Amity Campus

Uttar Pradesh
India 201303

ASSIGNMENTS
PROGRAM: MFC
SEMESTER-II
Subject Name
Study COUNTRY
Roll Number (Reg.No.)
Student Name

: SECURITY ANALYSIS
: Zambia
: MFC001412014-2016002
: DERICK MWANSA

INSTRUCTIONS
a) Students are required to submit all three assignment sets.
ASSIGNMENT
Assignment A
Assignment B
Assignment C

DETAILS
Five Subjective Questions
Three Subjective Questions + Case Study
Objective or one line Questions

MARKS
10
10
10

b)
c)
d)
e)

Total weightage given to these assignments is 30%. OR 30 Marks

All assignments are to be completed as typed in word/pdf.
All questions are required to be attempted.
All the three assignments are to be completed by due dates and need to be
submitted for evaluation by Amity University.
f) The students have to attached a scan signature in the form.

Signature :
Date
:

_______________
____________________
________________29/11/2015_________________

( ) Tick mark in front of the assignments submitted

Assignment
Assignment B
Assignment C
A
1

SECURITY ANALYSIS
ASSIGNMENT A
Question 1
What is meant by Fundamental Analysis? How does it differ from
technical Analysis?
Answer.
Fundamental Analysis
Fundamental analysis is a method that attempts to understand, measure and predict the intrinsic
value of stocks based on an in-depth analysis of various economic, financial, qualitative, and
quantitative factors. Krantz (2009) suggests that fundamental analysis is the science which has its
fixed bases and steps to achieve its objectives in specifying the intrinsic value of the share in the
stock market, through a general framework which takes the form of studying the expected
economic forecasts reaching the sectors from which an increase in the sales and profits is
expected. According to its proponents, fundamental analysis offers a fuller picture of the possible
movements of both the stock market and individual stocks because as many elements as possible
are investigated where as Technical analysis, only looks at past data of stock prices.
According to Thomsett (2006), fundamental analysis is the study of a companys financial
strength based on historical data, sector and industry position, management, dividend policy,
capitalization, and potential for future growth. Fundamental analysis attempts to predict which
stocks are valuable and which are not. The strength of the firms is studied financially based on
the historical financial information and their current conditions and measuring the efficiency of
their management and their commercial opportunities and specifying the intrinsic value of
shares. This is followed by comparing them with the market values resulting from the
interactions between the demand and supply to determine the investments opportunities.
The combination of historical and fiscal status collectively represents all data not directly related
to the price of the stock and this body of information is used to define value in investing and to
compare one stock with another. Fundamental analysis observes numerous elements that affect
2

stock prices such as sales, price to earnings (P/E) ratio, profits, earnings per share, and
macroeconomic and industry specific factors. The fundamental analysts observes trends, market
and price movements, company financial statements, interest rates, return on equity (ROE) and
numerous other indicators with one goal in mind: buying or selling stocks that will provide a
high return on investments (ROI).
The end goal of performing fundamental analysis is to produce a value that an investor can
compare with the security's current price with the aim of figuring out what sort of position to
take with that security, either to buy if the security is underpriced, or to sell if the security is
overpriced. Fundamental analysis is built on the idea that the stock market may price a company
wrong from time to time. Profits can be made by finding underpriced stocks and waiting for the
market to adjust the valuation of the company. By analyzing the financial reports from
companies fundamentalists get an understanding of the value of different companies and
understand the pricing in the stock market. Fundamental analysis gives a better understanding of
whether the price of the stock is undervalued or overvalued at the current market price.
Fundamental analysis can also be performed on a sectors basis and in the economy as a whole.
According to Thomsett (2006) a fundamental analyst believes that the market price of a stock
tends to move towards its intrinsic value, which is the true value of a company as calculated by
its fundamentals. If the market value does not match the true value of the company, there is an
investment opportunity. Example of this is that if the current market price of a stock is lower
than the intrinsic price, the investor should purchase the stock because he expects the stock price
to rise and move towards its true value. Alternatively, if the current market price is above the
intrinsic price, the stock is considered overbought and the investor sells the stock because he
knows that the stock price will fall and move closer to its intrinsic value. To determine the true
price of the company's stock, the following factors need to be considered.
Fundamental Analysis and Technical Analysis Compared
In order to a clear distinction between fundamental analysis and technical analysis there is need
to understand the latters meaning. Edwards, Magee and Bassetti (2013) defined technical
analysis as the science of recording, usually in graphic form, the history of trading (price changes

and volume of transactions) in a certain stock or in the averages and then deducing from that
pictured history the probable future trend. Technical analysis may be suitable as one of the
effective means in extracting useful information from the market. The differences between the
technical and the fundamental analysis can be summarized as follows:
Although both use different types of historical information, the fundamental approach uses the
information related to stock dividend, sales, income and other rates, whereas the technical
analysis uses just simple information such as price and the volume factors. Edwards et al (2013)
States that while technical analysis is focused on the study of past performance of the market
action Fundamental analysis concentrates on the fundamental reasons that make an impact on the
market direction. Although the purpose of both methods is an attempt to forecast and determine
the future price movements the difference lies in how these two methods achieve that objective.
Edwards et al (2013) postulates that fundamentalists study the cause of price movements
whereas the technicians study the results. Technicians do not find it necessary to know the
reasons why markets change but fundamentalists try to discover why. Technicians who are also
called chartists are interested in the price movement. They try to understand and study the
emotions in the market.
The Fundamental Analysis looks at the shares prices linked to the intrinsic value and comparing
it with the market value to reach whether it is estimated at less than its intrinsic value
(undervalued) or whether it is overvalued, but the technical analysis depends on the prices and
trends.
The other distinctive factor between fundamental analysis and technical analysis lies in their time
horizon. Fundamental Analysis is applied for long periods of time (i.e. years) to become more
credible in its results; whereas the technical analysis strategies is applied in short term periods
(i.e. hours, days, weeks, months) so that the results will have better credibility. Finally technical
analysis is generally used for trade whereas fundamental analysis is more appropriately used for
investment purposes.
Conclusion
Therefore, Technical Analysis is more sensitive to changes in prices, where they can produce
many signals (buying or selling during the daily trading). It is clear that both the technical
analysis and the fundamental analysis are methods which specialize in forecasting the future

status of the market - specifying the trend of prices, which the market is expected to move
towards. The only difference is that each of these two methods attempts to get nearer to solve
this problem from a different point of view. Murphy (2001) believes that if the fundamental
analysis is reflected in the market price, then there is no necessity to study these fundamental
analyses. So that, reading the graph becomes as one of the technical analysis tools which is a
summarized model of fundamental analysis. However the contrast cannot be correct where the
fundamental analysis does not include a study of the movement of the price.

ASSIGNMENT A
Question 2
Define risk & distinguish between Systematic & Unsystematic risk
Answer.
Risk
According to the business dictionary risk is a probability or threat of damage, injury, liability,
loss, or any other negative occurrence that is caused by external or internal vulnerabilities and
that may be avoided through preemptive action. It is the probability that an actual return on an
investment will be lower than the expected return. Risk consists of two components, the
systematic risk and unsystematic risk. The systematic risk is caused by factors external to the
particular company and uncontrollable by the company. The systematic risk affects the market as
a whole. In the case of unsystematic risk the factors are specific, unique and related to the
particular industry or company
Baker and Nofsinger (2010) said risk is based on the probability of actually earning less than
the expected return. Davis and Steil (2001) further defined risk as the danger that a certain
contingency will occur often applied to the future events that are susceptible to being reduced to
objective probabilities. Culp (2008) asserted that risk was any source of randomness that may
have an adverse impact on the market value of a corporations assets, net liability, on earnings
and/or on its raw cash flows. Risk therefore implies future uncertainty about deviation from
expected earnings or expected outcome. Risk measures the uncertainty that an investor is willing
to take to realize a gain from an investment. Risk includes the possibility of losing some or all of
the original investment.

Requirements for Risk To Exist

From the above definitions we can agree with Holton (2004) who argues that there are two
ingredients that are needed for risk to exist. The first is uncertainty about the potential outcomes
from an experiment and the other is that the outcomes have to matter in terms of providing
utility. He notes, for instance that a person jumping out of an airplane without a parachute faces
no risk since he is certain to die (no uncertainty) and that drawing a balls out of a container does
not expose one to risk since ones wellbeing or wealth is not affected by whether a red or black
ball is drawn. However attaching monetary value to a red or black ball would convert this
activity to a risk one.
Differences between Systematic and Unsystematic Risk
While investing in a stock market one needs to take into account two types of risks one is
systematic and other is unsystematic risk. Systematic risk refers to the risk which affects the
whole stock market and therefore it cannot be reduced or diversified away. For example any
global turmoil will affect the whole stock market and not any single stock, similarly any change
in the interest rates affect the whole market though some sectors are more affected then others.
This type of risk is called non diversifiable risk because no amount of diversification can reduce
this risk. Conversely Unsystematic risk is the extent of variability in the stock or securitys return
on account of factors which are unique to a company. For example it may be possible that
management of a company may be poor, or there may be strike of workers which leads to losses.
Since these factors affect only one company, this type of risk can be diversified away by
investing in more than one company because each company is different and therefore this risk is
also called diversifiable risk.
Unsystematic Risk
Unsystematic risk is also known as micro level risk whereas systematic risk is also known as the
macro level risk. Unsystematic risk is concerned with the company or industry. Strike, wrong
decisions by the management, change in management, increase in input costs (without increase
in sale price), change in government policy regarding particular type of companies or products,
emerging of substitutes of the company's product(s), cancellation of export order, key-person
leaving the company, fire, embezzlement by employees, unexpected tax demand and major
6

problem in the plant. The incidence of such risks can be reduced through effective portfolio
selections. The serious unsystematic risks are:
Business risk:
Business risk is the possibility of adverse change in EBIT. Examples are: Reduction in demand
for companys products, increase in costs of inputs, change in import-export policy concerning
the company, Labour strike, some key-persons leaving the company, cancellation of large sized
export order etc.
Financial risk:
It
is
the
possibility
of
bankruptcy.
It
dependence on borrowed funds and that to it high interest rates.

arises

because

of

Default risk:
The major customer of the company may go bankrupt.
Systematic Risk
It is known as macro level risk. It is concerned with the economy as a whole. The factors causing
this

type

of

risk

affect

all

the

investments

in

similar

fashion

(and

not in a similar degree). Examples are: failure of monsoon, change in government, change in
credit policy, recession, war, change in tax policy, etc. Every portfolio has to bear this risk. The
most serious systematic risks are:
Interest rate risk:
Increase in interest rates generally has adverse effects on the financial position and earnings of
the companies.
Inflation risk:
Inflation
disturbs
business
plans
of
the
most
of
the
organizations. Input costs may go up, all the increase in input costs may not been passed to the
customers.
Political risk:
This risk involves change in government policies and political instability.

Conclusion
The difference between systematic risk and unsystematic risk is a key element of investment
strategies, and one that serious investors need to understand. Risk is one of the two most
significant factors that differentiate one investment product from another, with the other being
rate of return. Understanding the different kinds of risk helps an investor make investment
decisions, whether the investor is an active participant in the stock market or is a cautious firsttimer.
ASSIGNMENT A
Question 3
Explain the Whitebeck Kisor model?

Answer.
Whitebeck Kisor Model
The Whitbeck - Kisor model was developed by V. S. Whitbeck and M. Kisor Jr. in order to test
the relationship between variables like growth rate, dividend payment rate and risk in growth rate
using multiple regression technique and indicate the impact of all three variables on the PriceEarnings (P/E) ratio.
Analysis of Whitebeck Kisor Model
Whitbeck-Kisor model was one of earliest attempt to use a multiple regression analysis to
explain price earnings (P/E) ratio. According to Kevin (2015) Whitbeck and Kisor set out to
measure the P/E ratio of a stock to its dividend policy, growth and risk. The duo used dividend
payout rate, earnings growth rate and the variation (standard deviation) of growth rates to
measure the determining variables. They then used multiple regression analysis to define the
average relationship between each of these variables and the P/E ratio. They took 135 stocks and
estimated the relations hip between P/E and the above mentioned variables. The results they
found are given below:
= 8.2 + 1.5 + 0.067 0.2

Where g is the growth in dividend

D/E is the dividend payout rate and
is the standard deviation.
The numbers in the equation are the regression coefficients. 8.2 is the constant term and the other
numbers represent the weightage of the respective independent variables or factors influencing
the P/E ratio. The coefficients of the equation indicate the weights of the variables on the P/E
ratio. The signs show the direction of impact of the particular variable on the P/E ratio. One
percent increase in the standard deviation of growth rate would cause 0.2 unit decrease in the P/E
ratio. Further, the equation indicates that 1 percent increase in earnings' growth would cause
1.5unit increases, in the P /E ratio. One percent increase in payout ratio would result in
0.067units increase in the P/E ratio. Thus, the equation indicates higher growth, higher dividends
and lower risk would lead to high P/E ratio and vice versa.

With the help of the Whitbeck- Kisor model, the analyst can calculate the theoretical value of the
P/ E ratio and compare it with actual value. If,
Theoretical P/E > actual P/E Sell
Theoretical P/E < actual P/E Buy
The model is sample sensitive. The coefficients of the particular period and sample may not give
correct estimation of P/E for another period.
ASSIGNMENT A
Question 4
What is Macaulays Duration?
Answer.
Macaulays Duration
Macaulay Duration was developed in 1938 by Frederic Macaulay. This form of duration
measures the number of years required to recover the true cost of a bond, considering the present
value of all coupon and principal payments received in the future. It is the only type of duration
quoted in years. Interest rates are assumed to be continuously compounded.

The original idea of duration of a bond was the brainchild of Frederick Macaulay, a Canadianborn economist, published in the early 20th century. Macaulays idea was to compute the
weighted average time until a bondholder would receive the cash flows from a bond, where the
weight for each time period is the present value of the cash flow to be received at that time,
divided by the present value of all cash flows (market price of the bond). Since Macaulay
duration is a measure of time, the units of Macaulay duration are typically years. The Macaulay
duration of a bond is the weighted average maturity of cash flows, which acts as a measure
of a bond's sensitivity to interest rate changes. Bonds with a higher duration will carry more
risk, and hence have a greater volatility in prices, when compared to bonds with lower durations.
Importance of Duration
The concept of duration is important because it provides more meaningful measure of the length
of a bond, helpful in evolving immunization strategies for portfolio management and measures
the sensitivity of the bond price to changes in the interest rate.
Duration and price changes
The price of the bond changes according to the interest rate. Bonds price changes are commonly
called bond volatility. Duration analysis helps to find out the bond price changes as the yield to
maturity changes.

ASSIGNMENT A
QUESTION 5

Explain Efficient market Hypothesis?

Answer.
Efficient Market Hypothesis (EMH)

The Efficient Markets Hypothesis (EMH) is a theory developed by Professor Eugene Fama in the
1960s. The theory states that the prices of traded assets such as company shares and bonds take
into account all available information. In other words, the price of a traded asset is never
undervalued or overvalued but the price represents exactly what its worth at that point in time is.
The efficient markets hypothesis assumes that markets, such as the London Stock Exchange
(LSE), are efficient so that the prices of all assets are at a value that takes into account all the
information investors have access to. Therefore it states that no investor can beat the market by
10

investing in undervalued or overvalued assets because the prices all represent their fair value at
that point in time.
Mortimer (2013) defines an efficient market as a market where there are large numbers of rational,
profit maximizers actively competing, with each trying to predict future market values of individual
securities and where important current information is almost freely available to all participants. In an
efficient market, competition among the many intelligent participants leads to a situation where, at any
point in time, actual prices of individual securities already reflect the effects of information based both
on events that have already occurred and on events which, as of now, the market expects to take place
in the future. In other words, in an efficient market at any point in time the actual price of a security will
be a good estimate of its intrinsic value. There are three common forms in which the efficient-market
hypothesis is commonly stated weak-form efficiency, semi-strong-form efficiency and strong-form
efficiency, each of which has different implications for how markets work.
Strong form Efficiency
In its strongest form, Mortimer (2013) says EMH is efficient if all information relevant to the value of a
share, whether or not generally available to existing or potential investors, is quickly and accurately
reflected in the market price. For example, if the current market price is lower than the value justified by
some piece of privately held information, the holders of that information will exploit the pricing anomaly
by buying the shares. They will continue doing so until this excess demand for the shares has driven the
price up to the level supported by their private information. At this point they will have no incentive to
continue buying, so they will withdraw from the market and the price will stabilize at this new
equilibrium level. This is called the strong form of the EMH. It is the most satisfying and compelling form
of EMH in a theoretical sense, but it suffers from one big drawback in practice. It is difficult to confirm
empirically, as the necessary research would be unlikely to win the cooperation of the relevant section
of the financial community such as the insider dealers.
Semi-strong form Efficiency

The semi-strong-form of EMH is a slightly less rigorous form. The EMH says a market is
efficient if all relevant publicly available information is quickly reflected in the market price. If
the strong form is theoretically the most compelling, then the semi-strong form perhaps appeals
11

most to our common sense. It says that the market will quickly digest the publication of relevant
new information by moving the price to a new equilibrium level that reflects the change in
supply and demand caused by the emergence of that information. What it may lack in intellectual
rigor, the semi-strong form of EMH certainly gains in empirical strength, as it is less difficult to
test than the strong form.
One problem with the semi-strong form lies with the identification of relevant publicly available
information. Neat as the phrase might sound, the reality is less clear-cut, because information
does not arrive with a convenient label saying which shares it does and does not affect.
Weak-form Efficiency
The third and least rigorous form is known as the weak form. The EMH confines itself to just
one subset of public information, namely historical information about the share price itself. The
argument runs as follows. New information must by definition be unrelated to previous
information; otherwise it would not be new. It follows from this that every movement in the
share price in response to new information cannot be predicted from the last movement or price,
and the development of the price assumes the characteristics of the random walk. In other words,
the future price cannot be predicted from a study of historic prices.
Conclusion
Each of the three forms of EMH has different consequences in the context of the search for
excess returns, that is, for returns in excess of what is justified by the risks incurred in holding
particular investments.
If a market is weak-form efficient, there is no correlation between successive prices, so that
excess returns cannot consistently be achieved through the study of past price movements. This
kind of study is called technical or chart analysis, because it is based on the study of past price
patterns without regard to any further background information.
If a market is semi-strong efficient, the current market price is the best available unbiased
predictor of a fair price, having regard to all publicly available information about the risk and

12

return of an investment. The study of any public information and not just past prices cannot yield
consistent excess returns. This is a somewhat more controversial conclusion than that of the
weak-form EMH, because it means that fundamental analysis the systematic study of
companies, sectors and the economy at large cannot produce consistently higher returns than
are justified by the risks involved. Such a finding calls into question the relevance and value of a
large sector of the financial services industry, namely investment research and analysis.
If a market is strong-form efficient, the current market price is the best available unbiased
predictor of a fair price, having regard to all relevant information, whether the information is in
the public domain or not. As we have seen, this implies that excess returns cannot consistently be
achieved even by trading on inside information. This does prompt the interesting observation that
somebody must be the first to trade on the inside information and hence make an excess return.
ASSIGNMENT B
Question 1
Explain bond value theorems?
Answer.
Bond value theorem
Singh (2013) postulated that the relationship between bond value or price and the changes in the
market interest rates have been stated by Burton G. Malkiel in the form of the five general
principles. These five principles are known as the bond value or bond pricing theorems.
According to Malkiel (in Singh 2013) the value of the bond depend upon the factors namely, the
coupon rate, years to maturity and the expected yield to maturity or the required rate of return.
On the basis of this, bond value theorems have evolved.
Theorem 1
Theorem 1 states that bond prices and bond yields move in opposite directions. As a bonds price
increases, its yield decreases. Conversely, as a bonds price decreases, its yield increases. This
13

means that as interest rates decline, the prices of bonds rise; and as interest rates rise; the prices
of bonds decline. So if an investor holds two bonds of same maturity and coupon rate, the
difference in the market price will lead to differences in the yield. The bond with low price will
have a high yield because with lesser amount of money more return is earned.

Theorem 2
Theorem 2 says, For a given change in a bonds Yield to Maturity (YTM), the longer the term
to maturity of the bond, the greater will be the magnitude of the change in the bonds price. This
means, the bond with a short term to maturity sells at a lower discount than the bond with a long
term to maturity. The bond value or price variability is therefore directly related to the term to
maturity; which means that for a given change in the level market interest rates, changes in bond
prices are greater for longer term maturities. This further means that if rates are expected to
increase, a prudent portfolio manager will avoid investing in long-term securities. The portfolio
could see a significant decline in value. If an investor expects interest rates to decline, he/she
may well want to invest in long-term zero coupon bonds. As interest rates decline, the price of
long-term zero coupon bonds will increase more than that of any other type of bond.
Theorem 3
According to theorem 3 for a given change in a bonds YTM, the size of the change in the bonds
price increases at a diminishing rate as the bonds term to maturity lengthens or if a bond's yield
remains constant over its life, the discount or premium amount will decrease at an increasing rate
as its life gets shorter. This means that a bonds sensitivity to the market interest rates increases at
a diminishing rate as the time remaining until its maturity increases.
Theorem 4
Theorem 4 states that for a given change in a bonds YTM, the absolute magnitude of the
resulting change in the bonds price is inversely related to the bonds coupon rate. This means
that bond volatility is related negatively to the coupon rate, which implies that the percentage
14

change in the bond price due to change in the market interest rate will be smaller if its coupon
rate is higher or will be higher if its coupon rate is smaller. For a given change in interest rates,
the prices of lower-coupon bonds change more than the prices of higher-coupon bonds.
The lower a bonds coupon rate, the greater its price volatility and hence, lower coupon
bonds have greater interest rate risk.
The lower the bonds coupon rate, the greater the proportion of the bonds cash flow
investors will receive at maturity.
All other things being equal, a given change in the interest rates will have a greater
impact on the price of a low-coupon bond than a higher-coupon bond with the same
maturity.
Theorem 5
Theorem 5 says that for a given absolute change in a bonds YTM, the magnitude of the price
increase caused by a decrease in yield is greater than the price decrease caused by an increase in
yield. This implies that the price changes resulting from equal absolute increases in the market
interest rates are not symmetrical. Singh (2013) says, For any given maturity, a decrease in the
market interest rates causes a price rise that is larger than the price decline that results from an
equal increase in the market interest rates. For example a 2% decrease in the market interest
rates would cause a bond price increase which is higher than the price decline that would result
from a 2% increase in the market interest rates.
Conclusion
Therefore, a decline (rise) in interest rates will cause a rise (decline) in bond prices, with the
most volatility in bond prices occurring in longer maturity bonds and bonds with low coupons.
To receive maximum price impact of an expected drop in interest rates- bond buyer should
purchase low-coupon, long-maturity bonds. If rates are expected to increase, buy large coupons
and short maturities. Investors cannot control interest rates but can control the coupon and
maturity of the portfolio.

ASSIGNMENT B
Question 2

15

Determine the price of Rs.1, 000 zero coupon bond with yield to
maturity of 18% and 10 years to maturity & determine yield to
maturity of this bond if its price is Rs 220?
Answer.

Price of the Bond

0 = (1+)

0 =
= ( f = R s . 1 0 0 0 )
= ( r = 1 8 % )
= ( t = 1 0 yr s )

0 =
0 =

1000
(1+0.18)10
1000
(1.18)10

0 = . 191.06

Yield to Maturity (YTM)

1

= ( ) 1
0

1000 1

= (

220

)10 1

= 1.1635 1
= 16.35%

16

ASSIGNMENT B
Question 3
Explain in detail the Dow Theory and how it is used to determine the
direction of stock market?
Answer.
Background
Dow Theory was formulated from a series of Wall Street Journal editorials authored by Charles
H. Dow from 1900 until the time of his death in 1902. These editorials reflected Dows beliefs
on how the stock market behaved and how the market could be used to measure the health of the
business environment.
Dow first used his theory to create the Dow Jones Industrial Index and the Dow Jones Rail Index
(now Transportation Index), which were originally compiled by Dow for The Wall Street
Journal. Dow created these indexes because he felt they were an accurate reflection of the
business conditions within the economy because they covered two major economic segments:
industrial and rail (transportation). While these indexes have changed over the last 100 years, the
theory still applies to current market indexes.
The Dow Theory
The first basic premise of Dow Theory suggests that all information - past, current and even
future - is discounted into the markets and reflected in the prices of stocks and indexes. That
information includes everything from the emotions of investors to inflation and interest-rate data,
along with pending earnings announcements to be made by companies after the close. Based on
this tenet, the only information excluded is that which is unknowable, such as a massive
earthquake. But even then the risks of such an event are priced into the market. Like mainstream
technical analysis, Dow Theory is mainly focused on price. However, the two differ in that Dow
Theory is concerned with the movements of the broad markets, rather than specific securities. It's
important to note that while Dow Theory itself is focused on price movements and index trends,
implementation can also incorporate elements of fundamental analysis, including value- and

17

fundamental-oriented strategies. However, Dow Theory is much more suited to technical

analysis.
Dow Theory Trend Analysis
The Dow Theory uses trend analysis. An important part of Dow Theory is distinguishing the
overall direction of the market. Before we can get into the specifics of Dow Theory trend
analysis, we need to understand trends. First, it's important to note that while the market tends to
move in a general direction, or trend, it does not do so in a straight line. The market will rally up
to a high (peak) and then sell off to a low (trough), but will generally move in one direction.
Dow Theory identifies three trends within the market: primary, secondary and minor. A primary
trend is the largest trend lasting for more than a year, while a secondary trend is an intermediate
trend that lasts three weeks to three months and is often associated with a movement against the
primary trend. Finally, the minor trend often lasts less than three weeks and is associated with the
movements in the intermediate trend. The primary trend is the major trend of the market, which
makes it the most important one to determine. The primary trend will also impact the secondary
and minor trends within the market. For example, if in an uptrend the price closes below the low
of a previously established trough, it could be a sign that the market is headed lower, and not
higher. Regardless of trend length, the primary trend remains in effect until there is a confirmed
reversal.
Primary, Secondary and Minor Trends
In Dow Theory, a primary trend is the main direction in which the market is moving.
Conversely, a secondary trend moves in the opposite direction of the primary trend, or as a
correction to the primary trend. For example, an upward primary trend will be composed of
secondary downward trends. In general, a secondary, or intermediate, trend typically lasts
between three weeks and three months, while the retracement of the secondary trend generally
lasts between one third to two thirds of the primary trend's movement. Another important
characteristic of a secondary trend is that its moves are often more volatile than those of the
primary move. The last of the three trend types in Dow Theory is the minor trend, which is
defined as a market movement lasting less than three weeks. The minor trend is generally the
corrective moves within a secondary move, or those moves that go against the direction of the
18

secondary trend. Due to its short-term nature and the longer-term focus of Dow Theory, the
minor trend is not of major concern to Dow Theory followers. But this does not mean it is
completely irrelevant; the minor trend is watched with the large picture in mind, as these shortterm price movements are a part of both the primary and secondary trends.
Most proponents of Dow Theory focus their attention on the primary and secondary trends, as
minor trends tend to include a considerable amount of noise. If too much focus is placed on
minor trends, it can to lead to irrational trading, as traders get distracted by short-term volatility
and lose sight of the bigger. Stated simply, the greater the time period a trend comprises, the
more important the trend.

Phases of the Primary Trend

Since the most vital trend to understand is the primary trend, this leads into the third tenet of
Dow theory, which states that there are three phases to every primary trend the accumulation
phase (distribution phase), the public participation phase and a panic phase (excess phase). It is
important to look at each of the three phases as they apply to both bull and bear markets
Accumulation Phase.
The first stage of a bull market is referred to as the accumulation phase, which is the start of the
upward trend. This is also considered the point at which informed investors start to enter the
market. The accumulation phase typically comes at the end of a downtrend, when everything is
seemingly at its worst. But this is also the time when the price of the market is at its most
attractive level because by this point most of the bad news is priced into the market, thereby
limiting downside risk and offering attractive valuations. However, the accumulation phase can
be the most difficult one to spot because it comes at the end of a downward move, which could
be nothing more than a secondary move in a primary downward trend - instead of being the start
of a new uptrend. This phase will also be characterized by persistent market pessimism, with
many investors thinking things will only get worse.
Public Participation Phase

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When informed investors entered the market during the accumulation phase, they did so with the
assumption that the worst was over and a recovery lay ahead. As this starts to materialize, the
new primary trend moves into what is known as the public participation phase. During this
phase, negative sentiment starts to dissipate as business conditions - marked by earnings growth
and strong economic data - improve. As the good news starts to permeate the market, more and
more investors move back in, sending prices higher. This phase tends not only to be the longest
lasting, but also the one with the largest price movement. It's also the phase in which most
technical and trend traders start to take long positions, as the new upward primary trend has
confirmed itself - a sign these participants have waited for.

The Excess Phase

As the market has made a strong move higher on the improved business conditions and buying
by market participants to move starts to age, we begin to move into the excess phase. At this
point, the market is hot again for all investors. The last stage in the upward trend, the excess
phase, is the one in which the smart money starts to scale back its positions, selling them off to
those now entering the market. The perception is that everything is running great and that only
good things lie ahead.
This is also usually the time when the last of the buyers start to enter the market - after large
gains have been achieved. Unfortunately for them, they are buying near the top. During this
phase, a lot of attention should be placed on signs of weakness in the trend, such as strengthening
downward moves. Also, if the upward moves start to show weakness, it could be another sign
that the trend may be near the start of a primary downtrend.
Distribution Phase ( in Bear Market)
The first phase in a bear market is known as the distribution phase, the period in which informed
buyers sell (distribute) their positions. This is the opposite of the accumulation phase during a
bull market in that the informed buyers are now selling into an overbought market instead of
buying in an oversold market. In this phase, overall sentiment continues to be optimistic, with
20

expectations of higher market levels. It is also the phase in which there is continued buying by
the last of the investors in the market, especially those who missed the big move but are hoping
for a similar one in the near future. This phase is similar to the public participation phase found
in a primary upward trend in that it lasts the longest and will represent the largest part of the
move - in this case downward. During this phase it is clear that the business conditions in the
market are getting worse and the sentiment is becoming more negative as time goes on. The
market continues to discount the worsening conditions as selling increases and buying dries up
Final Phase in Downward Market Trends
The last phase of the primary downward market tends to be filled with market panic and can lead
to very large sell-offs in a very short period of time. In the panic phase, the market is wrought up
with negative sentiment, including weak outlooks on companies, the economy and the overall
market. During this phase you will see many investors selling off their stakes in panic. Usually
these participants are the ones that just entered the market during the excess phase of the
previous run-up in share price. But just when things start to look their worst is when the
accumulation phase of a primary upward trend will begin and the cycle repeats itself.
Conclusion
Charles Dow relied solely on closing prices and was not concerned about the intraday
movements of the index. For a trend signal to be formed, the closing price has to signal the trend,
not an intraday price movement. Another feature in Dow Theory is the idea of line ranges, also
referred to as trading ranges in other areas of technical analysis. These periods of sideways (or
horizontal) price movements are seen as a period of consolidation, and traders should wait for the
price movement to break the trend line before coming to a conclusion on which way the market
is headed.
CASE STUDY
Answer.
The table below shows the expected returns from each of the three
bond investments over a period of 3 years .

21

Bond A

Bond B

Bond C

0
5
11%
5

Coupon Rate
Maturity(Years)
Yield To Maturity
Duration
Price
Price After 3 Years
Holding Period Return

Rs. 593.45
Rs.811.62

10%
7
12%
6.58
Rs. 829.31
Rs.939.25

37%

10%
5
11%
4.68
Rs.962.99%
rs.982.87

49%

33%

Mr. Jose should pick Bond A and Bond B:

Below are some of the reasons for picking bond A and B
Bonds A and B offer higher capital appreciation than Bond C
The holding period return is higher for Bonds A and B than for C as shown in the table.
Although the longer maturity period of bond B makes it susceptible to price decline as
interest rates rise due to the expected rise in inflation, the situation will not be sustained
as the Reserve Bank of India is already planning a credit squeeze. Further the high
coupon rate for bond B makes its price to be less volatile.
ASSIGNMENT C
Multiple choice.
1
2
3
4
5
6
7
8
9
10

D
C
A
C
B
D
C
C
C
A

11
12
13
14
15
16
17
18
19
20

A
B
B
D
C
C
C
B
A
B

21
22
23
24
25
26
27
28
29
30

22

B
C
A
D
B
B
C
D
D
A

31
32
33
34
35
36
37
38
39
40

D
C
E
D
B
C
D
B
A
C