Security Analysis - Investment Management

UNIT - I
Decision Support System : Overview, components and classification, steps in

constructing a dss, role in business, group decision support system.
UNIT - II
Information system for strategic advantage, strategic role for information system,
breaking business barriers, reengineering business process, improving business
qualities.
UNIT - III
Information system analysis and design, information SDLC, hardware and software
acquisition, system testing, documentation and its tools, conversion methods.
UNIT - IV
Marketing IS, Manufacturing IS, Accounting IS, Financial IS.
MBA3rd SEMESTER, M.D.U., ROHTAK
SYLLABUS
External Marks : 70
Time : 3 hrs.
Internal Marks : 30
SECURITY ANALYSIS & INVESTMENT MANAGEMENT
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FINANCE : SPECIALIZATION PAPERS
UNIT I
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Q. Define Investment.
Ans. Meaning of Investment : Investment involves making of a sacrifice in the present with
the hope of deriving future benefits. Investment has many meanings and facets. The two
most important features of an investment are current sacrifice and future benefit.
We can now give a simple yet a broad definition of investment. We can define investment as
postponed consumption.
When you postpone consumption, sacrifice takes place n the present and is certain whereas
the benefits occur n future and are uncertain. Therefore, risk and expected return from the
investment are the two key determinants of investment process.
Investment Process : A typical investment decision undergoes a five step procedure
which, in turn, forms the basis of the investment process. These steps are:
(1) Determine the investment objectives and policy
(2) Undertake Security Analysis.
(3) Construct a portfolio.
(4) Review the Portfolio.
(5) Evaluate the performance of the portfolio.
Investment Attributes/ Factors Influencing Selection of Investment : In chossing
specific investments, investors will need definite ideas regarding features which their
portfolios should possess. For evaluation of investment avenue, the following attributes are
relevant:
(1) Returns
(2) Capital Appreciation
(3) Safety and Security of Funds.
(4) Tax Benefits
(5) Concealability
(6) Adequate Liquidity
(7) Stability of Income
(8) Risk.
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Q. Define Risk. What are the different types of risk influences on investment?
Ans : Meaning of Risk : Risk can be defined as the probability that the expected return from
the security will not materialize. Every investment involves uncertainties that make future
investment returns risk-prone. Uncertainties could be due to the political, economic and
industry factors.
Types of Investment Risk: Investment Risks are:
Types of Investment Risk
Systematic Risk Non-Systematic Risk
Market Risk Regulation Risk
Interest Rate Risk Regulation Risk
Purchasing Power Risk Regulation Risk
Business Risk
Bull-Bear Risk
Exchange Rate Risk Management Risk
Default Risk
International Risk
Industry Risk
Country Risk Liquidity Risk
Dividing total risk into its two components, a general (market) component and a specific
(issuer) component, we have systematic risk and non-systematic risk, which are additive:
Total Risk = General Risk + Specific Risk
= Market Risk + Issuer Risk
= Systematic Risk + Non -Systematic Risk
(A) Systematic Risk : Variability in a securitys total returns that is directly associated with
overall movements in the general market or economy is called systematic risk.
Virtually all securities have some systematic risk because systematic risk directly
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encompasses interest rate, market, and inflation risks. Systematic risk is attributable
to broad macro factors affecting all securities. Different types of systematic risk are
explained as under:
(1) Market Risk : The variability in a securitys returns resulting from fluctuation in
the aggregate market is known as market risk. Market risk is sometimes used
synonymously with systematic risk. All securities are exposed to market risk
including :
Recession
Wars
Structural changes in the economy
Tax law Changes
Changes in Consumer Preferences.
(2) Interest Rate Risk : The variability in a securitys 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
prices move inversely to interest rates.
(3) Purchasing Power Risk : A factor affecting all securities is purchasing power
risk, also known as inflation risk. With uncertain inflation, the real (inflation-
adjusted) return involves risk even if the nominal return is safe. This risk is
related to interest rate risk, since interest rates generally rise as inflation
increases, because lenders demand additional inflation premiums to
compensate for the loss of purchasing power.
(B) Non-Systematic Risk : The variability in a securitys total returns not related to overall
market variability is called the non-systematic (non-market) risk. Non-systematic risk
is specific to an industry or the company individually. This risk is unique to a particular
security and is associated with such factors as business and financial risk as well as
liquidity risk. Different types of non-systematic risks are explained as under:
(1) Regulation Risk : Some investments can be relatively attractive to other
investments because of certain regulations or tax laws that give them an
advantage of some kind. Municipal bonds, for example, pay interest that is
exempt from local, state and federal taxation. As a result of that specific tax
exemption, municipals can price bonds to yield a lower interest rate since the net
after-tax yield may still make them attractive to investors.
(2) Business Risk : The risk of doing business in a particular industry or
environment is called business risk. For example, as one of the largest steel
producers, U.S. Stee faces unique problems.
(3) Bull-Bear Market Risk : This risk arises form the variability in the market returns
resulting from alternating bull and bear market forces.
When security index rises fairly consistently from a low point, this upward
trend is called a bull market. The bull market ends when the market index
reaches a peak and starts a downward trend.
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The period during which the market declines, this downward trend is
called a bear market.
(4) Management Risk : Management, all said and done, is made of people who are
mortal, fallible and capable of making a mistake or a poor decision. Errors made
by the management can harm those who invested in their firms.
(5) Default Risk : It is that portion of an investments total risk that results from
changes in the financial integrity of the investment. For example, when c
company that issues securities moves either further away from bankruptcy or
closer to it, these changes in the firms financial integrity will be reflected in the
market price of its securities. The variability of return that investors experience,
as a result of changes in the credit worthiness of a firm in which they invested, is
their default risk.
(6) International Risk : International risk can include country risk and exchange
rate risk.
(i) Exchange Rate Risk : All investors who invest internationally in todays
increasingly global investment arena face the prospect of uncertainty in
the returns after the convert the foreign gains back to their own currency.
(ii) Country Risk : Country risk, also referred to as political risk, is an
important risk for investors today. With more investors investing
internationally, both directly and indirectly, the political and therefore
economic stability and viability of a countrys economy need to be
considered.
(7) Industry Risk : An industry may be viewed as group of companies that compete
with each other to market a homogeneous product. Industry risk is that portion of
an investment s total variability of return caused by events that affect the
products and firms that make up an industry.
(8) Liquidity Risk : Liquidity risk is the risk associated with the particular secondary
market in which a security trades. An investment that can be bought or sold
quickly and without significant price concession is considered liquid. The more
uncertainty about the time element and the price concession, the greater the
liquidity risk.
Measurement of Risk : There are three methods:
(1) Volatility : Volatility may be described as the range of movement (or price fluctuation)
from the expected level of return. For example, the more a stock goes up and down in
price, the more volatile that stock is.
(2) Standard Deviation : Investors and analysts should be at least somewhat familiar
with the stud of probability distributions. Since the return an investor will earn from
investing is not known, it must be estimated. An investor may expect the total return on
a particular security to be 10% for the coming year but in truth this is only a point
estimate. The formulas of measuring risk with the help of standard deviation are:
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(i) Risk of Portfolio (two assets):
ss= W s + W +2 W W rss
sP = Standard deviation of portfolio consisting securities A and B
WA WB = Proportion of funds invested in Security A and B
sA sB = Standard deviation of returns of Security A and Security B
AB = Correlation coefficient between returns of Security A and Security B
The correlation coefficient can be calculated as follows:
Cov AB
AB =
ss
B A
(ii) Risk of Portfolio (three assets):
sP = W 2 s2 + W 2 s2 + W 2 s 2 +2 WxWy ryz sy sz+ WxWz rxz sx sz
W 1, W2, W3= Proportion of amount invested in securities X, Y and Z
sxsy sz = Standard deviation of Securities X, Y and Z
rxy = Correlation coefficient between Securities X and Security Y
ryz = Correlation coefficient between Securities Y and Security Z
rxz = Correlation coefficient between Securities X and Security Z
(3) Beta : Beta is a measure of the systematic risk of a security that cannot be avoided
through diversification. Beta is a relative measure of risk- the risk of an individual stock
relative to the market portfolio of all stocks. For example, a security with a beta of 1.5
indicates that, on average, security returns are 1.5 times as volatile as market returns,
both up and down.
Q. Define Return. Also explain its component and types.
Ans. Meaning of Return : Return is the amount or rate of produce, proceeds, profits which
accrues to an economic agent from an undertaking or investment. It is a reward for and a
motivating force behind investment, the objective of which is usually to maximize return.
Determinants of Return : Three major determinants of the rate of return expected by the
investor are:
(i) The time preference risk-free real rate.
(ii) The expected rate of inflation
(iii) The risk associated with the investment, which is unique to the investment.
Required Return = Risk-free real rate + Inflation premium + Risk Premium
2 2 2
2
sA B AB A B
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Component of Return : The rate of return from an investment consists of the two:
(i) Yield : The interest or dividend received is called yield.
(ii) Capital Appreciation : The difference between the sale price and the
purchased price is the capital appreciation.
Formula:
It + [Pt Pt-1]
Rate of Return (Rt) = -
Pt-1
Rt = Rate of return per time period t
It = Income for the period t
Pt = Price at the end of time period t
Pt-1 = Initial price, i.e., price at the beginning of the period t
The above equation can be split into two components:
It [Pt Pt-1]
Rate of Return (Rt) = +
Pt-1 Pt-1
It
Where is called the current yield,
Pt-1
[Pt Pt-1]
And is called the capital gain yield
Pt-1
Or ROR = Current Yield + Capital Gain Yield
Example : The following information s given for a corporate bond.
Price of the bond at the beginning of the year = Rs. 90
Price of the bond at the end of the year = Rs. 95.40
Interest received for the year = Rs. 13.50
Compute the rate of return.
Solution:
The rate of return can be computed as follows:
It + [Pt Pt-1]
Rate of Return (Rt) = -
Pt-1
13.50 + [95.40 90]
Rate of Return (Rt) = = 21% per annum
90
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The return of 21% consists of 15% current yield and 6% capital gain yield
Return of Portfolio (Two Assets) :
The expected return from a portfolio of two or more securities s equal to the weighted
average of the expected returns from the individual securities.
S(R ) = W (R ) + W (R )
S(Rp) = Expected return from a portfolio of two securities
WA = proportion of funds invested in Security A
WB = Proportion of funds invested in Security B
RA = Expected return of Security A
RB = Expected return of Security B
WA+WB = 1
Example : A Ltd.s share gives a return of 20% and B Ltd.s share gives 32% return. Mr.
Gotha invested 25% in A Ltd.s share and 75% of B Ltd.s shares. What would be the
expected return of the portfolio?
Solution :
Portfolio Return = .25 (20) + .75 (32) = 29%
Types of Return :
(1) Internal Rate of Return : The internal rate of return (IRR) is the rate of discount which
makes the present value of all the revenues (cash flows) from the investment equal to
the total cost of that investment. This is also known as the yield or yield rate.
(2) Bond Rate : It is the interest rate received on the face value or the par value of the
bond. If a company or the government issues a 10-ear bond with Rs. 100 as face value
and 15 per cent rate of interest, it would be described as 15 per cent bond.
(3) Realised and Expected Return : Return is not as simple a concept as it appears to be
because it is not guaranteed, it is mostly expected, and it may or may not be realized.
Thus expected return is an anticipated, predicted, desired which is subject to
uncertainty. Realised return, on the other hand, is actually earned.
(4) Holding Period Return/Return : Holding period yield (HPY) measures the total
return from an investment during a given time period in which the asset is held b the
investor. It is to be noted that HP does not mean that the security is actually sold and
the gain or loss is actually realised by the investor. The concept of HPY is applicable
whether one is measuring the realized return or estimating the future return. It can be
calculated as follows:
Any cash payments received + price change over the holding period
HPY =
Price at which the asset is purchased (beginning price)
p A A B B
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(5) Redemption Yield or Yield to Maturity (YTM) : Redemption yield is the indicated or
promised rate of return an investor will receive from a bond purchased at the current
market price and held till maturity.
Annual Interest + Average annual appreciation or depreciation
YTM =
Redemption or face value
(6) Dividend Yield : Dividend yield is the ratio of per share expected dividends, to the
current market price of the share.
(7) Earnings Yield : Earnings yield is the ratio of expected earnings per share of the firm
to the current marker price of the share. The dividend yield and earnings yield do not
differ if the firm distributes all net earnings in the form of dividends i.e. if it practices 100
per cent dividend payout ratio.
(8) Nominal and Real Return : While the nominal return is the return in nominal rupees,
the real return is equal to the nominal return adjusted for changes in prices i.e. rate of
inflation.
(9) Gross and Net Yield : While gross yield refers to the yield realized by the investor
before paying taxes, the net yield is what remains with him after paying the taxes. The
net yield can be calculated as follows:
Net Yield = Gross Yield (1- Tax Rate)
Q. Explain the Operations of Indian Stock Market.
Ans. Meaning of Stock Exchange : Stock exchange means an organized market where
securities issued by companies, government organizations and semi-organisations are sold
and purchased. Securities include:
(i) Shares
(ii) Debentures
(iii) Bonds etc.
Definition of Stock Exchange :
According to Pyle :
Stock Exchange are market places where securities that have been listed thereon,
may be bought and sold for either investment or speculation.
Features of Stock Exchange : The main features of stock exchange are as follows:
(1) Organised Market : Stock Exchange is an organized market. Every stock exchange
has a management committee, which has all the rights related to management and
control of exchange. All the transactions taking place in the stock exchange are done
as per the prescribed procedure under the guidance of management committee.
(2) Dealing in Securities issued by various concerns : Only those securities are
traded in the stock exchanges which are listed there. After fulfilling certain terms and
conditions, a company gets it security listed on stock exchange.
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(3) Dealing only through Authorised Members : Investors can sale and purchase
securities in stock exchange only through authorized members. Stock exchange is a
specified market place where only the authorized members can go. Investor has to
take their help to sale and purchase.
(4) Necessary to obey the Rules and Bye-Laws : While transacting in stock exchange,
it is necessary to obey the rules and bye-laws determined by stock exchange.
Functions of Stock Exchange : The main functions performed b stock exchange are as
follows:
(1) Providing Liquidity and Marketability to existing securities : Stock exchange is a
market place where previously issued securities are traded. Various types of
securities are traded here on regular basis. Whenever required, investor can invest his
money through this market into securities and can reconvert this investment into cash.
(2) Pricing of Securities : A stock exchange provides platform to deal in securities. The
forces of demand and supply work freely in the stock exchange. In this way, prices of
securities are determined.
(3) Safety of Transactions : Stock exchanges are organized markets. The fully protect
the interest of investors. Each stock exchange has its own laws and be-laws. Each
member of stock exchange has to follow them and any member found violating them,
his membership is cancelled.
(4) Contributes to Economic Growth : Stock exchange provides liquidity to securities.
This gives the investor a double benefit-first, the benefit of the change in the market
price of securities and secondly, n case of need for money they can be sold at the
existing market price at any time.
(5) Spreading Equity Cult : Share market collects every types of information in respect
of the listed companies. Generally this information is published or otherwise n case of
need anybody can get it from the stock exchange free of any cost. In this way, the stock
exchange guides the investors by providing various types of information.
(6) Providing Scope for Speculation : When securities are purchased with a view to
getting profit as a result of change in their market price, it s called speculation. It is
allowed or permitted under the provisions of the relevant Act. It is accepted that in
order to provide liquidity to securities, some scope for speculation must be allowed.
The share market provides this facility.
Stock Exchange in India : There are 24 stock exchanges functioning currently in India. The
names are given below:
(1) Mumbai Stock Exchange OR (13) Cochin Stock Exchange
Bombay Stock Exchange-BSE
(2) National Stock Exchange (NSE) (14) Coimbatore Stock Exchange
(3) Over the Counter Exchange of India (OTCEI) (15) Guwahati Stock Exchange
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(4) Calcutta Stock Exchange(CSE)
(5) Delhi Stock Exchange (DSE) (17) Kanpur Stock Exchange
(6) Chennai Stock Exchange (18) Ludhiana Stock Exchange
(7) Ahmedabad Stock Exchange (19) Mangalore Stock Exchange
(8) Hyderabad Stock Exchange (20) Meerut Stock Exchange
(9) Bangalore Stock Exchange (21) Patna Stock Exchange
(10) Indore Stock Exchange (22) Pune Stock Exchange
(11) Baroda Stock Exchange (23) Rajkot Stock Exchange
(12) Bhubaneswar Stock Exchange (24) Capital Stock Exchange
Kerala Ltd.
Q. Define of New Issue Market. Write on functions of new issue market.
Ans. New Issue Market OR Primary Market : New issue market is the segment in which
new issues are made. In the new issue market, new issues may be made in three ways
namely:
(i) Public Issue
(ii) Rights Issue
(iii) Private Issue.
Classification of New Issue Market : The new market can be classified as:
(i) A market where firms go to the public for the first time through initial public offering
(IPO).
(ii) A market where firms which are already trade raise additional capital through
seasoned equity offering (SEO).
Functions of New Issue Market : The main function of new issue market is to facilitate
transfer resources from savers to the users. The savers are individuals, commercial banks,
insurance company etc. the users are public limited companies and the government. The
new issue market plays an important role in mobilizing the funds from the savers and
transferring them to borrowers for production purposes, an important requisite of economic
growth. The main function of new issue market can be divided into three service functions:
(1) Origination
(2) Underwriting
(3) Distribution
(1) Origination : Origination offers to the work of investigation, analysis and processing
of new project proposals. Origination starts before an issue is actually floated in the
market. There are two aspects in these functions:
(i) Technical, Economic and Financial AnalysisH : A careful study of the
technical, economic and financial viability to ensure soundness of the project.
This is a preliminary investigation undertaken b the sponsors of the issue.
(16) Jaipur Stock Exchange
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(ii) Advisory Services : Advisory services which improve the quality of capital
issues and ensure its success. The advisor services include:
Type of issue
Magnitude of issue
Time of floating an issue
Pricing of an issue- whether shares are to be issue at par or at premium
Methods of issue.
Technique of selling securities
The function of origination is carried out by merchant banker, who may be commercial
banks, and Indian financial institutions, or private firms.
(2) Underwriting : Underwriting is an agreement whereby the underwriter promises to
subscribe to a specified number of shares or debentures or a specified amount of
stock in the event of public not subscribing to the issue. If the issue is fully subscribed
then there is no liability for the underwriter. If a part of share issues remains unsold, the
underwriter will buy these shares. Thus underwriting is a guarantee for the
marketability of shares.
Methods of Underwriting : An underwriting agreement may take any of the following
three forms:
(i) Standing behind the issue: Under this method, the underwriter guarantees
the sale of a specified number of shares within a specified period. If the public do
not subscribe to the specified amount of issue, the underwriter buys the balance
in the issue.
(ii) Consortium Method: Underwriter is jointly done by a group of underwriters in
this method. This method is adopted for large issue.
Advantages of Underwriting : Underwriting assumes great significance as it offers the
following advantages to the issuing company:
(i) The issuing company is relied from the risk of finding buyers for the issue offered
to the public. The company is assured of raising adequate capital
(ii) The company is assured of getting minimum subscription within the stipulated
time, a statutory time, and statutory obligation to be fulfilled by the issuing
company.
(iii) Underwriters undertake the burden of highly specialized function of distributing
securities.
(iv) Provide expect advice with regard to timing of security issue, the pricing of issue,
the size and type of securities to be issued etc.
(v) Public confidence on the issue enhances when underwritten by reputed
underwriter.
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Underwriter in India : The underwriters in India may be classified into two categories:
(i) Institutional Underwriters:
Life Insurance Corporation of India (LIC)
Unit Trust of India (UTI)
Industrial Development Bank of India (IDBI)
Industrial Credit and Investment Corporation of India (ICICI)
Commercial Banks and general insurance companies.
(ii) Non-Institutional Underwriters
(3) Distribution : Distribution is the function of sale of securities to ultimate investors,
Brokers and agents, who maintain regular and direct contact with the ultimate
investors, perform this service.
Q. Define New Issue Market. What are the methods of floating new issues? Explain
in detail.
Ans : New Issue Market OR Primary Market : New issue market is the segment in which
new issues are made.
Classification of New Issue Market : The new market can be classified as:
(i) A market where firms go to the public for the first time through initial public offering
(IPO).
(ii) A market where firms which are already trade raise additional capital through
seasoned equity offering (SEO).
Methods of Floating New Issues : The various methods which are used in the floating of
securities in the new issue market are:
(1) Public Issues : Under this method, the issuing company directly offers to the general
public/institutions a fixed number of shares at a stated price through a document
called prospects. This is the most common method followed by join stock companies
to raise capital through the issues of securities. The following information are given in
the prospectus:
(i) Name of the Company
(ii) Address of the registered office of the company
(iii) Existing and proposed activities
(iv) Location of the industry
(v) Name of Directors
(vi) Authorized and proposed issue capita to the public
(vii) Dates of opening and closing the subscription list
(viii) Minimum Subscription
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(ix) Names of brokers/underwriter/bankers/managers and registrars to the issue.
(x) A statement b the company that it will apply to stock exchange for quotations of
its shares.
According to the Companies Act, 1956 every application form must be accompanies
by a prospectus.
(2) Offer of Sale: The method of offer of sale consists in outright sale of securities through
the intermediary of issue houses or share brokers. In other words, the shares are not
offered to the public directly. This methods consists of two stages:
(i) The first stage is a direct sale by the issuing company to the issue house and
brokers at an agreed price.
(ii) In the second stage, the intermediaries resell the above securities to the
ultimate investors. The issue houses or stockbrokers purchase the securities at
a negotiated price and resell at a higher price. The difference between in the
purchase and sale price is called turn or spread.
Advantages : One chief advantage of this method is that the company is relieved from
the problem of printing and advertisement of prospectus and making allotment of
share. Offer of sale is not common in India.
(3) Placement : Under this method, the issue houses or brokers buy the securities
outright with the intention of placing them with their clients afterwards. Here, the
brokers act as almost wholesaler selling them in retail to the public. The brokers would
make profit in the process of reselling to the public. The issue houses or brokers
maintain their own list of client and through customer contact sell the securities.
Advantages : Placement has the following advantage:
(i) Timing of issue is important for successful floatation of shares. In a depressed
market conditions when the issues are not likely to draw public response though
prospectus, placement method is a useful method of floatation of shares.
(ii) This method is suitable when small companies issue their shares.
(4) Right Issues : If an existing company intends to raise additional funds, it can do so by
borrowing or b issuing new shares. One of the most common methods for a public
company to use is to offer existing shareholder the opportunity to subscribe further
shares. This mode of finance is called Right Issues. The existing shareholders have
right ot entitlement of further shares in proportion to their existing shareholding. The
rights of entitlement of a shareholder, who does not want to buy the right share, can be
sold to someone else.
Number of outstanding shares
N = -
Number of new shares to be offered
Where N= Number of rights needed to buy one new share
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Provisions regarding Right Issues : Section 81 of the Companies Act, 1956 deals with the
provisions relating to rights issues:
Any company
(i) Which has completed two years after its incorporation or
(ii) Which has completed one year from the first allotment of shares after its
incorporation
Whichever is earlier, if it proposes to increase its subscribed capital by allotment of
further shares, then the subsequent provisions shall apply.
Those further shares shall be first be offered to the existing shareholder in proportion
to the shares held by them in the paid up capital, on the date of such offer.
At least 15 days notice shall be given from the date of offer. The notice shall specify the
number of shares offered and the limiting time of the offer.
The notice shall mention that if the offer is not accepted within the time of offer, will be
deemed to have been declined.
Advantages of Right Issue :
(i) To Companies : The company benefits from lower issue costs, in that administration
and underwriting costs are lower and the issue is made at the discretion of the
directors rather than via a general meeting of the company.
(ii) To the Shareholders : The main attraction of the rights issue for current shareholders
is that they are able to maintain their original proportion of share ownership.
Q. What do you mean listing of securities? Explain.
Ans. Listing of Securities : Listing means admission of the securities to dealings on a
recognized stock exchange. The securities of any public limited company, central or state
government, quasi government and other financial institutions/corporations, municipalities,
etc.
When listing is granted to a company, it means that the securities are included in the official
list of the stock exchange for the purpose of trading. Security listing ensures that a company
is solvent and its existence is legal. Government security is not required to be listed.
Objectives of Listing : The objectives of listing are mainly to:
(i) Provide liquidity to securities.
(ii) Mobilize savings for economic growth.
(iii) Protect interest of investors by ensuring full disclosures.
Advantages of Listing on Stock Exchange :
(i) Detailed information about the company is available.
(ii) Information increases the activity of purchase and sale of the security of that
organization.
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(iii) Continuous dealing raises the value of security.
(iv) Convenience of sale of security, lending liquidity to the shares.
(v) There is safety in dealing.
(vi) It ensures creditworthiness.
(vii) Widens the market of the security.
Rules for Listing of Securities : The following statutory rules have been laid down for the
listing of securities under SEBI. A company requiring a quotation for its shares must apply in
the prescribed form supported b the documentary evidence given below:
(1) Documents to be Attached :
(i) Copies of Memorandum and Articles of Association, Prospectus or Statement in
lieu of Prospectus, Directors reports, Balance Sheets and Agreement with
Underwriters etc.
(ii) Specimen copies of share and debentures Certificates, letter of allotment, etc.
(iii) Particulars regarding its capital structure.
(iv) A statement showing the distribution of shares.
(v) Particulars of dividends and cash bonuses during the last ten years.
(vi) A brief history of the companys activities since its incorporation.
(2) Criteria for Listing : The stock exchange has to direct special attention to the
following particulars while scrutinising the application:
(i) Articles:
(a) Whether the Articles contain the following provisions:
A common form of transfer shall be used.
Fully paid shares will be free from lien
Calls paid in advance may carry interest, but shall not confer aw right to
dividend.
Unclaimed dividends shall not be forfeited before the claim becomes time
barred.
(b) Whether at least 49% of each class of securities issued was offered to the public
for subscription through newspapers for not less than three years.
(c) Whether the company is of a fair size, has a broad-based capital structure and
there is sufficient public interest in its securities.
(3) Listing of Agreement : After scrutiny of the application, the stock exchange
authorities may, if they are satisfied call upon the company to execute a listing
agreement, which contains the obligations and restrictions which listing will entail.
This agreement contains 39 clauses with a number of sub-clauses. These covers
various aspects of :
(i) Issue of letters of allotment
(ii) Share Certificates
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(iii) Transfer if Shares
(iv) Information to be given to the stock exchanges regarding closure of register of
members for the purpose of payment of dividend
(v) Issue of bonus and right shares and convertible debentures
(vi) Holding of meeting of the board of directors for recommendation or declaration
of dividend or issue of rights, bonus shares or convertible debentures
(vii) Submission of copies of directors report
(viii) Submission of copies of annual accounts.
(ix) Submission of other notices
(x) Resolution and so on to the shareholders.
A company enlisting the securities of a company for the purpose of trading insists that all
applicants for shares will be treated with equal fairness in the matter of allotment. Infact, in
the event of over-subscription, the stock exchange will advise the company regarding the
basis for allotment of shares. It will try to ensure that applicants for large blocks of shares are
not given undue preference over others.
Q. What are the main features of OTCEI? Explain the trading process of OTCEI.
Ans. Over the Counter Exchange of India (OTCEI): The OTCEI is a completely
computerized and special ringless stock exchange which is different from the traditional
stock exchange and on which the buying and selling of securities is absolutely transparent
and moves at a great speed. Its counters are spread all over the country where transactions
are made with the help of telephone.
The OTCEI was established under section 25 of the Companies Act, 1956 in October, 1990.
The promoters of the OTCEI are the following financial and other institutions:
The Unit Trust of India
The Industrial Credit and Investment Corporation of India.
The Industrial Development Bank of India
The Industrial Finance Corporation of India
The Life Insurance Corporation of India
The General Insurance Corporation of India
The SBI Capital Market Limited
The Canbank Financial Services Limited.
Features or Nature of OTCEI : The main features of the OTCEI are the following:
(1) Ringless Trading : There s no particular place for transacting business in securities
under the OTCEI. This exchange has its counters/offices throughout the country. Any
buyer or seller of securities can go the counter/officer and have transaction through
the medium of the operator.
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(2) Nation Network : The OTCEI has its network all over the country. All the counters are
linked with the central terminal through the medium of computers. Therefore, the
facility of nationwide listing is available here. In other words by listing on one
exchange, one can have transactions with all the counters in the whole country.
(3) Exclusive List of Companies : On the OTCEI only those companies are listed whose
issued capital is 30 lakhs or more. In the old share markets this amount used to be ten
crores on the BSE and three crores on the other exchanges and hence, listing was not
possible in case the issued capital was less than three crores. Those companies
which have been listed on the old share markets cannot be listed on the OTCEI.
(4) Fully Computerised : This exchange is fully computerized. It means that all the
transactions done on this exchange are done through the medium of computers.
(5) Sponsorship : In order to get listed on the OTCEI, a company has to find a member to
sponsor it. The main job of a sponsor is market making. T means a sponsor has to be
read to buy or sell the shares of that company at least for a period of 18 months. In this
way, a sponsor creates liquidity in securities.
(6) Investors Registration : All the investors doing transactions on the OTCEI have got
to register themselves compulsorily. Registration can be got done b giving an
application at an counter. The registration is called the INVESTOTC CARD. On the
basis of this card, one can do transactions of securities at any counter throughout the
country.
(7) Greater Liquidity : There is greater liquidity in securities because of the sponsors job
of market making.
(8) Transparency in Transactions : All the transactions are done in the presence of the
investor. The rates of buying and selling can be seen on the computer screen. The
operator cannot do any fraud or mischief with the transactions.
(9) Faster Delivery and Payment : On the OTCEI, delivery in case of buying and
payment in case of selling are both very fast. The work of delivery and payment in case
of listed securities and permitted securities is completed within seven days and 15
days respectively.
(10) Two ways of Public Offer : A company listed on the OTCEI can issue security n two
was. Firstly, the company can go directly to the public. This is called Direct Offer
System. Secondly, the company sells its securities to the sponsor at a particular price.
Then the sponsor sells them to the public. This is called Indirect Offer System.
(11) Easy Access : In the big cities the counters of the OTCEI can be seen like ordinary
shops. Any body can go the counter and do buying and selling of securities.
Trading Process : One can trade in securities b going to any counter of the OTCEI. All the
counters are linked with the central computer at the OTCEI headquarter. This office is in
Mumbai. There can be three types of trading on the OTCEI:
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(1) Initial Allotment : When an investor is allotted shares through the medium of OTCEI,
he is given a receipt which is called counter receipt-CR. This receipt is just like the
share certificate. Selling and buying can be done through the medium of this receipt.
(2) Buying in the Secondary Market : For the purpose of buying shares listed on the
OTCEI, a person has to get himself registered (if he is not already registered). After
this, he informs the counter operator about the number of the shares to be purchased.
The counter operator displays the rates on the screen. After getting himself satisfied
with the rate, the investor hands over the cheque to the operator. On the encashment
of the cheque, the CR is handed over to the investor. This procedure takes about a
week.
(3) Selling in the Secondary Market : An investor who has purchased shares from the
OTCEI can sell his shares at any counter of the OTCEI. After getting himself satisfied
with the rate displayed on the screen, the investor hands over the Counter Receipt and
the Transfer Deed to the Operator. The operator prepares the Sales Confirmation Slip
(SCS) and a copy of it is handed over to the seller. The operator sends the CR, TD and
SCS to the Registrar for confirmation. After confirming every detail the Registrar sends
them back to the counter operator. In the end the operator issues a cheque to the seller
and receives back the SCS from the seller.
Purposes of OTCEI : The objects of the establishment of the OTCEI may be described as
under:
(1) Liquidity : The first object for the establishment of the OTCEI is o maintain liquidity in
the securities of the small companies. The sponsor has got to do the job of market
making.
(2) Transparency : The second aim of this share market is to maintain transparency of
transactions. Here all the transactions are made on the computer screen. This
eliminates any chance of fraud.
(3) Investors Grievances : An important aim of the establishment of the OTCEI is the
speed solution of the problems of the investors.
(4) Quick Settlement : In the traditional share markets both the delivery and payment
take time. This problem has been overcome with the help of the OTCEI.
(5) Listing of Small Companies : Small companies remain deprived of being listed
because they are unable to fulfil the conditions laid down by the old share markets.
(6) Access : This stock exchange is of the ringless type and therefore, has its counters all
over the country.
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UNIT II
Q. Explain the Mechanics of security trading in Stock Exchange
OR
Q. Explain the mechanics of Investing in Securities.
Ans. Introduction : An investor must have some knowledge of how the securities markets
operate. The marketing of old or new securities on the stock markets can be done only
through members of the Stock Exchange. These members are either individuals or
partnership firms. An individual; must use the facilities of these members for trading
insecurities unless he himself is a registered dealer or member of an organized stock
exchange. Trading among the members of a recognized stock exchange is to be done under
the statutory regulations of the stock exchange. The members carrying on business are
known as brokers and can trade only on listed securities. These members execute
customers orders to buy and sell on the exchange and their firms receive negotiated
commissions on those transactions.
Process of Investing in Securities : There are the following steps involved in the process
of investing in securities:
(1) Finding a Broker: The selection of a broker depends largely on the kind of services
rendered by a particular broker as well as upon the kind of transaction that a person
wishes to undertake. An individual usually prefers to select a broker who can render
the following services:
(i) Provide information
(ii) Availability of Investment literature.
(iii) Appoint competent representatives
(2) Selection of Brokers : There are following types of brokers:
(i) Commission Broker : All brokers buy and sell securities for earning a
commission. From the investors point of view, he is the most important member
of the exchange because his main function and responsibility is to buy and sell
stock for his customers. He acts as an agent for his customer and earns a
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commission for the service performed. He is independent dealer in securities.
He purchases and sells securities in his own name. He is not allowed to deal with
the non-members. He can either deal with a broker or another jobber.
(ii) Floor Broker : Floor brokers are not many in number. They execute orders for
fellow members and receive a share brokerage commission charged by a
commission broker to his/her constituent. He helps other brokers when they are
busy.
(iii) Tarniwala : He/she is a jobber or specialist in selected shares. He/she makes
the market i.e. provide continuity to dealings. They specialize in stocks which
are traded inactively.
(iv) Dealer in Non-cleared Securities : He/she deals in securities that are not on
the active list.
(v) Odd-lot Dealer : He/she specializes in buying and selling in amounts that are
less than present trading units. They buy and sell odd lots, make them up into
marketable trading units. These dealers receive commission. The odd-lot dealer
has become an important operator since the growth of new issues.
(vi) Budiwalas : He/she specializes in buying and selling simultaneously in different
markets. The difference between the buying prices in other markets constitutes
his profit.
(vii) Security Dealer : This dealer specializes in trading in government securities.
He/she many acts as a jobber and takes risks inherent in ready purchase and
sale of securities. They maintain daily contacts with the Reserve Bank of India
as well as commercial banks and other financial institutions.
(3) Opening an Account with Broker : After a broker has been selected, the investor
has to place an order on the broker. The broker will open an account n the name of the
investor in his books. He will also ask the investor for a small sum of money called
margin money advance. In case, the investor wishes to sell his securities, he will have
to deposit with the broker share certificates and transfer deeds. He will also have to
sign in the transferors column on the transfer deed. The physical preference of share
certificates is not required any more in India if shares have been through the demat
process.
(4) Order: Brokers receive a number of different types of buying and selling orders from
their customers. Brokerage orders very as to the price at which the order may be filled,
the time for which the order is valid, and contingencies which affect the order. The
customers specifications are strictly followed. The broker is responsible for getting the
best price for his customer at the time of the order is placed.
(5) Exercising Choice of Orders : Types of orders are:
(i) Spot Delivery : Spot delivery means delivery and payment on the same day as
the date of the contract or on the next day.
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(ii) Hand Delivery : Hand delivery is the transaction involving delivery and payment
within the time of the contract or on the date stipulated when entering into the
bargain, which time or date is usually not more than 14 days following the date of
the contract.
(iii) Special Delivery : Special deliver is the delivery and payment exceeding 14
days.
(iv) Market Orders : Market orders are instruction to a broker to buy or sell at the
best price immediately available. Market orders are commonly used when
trading in active stocks or when a desire to buy or sell is urgent.
(6) Giving Margin Money to Broker : Marin is the amount of money provided by
customer to the brokers who have agreed to trade their securities. It may also be called
a provision to absorb any probable loss when a customer bus on margin, the customer
pays only part of the margin, the broker lend the remainder.
(7) Execution of order in the Stock Exchange : When the broker receives the margin
money and is clear about the order received by him, he puts the details n the order
book. The broker in the beginning of his career makes the deal himself. Once his
business grows, he employs clerks to transact his orders.
(8) Preparing Contract Note in the Stock Exchange : The clerk takes the details of the
days transaction to the broker at the end of the working day. The broker scrutinizes all
transactions of the day and prepares a contract note and signs it on a prescribed form.
The contract note gives the details of the contract for the purchase or sale of securities.
It records the number of shares, rate and date of purchase or sale.
(9) Settlement of Contracts : The last step is the settlement of the contract by the broker
for his client. The procedure for settlement is to be made for (a) ready delivery
contracts and (b) for forward delivery contracts.
(i) Ready Delivery Contracts : A ready delivery contract s to be settled within
three days in Kolkata Stock Exchange and 7 days at the Mumbai and Chennai
Stock Exchange. A read delivery contract is also called a spot contract. The
settlement under this contract can be made on the same day or during the
maximum period of 7 days and there can be no extension or postponement of
the time of settlement.
(ii) Forward Delivery Contracts : Forward dealings can be made n stock
exchange only n those securities which are placed on the forward list by an
exchange. Forward delivery contracts are done with the object of making profit.
These forward delivery contracts are settled on a fixed settlement day occurring
at fortnightly intervals. The date of transaction can be postponed.
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Q. Write a brief note on different types of brokers.
Ans. Broker : Stock broker means a member of a stock exchange. Trading on stock
exchanges is carried out through brokers and dealers. All members can act as brokers and
for this purpose the have to maintain security deposits. Brokers act as agents buying and
selling or other for which they receive brokerage commission at stipulated rates. Dealers act
as principals and sell securities on ther own accounts.
Types of Brokers : Types of brokers are:
(1) Commission Broker : All brokers buy and sell securities for earning a commission.
From the investors point of view, he is the most important member of the exchange
because his main function and responsibility is to buy and sell stock for his customers.
He acts as an agent for his customer and earns a commission for the service
performed. He is independent dealer in securities. He purchases and sells securities
in his own name. He is not allowed to deal with the non-members. He can either deal
with a broker or another jobber.
(2) Floor Broker : Floor brokers are not many in number. They execute orders for fellow
members and receive a share brokerage commission charged by a commission
broker to his/her constituent. He helps other brokers when they are busy and as
compensation, receives a portion of the brokerage charged by the commission agent
to his customer.
(3) Tarniwala : He/she is a jobber or specialist in selected shares. He makes an orderly
and continuous auction in the market n the stock n which he specializes He/she makes
the market i.e. provide continuity to dealings. They specialize in stocks which are
traded inactively.
(4) Dealer in Non-cleared Securities : He/she deals in securities that are not on the
active list.
(5) Odd-lot Dealer : He/she specializes in buying and selling in amounts that are less
than present trading units. They buy and sell odd lots, make them up into marketable
trading units. These dealers receive commission. The odd-lot dealer has become an
important operator since the growth of new issues.
(6) Budiwalas : He/she specializes in buying and selling simultaneously in different
markets. The difference between the buying prices in other markets constitutes his
profit.
(7) Security Dealer : This dealer specializes in trading in government securities. The
purchase and sale of government securities is carried on the stock exchange by
Security Dealers. He/she many acts as a jobber and takes risks inherent in ready
purchase and sale of securities. They maintain daily contacts with the Reserve Bank
of India as well as commercial banks and other financial institutions. Dealings in
government securities are transacted between 12 p.m. and 3 p.m. on the Bombay
Stock Exchange.
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Q. Write a note on Investment Companies.
Ans. Meaning of Investment Companies : Investment companies are firms that invite
individual investors to subscribe to their capital, combine the capital thus collected into a
common pool of investible resources and then seek to accomplish the investment objectives
of the investors by investing these resources in an appropriate portfolio of securities.
Investment companies may have a number of different schemes catering to the specific
investment objectives of different classes of investors.
Portfolio Management Process in Investment Companies : Portfolio management in
investment companies is a four stage process comprising the following stages:
Stage 1 : Identifying the objectives, and level of risk acceptable to, the target group of
investors and setting goals and objectives for the scheme so as to meet the
objectives of this target group of investors.
Stage 2 : Evaluating individual securities with respect to their risk-return characteristics.
Stage 3 : Identifying the set of efficient portfolios and selecting an optimal (with respect to
the expectations of the target group of investors) portfolio out of this set of
efficient portfolios.
Stage 4 : Reviewing the portfolio on a continuous basis and reforming it as and when
required.
Investment Companies in India : By our definition of investment companies, we can
identify quite a large number of investment companies in India. The Investment Companies
in India are:
(1) Unit Trust of India (UTI) : The UTI was established in 1964 with the objective of
making available the benefits of industrial growth to small savers. The UT collects
investible resources from investors through the sale of securities called units. These
funds arte then invested by UTI in various financial assets. Holders of units received
dividends from UTI. Since its inception, UTI has offered various schemes to cater to
the need of different classes of nvestors. Most of these schemes are:
(i) Income Oriented Schemes : These funds offer a return much higher than the
bank deposits but with less capital appreciation. The emphasis being on regular
returns, the pattern of investment in general is oriented towards fixed income
yielding securities like non-convertible debentures of consistently good
dividend paying companies, etc.
Example : Income-Oriented Scheme issued by UTI:
Units Scheme of 1964
Growing Income Unit Scheme of 1987
(ii) Growth Oriented Schemes : These funds do not offer fixed regular returns but
provide substantial capital appreciation in the long run. The pattern of
investment in general is oriented towards shares of high growth companies.
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Example: Growth-Oriented Scheme issued b UTI:
Master Share
Master Share Plus
Master Gain
UGS-200
(iii) Open-Ended Scheme : In open-ended funds, there is no limit to the size of the
funds. Investors can invest as and when the like.
(iv) Close-ended Scheme : These funds are fixed in size as regards the corpus of
the fund and the number of shares. In close-ended funds, no fresh units are
created after the original offer of the scheme, expires.
(v) Tax Planning Schemes : The investments made under these schemes are
deductible from the taxable income up to certain limits, thus providing
substantial tax relief to the investors.
Example: Tax planning schemes issued by UTI is Unit Linked Insurance Plan of
UTI.
(2) Mutual Funds of Commercial Banks (MFS) : Since 1987, the nationalized
commercial banks like the Canara Bank, State Bank of India, Indian Bank etc. have
been floating mutual fund schemes. Over the ears, the merchant banking subsidiaries
of these banks have been offering numerous schemes catering to the investment
needs of a wide variety of investors. There are various schemes issued by
Commercial Banks such as :
(i) Open-ended schemes
(ii) Close-ended schemes
(iii) Income-oriented Schemes : Example of Income-oriented schemes are:
Magnum Monthly Income Schemes SBI Mutual Fund
Rising Monthly Income Schemes BOI Mutual Fund
Swarna Pushpa Indbank Mutual Fund
PNBRIPS PNB Mutual Fund
(iv) Growth Oriented Schemes : Example of Growth Schemes are:
(a) Magnum Express, Magnum Multiplier SBI Mutual Fund
(b) Cabshare, Canstar Cap, Cangrowth, Canbonus Canbank Mutual Fund.
(c) Ind Ratna, Ind Sagar, Ind Moti Indbank Mutual Fund
(v) Growth and Income Funds : Example of Growth and Income Funds are:
Canstock, Can Double Canbank Mutual Fund
PNB Premium Plus-91 PNB Mutual Fund
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(vi) Tax Planning Schemes : Example of tax planning schemes are:
PNB ESS PNB Mutual Fund
MELS-91 SBI Mutual Fund
Ind Shelter Indbank Mutual Fund
(vii) Schemes targeted at small individual investors, large individual investors and
corporate investors.
(3) Life Insurance Corporation (LIC) : The premium collected by the LIC from its
insurance policy holders is administered b LIC and invested in the capital markets. LIC
has been one of the largest players in the stock market of India. Of late, it has started
floating specific investment schemes targeted at different investors groups, which
provide both an insurance cover and a share in the returns from the investments made
by LIC. Schemes issued by LIC are:
Tax Planning Schemes : Tax planning Scheme issued by LIC:
Schemes of LIC Mutual Fund : These offer some or all of the following
benefits:
(a) Life Insurance Cover
(b) Accident Insurance Cover
(c) Safety of Capital
(d) Reasonable Capital Appreciation
(e) Units are not transferable, but bank loan facility is available
(f) Tax exemption on dividends
Q. Define Market Indices. How are stock market indices useful?
Ans. Indices : An index is used to provide information about the price movements of
products in the financial, commodities or any other markets. Financial indices are
constructed to measure price movements of stocks, bonds, T-bills and other forms of
investments. Stock market indices are meant to capture the overall behaviour of equity
markets. A stock market index is created by selecting a group of stocks that are
representative of the whole market or a specified sector or segment of the market. An index
is calculated with reference to a base period and a base index value.
Usefulness of Stock Market Indices : Stock market indices are useful for a variety of
reasons. Some of them are:
(1) Historical Comparison of Returns : The provide a historical comparison of returns
on money invested n the stock market against other forms of investments such as gold
or debt.
(2) Comparison of Performance of Equity Fund : They can be used as a standard
against which to compare the performance of an equity fund.
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(3) Indicator of the Performance of the Overall Economy : It is a lead indicator of the
performance of the overall economy or a sector of the economy.
(4) Up to date Information : Stock indexes reflect highly up to date information.
(5) Important role in Financial Investment and Risk Management : Modern financial
applications such as Index Funds, index Futures, index Options play an important role
in financial investments and risk management.
The stock market index captures the behaviour of the overall market. The ups and downs of
an index reflect the changing expectations of the stock market about future dividends of the
corporate sector. When the index goes up, it is because the stock market thinks that the
prospective returns in the future will be better than previously anticipated. When the
prospects of dividends in the future become pessimistic, the index drops. Every stock price
moves for two possible reasons :
(a) News about the company e.g. a product launch, closure of the factory etc.
(b) News about the country e.g. budget announcement etc.
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UNIT III
Q. Define Investment. Write a brief note on investment avenues OR Investment
Alternatives.
Ans. Meaning of Investment : Investment involves making of a sacrifice in the present with
the hope of deriving future benefits. Investment has many meanings and facets. The two
most important features of an investment are current sacrifice and future benefit.
We can now give a simple yet a broad definition of investment. We can define investment as
postponed consumption.
When you postpone consumption, sacrifice takes place n the present and is certain whereas
the benefits occur n future and are uncertain. Therefore, risk and expected return from the
investment are the two key determinants of investment process.
Investment Alternatives/Investment Avenues : Two basic investment avenues are:
(A) Investment in Financial Assets (B) Investment in Physical Assets
Further classification of Investment can be presented with the help of following diagram
Investment Alternatives
Investment in Investment in
Financial Assets Physical Assets
Securitized Non-Securitized Gold, Real
Investment Investment Silver, Estate
Fixed Income Preference Shares
Equity Bond
Money Market Instruments Government Securities
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Bank Deposit Diamond etc.
Post office Scheme
Small Saving Certificate
Mutual Funds
Others
(A) Investment in Financial Assets : Investment in financial assets consists of:
(1) Securitized Investment
(2) Non-Securitized Investment
(1) Securitized Investment : The term securities is used in the broadest sense,
consisting of those papers that are quoted and are transferable. Securitized
investment are divided into three categories:
(a) Fixed Income Securities : In fixed income securities we include those
securities on which rate of return are fixed. Fixed income securities includes:
(i) Preference Shares : Preference shares are a hybrid security. They have
some features of bonds and some of equity shares. Preference dividends
are specified like bonds. This has to be done because they rank prior to
equity share for dividends. Preference shares are less risky than equity
because their dividends are specified and all arrears must paid before
equity holders get dividends. They are, however, more risky than bonds
because the latter earn priority in payment and liquidation.
(ii) Bonds : Bond 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.
(iii) Government Securities : Government securities or gilts are sovereign
securities, which are issued by the Reserve Bank of India (RBI) on behalf
of the Government of India (GOI). The GOI uses these funds to meet its
expenditure commitments.
Dated Securities : These securities generally carry a fixed interest
rate and have a fixed maturity period.
Zero Coupon Bonds : These securities are issued at discount to
the face value and redeemed at the par i.e. they are issued at below
face value and redeemed at face value.
Partly Paid Stock : In these securities, the payment of principal is
made in installment over a given period of time.
Floating Rate Bonds : These types of securities have a variable
interest rate, which is calculated as a fixed percentage over a
benchmark rate.
Capital Indexed Bonds:These securities carry an interest rate,
which is calculated as a fixed percentage over the wholesale price
index.
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(b) Equity : On equity shares, there is no fixed rate of dividend. First of all dividends
are paid on preference share, after that dividend is paid on equity shares. Equity
share are more risky in comparison to bonds and preference shares.
(c) Money Market Instruments : A money market is the market in which short-term
funds are borrowed and lent. The money market does not deal in cash or money
but in trade bills, promissory notes and government papers, which are drawn for
short periods. These short-term bills are known as near money.
Types of Money Market Instruments : The major short-term credit instruments
dealt with in a money market include:
Trade Bills : These are bills exchange arising out of bona fide commercial
transactions. They include both inland bills and foreign bills.
Bankers Acceptance : These are bills of exchange accepted b
commercial banks on behalf of their customers. The fact that a bank of
repute accepts a bill increases its creditworthiness, which, in turn, means
that t can easily be discounted.
Short-dated Government Securities : These are securities issued by
the government for short periods. Long-term government securities that
are nearing maturity are also sometimes included in this category.
Commercial Papers : These are short-term unsecured securities issued
b highly creditworthy large companies. Commercial papers are regulated
by RBI.
Zero Coupon Bonds : These securities are issued at discount to the face
value and redeemed at the par i.e. they are issued at below face value and
redeemed at face value.
(2) Non-Securitized Investments : In India, the household sectors investment in non-
security forms constitutes a major proportion of its total investment in financial assets.
There are a large number of non-security forms of financial assets that are available to
investors in India. Most of the investments are illiquid but are generally accepted as
good collateral for borrowing from banks.
Bank Deposit
Post office Scheme
Small Saving Certificate
Mutual Funds
Others
(B) Investment in Physical Assets : Another popular investment avenue is the
investment in physical assets such as
(1) Gold (2) Silver
(3) Diamonds (4) Real Estate : In real estate assets we include:
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Residential House
Source of Housing Finance
Features of Housing Finance
Guidelines for buying a flat
Commercial Property.
Agricultural Land.
Suburban Land
Time share in a holiday resort
Unimproved Land
Improved real Estate
New and used residential property
Vacation homes
Other Income-Producing real estate such as:
Office Buildings
Shopping Centres
Industrial or Commercial Properties.
Q. What are the various models of valuation of fixed income securities?
Ans. Fixed Income Securities : Fixed income securities 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.
Therefore, their primary role in an investment portfolio is to provide continuity of income
under all reasonably conceivable conditions.
Valuation of Fixed Income Securities : For the purpose of valuation we include the
following two securities:
1) Valuation of Bond :
Meaning of Bond : A Bond contains a promise to pa a stated rate of interest for a defined
period and then to repay the principal at a given date of maturity.
Bond Features :
Maturities : Maturities vary widely. Bonds are usually grouped by their maturity
classes.
Interest Payments : Bond interest is usually paid sem-annually, though annual
payments are also popular.
Types of Bonds :
Convertible Bonds
Non-Convertible Bonds
Income Bonds
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Redeemable Bonds
Irredeemable Bonds
Participating Bonds
Secured Bonds
Bond Valuation : Debt securities issued by governments, government and quasi-
govrnment organizations, and private business firms are fixed income securities. Bonds and
debentures are the most common examples.
The intrinsic value of bond or debenture is equal to the present value of its expected cash
flows. The coupon interest payment, and the principal repayment are known and the
present value is determined by discounting these future payments from the issuer at an
appropriate discount rate.
Preference Shares
Formula : The usual present value calculation are made with the help of the following
equation:
n C C
PV = S +
t = 1 (1+r)t (1+r) n
Where PV = Present value of the security today
C = Coupon or interest payment pr time periodt
R = Appropriate discount rate
N = number of years to maturity
Example :
Consider a Rs. 1000 bond issued with a maturity of five years at par to yield 10%. Nterest s
paid annually and the bond is newly issued.
Solution:
The value of the bond would be as follows:
100 100 100 100 100
PV = + + + +
1 2 3 4 5

(1+.10) (1+.10) (1+.10) (1+.10) (1+.10)
= 100 x .90.91 + 100 x .8264 + 100 x .7513 + 100 x .6830 + 100 x .6209
= 90.91 + 82.6 + 75.13 + 68.30 + 682.99
= 999.97 or approx.
Estimating returns on Fixed Income Securities:
Stated (coupon) interest per year
Current Yield =
Current market price
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Example : 15% Rs. 200 debenture is currently selling for Rs. 220, the annual current yield
would be :
30
Current Yield = = 13.64%
220
2) Valuation of Preference Shares :
Meaning of Preference Shares : Preference shares are a hybrid security. They have some
features of bonds and some of equity shares. Preference dividends are specified like bonds.
This has to be done because they rank prior to equity share for dividends. Preference shares
are less risky than equity because their dividends are specified and all arrears must paid
before equity holders get dividends. They are, however, more risky than bonds because the
latter earn priority in payment and liquidation.
Valuation Formula : The intrinsic value of shares will be estimated from the following
equation:
D
VP =
Kps
VP = Value of Preference Share
D = Dividend
Kps = Required rate of return
Example : What s the value of a preference share where the dividend rate is 18% on a Rs.
100 par value. The appropriate discount rate for a stock of this risk level is 15%.
Solution :
18
VP = = 120
0.15
Q. What are the various models of valuation of variable income securities?
Ans. Variable Income Securities : Variable income securities are those on which rate of
return is not fixed. In variable income securities we include equity shares because return on
equity shares is depend on the volume of profitability after taxes. If profits are more, then
more dividend is paid on equity and vice-versa.
Equity Valuation Model : The actual models of equity valuation are:
(1) Dividend Valuation Model : A difficult problem in using the dividend valuation model
is the timing of cash flows from dividends. Since equity shares have no finite measure,
the investor must forecast all future dividends. This might imply a forecast of intently
long stream of dividends. Clearly, this would be almost impossible. An therefore, in
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order to manage the problem, assumptions are made with regard to the future growth
of the dividend of the immediately previous period available at the time the investor
wants to determine the intrinsic value of his/her equity shares. The assumptions can
be:
(i) Dividends do not grow in future i.e., the constant or zero growth assumption.
(ii) Dividends grow at a constant rate in future i.e., the constant assumption.
The dividend valuation model is now discussed with these assumptions:
(a) The Zero-growth Case : In zero-growth case, the formula will be:
D1
V =
K
V = Value of Share
D 1 = Dividend per share
K = Required rate of return
Example : Assume that the dividend per share is estimated to be Rs. 4.00 per year
indefinitely and the investor requires a 20% of return.
4
V = - = Rs. 20
0.20
(b) Constant Growth Case : When dividends grow in all future periods at a uniform rate
g, the formula will be :
D1
V =
K-g
V = Value of Share
g = Growth Rate
Example : A ltd. Paid a dividend of Rs. 2.00 per share for the year ending March 31, 1991. A
constant growth of 10% income has been forecast for an indefinite future period. Investors
required rate of return has been estimated to 15%. You want to buy the share at a market
price quoted on July1, 1991 in the stock market at Rs. 60.00. What would be our decision?
Solution : This is a case of constant growth rate situation. The above equation can be used
to find out the intrinsic value of the equity share as under:
D1 2(1.10) 2.20
V = - = = = Rs. 44.00
K-g 0.15-0.10 0.05
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The intrinsic value of Rs. 44 is less than the market price of Rs. 60.00. Hence, the share is
overvalued and you should not buy.
(2) Models Based on Price Ratio Analysis : According to this method, the price of an
equit share is calculated by the following formula:
P = EPS X P/E ratio
The P/E ratio is an important ratio frequently used by analyst in determining the value of an
equity share. It is frequently reported in the financial press and widely quoted in the
investment community.
This approach seems quite straight and simple. There are, however important problems
with respect calculation of both P/E ratio and EPS. Pertinent question often asked are:
(i) How to calculate the P/E ratio?
(ii) What is the normal P/E ratio?
(iii) What determines P/E ratio?
(iv) How to relate company P/E?
Decision Rule :
(i) Higher the P/E ratio, other things remaining the same, higher would be the value of an
equity share.
(ii) Lower the P/E ratio, other things remaining the same, lower would be the value of an
equity share.
Q. Explain the Risk-Return Trade-Off.
OR
Q. Explain the Risk-Return Relationship in Investment Decision.
Ans. Meaning of Risk : Risk can be defined as the probability that the expected return from
the security will not materialize. Every investment involves uncertainties that make future
investment returns risk-prone. Uncertainties could be due to the political, economic and
industry factors.
Meaning of Return : Return is the amount or rate of produce, proceeds, profits which
accrues to an economic agent from an undertaking or investment. It is a reward for and a
motivating force behind investment, the objective of which is usually to maximize return.
Risk-Return Relationship : The objective of maximizing return can be pursued only at the
cost of incurring higher risk. The financial markets offer a wide range of assets from very safe
to very risky. While selecting the asset for investment, the investor has to consider both its
return potential and the risk involved. The empirical evidence shows that generally there is a
high correlation between risk and return over longer periods of time. The securities are
generally priced such that high risk is rewarded with high return, and low risk is accompanied
by a corresponding low return. This relationship is known as risk-return trade-off.
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Ordinary Shares
Preference Shares
Subordinate loan stock
Unsecured loan
Debenture with floating charge
Mortgage loan
Government Stock (risk-free)
0
Degree of Risk
R
e
t
u
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n
Low Risk
Average
Risk
M
High Risk
Degree of Risk
The risk and return are directly variable, i.e., an investment with higher risk should produce
higher return.
Low levels of uncertainty (low risk) are associated with low potential returns. High levels of
uncertainty (high risk) are associated with high potential returns. The risk-return trade-of is
the balance between the desire for the lowest possible risk and the highest possible return.
Graphic Presentation of Risk-Return Relationship : The figure below represents the
relationship between risk and return.
The slope of market line indicates the return per unit of risk required by all investors. Highly
risk-averse investors would have a steeper line, and vice-versa.
Risk-Return Relationship of Different Stocks :
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The risk-return trade-off tells us that the higher risk gives us the possibility of higher returns.
But there are no guarantees. Just as risk means higher potential returns, it also means
higher potential losses.
Q. Explain Government Securities (G-secs).
OR
Q. Explain Gilts.
Ans. Meaning of Government Securities (G-secs) : Government securities or gilts are
sovereign securities, which are issued by the Reserve Bank of India (RBI) on behalf of the
Government of India (GOI). The GOI uses these funds to meet its expenditure
commitments.
Types of Government Securities :
1) Dated Securities : These securities generally carry a fixed interest rate and have a
fixed maturity period.
For example an 11.40% GOI 2010 G-sec. In this case, 11.40 is the interest rate and it is
maturing in the year 2010.
Features of Dated Securities : The salient features of dated securities are:
(i) These are issued at the face value.
(ii) The rate of interest and tenure of the security is fixed at the time of issuance and
does not change till maturity.
(iii) The interest payment is made on half yearly rest.
(iv) On maturity the security is redeemed at face value.
2) Zero Coupon Bonds : These securities are issued at discount to the face value and
redeemed at the par i.e. they are issued at below face value and redeemed at face
value.
Features of Zero Coupon Bonds : The salient features of zero coupon bonds are:
The tenure of these securities is fixed.
No interest is paid on these securities.
3) Partly Paid Stock : In these securities, the payment of principal is made in installment
over a given period of time.
Features of Partly Paid Stock : The salient features of partly paid stock are:
(i) These types of securities are issued at face value and the principal amount is
paid in installment over a period of time.
(ii) The rate of interest and tenure of the security is fixed at the time of issuance and
does not change till maturity.
(iii) The interest payment is made on half yearly rest.
(iv) These are redeemed at par on maturity.
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4) Floating Rate Bonds : These types of securities have a variable interest rate, which is
calculated as a fixed percentage over a benchmark rate.
Features of Floating Rate Bonds : The salient features of floating rate bonds are:
(i) These are issued at the face value.
(ii) The interest rate is fixed as a percentage over a predefined benchmark rate. The
benchmark rate may be a bank rate, Treasury bill rate etc.
(iii) The interest payment is made on half yearly rests.
(iv) The security is redeemed at par on maturity, which is fixed.
5) Capital Indexed Bonds : These securities carry an interest rate, which is calculated
as a fixed percentage over the wholesale price index.
Features of Capital Indexed Bonds : The salient features of capital indexed bonds
are:
These securities are issued at face value.
The interest rate changes according to the change in the wholesale price index,
as the interest rate is fixed as a percentage over the wholesale price index.
The maturity of these securities is fixed and the interest is payable on half yearly
rates.
The principal redemption is linked to the wholesale price index.
Invest in Government Securities : Entities registered in India including:
(i) Banks
(ii) Financial Institutions
(iii) Primary Dealers
(iv) Partnership firms
(v) Mutual Funds
(vi) Foreign Institutional Investors
(vii) State Governments
(viii) Provident funds
(ix) Trusts
(x) Research Organizations
(xi) Nepal Rashtra Bank
And Individuals can invest in government securities.
Advantages of Investing in Government Securities :
(1) Minimal Default Risk : The main advantage of investing in G-secs is that there is a
minimal default risk, as the instrument is issued b the GOI.
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(2) Long-term Debt : G-secs especially dated securities, offer investors the opportunity
to invest in very long-term debt (at times with maturity over 20 years), which is usually
not available from the private sector.
(3) Liquidity : Although some issues of G-secs tend to be illiquid, there is adequate
liquidity in most other issues.
Disadvantages of Investing in Government Securities : The main disadvantage of
investing in G-sec is the same as in the case of investing in any other debt instrument i.e.
possibility of higher interest rates and inflation.
Tax Benefits by Investing in Government Securities : There is no tax deducted at source
and the investor can avail tax benefit u/s 80C.
Minimum amount for investing in Government Securities : The minimum amount for
investing in G-secs varies depending on the primary dealer. For example, in case of IDBI
Capital markets, which are primary dealers, the minimum amount for investing in G-secs is
Rs. 10,000.
Commonly used Terms :
(1) Coupon Rate : Every government security carries a coupon rate also called interest
rate, which is fixed.
(2) Face Value : The par value of the security is the face value.
(3) Current Price : As these G-secs traded in the secondary market, the price of these G-
sec fluctuations according to the demand/supply in the market for that security. The
current price is the prevailing price in the secondary market.
(4) Wholesale price index : A wholesale price index is an index of prices of select
commodities. The percentage in the index reflects the inflation/deflation.
(5) Primary Dealer : Primary dealer is an intermediary who buys and sells government
securities and treasury bills, He is authorized by the RBI.
(6) Secondary Market : Like the stock market where stocks are traded there is a
secondary market where the debt instruments like gilts, bonds and treasury bills can
be bought and sold.
Q. Explain Non-Security Forms of Investment.
Ans. Non-Security Forms of Investment : In India, the household sectors investment in
non-security forms constitutes a major proportion of its total investment in financial assets.
There are a large number of non-security forms of financial assets that are available to
investors in India. Most of the investments are illiquid but are generally accepted as good
collateral for borrowing from banks. The following table describes the main features of these
investments
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Non-Security Forms of Investment Avenues
S.No. Name of Investment Rate of Interest (P.a.) Term
1. Bank Deposit:
(i) Saving Bank A/c 5% Short
(ii) Fixed Deposits 9-12% Medium
(iii) Recurring Deposits 9-12% Medium
2. Post Office Schemes :
(i) P.O. Savings Bank 5.5% Short
(ii) Public Provident Fund (PPF) 12% Long
(iii) Recurring Deposits (RD) 11% Long
(iv) Time Deposits 9-11% Long
(v) Monthly Income Schemes (MIS) 13% Long
(vi) National Saving Scheme (NSS) 11% Long
3. Small Saving Certificates :
(i) NSC 12% Long
4. UTI/Mutual Funds:
(i) US 64 Variable Long
(ii) Units of Mutual Funds Variable Long
(iii) ELSS Variable Long
5. Others :
Life Insurance Policy Variable Long
Q. Explain Real Estate Investment.
Ans. Meaning of Real Estate Investment : Real estate has historically has been useful n a
portfolio for both income and capital gains. Home ownership, in itself, is a form of equity
investment, as is the ownership of a second or vacation home, since these properties
generally appreciate in value. Other types of real estate, such as residential and commercial
rental property, can create income streams as well as potential long term capital gains.
Real estate investments can be made directly, with a purchase n your own name or through
investments in limited partnerships, mutual funds, or Real Estate Investment Trusts. Real
Estate Investment Trust s a company organized to invest in real estate.
Types of Real Estate Investments : There are many kinds of investments. Some are very
speculative while others are more conservative. The major classifications are:
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1. Residential House
2. Source of Housing Finance
3. Features of Housing Finance
4. Guidelines for buying a flat.
5. Commercial Property.
6. Agricultural Land.
7. Suburban Land
8. Time share in a holiday resort
9. Unimproved Land
10. Improved real Estate
11. New and used residential property
12. Vacation homes
13. Other Income-Producing real estate such as:
14. Office Buildings
15. Shopping Centres
16. Industrial or Commercial Properties.
Advantages of Real Estate Investment :
(1) Potential for High Return : The potential for high return in real estate exists due, in
part to the frequent use of financial leverage. Financial leverage is the use of borrowed
funds, as in a long-term mortgage, to try to increase the rate of return that can be
earned on the investment. When the cost of borrowing is less than what can be earned
on the investment, it is considered favourable leverage, but when the reverse is true,
it is considered unfavourable leverage.
(2) Potential Tax Advantage : There are potential tax advantages in real estate. First, for
personal use residential property, there is the opportunity to deduct interest paid.
There may also be a deduction for property taxes. If the property is income producing,
other expenses may be deductible as well, such as depreciation, insurance, and
repairs.
(3) Hedge against Inflation : Some consider real estate a good hedge against inflation.
(4) Positive Cash Flow : Good quality carefully selected income property will generally
produce a positive cash flow.
Disadvantages of Real Estate Investment :
(1) Limited Marketability : There is generally limited marketability in real estate
(depending on the nature and location of the property).
(2) Lack of Liquidity : There s also a lack of liquidity, in that there is no guarantee that the
propert can be disposed of at its original value, especially if it must be done within a
short period of time.
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(3) Large Initial Investment : A relatively large initial investment often is required to buy
real estate.
(4) High Risk : Real estate is often considered high risk because it is fixed in location and
character.
(5) The Tax Reform Act of 1986 eliminated many of the previously-available tax
advantages relating to real estate.
Q. Explain the Investment Instruments of the Money Market.
Ans. Meaning of Money Market : A money market is a mechanism that makes it possible
for borrows and lenders to come together. Essentially it refers to a market for short-term
funds. It meets the short-term requirements of the borrowers and provides liquidity of cash to
the lenders.
A money market is the market in which short-term funds are borrowed and lent. The money
market does not deal in cash or money but in trade bills, promissory notes and government
papers, which are drawn for short periods. These short-term bills are known as near money.
Types of Money Market Instruments : The major short-term credit instruments dealt with
in a money market include:
(1) Trade Bills : These are bills exchange arising out of bona fide commercial
transactions. They include both inland bills and foreign bills.
(2) Bankers Acceptance : These are bills of exchange accepted b commercial banks on
behalf of their customers. The fact that a bank of repute accepts a bill increases its
creditworthiness, which, in turn, means that t can easily be discounted.
(3) Treasury Bills (T-Bills) : Treasury bills are short-term money market instruments,
which are issued by RBI on behalf of the GOI. The GOI uses these funds to meet its
short-term financial requirements of the government.
Features of Treasury Bills: The salient features on T-Bills are:
(i) These are zero coupon bonds, which are issued at discount to face value and
are redeemed at par.
(ii) No tax is deducted at source and there is minimal default risk.
(iii) The maximum tenure of these securities is one year.
(4) Short-dated Government Securities : These are securities issued by the
government for short periods. Long-term government securities that are nearing
maturity are also sometimes included in this category.
(5) Commercial Papers : These are short-term unsecured securities issued b highly
creditworthy large companies. Commercial papers are regulated by RBI.
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Features : The main features of commercial papers are:
(i) Only those companies are allowed to issue commercial papers which have a net
worth of Rs. 10 crore or more
(ii) The minimum size of an issue is Rs. 25 lac and the size of each commercial
paper should not be less than Rs. 5 lacs.
(iii) Their maturity period ranges between 90 to 180 days.
Advantages : The main advantages of commercial papers are:
(i) It s a cheaper source of short-term finance as compared to bank credit
(ii) It is an useful source of finance during period of tight bank credit.
Limitations : The limitations of commercial papers are:
(i) It can be used only by large and financially sound companies.
(ii) Commercial papers cannot be redeemed before maturity date even if the
issuing firm has surplus funds.
(iii) Maturity date of commercial papers cannot be extended even is the issuing firm
is facing financial difficulties.
(6) Zero Coupon Bonds : These securities are issued at discount to the face value and
redeemed at the par i.e. they are issued at below face value and redeemed at face
value.
Features of Zero Coupon Bonds : The salient features of zero coupon bonds are:
(i) The tenure of these securities is fixed.
(ii) No interest is paid on these securities.
New Instruments Introduced :
(i) Non-Convertible Debentures
(ii) Zero Interest Fully Convertible Debentures
(iii) Fully Convertible Cumulative Preference Shares
(iv) Fully Convertible Bonds with Interest
(v) Discount Bonds
(vi) Deep Discount Bonds.
Issuer of Money Market Instruments : Issuers of money market instruments are:
(i) Government of India and other sovereign bodies
(ii) Banks and development financial institutions.
(iii) Public Sector Undertakings.
(iv) Private Sector Companies
(v) Government or quasi-government owned non-corporate entities.
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UNIT IV
Q. Explain Fundamental Approach in detail.
Ans. Introduction : Investment decisions are a part of our economic life. Everybody makes
such decisions in different contexts at different times. Some are able to reap more profits
through them; while other simply lose their money. Attempts should, therefore, be made to
understand and know the way sound investments decision can be made in order to improve
the change of making profit through them. Thus, investment decision-making is an important
area probing further.
Investment decision-making being continuous in nature should attempt systematically.
Broadly approaches are suggested in the literature. These are:
(A) Fundamental Analysis.
(B) Technical Analysis.
(A) Fundamental Analysis : In the fundamental approach an attempt is made to analyze
various fundamental or basic factors that affect the risk-return of the securities. The
effort here is to identify those securities that on perceives as mispriced in the stock
market. The assumption in this case is that the market price of security and the price
is justified by its fundamental factors called intrinsic value are different and their
market place provides an opportunity for a discerning investor to detect such
discrepancy. The moment such a description is identified, a decision to invest or
disinvest is made.
The price prevailing in market is called market price (MP) and the one justified b its
fundamentals is called intrinsic value (IV).
Criteria for selecting an Investment :
(1) If IV > MP, buy the security
(2) If IV < MP, sell the security
(3) If IV = Mp, no action.
The fundamental factors mentioned above may relate to the economy or industry or
company or all some of this. Thus Fundamental Approach includes three analysis:
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(1) Economic Analysis
(2) Industry Analysis
(3) Company Analysis
Fundamental Analysis :

(1) Economic Analysis : In actual practice, you must have noticed that investment
decisions of individuals and the institutions made in the economy set-up of a particular
country. It becomes essential, therefore, to understand the star economy of that
country at the macro level. The analysis of the state of the economy at the macro level
incorporates the performance of the economy in the past, how it is performing in the
present and how it is expected to perform in future.
Macro Economic Analysis : The analysis of the following factors indicates the trends
in macro economic changes that effect the risk and return on investment:
(i) Growth Rate of Gross Domestic Product : The gross domestic product is a
measure of the total production of final goods and services in the economy
during a specified period usually a year. The growth rate of GDP is the most
important indicator of the performance of the economy. The higher the growth
rate of GDP, other things being equal, the more favourable it is for the stock
market.
(ii) Industrial Growth Rate : The GDP growth rate represents the average of the
growth rates of the three principal sectors of the economy, viz. the services
sector, the industry sector, and the agricultural sector.
Publicly listed companies play a major role in the industrial sector but only a
minor role in the service sector and the agricultural sector. Hence stock market
analyst focus more on the industrial sector. They look at the overall industrial
growth rate as well as the growth rates of different industries.
Economic Analysis
Industry
Company
Analysis
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The higher the growth rate of the industrial sector, other things being equal, the
more favourable it is for the stock market.
(iii) Monsoons : Agriculture accounts for about a quarter of the Indian economy and
has important linkages, direct and indirect, with industry. Hence, the increase or
decrease of agricultural production has a significant bearing in industrial
production and corporate performance. Companies using agricultural raw
materials as inputs or supplying inputs to agriculture are directly affected by the
changes in agricultural production. Other companies also tend to be affected
due to indirect linkages.
A spell of good and monsoons imparts dynamism to the industrial sector and
buoyancy to the stock market. Likewise, a streak of bad monsoons casts its
shadow over the industrial sector and the stock market.
(iv) Fiscal Deficit : Government play an important role in most economies,
including the Indian economy. The central budget as well as the state budgets
prepared annually provides information on revenues, expenditures and deficit
or surplus.
In India, governmental revenues come more from indirect taxes such as excise
duty and custom duty and less from direct taxes such as income tax. Th bulk of
the government expenditures goes toward administration, interest pament,
defence and subsidies etc.
If Government Expenditure > Government Revenues Deficit
If Government Revenues > Government ExpenditureSurplus
Investment analyst examines the government budget to assess how it is likely to
impact on the stock market. They generally classify favourable and
unfavourable influences as follows:
Favourable Unfavourable
A reasonably balanced budget A budget with a high
surplus or deficit
A level of debt which can be A level of debt which is difficult
serviced comfortably to service
A tax structure which provides A tax structure which provides
incentive for stock market investment disincentive for stock
market investment.
(v) Interest Rate : A rise in interest rates depresses corporate profitability and also
leads to an increase in the discount rate applied by equity investors, both of
which have an adverse impact on stock prices. On the other hand, a fall in
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interest rates improves corporate profitability and also leads to a decline in the
discount rate applied by equity investors, both of which have a favourable
impact on stock prices.
(vi) Inflation : The effect of inflation on the corporate sector tends to be uneven.
While certain industries ma benefit, others tend to suffer. Industries that enjoy a
strong market for their products and which do not come under the purview of
price control may benefit. On the other hand, industries have a weak and which
come under the purview of price control tend to lose.
(vii) Balance of Payments, Forex Reserves, and Exchange Rates : Balance of
Payment Deficit = Balance of Trade Deficit (Imports minus exports) + Balance
on invisible like tourism and interest rates (payment on account of invisibles
minus receipts on account of invisibles) + Balance on account of capital account
( Repayment on account of loans minus receipt of loans)
A balance of payments deficit depletes the forex reserves of the country and has
an adverse impact on the exchange rate; on the other hand a balance of
payments surplus augments the force reserves of the country and has a
favourable impact on the exchange rate.
(viii) Capacity Utilisation
(ix) Unemployment
(x) Institutional Lending
(xi) Productivity of factors of production.
(xii) Industrial Wages
(xiii) Status of political and economic stability
(xiv) Technological innovations
(xv) Infrastructural facilities
(xvi) Economic and industrial policies of the government
(xvii) Debt recovery and loans outstanding.
(xviii) Trends in capital market
(xix) Foreign Investment.
(xx) Stage of the business cycle
(2) Industry Analysis : After conducting an analysis of the economy, the analyst must
look into various sectors of the economy in terms of various industries. An industry is a
homogeneous group of companies. That is, companies with similar characteristic can
be divided into one industrial group. There are man bases on which grouping of
companies can be done.
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Classification of Industries :
(i) Growth Industry : This is an industry that s expected to grow consistently and
its growth may exceed the average growth of the economy.
(ii) Cyclical Industry : In this category of the industry, the firms included are those
that move closely with the rate of industrial growth of the economy and fluctuate
cyclically as the economy fluctuates.
(iii) Defensive Industry : It is a grouping that includes firms, which move steadily
with the economy and less than the average decline of the economy in a cyclical
downturn.
Key Indicators in Analysis : The analyst is free to choose his or her own indicators for
analyzing the prospectus of an industry. However, many commonly adopt the
following factors.
(i) Performance Factors : Performance factors like:
Past Sales Past Earnings
(ii) Environment Factors : Environment factors like:
Attitude of government Labour conditions
Competitive conditions Technological progress
(iii) Outcome factors : Outcome factors lime:
Industry share prices Strengths and weaknesses
Opportunities and threats
Analytical Framework : We have identified various factors and questions relating to
industry analysis. Now, we shall consider the frameworks within which the analysis may be
carried out.
Industry Life-Cycle Stages : Ever industry passes through different stages in its lifetime.
Th stages can be identified as follows:
(i) Pioneering Stage : This stage is characterized by introduction of a new product, and
an uptrend in business cycle that encourages new product introductions. Demand
keeps on growing at an increasing rate. Competition is generated b the entry of new
firms to grab the market opportunities. Weaker firms face premature death while
stronger one survives to grow and expand.
(ii) Expansion Stage : This is characterized by the hectic activity of firms surviving the
pioneering stage. The market continues to grow but slowly, offering steady and slow
growth in sales of the industry. It is a phase of consolidation wherein companies
establish durable policies relating to dividends and investments.
(iii) Stabilization Stage : This stage shows signs of slow progress and also prospects of
decay.
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(iv) Decay Stage : An industry reaches this stage when it fails to detect the death signal
and implement- proactively or reactively-appropriate strategies. Obsolescence
manifests itself, effecting a decline in sales, profit, dividends and share prices.
Implications to the Investor : This approach is useful to the analyst as it gives insights, not
apparent merits and demerits of investment in a given industry at a given time. What the
investor has to do is.
(i) Collect relevant data to identify the industry life cycle stage.
(ii) Forecast the probable life period of the stage.
(iii) Decide whether to buy, hold or sell.
Although the industry life cycle theory appears to be very simple, it is no so in practice.
Proper identification of the life cycle stage is difficult. The internal analysis can be done
periodically to evaluate strengths and weaknesses either by inside company executives or
outside consultants. This can be done b using a form such as the on shown in the following
table:
Strengths Weaknesses Analysis
Factor Performance Importance
Neutral Minor Major High Medium
(A) MARKETING :
(i) Popularity and regard
(ii) Relative market share
(iii) Quality image
(iv) Service reputation
(v) Distribution costs
(vi) Sales force
(vii) Market location
(B) FINANCE :
(i) Cost of Capital
(ii) Funds availability
(iii) Financial Stability
(iv) Profitability
(C) MANUFACTURING :
(i) Facilities
(ii) Economies of scale
(iii) Capacity Utilisation
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(iv) Labour productivity.
(v) Manufacturing costs
(vi) Raw material availability
(vii) Technology of process
(D) HUMAN RESOURCES :
(i) Leadership
(ii) Management capabilities
(iii) Worker attitudes
(iv) Skill development
(v) Structural flexibility
(vi) Industrial Relations
(3) Company Analysis : The two major components of company analysis are:
(i) Financial Analysis: Financial analysis includes:
(a) Assets Value vs. Earning Value
Assets Value : The asset value of a security is determined b estimating the
liquidating value of the firm, deducting the claims of firms creditors and
allocating the remaining net asset value of the firm over the outstanding shares
of stock. The asset value is usually estimated by consultation with:
A specialist who appraises assets values and/or
An accountant who gives book value of the firm.
Earnings Analysis : Investment analysis focus their attention on the trends of
earnings and the related factors like dividends, bonus shares, right shares, and
appreciation of the market value of the share. It is believed that the appropriate
indices for a companys performance are market price per share (MPS) and
earnings per share (EPS)
Net Profit Dividend on Preference Shares
EPS = -
Number of Equity Shares
(b) Quantitative Analysis : This approach helps us to provide a measure of future
value of equity share based on quantitative factors. The methods commonly
used under this approach are:
Dividend Discounted Method : Dividend discounted method is based on the
premise that the value of an investment is the present value, its future returns.
The present value calculated by discounting the future returns, which are
divided in the formula, thus, is
The Zero-growth Case : In zero-growth case, the formula will be:
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D1
V =
K
V = Value of Share
D1 = Dividend per share
Constant Growth Case : When dividends grow in all future periods at a uniform rate g, the
formula will be :
D1
V =
K-g
V = Value of Share
g = Growth Rate
Models Based on Price Ratio Analysis : According to this method, the price of an
equit share is calculated by the following formula:
P = EPS X P/E ratio
The P/E ratio is an important ratio frequently used by analyst in determining the value
of an equity share. It is frequently reported in the financial press and widely quoted in
the investment community.
Decision Rule :
Higher the P/E ratio, other things remaining the same, higher would be the value
of an equity share.
Lower the P/E ratio, other things remaining the same, lower would be the value
of an equity share.
(c) Ratio Analysis : Based in the financial data available in income statement and
balance sheets relevant ratios ma be calculated and analyzed to appraise the financial
soundness of a company
S. No. Indicator Ratios
(A) Technical Solvency (i) Current Ratio
(ii) Liquid Ratio
(B) Actual Solvency (i) Debt-equity Ratio
(ii) Return on Investment
(iii) Profit Margin
(iv) Fixed assets to total assets
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(C) Profitability (i) Gross profit margin
(ii) Net Profit Margin
(iii) Return on Investment
(iv) Earning per share
(v) Dividend yield ratio
(vi) P/E Ratio
(ii) Non-Financial Analysis : Non-financial analysis is also important in evaluating the
worth of a company for investing in securities. This could be obtained b gathering and
analyzing information about companies, publized in the media, the stock exchange
director, annual reports and prospectus. Non-financial analysis includes internal
factors as well as external factors.
(a) Internal Factors : Internal factors include analysis of the following factors:
History and business of the company
To management team
Collaboration agreements
Product range
Future plans of expansion/diversification
Research & development
Market standing-competition and market share
Corporate social responsibility
Industrial relations scenario
Corporate image etc.
(b) External Factors : Besides these internal factors, the external environment
related to the company survival and image:
Statutory Controls
Government Policy
Industry life cycle stage
Business cycle stage
Environmentalism
Consumerism, etc.
Q. What is Technical Analysis? What are the tools or techniques of technical
analysis?
Ans. Meaning of Technical Analysis : Technical analysis is a method of evaluating
securities b analyzing the statistics generated b market activity, such as past prices and
volume. Technical analysts do not attempt to measure a securitys intrinsic value, but instead
use charts and other tools to identify patterns that can suggest future activity.
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Unlike fundamental analysts, technical analysts dont care whether a stock is undervalued-
the only thing that matters is a securitys past trading data and what information this data can
provide about where the security might move in the future.
Basic Technical Assumptions : The basic technical assumptions are:
(i) The market Discounts Everything : A major criticism of technical analysis s that it
only considers price movement, ignoring the fundamental factors of the company.
However, technical analysis assumes that, at an given time, a stocks price reflects
everything that has or could affect the company-including fundamental factors.
(ii) Price Moves in Rrends : In technical analysis, price movements are believed to
follow trends. This means that after a trend has been established, the future price
movement s more likely to be in the same direction as the trend than to be against it.
Most technical strategies are based on this assumption.
(iii) History Tends to Repeat Itself : Another important postulate in technical analysis s
that history tends to repeat itself, mainly in terms of price movement. The repetitive
nature of price movements is attributed to market psychology; in other words, market
participants tend to provide a consistent reaction to similar market stimuli over time.
Technical analysis uses chart patterns to analyze market movements and understand
trends.
Tools of Technical Analysis : The tools of technical analysis are:
(1) Dow Theory : The Dow Theory is one of the oldest and most famous technical tools. T
was originated by Charles Dow, who founded the Dow Jones company and was the
editor of The Wall Street.
According to Dow
The market is always considered as having three movements, all going at the same
time. The first is the narrow movement from day-to-day. The second is the short swing
running from two weeks to a month or more, the third is the main movement covering at
least four years in duration.
These movements are called :
(a) Daily Fluctuations (Minor Trends) :The minor trends have little analytical value,
because of their short duration and variations in amplitude.
(b) Secondary Movements (trends) : The secondary trend acts as a restraining force on
the primary trend. It ends to correct deviations from its general boundaries.
(c) Primary Trends : The primary trends are the long range cycle that carries the entire
market up or down (bull or bear markets).
Types of Averages : The Dow Theory is build upon the assertion that measured of stock
prices tend to move together. It employs two of the Dow Jones Averages.
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(a) Dow-jones Industrial Average
(b) Dow-jones Transportation Average
Types of Market : There are three types of market:
(a) Bull Market: If both the averages are rising.
(b) Bear Market: If both the averages are falling
(c) Uncertain: If one rising and other is falling
Criticism of Dow Theory : Several criticisms are leveled against the Dow Theory:
(a) It is not a theory but an interpretation of known data. A theory should be able to
explain why a phenomenon occurs. No attempt was made by Dow or his
followers to explain why the two averages should be able to forecast future stock
prices.
(b) It has poor predictive power.
(2) Trend Analysis : There are three types of trend:
(a) Upward Trend : As the name imply, when each successive peak and trough s
higher, its referred to as an upward trend.
(b) Downward Trend : If the peaks and troughs are getting lower, its a downtrend.
(c) Horizontal Trend : When there is little movement up or down in the peaks and
troughs, its a sideways or horizontal trend.
(3) Charts Types : Technical analysts use three basic types of charts:
(a) Line Charts : The most basic chart is the line chart because it represents only
the closing prices over a set period of time. The line of formed by connecting the
closing prices over the time frame. Line charts do not provide visual information
of the trading range for the individual points such as the high, low and opening
prices. However, the closing price is often considered to be the most important
price in stock data compared to the high and low for the day and this is why t is
the only value used in line charts.
(b) Bar Charts : Most investors interested in charting use bar charts-primarily
because the have meanings familiar to a technical analysts, but also because
these charts are east to draw. The procedure for preparing a vertical line or bar
chart is simple. The vertical dimensions of the line represent price, the horizontal
dimension indicates the time involved by the chart as a whole.
(4) Chart Pattern : A chart pattern is a distinct formation on a stock chart that creates a
trading signal, or a sign of future price movements. Chartists use these patterns to
identify current trends and trend reversals and to trigger buy and sell signals. There
are various types of chart patterns:
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(a) Head and Shoulders : This is one of the most popular and reliable chart
patterns n technical analysis. Head and shoulders are a reversal chart pattern
that when formed, signals that the security likely to more against the previous
trend. There are two types of Head and Shoulders Chart patterns:
Head and Shoulders Top :
Head and Shoulders Bottom :
(e) Double Top : It represents a bearish development, signaling that the price is expected
to fall.
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(f) Double Bottom : It reflects a bullish development signaling that the price is expected
to rise.
(g) Triangles : Triangles are some of the most well-known chart patterns used in
technical analysis.
(5) Moving Averages : Most chart patterns show a lot of variation in price movement.
This can make it difficult for traders to get an idea of a securitys overall trend. One
simple method traders use to combat this is to apply moving averages.
A moving average is the average price of a security over a set amount of time. It simple
takes the sum of all of the past closing prices over the time period and divides the
results by the number of prices used in the calculation. For instance, in a 10-day
moving average, the last 10 closing prices are added together and then divided by 10.
Criticism of Technical Analysis : The various limitations of technical analysis were pointed
out by its critics are as given under:
(i) Difficult in interpretation : Technical analysis is not as simple as it appears to be.
While the charts are fascinating to look at, interpreting them correctly is very difficult.
(ii) Frequent Changes : With changes in market, chart patterns keep on changing.
Accordingly, technical analysts change their opinions about a particular investment
frequently. One day they put signal. A couple of weeks later, the see a change pattern
and put up a sell signal.
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(iii) Unreliable Changes : hanges in market behaviour observed and studied by technical
analysts man not always be reliable owing to ignorance or intelligence or manipulative
tendencies of some participants.
(iv) History does not repeat itself : One of the major limitations of technical analysis is
that the entire data s based on the past. It is presumed that future resembles the past.
There s no guarantee that history repeats itself.
(v) False signals can occur : Technical analysis is a signaling device. Like a
thermometer, it may give a false indication when there is no alarm.
Q. What is the difference between technical and fundamental analysis?
Ans. Meaning of Fundamental Analysis : In the fundamental approach an attempt is
made to analyze various fundamental or basic factors that affect the risk-return of the
securities. The effort here is to identify those securities that on perceives as mispriced in the
stock market. The assumption in this case is that the market price of security and the price is
justified by its fundamental factors called intrinsic value are different and their market place
provides an opportunity for a discerning investor to detect such discrepancy. The moment
such a description is identified, a decision to invest or disinvest is made.
Meaning of Technical Analysis : Technical analysis is a method of evaluating securities b
analyzing the statistics generated b market activity, such as past prices and volume.
Technical analysts do not attempt to measure a securitys intrinsic value, but instead use
charts and other tools to identify patterns that can suggest future activity.
Difference between Fundamental and Technical Analysis :
S. No. Basis of Fundamental Technical
Difference Analysis Analysis
1. Nature His perspective is long-term His outlook is short-term
in nature. He is conservative oriented. He is aggressive.
in his approach. He acts on He acts on what is
What should be
2. Difference He considers total gain from He does not distinguish
between equity investment consists of between current income and
current current yield by way of capital gains. He is interested
income dividends and long-term in short-term profits.
and capital gains by way of capital
gains appreciation.
3. Base of He forecasts stock prices on He forecasts security prices byy
Analysis the basis of economic, studying patterns of supply of
industry and company and demand for securities.
statistics. The principal Technical analysis is study of
decision variables take the stock exchange information.
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form of earnings and
dividends. He makes a
judgment of the stocks
value with a risk-return.
4. Tools He uses tools of financial He uses mainly changes of
analysis and statistical financial variables besides
forecasting techniques. some quantitative tools.
Q. Explain the Efficient Market Theory.
Ans. Introduction : An efficient capital market is one in which security prices adjust rapidly
to the arivale of new information and, therefore, the current prices of securities reflect all
information about the security. You need to understand the meaning of the terms efficient
capital market and efficient market hypothesis because of its importance and controversy
associated with it.
Why Should Capital Market be Efficient : As noted earlier, in an efficient capital market,
security prices adjust rapidly to the infusion of new information, and therefore currency
security prices fully reflect all available information. To be absolutely correct, this is referred
to as an informationally efficient market. Although the idea of an efficient capital market is
relatively straightforward, we often fail to consider why capital markets should be efficient.
What set of assumptions imply an efficient capital market?
(1) An initial and important premise of an efficient market requires that a large number of
profit maximizing participants analyze and value securities, each independently of the
others.
(2) A second assumption is that new information regarding securities comes to the market
in a random fashion, and timing of one announcement is generally independent of
others.
(3) The third assumption is especially crucial: profit maximizing investors adjust security
pries rapidly to reflect the effect of new information.
Alternative Efficient Market Hypotheses (EMH) : There are three types of efficient market
hypotheses:
(1) Weak-form EMH : The weak form EMH assumes that current stock prices full reflect
all security market information, including
Historical sequence of prices
Rates of Return
Trading volume data
Other market generated informations.
This hypotheses implies that past rates of return and other historical market data
should have no relationship with future rates of return (that is, rates of return should be
independent).
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(2) Semi Strong-form EMH : The semi strong-form asserts that security prices adjust
rapidly to the release of all public information, that is, current security prices full reflect
all public information. The semi strong-form hypotheses encompasses the weak form
hypotheses because a the market information considered by the weak form
hypotheses such as stock prices, rate of return and trading volume, is public
information. Public information also includes all non market information such as:
Earnings and dividend announcements
P/E ratio
Dividend payout ratio
News about the economy
Political news.
(3) The Strong-form EMH : The strong form EMH contends that stock prices full reflect
all information from public and private sources. The strong form EMH extends both the
weak form and the semi-strong form EMH.
Q. Explain recent developments in the Indian Stock Market.
Ans. Recent Development in Indian Stock Market : The recent development in Indian
Stock Market are studied in two section:
A. Financial Reforms : The globalization of financial markets and the consequential
changes in the Indian segment have created a new thrust for desirable reforms.
Developed financial markets allocate capital through a supply and demand
mechanism, establishing the cost of capital at the equilibrium of supply and demand
for the securities. The financial services industry has assumed a key position by
providing means for transfer of goods and services and payment thereof. In the
process, they act as intermediaries between the countries with excess funds and
those in need of funds, both for capital and trade purposes.
Financial reforms have brought about many changes:
(1) Free flow of Investment : These reforms have removed the shackles of control and
have promoted the free flow of investment, new instruments of investments and state
of the art technologies and procedures that are n operation in the other developed
markets.
(2) Industrial Growth : With the larger availability of resources, industrial activity has
received a boost.
(3) Growth in Indian Economy : The active participation of foreign investors with
resources and modern know-how has opened new vistas of growth and development
in the Indian economy.
(4) Removal of Restrictions and Constraints : Removal of restrictions and constraints,
freedom to work within broad government guidelines and supportive policies that are
investor-friendly, are the chief distinguishing features of the financial reforms.
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(5) Modification in Foreign Exchange Control Act : The Foreign Exchange Control Act
has been modified and rechristened the Foreign Exchange Management Act,
symbolic of the present times, which seek to promote development rather than control
of inflow and outflow of investments.
(6) Delegation of Powers : The laws of securities in India were originally contained in the
Capital Issues (Control) Act, 197, Securities Contracts (Regulation) Act, 1956 and the
Companies Act, 1956. The Government exercising the delegated powers under these
laws, prescribed detailed procedures n rules and regulations. With the promulgation of
the securities of the Securities and Exchange Board of India Act, 1992, the Capital
Issue Act, 1947 and delegated legislation thereunder were repealed and SEBI was
empowered to regulate all matter relating to capital issue in respect of listed
companies. These developments significantly changed the face of the Indian Capital
Market.
(7) The market was thrown open to foreign investors with Indian Companies being
allowed to raise capital abroad and receive investments from foreign institutional
investors, in order to integrate Indian capital market with the global market, many
evolutionary efforts have been taken.
(8) The changes in the capital market are not a one-shot affair and have to go through a
learning curve.
Conclusion : The process of financial reforms is still under way and is likely to brng about
even more drastic changes that ma make the markets healthier and stronger. Indias
approach to financial sector reforms, in general and to the management of the external
sector, n particular has erved the country well, in terms of
Aiding Growth
Avoiding Crisis
Enhancing Efficiency and
Imparting resilience to the system.
B. Impact of Liberalisation : It is needless to say that liberalisaton has had a remarkable
effect on both the economy in general and the capital market in particular. These
measures for liberalisation initiated in 1991 by the government led to restoring of both
domestic and international confidence in the Indian economy. The balance of payment
position, which had reached alarming levels showed stead improvement, which was
reflected in the growth of foreign exchange reserves. Trade deficit and inflation have
also been brought under control. The private sector has been given a place of pride in
allocating resources for the governments five year plans.
(1) The private sector, in turn will be tapping the capital market to meet its
requirements.
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(2) A key role in the growth of capital market is assigned to the household sector,
which earlier hoarded the savings and invested in jewellery and fixed income
securities like UTI units, bank fixed deposits etc.
(3) Since the mid-1990s, equity prices showed a sharp rise in the market, leading to
substantial increase in market capitalization and diversion of attention by the
household sector from traditional targets towards since capital market. The ratio
of shares and debenture held by the household sector has increased
substantially since 1990.
(4) Alongside these developments, a number of recognized stock exchanges have
grown in India.
(5) Mutual Funds came to play a significant role in the mobilization of resources for
the corporate sector. Earlier there were only 8 players in the mutual fund
segment, comprising of UTI and subsidiaries of investment institutions and
nationalized banks, prior to the entry of the private sector. More players arrived
on the mutual fund scene to mop up savings from the household sector and
invest them in corporate securities.
(6) Listed companies operate substantially under stock exchanges in India. The
market capitalization of listed companies has grown manifold and the market
trends have been on the upswing as reflected in the BSE sensitive index and
NSE index. The new policy of the government to privatize the public sector
enterprises by offloading part of the government holdings to mutual funds and
financial institutions has opened up new opportunities for growth in the capital
market.
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