STET SCHOOL OF MANAGEMENT

(Affiliated to Bharathidasan University)

(Accredited with ‘A’ Grade {3.45/4.00} By NAAC)
(An ISO 9001: 2015 Certified Institution)
Sundarakkottai, Mannargudi-614 016.
Thiruvarur (Dt.), Tamil Nadu, India.

SECURITY ANALYSIS & PORTFOLIO

MANAGEMENT

S.SANGEETHA
ASSISTANT PROFESSOR
DEPARTMENT OF MBA
 II MBA
Semester-III
ELECTIVE COURSE III-SECURITY ANALYSIS & PORTFOLIO MANAGEMENT-
P16MBA3EF3
Inst. Hours/Week : 5 Credit : 4
Objectives:
This course provides (a) an understanding of the conceptual framework
underlying Security Analysis & Portfolio Management and (b) an appreciation of
the regulatory and tax framework circumscribing investment in securities; and (c)
some insights into the operations of the Indian Stock Market.
Unit I
Calculation of Bond returns. Valuation of Bonds: Measures of Yield,
Duration & Convexity, Measures of Risk, Determinants of Interest Rates and
Theories on Term Structure, Bond Swaps.
Unit II
Derivative Securities: Equity Options: Concept, Applications & Valuation,
Economic Analysis, Industry Analysis.
Unit III
Valuation of Equity Stocks: Approaches of Equity Stock Valuation, Index
features, concept, applications and valuation.
Unit IV
Valuation of Equity Stocks: Company Analysis, Technical Analysis,
Efficient Markets Hypothesis.
Unit V
Portfolio Management – The Conceptual Framework: Modern Portfolio
Theory, Portfolio Management, Performance Evaluation of Portfolio,
Applications of Options & Futures in Portfolio Management.
Reference Books

1. For Unit I and II

Security Analysis and Portfolio management By Punithavathy Pandian,
Vikas publishing House PVT Ltd.,
2. For Unit III, IV and V
Security Analysis and Portfolio Management with CAPM – By Dr.
Sankara Narayanan – ANE Books Chennai –

Email : [email protected]
3. Security Analysis and Portfolio Management by RITTU Ahuja,

Atlantic publishing Co.,

4. Portfolio Management By Samir K. BARUA and others, Tata Mcgraw Hill.
5. Security Analysis and Portfolio Management, By S. Kevin, PHI learning PVT
Ltd.,
6. Investment Analysis and Portfolio Management By Prasanna Chandra,

Tata Mcgraw Hill Co.,

*****************
 UNIT-I
SECURITY ANALYSIS & PORTFOLIO MANAGEMENT
INTRODUCTION OF INVESTMENT
Investment is the employment of funds on assets with the aim of earning income
or capital appreciation. Financial Investment is the allocation of money to assets that
are expected to yield some gain over a period of time. It is an exchange of financial
claims such as stocks and bonds for money.

MEANING OF INVESTMENT
The art of investment is to see that the return is maximised with the minimum of
risk, which is inherent in investments. If the investor keeps his money in a bank in
savings account, he takes the least risk, as the money is safe and he will get back when
he wants it.
DEFINITION OF INVESTMENT
Investment may be defined as an activity that commits funds in any
financial/physical form in the present with an expectation of receiving additional return
in the future. The expectation brings with it a probability that the quantum of return may
vary from a minimum to a maximum. This possibility of variation in the actual return
is known as investment risk. Thus every investment involves a return and risk
CHARACTERISTICS OF INVESTMENT
The characteristics of investment can be understood in terms of as - return, - risk,
- safety, liquidity etc.
Return:
All investments are characterized by the expectation of a return. In fact,
investments are made with the primary objective of deriving return. The expectation of
a return may be from income (yield) as well as through capital appreciation.
Risk:
Risk is inherent in any investment. Risk may relate to loss of capital, delay in
repayment of capital, non-payment of return or variability of returns. The risk of an
investment is determined by the investments, maturity period, repayment capacity,
nature of return commitment and so on. Risk and expected return of an investment are
related.
Liquidity:
An investment that is easily saleable without loss of money or time is said to be
liquid. A well developed secondary market for security increase the liquidity of the
investment. An investor tends to prefer maximization of expected return, minimization
of risk, safety of funds and liquidity of investment. Investment categories: Investment
generally involves commitment of funds in two types of assets: -Real assets - Financial
assets
Real Assets:
Real assets are tangible material things like building, automobiles, land, gold etc.
Financial Assets:
Financial assets are piece of paper representing an indirect claim to real assets
held by some one else. These pieces of paper represent debt or equity commitment in
the form of IOUs or stock certificates.

DIRECT INVESTMENT AND INDIRECT INVESTMENT

❖ In Direct Investing, investors buy and sell securities themselves, typically
through brokerage accounts. Active investors may prefer this type of investing.
❖ In Indirect Investing, investors buy and sell shares of investment companies,
which in turn hold portfolios of securities. Individual who are not active may
prefer this type of investing.
 STAGES OF INVESTMENT PROCESS

Investment
Process

Investment Policy Security Portfolio

Analysis Valuation Construction Portfolio
Evaluation

Investible Fund Diversification Appraisal

Objectives Selection and Revision

Intrinsic
Knowledge Market allocation
Value
Industry
Company
Future
Value
SECURITY ANALYSIS
Security analysis is the first part of investment decision process involving
the valuation and analysis of individual securities. Two basic approaches of
security analysis are fundamental analysis and technical analysis.

◼ Fundament analysis is the study of stocks value using basic financial

variables in order to order to determine company’s intrinsic value.
The variables are sales, profit margin, depreciation, tax rate, sources
of financing, asset utilization and other factors. Additional analysis
could involve the company’s competitive position in the industry,
labor relations, technological changes, management, foreign
competition, and so on.
◼ Technical analysis is the search for identifiable and recurring stock
price patterns.

DEFINITION OF SECURITY ANALYSIS

The process of analysing the individual securities and the market as a
whole and estimating the risk and return expected from each of the investments
with a view to identifying undervalued securities for buying and overvalued
securities for selling is both an art and a science and this is what is called security
analysis.
DEFINITION OF BOND:
A bond is a contract that requires the borrower to pay an interest to the
lender. It is issued by the government or corporations. The par value of the bond
indicates the face value of the bond and the face value may be Rs. 1000, Rs.2000,
Rs.5000 and the like. Most bonds offer fixed interest payments till the maturity.
The interest rates are known as the coupon rates and are paid quarterly, semi-
annually and annually.
CHARACTERISTICS OF A BOND

Par Value

The stated face value of a bond

Coupon Interest Rate

The fixed “rate of interest” which remains the same throughout the life of
the bond

Maturity Date

Specified maturity date on which par value must be paid

Call Option

It gives the issuer the opportunity to repurchase the bonds prior to maturity

TYPES OF BONDS

Following are the types of bonds:

1. Fixed Rate Bonds
In Fixed Rate Bonds, the interest remains fixed through out the
tenure of the bond. Owing to a constant interest rate, fixed rate bonds are
resistant to changes and fluctuations in the market.
2. Floating Rate Bonds
Floating rate bonds have a fluctuating interest rate (coupons) as per
the current market reference rate.
3. Zero Interest Rate Bonds
Zero Interest Rate Bonds do not pay any regular interest to the
investors. In such types of bonds, issuers only pay the principal amount to
the bond holders.
4. Inflation Linked Bonds
Bonds linked to inflation are called inflation linked bonds. The
interest rate of Inflation linked bonds is generally lower than fixed rate
bonds.
5. Perpetual Bonds
Bonds with no maturity dates are called perpetual bonds. Holders of
perpetual bonds enjoy interest throughout.
6. Subordinated Bonds
Bonds which are given less priority as compared to other bonds of
the company in cases of a close down are called subordinated bonds. In
cases of liquidation, subordinated bonds are given less importance as
compared to senior bonds which are paid first.
7. Bearer Bonds
Bearer Bonds do not carry the name of the bond holder and anyone
who possesses the bond certificate can claim the amount. If the bond
certificate gets stolen or misplaced by the bond holder, anyone else with
the paper can claim the bond amount.
8. War Bonds
War Bonds are issued by any government to raise funds in cases of
war.
9. Serial Bonds
Bonds maturing over a period of time in instalments are called serial
bonds.
10.Climate Bonds
Climate Bonds are issued by any government to raise funds when
the country concerned faces any adverse changes in climatic conditions.
RISKS IN BONDS
Risk
▪ Uncertainty or a situation involving exposure to danger.
▪ Its pervasive and is inevitable
▪ Every investment should be viewed in terms of risk and return.

Bonds
Bonds are subjected to diverse risks, such as interest rate risk, inflation risk,
real interest
rate risk, default risk, call risk, liquidity risk, and reinvestment risk.
MEASURES OF RISK
Interest Rate Risk
➢ Interest rate risk is the risk that arises for bond owners from fluctuating
interest rates. How much interest rate risk a bond has depends on how
sensitive its price is to interest rate changes in the market.
➢ Bond price and interest rates are inversely correlated
➢ A bond is issued at a coupon rate which is equal to interest rate prevailing in
the market. Subsequent to issue the market interest rate may change, but the
coupon rate remains the same constant till maturity. This change in the market
interest rate relative to coupon rate of the bond causes change in the market
price.
➢ If the market interest rate increases than the coupon rate, the market price of
the bond decreases and vice versa.
➢ It seems good for the issuer, but bad for the investor.
Inflation Risk
✓ Inflation is the increase in the cost of living.
✓ Interests rates are defined in nominal terms (Nominal rate= real rate +
Inflation rate)
✓ As inflation rate increases, govt make efforts to slowdown by increasing
interest rates.
✓ Increase in inflation, decreases the purchasing power of interest payment a
bond makes. When investors worry that the bonds yield won’t keep up with
the rising cost of inflation, the price of the bond drops because there is less
investor demand for it.
Real Interest Rate Risk
 Even if there is no inflation risk, borrowers and lenders are still exposed to
risk of change in real interest rate.
 Real interest rate is what one get for the postponement of consumption and
change in real interest rate may happen due to change in supply and demand
of funds.
 Eg: Assume the real interest rate has fallen from 6 to 4%, in such cases the
firm will suffers as it pays 6%, where as its return on investment will be 4%.
 Thus change in real interest rate indicates the risk the borrowers and lenders
has to face
Default Risk
❖ Default risk is the risk that the borrower may not pay interest and /or
principal on time.
❖ Even though the actual default risk is unlikely, change in the perceived
default risk of a bond would have impact on its market price.
❖ These bonds are sold at low prices than government securities but gives
higher yield to maturity. Call Risk
❖ A bond may have a call option, that gives the issuer an option to redeem the
bond before maturity, but after a specific period.
❖ The issuer would generally exercise the call option when interest rates
decline, which is favourable for the firm but exposes the bond holder to call
risk
 ❖ When interest rate decreases, the existing bonds are called back and bonds
are issued at low rate of interest. In such case investors with no option has to
accept low rate of interest
Liquidity Risk
➢ Most debt instruments do not seem to have a very liquid market. Investors
face difficulty in trading debt instruments, particularly when quantity is
more.
➢ They have to accept a discount over the quoted price while selling and pay
premium while buying. Event Risk
➢ An issuer’s ability to meet interest and principal payments changes
dramatically and unexpectedly because of factors such as natural disaster,
takeover or corporate restructuring.
Sovereign Risk
❖ An investor who is holding a bond issued by a foreign entity, he/she may be
exposed to default risk or even in the absence of default, an unfavourable
price change.
Reinvestment Risk
 Bonds pays the periodic interest rates, but there is risk that these interest
payments have to be reinvested in the lower rate such risk is called
reinvestment risk.
 Reinvestment risks are higher for the bonds with longer maturity and for
bonds with higher interest payments.
Foreign Exchange Risk
❖ Some the bond payments are made in foreign currency. Foreign exchange
risk is the risk that arises when the foreign currency will depreciate in
relation to the Indian rupee.
DEFINITION OF BOND VALUATION:
Bond valuation is a technique for determining the fair value of a particular
bond. Bond valuation includes calculating the present value of the bond’s future
interest payments, also known as its cash flow, and the bond’s value upon
maturity, also known as its face value or par value. Bond valuation is less
glamorous than stock valuation for two reasons. First, the returns from investing
in bonds are less impressive and fixed. Second, bond prices fluctuate less than
equity price.

BOND RETURN
Holding Period Return: When an investor buys a bond and sells it after
holding it for a while, the rate of return in that holding period is known as holding
period return.
HPR = (Price gain or loss during the holding period + Coupon interest rate ) /
(Price at the beginning of the holding period)
1. An investor purchase a bond at Rs. 900 with Rs.100 as coupon payment and
sells it at Rs.1000. What is his holding period return?
2. If the bond is sold for Rs. 750 after receiving Rs.100 as coupon payment, what
is the holding period return?
1. HPR = (100 + 100)/900 = 200/900 = 22.22%
2. HPR = (-150+100)/900 = -50/900 = -5.5%
CONVEXITY OF BOND
 Bond Price and Yield are inversely related.
 The relationship is not linear.
 The degree of convexity depends on size of the bond, years to maturity
and the current market price.

Bond price

Yield to maturity

DURATION
Duration measures the time structure of a bond and the bond’s interest rate
risk. It may be defined as the weighted average of the length of time until the
remaining cash flows are received.
Years to Maturity- Years an investor has to wait until the bond matures and the
principal money is paid back.
Macaulay’s duration – The average time taken for all interest coupons and the
principal to be recovered.
Pv (Ct) C1 + C2 + ……. + Ct
D = ∑ --------- x (t) , Pv(Ct) = ----- ------ ------
Po (1+r) (1+r)2 (1+r)t
D= Duration C= Cash flow, r = Current yield to maturity t = Number of years
Pv(Ct) = Present value of the cash flow, Po = Sum of the present values of cash
flows.
MEASURES OF BOND YIELD
 Current Yield
 Yield to Maturity
 Yield to Call
 Realized Yield to Maturity

CURRENT YIELD
The current Yield relates the annual coupon interest to the market price. It
is expressed as:
Current Yield = Annual interest
Price
EXAMPLE
The Current Yield of a 10 Year, 12 % coupon Bond with a Par value of
Rs.1000 and selling for Rs.950. what is current yield.
Current yield = 120

950
= 12.63

YIELD TO MATURITY
When you purchase a bond, you are not quoted a promised rate of return.
Using the information on Bond price, maturity date, and coupon payments, you
figure out the rate of return offered by the bond over its life.

Formula
C C C M
P = (1+r) + (1+r)2 + (1+r)n + (1+r)n
YIELD TO CALL
Some bonds carry a call feature that entitles the issuer to call( buy back)
the bond prior to the stated maturity date in accordance with a call schedule for
such bonds.

REALIZED RETURN
Sometimes you will be asked to find the realized rate of return for a bond.
 This is the return that the investor actually realized from holding a bond. 
Using time value of money concepts, you are solving for the required rate of
return instead of the value of the bond.

THE TERM STRUCTURE OF INTEREST RATE (YIELD CURVE) –

RELATIONSHIP BETWEEN THE YIELD AND YEARS TO MATURITY.

Expectation Theory – Anticipation of fall in inflation rate , balanced budget, cut

in fiscal deficit, recession in economy
Liquidity Preference Theory – Investors prefer short term than long term bonds.
Segmentation Theory- The yield is determined by the demand for and supply of
funds.
Preferred habitat theory- This theory emanates from the market segmentation
theory.
It postulates that if there is a mismatch in demand and supply for funds in a given
maturity sector, investors will shift to maturities showing the opposite
imbalances.
BOND SWAPS
A bond swap is the term for selling bonds you currently own and using the
proceeds from the sale to purchase other bonds. For example, if you anticipate
higher interest rates, you might consider selling your long-term bonds and
moving into shorter-term maturities that would fluctuate less in price. Inversely,
if you expect interest rates to head lower, swapping out of short-term bonds and
into longer-term issues would allow you to lock in higher yields and possibly
improve the total return performance of your bond portfolio.
TYPES OF BOND SWAPS
There are a number of reasons you might consider a bond swap. Here are
some of the motivations:
Quality swaps alter the overall credit quality of a fixed income portfolio. You
might change the credit quality from AAA-rated bonds to AA-rated bonds, for
example.
Yield (maturity) swaps change the yield and maturities of the bonds in your
portfolio. If you are seeking to raise your overall yield, you might sell bonds with
shorter maturities and purchase longer-term bonds. Bonds with longer maturities
generally yield more than shorter maturity bonds.
Product swaps modify the type of bonds you hold. Treasury bonds, CDs,
corporate bonds and municipal bonds are different sectors within the fixed-
income markets, each with unique characteristics and yields.
Portfolio structure swaps change the makeup of the portfolio. Swaps can be
used to increase the number of bonds within a portfolio, enhancing
diversification. Altering the number of callable bonds or swapping bonds with
varying levels of call protection are also examples of portfolio structure swaps.
For example, during periods of declining interest rates, you might minimize
reinvestment risk by swapping out of callable bonds (those that can be fully repaid
at any time) and buying non-callable bonds. The opposite is true during periods
of rising rates.
Tax swaps deliver valuable tax benefits. If the value of a bond in your portfolio
is less than its cost, you may sell the bond and use the capital loss to offset capital
gains elsewhere in your portfolio. Tax laws allow you to offset capital gains dollar
for dollar, as well as up to $3,000 of ordinary income each year. Losses that are
unused in one year may be carried forward to future years indefinitely.