 2–b, 3–c, 4–c, 5-b 10.10 REFERENCES Textbooks  Chandra Prasanna (2009) Investment Analysis and Portfolio Management Tata McGraw Hill Website  https://corporatefinanceinstitute.com  https://pdfcoffee.com 116 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 11 INTRODUCTION TO ASSET PRICING MODEL STRUCTURE 11.0 Learning Objectives 11.1 Introduction 11.2 Asset Pricing 11.3 Asset Pricing Models 11.3.1 Capital Asset Pricing Model 11.3.2 Arbitrage Pricing Model 11.3.3 Sums on CAPM and APT 11.4 Summary 11.5 Keywords 11.6 Learning Activity 11.7 Unit End Questions 11.8 References 11.0 LEARNING OBJECTIVES After understanding this chapter you will be able to  Define the term Asset Pricing  Explain the different models used in Asset Pricing  Calculate the expected return of an asset using these models 11.1 INTRODUCTION The pricing of assets is a very important consideration across asset and financial management. A firm wants to know the cost of capital and returns required before investing in a long term project. A key input in portfolio management is the expected return for an asset. Asset pricing models describes the relationship between risks and expected return. 117 CU IDOL SELF LEARNING MATERIAL (SLM)

An estimate of the expected returns that providers of capital require on investment is needed in order to value an asset. Asset pricing models helps to calculate the expected return of an investment that investors require given the risk associated with an investment. The expected returns calculated using different models helps the investor to value the asset and accordingly take decisions. After studying this chapter you will understand the ways to calculate the expected return of an asset using different models. 11.2 ASSET PRICING Asset pricing helps in determining the expected return of an asset. It helps in establishing relationship between risk and return. Asset pricing is a development and treatment of two main pricing principles. Asset pricing models which have been developed over time are a result of either general equilibrium asset pricing or rational asset pricing. Asset pricing models help in determining the asset specific required rate of return on the investment in question. Expected rate of return determined using these models help the investor to take decisions whether to buy, sell or hold on to investments after comparing with actual rate of returns of the asset. 11.3 ASSET PRICING MODELS We are going to study three models of asset pricing  Capital Asset Pricing Model (CAPM)  Arbitrage Pricing Model 11.3.1 Capital Asset Pricing Model (CAPM) theory Markowitz, William Sharpe, John Lintner and Jan Mossin provided the basic structure for the CAPM model. It is a model of linear general equilibrium return. The required rate of return has a linear relationship with asset’s beta value i. e. undiversifiable or systematic risk. Following are the assumptions of the CAPM theory  An individual seller or buyer cannot affect the price of the stock. 118 CU IDOL SELF LEARNING MATERIAL (SLM)

 Investors make their decisions only on the basis of standard deviation, expected returns and co-variances of all pairs of securities.  Investors are assumed to have homogenous expectations during the decision-making period.  The investors can borrow or lend any amount of funds at the riskless rate of interest.  Assets are infinitely divisible.  There is no transaction cost.  There is no personal income tax.  Unlimited quantum of short sales is allowed. The Capital Asset Pricing Model (CAPM) describes the relationship between expected returns and risk of investing in a security. It shows that the expected return of a security is a risk free rate plus a risk premium which is based on beta of that security. The formula for calculating expected return on a security E(RA) = Rf +(Rm-Rf) x βA Where E(RA) = Expected return of the security Rf = Risk free rate of interest Rm = Market return Β = Beta of security Rm –Rf = Risk premium Expected return of the security E(RA) is a long term assumption about how an investment will play out over its entire life. Risk free rate of interest Rf is the rate of interest on government securities. Beta β is a measure of the volatility of the returns measured as price fluctuations relative to the overall market. If beta= 1 expected return on the security is equal to the market return. If beta = 1.6 it means the security has 160% of the volatility of the market average. If beta = -1 it means the security has perfect negative correlation with the market. 119 CU IDOL SELF LEARNING MATERIAL (SLM)

Market risk premium is the additional return over and above the risk free rate to compensate investors for investing in a riskier asset class. The more volatile the market the higher the market risk premium will be. Importance of CAPM The CAPM is widely used in the finance industry. It is vital in computing the weighted average cost of capital as CAPM computes the cost of equity. CAPM is used extensively in financial modelling. It can be used to calculate the net present value of the future cash flows of an investment and to calculate the enterprise value and finally its equity value. Note: Financial model is a tool built in spreadsheet software such as MS Excel to forecast a business financial performance into the future. Enterprise Value is the entire value of a firm which is equal to equity value and debt value. Security Market Line (SML) SML is a line drawn on a chart that is a graphical representation of the CAPM. It shows the different levels of systematic risk or market risk of various marketable securities plotted against the expected return of the entire market at any given time. It is also known as the characteristic line where the x axis of the chart represents risk (in terms of beta) and the y axis of the chart represents expected return. The market risk premium is determined by where it is plotted on the chart relative to the SML. SML is and investment evaluation tool derived from CAPM which describes the risk -return relationship for securities. It is based on the assumption that investors need to be compensated for both the time value of money and the corresponding level of risk associated with any investment referred as the risk premium. SML helps us to determine the expected return for a security based on its level of systematic risk β. Given a securities β ideally its actual return should lie on SML. SML helps us to determine whether a security is properly priced or not which in turn helps us to decide an Investment strategy We can decide the investment strategy depending upon returns plotted on the graph. Where the returns plotted are above SML it means actual returns is greater than CAPM, hence it is undervalued. Investment strategy should be buy/hold. When the returns plotted are below SML it means actual returns is less than CAPM hence it is overvalued. Investment strategy should not to buy/sell. 120 CU IDOL SELF LEARNING MATERIAL (SLM)

When the returns plotted are on SML it means the security is correctly price. Investment strategy should be buy/hold. 11.3.2 Arbitrage Pricing Model (APT): It is a theory of asset pricing that holds that an asset’s returns can be forecasted with the linear relationship of the asset’s expected returns and macroeconomic factors that affect the asset’s risk. The theory was created by an American economist Stephen Ross in 1976. It offers analysts and investors a muti-factor pricing model for securities based on the relationship between financial asset’s expected return and its risks. The APT theory pinpoints that the fair market price of a security may be temporarily incorrectly priced. Therefore assets are mispriced either overvalued or undervalued for a brief period of time. However markets get eventually corrected and prices come back to its fair market value. To an arbitrageur temporarily mispriced securities present a short term opportunity to earn risk less profits. The APT operates with a pricing model that factors in many sources of risk and uncertainty. The APT model takes into account several macroeconomic factors while determining the risk and return of the asset while CAPM takes into account the single factor of risk level of the market. The macroeconomic factors in APT provide risk premium for the investor because these factors carry systematic risk which cannot be eliminated by diversification. Investors diversify their portfolio and choose their profile of risk and return based on the premium and sensitivity of macroeconomic factors. Arbitrage is the process of simultaneous purchase and sale of an asset on different exchanges taking advantage of slight price discrepancies to earn risk free profit. (xplaind.com, n.d.)Expected return as per APT is calculated as follows: E(R) = Rf +β1xFP1 + β2 xFP2 +………βn xFPn Where Rf = Risk free rate Β1 = Beta for the first factor FP1 = Factor risk premium for the first factor Β2 = Beta for the second factor FP2 = Factor risk premium for the second factor and so on 121 CU IDOL SELF LEARNING MATERIAL (SLM)

We can define any number of risk factors having plausible relationship to the expected return. However the factor must be systematic in nature because unique risk can be diversified and not compensated by an efficient market. Beta of portfolio: It is found out by applying weights to each security and multiplying with the beta of each security. The sum of all individual securities found out will be weighted beta. Beta of the portfolio = Waβa +Wbβb + Wcβc +Wdβd After finding out beta of the portfolio it is applied in the CAPM equation to find out the expected return of the portfolio. 11.3.3 Sums on CAPM and APT 1. Mr Kishore has invested in four securities (A, B, C, D) the following sums A 10000 B 20000 C 16000 D 14000 The beta of the above securities are 0.80, 1.20, 1.40 and 1.75 respectively. If the risk free return is 4.25% and the market return is 11%. What is the expected return on the portfolio? Ans: Beta of the portfolio = Waβa +Wbβb + Wcβc +Wdβd The total amount invested is 60000. Therefore individual weights of the securities will be 10000/60000 for A and similarly for other securities Βp = 10/60x0.80 + 20/60x1.20 + 16/60x1.40 +14/60x1.75 Βp = 1.315 As per CAPM model expected return on the portfolio is E(Rp) = Rf +(Rm-Rf) x βA = 4.25 + (11-4.25)1.315 Rp = 13.13% 2. From the following data compute beta of security x Standard deviation of x =12 , Standard deviation of market = 9, Correlation between xm = 0.7 Ans . 122 CU IDOL SELF LEARNING MATERIAL (SLM)

Beta = Correlation xm / standard deviation of x multiplied by standard deviation of m (market) β = ρxm /σx x σm = 0.72 x 12÷9 = 0.96. 3. Mr N has the following investments in a portfolio of short-term equity instruments. Details are as follows Investment No of shares Beta Market price per Expected yield share 1 60000 1.16 4.29 19.50% 2 80000 2.28 2.92 24% 3 100000 0.90 2.17 17.50 4 125000 1.50 3.14 23% The current market return is 19% and risk free rate is 11% Calculate the risk of the portfolio and the expected return Ans: Investment No of Beta Market Weights Expected shares Value Return as per CAPM 1 60000 1.16 4.29 257400 0.23 11+(19- 11)1.16 = 20.28 2 80000 2.28 2.92 233600 0.21 29.24 3 100000 0.90 2.17 217000 0.20 18.2 123 CU IDOL SELF LEARNING MATERIAL (SLM)

4 125000 1.50 3.14 392500 0.36 23 1100500 Expected Return as per CAPM E(R)s = Rf + (Rm-Rf)βs Beta of the portfolio = W1β1 +W2β2 + W3β3 + W4β4 = 0.23x1.16 + 0.21x2.28 +0.2x0.90 + 0.36x1.5 = 1.4656 or 1.47 Security Return as given % Return as per CAPM Strategy % 1 19.5 20.28 Overvalued 2 24 29.24 Overvalued 3 17.5 18.2 Overvalued 4 23 23 Correctly priced Expected return of the portfolio E(R)p = Rf + (Rm-Rf) βp = 11+ (19-11)1.47 = 22.76% 4. Assume that there are two factors Factor 1 & Factor 2 impact security returns. Investments A, B and C have the following sensitivities to these two factors Investment Beta of factor 1 Beta of factor 2 A 1.75 0.25 B -1.00 2.00 C 2.00 1.00 124 CU IDOL SELF LEARNING MATERIAL (SLM)

The risk free rate is 6% The expected risk premium is 4% on factor 1 and 8% on factor 2. Calculate expected returns Ans: As per APT theory expected return is E(R) = Rf +β1xFP1 + β2 xFP2 +………βn xFPn Security A E(R) = 6 + 4 x 1.75 + 8 x 0.25 = 15% Security B E(R) = 6 + 4 x (-1) + 8x2 = 18% Security C E(R) = 6 + 4x2 + 8x1 = 22% 11.4 SUMMARY  We have learnt that asset pricing models help us to establish relationship between risk and return. CAPM model and APT models are the most popular models used in asset pricing. It helps the investor in taking investment decisions.  CAPM model considers risk of the market as the only risk factor an investor bears. Beta is a measure of sensitivity or volatility of the stock in relation to the market. Beta is a measure of systematic risk. As per this model an investor who bears the market risk has to be rewarded with returns. Beta of the security helps in determining security risk with respect to market. A beta of 1 means risk is the same as market risk. If beta is greater than 1 it means stock is more riskier compared to market.  CAPM model helps in calculating the expected returns from the security by factoring in beta with the market risk premium. Market risk premium is the additional return over the risk free rate for taking greater risk. The investor can make investment decisions based on the expected returns calculated as per CAPM.  The CAPM model takes into account only market risk the investor bears. However investment decisions are influenced by various macroeconomic factors such as GDP, interest rates, inflation e t c. The APT model takes into account all these risk factors 125 CU IDOL SELF LEARNING MATERIAL (SLM)

and assigns a sensitivity value for all these factors and risk premium the investor should get for bearing all such risks. Total risk premium is the sum of products of individual factor risk and individual factor beta i.e. Factor 1 beta x Factor 1 risk premium + Factor 2 beta x Factor 2 risk premium and so on. Expected return as per APT theory is obtained by adding risk premium to the risk free interest. 11.5 KEYWORDS  CAPM model: It explains the risk return relationship by considering beta of the security as the only factor. It helps in calculating expected returns of the security  Security Market Line: It is also called characteristic line. It is a graphical representation of the CAPM model where x axis represents risk (beta) and y axis represents returns.  Beta: It is a measure of volatility or sensitivity of the stock to the market returns.  Risk premium: It is the difference between market rate and risk free rate  APT model: It is a multi-factor model which takes into various macroeconomic factors to determine factor wise risk premium and the expected return of the security 11.6 LEARNING ACTIVITY 1. What is the importance of CAPM model in finance? ___________________________________________________________________________ ___________________________________________________ 2. What are the macro economic factors which influence investment decisions? ___________________________________________________________________________ ___________________________________________________ 11.7 UNIT END QUESTIONS A. Descriptive Questions 126 Short Questions 1. What do you understand by Asset Pricing? 2. Define Beta. CU IDOL SELF LEARNING MATERIAL (SLM)

3. What is Characteristic line? 4. What is risk premium? 5. List some risks other than market risk which are borne by the investor Long Questions 1. What are the assumptions of CAPM model 2. The limitations of CAPM theory are overcome by APT theory. Explain 3. CAPM model helps the investor in taking investment decisions. Explain with example 4. Market rewards the investor only for risks which cannot be diversified. Explain 5. The rates of return on stock X and market portfolio for 15 period are as follows Period Return on stock X % Return on market portfolio % 1 10 12 2 15 14 3 18 13 4 14 10 5 16 9 6 16 13 7 18 14 84 7 9 -9 1 10 14 12 11 15 -11 12 14 16 127 CU IDOL SELF LEARNING MATERIAL (SLM)

13 6 8 14 7 7 15 -8 10 What is Beta of stock A? 128 B. Multiple Choice Questions 1. SML is a graphical representation of ____________model a. APT b. Single index model c. no risk d. CAPM 2. ______________ is the measure of sensitivity of the stock to market returns a. Average risk b. Alpha c. Beta d. High risk 3. Asset pricing models helps in taking __________ decisions. a. Purchase b. Investment c. merger d. disposal 4. ___________ factors come within systematic risk CU IDOL SELF LEARNING MATERIAL (SLM)

a. Labour b. Microeconomic c. Macroeconomic d. Inflationary 5. Market rewards the investor for ____________ risk a. capital b. unsystematic c. systematic d. inflation Answers 1–d, 2–c, 3–b, 4–c, 5-c 11.8 REFERENCES Reference book  Chandra Prasanna (2009) Investment Analysis and Portfolio Management Tata McGraw Hill Website  https://corporatefinanceinstitute.com  https://xplaind.com  https://pdfcoffee.com 129 CU IDOL SELF LEARNING MATERIAL (SLM)

130 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 12 ANALYSIS AND MANAGEMENT OF COMMON STOCK STRUCTURE 12.0 Learning Objectives 12.1 Introduction 12.2 Macro and micro analysis 12.3 Industry analysis 12.4 Company Analysis 12.5 Technical Analysis 12.6 Equity Portfolio Management Strategies 12.7 Summary 12.8 Keywords 12.9 Learning Activity 12.10 Unit End Questions 12.11 References 12.0 LEARNING OBJECTIVES After studying this chapter you will be able to  Describe fundamental analysis  Identify macroeconomic factors and microeconomic factors  Undertake industry and company analysis  Describe Technical Analysis  Explain equity portfolio management strategies 131 CU IDOL SELF LEARNING MATERIAL (SLM)

12.1 INTRODUCTION An investor needs to study the financial of the company such as Balance Sheet, Profit & Loss A/c, cash flows and important ratios before purchasing shares of the company. He is also required to study the industry to which the company belongs to. He is required to analyse the type of product or services sold, level of competition, type of industry, prospects of growth and so on before investing. Thus he is required to undertake company analysis and industry analysis (industry to which the company belongs) before investing. Apart from factors at the micro level certain macroeconomic factors do affect investment in the economy. The overall growth rate is one such factor. In this chapter we will study micro and macroeconomic factors influencing investment of an individual /firm. Such analysis is termed as fundamental analysis. We will also be discussing technical analysis in brief. Both fundamental and technical analysis helps in determining the intrinsic value of a stock. The investors can compare the intrinsic value of stock with the current market price and arrive at a decision whether it is overpriced or under-priced. We will also go through some portfolio management strategies. 12.2 MACRO AND MICRO ANALYSIS Macro and micro analysis is required to be undertaken before taking investment decisions. This analysis is called fundamental analysis. Fundamental analysis is the examination of the earnings, growth rate and risk exposure of the company to determine the intrinsic value of share. Fundamental analysis consists of  Economic Analysis  Industry Analysis  Company Analysis It is the analysis of various macroeconomic factors which have a significant bearing on the stock market. The various macroeconomic factors are  Gross Domestic Product (GDP) 132 CU IDOL SELF LEARNING MATERIAL (SLM)

 Savings and Investment  Inflation  Interest rates  Tax structure  Exchange rate movements  Monetary policy drivers repo rates, liquidity, Cash reserve ratio, Statutory liquidity ratio e t c  Core sector growth  Imports, exports and trade deficit  Fiscal deficit and current account deficit To mention the impact of a few when the government reduces the interest rates it encourages investment by businesses, creates employment opportunities, increases the demand for goods & services and further increases investment. If the tax rates are favourable it induces investment and also increases collection in terms of more tax compliance. When the growth rate of the economy is expected to be high in the long run global investors are ready to invest since they will gain in the long run. Each factor at the macro level has an impact on investment levels in the economy. In order to develop global investment strategies the investor should be able to forecast factors that drive long-term sustainable growth trends. Forecasting the future state of the economy is needed for decision making Following forecasting methods are used for analysing the state of the economy  Economic indicators: Indicates the present status, progress or slowdown of the economy  Leading indicators: Indicate what is going to happen in the economy. Indicators are fiscal policy, monetary policy, and rainfall and capital investment.  Coincidental indicators: Indicate what the economy is –GDP, industrial production, interest rates and so on. 133 CU IDOL SELF LEARNING MATERIAL (SLM)

 Lagging indicators: Changes occurring in the leading and coincidental indicators are reflected in lagging indicators. Unemployment rate, consumer price index, flow of foreign funds are examples.  Diffusion index: It is a consensus index which has been constructed by the National Bureau of Economic Research in USA 12.3 INDUSTRY ANALYSIS (grow.in/p/industry-analysis/, n.d.)Industry Analysis is a tool used by businesses and analysts to understand the dynamics of an industry. It helps to determine the degree of competition in the industry, demand-supply position, state of competition of the industry with other industries, future prospects taking into account technological changes, credit system within the industry and other external factors influencing the industry. (pdfcoffee.com, n.d.)Industries can be classified into following types  Growth industry: They have high rate of earnings and growth is independent of business cycle.  Cyclical industry: Growth and profitability move along with business cycle.  Defensive industry: It is an industry which defies the business cycle.  Cyclical growth industry: It is an industry that is cyclical and at the same time growing An investor has to analyse the following factors while performing industry analysis  Growth of the industry  Cost structure and profitability  Nature of the product  Nature of competition  Government policy An investor needs to understand the industry to which the company belongs to. It helps the investors to position the company against other competitors from the same industry. It gives the investor a picture of opportunities and roadblocks that come in the way of the company and industry. For example while investing in a pharmaceutical company the investor needs to 134 CU IDOL SELF LEARNING MATERIAL (SLM)

consider drug regulations, patenting, and demand situation of medicines e t c. Such considerations will not apply to FMCG sector. 12.4 COMPANY ANALYSIS Company Analysis is analysis of both quantitative and qualitative aspects of the company so that the present and future value of shares can be known. Some factors which are considered by the investor are  Growth of sales  Stability of sales  Market share  Competitive advantage  Business model  Management  Corporate Governance An investor needs to identity the company and its industry characteristic, products/services provided, risks and concerns of the company. An important part of the analysis is financial analysis Financial Analysis: It involves analysing the financial statements of the company which include  Balance Sheet: It shows the financial position of the company at the end of the year  Profit & Loss: It shows the profit or loss made by the company during the year.  Cash flow statement: It includes cash inflows and cash outflows of the company during the year. Financial Analysis helps the investor in determining the financial position and progress of the company. Following analyses are used to ascertain the financial position of the company  Comparative Financial Statement: The current year’s financial statements are compared with the previous year’s financial statements 135 CU IDOL SELF LEARNING MATERIAL (SLM)

 Trend Analysis: It shows the growth and decline of sales over the years.  Common size income statement: It shows each item of expense as a percentage of net sales.  Fund flow analysis: It shows the sources and application of funds  Cash flow analysis: It shows the cash inflows and outflows which determines the liquidity position of the company  Ratio Analysis: It shows the numerical relationship between two items. Examples of ratios are current ratio, quick ratio, debt-equity ratio, debtors turnover ratio e t c each ratio helps the investor to properly determine the financial position of the company. 12.5 TECHNICAL ANALYSIS (vtusolution.in, n.d.)Technical Analysis is a tool used to predict probable future price movement of a security such as stock based on market data. The theory behind the validity of technical analysis is that collective actions of buying and selling of all the participants in the market accurately reflect all relevant information pertaining to a traded security. Hence the security trades at a fair value. It is a process of identifying trend reversals at an early stage to formulate buying and selling strategies. Technical analyst studies the relationship between price-volume, supply-demand for the overall market and individual stock. The assumptions of technical analysis are 1. The market value of the stock is determined by the interaction of demand and supply. 2. The market discounts everything. 3. The market always moves in trend. 4. History repeats itself. It is true to the stock market also. Origin of technical analysis It is based on the doctrine given by Charles H Dow in 1884 in the Wall Street Journal A.J. Nelson a close friend of Charles Dow formalised the Dow Theory for economic forecasting Analysts used charts of individual stocks and moving averages in the early 1920s 136 CU IDOL SELF LEARNING MATERIAL (SLM)

Dow Theory Dow developed his theory to explain the movement of indices Dow Jones Averages This theory is based on certain hypotheses  No single individual or buyer can influence the major trend of the market.  The market discounts everything.  The theory is not infallible According to Dow Jones the trend is divided into  Primary  Intermediate/Secondary  Short term/Minor Primary trend The security price trend is either increasing or decreasing. When the market exhibits an increasing trend it is called bull market when it exhibits a decreasing trend it is called bear market. Bull market  The bull market shows three clear cut peaks.  Each peak is higher than the previous peak.  The bottoms are also higher than the previous bottoms. Bear market 137  The market exhibits falling trend  The peaks are lower than the previous peaks.  The bottoms are also lower than previous bottoms. Secondary Trend The secondary trend moves against the main trend and leads to correction. The correction would be 33% or 66% of the earlier fall or increase. CU IDOL SELF LEARNING MATERIAL (SLM)

Compared to the primary trend the secondary trend is fast and quicker Minor trend The minor trend or tertiary moves are called random wriggles. They are simply daily price fluctuations. Minor trend tries to correct secondary trend movement Support and Resistance level In the support level fall in the price level may be halted for the time being or it may result even in price reversal. In this level demand for the particular scrip is expected. In the resistance level increase in the price is halted for the time being. The supply of the scrip is greater than demand. Further rise in price is prevented. Selling pressure is greater. Indicators Volume of trade:  Volume expands along with the bull market and narrows down in the bear market.  Technical analyst use volume as an excellent method of confirming the trend. Breadth of the market:  The net difference between the number of stock advanced and declined during the same period is breadth of the market.  A cumulative index of the net differences measures the market breadth. Short Sales:  It is a technical indicator also known as short interest  It refers to selling of shares without owning it.  They show the general situations. Moving Average  The word moving means the body of data moves ahead including the recent observation.  The moving average indicates the underlying trend in the scrip.  For identifying short –term trend 10 to 30 days moving averages are used. 138 CU IDOL SELF LEARNING MATERIAL (SLM)

 In case of medium-term trend 50-125 days are adopted.  To identify long-term trend 200 days moving average is used. Oscillators:  Oscillators shows the share price movement across a reference point from one extreme to another. The momentum indicates  Overbought or oversold conditions of the scrip or market.  Signalling the possible trend reversal.  Rise or decline in the momentum. Relative Strength Index (RSI):  RSI was developed by Wells Wilder  It identifies the inherent technical strength and weakness of a particular scrip or market.  RSI can be calculated for a scrip by adopting the following formula  RSI = 100 – (100 ÷ 1+RS)  RS = Average gain per day ÷ Average loss per day  If the share price is falling and RSI is rising a divergence is said to have occurred.  Divergence indicates turning point of the market. Rate of change (ROC) ROC measures the rate of change between the current price and the price “n” number of days in the past. It helps to find out overbought and oversold positions in a scrip. ROC can be calculated by two methods In the first method current closing price is expressed as a percentage of 12 days or weeks in the past. In the second method the percentage variation between the current price and the price 12 days in the past. Charts: 139 CU IDOL SELF LEARNING MATERIAL (SLM)

Charts are graphic presentation of the stock prices. They have the following uses  Spots the current trend for buying and selling.  Indicates the probable future action of the market by projection.  Shows the past historic movement.  Indicates the important areas of support and resistance Point and Figure Charts  These charts are one dimensional and there is no indication of time or volume  The price changes in relation to previous price changes are shown  The change of price direction can be interpreted Some disadvantages are: They do not show intra-day price movement. Only whole numbers are considered resulting in loss of information regarding minor fluctuations. Volume is not mentioned in the chart. Bar Charts: The bar chart is the simplest and most commonly used tool of a technical analyst. The dot is entered to represent the highest price at which stock is traded on the day, week or month. Another dot is entered to indicate the lowest price on that particular date. A line is drawn to connect both points. A horizontal nub is drawn to mark the closing price. Chart Patterns: V formation Double top and bottom Inverted head and shoulders Tops and bottoms 140 CU IDOL SELF LEARNING MATERIAL (SLM)

Head and shoulders Triangles: The triangle formation is easy to identify and popular in technical analysis. The different triangles are Symmetrical Ascending Descending- inverted 12.6 EQUITY PORTFOLIO MANAGEMENT STRATEGIES Equity portfolio management refers to planning, implementation of various methods and strategies for beating the equity market. There are two types of equity portfolio management strategies Active management Passive management One way to distinguish these strategies is to break up the total actual return that the portfolio manager attempts to produce. Under passive strategy Actual Return is Risk free rate + Risk premium Under active strategy Actual Return is Risk free rate +Risk premium + Alpha The objective of the portfolio manager under passive strategy is to capture the expected return consistent with the risk level of their portfolios. The objective of the portfolio manager under active strategy is to beat the market, to form a portfolio that can produce actual returns in excess of the risk-adjusted expected returns. The difference between the actual and expected returns is called portfolio alpha. Under passive strategy the portfolio return will track those of a benchmark index over time. No attempt is made by the portfolio manager to generate alpha. Managers are tracked by how well they track the target and minimise the deviation between stock portfolio and index. Under active strategy an attempt is made to outperform a passive benchmark portfolio on a risk adjusted basis by seeking the alpha value. Managers attempt to add alpha tactical adjustments (equity style or sector timing) or stock picking 141 CU IDOL SELF LEARNING MATERIAL (SLM)

Passive management strategies include buy and hold of stocks, purchase of index fund and exchange traded funds. An attempt is made to replicate performance of an index. The rationale for following this approach is stock markets throughout the world are fairly efficient. The cost of active management (1 to 2%) are hard to overcome in risk adjusted performance. However passive strategies are not costless to employ. Events may occur which change the composition of benchmark itself. It may underperform the target index due to fees and commissions. 12.7 SUMMARY  An investor undertakes macro and micro analysis to make investment decisions. Fundamental analysis include economic analysis at the macro level and industry & company analysis at the micro level. Key factors analysed at the macro level include GDP, fiscal policy, interest rates, fiscal policy e t c. Government policies regarding taxes, concessions e t c determine the investment climate in the country  Industry analysis includes the type of industry the company belongs to, degree of competition, future prospects, technological change, government policy pertaining to the industry, nature of the product e t c. This industry analysis helps the investor to determine the opportunities and obstacles which will be faced by the company. It also helps to determine whether potential for growth is present or not  Company analysis include l Growth of sales  Stability of sales  Market share  Competitive advantage  Business model  Management  Corporate Governance 142 CU IDOL SELF LEARNING MATERIAL (SLM)

 Financial Analysis is an important part of company analysis. Ratio analysis, comparative financial statement analysis, fund flow analysis, trend analysis helps the investor to determine the financial position of the company and the viability of investment.  Technical Analysis is a tool used to predict probable future price movement of a security such as stock based on market data. It is a process of identifying trend reversals at an early stage to formulate buying and selling strategies. Technical analyst studies the relationship between price-volume, supply-demand for the overall market and individual stock.  Equity portfolio management is the planning, implementation of various strategies to beat the market. There are two types of strategies Active management Passive management  Under Active management the portfolio manager structures the portfolio to beat the market and earn returns in excess of the risk-adjusted returns. Under passive strategy the portfolio manager aims to earn the expected returns consistent with the risk level of the portfolio. 12.8 KEYWORDS  Relative Strength Index (RSI): It identifies the inherent technical strength and weakness of a particular scrip or market.  Rate of change (ROC): ROC measures the rate of change between the current price and the price “n” number of days in the past.  It helps to find out overbought and oversold positions in a scrip.  Volume of trade: Volume expands along with the bull market and narrows down in the bear market. Technical analyst use volume as an excellent method of confirming the trend  Breadth of the market: The net difference between the number of stock advanced and declined during the same period is breadth of the market.  Moving Average: The moving average indicates the underlying trend in the scrip 143 CU IDOL SELF LEARNING MATERIAL (SLM)

12.9 LEARNING ACTIVITY 1. What are the methods used to forecast state of economy? ___________________________________________________________________________ ___________________________________________________ 2. How are charts useful in technical analysis? ___________________________________________________________________________ ___________________________________________________ 12.10 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Why is industry analysis necessary? 2. Name some factors considered while conducting economic analysis 3. What are the factors to be considered while performing industry analysis? 4. What are the qualitative aspects to be considered before investing in a company? 5. Name the different types of charts used in technical analysis Long Questions 1. Explain how financial analysis of a company helps in taking investment decisions 2. Describe the factors to be considered while performing company analysis 3. What are the different strategies in equity portfolio management? 4. What are the indicators used in technical analysis? Describe any three 5. What is technical analysis? What are its assumptions? B. Multiple Choice Questions 1. Technical analysis predicts future movement of a stock based on ________ data a. Economic b. Industry c. Market 144 CU IDOL SELF LEARNING MATERIAL (SLM)

d. Company 2. The ____________ trend moves against the main trend. a. Tertiary b. Secondary c. Primary d. Market 3. ____________ factors affect all industries in the economy. a. Labour b. Micro c. Local d. Macro 4. Industries grow and earn profits along with the business cycle in _________ industries a. Growth b. Cyclical c. Defensive d. Core 5. When a country has a _______________ core sector growth it promotes trade and business. a. average b. good c. sound d. positive 145 CU IDOL SELF LEARNING MATERIAL (SLM)

Answers 1-c, 2-b, 3-d, 4-b, 5-c 12.11 REFERENCES Reference book  Chandra Prasanna (2009) Investment Analysis and Portfolio Management Tata McGraw Hill Website  https://grow.in  https://corporatefinanceinstitute.com  https://pdfcoffee.com  https://vtusolution.in  corporatefinanceinstitute.com. (n.d.). Retrieved from https://corporatefinanceinstitute.com  grow.in/p/industry-analysis/. (n.d.). Retrieved from grow.in: https://grow.in  pdfcoffee.com. (n.d.). Retrieved from pdfcoffee.com: https://pdfcoffee.com  vtusolution.in. (n.d.). Retrieved from vtusolution.in: https://pdfcoffee.com  xplaind.com. (n.d.). Retrieved from xplaind.com: https://xplaind.com 146 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 13 ANALYSIS AND MANAGEMENT OF FIXED INCOME SECURITIES STRUCTURE 147 13.0 Learning Objectives 13.1 Introduction 13.2 Concept & Features of Bond 13.3 Types of Bonds 13.4 Bond Valuation 13.4.1 Yield 13.4.2 Yield to Maturity 13.4.3 Bond Equivalent Yield 13.5 Duration of bond 13.6 Concept & Features of Preference Shares 13.7 Concept of Equity Shares 13.8 Dividend Valuation models 13.9 Summary 13.10 Keywords 13.11 Learning Activity 13.12 Unit End Questions 13.13 References 13.0 LEARNING OBJECTIVES After studying this unit you will be able to  Describe features of a bond and its types  Value the intrinsic value of a bond  Explain concept and features of preference shares CU IDOL SELF LEARNING MATERIAL (SLM)

 Describe equity shares  Value equity shares of a company using dividend valuation models 13.1 INTRODUCTION We had learnt in the previous chapters that an investor has several avenues available for investment. The investor considers the risk-return trade off while investing. Risk averse investors prefer investing in safe securities like government bonds, fixed deposits, post office deposits and so on. Such investors prefer safety of their principal and assured returns but at the same time are required to compromise in the form of low returns. This risk-return trade off was discussed earlier. In this chapter you will be learning various terms used in relation to bonds. You will understand the different types of bonds available for the investor. The relationship between yield, interest rate and price of bonds will be understood by you. You will learn to calculate the intrinsic value of the bond. You will understand what preference shares are and why they are called as preference shares. The features of preference shares will also be discussed and its types. An investor who is interested in investing in equity shares of a company needs to know whether the price paid by him in the market is really worth the share. So we will be discussing the dividend valuation models of valuing equity share. The intrinsic value of share found out using these models will help to decide for the investor whether it is overvalued, undervalued or correctly valued. 13.2 CONCEPT & FEATURES OF BOND (https://groww.in/p/bonds/, n.d.)Bonds are high-security debt instruments that enable an entity to raise fund to meet their capital requirements. Bonds are issued for a specific tenure to individual investors. Companies, municipalities, governments and other entities issue bonds for investors in the primary market. The corpus collected helps to meet their short-term and long-term fund requirements. Investors purchase bonds at their face value which is returned at the end of tenure. Issuers pay interest to the bond holders determined in advance. Issuers have a legal obligation to pay the face value of the bond on maturity. When a company faces bankruptcy bond holders have a priority to be paid before other stakeholders of the company. The features of bond are as follows 148 CU IDOL SELF LEARNING MATERIAL (SLM)

1. Maturity: Bonds are issued for a specific period of time. Maturity is the time when the bond holder is paid back by the issuer. “Term to maturity” is the amount of time until the bond matures. There are basically three types based on time period for which it is issued. Short term bonds: Period is 1 year to 5 years Medium term bonds: Period is 5 years to 12 years Long term bonds: Period is 12 years or more. Maturity is an important aspect because  It shows the length of time when the bond holder will receive interest payment and principal amount back.  Longer the maturity higher the interest rates  It affects the volatility of the bond. A longer maturity typically indicates higher volatility. 2. Face Value: Face Value of the bond is the price of a single unit of a bond. Principal, nominal value and par value mean the same as face value. The issuer has to pay back the face value of the bond on maturity to the bond holder. Face Value of the bond is different from market value of the bond since market value is determined by operations in the market. 3. Interest rate: The bond holders are paid a fixed percentage as interest to the investors. Interest rates are also known as coupon rates. The interest rates may be fixed or floating depending upon the type issued. The interest rate depends on factors like tenure of the bond, issuer’s repute e t c. Issuers who regularly pay interest win confidence of the investors which builds their reputation in the market. 4. Credit rating: Credit rating is the opinion of a particular credit agency regarding the ability and willingness of the enterprise to service its debts. It refers to the regularity and timeliness of payment of interest and principal. Investors check the credit rating of the enterprise before buying bonds. Some of the credit rating agencies in India are CRISIL Ltd, ICRA Ltd, CARE Ltd e t c 13.3 TYPES OF BONDS Following are the different types of bonds: 149 CU IDOL SELF LEARNING MATERIAL (SLM)

 Fixed interest bonds: They give a consistent interest payment to the investors as the coupon rates are fixed for the entire tenure. The investors thus can predict the return on their investments irrespective of changes in market conditions.  Floating interest bonds: These bonds carry coupon rates which are subject to market fluctuations and keep changing within the tenure of the bond. The return on investment for the investors is inconsistent as it is determined by market factors such as inflation, condition of economy and monetary policy.  Inflation linked bonds: These are special debt instruments to compensate the investors for the impact of economic inflation. The coupon rates are lower than fixed interest bonds. It reduces the negative consequence of inflation by bringing changes in coupon rates prevailing in the debt market.  Perpetual bonds: These bonds do not have any maturity period as the issuers do not have to return the principal amount to the investor. These instruments give steady interest payment to the investors. We have other types of bonds as well like zero coupon bonds, convertible bonds and deep discount bonds  Zero coupon bonds: As the name suggests they do not have any interest rates. They are sold at a discount from their maturity values. The difference between the discounted value and the maturity or face values represents the interest that will be earned by the investor.  Convertible bonds: These bonds give the holder the option to convert it into a predetermined number of shares in the issuing company. The interest rates on these bonds are slightly lower than regular corporate bonds. Investors accept a lower coupon rate than other regular bonds since it offers conversion features. Companies (issuer of bonds) thus can save a substantial amount in terms of interest expenses.  Deep discount bonds: These bonds are issued at a discount than its face value or trades at a lower value than its par value. These are similar to zero coupon bonds since they are issued at a discount. For e.g. A bond having face value ₹ 1000 may be issued at ₹ 994 in case of zero coupon bond whereas in case of deep discount bonds they may be issued at ₹ 600 hence the name deep discount. Zero coupon 150 CU IDOL SELF LEARNING MATERIAL (SLM)