OUM BBAP 4103 Investment Analysis

BBAP4103
INVESTMENT
ANALYSIS
Dr Saiful Bahri Sufar
Dr Shamsubaridah Ramlee
Dr Izani Ibrahim
Mohammed Zain Yusof
Mohd Hasimi Yaacob
Copyright Open University Malaysia (OUM)

Project Directors: Prof Dato Dr Mansor Fadzil
Prof Dr Wardah Mohamad
Open University Malaysia
Module Writers: Dr Saiful Bahri Sufar

Dr Shamsubaridah Ramlee
Dr Izani Ibrahim
Mohammed Zain Yusof
Mohd Hasimi Yaacob
Universiti Kebangsaan Malaysia
Moderators: Assoc Prof Loo Sin Chun

Loo Sze Wei
Developed by: Centre for Instructional Design and Technology

Printed by: Meteor Doc. Sdn. Bhd.

Lot 47-48, Jalan SR 1/9, Seksyen 9,
Jalan Serdang Raya, Taman Serdang Raya,
43300 Seri Kembangan, Selangor Darul Ehsan
First Edition, September 2004

Second Edition, August 2013 (rs)
Copyright Open University Malaysia (OUM), August 2013, BBAP4103

All rights reserved. No part of this work may be reproduced in any form or by any means
without the written permission of the President, Open University Malaysia (OUM).

Table of Contents
Course Guide ix-xiii
Topic 1 Investment Markets 1

1.1 Definition of Investment 2
1.2 Types of Investment 2
1.3 Types of Financial Investments 3
1.4 Financial Markets 6
1.5 Market Players 9
1.6 Types of Information 9
1.6.1 Broad Market Measures 10
1.6.2 Price Information 10
Summary 12
Topic 2 Transaction in the Share Market 13

2.1 Transaction Procedures in Bursa Malaysia 13
2.2 Types of Orders 15
2.3 Margin Trading 17
2.3.1 Margin Call 19
2.4 Other Trading Transaction Jargon 21
Summary 22
Topic 3 Investment Returns and Risks 24

3.1 The Concept of Returns 25
3.2 The Historical Rate of Return 26
3.3 The Average Return and Standard Deviation 27
3.4 Expected Return 29
3.5 Portfolio 32
3.5.1 Portfolio Return 32
3.5.2 Portfolio Risk 32
3.6 Covariance 33
3.6.1 Correlation Coefficient 35
3.6.2 Correlation Coefficient and Portfolio Risk 37
3.7 Only Covariance between Assets is Important 43
3.8 Markowitz Efficient Diversification 44
3.9 The Efficient Frontier 45
Summary 47

iv TABLE OF CONTENTS
Topic 4 Equilibrium Models and Applications 48

4.1 Risk Free Assets 49
4.2 Risk Free (RF) and Risky Assets 49
4.3 The Market Portfolio 56
4.4 The Capital Asset Pricing Model 58
4.5 Estimating Beta 60
4.6 Applying the CAPM 64
4.7 Arbitrage Pricing Theory 67
Summary 69
Topic 5 Equity Valuation (Fundamental Valuation) 70

5.1 Valuation Process 71
5.2 Basic Valuation Model 71
5.2.1 Discounted Dividend Model 72
5.2.2 Constant Growth Model 74
5.2.3 The Relationship between Share Price 75
and Growth
5.2.4 Multistage Growth 77
5.3 Price Earning (PE) Ratio Method 78
5.4 Expected Rate of Return (k) 79
5.5 Framework to Evaluate Security 80
5.6 Economic Analysis 81
5.7 Industry Analysis 85
5.8 Company Analysis 88
Summary 90
Topic 6 Behaviour of Share Prices (Technical Analysis) 91

6.1 Basic Concepts of Technical Analysis 92
6.2 Tools for Technical Analysis 92
6.2.1 Market Statistics 93
6.2.2 Charts 93
6.2.3 Chart Formations 99
6.3 Efficient Market Hypothesis 100
6.3.1 Assumptions of the Efficient Market 101
Hypothesis (EMH)
6.3.2 Categories of Information 101
6.3.3 Levels of Efficiency 102
6.3.4 Efficient Market Hypothesis Implications 102
Summary 104

TABLE OF CONTENTS v
Topic 7 Fixed Income Security 105

7.1 Characteristics of Bonds 106
7.2 Risks Associated with Bonds 107
7.3 Bond Pricing 109
7.4 Bond Yields 111
7.4.1 Yield to Maturity 111
7.4.2 Current Yield 112
7.4.3 Yield to Call 112
7.4.4 Holding-period Return Versus YTM 113
7.5 Volatility in Bond Prices 114
7.5.1 Bond Prices Move Inversely with Interest Rates 114
7.5.2 Volatility of Bond Prices for Longer Term
Maturity Bonds 115
7.5.3 Measures of Volatility 116
7.5.4 Modified Duration 117
7.6 Bond Portfolio Management 119
7.6.1 Active Bond Management 120
Summary 125
Topic 8 Derivatives Market 126

8.1 General Description of Derivatives 127
8.2 Forward Contract 128
8.3 Futures Contract 130
8.3.1 Clearing House 131
8.3.2 Settlement Price 132
8.3.3 Daily Margin 132
8.3.4 Basis 133
8.3.5 Using Futures for Hedging 134
8.4 Options 140
8.4.1 Options Moneyness 142
8.4.2 Difference between Options and Futures 142
Contracts
8.4.3 Characteristics of Returns and Risk in Options 143
8.4.4 Put-Call-Parity 146
8.4.5 Factors Affecting the Price of an Option 148
8.5 Theories in Pricing of Options 149
8.5.1 The Binomial Pricing Model 149
8.5.2 The Black-Scholes Model 151
Summary 153

vi TABLE OF CONTENTS
Topic 9 Mutual Fund Investment and 154

Performance Measurement
9.1 Process of Portfolio Management 155
9.2 Investors Objectives 157
9.3 Mutual Funds: Professionally Managed 158
Investment Portfolios
9.3.1 Characteristics of a Fund 158
9.3.2 Types of Funds 159
9.4 Performance Evaluation 160
9.4.1 Sharpes Measure 160
9.4.2 Sharpes Differential Return 160
9.4.3 Treynors Measure 161
9.4.4 Treynors Differential Return 162
Summary 163
Answers 164

COURSE GUIDE

COURSE GUIDE ix
COURSE GUIDE DESCRIPTION

You must read this Course Guide carefully from the beginning to the end. It tells
you briefly what the course is about and how you can work your way through
the course material. It also suggests the amount of time you are likely to spend in
order to complete the course successfully. Please keep on referring to the Course
Guide as you go through the course material as it will help you to clarify
important study components or points that you might miss or overlook.
INTRODUCTION
BBAP4103 Investment Analysis is one of the courses offered by the Faculty of
Business and Management at Open University Malaysia (OUM). This course is
worth 3 credit hours and should be covered over 8 to 15 weeks.
COURSE AUDIENCE
This is an elective course for Bachelor of Business Administration students
specialising in Finance.
As an open and distance learner, you should be able to learn independently and
optimise the learning modes and environment available to you. Before you begin
this course, please confirm the course material, the course requirements and how
the course is conducted.
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend 120
study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.

x COURSE GUIDE
Table 1: Estimation of Time Accumulation of Study Hours
Study
Study Activities
Hours
Briefly go through the course content and participate in initial discussion 3
Study the module 60
Attend 3 to 5 tutorial sessions 10
Online participation 12
Revision 15
Assignment(s), Test(s) and Examination(s) 20
TOTAL STUDY HOURS 120
COURSE OUTCOMES
By the end of this course, you should be able to:
1. Identify the different types of investment instruments;
2. Interpret and compute investment returns, yields and risks;
3. Explain the fundamental economic, company and industry analyses to
investments;
4. Discuss the basic valuation model and review the process of securities
valuation;
5. Examine the behaviour of share prices based on technical analysis and
assumptions of efficient market hypothesis; and
6. Apply the methods in evaluating the performance of investment.
COURSE SYNOPSIS
This course is divided into nine topics. The synopsis for each topic is presented
below:
Topic 1 introduces the subject of investment. Students will be exposed to the

different kinds of instruments and the markets where these instruments are
traded. There are different types of investment markets to cater to the different
needs of investors.

COURSE GUIDE xi
Topic 2 focuses on trading in the equity market. Share trading is both intriguing and
the most prevalent form of investment. Each instrument has unique characteristics. A
basic investment instrument must provide returns. These returns are associated with
risks. It is important for an investor to calculate returns and determine risks.
Topic 3 discusses single assets as well as portfolio returns and risks. Students are
advised to put in extra effort in this topic. A good understanding of this topic will be
helpful in taking on Topic 4.
Topic 4 begins from the idea covered in Topic 3. Specifically, it discusses the
derivation of two well-known investment equilibrium models, namely, the Capital
Asset Pricing Model and Arbitrage Pricing Theory. These theories are discussed
without the use of laborious and difficult mathematical processes. However,
students are encouraged to enhance their understanding by reading other advanced
materials as this exercise will increase their analytical skills.
Topic 5 discusses security valuation. The emphasis is on equity evaluation. Concepts

from Topics 3 and 4 will be applied in this topic. The valuation process begins from
evaluating the economy to the characteristics of the industry, and finally to the
company. The discussion on the economy and industry is to provide the overall
investment scenario and the effects they have on a company.
Topic 6 focuses on another well-known investment concept, namely, the efficient

market hypothesis. The concept discusses the relationship between information and
shares prices. It is also related to the technique of technical analysis. In this
technique, the investor observes patterns in price behaviour as well as trading
volumes to forecast the direction of future prices.
Topic 7 discusses at length a fixed income security. The security used for analysis is a
bond. As the name suggests, fixed income securities provide stable income.
However, there are still some risks involved. Returns or yields and risks are
calculated in a slightly different way from equities. This topic also discusses the
factors that will affect yields and investment strategies that use bonds.
Topic 8 discusses securities that have evolved and gained in importance recently,
namely, derivatives. Derivatives instruments are mainly invented and used to hedge
risks. This topic will discuss the concept of hedging. Three main instruments are
discussed, namely, forwards, futures and options. The valuation concepts for these
instruments are difficult to grasp. Therefore, students are advised to go through the
materials very carefully.
Topic 9 attempts to conclude the investment process. It discusses the method to

evaluate the performance of investment. This is vital as it can be used as a

xii COURSE GUIDE
monitoring and controlling tool. In addition, this topic touches on mutual fund
investment. This method of investment has seen tremendous development in this
country for the past 20 years.
TEXT ARRANGEMENT GUIDE

Before you go through this module, it is important that you note the text
arrangement. Understanding the text arrangement will help you to organise your
study of this course in a more objective and effective way. Generally, the text
arrangement for each topic is as follows:
Learning Outcomes: This section refers to what you should achieve after you
have completely covered a topic. As you go through each topic, you should
frequently refer to these learning outcomes. By doing this, you can continuously
gauge your understanding of the topic.
Self-Check: This component of the module is inserted at strategic locations

throughout the module. It may be inserted after one sub-section or a few sub-
sections. It usually comes in the form of a question. When you come across this
component, try to reflect on what you have already learnt thus far. By attempting
to answer the question, you should be able to gauge how well you have
understood the sub-section(s). Most of the time, the answers to the questions can
be found directly from the module itself.
Activity: Like Self-Check, the Activity component is also placed at various

locations or junctures throughout the module. This component may require you
to solve questions, explore short case studies, or conduct an observation or
research. It may even require you to evaluate a given scenario. When you come
across an Activity, you should try to reflect on what you have gathered from the
module and apply it to real situations. You should, at the same time, engage
yourself in higher order thinking where you might be required to analyse,
synthesise and evaluate instead of only having to recall and define.
Summary: You will find this component at the end of each topic. This component
helps you to recap the whole topic. By going through the summary, you should
be able to gauge your knowledge retention level. Should you find points in the
summary that you do not fully understand, it would be a good idea for you to
revisit the details in the module.
Key Terms: This component can be found at the end of each topic. You should go
through this component to remind yourself of important terms or jargon used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms in the module.

COURSE GUIDE xiii
References: The References section is where a list of relevant and useful

textbooks, journals, articles, electronic contents or sources can be found. The list
can appear in a few locations such as in the Course Guide (at the References
section), at the end of every topic or at the back of the module. You are
encouraged to read or refer to the suggested sources to obtain the additional
information needed and to enhance your overall understanding of the course.
PRIOR KNOWLEDGE
Learners of this course are required to pass BBPW3103 Financial Management I and
BBPW3203 Financial Management II course.
ASSESSMENT METHOD
Please refer to myVLE.
REFERENCES
Frank, K. R., & Keith, C. B. (2003). Investment analysis and portfolio management
(7th ed.). Mason, OH: Thomson South Western.
Gitman, J. L., & Joehnk, D. M. (2001). Fundamentals of investing (8th ed.). Addison
Wesley.
TAN SRI DR ABDULLAH SANUSI (TSDAS)

DIGITAL LIBRARY
The TSDAS Digital Library has a wide range of print and online resources for the
use of its learners. This comprehensive digital library, which is accessible through
the OUM portal, provides access to more than 30 online databases comprising
e-journals, e-theses, e-books and more. Examples of databases available are
EBSCOhost, ProQuest, SpringerLink, Books24x7, InfoSci Books, Emerald
Management Plus and Ebrary Electronic Books. As an OUM learner, you are
encouraged to make full use of the resources available through this library.

xxvi X COURSE ASSIGNMENT GUIDE

Topic Investment
1 Markets
LEARNING OUTCOMES
By the end of this topic, you should be able to:

1. Describe the concept of investment;
2. Distinguish between financial assets and real assets;
3. Differentiate between the four types of financial investments;
4. Evaluate the types of financial markets;
5. Assess the major participants in the financial markets; and
6. Describe the types of information needed for financial decision-making.
INTRODUCTION
What do the Bursa Malaysia, the New York Stock Exchange, the Hong
Kong Stock Exchange and the Tokyo Stock Exchange have in common?
They are all financial markets where firms, households and governments borrow
and lend funds. This topic will provide an understanding of the investment
environment within the local and international financial markets. What makes up
the investment environment will be explained by examining how the financial
markets are classified, the types of securities being traded, the players involved
in financial securities trading, and the relevant regulatory bodies responsible for
overseeing the smooth functioning of the investment activities.

2 TOPIC 1 INVESTMENT MARKETS
1.1 DEFINITION OF INVESTMENT
Investment actually refers to current commitment of present resources,

mainly money, in the hope of gaining future benefits.
The commitment involves setting aside present resources to allow their value to
increase in the future. Hence, it requires us to postpone present consumption and
wait for some time in the future. For example, you might set aside a sum of
money to purchase shares today instead of spending it on a brand new car. What
you are doing is to postpone your spending today and commit your money in
the investment of shares. It is done in the hope of gaining future benefits such as
dividends earned or an increase in share price.
SELF-CHECK 1.1
What do you understand by investment? Does it refer to the money
kept in your fixed account or to property bought for long-term
investment? What about the shares that you bought from the
financial market?
1.2 TYPES OF INVESTMENT

Before we proceed with further discussion on various types of investment, let us
ponder over our earlier explanation of the definition of investment. Based on the
definition, funds deposited in fixed accounts, property bought for long-term
investment and shares purchased from the share market are all considered
as investment. But, what types of investment are they?
To help you understand the various types of investment, let us look at the
following example.
Let us say you have just won the lottery and you are not sure what to do with the
money. You could use the money to buy a shoplot and the rent collected in the
future will allow you to travel. Alternatively, you could avoid the risk of not
being able to collect your rent from your tenant or having to maintain the
building, by investing your winnings in the shares of a public-listed company.
Through this investment, you will be entitled to receive dividends when the
company makes profits. In addition, you have the opportunity to earn from the
investment if the price of the share appreciates in the future.

TOPIC 1 INVESTMENT MARKETS 3
In the above example, we see that there are two types of assets that we could
invest in:
Real assets
Financial assets
Investment in the shoplot is an example of an investment in real assets. The

shoplot is an asset, a premises used as an office space or business dwelling.
Hence, the capacity of the asset to generate tangible services is the main feature
of a real asset.
Investment in shares or any securities represents a claim on the real assets of a

company. Investments in shares of a public-listed company enable the investor to
have a claim over the real assets of the company. The claim can be in the form of
dividends paid out of the profits earned.
The above example illustrates how real assets can generate net income for the
economy. A financial asset, however, can simply be regarded as the allocation of
income or wealth among investors. Investors can choose between consuming
their wealth today or investing for the future.
When an investor buys the shares from a company, proceeds from the sale
will be utilised by the firm to purchase real assets such as machinery, equipment,
inventories and other real assets in order to generate profits for the firm. Hence,
the ultimate return of the company will come from the income that is produced
by the real assets that were financed by the issuance of the securities. The profits
are then distributed in the form of dividends to the shareholders.
1.3 TYPES OF FINANCIAL INVESTMENTS

Financial assets can be categorised into four distinct types of financial
investment according to the characteristics of the claims:
(a) Debt Claims
(b) Equity or Residual Claims
(c) Derivative Claims
(d) Hybrid Securities
Now, let us look at the different types of claims found in securities.

(a) Debt Claims
Security in the form of debt is normally referred to as bonds. It entitles the

investor (bondholder) to a specific amount of payment in the form of interest
and principal irrespective of whether the firm generates income or not.
Payment of interest rates for this type of debt security depends on the type of
security issued.
A bond can provide returns in the form of a coupon rate which is

determined at the time of issuance. The cash received in the form of coupon
payment is the coupon rate over the par value of the bond. Bonds have a
maturity period which states when the investor will get back the principal
from the firm. If the investor does not wish to hold the bond for the entire
maturity period, he can sell it. The selling price may be higher than the
purchase price and therefore there may be a possibility of a capital gain.
Sometimes a debt security does not have a coupon rate but it is sold at a
discount, which is at a price lower than its par value. The difference
between the par value and the purchase price at the maturity date is the
interest to the investor. Hence, the name fixed-income securities was given
to reflect the mandatory payment nature to the investor. In Malaysia, this
security is also called a private debt security. Examples of these securities
include government and corporate bonds and certificates of deposits.
Bonds provide a stable income to investors, hence, they are called

fixed-income securities.
(b) Equity or Residual Claims
Investment in equity type securities represents an ownership share in a firm.
Unlike fixed-income securities, investors (equity holders) are not promised

a fixed amount of payment. When the company makes profits, they will
receive dividends if the firm makes a dividend declaration. They will also
have a prorated claim over the companys real assets. If the company is
successful, the value of the equity will increase and vice versa. The
performance of the equity investments is tied directly to the success of the
firm and its real assets. Investments in equity-based securities include
investments in company shares. Investment in equity tends to be riskier
compared with debt securities.

(c) Derivative Claims
Investment in derivative securities such as options and future contracts is the

latest form of investment.
Income is not directly linked to a specific firm but from the prices of other
assets such as bonds and shares. For example, when investing in call
options or warrants (usually attached to a mother share), the return from
this investment is worthwhile if the price of the mother share appreciates
above the exercise price. The main reason for the increased investment in
derivatives is because firms want to hedge or transfer their risk to other
parties. Do not worry at this point if you are puzzled about derivative
claims. We will discuss them in detail in topic 8.
(d) Hybrid Securities
Hybrid securities are securities that have the characteristics of an

equity and debt.
An example of hybrid securities is a loan stock. Loan stock is a debt

instrument that can be converted to shares within a maturity period. Until
the loan stock is converted, the holder is entitled to the benefits that are
accrued to a debt holder. The investor will receive interest or coupon
income. Once it has been converted, the holder will then be an equity
holder and will be entitled to all the rights and privileges of a shareholder.
An example of hybrid securities in the Bursa Malaysia is Irredeemable
Convertible Unsecured Loan Stock (ICULS).

ACTIVITY 1.1
In the previous section, we discussed four types of financial investment.

Based on your understanding of these types of financial investments,
list the advantages and disadvantages of each security. You can get
additional information about the securities from newspapers, the digital
library and the Internet.
Types of Security Advantages Disadvantages
Debt claims
Residual claims
Derivative claims
Hybrid securities
1.4 FINANCIAL MARKETS

The Bursa Malaysia, the New York Stock Exchange and the Hong Kong Stock
Exchange are examples of financial markets. What is a financial market?
Financial markets provide venues for exchanging and creating value of

financial assets.
It provides the investor with the opportunity to trade financial assets in an

organised manner. In a financial market, both buyers and sellers meet to trade in
either debt or equity securities. There are at least three ways to classify the
financial market. They are:
(a) The type of financial claim, whether it is for a fixed dollar amount or by a
residual amount.
(b) Markets can also be classified according to where and when the securities
are acquired.
(c) Markets can be classified according to the maturity period of the security.

ACTIVITY 1.2
1. Open your newspaper and look at the business section. What do
these places have in common the Bursa Malaysia, the New York
Stock Exchange and the Hong Kong Stock Exchange?
2. Visit the Bursa Malaysia website at http://www.bursamalaysia.

com and get more information about the main board and second
board. Then, identify at least three companies listed under the
main board and second board. Why are these companies listed on
the main board or the second board?
3. Get more information on the criteria to determine which board

shares can be listed from the Securities Commission website at
http://www.sc.com.my.
Now, let us look at various types of markets available.
(a) Debt Market versus Equity Market

As explained in the financial investment section, a bond which is a debt
instrument is traded in the debt bond market. In Malaysia, trading of this
type of debt security is done in the private debt securities markets (PDS).
Equity type of security is normally traded in the stock or equity market. In
Malaysia, however, both these markets are located in the Bursa Malaysia.
Transactions in the Bursa Malaysia can be further categorised into the Main
Market and the ACE Market. Shares of firms traded will qualify under a
particular board according to criteria set by the Securities Commission.
(b) Primary versus Secondary Markets

In order to obtain funds for operation purposes, firms can issue securities to
the public. However, issuance of the firms shares can only be done after all
requirements and regulations of the Securities Commission and Bursa
Malaysia have been fulfilled. If it is the first time the firm is issuing the
security, the trade will occur in the primary market.
A primary market is the market for new issues.
It is sometimes called the Initial Public Offering (IPO) market. IPO is also a
means taken up by firms for the purpose of listing shares in the share

market. Firms will still have to go to the primary market if they intend to
issue additional securities. This additional issue is known as a seasoned
public offering.
Issues of shares that have been taken up in the IPO market can
change hands among investors in the secondary market.
Investors can buy shares from the share market if they were not able to do
so from the primary market. In the secondary market, shares are acquired
from other investors. Investors will have to go through a stockbroking firm
and will be charged a transaction cost. Hence, subsequent purchase and
sale of shares are done in the secondary market. Bursa Malaysia provides
the venue for such trading activities.
(c) Money versus Capital Markets

Financial assets are also traded according to their maturity periods.
Short-term securities that mature in less than one year are normally traded
in the money market.
The short maturity period is a feature of the security that makes the money
market more liquid. Treasury bills, certificate of deposits and Bank Negara
notes are some examples of securities that are traded in the money market.
Institutional investors comprising mostly financial institutions will
normally dominate this money market.
Assets that mature in more than one year will be traded in the capital
markets.
In this market, both long-term debt and equity securities are traded. The
long-term nature of these securities makes this market less liquid. Investors
in this market are willing to wait longer for the profits of their investments.
Investors in Cagamas Bonds that mature in 20 years will be receiving
interest payments from year one to 20. They have to wait 20 years before
their original principal investment is collected.

1.5 MARKET PLAYERS

Players in any financial market consist of three major participants. They are:
(a) Firms
Firms are the net borrowers who issue debt or equity securities if they
require funds. The funds generated from the issuance of these securities
will be invested in real assets in order to provide returns to investors.
(b) Household
Households are typically the providers of funds and are normally the net
savers. They purchase the securities issued by firms that need to raise
funds.
(c) Governments
Governments are institutions that can be either borrowers or lenders
depending on the status of their tax revenue and expenditures.
Governments facing a budget deficit will normally borrow to finance their
activities. Alternatively, any surplus will be invested in various types of
securities.
1.6 TYPES OF INFORMATION

There is a wide variety of information to help investors make decisions.
Generally, we can categorise information into two forms.
(a) Analytical Information

Analytical information includes opinions on economic forecast, projections
on the effects on the share market and recommendations to buy or sell
certain stocks. Typically, a good broker will provide this service. You can
sometimes obtain share market analyses from columnists in the
newspapers.
(b) Descriptive Information

Descriptive information is that which gives historical and current data on
the market. Here you can obtain past information on the economy,
industry and companies. Newspapers carry a lot of such information.
With recent developments in information technology, a lot of the above

information can also be obtained through the Internet.

1.6.1 Broad Market Measures

Sometimes a quick indication of the condition of a market is needed. This is
particularly helpful when appropriate timing is required to enter the market.
Two measures of the market can be used to show the general market condition.
An Index measures the current performance of a selected group of shares.

It is usually obtained by taking the current price of the selected shares and
comparing it with a base value. This base value would have already been set
earlier.
The FTSE Bursa Malaysia KLCI Index (FBMKLCI) is an example. It comprises 30

shares from the Bursa Malaysia. Apart from the FBMKLCI, the Bursa Malaysia
also produces sectorial indices and the syariah index.
Another measure is an average.
Averages are obtained by taking the arithmetic average price of a selected

number of shares at a given point of time.
The most famous is the Dow Jones Industrial Average (DJIA).
1.6.2 Price Information

Let us look at some basic information that you can get from a newspaper. As
mentioned earlier, most of the information is descriptive in nature. Some analysis
is provided by columnists.
The Bursa Malaysia price data are reported based on sectors. Shares are listed
according to their sectors. This classification is based on the principal activity of
a company. However, this can be quite ambiguous since a company may have a
lot of different activities.
A daily newspaper price report on each share will normally consist of the
company share code and its name. Three kinds of prices will be reported. They
are the highest and lowest prices for the year and the closing price. The closing
price is the last price traded the day before. The report will also include any price
changes from the day before yesterday. Lots traded is the number of lots that
changed hands between investors. One lot is equal to 200 units of shares. The

term Div Yield refers to dividend yield. This measure is obtained by taking the
dividend divided by the price. It shows the share returns in terms of its
dividends. The Price Earnings (PE) ratio is the earnings divided by price. The
next figure beside the PE ratio is the market capitalisation figure. This is obtained
by taking the number of shares times the price. Topic 5 of this module will
discuss the usage of dividend yields and PE ratios.
In the loans and debentures section, you will see some information on
outstanding bonds and debentures. The majority of them are loan stocks. The
report will show the closing price as well as the years highest and lowest prices.
A bond normally has a par value of RM100. Therefore, a closing price of
RM104 means that the bond is traded at a premium. A closing price below
the par value is a discount bond. The report also shows the date of issue and the
maturity date. The rate quoted in the report is the coupon rate. The yield is the
return required by investors from the bond. The coupon rate may not be the
same as the yield. If the closing price is higher than RM100, then the yield is
lower than the coupon rate. You will see this relationship in Topic 7 of this
module.
The report also shows the date you can get your coupon payment.
In the unit trust section, you will see information like buy, sell, NAV, initial
charge and annual fee.
(a) The price listed under the column Buy is the price the unit trust will buy
back from the unit holders.
(b) Under the column Sell is the price you have to pay if you want to buy the
unit trust.
Notice that the buy price is lower than the sell price. NAV is the net asset value.
It is obtained by taking the market value of the trust less expenses divided by the
number of units. Market value of the trust will represent the market value of
shares or bonds held by the trust.

Test your understanding by attempting the questions below.
EXERCISE 1.1
1. Differentiate between financial and physical assets.
2. List three examples of financial assets.
3. Explain what debt instrument being a claim on the firms assets
means.
4. Explain the returns that you can get from a share.
Investment refers to current commitment of present resources, mainly

money, in the hope of gaining future benefits.
There are four categories of financial investments:

(a) Debt Claims;
(b) Equity or Residual Claims;
(c) Derivative Claims; and
(d) Hybrid Securities.
The financial markets provide venues for exchanging and creating value of
financial assets and the players involved are firms, households and
governments.
Investors require analytical information and descriptive information in

investment decision-making.

Topic Transactions
2 in the Share
Market
LEARNING OUTCOMES

1. Explain the transaction procedures in the Bursa Malaysia;
2. Differentiate the types of orders;
3. Assess the mechanics of margin trading; and
4. Explain the terms used in share trading transactions.
INTRODUCTION
In Topic 1, we looked at the definition of investment, types of investments and
financial markets. In this topic, we will look at transaction procedures in the
stock market. After we have discussed transaction procedures, we will move on
to various orders that exist in share market transactions. Finally, we will discuss
margin trading or loan facility to buy shares.
2.1 TRANSACTION PROCEDURES IN BURSA

MALAYSIA
Its 9am on Sunday and you are at home reading the newspapers. In the business
section, you read that an established cosmetic company is expecting an increase
in profit. You are interested in buying shares in this company but do not have a
clue as to how to go about it. What is the first step that you should take?

14 TOPIC 2 TRANSACTIONS IN THE SHARE MARKET
The first step that you need to do is open a CDS Account and a Trading Account
with a remisier or a dealer from a licensed broker. Before proceeding with the
transaction procedures in the share market, let us clearly understand what a
remisier and a dealer are.
A remisier is an agent who handles individual investors while a dealer is an

agent who handles institution investors.
The trading account looks like any ordinary bank account where there are debit
and credit columns. All purchases are recorded on the credit side and all sales are
registered on the debit side. All transactions in the Bursa Malaysia do not involve
any physical transfer of share scripts between buyer and sellers. It is all done
electronically.
Having decided to purchase shares, the investor will then contact his remisier
and place a buy order. The order will specify the number as well as the price of
the purchase. Next, the order will be entered into the Bursa Malaysia automated
trading system or WinScore. The purchase will usually be completed if there is a
seller willing to sell below or at the same price offered by the buyer. If there is
more than one buyer, then the security will be sold to the highest bidder. If there
is more than one seller, the purchase will be fulfilled by the seller with the lowest
offer price.
The completed transaction will indicate the number of shares and the matched
price. The broker will then send details of any transaction to the investor in the
form of a contract note. The note will have information such as brokerage, stamp
duty and clearing fees. The contract note will serve as an indication that the
transaction bid or offer was successful.
The buyers account will then be credited with the number of shares on the third
day after the successful order. This is known as T+3. The buyer will own the
shares upon payment to the broker. The buyer cannot trade in these shares before
payment is made without the permission of the broker. The buyer is not allowed
to cancel the purchase since the bid was successful. If he fails to settle the
payment, the broker can sell off the shares.
Since the buyers account has to be credited or recorded on the third day, it is
important for the other party of the transaction, that is the seller, to have the
shares in his account two days after the successful order. This is known as T+2.
Sometimes, the buyer may sell the shares before the payment is made. This is
known as contra transaction. If the selling price is higher than the purchase price,

TOPIC 2 TRANSACTIONS IN THE SHARE MARKET 15
the buyer has made a profit. Then, the broker will pay the buyer this profit. If a
loss has been made, the client has to pay the broker the difference.
Bursa Malaysia has specified the minimum bids that can be used for any
transaction. This minimum bid is the change in price of a share that can be
offered or bid. For example, a share with a market price of RM5.50 can only be
offered or bid with a change in price of five sen. A buyer may bid to buy at
RM5.55 or RM5.60 but not at RM5.53. Notice the price change is at a minimum of
five sen and not three sen. Details of other price ranges can be obtained from the
Bursa Malaysia website.
ACTIVITY 2.1
1. Based on your understanding of the transaction procedures in a

share market, use a mind map to explain the roles of buyer, seller,
remisier and the share market.
2. Visit other share market websites such as the Hong Kong Stock
Market at http://www.asiadragons.com/hong_kong/finance/
stock_market/ and the New York Stock Market at
http://www.nyse.com/ and determine whether their trading
procedures are the same as that of the Bursa Malaysia procedures.
2.2 TYPES OF ORDERS

Remember in the earlier section, we noted that having decided to buy a share,
you must place a buy order with the remisier. In a stock market transaction, there
are five types of orders:
(a) Market Order
(b) Limit Order
(c) Stop Order
(d) Good Till Cancel Order
(e) Day Order

Let us discuss each type of order further.
(a) Market Order

Market order is an instruction that an investor gives to the broker to buy or
sell at the prevailing market price. This type of order is risky as the
difference in price can be very far from the price anticipated by the investor.
(b) Limit Order

To protect against too great a price range, an investor can set limits to the
price the broker can use.
In a limit buy order, the investor sets the highest price that he is willing to pay
for a stock. If the market price of the stock is thought to be too high and does
not fall below this limit, then the buy order will not be executed. If the price is
lower than the limit buy order, the broker should buy at the best price.
In a limit sell order, the investor sets the lowest price he is willing to sell a
particular stock. In this case, the stock will not be sold if there is no buyer
willing to pay the stated price.
(c) Stop Order

Stop order is an instruction to protect an investor from profit or limit losses.
It is used when the investor thinks the price is going to fall and he needs to
protect his investment. For example, an investor buys some shares for RM3
each and the price is now RM4. He gains a profit of RM1.00 and wants to
protect it. Thus, he places a stop loss order of RM3.75. If the price falls to
RM3.75, the broker will try to sell the share. Sometimes, the broker may not
be able to complete the transaction at that price and may sell it at a lower
price. The risk in this type of arrangement is that the price drop is
temporary. The price may go up again and the investor will lose the
opportunity to get higher returns once the share is sold.
A stop order can be combined with a limit order. For example, the above
investor can issue a stop order of RM3.75 and a limit sell order of RM3.50. If
there is no buyer willing to buy at RM3.50, then the stock will not be sold.
(d) Good Till Cancel Order

Good till cancelled is an order that is valid until the client instructs it to be
cancelled.
(e) Day Order

Day order is an order that will be valid for a day. It will not be carried to
the next trading day.

Visit Bursa Malaysia website at http://www.bursamalaysia.com or any broker

companys website and list other order(s) that is(are) not discussed in this
section.
EXERCISE 2.1
1. Explain why it is risky to place a market order.
2. Explain what kind of order an investor can make if he is not a risk
taker.
2.3 MARGIN TRADING
Margin trading is a loan facility that an investor can use to buy stocks.
This loan is provided by the broker. The loan amount is based on an agreed
percentage of the value of the shares. Interest will be charged on the amount of
the loan as well as the length of time the loan was used.
Table 2.1 shows a margin trading situation using an example of purchasing five
lots of shares at a price of RM3 per share. The amount of cash flow needed is
RM1,500. The investor is given a margin facility of 40% of the investment value.
Therefore the investor needs to come up with RM900 of his own funds.
Margin facility can effectively increase an investors return. It provides a leverage

effect on the returns. Panel A on Table 2.1 shows the effect on the returns if the
price of the shares rises to RM5. If the investor sells the shares at that price, the
amount of cash he will receive is RM2,500 (500 x RM5). From the sale, he has to
pay interest as well as the principal amount that he borrowed. The net cash flow
from the sale is RM1,840 (RM2,500 RM600 RM60) and after deducting his
initial capital, the net cash flow from the investment is RM940 (RM1,840
RM900). The rate of return for the investment is just the net cash flow from the
investment divided by the initial capital [(RM940 900) x 100]. Therefore, if the
price rises to RM5, then the rate of return for this investor is 104.44%.
However, the leverage effect can be risky to an investor. If the price falls to RM2,
Panel A shows that the rate of return is negative 62.22%. The use of margin
trading is similar to a firm that uses debt to finance an operation. It adds risk to
the investor.
Look at Panel B where the investor buys shares without the margin trading. With
RM900, the investor will only be able to purchase three lots of shares. If the price
rises to RM5, the rate of return is only 66.67%. However, if the price falls to RM2,
the rate of return is negative 33.3%, which is lower than 62.22% as compared to
the rate of return when margin trading is used.
Table 2.1: Calculation of Share Trading with and without Margin Trading
A: Trade with Margin Trading

B: Trade without Margin Trading
SELF-CHECK 2.1
The cosmetic companys shares that you read about in Sundays
newspaper cost RM3 per share. You are interested in purchasing five
lots, and it will cost you RM1,500. If you do not have sufficient cash to
purchase the shares, how would you finance your investment?
2.3.1 Margin Call

The value of investment can change if the price of the share changes. Thus, the
broker needs to protect himself against any default by the customer. The broker
can insist on a maintenance margin against the value of an investment.
A maintenance margin is a level to which the investment value can drop before
the investor has to increase his contribution to the investment.

Let us look at Table 2.2 for a clearer picture.
Table 2.2: Margin Call
Panel A of Table 2.2 shows the initial position of the investor in a margin trading
situation (based on 2.3 example). The investment value is financed partly by the
loan from the broker and the investors own funds known as equity value. Lets
say that the broker needs a 30% maintenance margin. This means that the equity
portion of the investment must not fall below 30% of the total investment value.
Panel B is the position if the share price increases to RM5. Notice that the loan
figure is still the same while the equity figure has increased from RM900 to
RM1,900. The investor is safe at this level of share price.

Panel C is a position where the price of the share drops to RM1.72 and
consequently the equity value falls. The equity value has dropped by 30% of the
total investment value. If the price falls any further, the equity portion is going to
be less than 30%. This is shown in Panel D. A price drop of RM1.60 will cause the
equity value to drop to 25% of the total investment value. Therefore, the investor
needs to contribute some cash to meet the maintenance margin. This contribution
of the new cash is known as a margin call.
Panel E is the position when the cash has been collected from the investor. The
investment will now comprise RM800 worth of stocks and RM57.14 cash. The
new cash is then included in the equity of the investor. This will raise the equity
level to 30%. Please take note that the investor had actually borrowed 40% of the
initial investment value.
Sometimes, it is easier to determine the price that the share can drop to before a
margin call is made. This drop in price can be obtained through the equation
below:
Loan
Price drop = BuyingPrice
Initial Value - (Initial Value Maintenance Margin)
RM600
RM1.71 = RM3.00
RM1, 500 - (RM1500 0.3)
The broker will make a margin call if the share price drops below RM1.71.
2.4 OTHER TRADING TRANSACTIONS JARGON

There is some interesting jargon that market players use in share trading
transactions. If an investor is buying and intends to hold the share for a while,
then he is regarded as being in a long position. An investor is said to be in a short
position if he is not interested in a share, or if he has any, he intends to sell it.
A bull trend is a condition where the market is on the rise. If an investor feels
bullish, then he may think that a share may increase in price and it is a good time
to buy. A bear trend is a market that is on the decline. A bearish situation is when
investors think it is time to sell or may also indicate that it is not the time to enter
the market.
Short selling is a situation where we sell shares that we do not own. This is done
when there is a forecast that the price of a share is going to fall. The procedure is
to borrow shares and sell them. Then wait for the price to fall after which we will
buy them at a lower price. The shares are then returned to the lender. The
difference between the selling and buying price is the profit made. This move is
very risky and involves a lot of speculation. If it is done on a large scale, it may
also upset the situation in the market. Some exchanges may ban this type of
transaction.
Visit the Bursa Malaysia website at http://www.bursamalaysia.com and list

other transaction jargons that used in share trading transactions.
EXERCISE 2.2
Share A is selling at RM3. You only have RM15,000 to invest. The

first alternative is to use only your funds to buy the shares. The
second alternative is to arrange a margin trading with your broker.
You can borrow up to 50% of your investment value. The interest
rate is 8%.
(a) How many units of shares can you buy with the first
alternative?
(b) How many units of shares can you buy with the second
alternative?
(c) If the price goes up to RM3.80, how much return can you get
from your investment from each alternative?
(d) With the margin trading, calculate how far the price could drop
before you get a margin call. The broker insists on a 30%
maintenance margin.
An account is needed before an investor can trade in shares.
Different kinds of orders can be made during trading, which can be suited to
the requirements of the investor.
Investors can use margin trading for the purpose of funding an investment.
Margin trading has a leverage effect.

Although it is risky, it can also maximise an investors rate of return.
Terms used in share market trading include:

Long position
Short position
Bull trend
Bear trend.

Topic Investment
3 Returns and
Risks
LEARNING OUTCOMES

1. Calculate investment returns and risks;
2. Differentiate between expected and realised returns;
3. Explain the concept of portfolio;
4. Calculate portfolio returns and risks;
5. Analyse the concepts of covariance and correlation coefficient and their
effects on portfolio risks; and
6. Describe the concept of efficient frontier.
INTRODUCTION
This topic focuses on the determination of returns and risks. Before an investor
makes any decisions with regard to his investment plans, he must have some
basic knowledge of the returns and risks of the investment. Apart from helping
the investor to make decisions, returns and risks measures can be used to
compare alternative investments and performance evaluation. This topic will also
show how to determine portfolio returns and risks. Almost all investors will
diversify and invest in more than one asset. In this situation, knowledge of
mathematics of portfolio analysis will be useful.

TOPIC 3 INVESTMENT RETURNS AND RISKS 25
3.1 THE CONCEPT OF RETURNS
Investment actually refers to current commitment of present resources,

mainly money, in the hope of gaining future benefits.
The main objective of investment is to increase the wealth of the investor. This
can be achieved by investing in an investment that will provide a return. The
return can then be measured from the cash flow obtained from the investment. If
the investment is in the form of shares, the cash flows obtained are in the form
of dividend and capital gain. Capital gain is the extra selling price above the
purchase price. Investment in bonds, on the other hand, will provide cash flows
in the form of coupon payments and capital gain.
In this topic, share equity will be used for the discussion on the relationship
between cash flows and returns. The following dividend model shows the
relationship between price, dividend and required rate of return.
D1
P0 (3.1)
(k g )
P0 = Price or the current value of the share

D1 = Expected dividend next year or year 1
k = Required rate of return (sometimes k is also known as the
expected rate of return)
g = Rate of growth
An explanation of the above model will be given in Topic 5. The expected

rate of return can be obtained as follows:
D1
k g (3.2)
P0
The above model assumes that investment is done indefinitely. If the investor
invests only for a limited period of time, the calculation of return should be
adjusted accordingly. For example, if the investment is done in two different
periods and the shares are then sold at the end of the period with a price, P1, the
rate of return is:

26 TOPIC 3 INVESTMENT RETURNS AND RISKS
D 1 P1 P0
k (3.3)
P0 P0
or
(D 1 P1 ) P0
k (3.4)
P0
Formula 3.3 above clearly shows how the rate of return is related to the cash
flows received from shares. D1/P0 is known as dividend yield and (P1 P0)/P0 is
the capital gain. If the cash flows are actually realised, then k will be known as
the realised rate of return.
Formula (3.1) is often used for obtaining the share value, P0. It is also used to
show the relationship between the values of P0 with k. The relationship between
P and k is inversely related.
If the investor increases the expected return, the share price will fall. There are
several factors that make the investor require a high rate of return from a share.
One of these factors is due to the increase in the risk of the share.
SELF-CHECK 3.1
In Topics 1 and 2, we were introduced to the concept of investment.
Based on your understanding of the investment concept, why do
people invest? What do they hope to achieve? Explain.
3.2 THE HISTORICAL RATE OF RETURN

Sometimes, for the purpose of measurement and analysis of performance,
we need to determine the investment return from past data or historical data.
However, we have to remember that the past cash flows have been realised, thus
the return determined from such data can also be known as the realised return.
As an example, Table 3.1 shows the price and dividend data from share A for the
past five years.

Table 3.1: Price, Dividend and Rate of Return
The performance of the share between 1998 and 1999 can be determined
by using formula (3.4).
(0.20 3.50) 3.00
k
3.00
0.233 or 23.3%
The return for the following years is shown in the Total Return column of Table 3.1.
The returns data above can then be used for further analysis.
3.3 THE AVERAGE RETURN AND STANDARD

DEVIATION
Data from Table 3.1 can be used to determine the average annual return of the
share for the past five years.
The calculation for obtaining the average return is as follows:

0.233 0.09 + 0.266 + 0.11
Average Return
4
0.13 or 13%
This average return shows one descriptive value on the estimated yearly return
that could be achieved from the asset for that five-year period. This return is
assumed to be perpetual and compounded every year. However, as
demonstrated in Table 3.1, the return for each year can be higher or lower than
the average return. In the process of determining the risk, this deviation must be
determined. This process is shown in Table 3.2.
In column three of Table 3.2, there are positive and negative deviation values.
This shows that there exists the actual yearly returns which are higher or lower
than the average return. If we calculate the total in column three, we will see that

the positive numbers will be reduced by the negative numbers. This will not give
a realistic guidance about the return deviation with the average returns.
Therefore, the deviation values from column three should be squared. This
process is required to get rid of the negative elements of the deviation and the
results are shown in column four.
Table 3.2: Average Return and Standard Deviation
(1) (2) (3) (4)

Period Return (R ) Deviation ( R - R ) ( R - R )2
1 0.233 0.103 0.011
2 0.09 0.220 0.048
3 0.266 0.136 0.019
4 0.11 0.020 0.000
Total 0.519 0 0.078
0.130 Variance (2) 0.026

Average R
Standard Deviation () 0.161
Variance ( ) is the total of column 4 divided by 3. Standard
2
deviation () is the square root of the variance.
The variance is calculated by dividing the total in column four by three. This
number 3 is the total number of periods subtracted by 1 (N 1). To get the
Standard Deviation (), the variance has to be square rooted.
In the above example, the average return is 13%. For one standard deviation (1 ),
the return can be above the said average return up to 0.291(0.13 + 0.161) and can
be below the average return up to 0.031 (0.13 0.161). If we look at two times
deviations, the return can be between negative 0.452 and 0.192.
By now, it will be clear that the standard deviation can be used to measure the
range of the probability of returns. The probability of return can be higher or
lower than the average return. This proves that standard deviation is a suitable
measure to describe the risk of a certain asset.
As an example, share A has an average return of 12% and standard deviation of

5%, while share Bs average return is 12% and standard deviation is 2%.
Based on this information we know that share A has a higher risk. Share A in one
deviation can be as high as 17% and can also be as low as 7%. Share B, on the

other hand, can reach up to 14% and can slide down to 10%. Based on this
standard deviation, share B is less risky.
Generally, the average return R can be determined as follows:

m
Rij
R m
j 1
(3.5)
Standard deviation is determined as below:

m
(Rij R )2
ij m 1
(3.5)
Where Rij is return on asset i at time j and total time period is m.
3.4 EXPECTED RETURN
The expected return is the return that is required by the investor.
There are several models that can be used to determine this rate. In this topic, we
will use one short and simple model. Other sophisticated models will be
discussed later in the following topics.
There are three steps involved in determining the expected return.
Step 1: An investor has to recognise several economic situations and estimate

the probability that situations will occur. Economic conditions, for
instance, can be classified as high growth, normal growth, constant,
recession and stagflation. If the investor chooses the share market, the
situations can be divided into bull, constant and bear market.
Step 2: The investor then has to assign probabilities for each situation or
condition.
Step 3: Finally, we have to forecast the required rate of return for each situation.
Table 3.3 shows the example of the above process. There are three market
situations that have been identified. Each of the situations has been given a
probability. Total probability is one. Then, a rate of return will be estimated for
each market condition. The process of determining the probability and estimated

rate of return can be done with the help of professionals in the economics and
investments fields.
Table 3.3: Expected Return and Standard Deviation
(1) (2) (3) (4) (5) (6)

Market Probability Pr Return Ri Pr x R i Deviation (R ERi)2Pr
Situation Ri ERi
Bull 0.15 0.3 0.045 0.1425 0.003046
Constant 0.7 0.15 0.105 0.0075 0.000039
Bear 0.15 0.05 0.0075 0.1075 0.001734
Expected 0.1575 Variance (2) 0.004819
Return ERi
Standard 0.069419
Deviation ()
The expected return is obtained by taking the total of the multiplication results of
the rate of return and the probability, i.e., total of column 4. Generally, it can be
shown by the following formula:
m
E (Ri ) P R
j 1
ij ij (3.7)
Where, Pij is the probability return of asset i in market situation j and Rij is the
return for asset i in market situation j.
Risk is the deviation of the return from the expected return. It is measured by
determining the variance and the standard deviation. The calculation process is
shown in Table 3.3. Column 5 shows the deviation of the return from the
expected return, while column 6 shows the square of the deviation. The total of
column 6 is known as variance (2). It is important to note that we do not have to
divide this total with any number or value as in equation (3.6). This is a bit
different from the way variance is determined in the previous section. The value
of variance is then square rooted to get the value of standard deviation ().
Generally, the process of determining the variance is as follows:
m 2
i 2 Pij Rij E (Ri ) (3.8)
j 1
and the standard deviation is:

m
i P [R
j 1
ij ij E (Ri )]2 (3.9)

It looks like conceptually there is no difference between the standard deviation

calculation for expected return and the average return. The difference is, in
determining the expected return we have to use the value of probability. The
method of calculating and the use of standard deviation are not much different.
Therefore, standard deviation can still be used to measure investment risk, for
analysing past data and also the expected data.
ACTIVITY 3.1
Select at least three shares listed in the Bursa Malaysia and obtain its
annual report from the companys website. Based on the concept of
return, which share would you invest in? Why?
EXERCISE 3.1
1. What do you understand by risk and return for an investment?
2. Briefly explain the difference(s) between expected rate of return and

average rate of return.
3. What are the components of return if you invest in shares and in

bonds?
4. Ahmad would like to invest in shares of Ingress Corporation. The

current price of the shares is RM2.50. Last year the company paid a
dividend of RM0.20 per share and the dividend is expected to grow
at a rate of 5% per year.
(a) What is the expected return for Ahmad if he decides to invest
in this company indefinitely?
(b) What is the expected return if after one year Ahmad sells the
share for RM3?
(c) What is the dividend yield for this investment?

3.5 PORTFOLIO
A portfolio is when an investor divides his funds and invests in more than one
asset. The main aim of a portfolio is to reduce risk through diversification.
We will see later that this objective cannot be achieved by simply dividing funds
into different assets. Therefore, the objective of constructing a portfolio is to
determine the amount of funds in each asset that will result in minimum risk
given the level of return that the investor requires.
SELF-CHECK 3.2
If you have RM1 million to invest, would you invest all your money in
one investment? What is the risk of putting all your money in one
investment instead of diversifying investment? Justify your answer.
3.5.1 Portfolio Return

In the previous section, we discussed how the return and risk of a single asset are
determined. Let us say we have a pair of assets as shown in Table 3.4.
Table 3.4: Expected Return and Standard Deviation of Two Assets
Asset A B
Expected Return 10 18
Standard Deviation 6 9
We can either invest in asset A or B or divide our funds between A and B. Lets say the
fund is divided and 50% invested in A and 50% in B. The portfolio return would be:
(0.5 x 10) + (0.5 x 18) = 14
The general formula will look like:

(3.10)
ERP w AERA w B ERB
and
w A wB 1 (3.11)

Where ERA and ERB are the expected returns, WA and WB are the weights or
percentage of funds in asset A and B respectively. The total weight of the funds
must be equal to one.
If we have three assets, then the formula becomes:

ERP w A ERA w B ERB wC ERC (3.12)
and
w A w B wC 1 (3.13)
The general formula if we have n number of assets, the return of the portfolio
and the sum of weights is:
ERP w AERA w B ERB w n ERn ,
(3.14)
w A w B w n 1
3.5.2 Portfolio Risk

The risk of a portfolio for two assets can be determined using the following
formula:
P w A2 A2 w B2 B2 2w Aw B AB
(3.15)
Where A2 and B2 are the variance of Asset A and Asset B respectively. AB is

known as the covariance of A and B. Lets say the value of this covariance is 43.2.
Based on the example in 3.5.1, 50% of funds is in A, the risk of this portfolio is:
p (0.52 )(6 2 ) (0.52 )(9 2 ) 2(0.5)(0.5)(43.2) 7.13 (3.16)
This covariance is a new concept that we will discuss next.
3.6 COVARIANCE
Covariance measures the relationship between two assets. The returns of two
shares can move either with each other or against each other.
If the covariance is large and positive, then the two shares returns move in the
same direction. If one of the shares moves up the other share moves up as well. A
small and positive covariance will also mean that the two shares move in the

same direction. However, the relationship is not strong. There are times when the
shares do not move in the same direction.
A negative covariance means that the two assets will move in the opposite
direction. This means that if one asset moves up, the other will move down. A
large negative covariance will mean the pair of assets will go into different
directions. Table 3.5 shows the technique to calculate covariance.
Table 3.5: Calculation of Covariance and Correlation Coefficients for Pairs of Assets
Probability Asset Returns
Economic Event
(Pi) R S T U
High 0.333 15 15 5 10
Normal 0.333 10 10 10 15
Low 0.333 5 5 15 5
Expected Return
10 10 10 10
(ERi)
Risk (i) 4.08 4.08 4.08 4.08
Panel 1:
Probability
Event R (RR ERR) S (RS ERS) (RR ERR) (RS ERS)Pi
(Pi)
High 0.333 15 5 15 5 8.33
Normal 0.333 10 0 10 0 0.00
Low 0.333 5 -5 5 -5 8.33
Covariance (RS) 16.67
Correlation Coefficient (RS) 1
Panel 2:
Probability
Event R (RR ERR) T (RT ERT) (RR ERR) (RT ERT) Pi
(Pi)
High 0.333 15 5 5 -5 -8.33
Normal 0.333 10 0 10 0 0.00
Low 0.333 5 -5 15 5 -8.33
Covariance (RT) -16.67
Correlation Coefficient (RT) -1
Panel 3:
Probability
Event R (RR ERR) U (RU ERU) (RR ERR) (RU ERU) Pi
(Pi)
High 0.333 15 5 10 0 0
Normal 0.333 10 0 15 5 0
Low 0.333 5 -5 5 -5 8.33
Covariance (RU) 8.33
Correlation Coefficient (RU) 0.5

The top part of Table 3.5 shows the data needed for the calculation. Lets say we
have four assets from R to U and for each asset, we have the probable return for
each event and the probability of the event. This is similar with the concept
discussed in Section 3.4. From the probable returns and the probabilities, the
expected return and standard deviation of each asset can be determined.
For instance, Panel 1 of the table shows the calculation to determine the
covariance of Asset R and Asset S. Column 4 of this section shows that we need
to determine the deviation of each probable return from its expected return. For
example, for asset R, from event 1, the deviation is (15 10).
Column 7, Row 4 of Panel 1 shows the product of two deviations is multiplied

with the probability. In this case, it is the product of two deviations between R
and S. Taking the total value of this column will give the covariance between R
and S.
ACTIVITY 3.2
Select a pair of shares listed in the Bursa Malaysia and determine the
covariance between the shares. You can use the companys annual report
information to obtain relevant information. What can you conclude?
3.6.1 Correlation Coefficient

The value of the covariance can be positive or negative and the value can be any
number. In order to make comparisons between pairs of assets easier and to
standardise the degree of the relationship, we can use the correlation coefficient
(). The value can be determined by the formula below:
RS
RS (3.17)
R S
The correlation coefficient between R and S,( RS) is just the covariance of R and
S, (RS) divided by the product of the standard deviation of R(R) and S(S).
The value of is between 1 and +1. This makes it easier to compare the
relationship between two pairs of assets. Table 3.5, Column 7, Row 5 of Panel 1-3
shows the result of this process.
If a pair of assets has a of +1, it means that the 2 assets are perfectly positively
correlated. This means that the 2 assets move in a perfect direction. Our example

showed that for assets R and S, the amount of returns are the same in each event.
Between assets R and T, this relationship is perfectly negative. Observe that the
returns for T are low when the returns for asset U are high. The relationship
between assets R and U however is positive but not perfect.
Table 3.6: The Effect of Correlation Coefficient on a Portfolios Risk

ERA = 10 A = 6
ERB = 18 B = 9
Panel 1: Correlation Coefficient (AB ) = +1
2 2 2 2 2
wA wB ERp w A A w B B 2wAwBABAB P P
1 0 10 36 0 0 36 6
0.9 0.1 10.8 29.16 0.81 9.72 39.69 6.3
0.8 0.2 11.6 23.04 3.24 17.28 43.56 6.6
0.7 0.3 12.4 17.64 7.29 22.68 47.61 6.9
0.6 0.4 13.2 12.96 12.96 25.92 51.84 7.2
0.5 0.5 14 9 20.25 27 56.25 7.5
0.4 0.6 14.8 5.76 29.16 25.92 60.84 7.8
0.3 0.7 15.6 3.24 39.69 22.68 65.61 8.1
0.2 0.8 16.4 1.44 51.84 17.28 70.56 8.4
0.1 0.9 17.2 0.36 65.61 9.72 75.69 8.7
0 1 18 0 81 0 81 9
Panel 2: Correlation Coefficient (AB ) = -1
2 2 2 2 2
1 0 10 36 0 0 36 6
0.9 0.1 10.8 29.16 0.81 9.72 20.25 4.5
0.8 0.2 11.6 23.04 3.24 17.28 9 3
0.7 0.3 12.4 17.64 7.29 22.68 2.25 1.5
0.6 0.4 13.2 12.96 12.96 25.92 0 0
0.5 0.5 14 9 20.25 27 2.25 1.5
0.4 0.6 14.8 5.76 29.16 25.92 9 3
0.3 0.7 15.6 3.24 39.69 22.68 20.25 4.5
0.2 0.8 16.4 1.44 51.84 17.28 36 6
0.1 0.9 17.2 0.36 65.61 9.72 56.25 7.5
0 1 18 0 81 0 81 9
Panel 3: Correlation Coefficient (AB ) = 0
2 2 2 2 2
1 0 10 36 0 0 36 6
0.9 0.1 10.8 29.16 0.81 0 29.97 5.47
0.8 0.2 11.6 23.04 3.24 0 26.28 5.13
0.7 0.3 12.4 17.64 7.29 0 24.93 4.99
0.6 0.4 13.2 12.96 12.96 0 25.92 5.09
0.5 0.5 14 9 20.25 0 29.25 5.41
0.4 0.6 14.8 5.76 29.16 0 34.92 5.91
0.3 0.7 15.6 3.24 39.69 0 42.93 6.55
0.2 0.8 16.4 1.44 51.84 0 53.28 7.30
0.1 0.9 17.2 0.36 65.61 0 65.97 8.12
0 1 18 0 81 0 81 9

EXERCISE 3.2
The following table shows the historical investment data for an
investor in a company. Answer the following questions based on the
data from the table.
Dividend Purchase Price Selling Price
Year
(RM) (RM) (RM)
1999 4.00 100.00 97.00
2000 3.50 97.00 97.50
2001 3.40 95.00 94.00
2002 3.60 98.00 109.00
2003 3.60 99.50 112.00
(a) What is the expected return of the investment in year 2000?

(b) What is the dividend yield for the investment in 2001 and 2002?
(c) What is the capital gain for the investment in 2001?
(d) What is the average return for a five-year investment from 1999
to 2003?
(e) Calculate the variance and the standard deviation for the five-
year investment?
3.6.2 Correlation Coefficient and Portfolio Risk

When the correlation coefficient is used, the formula to determine a portfolios
risk is as follows:
P w A2 A2 w B2 B2 2w Aw B AB A B (3.18)
The correlation coefficient value can affect the risk of the Portfolio. Let us say we
have the two assets A and B from the previous example as shown in Table 3.7.

Table 3.7: Expected Return and Standard Deviation of Two Assets

Asset A B
Expected Return 10 18
Standard Deviation 6 9
If we allocate 50% of the funds in A and 50% in B, the expected return from the
portfolio is:
(0.5 x 10) + (0.5 x 18) = 14
If the correlation coefficient between A and B is +1, the portfolios risk is:
(0.52 )(62 ) (0.52 )(92 ) 2(0.5)(0.5)( 1)(6)(9) 7.5
When the correlation coefficient is 1, the portfolio risk becomes:
(0.52 )(62 ) (0.52 )(92 ) 2(0.5)(0.5)( 1)(6)(9) 1.5
The different correlation coefficient has provided two different levels of risk.
Table 3.6 showed the effect of the correlation coefficient on the portfolio risk
when the amount of funds invested in each asset was altered. Panel 1 of Table 3.6
showed the different levels of return and risk with different amounts of funds.
Columns three and eight showed the expected return and risk of the portfolio.
If all the funds are invested in asset A, then all the returns and risk will come
from that asset. If some funds are shifted from A to B, then we notice the
expected returns and risk will change.
Panel 1 of Table 3.6 shows a situation where assets A and B have a correlation
coefficient of +1. Take note that the risk increases when there is a shift of funds
from A to B.

The different levels of return and their risk is shown in Figure 3.1.
Figure 3.1: Portfolio opportunity set when AB = +1
At point A, the investment is 100% in asset A while at point B it is 100% in asset

B. From point A, the investor shifts funds from A to B and the level of return
increases. The line indicates that the risk increases as the return increases. There
is no risk advantage in shifting funds from A to B, since the increase in the return
is accompanied by an increase in the risk.
Panel 2 of Table 3.6 is a situation when the correlation coefficient is 1. Take note
that the expected returns are the same as in Panel 1. However, the pattern of risk
is very different. We notice that as funds are shifted from A to B, the portfolios
risk decreases. The risk continues to decrease until the level where the fund is
60% in A and 40% in B. At this level, the combination between A and B provide a
return with zero risk. After this level, further shift from A to B will increase
returns, but the level of risk will begin to increase as well.

The relationship between return and risk when the correlation coefficient is 1 is
shown in Figure 3.2.
Figure 3.2: Portfolio opportunity set when AB = 1
Observe that there are two lines. One line moves from point A to the y-axis. As
before, 100% of the fund is invested at point A. As the investor shifts from A to B,
the return increases but the level of risk decreases. There is an advantage in
shifting funds from A to B. The other line moves from the y-axis to point B. The
returns keep increasing as the funds are shifted. However, this time the risk
increases as well.
Also observe that at some points on the second line the return is more efficient
than the points on the first line. If we refer back to Table 3.6 and look at the
position where 70% of funds are invested in A, the return is 12.4 and the risk
level is 1.5. When 50% of funds are in A, the return is 14 and the risk is also 1.5.
This means that the investor can be more efficient by obtaining a higher return
with the same level of risk.
Combinations of assets in a portfolio that can provide zero risk can only be
obtained if two assets have a correlation coefficient of 1. However, it is very rare
to find two assets moving opposite each other perfectly. This is because assets or

investments are found within an economy, and the return and risk will be
affected by the general condition of the economy, thus, all of these assets will be
affected by the same variables. Only the degree of relationship is different. At
best, investors can only find pairs of assets that have a correlation coefficient of
less than +1.
Panel 3 in Table 3.6 shows the return and risk if the correlation coefficient
between A and B is 0. Take note that the risk decreases if funds are shifted from
A to B. However, the risk level does not reach zero. All the investor can manage
is to combine the assets and obtain a portfolio with minimum variance. Figure 3.3
shows the relationship between return and risk when the correction coefficient is
0. Observe the portfolio located at the point of minimum variance.
Figure 3.3: Portfolio opportunity set when AB = 0
We can combine Figures 3.1 and 3.2 as shown in Figure 3.4.

Figure 3.4: Superimposed portfolio opportunity set when AB = +1 and 1
We have noted earlier that the correlation coefficient can only be between +1 and
1. Therefore the lines from these two extremes can be used as a limit that shows
the relationship between returns and risks. If the correlation coefficient is
between +1 and 1, the line or curve must be inside the triangle.
This is illustrated in Figure 3.5. The lines and curves in Figure 3.5 are derived
from the summary in Table 3.6. Also notice that when the correlation coefficient
is 0.8, there is no combination of assets that can provide a minimum risk. This
can be confirmed from the results in Table 3.6 where the correlation coefficient is
0.8, the amount of risk did not decrease when finds are shifted from A to B.

Figure 3.5: Portfolio opportunity set with different values of AB
Another feature of the curves is that they are convex or curving towards the
y-axis and not away. This feature is in line with the behaviour of an investor who
prefers high returns with low risk. The only situation when the investment
opportunity is a straight line is when the correlation coefficient is +1 or 1.
3.7 ONLY COVARIANCE BETWEEN ASSETS IS

IMPORTANT
Let us look at the formula for portfolio risk when we have three assets, A, B and
C. We will use the formula with covariance as shown below,
P w A2 A2 w B2 B2 wC2 C2 2w Aw B AB 2w AwC AC 2w BwC BC

(3.19)

If we have four assets, the formula will look like this,
w A2 A2 w B2 B2 wC2 C2 w D2 D2
2w Aw B AB 2w AwC AC 2w Aw D AD
P (3.20)
2w BwC BC 2w B w D BD
2wC w D CD
Notice that the number of covariance increases more than the variance. If the
portfolio has two assets, the number of variance is 2 and the number of
covariance is also 2 (AB and BA). If there are three assets, the number of
variance is 3 and the number of covariance is 6 (AB, BA, AC, CA, BC, CB). If
the number of assets is four, the covariance is 12.
As the number of assets in the portfolio increases, the number of covariance will
be greater. The covariance between assets will become the major portion of the
portfolios risk in relation to the individual variance of the assets.
The general situation is that the relationship between the assets in the portfolio
(as measured by the covariance) will be more important than the individual
variance of the asset. As the number of assets gets larger, the investor can ignore
this individual variance of asset. In the next topic, we will see the full effect of
this situation.
3.8 MARKOWITZ EFFICIENT DIVERSIFICATION

Recall that the main objective of constructing a portfolio is to reduce risk through
diversification. In a share market, the investor attempts to distribute risk among a
number of shares. However, this diversification is not simply picking a few
shares at random.
It is pointless to include shares from the same industry as these shares will move
together and the correlation coefficient between them will be high. Markowitz
suggested that shares should be combined by taking into account their
correlation coefficient with each other.
Combinations of shares with correlation less than +1 are most preferable.

Therefore, it is advantageous for the investor if he can mix stocks from different
industries, since some industries do not have perfect correlation. We have seen
the effect of this exercise in the previous section.

3.9 THE EFFICIENT FRONTIER

An efficient portfolio will always offer the highest return within a risk level. A
portfolio can be more efficient than a single asset since the effect of correlation
coefficient can reduce risk. In other words, the risk of a single asset, when
combined with other assets, can be diversified away. For example, if all the
shares in the market are considered in the construction of portfolios then there
will be some portfolios that are more efficient than others. The minimum
requirement is that there must be at least one share that has a correlation
coefficient of less than +1 with other shares to form an efficient portfolio.
Earlier, we stressed that a portfolio curve moves towards the y-axis. Therefore, if
all shares in the share market are considered and the above condition exists, we
will have a selection of portfolios that are more efficient. These selections of
portfolios will lie on a curve that is known as the efficient frontier. The efficient
frontier is a curve shown in Figure 3.6.
Figure 3.6: The efficient frontier
Only portfolios are on the efficient frontier since individual shares will have
higher risks than portfolios. Individual shares and inefficient portfolios will lie
below the curve.

ACTIVITY 3.3
Select a pair of shares from two different industries in the Bursa Malaysia.
Jot down their prices at the end of each month for the past 12 months.
Calculate their average return, standard deviation and covariance. Based
on your findings, what can you say about the two industries?
EXERCISE 3.3
1. Abdullah decides to invest in the share market. He gathers some

information about the economic conditions and the probability of
the returns that he will get. You have been assigned to help
Abdullah to determine the risk and return of the investment by
answering the following questions using the data in the given table.
Economic Probability Return Return
Situation (Pr) Company A Company B
Recession 0.1 10% -15%
Average 0.5 15 10
Above average 0.3 25 20
Boom 0.1 30 40
(a) What is the expected return of each asset?

(b) What is the variance of the return?
(c) What is the standard deviation of the return?
(d) What is the range of the return within 1 standard deviation?
(e) Which company should Abdullah invest in? Why?
2. Use the data from Question 1 and calculate the covariance and
correlation coefficient between the two assets.
3. What is the return and risk of a portfolio that consists of 30% in A

and 70% in B from Question 1?

4. The following stocks are available for consideration

Stocks Ri i
N 25% 12%
O 25 8
P 10 5
Q 15 12
NO = 0.8, NP = -0.8, NQ = 0,
OP = -1, OQ = 0.8, PQ = 1,
Calculate the return and risk of portfolio that is made up of the

following combinations:
(a) 50% in N and 50% in O
(b) 30% in N, 30% in O and 40% in P
(c) 25% in N, 25% in O, 30% in P and 20% in Q
(d) Which combination is the best investment in terms of returns
per unit risk?
The main objective of a portfolio is diversification and reducing risk.
To achieve the effect of risk reduction, investors should combine assets that
are less correlated with one another.
Combinations of assets in a portfolio that can provide zero risk can only be
obtained if two assets have a correlated coefficient of 1.
An efficient portfolio is one that offers the most returns for a given amount of
risk, or the least risk for a given amount of returns.

Topic Equilibrium
4 Models and
Applications
LEARNING OUTCOMES
1. Explain risk-free asset;
2. Calculate the return and risk of a portfolio;
3. Explain the importance of the Capital Asset Pricing Model (CAPM) in
investment decision-making;
4. Review the concept of systematic risk or Beta; and
5. Explain the concept of Arbitrage Pricing Theory.
INTRODUCTION
In Topic 3, the discussion of portfolio theory showed how an efficient portfolio
was formed using a combination of risky assets. In this topic, we will extend the
analysis of portfolio as well as the usage of some tools derived from Topic 3. We
will be introduced to risk-free assets and changes observed in the shape of an
efficient frontier.
Next, we will discuss the concept of equilibrium condition and how assets are
being priced in these conditions. As a result, we will derive two equilibrium
models, namely the Capital Asset Pricing Model (CAPM) and the Arbitrage
Pricing Theory (APT).

TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS 49
4.1 RISK-FREE ASSETS
A risk-free asset is an asset with zero variance.
Technically, the asset will provide a return that is equal to its expected return.
Thus, there is no variability in the returns. An example of a risk-free asset is a
fixed deposit in the bank. If the bank promises to pay a fixed amount of interest
within a stated period, then the bank would normally fulfil its promise.
Therefore, the investor will neither expect the return to be lower nor expect the
bank to increase the return. Since this type of arrangement has no risk, the return
offered is normally low.
4.2 RISK-FREE AND RISKY ASSETS

An investor can choose to invest 100% in a risk-free asset (RF) or divide his funds
into risk-free assets and risky assets. For example, if RF is offering a return of 8%
and the expected return of risky Asset A is 10%, what is the expected return from
the portfolio? Risky Asset A has a standard deviation of 6% and the investor
places 40% of funds in RF . The correlation between the risky asset and risk-free
asset is zero, that is AF = 0. From Topic 3, we know that portfolio return (ERp) is:
ERP = wFRF + wAERA.
Where:
wF = Weights in RF
wA = Weights in Asset A
ERA = Expected return of Asset A.
Thus, ER(P) for the above example is:

ER(P) = (0.4 x 8) + (0.6 x 10)
= 9.2
The risk (P) of the above portfolio is:

P w F2 F2 w A2 A2 2w F w A AF F A
0.42 (0) 0.62 (62 ) 2(0.4)(0.6)(0)0(6) 3.6
Notice that the risk of Asset A made up the whole risk of the portfolio, in
proportion to the amount of funds invested in the asset. As mentioned earlier, we

50 TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS
can shift funds from RF to Asset A and build a set of portfolios and a range of
returns and risks.
Table 4.1 shows the range of portfolio returns and risks when funds are shifted
from RF to Asset A.
Table 4.1: Calculation of Portfolio Return and Risk between Asset A and Risk-Free Asset
RF = 8 RF = 0 A ARF = 0
ERA = 10 = 6
wRF wA ERp w2RFs2RF w2A2A 2wRFwAPRFARFA 2P P
1.0 0 8.0 0 0 0 0 0
0.9 0 8.2 0 0.36 0 0.36 0.6
0.8 0 8.4 0 1.44 0 1.44 1.2

0.7 0 8.6 0 3.24 0 3.24 1.8
0.6 0 8.8 0 5.76 0 5.76 2.4
0.5 0 9.0 0 9.00 0 9.00 3.0

0.4 0 9.2 0 12.96 0 12.96 3.6
0.3 0 9.4 0 17.64 0 17.64 4.2
0.2 0 9.6 0 23.04 0 23.04 4.8

0.1 0 9.8 0 29.16 0 29.16 5.4
0 1 10.0 0 36.00 0 36.00 6.0
Note: Please refer to Topic 3 for explanation on the calculations and symbols.
If the expected return and risk are plotted on a graph, we will get a straight line
as shown in Figure 4.1.

Figure 4.1: Portfolio return and risk of risk-free and asset A
Let us say there is another investment asset, Asset B for our investment
consideration. The expected return for Asset B is 11.6% and the standard
deviation is 5.3%. What is the portfolio combination of RF and Asset B? Figure 4.2
shows the portfolio combination that can be made between RF and Asset B. The
line is derived from the calculations in Table 4.2.
Figure 4.2: Combinations of RFA and RFB

Table 4.2: Portfolio Returns and Risks for Combinations between Risk-Free Asset (RF)
and Risky Asset A and Risky Asset B
wRF ERP1 P1 ERP2 P2

1 8 0 8 0
0.9 8.2 0.6 8.4 0.5
0.8 8.4 1.2 8.7 1.1
0.7 8.6 1.8 9.1 1.6
0.6 8.8 2.4 9.4 2.1
0.5 9 3 9.8 2.6
0.4 9.2 3.6 10.2 3.2
0.3 9.4 4.2 10.5 3.7
0.2 9.6 4.8 10.9 4.2
0.1 9.8 5.4 11.24 4.8
0 10 6 11.6 5.3
RF RF 0
RF RF 6 RE 0
RF RF 5.3 ARF 0
Portfolio P1 is combination of RP and asset A
Portfolio P2 is combination of RP and asset B
If we also plot the portfolio return and risk (risk-free asset and Asset A as in
Figure 4.2), you can see that the combination of RF and Asset B are more efficient
than the combination of RF and Asset A. At the same risk level (point 2 and point
1), the combination of RF and Asset B offers a higher return compared to the
combination of RF and Asset A.
In the last topic, it was shown that if all risky assets were to be combined to form
portfolios, then an efficient set of portfolios could be found. This efficient set is
located on the efficient frontier. We can combine RF with any portfolios in the
efficient set. Figure 4.3 shows the combinations that can exist between RF and the
efficient frontier.

Figure 4.3: Combinations of RF with any assets on the efficient frontier
Using the previous discussion, the line RFA are portfolios that are less efficient
than RFB. We can move upwards until a line is obtained that gives the highest
return with a given level of risk. This line just touches the efficient frontier at
point P. Asset P is known as the optimal portfolio. It is the portfolio that gives the
best sets of returns within its specific risk level. It is also the highest line or the
line with the greatest slope.
An investor now will not want to consider any other portfolios other than P,
since combinations of RF and this portfolio give him the best returns and risk
compared with any other combination below the line. Therefore, we can ignore
any portfolios or assets that are not on the RFP line. The investment selection now
shifts from the curve of the efficient frontier to the straight line. Figure 4.4 shows
the complete strategies an investor can choose.
At point RF, an investor invests 100% in the risk-free asset. At point P, he invests
100% in portfolio P. Between RF and P, he combines RF with P. Any position on
the line is where the investor lends some of his funds to RF and also invests some
portion in P.

The investor can extend his choice by borrowing and invest in P. This is shown
by the extended line PP1. The investor will expect a higher return but the risk will
increase. He will also need to pay interest on the borrowed funds. The interest
rate is RF.
Figure 4.4: Combinations of RF and optimal portfolio P; lending and borrowing positions

Table 4.3 shows the calculations for the RF PP1 line.
RF = 8 RF = 0 PRF = 0
ER P = 16 P = 7
wRF wP ERPortfolio w2Ps2P w2Ps2P 2wRFwPrRFPsRFsP s2Portfolio sPortfolio
1 0 8 0 0 0 0 0
0.9 0.1 8.8 0 0.5 0 0.5 0.7
0.8 0.2 9.6 0 1.9 0 1.9 1.4
0.7 0.3 10.3 0 4.2 0 4.2 2.1
0.6 0.4 11.1 0 7.5 0 7.5 2.7
Lending 0.5 0.5 11.9 0 11.8 0 11.8 3.4
0.4 0.6 12.7 0 17.0 0 17.0 4.1
0.3 0.7 13.4 0 23.1 0 23.1 4.8
0.2 0.8 14.2 0 30.2 0 30.2 5.5
0.1 0.9 15.0 0 38.2 0 38.2 6.2
0 1 15.8 0 47.1 0 47.1 7
-0.1 1.1 16.6 0 57.0 0 57.0 7.6
-0.2 1.2 17.3 0 67.9 0 67.9 8.2
Borrowing
-0.3 1.3 18.1 0 79.7 0 79.7 8.9
-0.4 1.4 18.9 0 92.4 0 92.4 9.6
-0.5 1.5 19.7 0 106.1 0 106.1 10.3
When the investor has 10% of his investment using borrowed funds, he is
investing 110% in P. The return from the portfolio is:
ERPortfolio w F RF w P ERP
( 0.1 8 ) (1.1 16)
16.8
The risk of the portfolio is:
Porfolio w F2 F2 w P2 P2 2w F w p pF F P
0.12 (0) 1.12 (72 ) 2( 0.1)(1.1)(0)0(7)
7.7

SELF-CHECK 4.1
You have two types of assets to be considered for investment. Asset A
is risk-free but only offers a return of 6% while Asset B is a risky asset
which offers 10% returns. Which asset would you invest in? Why?
4.3 THE MARKET PORTFOLIO

In the previous section, we discussed optimal portfolio P, the most efficient
portfolio. To maximise returns with the best risk level, the investor will not
consider any other risky assets. All investors would prefer to hold this portfolio
P. Therefore, this portfolio must include all risky assets. If not, there would be no
demand for that asset and therefore, it would not have any value (price).
If we consider an equilibrium situation and all assets are included, then the
optimal portfolio P is the market portfolio. All assets will be represented in
this market.
A portfolio consists of a combination of assets according to their respective

weights. Therefore, in this market portfolio, each asset will be represented by its
value in proportion to the total value of the market.
Efficiency is an important characteristic of this market portfolio. An efficient

portfolio will be a fully diversified portfolio. A fully diversified portfolio is where
all unique risks of the individual asset have been diversified away. The
remaining risk is the systematic risk of the individual asset. This systematic risk
is measured by the covariance of an individual asset with the market portfolio.
Take note that a market portfolio is a combination of all risky assets. An
individual asset in the market portfolio will therefore have a covariance with
every other single asset in the market. In the next section, we will find that this
covariance of an asset with the market will become a very significant
contribution to an asset return.
If we redraw Figure 4.4 and replace portfolio P with market portfolio M, we will
obtain Figure 4.5, the Capital Market Line.

Figure 4.5: Capital market line
The straight line is known as the Capital Market Line (CML). CML now becomes
the relevant efficient frontier. The vertical and horizontal lines represent the
expected returns and risks of portfolios respectively. The CML shows the
relationship between the expected returns and risks of portfolios. This
relationship, which is a straight line, is shown below:
(ERM RF )
ERP RF P.
M
(ERM RF )
The risk of the portfolio is: .
M
The above equation shows that expected returns (ERP) will be high when the
risks (P) of the portfolio are high. The value of the slope will be the same at any
point along the line. This slope represents the price of the risk that an investor
will face. The price will increase when the risk increases.
SELF-CHECK 4.2
If a portfolio is what an investor has when he divides his funds

and invests in more than one asset, what is a market portfolio?

4.4 THE CAPITAL ASSET PRICING MODEL
Capital Asset Pricing Model (CAPM) is a model that shows the relationship
between returns and risks of individual assets.
In the previous section, the CML provides the return-risk relationship of

portfolios. Though there are numerous risky assets in the market portfolio, the
most efficient is the market portfolio. There will be numerous risky assets in this
market portfolio. Now, we will examine the relationship of an individual asset
with this market portfolio.
CAPM was derived by using many assumptions. These assumptions are stated
below:
(a) There are many investors and they are all price takers. This situation is
similar to perfect competition where nobody has any influence on the
market.
(b) All investors have one holding period.
(c) All assets are in the market. Investors can borrow or lend any amount at a
fixed risk-free rate.
(d) There are no taxes and no transaction costs.
(e) All investors make decisions based on mean and variance.
(f) All investors have homogeneous expectations. Thus, they will behave the
same way if faced with the same situation.
In the last topic, we saw how a portfolio risk is determined. Portfolio risk is a
combination of individual assets variance and covariance with other assets. As
the number of assets in a portfolio increases, the number of covariance also
increases. The number of covariance will finally be more than the variance of
individual assets. This will indicate that the covariance between assets will be
more important than the variance as the number of assets in the portfolio
increases. The covariance between assets will contribute a major portion of the
portfolio risk. Therefore, the only risk that is relevant is the covariance of an
individual asset with other assets in the portfolio.
We also have stressed that the only efficient portfolio is the market portfolio.
Therefore, the only risk that is relevant to an individual asset (i) in the market
portfolio is its covariance with the market portfolio (iM).

Again, this return-risk relationship can be interpreted through Figure 4.6. We

have used the same format as in Figure 4.5. However, the vertical and horizontal
lines have been replaced with expected returns (ERi) and risk (covariance
between i and M, iM) of individual assets. The line is known as the Security
Market Line (SML).
Figure 4.6: The security market line (SML) representing the capital asset pricing model
Firstly, observe that the covariance of the market with itself is the variance of the
market, (MM) = (2M).
(ERM RF )
The slope of the SML is therefore:
M2
The equation for the SML is shown below:

(ERM RF ) iM
ERi RF iM or ERi RF (ERM RF )
M2 M2
Secondly, we can replace the term with a standardised format known as Beta (i)
or systematic risk. The equation of the SML can be shown as:
ERi RF i (ERM RF ).

This equation is known as the Capital Asset Pricing Model (CAPM). It states that
the expected return of an individual asset i is related to its systematic risk (i).
The investor should demand a reward to incur this risk. The general price of the
risk is the market risk premium (ERM RF). This risk premium is the same for all
assets. However, the amount of reward for each risky asset is the risk premium
multiplied by the systematic risk (i). Note that the amount of reward for each
risky asset together with the risk-free rate will determine the total expected
return.
Notice that if the covariance of the market with itself is the variance of the
market, (MM) = (2M), then the Beta of the market is equal to one. Figure 4.6 will
then change to Figure 4.7.
Figure 4.7: The capital asset pricing model
4.5 ESTIMATING BETA

The systematic risk or Beta can be estimated using the equation below:
Rit i i RMt
where:
Rit = the return for asset i during period t;
RMt = the return of the market portfolio during period t;
i = the constant term or the intercept of the regression line;
i = the beta of asset; and
= the random error for the line.

The above equation is similar to any time series regression model, where the
independent variable is RM and the dependent variable is Ri. Ri is assumed to
change when RM changes. The amount of change in Ri will be determined by i,
with some level of error, . The equation will give you a straight line. In this
context, we can call it a characteristic line. Please take note that the above
equation is not the CAPM.
The actual market portfolio cannot be observed since it is impossible to include

all risky assets. A complete market will have to include all financial and physical
assets as well as human assets, arts, properties, raw materials, natural resources
and others. The alternative is to use a proxy of the market. The accepted
procedure is to use a market index. In Malaysia, we can use the Bursa Malaysia
Composite Index.
Table 4.4 shows an example of how beta is calculated. We have used monthly
price data from Yeo Hiap Seng (YHS) and YTL Power (YTLPWR). The prices
have to be converted into returns. For example, the return for January 2002 is
obtained by taking the price for that month minus the price from December 2001
and divided by the December price. Hence, the return for YHS is
RM2.03 RM2
100 1.50 . Columns four and five as indicated in Table 4.4
RM2
are products of two deviations. For YHS, it will be (R KLCI R KLCI )(RYHS RYHS )
for each month.
Figure 4.8 shows the scatter plot for returns of YHS against the KLCI. The x-axis
represents the returns of the KLCI. Each dot represents the returns of the share
against the KLCI on a particular month. A line can be drawn across the dots to
show a general relationship between YHS returns against the KLCI.
In a regression model, this line is known as the line of best fit. We can call this
line the characteristic line. The slope of the line is the measure for Beta. Figure 4.9
shows the line for YTLPWR. Do you notice that the slope for YHS is steeper than
YTLPWR? This indicates that the beta (risk) for YHS is higher than YTLPWR.
ACTIVITY 4.1
Refer to the Bursa Malaysia website at http://www.bursamalaysia. com.
Select at least three shares from the same industry listed in the Bursa
Malaysia and determine their beta. What can you conclude from the
results obtained? You can also obtain the data required for your
calculation from the newspapers.

Table 4.4: Beta Calculation for YHS and YTLPOWER

Return (1)(2)= (1)(3)=
Date KLCI YHS YTLPWR RKLCI RYHS RYTLPWR RKLCI - RKLCI (1) RYHS - RYHS (2) RYTLPWR - RYTLPWR (3) (4) (5)
Dec-01 661.52 2 2.4

Jan-02 697.11 2.03 2.37 5.38 1.50 -1.25 5.56 3.43 -2.43 19.04 -13.53
Feb-02 707.68 2.07 2.27 1.52 1.97 -4.22 1.69 3.90 -5.40 6.60 -9.15
Mar-02 741.72 2.04 2.5 4.81 -1.45 10.13 4.99 0.48 8.95 2.38 44.63
Apr-02 761.42 2.12 2.89 2.66 3.92 15.60 2.83 5.85 14.42 16.57 40.85
May-02 789.93 2.23 2.87 3.74 5.19 -0.69 3.92 7.11 -1.88 27.90 -7.36
Jun-02 755.21 1.95 2.88 -4.40 -12.56 0.35 -4.22 -10.63 -0.84 44.83 3.52
Jul-02 744.62 1.91 2.82 -1.40 -2.05 -2.08 -1.22 -0.13 -3.27 0.15 4.00
Aug-02 721.65 1.92 2.75 -3.08 0.52 -2.48 -2.91 2.45 -3.67 -7.12 10.66
Sep-02 694.09 1.8 2.74 -3.82 -6.25 -0.36 -3.64 -4.32 -1.55 15.75 5.64
Oct-02 642.09 1.69 2.55 -7.49 -6.11 -6.93 -7.31 -4.19 -8.12 30.61 59.38
Nov-02 655.76 1.73 2.75 2.13 2.37 7.84 2.31 4.29 6.66 9.90 15.36
Dec-02 618.37 1.5 2.84 -5.70 -13.29 3.27 -5.52 -11.37 2.09 62.80 -11.54
Jan-03 626.17 1.46 2.8 1.26 -2.67 -1.41 1.44 -0.74 -2.59 -1.07 -3.73
Feb-03 661.25 1.48 2.8 5.60 1.37 0.00 5.78 3.30 -1.18 19.05 -6.84
Mar-03 635.66 1.46 2.8 -3.87 -1.35 0.00 -3.69 0.57 -1.18 -2.12 4.37
Average R -0.18 -1.93 1.18 Total* 245.28 136.26
SD ( ) 4.32 5.52 5.84
Variance
18.68 30.47 34.13
( )
2
Covariance
17.52 9.73
(im)
Beta ( ) 0.94 0.52
Alpha () -1.76 1.28
Column 4 is column 2 multiplied with column 1
Column 5 is column 3 multiplied with column 1
Total* is the total for the Column 4 and 5.
Covariance = Total* 14 ( 14 is the number of observation less 1, that is 15 months less 1).
Beta is (im 2KLCI ). Alpha for YHS is RYHS ( YHS R KLCI ) and accordingly for YTLPWR.

Figure 4.8: YHS characteristic line
Figure 4.9: YTLPWR characteristic line

EXERCISE 4.1
1. Using a rough sketch, determine the beta for Share A and B.
Year Market Return Return Share A Return Share B
1 3% 16 5
2 -5 20 5
3 1 18 5
4 -20 25 5
5 6 14 5
2. Currently the share price of Fatbody Corp is RM3. The firm is

experiencing a growth rate of 6% annually. Last years EPS (E0) is
RM0.40, and the dividend payout ratio is 50%. The risk-free rate is
5% and the market return is 10%. Determine the required return
and the beta of Fatbody.
4.6 APPLYING THE CAPM

Let us assume that we are able to obtain the following data for a set of shares
from an investment analyst:
Stock Beta
A 0.8
B 1
C 1.2
D 1.8
E -0.5
Also assume that the investment analyst has predicted that the market is
expected to provide a return (ERM) of 10% and the current risk-free rate (RF) of
4%. The market risk premium will be 6%.
With this scenario, the expected return (ERi) of each share will be calculated as in
Table 4.5.

Table 4.5: Expected Return
Beta Risk Premium

Stock Expected Return ERi = Risk-free RF
I (ERM RF)
A 8.8% = 4% 0.8 (10% 4%)
B 10% = 4% 1 (10% 4%)
C 11.2% = 4% 1.2 (10% 4%)
D 14.8% = 4% 1.8 (10% 4%)
E 1% = 4% -0.5 (10% 4%)
At equilibrium, all the shares should provide the returns as shown in Table 4.5.
This will also mean that the returns will depend on the SML. Figure 4.10 depicts
this situation. All shares will be in line with their respective betas.
Figure 4.10: Asset returns with their betas
Sometimes, you may face a situation where the expected returns are not in line
with the estimated returns. For instance, an investor may have his/her own
speculation on the selling price of each share, and this will result in an estimated
return that is different from the expected returns. For further elaboration, lets
say that the current price is P0 price and the investor expects to sell the shares at
P1 prices. The analysis for this scenario is described in Table 4.6.

Table 4.6: Analysis of Prices
Current Estimated Estimated Expected Actual

Price
Stock Price P0 Price P1 Return Return Value
Situation
(RM) (RM) (%) ERi (%) P0"(RM)
A 3.5 3.81 8.8 8.8 Correct 3.50
B 4.6 5.50 19.5 10 Undervalued 5.00
C 2.5 2.61 4.5 11.2 Overvalued 2.35
D 2.1 2.18 4.0 14.8 Overvalued 1.90
E 1.22 1.24 2.0 1 Close 1.23
The estimated return is obtained by taking the percentage change in price

P1 P0
100 . This estimated return is compared against the expected return
P0
from the CAPM. If the estimated return is equal to the expected return, then the
share is in equilibrium. The actual value P0 is the same as the current price, P0.
For stock B, the estimated return is higher than the equilibrium or the expected
return. Investors might think that the share can offer a higher return than
expected. Thus, there will be an increase in demand, since in equilibrium all
investors will have the same information and behaviour. The increase in demand
will increase the current price P0. As we can see, the current price, P0 of RM4.60 is
considered undervalued. The actual value P0 is RM5.00. With this increase, the
estimated return will converge to the expected return.
The situation for shares C and D is in reverse. In this case, investors estimate
returns that are below expectations. They are unlikely to hold these shares and
probably try to sell them if they are holding them. This will create less demand
and over supply of those shares. As a result, the price will decrease. Share D, for
example, is overpriced at P0 RM2.1. The actual value is only RM1.90. With the
decrease, the estimated return will converge to the expected return.
Figure 4.10 shows the relationship of the estimated return against the expected
return. The expected returns lie on the SML. All shares with estimated returns
above the SML are considered undervalued. The reverse is true for the
overvalued shares.

ACTIVITY 4.2
1. We often hear that investors speculations can affect the price of
shares listed in the share market. How do speculations affect the
price? Explain.
2. Visit the Bursa Malaysias website at http://www.bursamalaysia.
com to review some of the share prices available. And also review
business analysis in the newspapers to get input about why
speculations happened and how it affects share prices.
4.7 ARBITRAGE PRICING THEORY

Arbitrage Pricing Theory (APT) is another model that shows returns are also
related to risks. However, the model uses different assumptions and techniques.
According to APT, an opportunity exists when the investor is able to

generate profit without any risk and uses no capital.
However, in reality this situation is unlikely to occur. Firstly, in an equilibrium

market condition, there will be no such opportunity. Therefore, returns will
always be related to risk and some capital investment is needed before returns
can be obtained. If such a situation did arise, market forces will react quickly to
restore equilibrium.
Secondly, according to the APT, returns will be generated from the following
process:
where:
Ri = The expected return of security i

I1Ij = The value of index or factors that can influence security i.
= The expected value of the index or factor.
ei = A random error that resembles the portion of returns from an
unsystematic risk.
bi1.bij = The sensitivities of the security to each of the index. This is
similar to Beta in the CAPM. In CAPM, the factor is the market.
However, in APT, we have not specified the nature of the factor.
Thirdly, in order for APT to take effect, we need a large number of assets in the
market. The investor can then find a combination of assets that can eliminate

risks. These risks include all systematic risks measured by betas (b1..bj) and
unsystematic risks. Then, the investor is able to combine assets in such a way that
he/she does not have to use any capital. (The details and exact processes are
available from any advance book in finance and investment listed at the back of
this module.)
As mentioned earlier, in an equilibrium situation, the above condition cannot

exist because the investor will then obtain zero returns. Take note that a
relationship exists between expected returns and risks where an investment with
zero risk should provide zero returns. At this point, the investor will not even
earn the risk-free rate because he did not invest any capital.
Since unsystematic risks can be diversified away, investors will only need to be
compensated from systematic risks or the beta of the factors. As the factors are
general factors and will affect all assets, the price of risks for each factor will be
the same. The amount of this price for each asset will be determined by the value
beta related to that factor. If we let the price of this risk be , then APT can be
generalised into the following.
ERi 0 i 11 i 2 2 ................. ij j
Where:
ERi = the expected return of asset i.
i1, i2 ij = the systematic risks for each factor 1 to j;
0 = the risk-free rate; and
1, 2 j = the price of risk or risk premium that is required by investors
to bear the risk from factors 1 to j.
Different assets will have different returns based on their level of betas for each
factor. For example, lets assume there are two general factors and investors
perceive factor one should have a risk premium 1 of 5% and factor two 2 with
10% and the risk-free rate is 4%. Then, the APT model will look like this:
ERi 4 i 1 5 i 2 10
Asset A with 1 which is equal to 0.5 and 2 which is equal to 0.8 will have an
expected return of 14.5%. Asset B with 1 which is equal to 2 and 2 which is
equal to 0.5 will have an expected return of 19%.
The APT did not specify the number of factors and the nature of these factors.
Previous empirical tests have found several economic variables to be significant.
Among them are index of industrial production, default risk premium (the
difference between the yield of AAA and BBB bonds), difference in yield curve

(the difference between short-term and long-term rates of government bonds)

and unanticipated inflation.
EXERCISE 4.2
1. Your analyst has provided the following information. The expected

market return is 12% while the risk-free rate is 4%. The standard
deviation of the market is 8%. You are required to draw the capital
market line and the security market line.
2. Using the information from Question 1, what will happen to a
share with a beta of 1, if it is offering a return of 14%?
3. Assume that the risk=free rate is 6% and the expected rate of return
of the market is 16%. A share that sells for RM5.00 today is
expected to pay a dividend of RM0.60 per share at the end of the
year. Its beta is 1.2. At what price do investors expect to sell at the
end of the year?
Efficiency is an important characteristic of a market portfolio. An efficient

portfolio will be a fully diversified portfolio where all unique risks of the
individual have been diversified away.
CAPM is a model that shows the relationship between returns and risks of
individual assets. It states that the expected return of an individual asset is
related to its systematic risk (beta).
According to APT, an opportunity exists when the investor is able to generate

profit, without any risk and uses no capital.

Topic Equity
5 Valuation
(Fundamental
Valuation)
LEARNING OUTCOMES
1. Calculate the value of shares based on the Discounted Dividend Model,
Constant Growth Rate Model and Multistage Growth Model;
2. Interpret the relationship between share price and growth;
3. Explain the importance of price and growth;
4. Explain the importance of earnings ratio from investors point of view;
5. Describe the structure and characteristics of an industry; and
6. Perform a company analysis.
INTRODUCTION
This topic will discuss the process of share valuation. It begins by looking at
valuation models. The value of an asset can be obtained by determining the
present value of its future cash flows. For shares, the cash flow is future
dividends. Therefore, the first valuation model is the discounted dividend
model. We will also discuss the Price Earnings (PE) ratio model. PE ratio is the
most frequently used ratio when investors talk about equity investment.
This topic then discusses in detail the process by which we forecast the variables
in the valuation model. The investor needs to evaluate the economic background

TOPIC 5 EQUITY VALUATION (FUNDAMENTAL VALUATION) 71
of the firm. An economy can be adequately described by looking at the Gross

Domestic Product (GDP), inflation and interest rates. The effect of government
policy on the economy will also be discussed. The process of understanding the
industry is discussed later in the topic. This is finally followed by a discussion on
company analysis. This method of analysis is also known as Fundamental
Analysis.
5.1 VALUATION PROCESS

There are two approaches to evaluate security. They are:
(a) Top-down Approach; and
(b) Bottom-up Approach.
In the Top-down Approach, we begin by analysing the economy followed by the

industry and then proceed to the firms in the industry.
Investment analysts who follow this approach believe that a good economy will
provide a good background for the growth of industries and firms.
In the Bottom-up Approach, analysts will try to identify firms that are
undervalued. These firms were chosen without taking into account the
economic situation and environment.
This module will only discuss the first approach. Before we proceed with
the top-down approach, we will first discuss valuation models because factors
and variables that affect the Top-down Approach are based on these models.
5.2 BASIC VALUATION MODELS

In the basic valuation models, we will look at:
(a) The Discounted Dividend Model;
(b) The Constant Growth Model;
(c) The Relationship between Share Price and Growth; and
(d) Multistage Growth.

72 TOPIC 5 EQUITY VALUATION (FUNDAMENTAL VALUATION)
5.2.1 Discounted Dividend Model
In the Discounted Dividend Model, the share price is calculated by finding

the present value of the predicted dividend and the predicted selling price of
the share.
For example, share ABC promises a dividend of RM0.50 a year and the share is
being held for only one year. After one year, the share can be sold at RM2.00.
Lets assume that the rate of return expected by the investor is 10%. The present
value of the share is:
0.50 2.00
P0
1 0.1 1 0.1 (5.1)
RM2.273
Formula (5.1) can be simplified as:

D1 P1
P0 (5.2)
(1 k )1 (1 k )1
If the investors want to hold the share for two years, formula (5.2) will be:
D1 D2 P2 (5.3)
P0
(1 k )1 (1 k )2 (1 k )2
The value calculated from formula (5.3) will be no different from (5.2) if the
investor bought the share at the end of year one. The value of the share will be
calculated as follows:
D2 P2
P1 (5.4)
(1 k )1 (1 k )1
If formula (5.4) is combined with formula (5.2), we will get the following:
D2 P2

D1 (1 k ) (1 k )
P0
(1 k )1 (1 k )1
D2 P2
D1 (1 k ) (5.5)
P0
(1 k )1 (1 k )
D1 D2 P2
P0
(1 k )1 (1 k )2

Lets say share XYZ promises a dividend of RM0.50 at the end of the first year
and RM0.60 at the end of the second year. The price (P2) at the second year is
RM2.20.
Using formula (5.5), P0 is:

0.50 0.6 2.20
P0
(1.1) (1.1)2
RM2.77
Using formula (5.4), P1 is:

0.60 2.20
P1
(1.1) (1.1)
RM2.55
By incorporating the above result into formula (5.2), P0 will be:

0.50 2.55
P0
(1.1) (1.1)
RM2.77
Based on the example discussed, the Discounted Divided Model will look like
this:
D1 D2 D3 Dn
P0 (5.6)
(1 k )1 (1 k )2 (1 k )3 (1 k )n
where:
P0 = The value or estimated price of share.
D1Dn = The dividends from one year to infinity. This is if the share is held
forever.
k = The rate of expected return, which is a rate set by the investors
themselves after taking into account the share risk. We can also
use the CAPM to determine this return.

5.2.2 Constant Growth Model

If there is a rise in the dividend, the Discounted Dividend Model (formula 5.6)
will have to be adjusted. For example, let us assume that a company has just paid
a dividend of RM0.50 per share and the dividend of the company increases at a
rate of 5% per year. So, if we take three years ahead, the dividend will be:
D1 = 0.50(1.05) = 0.525
D2 = 0.525(1.05) = 0.55125 or 0.05(1.05)2
D3 = 0.55125 (1.05) = 0.579 or 0.05(1.05)3
Generally, the situation above is the same as:

D1 = D0(1+g)
D2 = D1(1+g) or D0 (1+g)2
D3 = D2(1+g) or D1(1+g)3
Note: g is the growth rate.
If the example above is inserted into formula 5.6, we will have:

D0 (1 g )1 D0 (1 g )2 D0 (1 g )3 D0 (1 g )n
P0 (5.7)
(1 k )1 (1 k )2 (1 k )3 (1 k )n
Formula 5.7 can be simplified as:

D0 (1 g )1 D1 (5.8)
P0
k g k g
Based on the above example, the share price (P0) will be:
D1 RM0.525
RM10.50
k g 0.10 0.05

ACTIVITY 5.1
Based on your understanding of constant growth, what will happen to

the share price if:
(a) The cash dividend increases or decreases.
(b) The growth rate (g) increases or decreases. Please take note that g
cannot exceed the rate of return (k).
(c) the rate of return increases or decreases.
You can use formula (5.8) to explain how the dividend, growth rate and
rate of return affect share prices.
5.2.3 The Relationship between Share Price and

Growth
To see the relationship between share price and growth, let us look at how
growth rate is determined.
The growth rate is calculated as:

g = ROE b. (5.9)
where ROE is the rate of return on equity and b is the portion of profit that is
invested back into the firm. b is sometimes known as profit retention rate.
For example, lets say Mawar Enterprise has a net income of RM2 million and the
dividend payout ratio is 30%.
So, b which is equal to (1 dividend payout) = (1 0.3) = 70% or 0.7
Let us say ROE is 12%.
So, g = 0.12 0.7 = 0.084 or 8.4%.
Therefore, the growth rate of a company depends on the total income reinvested
into the company and also the ROE. These two factors are important to help the
growth of a company. However, growth will only increase share prices if the
ROE is higher than the expected rate of return (k).

For example, Mawar Enterprise wants to offer a dividend (D1) of RM1.00.

Growth rate g is 0 and the expected rate of return k is 10%. By using formula
(5.8), the share price of the company is RM10. Since the company does not
reinvest its income, there would be no growth that will lead to an increase in
income.
In another situation, lets say Mawar Enterprise only pays a dividend of RM0.30
out of a earning per share (EPS) of RM1.00. From formula (5.8), we will find that
the share price will fall. But then, the company reinvested the income that was
not paid out as dividend at a rate of ROE 12%. By using formula (5.9), this will
give a growth rate g of 8.4%.
Thus, the share price will become:

D1
P0
k g
0.3

0.10 0.084
RM18.75
We can see that Mawars share price is higher when the firm reinvests its income.
However, this price increase also depends on the companys ROE. The price will
only show a further increase if ROE exceeds k.
If ROE is 10% and k = 10%, the divided payout ratio is 30%, then:
g = 0.1 x 0.7
= 0.07 or 7%.
If D1 is 0.30, the share price is:

D1 0.3
P0 RM10
k g 0.10 0.07
We can see that although there is a growth of 7%, there is no difference in the
share price when growth rate is zero. This occurs because ROE is equal to k.
It is important to note that in order for a share to increase in price, the company
has to reinvest its income in an investment that exceeds the rate of return
expected by the shareholders.

SELF-CHECK 5.1
In the earlier Section (5.2.2), we know that we can use the growth rate
to estimate the price of a share. Based on formula (5.8), what is the
relationship between the growth rate and the share price? Explain.
5.2.4 Multistage Growth

In some instances, we may find firms with non-constant growth rates. This
normally occurs at the beginning of the firms or industrys life. Growth is
highest in the early periods. However, this high growth cannot persist as
competition exists and new firms will be attracted to the industry. Therefore,
there seems to be a time horizon for this high growth and we need to forecast the
dividend in this time horizon.
Let us use an example to explain the situation. A firm is expected to experience a

30% growth per year for the next three years. After that period, it is forecast that
growth will be normal at 5% per year forever. The required rate of return is 10%.
The price of the share can be determined as below:
D1 D2 D3 P3
P0 ,
(1 k ) (1 k )2 (1 k )3 (1 k )3
D4
where P3
(k g )
Notice that we have a time horizon of three years in the formula and we need to
determine the price at the end of the time horizon. The end price is the constant
growth dividend model. If the current dividend is RM1.00, then the price of the
share is:
RM1.30 RM1.69 RM2.20 RM46.2
P0
(1 0.1) (1.1)2 (1.1)3 (1.1)3
RM38.94
RM2.20(1 0.05)
where P3 RM46.20
(0.1 0.05)

5.3 PRICE EARNINGS (PE) RATIO MODEL

Another model to value a share is by using the PE ratio. This model is also
known as the earnings multiplier model. This is because the PE ratio is also
known as the earnings multiplier.
Price
Earnings multiplier =
Earnings
The above formula can be interpreted as a measure of the investors willingness

to buy shares to get an expected return. It also measures the level of confidence of
investors in the firm.
The dividend model in formula (5.8) can also be used to calculate the PE ratio. If
we recall, the formula is:
D1
P0
k g
If the model is divided by expected earnings (E1), the model will become:
D1
P0 E1

E1 k g
The above formula showed that PE ratio will depend on the dividend payout
ratio (D1/E1), required rate of return (k) and growth rate for dividend (g).
For example, lets say a firm expects to earn RM2 per share and pays dividends
of RM1. The rate of return expected by the investors is 15% and the growth rate is
10%. The PE ratio is:
P 0.50
10
E 0.15 0.10
If the firm expects to pay a dividend of RM0.80, the PE ratio will be 8. If the
dividend is RM1.20, then the ratio is 12. The higher the ratio, the higher should
be the price. We can then compare the calculated PE ratio with the current PE
ratio. The calculated PE ratio will be based on forecasted D1, k and g.
We will multiply the PE ratio with the forecasted earnings to obtain the
estimated price of the share. Using the above example, when earnings are RM2
and the dividend is RM1, the estimated price is 10 RM2 = RM20. When the

dividend is RM0.80, the estimated price is 8 RM2 = RM16. When the dividend
is RM1.20, then the estimated price will be 12 RM2 = RM24.
ACTIVITY 5.2
Based on the example discussed in section 5.3, how do the following
factors affect the price of a share:
1. Dividend payout ratio;
2. Required rate of return; and
3. Growth rate of dividend. You should review business magazines
and the business information section in the newspapers for more
input.
5.4 EXPECTED RATE OF RETURN (k)

In Topic 4, we discussed the CAPM. According to CAPM, rate (k) can be
calculated as:
k R f (ER M R f )
where:
Rf will be affected by the present as well as the economic outlook. By taking into
account the inflation factor, this rate will become a nominal rate Rf. Therefore, the
basic rate can be affected by the economy and inflation.
The rate of return k, will also be influenced by the systematic risk . Risk usually
comes in the form of business risks, financial risks, liquidity risks, foreign
exchange risks and a countrys political risks.

ACTIVITY 5.3
Expected rate of return is affected by many factors. Select one share listed
in the Bursa Malaysia and analyse how the following factors affect the
shares expected rate of return.
Factors Analysis (Findings)

Inflation
Business risk
Financial risk
Liquidity risk
Foreign exchange risk
Countrys political risks
Your analysis should be based on the review of the current economy

market in Malaysia and also the companys situation. You can compare
your findings with that of your peers.
SELF-CHECK 5.2
What is the expected rate of return and why is it important in stock

valuation?
5.5 FRAMEWORK TO EVALUATE SECURITY

Generally, if we use formula (5.8) as a basis to obtain the value of a security we
will require a prediction of net income (E), the dividend amount (D), the
investors rate of return (k) and the growth rate (g).
Forecasted net income (E) is obtained by deducting production costs, interest and
taxes from expected sales. Therefore, the process of evaluating a security starts by
predicting sales and getting the net margin. Then, we have to decide the firms
dividend payout. This will affect the retention rate of earnings that can affect
growth rate (g). We have seen that ROE can also influence growth.

Each of these variables can be influenced by external factors. In the next section,
we will discuss economic and industrial factors that affect security valuation.
Before we proceed, let us test your understanding by attempting the following

exercise.
EXERCISE 5.1
1. The last dividend paid by Denting Bhd. was RM0.24. In view of the
companys strong position and its consequent low risk, its required
rate of return is only 12%. If dividends are expected to grow at a
constant rate, g of 5% in the future, what is Dentings expected share
price five years from now?
2. Compron Bhd is experiencing a period of rapid growth. Earnings
and dividends are expected to grow at a rate of 15% during the next
two years, at 10% in the third year and at a constant rate of 6%
thereafter. Comprons last dividend was RM0.15 and the required
rate of return on the share is 12%. Determine the price of the share.
Calculate the variance and the standard deviation for the five-year
investment.
5.6 ECONOMIC ANALYSIS

The prospect and future of a firm depends on the economic situation and
business environment in which the firm operates. Sometimes, the environment
plays a big role in the performance of a firm.
In the previous section, we introduced the top-down approach to analyse the

prospects of a firm in the future. The first step in this approach is to evaluate the
position of the countrys economy. Malaysia practises an open economy system.
Therefore, the position of the countrys economy will also be affected by the
international environment.
In the evaluation of share prices, we have to evaluate the following economic and
industrial situations:
(a) World environment;
(b) Domestic economy; and
(c) Government policy.

(a) World environment

Every country trades with other countries. The economy of a country will at
least be affected by the economic situation in other countries. The factors
that can influence the relations or trade between countries include:
(i) Political situations.
(ii) Trade policies. Are any of the policies too restrictive in terms of free
trade?
(iii) Foreign exchange rates. An increase or decrease of the exchange rate
of a country will affect the industry that deals with imports and
exports.
(b) Domestic economy

The economic situation of a country can be observed from a few indicators.
(i) Gross Domestic Product
Gross Domestic Product (GDP) measures the total production of goods and
services in a country.
It also shows the activities that take place in an economy. GDP can be
studied through the demand and supply aggregate.
From the demand point of view, the GDP will show information as
follows:
Consumer spending that is divided between the private sector and
government spending.
The formation of fixed capital by the private and public sectors.
This is the investment by the country.
The countrys imports and exports.
From the supply point of view, GDP can be seen as the
productivity of the sectors of the economy.
Please refer to the BNM report at http://www.bnm.gov.my to know what

sectors are available in Malaysia for the purpose of valuation.

(ii) Inflation
Inflation is the rate of price increase of goods and services or a currencys

buying power.
An increasing rate reflects that an economy might have reached its

peak. Products and services demand exceeds supply. It might also be
an indicator that the production factors have come to full capacity and
can no longer meet consumers demand.
From another point of view, high inflation means an unhealthy

economy. There are not enough products to meet demand, causing
prices to increase. Lack of products might have been caused by a lack
of economic activities and production. We have to study the reasons
for the lack of activity.
The inflation rate can affect the rate of return expected by investors
evaluating a security. They will increase the expected return if they
predict an increase in the inflation rate. Inflation can also affect a
firms returns. However, the effect is not clear. Some firms can
increase the price of their products by adapting to the inflation rate
and have no effect on their profit. Some firms cannot increase their
prices as they might lose their customers. Some firms will have to bear
higher costs of production during inflation and sustain a lower profit
margin.
(iii) Interest Rates

Interest rates are decided by the demand and supply of funds. Any
increase in interest rates will increase the cost of loans. This will
reduce capital investment and business growth will slow down or
stop.
Increasing costs will decrease profit. However like inflation, the

relationship between cost and profit is not clear. Some firms can
increase their product prices because of increasing cost, without
affecting sales, and therefore increase their profit margin. Some firms
cannot increase price and their profit margin will decrease.

(c) Government policy

The economy can also be influenced by government policies. Every policy
will influence aggregate supply and demand. There are two types of
policies:
(i) Fiscal policy is the government spending and tax policy. A deficit
budget occurs when the government spends more than its income or
tax. In this situation, the government will take loans. A surplus
budget occurs when income exceeds spending. Thus, the government
will make investments.
Demand will increase when government increases spending. This will

accelerate economic growth and provide a multiple effect. A budget
deficit is sometimes used to trigger the economy.
(ii) Monetary policy is a policy where the level of total money supply is
managed to control the economy. Changes in the money supply levels
can affect interest rates and inflation. For example, by increasing the
money supply, interest rates will drop. The drop in interest rates will
increase business growth. Increasing the money supply will also
increase the liquidity. The excess liquidity will be used to buy
securities, thus increasing price. However, too much liquidity may
inflate prices.
One of the ways in which a government influences the money supply

is by entering the market. When the government buys back treasury
instruments, the money supply will increase. The government can
also increase the money supply by decreasing the banks reserve
requirements.
ACTIVITY 5.4
The speculation of the ringgit in 1997 led our economy into a recession.
Review the economic situation at that time and analyse how the
situation affected share prices.
You can obtain more input for the analysis from the Internet, the OUM
Digital Library and archived news.

5.7 INDUSTRY ANALYSIS

The purpose of industrial analysis is to understand the characteristics and
structure of an industry. There is a relationship between the character and
structure of the industry with earnings that can be generated by firms in the
industry. In addition, a good firm usually is in a healthy and growing industry.
It is quite hard to identify an industry. A simple definition would be a group of

firms running the same business. However, these firms are sometimes involved
in different kind of activities. The Bursa Malaysia has its own classifications of
industry.
The first step is to identify the factors that can influence industry sales. There are
four techniques used to predict sales.
(a) Sales level and industry life cycle;
(b) Input-output analysis;
(c) Relation between sales and economy; and
(d) Competitive structure in industry.
Let us discuss this further.
(a) Sales Level and Industry Life Cycle

In this technique, an industry is said to go through a life cycle. The life cycle
is divided into a few stages as shown in Figure 5.1.
Figure 5.1: Industry life cycles

(i) Pioneering Development

During this stage, the industry sales increase slowly. Profit margin is
low and sometimes negative. Development cost is high.
(ii) Rapid Growth

During this stage, demand for products from the industry will be
increasing. The market for the product will be developing at a fast rate
and the profit margin will start to increase. Demand exceeds supply
and firms may not be able to fulfil orders.
(iii) Mature Growth

During this stage, sales are still high. However the sales growth will
be decreasing. Profit margin will decrease because more firms will
enter the industry and increase competition.
(iv) Stable Stage and Matured Market

During this stage, the industrial growth is in line with the economy. If
the economy goes up, so will the growth. Profit margin will depend
on the ability of firms to control costs and the market.
(v) Growth Reduction

During this stage, there will be a replacement for the product. The
profit margin will be smaller and there will be firms losing. There will
also be firms running out of business. Firms that are still running will
have low rates of return.
(b) Input-Output Analysis

In this analysis, a particular industry is classified as either a supplier or a
consumer. It means the industry is classified between the industry that
supplies products and the consumer industry that uses the product. Both
industries will depend on each other. The future of the supply industry will
depend on the potential and future of the consumer industry and vice
versa. Sales of the supply industry are calculated based on predictions of
the consumer industry. The growth of the consumer industry depends on
the constant supply from the supplier industry.
(c) Relation between Sales and Economy

Industry sales can also be predicted by looking at its relation with the
economy. This relation can be examined in a global as well as domestic
perspective.
For example, consumer products or retail industries can be related to
consumers income. Industrial products can be related to economic growth
or government spending.

(d) Competitive Structure in Industry

We can complete the industry analysis by examining the competitive
structure of an industry. The competitive structure can give insight into the
earnings of firms in the industry. The tighter the competition, the harder it
will be for firms to get or maintain high profit.
According to Michael Porter, there are five factors that depict the
competitive structure of an industry.
(i) Entry of New Firms whether the industry can easily accept new
firms
Among the challenges of entering an industry are high investment
cost, good distribution systems, consumers loyalty to brands, firms
with copyright and sometimes government sanctions. If it is difficult
to enter the industry, there will be lower competition between firms in
the industry. Thus, profit can be controlled easily.
(ii) Competition from Existing Firms

Is competition in the industry tight? Usually when the industry
consists of firms of the same size, competition will be high.
Competition will occur in terms of price and cost controls. In this
situation, firms can only gain moderate profit.
Industries that have slow growth will also have tight competition.
This is because there are limited markets and competition will be
fierce.
(iii) Competition from Alternative Products

Industries are also vulnerable to product alternatives. A product that
can be easily replaced will affect the industrys potential and future
profit. Price cannot be altered easily. Example: between palm oil and
soya bean.
(iv) Buyers Bargaining Power

If there is only one buyer who requires most of the industrys
products, this buyer can influence the price. For instance, the tyre
industry can push the rubber producers to decrease the price. This can
decrease the profit of plantation companies.

(v) Suppliers Bargaining Power

If there is only one supplier, then price will be controlled by this
supplier. Firms that depend on this supplier will find that their profit
will depend on the suppliers price.
5.8 COMPANY ANALYSIS

The objective of a company analysis is to examine the nature and characteristics
of a company. It also involves examining the financial affairs of that company
and determining the quality of its earnings.
The basic input in undertaking a company analysis is the companys financial

statements. There are three main financial statements. They are:
(a) Balance Sheet which is a statement of the companys assets, liabilities and
stockholders equity.
(b) Income Statement which provides a summary of operating results.
(c) Statement of Cash Flows which provides a summary of cash flow and
events that caused the cash position to change.
A detailed description and analysis of the above statements should have been
covered in a basic finance course. A normal analysis will include ratio analysis,
common size statements, trend analysis and intra firm analysis. This module will
not go into detail about these analyses. However, we will pick some pertinent
features in the statements for further analysis.
In section 5.2.3, we observed that growth can be affected by ROE. It is also indicated
that this ROE must be more than the return required by the investor for share price
to increase. Based on this fact, we will examine this variable very closely.
ROE can be formulated into the following:

Net Profits Pre-tax Profits EBIT Sales Assets
ROE =
Pre-tax Profits EBIT Sales Assets Equity
Pre-tax profit is profit before tax. EBIT is earnings before interest and tax. The
second factor is the interest factor. Pretax profit divided by the EBIT will indicate
the interest burden that the firm has to bear. A high interest factor will indicate
that a high amount of debt has been used.
The third factor is the profit margin. Profit margin shows the capability of a firm to
generate income through sales. Therefore, it is important to identify factors that can
influence sales. Be alert that cost of operation can affect profit margin.
The fourth factor is asset turnover. The firm must be able to utilise its assets
optimally. The fifth factor is the leverage ratio. If leverage ratio equals to one,
then all the assets will be financed by equities. If it is equal to two, then 50% of
the assets is financed by debt. A higher ratio means more debt has been used.
However, take note that any undue increase in the fifth factor will increase the
financial risk of the company. Any increase in debt will also decrease the second
factor. Therefore, it is important for the analyst to examine the quality of the
increase in ROE.
There are two main strategies that a company can use in order to increase
earnings. They are:
(a) Low Cost Strategy

Through this strategy the company endeavours to increase earnings by
controlling costs. This is only done when there is no opportunity to increase
the price of the product.
(b) Differentiation Strategy

Through this strategy the company will maintain its pricing policy, being
confident that customers will not stop buying its products as it is perceived
to be different and maybe of high quality.
EXERCISE 5.2
1. An investor estimates next years sales of Amal Bhd. should amount

to RM75 million. The company has 2.5 million shares outstanding,
generates a net profit margin of about 5% and has a payout ratio of
50%. All figures are expected to hold for next year. Given this
information, compute the following.
(a) Estimated net earnings for next year.
(b) Next years dividend per share.
(c) The expected price of the share (assuming the PE ratio is 24.5
times earnings)
2. If an economy is in recession, what kind of monetary and fiscal

policies should be adopted?

There are two approaches to evaluate a security, namely:

(a) The Top-down Approach; and
(b) The Bottom-up Approach.
In the Discounted Model, the share price is calculated by finding the present
value of the predicted dividend and the predicted selling price of the share.
The basic valuation includes discussion of the following:

(a) The discounted dividend model;
(b) The constant growth model;
(c) The relationship between share price and growth; and
(d) Multistage growth.
The investors need to undertake economic analysis industry analysis as well

as company analysis in evaluating share prices as well as the business
environment in which the firm operates.

Topic Behaviour of
6 Share Prices
(Technical
Analysis)
LEARNING OUTCOMES
1. Explain the importance of Technical Analysis in forecasting the
dissection of future share prices;
2. Analyse the trends of share price movements;
3. Explain the three levels of market efficiency; and
4. Discuss the implications of Efficient Market Hypothesis on Security
Analysis.
INTRODUCTION
In this topic, we will discuss another alternative to fundamental analysis of share
evaluation. Technical analysis is about forecasting the direction of future share
prices. Decisions are then made based on the forecast. Investors that rely solely
on technical analysis are sometimes known as Technicians. This topic also
discusses the Efficient Market Hypothesis.

92 TOPIC 6 BEHAVIOUR OF SHARE PRICES (TECHNICAL ANALYSIS)
SELF-CHECK 6.1
In Topics 1 and 2, we were introduced to the concept of investment.
Based on your understanding of the investment concept, why do
people invest? What do they hope to achieve?
6.1 BASIC CONCEPTS OF TECHNICAL

ANALYSIS
Technical Analysis is a process that involves the examination of past data such
as share prices and volume of trading to forecast the direction of future prices.
It is based on these concepts as stated below:

(a) Share price is based on demand and supply.
(b) There are rational and irrational factors that will influence the demand and
supply.
(c) The behaviour of prices tends to follow a trend that persists for a length of
time. This is sometimes known as a momentum. Prices do not adjust
suddenly and it will take some time before the price reaches its equilibrium.
Technicians therefore will make a decision that is early enough before the
price settles.
(d) Another important feature is that the behaviour of price follows a certain
pattern. This pattern is thought to have happened in the past and is also
likely to occur again in the future. Technicians therefore study the present
and previous price behaviour.
6.2 TOOLS FOR TECHNICAL ANALYSIS
SELF-CHECK 6.2
We know that Technical Analysis is the process that involves the
examination of past data such as share prices and volume of trading
to forecast the direction of future prices. Based on earlier discussions
in the previous topic, how do investors obtain information on share
prices, trends, growth rates and others?

TOPIC 6 BEHAVIOUR OF SHARE PRICES (TECHNICAL ANALYSIS) 93
Technicians tools in technical analysis can be divided into two main categories:
(a) Market Statistics; and
(b) Charts.
6.2.1 Market Statistics

Market statistics are summaries of the behaviour of the market and the price
movement of shares. Examples are as follows:
(i) Market Volume

Market Volume measures the amount of investors interests in the market.
Volume is the number of shares traded in the market and its a reflection of
demand and supply. The market is considered to be strong if the volume is
high in a rising market. It is also considered strong when the volume is low
in a declining market. In the second situation technicians are expecting a
turnaround. The market is considered weak if the volume traded is high in
a declining market or low volume in a rising market.
(ii) Breadth of the Market

Breadth of the Market measures the strength of the market in terms of the
number of shares that experience increase, decrease or no change in price.
The market is considered strong if the number of shares with increased
price is higher than the number of shares with declined price. The market is
weakening if the difference between the number of increase and decline is
getting closer.
This measure can sometimes be used as an early indicator of the strength of

the market. If the market index is rising but the number of declines is
higher than advances, then the rise in the index is not that strong. It may be
an indication of a weakening market.
6.2.2 Charts
Charts are visual summaries of the behaviour of the market and price
movements of shares.
It is the most frequently used tool by technicians. It can provide early indications
of developing trends and the future behaviour of the market.

Charts are normally developed by registering the price of shares or index on a

time graph. The trend line can then be analysed.
The trends can be divided into:
(i) Primary Trend

The primary trend is a long-term indicator of the price trend. If it is taken in
the perspective of the market, a rising primary trend is known as a bull
market while a declining primary trend is known as a bear market. (Please
refer to Figure 6.1).
Figure 6.1: Primary trends
(ii) Secondary Trends

A secondary trend is a trend within the primary trend. In a rising primary
trend, there may be one or two secondary trends. Secondary trends occur
when the market declines for a while before resuming its rise. Sometimes it
is known as secondary movement.
The support line is a range of prices that analysts think will generate new
demand from investors. When this new demand goes into the market, the share
price will enjoy the next trend of price increase. Before this new demand, price
may appear to be stable or decline a little.

The resistance line is the reverse; it is a situation where investors are waiting to
sell. Price may increase a little before this extra supply comes into the market. If
price at this resistance level cannot be maintained, then price will continue to fall.
Some commonly used charts in forecasting share price direction are:
(i) The Bar Chart

A Bar Chart is formed by taking share prices in a specified time period. The
bar is formed by taking the highest, lowest and closing prices for the day.
The trend is then analysed. Figure 6.2 shows an example of the chart. We
can forecast the direction of the shares price by placing the resistance and
the support line on the chart.
(ii) The Point and Figure Chart

This chart does not relate price to time. It illustrates price changes or
reversals in the direction of the price. However, it requires the analyst to
record the shares closing price on a daily basis. Figure 6.3 shows an
example of a point and figure chart. The chart is divided into columns. The
analyst will record the closing price in each space within a column. If there
is an increase in price, the record can be in a form of an X. If there is a
decrease in price, then the analyst shifts to the next column and indicates
the decrease with a 0 mark.

ACTIVITY 6.1
Based on the chart, analyse the behaviour and price movement of

shares in Bursa Malaysia. You can then refer to The Star dated 15
December 2003 for the market analysis.
Source: The Star (2003).

Figure 6.2: A bar chart
If we begin at Day 1, and the price is RM2, the first X will be in Column a. The
price continues to increase and peak at RM2.50 on Day 3. Then the price drops to
RM2.4. This is when we shift to Column b. The price continues to drop until Day
9. It goes up again in Day 10 where we will shift to Column c. The price
continues to increase until Day 20. The price drops to RM2.1 on Day 21. This will
indicate a shift to the next column, and so forth. As in the case of bar charts,
resistance and support lines can be placed on the point and figure chart to
forecast price.

Figure 6.3: A point and figure chart
(iii) Moving Averages

A Moving Average line attempts to show a smooth general price trend. A
price trend can show a lot of volatility and offer a less meaningful insight.
There are several moving averages that can be used. Examples are 200 days
moving average or 200-MA. The 200-MA is determined by taking the
average of the previous 200 days prices. Obviously, we need 200 days of
prices before the first average can be calculated. Therefore, on the 201st day
we calculate the average of the previous 200 prices. On the 202nd day, we
take out the first days price from the calculation and include the 201st
price, and so on. So each time we will use 200 days.
Apart from showing a smooth trend line, the MAs can be used as support
or resistance lines. If the price is on the decline, the MA line will be above
the current price. If the price breaks through the MA line followed by heavy
volume, this may indicate a strong buying trend and prices may go up.
Figure 6.4 shows the trend for the Kuala Lumpur Composite Index (KLCI)
as well as its 50 days MA, from January 1990 to July 2003.

Figure 6.4: Monthly KLCI and 50 A (January 1990 to July 2003)
6.2.3 Chart Formations

The effect of price changes due to demand and supply visualised in the form of
charts will provide formations and patterns. For example, some of these patterns
are given names like head and shoulders, pennants, scallops, and triangles.
Description of these formations is beyond this module. Knowing them is one
thing, interpreting them is another. And there is also no assurance that accurate
forecasts can be made. Figures 6.5 and 6.6 show the charts for Yeo Hiap Seng.
You are encouraged to make some observations.
Figure 6.5: Daily bar chart for YHS 100 days prior to 10 November 2003

Figure 6.6: Daily price trend and 50 days MA for YHS 100 days prior to
10 November 2003
6.3 EFFICIENT MARKET HYPOTHESIS

The Efficient Market Hypothesis (EMH) stems from the idea that share prices
follow a random walk. This means share prices are unpredictable and
performing a security analysis will not help to forecast future prices.
Fama (1970) defines an efficient market as one in which prices fully reflect all
information.
Prices will be adjusted based on new information. New information, however, is

random and cannot be predicted. In an efficient market, there will be no
opportunity to obtain abnormal returns.
Investors will get returns from changes in prices. Prices will change due to new
information entering the market. If the price adjustment is correct and rapid, then
investors will not have the opportunity and the time to act. Therefore, there will
be no abnormal returns.

6.3.1 Assumptions of the Efficient Market Hypothesis

(EMH)
There are three assumptions of the Efficient Market Hypothesis:
(a) There are a large number of investors competing against one another and
analysing the value of securities.
(b) Information that comes into the market is not predictable. The information
is random and there is no connection between one set of information and
another. This information must also be freely available to all investors.
(c) Investors will react to the information rapidly and correctly.
6.3.2 Categories of Information

The above assumptions are almost similar to a perfect competition in terms of
receiving information. No one can prevent information from entering the market.
Therefore, the kind of information that is considered for analysis purposes can be
categorised into three types.
(a) Previous market information. Previous price data, volumes traded in the
market, trends and charts.
(b) Public information including company annual reports, economic and
industry reports and company news.
(c) All information that is public and non-public. This will include all the
above plus all information that has not yet been made public. Examples of
non-public news are company strategies, mergers, and news on financially
distressed firms. This news is sometimes known as inside information,
because only the management of the companies know this information.
Any inside information that is obtained illegally and used to make profit is
an offence. This kind of practice is known as insider trading. In the Bursa
Malaysia and in most other stock exchanges, insider trading is illegal.
ACTIVITY 6.2
Visit the Bursa Malaysia website at http://www.bursamalaysia.com
and find more information about insider trading:
(a) What is insider trading?
(b) What is the punishment for it?

6.3.3 Levels of Efficiency

In line with the three categories of information discussed in the previous section,
the market can be categorised into three levels of efficiency.
(a) Weak Form

At this level of efficiency, prices of securities are said to reflect past
information. This means that analysing previous information is useless.
Investors studying previous prices, volumes traded and other market
information can make no abnormal profit.
(b) Semi-strong Form

At this level, prices of securities fully reflect all publicly available
information from the past as well as the present. This level will encompass
the weak form level. This means that a market has to be in weak form
before it can be semi-strong. All information is reflected correctly and
quickly by the price. As such, although an investor has this information, he
is unable to make extra profit as the information is publicly known.
(c) Strong Form

At this level, prices will fully reflect all information whether public or non-
public. This information includes all company information that has not
been made public. Investors who have this information will not be able to
take advantage of it in order to get extra returns.
6.3.4 Efficient Market Hypothesis Implications

The EMH implies that if the market is efficient, it is pointless to perform any
security analysis. Technical analysis will be a useless exercise if the market is in
weak form efficiency since prices have fully reflected previous price behaviour. If
the market is in a semi-strong form, all economic and company events would
have been reflected in the price. Therefore, there is no point in performing a
fundamental analysis. Another implication is that no investor will obtain extra
returns without incurring extra cost and risks.
However, the fact that price must fully reflect all information and that this
information needs to be analysed shows that there is still a need to perform
analysis. By performing an analysis, the investor will also be able to separate
companies that are fundamentally strong from the weaker ones. Investors can
use this information to reduce their exposure to risk. In addition, there will be
investors who are willing to take risks. These investors need to perform analysis
and incur the extra cost.

EXERCISE 6.1
1. The data below shows closing price for YHS for 60 days up till
10 November 2003. Prepare a point and figure chart of the prices.
Prepare a simple chart price against time and discuss it against the
point and figure chart.
1.80 1.90 1.83 1.81

1.84 1.90 1.82 1.81
1.82 1.83 1.83 1.80
1.82 1.82 1.83 1.80
1.80 1.84 1.78 1.79
1.82 1.85 1.83 1.86
1.82 1.88 1.81 1.83
1.82 1.86 1.82 1.82
1.86 1.86 1.81 1.90
1.89 1.83 1.84 1.91
1.86 1.83 1.85 1.90
1.88 1.84 1.83 1.90
1.89 1.88 1.82 1.90
1.88 1.90 1.82 1.89 10 November 2003
1.86 1.92 1.80 1.90
2. Price will fully reflect all information. What will happen to the
price of a stock if the company declares a rise in dividends?
3. Based on Question 2, when will the price begin to respond to the

news? Answer with respect to each level of the EMH.

Technical Analysis is a process that involves the examination of past data such
as share prices and volume of trading to forecast the direction of future prices.
The Efficient Market Hypothesis (EMH) stems from the idea that share prices
follow a random walk are are unpredictable, and performing a security
analysis will not help to forecast future prices.
There are three levels of efficiency. They are:

(a) Weak Form;
(b) Semi-strong Form; and
(c) Strong Form.

Topic Fixed Income
7 Securities
LEARNING OUTCOMES
1. Identify the characteristics of bonds;
2. Explain the risks associated with bonds;
3. Compute the price of a bond;
4. Differentiate between yields to maturity, current yield and yield to call;
5. Formulate bond portfolio management strategies; and
6. Summarise the concepts of duration and immunisation.
INTRODUCTION
This topic discusses fixed income investments, and the main focus will be bonds.
Topics covered will include the different types of bonds available in the market.
The basic concepts of valuing a bond and the relationship between price, yield
and maturity period of the bond will be highlighted. This topic will also discuss
the risks involved in bonds. Finally, we will also see how bond portfolio is
managed via the concepts of duration and immunisation.

106 TOPIC 7 FIXED INCOME SECURITIES
7.1 CHARACTERISTICS OF BONDS
A bond is a fixed income security which promises the investor a fixed stream
of income for a specific time period.
Bonds are normally issued by firms and governments. It allows the issuer to tap
funds from the financial markets for various purposes which may include
business expansion. In its simplest form, it may be regarded as a loan. Some of
the key characteristics of bonds are:
(a) Maturity Period

Maturity period refers to a time period when the issuer fulfils the
obligations of the bond to the investor. The shortest time period for a bond
is six months.
(b) Maturity Value

Maturity value is also known as the principal value, redemption value or
face value. It is the value that has to be paid by the firms when the bond
matures.
(c) Coupon Rates

A coupon rate is the rate quoted on the bond. It will be used as a basis to
determine the interest that has to be paid to the investor. The interest
payment is known as coupon payment. It is paid either annually, semi-
annually, quarterly or monthly as stipulated in the bond agreement.
Bonds are normally issued at a coupon rate attractive enough to induce

potential investors. Rates would normally take into account various types
of risks that will be faced by the issuer and investor. The coupon payment is
determined by multiplying the rate with the face value of the bond.
(d) Floating Rate

A floating rate indicates that the coupon rate may change according to the
current interest rate. This current interest rate is dependent on the state of
the economy.
(e) Zero-coupon Bonds

Zero-coupon bonds are bonds which do not pay any coupon.

TOPIC 7 FIXED INCOME SECURITIES 107
(f) Embedded Options

Embedded options are specific characteristics stipulated in the bond
indentures. These characteristics may include the option to call the bond at
an earlier date before maturity. Another type of option is when bonds can
be converted to equity. The latter is known as convertible bond.
To further clarify the characteristics of a bond, lets use an example of a bond that
matures in three years, with a face value of RM1,000, and a coupon rate of 10%
paid semi-annually. Based on this information, every six months the investor will
get RM50 and at the end of the third year, he will get back RM1,000.
A zero coupon bond will not pay any coupon. However, when it is sold for the
first time, the price is below the face value. For example, a one-year zero coupon
bond with a face value of RM1,000 can be sold for RM900. At the end of the year,
the investor will get back the RM1,000.
ACTIVITY 7.1
Visit the website of Bank Negara Malaysia at http://www.bnm.
gov.my or other major financing institutions on the worldwide web,
and list the types of bonds issued by these institutions.
7.2 RISKS ASSOCIATED WITH BONDS

Bonds may promise a periodical fixed income but not without risks. Investors
may be exposed to the following types of risk:
(a) Interest Rate Risk

The uncertainty in income for the investor may result from the change in
bond price as a result of changes in market interest rates. An increase in
current market rates will make the existing bond unattractive since an
alternative investment now can fetch a higher rate of return. An increase in
the demand for an alternative security will motivate investors to dispose of
their existing bonds, hence pushing down the price of the bonds. (In the
next section, mathematical explanation will show the relationship between
price and interest rates).
(b) Reinvestment Risk

The yield from a bond is always under the assumption that the coupon
amount is reinvested. This stems from the idea of compounding interest.
However, an investor is faced with the risk that the current rate of interest

might fall. Should this happen, the coupon payment that they receive will
be reinvested at a lower rate.
(c) Redemption Risk (or Risk of a Call)

A bond that allows the issuer to redeem or recall the security, poses risks to
its investors. A bond that is recalled earlier than maturity will deprive the
investors of the potential income that they may otherwise receive. A bond
may be recalled because the market interest rates have fallen and the issuer
now wants to issue a new bond with a lower coupon payment. The investor
will therefore lose potential income since they are offered a new but lower
coupon rate.
(d) Default Risk

The uncertainty of income as a result of the failure of the bond issuer to pay
its coupon and principal payments.
(e) Inflation Risk

Income that will be received from a bond is fixed. However, if the level of
price in the economy rises, say from 5% to 7%, then in real terms, the
purchasing power that can be derived from the income will be actually
reduced. In short, you have less income to buy what your heart desires.
(f) Liquidity Risk

The ability to convert the bond into cash immediately without eroding its
value is very important for an investor who does not wish to hold the bond
until maturity. Unless an economy has a liquid secondary market for
bonds, investors will be faced with this type of risk.
These are some of the types of risks related to bonds. As the markets and
purpose of the bonds become more complex, other types of risks may exist.
Next, we will discuss the value of bonds. We will see how the risk factors
can influence the value/price of bonds.
SELF-CHECK 7.1
Based on your understanding of bonds, why do you think people

invest in them? Explain.

7.3 BOND PRICING

The price/value of a bond is the present value of the expected cash flow from the
bond. The expected cash flows are the coupon payments and the face value.
These cash flows are then discounted at the required rate of return. This rate of
return is normally called the yield of the bond. This yield will depend vastly on
the present market interest rate.
The present market interest rate will consider the risk-free rate of return and
compensate its investor for the expected inflation. Depending on the risk
structure of the bond, the investor will also be compensated for additional risks
faced throughout the life of the bond. These risks may include liquidity, default
or call risk which are normally specific to the security and firms.
For example, a three-year RM1,000 bond with 10% coupon rate with a yield of 8%
will have a value of:
C1 C2 C3 FV
VB
(1 r ) (1 r ) (1 r ) (1 r )3
1 2 3
RM100 RM100 RM100 RM1,000

(1 0.08) (1.08)2 (1.08)3
1
(1.08)3
RM1,051.54
Specifically the value of a bond is:
Bond value = Present value of coupon + Present face value
We can call the maturity date T and the discount rate r, hence the bond value can
be expressed as below:
T
(1 r )
Ct FV
VB (7.1)
t 1
t
(1 r )T
The summation sign in Equation 7.1 indicates that the periodical coupon
payments must be discounted until the maturity time T. The first term in the
equation also indicates that the present value of an annuity is discounted at a rate
r. The second term is the present value of a single amount, which is the final
payment of the bonds par value.

Now let us see the model of valuation if the coupon rate is paid semi-annually.
T *2
Ct
VB 2 FV
r t *2 r
t 1
(1 ) (1 )T *2
2 2
Using the above three-year bond above and coupon paid semi-annually, the price
of the bond is:
50 50 50 50 50 50 100
VB =
1 0.04 1 0.04 1 0.04 1 0.04 1 0.04 1 0.04 1 0.04
1 2 3 4 5 6 6
= RM1050.42
EXERCISE 7.1
1. What are the factors that influence the price of bonds?
2. Explain how each of the factors in question 1 influence the bond

price.
3. Channel 9 Bhd. issued an 8% coupon bond with a par value of

$1,000 and will mature in 10 years time. A similar bond in the
market yields 6%.
(a) What is the price of the Channel 9 bond?
(b) What is the price of the bond in three years time if the yield
is 8%?
(c) What is the price of the bond in five years time if the yield
is 10%?
4. Calculate the bond price in question 3 if the coupon rate is paid

twice a year.
5. Why is the price in question 4 different from question 3?

7.4 BOND YIELDS

If you examine the bond market tables published on the Bank Negara Malaysia
website at http://rmbond.bnm.my/RinggitBondMarkets.nsf you will typically
see information regarding each bonds maturity date, price, and coupon interest
rate. Often the yield is quoted as the indicative yield to maturity (YTM).
7.4.1 Yield to Maturity

The rate of return earned from investing in bonds until the bond matures is
termed yield to maturity. Yield to maturity is also viewed as the promised rate of
return accruing to investors. However, investors can only expect the promised
return if:
(a) The probability of the issuer defaulting in payment is zero; and
(b) The bond cannot be called before maturity.
If there is some default risk, or if the bond may be called, then there is a
probability that the promised payments to maturity will not be received, in this
case the calculated yield to maturity will differ from the expected return. From
equation (7.1) the YTM is the rate r.
Lets say in the market there is a three-year RM1,000 bond, with a coupon rate of
10%, and it is going at a price of RM951.97. Fitting these values into equation (7.1)
will show:
RM100 RM100 RM100 RM1,000
RM951.97
(1 r )1 (1 r )2 (1 r )3 (1 r )3
You could substitute values for r until you find a value that forces the sum of the
PVs on the right side of the equal sign to equal RM951.97. It involves finding r by
trial-and-error and is a tedious process, but as you may have guessed, it is easy
with a financial calculator. The answer is 12%.
The YTM for a bond that sells at par consists entirely of an interest yield. If the
bond is priced at RM1,000, we will get a YTM of 10%. This is the same rate as the
coupon rate. But if the bond sells at a price other than its par value, the YTM
consists of the interest yield plus a positive or negative capital gains yield. As
above, the YTM is 12% which is 2% higher than the coupon rate.
Yields are normally reported on an annualised basis. For semi-annual bonds, the
calculated YTM can be multiplied by two to get the annual YTM.

The effective annual yield of the bond however, accounts for compound interest.
If one earns 3% interest every six months, then after one year, each dollar
invested grows with interest to $1x (0.03)2 = 1.0609, and the effective annual
interest rate on the bond is 6.09%.
The bonds yield to maturity is the internal rate of return on an investment in the
bond. YTM can be regarded as the compound rate of return over the life of the
bond under the assumption that all bond coupons can be reinvested at an interest
rate equal to the bonds yield to maturity. YTM therefore is an accepted proxy for
average return.
7.4.2 Current Yield
The current yield of a bond is just the coupon payment divided by the price.
As in the example above, the current yield is:

RM100
0.1050 or 10.5%
RM951.97
7.4.3 Yield to Call

If you purchased a bond that is callable, where issuers can call or redeem their
bond when the market interest rate is generally falling, you would not have the
option of holding the bond until it matures. Thus, you lose the chance to earn
YTM. For example, suppose KFC Holdings originally issued a 10% coupon bond
and then decides to save its coupon payment when market interest rates fall to
5%. The company will call in the 10% coupon bond, pay off the investor and
replace the bond with a new 5% bond. KFC will save 5% interest per bond per
year. This will be beneficial to the issuer but not to investors.
The investor should understand that if the current interest rates are well below
the coupon rate, there would always be a possibility that the bond will be called.
Investors will therefore estimate its expected return as the yield to call (YTC) and
not YTM. To calculate the YTC, we solve the following equation for r:
N
(1 r )
Ct CALL PRICE
VB
t 1
t
(1 r )N
Here, N is the number of years until the company can call the bond. The call
price is the amount the issuer has to pay in order to call the bond. The price is

normally set above the par value. At least it is the face value plus one-year
coupon payment. This will normally compensate investors for the reinvestment
risk faced when bonds are recalled.
7.4.4 Holding-Period Return Versus YTM

You should be able to differentiate and not be confused by the difference
between rate of return on a bond over any particular holding period and the
bonds yield to maturity. The yield to maturity is that discount rate that equates
the present value of payments to the price of bonds when purchased. It is the
measure of an average return over the bonds life if it is held until maturity.
The holding period return equals income earned over a period (including
capital gains or losses) as a percentage of the bond price at the start of the
period.
The return can be calculated for any holding period based on the income
generated over that period.
As an illustration, if a 30-year bond paying an annual coupon of $80 is purchased

for $1,000, its yield to maturity is 8%. One year later you decided to sell the bond
with a market price of RM1,050. With the latest price, the yield to maturity will
no longer be 8% (the bond is now selling above par value, so the YTM must be
less than the 8% coupon rate). However, your holding period return for the year
is greater than 8%:
$80 ($1,050 $1,000)
Holding period return
$1,000
0.13 or 13%
SELF-CHECK 7.2
Based on formula (7.1), how do you think the price of a bond is

determined?

7.5 VOLATILITY IN BOND PRICES

In the last section, we discussed how to determine the value and price of a bond.
You should by now understand that the price of a bond is determined by the
coupon payments, maturity period and value, and the yield to maturity.
The most important factor that influences the value of the bond is the market
interest rate, which directly influences the yield that an investor is looking for.
Changes in this interest rate will affect changes in the price of bonds, referred to
as the volatility of bond prices.
7.5.1 Bond Prices Move Inversely with Interest Rates

Generally, the price of bonds will move counter cyclical to the movements in
interest rates. In other words, if the price of bonds has a tendency to fall, then it
may be due to the upward movement of interest rates in the market. To illustrate,
if we have a five-year 8% coupon bond, the behaviour of its price in relation to
the market interest rate is as follows:
Interest Rates % 4 6 8 10 12 15
Price (RM) 1,178.07 1,084.25 1,000.00 924.18 855.81 765.35
Notice that as interest rates increase, the price of the bond falls. Diagrammatically
the relationship can be observed in the following Figure 7.1:
Figure 7.1: Relationship between a bonds price and interest rates

Table 7.1 shows a few more examples of how bonds with different maturities
react to changes in interest rates.
Table 7.1: Bond Prices at Different Levels of Interest Rates
Time to
4% 6% 6% 8% 12%
Maturity
1 year $1,038.83 $1,019.13 $1,000.00 $981.41 $963.33
5 years $1,178.07 $1,084.25 $1,000.00 $924.18 $855.81
10 years $1,327.03 $1,148.77 $1,000.00 $875.38 $770.60
20 years $1,547.11 $1,231.15 $1,000.00 $828.41 $699.07
30 years $1,695.22 $1,276.76 $1,000.00 $810.71 $676.77
Table 7.1 above shows that as the market interest increases, prices of bonds will
decrease irrespective of the maturity periods.
7.5.2 Volatility of Bond Prices for Longer Term

Maturity Bonds
Bonds with longer maturity periods experience more volatile price movements.
Table 7.1 shows that the rate of change in price is higher for a 10-year bond
compared to a one-year bond. A 2% increase in interest rates (from 4% to 6%)
will result in a 1.8% reduction in bond price for a one-year bond versus a 13.8%
drop in price for a 10-year bond. Observe also that the rate of change in price
reduces at a decreasing rate as the maturity period increases given the same level
of interest rate. Given an interest rate of 6%, the rate of change in price is 7.4%,
1.5% and 1.2% for the bonds that mature in 10 years, 20 years and 30 years
respectively.
Another observation from the above table is that a change in the price depends
on the direction of interest rate movements. An example will be the 10-year bond.
When interest rates increase from 8% to 10%, the price of the bond drops from
$1,000 to $875.38, a reduction of 12.5%. If interest rates reduce from 10% to 8%,
the price of the bond increases from $875.38 to $1,000, giving a percentage change
of 14.3% ($1,000 - $875.38/$875.38). While the percentage change in market
interest rates remains the same at 2%, the percentage change in price is higher
when the interest rate drops rather than increases. It can therefore be said that the
price of bonds is more critical when interest rates are in a downward trend.

7.5.3 Measures of Volatility

We have seen how the price of bonds is influenced by the change in market
interest rates, coupon rates and maturity periods. Duration measures this
sensitivity of bond price against interest rates. Sometimes duration is also known
as the effective maturity period. The following example shows how duration is
calculated for Bond A that has a five-year maturity period with a coupon rate of
5% to be paid semi-annually and a yield to maturity of 10%. Refer to Table 7.2.
Table 7.2: Bond A, Coupon Rate 5%, Maturity Period 5 Years, Coupon Payments 2X
PV Cash flow PV of Cash flows x t

Time PV factor 5% Cash flow
(2) x (3) (1) x(4)
(1) (2) (3) (4) (5)
1 0.9524 25 23.81 23.81
2 0.9070 25 22.67 45.35
3 0.8638 25 21.60 64.80
4 0.8227 25 20.57 82.28
5 0.7835 25 19.59 97.95
6 0.7462 25 18.66 111.96
7 0.7107 25 17.77 124.39
8 0.6768 25 16.92 135.36
9 0.6446 25 16.12 145.08
10 0.6139 1025 629.25 6292.5
Total RM806.96 RM7,123.49
Duration = $7,123.49/ $806.96 = 8.828 years
Column four shows the present values of the expected cash flow obtained by
multiplying columns two and three at a 5% discounted rate. Column five is
obtained by multiplying column one and four to give the present value of
expected cash flow at various time periods. Since the coupon payment is made
twice, the duration should be divided by two, which gives it a value of 4.414.
Lets now look at Table 7.3, Bond B.

Table 7.3: Bond B, Coupon Rate 5%, Maturity Period 5 Years,

Coupon Payments Annually
PV of Cash flows x t
Time PV factor 10% Cash flow PV of Cash flow
(4) x (1)
(1) (2) (3) (4) (5)
1 0.9091 50 45.49 45.49
2 0.8264 50 41.32 82.64
3 0.7513 50 37.56 112.68
4 0.6830 50 34.15 136.60
5 0.6209 1050 651.95 3259.73
Total 810.47 3637.14
Duration = 3,637.14/810.47 = 4.48 years
The duration for Bond B is 4.48 years. Notice the difference in the two
computations for Bond A and Bond B. The higher the duration, the higher the
sensitivity of price to changes in interest rates, hence, the more risky is the bond.
In the above example, bond B appears to be riskier.
Characteristics of duration are:

(a) Duration is normally lower than a bonds maturity period.
(b) Coupon rates and duration always have an inverse relationship.
(c) Duration is equal to the maturity period if a bond has a zero coupon rate.
(d) The relationship between duration and maturity period is linear. A bond
with a short maturity period will normally have a short duration.
(e) The relationship between yield to maturity and duration is inverse. An
increase in yield will reduce the duration.
(f) Duration is influenced by the availability of sinking funds and redemption
clauses stipulated in the bond indentures.
7.5.4 Modified Duration

Modified duration is used to estimate the sensitivity of bond price as a result of a
change in interest rates. It is calculated as:
D*
Dmod
i (7.2)
1 n


Where D* is the Macaulay Duration, i is the yield and n is the number of times
the coupon rate is paid in a year. If a bond is sold at RM1,000, and has a
Macaulay Duration of five years with a yield of 8% and pays the coupon twice in
a year, then the modified duration is:
5
Dmod 4.81 years
0.08
1 2

Modified Duration is used to determine the percentage change in price as a result

of a change in interest rates or yield. This can be done by using the following
formula:
P/P x 100 = Dmod x i % (7.3)
where:
P = the change in price
P = the original price of bond
Dmod = the modified duration
i = the change in yield
To illustrate, consider a bond with a Macaulay Duration of five years, pays a

coupon twice in a year. The bonds yield changes from 8% to 9%. How does this
affect the price of the bond? Firstly, we used the earlier Dmod calculated figure,
which was 4.81. Hence, the change in price is:
%P = 4.81 x 1 % = 4.81%
From the calculation, we can deduce that if there is an increase of 1% in interest

rates, the price of the bond will decline by 4.81%. The price will now be $951.90.
ACTIVITY 7.2
Visit the website of Bank Negara Malaysia at http://rmbond.bnm.
gov.my/RinggitBondMarket.nsf. Examine the bond market tables and
analyse the volatility in the bonds prices. From your analysis, what can
you conclude about Malaysian bonds?

SELF-CHECK 7.3
In our previous discussion, we looked at the concept of a portfolio.
What do you understand about portfolios and how does it apply to
bond management?
7.6 BOND PORTFOLIO MANAGEMENT

Investors can put their money in more than one bond to create a bond portfolio.
There are two types of management strategies, namely passive and active.
(a) Passive Strategy

In this approach, there are basically two types of strategies which include:
(i) Buy and Hold Strategy

In this strategy, the portfolio is managed based on the objectives and
constraints dictated by the investor. The bonds will be bought and
held until maturity. After choosing a bond that is considered good,
the investor will match the maturity and the duration of the bond
during the investment period. An aggressive investor will normally
invest at the right market timing.
(ii) Index Strategy

In this strategy, an investor will form his portfolio based on one index.
Normally, the index will be formed from bonds with varying types of
risk structures combined together in a portfolio. The first important
step is to develop a reasonably good index. Bonds to be purchased
will be matched with the index. The proportion of portfolio
investment will be almost similar to the index constructed. The
portfolio manager will compare its portfolio to that of the index.
(b) Active Strategy

There are four sources of active management strategies, namely:
(i) Interest Rates Forecasting

This strategy is the riskiest strategy as it involves the forecasting of
future interest rate movements. The main idea here is to maintain
existing capital when interest rates are forecasted to rise and increase
capital gains when interest rates are predicted to fall. This is done by
adjusting the maturity and duration period of bonds held in the
portfolio.
(ii) Choosing a Sector

In this strategy, the manager will pick the sectors that are believed to
give high returns. A manager may pick a sector having a high credit
risk.
(iii) Movements Between Sectors

This strategy involves movement of funds from one sector to another.
The bond market can basically be divided into government and
corporate, long-term and short-term sectors.
(iv) Choosing a Wrongly Priced Bond

In this strategy exist two situations. Firstly, to assume that the bond is
priced correctly and then to find the best bond within the category.
Bonds ranking AAA are said to be the best and choosing the best from
this category will be appropriate. Secondly, find a bond that is
wrongly ranked; it should have been an AA bond but is ranked BB
instead.
ACTIVITY 7.1
How are bonds ranked and who is responsible for ranking the bonds
in Malaysia? You can obtain the information in the business section of
the daily newspaper and through the Internet.
7.6.1 Active Bond Management

In an active bond portfolio management, there is always a need to change the
portfolio of bonds. A bond manager may have to switch from one sector to
another, or from one bond to another. Sometimes there is no need to actually buy
and sell bonds. Instead the manager can just enter a swap.
A swap is an exchange of one bond for another.
Some examples of swap are discussed below.
(a) Substitution Swaps

A substitution swaps is an exchange of one bond for a nearly identical
substitute. The substituted bonds should be of essentially equal coupon,

maturity, quality credit rating, call features, sinking fund provisions, and
other conditions as stipulated in the bond indentures.
(b) Yield Pick Up Swaps

Yield pick up swaps involve an exchange of a shorter duration bond for a
longer duration bond. It is done because of the perception that there is a
misprice. As such, a means of increasing return is through holding higher
yielding and longer maturity bonds.
(c) Rate Anticipation Swaps

Bonds of different maturities are exchanged due to an anticipation of a
change in interest rates. Investors who believe interest rates will fall will
swap bonds with longer duration. For example, the investor might sell a
five-year maturity Treasury bond, replacing it with a 25-year maturity
Treasury Bond. The new bond has the same level of credit risk as the old
one, but it has a longer duration.
Now, lets look at two examples of active management strategy.
(a) Interest Rate Swaps

This is a contract between two parties to exchange cash flow corresponding
to different securities without actually exchanging the securities directly.
Swaps arose originally as a way to manage interest rate risks.
To illustrate how it works, consider an investor A who has a bond which

pays a fixed coupon rate of 5%; while investor B holds a bond with a
floating coupon rate of 5%. Having the same principal value of $10 million,
the cash flow from interest payments of the two bonds can be exchanged
when market interest rates change.
The following table shows the amount investors A and B would exchange
when the interest rate changes.
Year Interest Rates (%) A Pays to B B Pays to A
1 5 $500,000 $500,000
2 5.5 $500,000 $550,000
3 6.0 $500,000 $600,000
4 6.5 $500,000 $650,000
5 4.0 $500,000 $400,000
6 4.5 $500,000 $450,000

Note that A will pay the same amount of $500,000 irrespective of the
changes in interest rates while B pays a fluctuating amount to A. The
exchange of interest payments is facilitated by a middleman, normally a
swap dealer.
(b) Liability Funding Strategy

Apart from maximising profits given a specific level of risk, investments in
bonds provide a buffer against contingent claims. For example, an
insurance company receiving premiums must be able to pay its customers
claims at the end of the life of the insurance. This does not include any
unexpected claims made by the clients.
To ensure the company is capable of meeting the claims, it must therefore

think of an investment that is able to generate enough returns and cash
flow. Investments in bonds is one way but it is often affected by the interest
rate movements. Immunisation strategy is one way to manage investments
in the case of fluctuating interest rates.
To illustrate how immunisation strategy works, we look at the following

scenario, where an insurance firm collects a premium amounting to $1,000
and promised a return of 9% per year for seven years. At the end of the
seventh year the firm will have to pay $1,000 (1 + 0.09)7 = $1,828.04 to its
customers. What can the firm do to ensure that it is able to fulfil its
obligations to its clients?
Alternative 1
Buy a seven-year bond with a 7% coupon rate. Let us look at the situation where
interest rates change.
Table 7.4: 7-year bond with a 7% Coupon Rate
Coupon Payment Value Value at the

Interest Rates (%) Maturity
FVFA* End of the 7th Year
7 $90 x 8.6540 + $1,000 $1,778.86
9 $90 x 9.2004 + $1,000 $1,828.036
12 $90 x 10.089 + $1,000 $1,908.01
* FVIFA- future value interest factor annuity at the prevailing interest rate
In this alternative, the firm will experience interest rate risks. A fall in interest
rates will leave the firm with an inadequate cash flow to fulfil claims made by its
clients. This is because the coupon payments can only be reinvested at a rate of
7% giving a future value of RM778.86. This cash, together with the face value of

RM1,000, will only give a total value of RM1,778.86. The liability is RM1,828.04.
This strategy suffers from falling interest rates.
Alternative 2
Buy a 15-year bond with $1,000 maturity value and a 9% coupon rate. Lets look
at what happens at the end of year seven when interest rates change. Note how
much the value changes at the end of the seventh year as a result of a change in
interest rates.
Table 7.5: 15-Year Bond with 9% Coupon Rate
Interest Rates (%) Coupon Payment Bond Value at End Value at the End of
FVFA* of 7th Year 7th Year
7 $90 8.6540 + $1,119.43 = $1,898.34
9 $90 9.2004 + $1,000.00 = $1,828.04
12 $90 10.089 + $ 850.98 = $1,758.98
* FVIFA- future value interest factor
When the interest rate is at 7%, the company will have a low reinvestment return
from its coupon payment, but obtain a high price for the bond. Note that at the
end of the seventh year, this bond will have an additional eight more years
before maturity and it can fetch a price of $1,119.43. The total cash flow at the end
of the 7th year is RM1,893.34, which is more than enough to pay the liability.
However, if the interest rate goes up to 12%, the company gains from
reinvestment but loses in terms of a lower selling price. The total cash flow is
lower than the liability. Therefore, this strategy suffers from increases in the
interest rate.
Alternative 3
Buy a bond that matures in 10 years, and has coupon rate of 9% with a face value
of $1,000. Let us see what happens at the end of the seventh year at the same
level of interest rates. Note the value of bond at the end of the seventh year and
bear in mind that we have three more years before the bond matures.

Table 7.6: 10-Year Bond with 9% Coupon Rate
Coupon Payment Value at the End of

Interest Rates (%) Maturity Value
FVIF 7th Year
7 $90 x 8.6540 + $1,052.49 $1,831.35
9 $90 x 9.2004 + $1,000.00 $1,828.04
12 $90 x 10.089 + $927.95 $1,835.96
Notice that the third alternative is the most suitable. At all levels of interest rates,
the firm will have an adequate cash flow to meet the claims of its customers. The
trick is to find a bond that has the same duration as the liability period. In fact by
buying this 10-year bond whose duration is equal to its clients liability period of
seven years, the firm will be relieved of the burden of inadequate cash flow.
The third alternative also does not bear any interest rate risks since the bond
duration is equal to the firms liability period. We can therefore conclude that in
an immunisation strategy, the firm will equate the duration of investment to that
of the liability period. In this case it is seven years.
EXERCISE 7.2
1. Calculate the yield to maturity (YTM) of the following bonds:
Coupon
Maturity Coupon Maturity Current
Bond Payment
Period Rate Value Price
Per Year
A 5 8 $1000 $1,180.46 4
B 5 8 $1000 $1,170.65 2
C 5 8 $1000 $1,178.07 1
D 10 8 $1000 $774.00 1
2. SBS is considering the purchase of a 10-year bond with a coupon rate

of 10%. The current yield is 8%. He intends to hold the bond for five
years only. He anticipates that the yield will increase from the fifth
year to the 10th year at 12%. What price do you think he is willing to
pay today?

3. SBS has now some new information. The yield rate will fall in the
third year to 5%, increase to 9% in the fourth year and 12% in the
fifth year. Using your answer in 2, calculate the rate of return if SBS
were to purchase and hold the bond for five years.
4. If you predict that interest rates will fall, will you choose a short-
term bond or a long-term bond? Explain.
5. Calculate the duration of a three-year bond with a coupon rate of

8%, a yield of maturity of 10% and a par value of $1,000.
(a) Calculate the modified duration of this bond.
(b) If YTM falls from 10% to 9.5%, what is the change in price?
Calculate the bond price first.
6. What happens when a firm engages in an interest rate swap? Why

would a firm engage in interest rate swaps?
There are six characteristics of bonds which include: Maturity Period,

Maturity Value, Coupon Rates, Floating Rate, Zero-coupon Bonds and
Embedded Options.
The most important factor that influences the value of the bond is the market
interest rate, which directly influences the yield that an investor is looking
for. Changes in this interest rate will affect the changes in the prices of bonds,
referred to as the volatility of bond prices.
Bond investors are exposed to interest rate risks, investment risk; redemption
risk; default risks, inflation risk and liquidity risks.
There are two types of management strategies, namely passive and active.
In an active bond portfolio management, there is always a need to change the

portfolio.

Topic Derivatives
8 Market
LEARNING OUTCOMES
1. Explain the nature and characteristics of forward contract, futures
contract and options;
2. Analyse the factors that influence the price of options;
3. Differentiate between options and futures contract;
4. Justify the importance of hedging in managing risk; and
5. Evaluate how derivatives are priced using the basic Binomial Pricing
theorem and the Black-Scholes pricing model.
INTRODUCTION
Among the most innovative and most rapidly growing markets to be developed
in recent years are the markets for financial futures and options. Futures and
options trading are designed to protect the investor against interest rate risks,
exchange rate risks and price risks. In the financial futures and options markets,
the risk of future changes in the market prices or yields of securities are
transferred to someone (an individual or an institution) who is willing to bear
that risk. Financial futures and options are used in both short-term money
markets and long-term capital markets to protect both borrowers and lenders
against the risks involved.
Although financial futures and options are relatively new in the field of finance,
risk protection through futures and options trading is an old concept in
marketing commodities. As far back as the Middle Ages, traders in farm
commodities developed contracts calling for futures delivery of farm products at
TOPIC 8 DERIVATIVES MARKET 127
a guaranteed price. Trading in rice futures began in Japan in 1697. In the United
States, the Chicago Board of Trade established a futures market in grain in 1848.
More recently, the Chicago Board developed futures and options markets for
financial instruments. The Malaysian first derivatives exchange was established
in July 1993 under the name Kuala Lumpur Options and Financial Futures
Exchange (KLOFFE). In October 1995, the Malaysian Derivatives Clearing House
(MDCH) was established for both KLOFFE and the Commodity and Monetary
Exchange of Malaysia (COMMEX), and the Malaysian Derivative Exchange
(MDEX) is the only derivative exchange in Malaysia. MDEX in now known as
Bursa Malaysia Derivatives Berhad (BMD) and it operates under the supervision
of Securities Commission.
8.1 GENERAL DESCRIPTION OF DERIVATIVES

A derivative security is a financial contract written on an underlying asset.
The underlying asset may be a share, Treasury Bill, foreign currency or even
another derivative security. For example:
(a) The value of a share option depends upon the value of the share on which it
is written.
(b) The value of a Treasury Bill futures contract depends upon the price of the
underlying Treasury Bill.
(c) The value of a foreign currency forward contract depends upon the foreign
currency forward rates.
(d) The value of a swap depends upon the value of the underlying swap
contract.
Two types of derivative security, futures and options, are actively traded on
organised exchanges. These contracts are standardised with regard to a
description of the underlying asset, the right of the owner, and the maturity date.
Forward contracts, on the other hand, are not standardised; each contract is
customised to its owner, and they are traded in what is called over-the-counter.
Options can be found embedded in other securities, convertible bonds and
extendible bonds being two such examples. A convertible bond contains a
provision that gives an option to convert the security into common share. As
extendible bond contains a provision that gives an option to extend the maturity
of the bond.

128 TOPIC 8 DERIVATIVES MARKET
Once we understand simple derivative securities, then it will be easy to

understand the complicated examples of derivative securities such as these
embedded options. This topic explains derivative securities: forward contracts,
futures, and both call and put options.
8.2 FORWARD CONTRACT

A forward contract is an agreement to buy or sell a specified quantity of asset at
a specified price, with delivery at a specified time and place.
The specified price will be referred to as the delivery price. At the time the
contract is written, the delivery price is set such that the value f of the forward
contract is zero. The party that agrees to sell the underlying asset is said to have a
short position. The party that agrees to buy the underlying asset is said to have a
long position.
A forward contract is settled at the delivery date, sometimes called the maturity
date. The holder of the short position delivers the specified quantity of the assets
at the specified place and in return receives from the holder of the long position a
cash payment equal to the delivery price. No cash exchange occurs prior to the
delivery date.
For example, suppose that a company enters into a forward contract today, at
date t. The forward contract matures at date T. Let f(t, T) denote the forward
price. There are two arguments in this price. The first argument, t, denotes the
date that forward price is quoted, and the second argument, T, denotes the
delivery date of the contract.
When the contract is initiated, by definition the forward price equals the delivery
price, denoted by K(t). The delivery price is determined so that no cash is
exchanged at this time; the delivery price is fixed over the life of the contract.
f(t, T) K(t)
t T
Initial date Delivery date
Let S(t) denote the spot exchange rate (RM/USD) at date t. When the contract
matures at date T, the spot exchange rate is denoted by S(T). This spot exchange
rate is unknown when the forward contract is initiated. It is called a random

variable. The value of the forward contract at the delivery date, date T, to the
long position initiated at date t for one currency is:
S(T) K(t)
Note that the argument t in the delivery price refers to the date the contract was
initiated. The value of the forward contract at delivery equals the value of the
foreign currency, S(T), less the delivery price paid, K(t). As illustrated in the
above example, the value of the forward contract at delivery can be either
positive or negative. A graph of the possible values is shown below.
Figure 8.1: Possible value of a forward contract
The delivery price K(t) equals the forward price f(t, T) when the contract is
initiated.
If the spot exchange rate at the delivery date is less than the delivery price S(T) <
K(t), then the value of the forward contract is negative; otherwise, it is zero or
positive. The delivery price equals the prevailing forward price, K(t) = f(t, T),
when the contract is initiated. Once the contract is written, the delivery price is
fixed over the life of the contract. The forward price, which represents the
delivery price of newly written contracts, of course can change. If you contracted
with a financial institution tomorrow, date t + 1, about buying USD for delivery
date T, in general there would be a new delivery price or forward price, K(t + 1)
= f(t + 1, T).
This completes the institutional description of a forward contract. We will return

to these contracts when we analyse pricing and hedging.

ACTIVITY 8.1
List at least three examples of forward contracts available in the
Malaysian market. You can refer to the Malaysian Investor website at
http://www.min.com.my under products, and other resource
materials such as business newspapers and magazines. Also list the
advantages and disadvantages of a forward contract.
8.3 FUTURES CONTRACT

A futures contract is an agreement to buy or sell a specified quantity of an asset
at a specified price, and at a specified time and place.
This part of the definition of a futures contract is identical to that of a forward

contract. But futures contracts differ from forward contracts in four important
ways. The differences are:
(a) Futures contracts allow participants to realise gains or losses on a daily
basis, while forward contracts are cash settled only at delivery.
(b) Futures contracts are standardised with respect to the quality and the
quantity of the asset underlying the contract, the delivery date or period,
and the delivery place if there is physical delivery. In contrast, forward
contracts are customised on all these dimensions to meet the needs of the
two counterparties.
(c) Futures contracts are settled through a clearing house. The clearing house
acts as a middleman. This minimises credit risk as the second party to a
futures contract is always the clearing house.
(d) Futures markets are regulated, while forward contracts are unregulated.
Now let us look at an example of a futures contract.
Consider that A wants to sell futures (that means he wants to sell the underlying
asset) that matures in three months. The price of the underlying asset now is
RM2.30 and the risk-free interest rate is 4% per year. What A could do is: (1)
borrow RM2.30 from a bank for three months, and (2) use the borrowed money
to buy the asset at RM2.30. After three months, A will sell the asset at the agreed
price f and the proceeds will be used to pay the loan and he can keep the balance.
This strategy is called the cash-and-carry strategy.

The payoff from this strategy is:

Stock investment 2.30
Futures contract [2.30 f ]
Repay borrowing 2.30 (1 + 0.04 0.25)
Net payoff f 2.30(1 + 0.04 0.25)
8.3.1 Clearing House

This intervention of the clearing house means that the futures market has no
counterparty risk. If A plans to buy futures and B plans to sell futures, both
parties will refer to the clearing house to fulfil their intentions. The clearing
house is thus the counter party to every contract. In this case, B is not the counter
party to A.
The clearing house must have reserves to guarantee that its contracts are
executed and are considered risk-free. It actually accepts that the counterparty
may default on the contract and for this it charges a small fee for each contract
executed. Further, the clearing house only accepts contracts from recognised
traders and sets a margin account. In margin accounts, investors are required to
maintain or keep some amount of money. In Malaysia, the clearing house
derivatives is the Malaysian Derivative Exchange (MDEX). Please note that if the
net payoff is not equal to zero, then arbitrage profit is possible.
The functions of the Clearing House can be summarised as shown in Figure 8.2.
Figure 8.2: Clearing House functions

8.3.2 Settlement Price

A futures contract is marked-to-market each day. When each trading is closed,
the exchange will establish the closing price, which is the settlement price.
This settlement price is used to compute the investors position, whether at a loss
or a gain compared with the initial settlement price agreed upon at the inception
of the contract. This means that the change in the futures price over the day is
credited (debited) to the account of the long (short) if the change is positive. If the
change is negative, the account of the long (short) is debited (credited).
8.3.3 Daily Margin

When a person enters into a futures contract, the individual is required to deposit
funds in an account with the broker. This account is called the margin account.
The exchange sets the minimum amount of margin required, but brokers can
increase the margin if they feel that the risk of the investors default is increased.
This margin account may or may not earn interest. The economic role of the
margin account is to act as collateral to minimise the risk of default by either
party in the futures contract.
Since the price of futures is marked-to-market, the gain or loss on the futures
contract will also change on a daily basis. Thus the margin needs to be adjusted
to reflect these changes. These changes are reflected in what is known as the
maintenance margin. This will ensure that a minimum amount is kept in the
margin account with respect to the changes in gain or loss.
Lets look at an example of the initial margin and the maintenance margin.
Consider A, who on 3 March enters into a futures contract to buy 100 troy ounces
of gold at the futures price of RM365 per troy ounce. The initial margin for the
contract is set at RM2,000 and the maintenance margin is set at 75% of the initial
margin, or RM1,500.
Table 8.1 below shows the calculation that reflects the changes in the margin
when the daily price changes. We observe that on 5 March, the price drops to
RM359 and a cash flow of RM300. This reduces the initial margin to RM1,400
which is below the maintenance margin of RM1,500. At this point, A has to top-
up the margin account back to the original RM2,000. Thus, A has to withdraw or
put in RM600 into the margin account. We assume that A will withdraw any
excess margin (in excess of RM2,000).

Table 8.1: Margin and Marking to Market

Cash Deposit/
Date Futures Price Cash Flow Ending Margin
Withdrawal
3/3 365 0 2000 2000
4/3 362 300 0 1700
5/3 359 300 600 2000
6/3 364 +500 500 2000
7/3 365 +100 100 2000
8/3 367 +200 200 2000
8.3.4 Basis
Let F(t, T) denote the futures price at date t, for delivery at time T. Let the
contract be written on an underlying asset, with spot price S(t). In a well-
functioning and efficient market, the futures price equals the price of the
underlying asset at the delivery date. Figure 8.3 shows that F(t, T) = S(T).
s(t) S(T)
t
F(t, T) T
Figure 8.3: F(t, T) = S(T)
In fact, the futures price at T for immediate delivery should be equal to S(T). That
is F(T, T) = S(T). The difference between the futures price and the spot price is
known as the basis. Thus, the basis at time t is;
Basist = F(t, T) S(t).
In the forward or futures contracts investment, the risk involved is represented

by the change in the value of the basis. Thus, when the change in the basis is
relatively large, the risk involved in that investment is also large. This is
important when we consider the use of forward or futures contracts to hedge, for
instance, our investment in the cash market. We will consider this idea later in
the topic.
A typical graph of the basis with respect to maturity is shown in Figure 8.4.

Figure 8.4: Basis with respect to maturity
In the graph above, we see that the basis is positive. However, this is not always true.
Basis can also be negative. What is important is that the graphs should converge.
8.3.5 Using Futures for Hedging

Futures are usually used to hedge our investment or lock the price of the
underlying asset. Thus with hedging, we can construct a portfolio consisting of
assets on both the spot and the derivatives markets. It is important to understand
that in the spot market, we are dealing with the price risk whereas in the futures
market, we are faced with the basis risk. If basis0 = basisT, then we should be able
to use perfect hedging, which means the value of the underlying asset at time 0
and time T are equal.
Hedging is easier to understand by using examples. Lets look at examples where

futures are used for hedging. Be sure to follow the example and understand what
happens to the value of our portfolio when basis0 basisT.
We will assume that as the price in the spot market increases, the price in the
futures market will also increase. This is to say that the two prices are closely

correlated, which is what we usually observe. Suppose you sell one unit of
futures and buy one unit of the underlying asset. Thus, your portfolio is (S F).
At time t, your portfolio is worth (S(t) F(t)), and at time T, it is worth (S(T)
F(T)).
Thus, the change in spot price is (S(T) S(t)) and the change in the futures price is
(F(T) F(t)). To see how the value of our portfolio changes, refer to the following
formula.
(S(t) F(t)) = S(t) F(t) = (S(T) S(t)) (F(T) F(t))
= (S(T) F(T)) (S(t) F(t))
= BasisT Basist
= (Basis)
If there is no change in the basis, then the value of our portfolio remains the
same, thus we have locked in the value of the portfolio. The result would be
different if the values of the basis are not constant.
Now, lets look at the mechanism in using futures for hedging using two companies,
Gold Mining Company and Jewellery Company. The Gold Mining Company
expects to sell 1,000 ounces of gold next month and the Jewellery Company expects
to buy 1,000 ounces of gold next month. However, to hedge against the risk of
changes in the price of gold in a months time, both companies want to lock in
todays price. Assume that todays price for gold is $352.40 per ounce and the
current futures price is $397.80. Each futures contract is for 100 ounces.
You are advised to carefully study Tables 8.2 8.5 on the next page to understand
the mechanism of using futures in hedging. Attention should be given to what
happens to hedging when the basis at the time the contract is initiated is not equal
to the basis when the futures mature. This will explain the basis risk which will
ultimately influence the gain or loss when futures are used. We also note that since
the Gold Mining Company wishes to sell gold in the future, then it will short or
sell futures when the contract is initiated. Similarly, the Jewellery Company will
long or buy futures since it wishes to buy gold in the future.

Table 8.2: Hedging Price That Locks Gold Spot Price: Spot Price Decrease
Assumption
Spot price when hedging is made $352.40 per oz.
Futures price when hedging is made 397.80 per oz.
Spot price when hedging expires 304.20 per oz.
Futures price when hedging expires 349.60 per oz.
Number of ounces hedged 1000
Number of ounces in one futures contract 100
Number of futures contract used 10
Short (sell) hedging by Gold Mining Company
Cash market Futures market Basis
When hedging is made
Value of 1,000 ounces: Sell 10 contracts:
1,000 x $352.40 = $352,400 10 x 100 x $397.80 = $397,800 $45.40 per oz.
When hedging expires

Value of 1,000 ounces: Buy 10 contracts:
1,000 x $304.20 = $304,200 10 x 100 x $349.60 = $349,600 $45.40 per oz.
Loss in cash market Gain in futures market

= $48,200 = $48,200
Overall loss or gain

= $0
Long (buy) hedging by Jewellery Company
1,000 x $352.40 = $352,400 10 x 100 x $397.80 = $397,800 $45.40 per oz.

1,000 x $304.20 = $304,200 10 x 100 x $349.60 =$349,600 $45.40 per oz.
Gain in cash market Loss in futures market

= $48,200 = $48,200

= $0

Table 8.3: Hedging Price That Locks Gold Spot Price: Spot Price Increase
Assumption
1,000 x $352.40 = $352,400 10 x 100 x $397.80 = $397,800 -$45.40 per oz.

1,000 x $392.50 = $392,500 10 x 100 x $437.90 = $437,900 -$45.40 per oz.

= $40,100 = $40,100

= $0
1,000 x $352.40 = $352,400 10 x 100 x $397.80 = $397,800 -$45.40 per oz.

1,000 x $392.50 = $392,500 10 x 100 x $437.90 = $437,900 -$45.40 per oz.

= $40,100 = $40,100

= $0

Table 8.4: Hedging Price That Locks Gold Spot Price:

Spot Price Decrease and Basis Increase
Assumption
1,000 x $352.40 = $352,400 10 x 100 x $397.80 = $397,800 -$45.40 per oz.

1,000 x $304.20 = $304,200 10 x 100 x $385.50 = $385,800 -$81.60 per oz.

= $48,200 = $12,000

= $36,200
1,000 x $352.40 = $352,400 10 x 100 x $397.80 = $397,800 -$45.40 per oz.

1,000 x $304.20 = $304,200 10 x 100 x $437.90 = $385,800 -$81.60 per oz.

= $48,200 = $12,000

= $36,200

Table 8.5: Hedging Price That Locks Gold Spot Price: Spot Price Increase Basis Increase
Assumption
1,000 x $352.40 = $352,400 10 x 100 x $397.80 = $397,800 -$45.40 per oz.

1,000 x $392.50 = $392,500 10 x 100 x $474.10 = $474,100 -$81.60 per oz.

= $40,100 = $76,300

= $36,200
1,000 x $352.40 = $352,400 10 x 100 x $397.80 = $397,800 -$45.40 per oz.

1,000 x $392.50 = $392,500 10 x 100 x $474.10 = $474,100 -$81.60 per oz.

= $40,100 = $76,300

= $36,200

EXERCISE 8.1
1. Suppose you bought a share at time t at RM4.70, and the price of
the futures on the share is RM4.60. At time T, the price of the
share drops to RM3.90 and the price of the futures drop to
RM4.00. If you short (sell) the futures at time t, what is the value
of your share at time T?
2. Consider a forward contract written on a non-dividend paying

asset. The current spot price is RM65. The maturity of the
contract is 90 days and the simple interest rate for this period is
4.50% per annum.
(a) Determine the forward price. What is the value of the
contract?
(b) A corporate client wants a 90-day forward contract with the
delivery price set at RM60. What is the value of the
contract?
(Assume a 365-day year).
8.4 OPTIONS
Before we proceed further with options, an important concept that needs to be
stressed is the difference between options and futures contracts, how the pricing
of options are determined, and how investors can reduce their investment
risk or reach their investment objectives by using options contracts.
An options contract is a contract where the writer (or seller) of the options
gives to the buyer of the options the right, but not an obligation, to buy
(call options) or sell (put options) to the writer something (or the
underlying) at a specified price, during a specified period (or specific time).
By giving the right, the writer will receive a fee called the price of the options or
the options premium.

Elements in an options contract consist of the following:

(a) Either the buyer of the call options has the right to buy something or the
buyer of put options has the right to sell something.
(b) The underlying is usually a financial instrument, index or commodity that
could be traded.
(c) The strike price or the exercise price.
(d) Expiration date.
(e) Either the buyer of the options can exercise anytime during a specified
duration (for American options) or at a specific time (European options).
Now lets look at an example of European call options.

Price = c
Exercise price = K
Expiration date = three months
Initial price of share (the underlying) = S0
This means that the buyer of the call options can buy the share in three months
time at the price X, no matter what the price of the share will be.
Options can be traded in an organised market or over-the-counter. There

are three advantages when options are traded in an organised market:
(i) The exercise price and the expiration date can be standardised.
(ii) Clearing house can function in the options market similar to that in the
futures market.
(iii) The transaction cost is much lower compared with the options traded over-
the-counter.
Usually institutional options buyers need a specific or a tailor-made option that

matches their needs. This usually happens in portfolio management of fixed
income securities. In fact, in portfolio management of fixed income securities like
bonds, over-the counter trading is more popular because the risk in the cash
market can be hedged by using the options.

8.4.1 Options Moneyness
Options moneyness describes the relationship between the options stated price
and the price of the underlying asset and determines if it is a profitable
transaction.
The transaction can be immediately profitable or not. Moneyness is always

viewed from the buyers or the long position viewpoint and not from the sellers
viewpoint. Furthermore, moneyness is obtained by comparing the exercise price
with the spot value of the underlying asset. There are three types of moneyness
in options. They are shown in Table 8.6:
Table 8.6: Types of Moneyness
Types of However, the remarks are true only when:

Remarks
Moneyness For call options For put options
In-the-money An option is said to be Exercise price (K) < Exercise price (K)
(ITM) in-the-money if it is Spot price of > Spot price of
profitable to underlying asset underlying asset
immediately exercise.
At-the-money An option is said to be Exercise price (K) Exercise price (K)
(ATM) at-the-money if it does = Spot price of = Spot price of
not matter if underlying asset underlying asset
immediately exercised.
Out-of-the An option is said to be Exercise price (K) Exercise price (K)
-money (OTM) out-of-the-money if it is > Spot price of < Spot price of
not profitable to underlying asset underlying asset
immediately exercise.
8.4.2 Difference between Options and Futures

Contracts
There are some fundamental differences between futures and options. They are:
(a) Only the sellers (not the buyers) are obliged to buy or sell. The buyers of
options need not buy or sell the underlying. In the futures contract, the
buyers and sellers are obliged to buy or sell. Thus, the main advantage of
options is where the holder or the buyer of options will benefit from an
upside benefit while limiting a downside loss.

(b) The buyer of options must pay a fee or the price of the options to the seller
to get the right. In the futures contract, there is no exchange of money when
the contract is initiated.
(c) The buyer of the options will decide on the price of the options to buy (for
call options) or to sell (for put options) but can take the opportunity if the
price of the options is low. In the futures contract, the price is already fixed
and the parties to the contract cannot obtain profit or suffer losses from any
price movement.
SELF-CHECK 8.1
In the earlier section, we discussed the definition of options and futures

contracts. We also discussed the characteristics of each security. Based
on your understanding, what is the main difference between options
and futures contracts?
8.4.3 Characteristics of Returns and Risk in Options

There are four basis positions in options contracts. Most other options contracts
are some combinations of the four basis positions. The four basic options
contracts are:
(a) Buy call options
(b) Sell call options
(c) Buy put options
(d) Sell put options
The buyer of an option can seize opportunities to make a profit from the
movement of the price of the underlying asset. However, they must pay a fee for
this. The maximum profit for the seller of options is the price of the options itself.
At the same time, the seller of options is also exposed to the risk of loss from the
movement of the price of the underlying asset. Figures 8.6 8.9 show the gain or
loss incurred by the seller (writer) or the buyer of the respective options with the
following assumptions:

Price of options = $3
Exercise price (x) = $100
C = sell call options
+ C = buy call options
P = sell put options
+ P = buy put options
S = sell share
+ S = buy share
The following graphs show what happens to the profit or value of options
when the price of the underlying asset changes. A full understanding of the
graphs is very important as they are used in more exotic options portfolios, since
the concept is similar. For instance, in understanding put-call parity, all we need
to do is add the relevant linear graphs to look at the profit or the value of our
options portfolio.
Figure 8.5: Profit/loss

for seller (writer)
of call options
Figure 8.6: Profit/loss for

buyer of call options


Seller (writer) of put
options

buyer of put options
Figure 8.9: Value of asset

(S)

To understand the options transactions (buy and sell) better, let us look at the
following example.
Suppose that todays price of a MAS share is RM5.00. A European three-month

call option on the MAS share is quoted as RM4.90 MAS @ 0.30. (i.e. the price of
this call option is RM0.30). This means that in three months time the buyer of the
call option can exercise or buy a MAS share at RM4.90, at whatever the price
MAS shares will be. Based on this information:
Price of MAS in 3 months time Exercise Profit/Loss
Price of MAS share goes up to RM5.30 Exercise (buy) 5.30 4.90 0.30 = 0.10
Price of MAS share goes up to RM5.70 Exercise (buy) 5.70 4.90 0.30 = 0.50
Price of MAS share drops to RM4.30 Dont exercise 0.30
Using the same information given above, except that instead of a call option, the
option is a put option. Then we will have:
Price of MAS in 3 months time Exercise Profit/Loss

Price of MAS share goes up to RM5.30 Dont exercise 0.30
Price of MAS share goes up to RM5.70 Dont exercise 0.30
Price of MAS share drops to RM4.30 Exercise (sell) 4.90 4.30 0.30 = 0.30
8.4.4 Put-Call-Parity
Graphs can also be used to look at the profit/loss of some combinations of
call, put options and the underlying asset. One of the most important
portfolios of options is the portfolio (S + P C). This means when we buy
one share, we buy one put on the share and sell one call on the share. This
portfolio is an interesting portfolio as it gives what is known as put-call parity.
The graph for the portfolio is shown in Figure 8.10:

Figure 8.10: Graph for portfolio S + P C
To calculate the profit for portfolio (S + P C), lets look at the following
example.
Assume the exercise price for the options is X. We consider what happens to
the portfolio when the price of the underlying asset is less than X and when it is
greater than X. Further assume that the price of the underlying asset is S when
the option is exercised.
Price < X Price > X
Share S S
Put (X S) 0
Call 0 (S X)
Profit for S + P C X X
We observe that whatever the value of the underlying asset is, it always equals to
X, the exercise price. It should be clear that the graph in Figure 8.10 gives the
same result. Thus, we can plot the profit of a portfolio of options by using
either graphs or calculations similar to the above. The portfolio (S + P C) is a
riskless portfolio and should earn a riskless rate of return (Rf ).

We can value the portfolio (S + P C) by using the formula below:

X
S+P-C=
1+R f T
This formula is known as the put-call parity and it explains the relationship
between the price of call and put options.
8.4.5 Factors Affecting the Price of an Option

The diagram below shows the time diagram between time 0 and T, where we
include the relevant variables that affect the price of options. Then we will
tabulate to see how they affect the price of options.
where:
c : European call option price
C : American call option price
p : European put option price
P : American put option price
S0 : Share price today
ST : Share price at option maturity
K : Strike price
D : Present value of dividends during options life
T : Life of option
r : Risk-free rate for maturity T with continous compounding
: Volatility of stock price
We summarise how the variables affect the price of options below:

Variable c p C P
S0 + +
K + +
T ? ? + +
+ + + +
r + +
D + +

Where:
+ means the variable and the option move in the same direction (for example
if r increases then c will also increase);
means the variable and the option move in opposite directions (for example
if D increases then c will decrease); and
? means it depends on our expectations regarding the price of the
underlying asset.
8.5 THEORIES IN PRICING OF OPTIONS

We will look at how options are priced by considering the Binomial Pricing
Model and the Black-Scholes model. First, we will explain the Binomial Pricing
Model, followed by the Black-Scholes model, for which we will only state the
formula. The derivations of Black-Scholes model is beyond the scope of this
module.
8.5.1 The Binomial Pricing Model

In this model, we use a riskless portfolio (S C) where we buy a unit of
the underlying asset and sell a call option on the asset. We further assume that
there are only two possible states market goes up or market goes down.
The assumptions used in this model are as follows:
(a) There are no market frictions.
(b) Market participants entail no counterparty risk.
(c) Markets are competitive.
(d) Market participants prefer more wealth to less.
(e) There are no arbitrage opportunities.
We will now consider both the cash and the options markets. Assume that if the
market goes up, the price will increase by 20% and if the market goes down, it
will decrease by 20%. Thus, if the initial price of the share is S0, it will be
S0(1 + 0.20) if the market goes up and S0(1 0.20) if the market goes down. Here,
we assume that we only need one call option (in reality, we need to first calculate
the number of options needed).

Figure 8.11: Stock market
Figure 8.12: Option market
If we combine the two markets, we will have:
Figure 8.13: Combination of stock market and option market
Since the portfolio is a riskless portfolio, 1.20S0 fu = 0.80S0 fd. Thus we can
find the value of C by considering the formula below (assuming the maturity of
the portfolio is T);

1.20S 0 fu 0.8S 0 fu
S0 C = or S 0 C
1+R f T
1 R f T
From the formula above, we obtain:

1.20S 0 fu
C S0
1 R f T
It should be noted that S0, Rf and T are known when the contract is initiated.
Thus, we are left with the prices of call and put. If we know the price of the call,
we can find the price of the put, and vice-versa.
8.5.2 The Black-Scholes Model

The Black-Scholes model for pricing put (p) and call (c) options is as follows:
c S 0 N d 1 K e rT N d 2
p K e rT N d 2 S 0 N d 1
In S 0 IK r 2 I 2 T
where: d1
T
In S 0 IK r 2 I 2 T
d2 d1 T
T

N(d1), N(d2), = the cumulative probability density. The value for N(.) is obtained
from a normal distribution that is tabulated in most statistics textbooks.
c = European call option price p
P = European put option price
S0 = Share price today
ST = Share price at option maturity
K = Strike price
T = Life of option
R = Risk-free rate for maturity T with continous compounding
= Volatility of stock price
EXERCISE 8.2
1. Consider a European call option on an asset with price S(t), strike

price K, and maturity T.
(a) What is the payoff to this call option at date T? Consider a
European put option on the same asset S(t) with strike price
K and maturity T.
(b) What is the payoff to this put option at date T?
(c) Is the payoff to the call option exactly opposite to the payoff
to the put option? Explain.
2. The current share price is RM50. The value of a European call

option with a strike price of RM47 and maturity 100 days is RM4.
The 100-day default-free discount rate is 5%, assuming a 360-day
year.
(a) For a put option with a strike price of RM47 and maturity
100 days, you are quoted a price of RM2. Is this consistent
with the absence of arbitrage? Please justify your answer.
(b) If your answer to (a) is that arbitrage is possible, how
would you construct an arbitrage portfolio to take
advantage of the situation?

3. Suppose you construct the following portfolio:

(a) Long 1 call, strike price 40
(b) Short 1 call, strike price 50
(c) Short 1 call, strike price 70
(d) Long 1 call, strike price 80
All options are written on the same share and mature at the same
time. Without the aid of diagrams, describe the total value of the
portfolio when the options mature.
Derivatives are usually used to hedge the risk that exists in the cash markets.
It should be understood that when we discuss hedging, we are concerned
with reducing or transferring risk in the cash market.
The common derivatives used are the forward, the futures and the options.
The two types of options include call and put options.
Factors influencing the options are the price of the underlying asset, the
maturity, the exercise price, interest rate, dividend and the variance of the
price of the underlying.
The prices of call and put options are related through the put-call parity. This
means that once we know the price of call options, we can theoretically find
the price of put options.
Pricing of options can be complicated compared with pricing of futures. The

basic idea of options pricing can be seen from the binomial options pricing.
This method discusses the pricing in the two-state model and can be
extended into a multi-period model.

Topic Mutual Fund
9 Investment
and
Performance
Measurement
LEARNING OUTCOMES
1. Explain the process of managing funds in a portfolio;
2. Differentiate between open-end fund and closed-end fund; and
3. Evaluate the performance of investments, based on Sharps measure,
Treynors measure and Jensens measure.
INTRODUCTION
This topic discusses another alternative approach to investment. In this topic we
will mainly discuss investment in mutual funds. These mutual funds are
basically portfolios that are managed by professional financial service
organisations. There are various kinds of funds available in the market. To
manage the portfolio, they will need to go through a process. Finally, we will
discuss performance evaluation of investments.

TOPIC 9 MUTUAL FUND INVESTMENT AND PERFORMANCE MEASUREMENT 155
9.1 PROCESS OF PORTFOLIO MANAGEMENT

In Topic 3, we saw how an investor could invest in more than one asset. By
investing in a portfolio, we could manage our return requirement to suit our
tolerance of risk. In practice, we find that there are some commercial
organisations that manage large amount of funds and invest them in portfolios.
The process of managing funds in a portfolio involves four main steps:
(a) Step 1: Setting Objectives

The first step in building a portfolio is to set the investment objectives. In
general the objective will include the amount of return required, the level of
risk and the time horizon of the investment. There are many investors with
different risk tolerance and therefore the portfolio manager needs to cater to
different needs.
As an example, below is the objective of ASB taken from PNB website.
To generate long-term, consistent and competitive returns to the unit

holders whilst ensuring the preservation of capital at minimal risk tolerance
level.
(b) Step 2: Determining Asset Class

Asset class is classification of assets into different types. A general
classification is between equities, debts and money market instruments. In
each class, we can further classify them into smaller categories.

156 TOPIC 9 MUTUAL FUND INVESTMENT AND PERFORMANCE MEASUREMENT
An example is as follows:
Table 9.1: Asset Classification
Asset Class Smaller Classification Further Classification

Equities Domestic and Foreign
Bonds Domestic and Foreign Government, Corporate
Money Market Cash, Short term instrument
Properties Commercial, Industrial
Venture Capital
Arts
(c) Step 3: Asset Allocation

After determining the asset class, the asset manager needs to divide his
funds into the selected asset class. This is similar to determining the
weights or proportion of funds that we saw in Topic 3. Recall that we have
to determine the return, risk and the covariance between assets. For
example, the asset mix can be 60:30:10, where 60% of funds are invested in
equity, 30% in bonds and 10% in cash and money market.
The decision on the right mix will depend on the managers forecast. The
60:30:10 mix may be due to the increase in confidence in the stock market as
a high proportion of funds are invested in equities. A 20:50:30 mix is a
portfolio that is heavy on bonds. This may be due to unfavourable share
market conditions.
(d) Step 4: Monitoring and Rebalancing

Once the portfolios have been formed, their performance needs to be
monitored. There are various performance measures that can be used. Some
of it is discussed later in this topic. If the performance is not achieved or
if there is some new information that was acquired, the manager may
need to rebalance the portfolio. This may involve performing a new asset
allocation and the transfer of funds from one asset class to another.
However, there must be a policy on rebalancing. This is because frequent

rebalancing can increase transaction costs. Too little rebalancing may affect
returns when managers do not react to market conditions.

SELF-CHECK 9.1
Recall the concept and examples of portfolio management in Topic 3.

What are the processes involved in managing a portfolio?
ACTIVITY 9.1
We have discussed portfolio management processes which involve four

sequential steps. What will happen to an investor if the steps were not
followed in sequence or if one of the steps was not done?
9.2 INVESTORS OBJECTIVES

As we mentioned earlier, investors have different risk tolerance. Therefore, each
major group of investors will have different portfolios that suit their needs. The
easiest way to determine an investors profile is by age.
Table 9.1 shows a broad description of investors needs categorised according to

age.
Table 9.1: Investors Needs Categorised According to Age
Income
Return Recommended
Age Generating Risk Tolerance
Requirement Assets
Potential
25 to 35 High High High Equities with high
growth and price
appreciation.
35 to 45 High Require to Normal Mixture of growth
strengthen and income. Still
position heavy on equities.
45-60 Moderate Normal Moderate and Focus more on
will not be able income generating
to tolerate high portfolios.
risk
65 and above Low Normal Low Stable or fixed
income portfolios.

SELF-CHECK 9.2
You have RM40,000 and wish to invest in bonds. But first, you
should set your objective. What would it be? Compare your objective
with that of your peers. What can you conclude?
9.3 MUTUAL FUNDS: PROFESSIONALLY

MANAGED INVESTMENT PORTFOLIOS
A mutual fund is a pool of money that is managed by an investment

company which invests shareholders money in a diversified portfolio of
securities and/or derivatives with the goal of producing a certain return for
the investors.
A potential shareholder will need to see an agent of the fund to buy the shares. A
share scrip is then normally issued. However, in Malaysia most transactions are
done without any scrips and recorded electronically.
9.3.1 Characteristics of a Fund
An open-end fund is a type of fund where investors can buy shares from the
fund.
The fund is obliged to buy back the shares. The size of the fund is limited by
the number of shares it can issue. Once it reaches its limit, no new share
can be sold unless there are investors who sell back their shares. The
organisation that created the fund can form another fund if there is a high
demand for its services. Examples of this fund are ASN, ASB, and RHB Dynamic
Fund.
A closed-end fund is a fund where the number of shares is fixed. Investors

can buy these shares initially from the fund, but they cannot sell them back
to the fund.

The shares can only be sold to another investor in the stock exchange. Therefore,
when the shares cannot be bought initially, it can be purchased in the open
market. It is similar to ordinary shares in the share market. Currently in Malaysia
there is only one closed-end fund that is listed in the Bursa Malaysia. This is the
Amanah Small Cap Fund Berhad (ASFB).
9.3.2 Types of Funds

A fund can be specialised. It can either focus on equities, bonds or a mixture of
both. Some funds are more specific like Islamic and non-Islamic. Below are some
general examples of funds.
A growth funds specific objective is price appreciation. It targets securities that

will have long-term growth and capital gains and focuses less on securities that
give dividends or income. Because of this, a growth fund is risky. This type of
fund is suitable for investors in the age group of 25 to 40 years. Their objective is
to accumulate capital.
Income funds emphasise on current income. They will invest in securities that
provide stable income. Shares that provide high dividends are normally the
favourite choice as well as established blue chip companies. They, however, do
hold a few growth shares. Apart from shares, these types of funds also invest in
bonds. The investment is less risky than growth shares.
Index fund is a portfolio that replicates the combination of shares in an index.

For example, the KLCI contain 100 shares, with predetermined weight for each
share. A portfolio can be built to replicate that index and use the same 100 shares
and weights.
ACTIVITY 9.2
Refer to the business section in one of the local newspapers and
list down the different types of funds available in the Malaysian
market. In which categories do the funds fall?

9.4 PERFORMANCE EVALUATION

The final process of investment is to evaluate the performance. This process is
vital as it provides a feedback mechanism and control in our investment
management. The process that we describe here can be used to evaluate the
performance of individual stocks, portfolios as well as unit trusts.
SELF-CHECK 9.3
Why do you think we need to evaluate the performance of our

investment?
9.4.1 Sharpes Measure

Sharpes measure or index, as it is sometimes called, can be determined by using
the formula below.
RP RF
Sp
P
where, SP is the Sharpes index for the portfolio p, RP is the return of the
portfolio, RF is the risk free rate and P is the standard deviation or risk measure
for the portfolio.
Sharpes index measures the excess return (risk premium RP - RF) of a portfolio
relative to its risk measured by the standard deviation. The index uses the
Capital Market Line (CML) as a basis (see Topic 4). For example, if portfolio A
has a return of 10%, RF is 4%, and A is 13%. Then Sharpes index for the
portfolio is (10 4)/13 = 0.46. The higher the index, the better the investment
performance.
9.4.2 Sharpes Differential Return

As the index is based on the CML, we can also reinterpret the measure in
a form of differential return. As we know from Topic 4, the CML is based on the
following model:
R Rf
Ri Rf m i
m

We will compare the return from a portfolio with the return that is being stated by
the model above. We therefore need the market return as well as its standard
deviation. Using the example above where the return of portfolio A = 10% and its
standard deviation = 13%. If the market return equals to 12%, and its standard
deviation, m = 15%, then based on the model, portfolio A should have a return of
12 4
RA 4 13 10.93%
15
The Differential Return is the actual return minus the above return from the
model, which is 10 10.93 = 0.93. The performance is well below the standard
of the CML. A positive difference would indicate a better performance, the
higher the better.
9.4.3 Treynors Measure

Treynor s measure is calculated using the formula below:
RP RF
TP
P
where TP is Treynors measure for portfolio P, P is the Beta of portfolio, while the
other variables are the same as above. The difference between Sharpes and Treynor
s measures is the risk measurement used. Treynor uses the Beta of the
portfolio.
The Beta of the portfolio is obtained by taking the weighted average of all asset
Betas in the portfolio, as shown below:
P W1 1 w 2 2 .........W n n
where w1, w2.......wn are the percentage weights of funds in each asset 1 to n.
As an example, Portfolio C gives a return of 15%, RF is 4%, and C is 2. The

Treynors measure is (15 4 )/2 = 5.5. A portfolio with the highest measure is the better
portfolio.

9.4.4 Treynors Differential Return

Treynors Differential Return uses the Security Market Line (SML). Again you
can refer to Topic 4 for further details.
The expected return can be determined using the SML equation below:
RP Rf R m Rf p
The actual return is then compared with the return calculated by the model.
For example, portfolio C gives a return of 15%, RF is 4%, C is 2 and Rm = 12%,
and the model will show that the expected return is:
RC 4 12 4 2 20%
The differential return is 15% - 20% = -5%. Portfolio Cs performance is below

the performance of the model. Differential return calculated using Beta is
sometimes known as the Jensen index.
Investors can choose any of the indices. However, if the portfolio is well
diversified, the Treynor measure is most appropriate, since unsystematic risks
have been reduced. Treynors measure is also used when a portfolio is part
of many portfolios. If the portfolio contains a small number of assets, or is
the investors only portfolio, then Sharpes measure is more appropriate.
EXERCISE 9.1
1. Explain the difference between open-end fund and closed-end

fund.
2. Look into a newspaper and list down the different types of funds
available in the Malaysian market.
3. If you were a 35-year-old person, what kind of investment would
be suitable for you? Lets say you are earning RM3,500 a month.

4. Below are the data for the following portfolios
Portfolio SBS Portfolio IMB

Returns 13.8 12.2
Standard Deviation 14.5 8
Beta 1.5 1
If the market return is 11.5% with standard deviation of 10%, and

the risk free rate is 5%, determine the Sharpe, Treynor and Jensen
measures for each portfolio. Explain the performance of the
portfolios.
The process of managing funds in a portfolio involves four main steps,

namely, setting objectives, determining asset class, asset allocation as well as
monitoring and rebalancing.
A mutual fund is a pool of money that is managed by an investment

company which invests shareholders money in a diversified portfolio of
securities and/or derivatives with the goal of producing a certain return for
the investors.
Investment funds can either focus on equities, bonds or a mixture of both.

General examples of funds can be classified into growth funds, income funds
and index funds.
Investment performance can be evaluated based on three measures Sharps

measure, Treynors measure and Jensens measure.

164 ANSWERS
Answers
TOPIC 1 INVESTMENT MARKETS
Exercise 1.1
1. Financial Assets are claims, ownerships and rights to a business or assets.

Physical Assets are properties that are tangible.
2. Common stocks, bonds, treasury bills.
3. The firm has an obligation to pay interest and the borrowed principal
amount. The lender has the right on the cash promised by the firm. Cash is
an asset. If the firm cannot provide the cash they have to sell other assets. If
it is a mortgaged loan, then the lender has the right to sell the asset.
4. Dividends and capital gains. Capital gain is obtained when the share can be
sold at a higher price than the buying price.
TOPIC 2 TRANSACTIONS IN THE SHARE MARKET
Exercise 2.1
1. The broker will execute the transaction at any price that he can get. The price
may not be suitable for the investor.
2. A limit order.
Exercise 2.2
(a) 50 lots (at 100 units per lot);

(b) 100 lots;
(c) 1st Alternative, RM4,000 15,000 = 26.67% ,
2nd Alternative RM38,000 30,000 = RM8,000 less interest RM1,200
=RM6,800 15,000 = 45.53%;
(d) RM1.77

ANSWERS 165
TOPIC 3 INVESTMENT RETURNS AND RISKS
Exercise 3.1
1. Return is the amount of cash flow that can be obtained from an investment.
Risk is the possibility that the investor obtained an actual return that is
higher or lower than expected.
2. Expected return is obtained when the investor makes a forecast of the future
based on the current situation. Average return is a summary of historical
returns.
3. A share can provide returns in the form of dividends and capital gains. A
bond provides returns in terms of coupon payment, reinvestment returns
and capital gains.
4. (a) 13.4%; (b) (0.20 1.05) (3.00 2.50) (c) dividend yield 8.4%

2.5 2.50
8.4% 20%
28.4%
Exercise 3.2
Purchase Selling
Year Dividend Price Price Dividend Capital Return
Yield Gains
1993 4.00 100.00 97.00 0.040 -0.030 0.010

1994 3.50 97.00 97.50 0.036 0.005 0.041
1995 3.40 95.00 94.00 0.036 -0.011 0.025
1996 3.60 98.00 109.00 0.037 0.112 0.149
1997 3.60 99.50 112.00 0.036 0.126 0.162
Average Return 0.077
Variance 0.0052
Standard Deviation 0.0721
(a) 4.1%
(b) 3.6 and 3.7%
(c) 1.1%
(d) 7.7%
(e) 0.52%; 7.2%

166 ANSWERS
Exercise 3.3
1. (a) Expected Return A = 19%, Expected Return B = 13.5%

(b) Variance A = 39%, Variance B = 170.25%
(c) Standard Deviation A = 6.24, B = 13.05%
(d) A is between 12.76 and 25.24
(e) A is the better investment in terms of risk per unit return
2. Covariance = 73.5, Correlation coefficient = 0.902
3. Expected return 15.5%, Standard Deviation 10.85%
4.
Part Question Return Standard Deviation Return/Risk
(%) (%)
(a) 25 9.51 2.63
(b) 19 3.93 4.84
(c) 18.59 5.68 3.26
(d) Portfolio (b) is the best. It offers the highest return per unit risk.
TOPIC 4 EQUILIBRIUM MODELS AND APPLICATIONS
Exercise 4.1
1. Characteristic line for stock A, beta is approximately equal to negative 0.4.

ANSWERS 167
Characteristic line for stock B, beta is zero.
D1
2. k g
P0
13.1%
Exercise 4.2
1. Your analyst has provided the following information. The expected market
return is 12% while the risk free rate is 4%. The standard deviation of the
market is 8%. You are required to draw the capital market line and the
security market line.

168 ANSWERS
Capital Market Line
Security Market Line
2. Price will increase
3. RM5.30

ANSWERS 169
TOPIC 5 EQUITY VALUATION (FUNDAMENTAL

VALUATION)
Exercise 5.1
D1 0.24 1.05
1. P0 RM3.6
k g 0.12 0.05
0.15 1.15 1.1 1.06

2
0.15 1.15 0.15 1.15 0.15 1.15 1.1 0.12 0.06

2 2
2.
1.12 2 1.12 3 1.12
3
1.12
0.154 0.158 0.155 2.74 RM3.207
Exercise 5.2
1. (a) Profit = RM75m 0.05 = RM3.75m

EPS = RM3.75m 2.5m units = RM1.5
(b) Dividend Per share = 0.5 RM1.5 = RM0.75
(c) Price = PE EPS = 24.5 RM1.5 = RM36.75
2. Increase government spending and reduce taxes. Reduce interest rates and
increase money supply. However, inflation has to be kept in check.

170 ANSWERS
TOPIC 6 BEHAVIOUR OF SHARE PRICES (TECHNICAL

ANALYSIS)
Exercise 6.1
1. Price against Time

ANSWERS 171
Point and Figure Chart
Price
1.92 x
1.91 x x
1.9 x x xox
1.89 x x x o
1.88 x xo x x
1.87 x o x x
1.86 xo o x ox x
1.85 x x ox x
1.84 x x xox x
1.83 x x o o x x o
1.82 xox o o x o o
1.81 xo o o ox
1.8 xo o o
1.79 o
1.78 o
Price is stable. Does not seem to be able to break above RM1.92.
2. Price should increase as investors think the firm is in a good financial

position.
3. If the market is in weak form efficiency, price may rise once the declaration is
announced. If the market is in a semi strong form, the price may increase
when the firm publishes its financial results and indicates that dividend
increase is possible. If the market is in a strong form, the price will respond
even before the financial results are announced.

172 ANSWERS
TOPIC 7 FIXED INCOME SECURITIES
Exercise 7.1
1. The coupon rate, the maturity period and most importantly, the market
interest rate.
2. There is a negative relationship between price and market interest rate. If

interest rate goes up, the price will come down. The amount of change in
price will depend on the coupon rate and the maturity period of the bond.
3. (a) RM1,147.20; (b) RM1,000; (c) RM924.184
4. RM1,148.775
5. The price is different because the semi-annual bond pays coupon at a more
frequent rate than the annual bond. Investors of semi-annual bonds will also
get their coupon payment earlier.
Exercise 7.2
1. A = 4%, B = 4.2%, C = 4%, D = 12%
2. Price of the Bond at the fifth year is RM927.90, Taking this price, SBS should
purchase the bond at RM1,030.784
3.
Year Cash Flow Calculations RM
1 100(1.08)(1.08)(1.05)(1.09)(1.12) = 149.51
2 100(1.08)(1.05)(1.09)(1.12) = 138.44
3 100(1.05)(1.09)(1.12) = 128.18
4 100(1.09)(1.12) = 122.08
5 100(1.12) = 112.00
5 Selling price at end of year 5 = 927.9
Total Cash Flow at end of year 5 = 1578.12
1578.12
return 5 1 0.0889 or 8.89%
1030.78

ANSWERS 173
4. A long term bond. Firstly, you will still get better coupon rates. Secondly, a
short term bond will have to be reinvested at a much lower rate.
5. 1 2 3 4 41
Period Cash flow PV PV Cash flow
1 80 0.909091 72.73 72.73
2 80 0.826446 66.12 132.23
3 1080 0.751315 811.42 2434.26
Total 950.26 2639.22
Duration 2639.22950.26 2.777
Modified Duration 2.77(1+0.1) 2.525
% P = 2.525 x 0.5% = +1.263%, new price is RM950.26 x 1.01263 =

RM962.26
6. The firm will exchange interest payments. A firm may swap a variable
interest payment for a fixed schedule. Swaps are made because a firm might
need to plan its operating cash flow to be in line with interest payments. It
may be that initially, a firm requires a fixed interest payment but may not be
in a better financial position to receive one, or vice versa.
TOPIC 8 DERIVATIVES MARKET

Exercise 8.1
1.
therefore value of share at time T = 4.70 + ( 0.20) = 4.50.
S0 = 65.00
2. (a)
0 4.50% 90 days

174 ANSWERS
f = S 0(1+ i )
90
f = 65.00 1+ .0.045 = 65.72
365
(b) 65.72 60.00 = 5.72
Exercise 8.2
1. Refer to topic.
S0 = 50.00
2. (a)
0 5.0% 100 days
c=4 X = 47
p=?
X
Using put-call parity; S + p c = ;
(1 i )
S p + c = 50 + 2 4 = 48.00
X 47 47
46.37
(1 i ) (1
100
.0.05 (1 0.01389
360
X
Since S p + c > ; thus not consistent with the absence of
(1 i )
arbitrage.
X
(b) Since S p + c > , we therefore sell (instead of buying) portfolio
(1 i )
(S p + c), save the proceeds in a bank that earns 0.05%. After 100
days,
100
this will accumulate to (S p + c)(1 + .0.05 ) > 47.00. Closing
360
100
position at time T will provide profit (S p + c)(1 + .0.05 ) 47.00 =
360
48.67 47.00 = 1.67.

ANSWERS 175
3. The table below is generated using Excel. Students are encouraged to

generate the table (by using the appropriate formula commands).
Long 1 call short 1 call short 1 call long 1 call

Price of stock Portfolio
strike price strike price strike price strike price
at maturity value
40 50 70 80
20 0 0 0 0 0
23 0 0 0 0 0
26 0 0 0 0 0
29 0 0 0 0 0
32 0 0 0 0 0
35 0 0 0 0 0
38 0 0 0 0 0
41 1 0 0 0 1
44 4 0 0 0 4
47 7 0 0 0 7
50 10 0 0 0 10
53 13 -3 0 0 10
56 16 -6 0 0 10
59 19 -9 0 0 10
62 22 -12 0 0 10
65 25 -15 0 0 10
68 28 -18 0 0 10
71 31 -21 -1 0 9
74 34 -24 -4 0 6
77 37 -27 -7 0 3
80 40 -30 -10 0 0
83 43 -33 -13 3 0
86 46 -36 -16 6 0
89 49 -39 -19 9 0
92 52 -42 -22 12 0
95 55 -45 -25 15 0
98 58 -48 -28 18 0
101 61 -51 -31 21 0
104 64 -54 -34 24 0
107 67 -57 -37 27 0
110 70 -60 -40 30 0
113 73 -63 -43 33 0
116 76 -66 -46 36 0

176 ANSWERS
TOPIC 9 MUTUAL FUND INVESTMENT AND

PERFORMANCE MEASUREMENT
Exercise 9.1
1. An open-end fund is a type of fund where investors can buy shares from the
fund and sell them back to the fund.
A close-end fund is a fund where the number of shares is fixed. Investors

can buy these shares initially from the fund, but they cannot sell it back to
the fund. The shares can only be sold to another investor in the stock
exchange.
2. Some examples are: Affin Equity, ASM Index, Alliance First, Amanah Saham
Kedah, Alliance Money Plus.
3. You will need to accumulate capital but will need to invest in investments
with moderate risk. A balanced fund is recommended. It has a growth and
income features.
4. Portfolio SBS Portfolio IMB

Sharpes Index 0.61 0.9
Treynors Index 5.87 7.2
Jensens Index 0.95 0.7
All three measures showed IMB is the better performer.

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1. E-mail your comment or feedback to modulefeedback@oum.edu.my
OR
2. Fill in the Print Module online evaluation form available on myVLE.
Thank you.
Centre for Instructional Design and Technology

(Pusat Reka Bentuk Pengajaran dan Teknologi)
Tel No.: 03-27732578
Fax No.: 03-26978702

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BBAP4103

Copyright Open University Malaysia (OUM)

Module Writers: Dr Saiful Bahri Sufar

Moderators: Assoc Prof Loo Sin Chun

Developed by: Centre for Instructional Design and Technology

Printed by: Meteor Doc. Sdn. Bhd.

First Edition, September 2004

Copyright Open University Malaysia (OUM), August 2013, BBAP4103

Copyright Open University Malaysia (OUM)

Topic 1 Investment Markets 1

Topic 2 Transaction in the Share Market 13

Topic 3 Investment Returns and Risks 24

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Topic 4 Equilibrium Models and Applications 48

Topic 5 Equity Valuation (Fundamental Valuation) 70

Topic 6 Behaviour of Share Prices (Technical Analysis) 91

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Topic 7 Fixed Income Security 105

Topic 8 Derivatives Market 126

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Topic 9 Mutual Fund Investment and 154

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COURSE GUIDE DESCRIPTION

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Table 1: Estimation of Time Accumulation of Study Hours

Topic 1 introduces the subject of investment. Students will be exposed to the

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Topic 5 discusses security valuation. The emphasis is on equity evaluation. Concepts

Topic 6 focuses on another well-known investment concept, namely, the efficient

Topic 9 attempts to conclude the investment process. It discusses the method to

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TEXT ARRANGEMENT GUIDE

Self-Check: This component of the module is inserted at strategic locations

Activity: Like Self-Check, the Activity component is also placed at various

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References: The References section is where a list of relevant and useful

TAN SRI DR ABDULLAH SANUSI (TSDAS)

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By the end of this topic, you should be able to:

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1.1 DEFINITION OF INVESTMENT

Investment actually refers to current commitment of present resources,

1.2 TYPES OF INVESTMENT

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Investment in the shoplot is an example of an investment in real assets. The

Investment in shares or any securities represents a claim on the real assets of a

1.3 TYPES OF FINANCIAL INVESTMENTS

Now, let us look at the different types of claims found in securities.

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(a) Debt Claims

Security in the form of debt is normally referred to as bonds. It entitles the

A bond can provide returns in the form of a coupon rate which is

Bonds provide a stable income to investors, hence, they are called

(b) Equity or Residual Claims

Investment in equity type securities represents an ownership share in a firm.

Unlike fixed-income securities, investors (equity holders) are not promised

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(c) Derivative Claims

Investment in derivative securities such as options and future contracts is the

(d) Hybrid Securities

Hybrid securities are securities that have the characteristics of an

An example of hybrid securities is a loan stock. Loan stock is a debt