Introduction to Investments

Investment involves employment of funds with the aim

of achieving additional income or growth in values.
It also involves waiting for the reward
Investments are result of savings and savings is an excess
income over expenditure, excess of profits or capital gain
Investment have to take into consideration the impact of
inflation, change in govt policies.
Specifically an investment is the current commitment of
funds for the period of time in order to derive future
payments that will compensate the investors for:
◦ The time the funds are committed
◦ The expected rate of inflation
◦ The uncertainty of the future payments
Types of Investors
• Individual Investors
• Institutional Investors
• All the investors are trading a fund today for some
expected future stream of payments that will be
greater than the current outlay.
Characteristics of Investment
Return
Risk
Safety
Liquidity
OBJECTIVES OF INVESTMENT
Maximization of return
Minimization of risk
Hedge against inflation
Types of Investment
• Financial Assets
• Physical Assets

 Investment v/s Speculation

◦ Risk
◦ Capital Gain
◦ Time period
Real Vs Financial Asset
Security Vs Non Security
Investment Alternatives
Investment Process
Set Investment Policy
Security Analysis
Valuation
Portfolio Construction
Portfolio Evaluation and Revision
Investment Policy
Investible Funds:
◦ The entire inv. Procedure revolves around availability of funds.
◦ Generating through savings and borrowings.
◦ Extra careful in the case of selection of investment alternatives,
if funds are borrowed.
◦ Return> interest pays
 Objectives
◦ They should be framed on the premises of required rate of
return, need for liquidity, safety of principal and regular
income.
◦ Risk takers objective should be high rate of return in the form
of cap appreciation.
◦ Where as Primary objective of risk averse is the safety of
principal.
 Knowledge
◦ Knowledge about investment alternatives and market plays an
important role.
◦ Inv alt ranges from security to real estate.
◦ Risk and return associated with inv alt differ from each other.
◦ E.g. inv in equity is high yielding but more risk than fixed income
securities.
◦ Tax sheltered schemes offer tax benefits to investors.
◦ Awareness of stock market structure and broker charges.
◦ Mode of operation varies among BSE, NSE and OTCEI.
◦ Brokerage charges also changes.
Security Analysis
▶ Market Analysis
◦ The growth in GDP and inflation are reflected in stock prices.
◦ The recession in the economy results in a bear market.
◦ The stock prices may be fluctuating in the short run but in the
long run they move in trends i.e. either upwards or downwards.
 Industry Analysis
◦ The industries that contribute to the output of the major segments of
the economy vary in their growth rates and overall contribution to
eco activity.
◦ Some industry grow faster than the GDP and are expected to
continue in their growth.

 Company Analysis
◦ CA is to help to investor for better analysis.
◦ Company’s earnings, profitability, operating efficiency, capital
structure and mgmt have to be screened.
◦ These factors have direct bearing on the stock prices and return of
the investors.
◦ Company with a high product market share is able to create
wealth to the investors in the form of cap app.
Construction of Portfolio
Its combination of securities and to meet investor’s goals
and objectives.
Max return and min risk.
Diversification:
Obj-> reducing a risk
Portfolio revision
• Portfolio revision includes the active and passive
revision strategies for maximising the returns and
minimising the risk in the constructed portfolio.
Portfolio Evaluation
• The return and risk performance of the security vary
time to time.
• It should be measured and compared.
• Steps should be taken to avoid loss.
Risk and Return
• The uncertainty associated with any of the
investments is called risk
• Expected return is the uncertain future return that an
investor expects to get from his Investment.
• The realized return on the contrary is the certain
returns that an investor has actually obtained from his
investment.
• The possibility variation of the actual return from the
expected returns is termed as risk
Different Types of Risks
 External Risk
◦ Uncontrollable in nature and affect large number of securities
 Internal Risk
◦ Controllable in nature and affect only that particular co.

External risk is also termed as systematic risk

Internal risk is termed as unsystematic risk
Total risk = Systematic Risk + Unsystematic Risk
Interest Rate Risk
• Interest rate risk is the variation in the single period
rate of return caused by the fluctuations in market
interest rate
• These rates affect debentures, bonds and stocks at the
most
• A bond is normally issued at a coupon rate which is
equal to the interest rate prevailing in the market.
• The fluctuations in the interest rate are caused by the
changes in the govt monetary policy.
Example_Interest rate risk
Let's assume you purchase a bond from Company XYZ.
Because bond prices typically fall when interest rates
rise, an unexpected increase in interest rates means that
your investment could suddenly lose value.
If you expect to sell the bond before it matures, this
could mean you end up selling the bond for less than
you paid for it (a capital loss).
Of course, the magnitude of change in the bond price is
also affected by the maturity, coupon rate, its ability to
be called, and other characteristics of the bond.
Market Risk
 Market risk is associated with consistent fluctuations
seen in the trading price of any particular shares or
securities.
 That is, it arises due to rise or fall in the trading price
of listed shares or securities in the stock market.
Purchasing Power & Inflation Risk
 Purchasing power risk is also known as inflation risk.
It is so, since it emanates (originates) from the fact
that it affects a purchasing power adversely.
 It is not desirable to invest in securities during an
inflationary period.
Business Risk
 Business risk is also known as liquidity risk. It is so,
since it emanates (originates) from the sale and
purchase of securities affected by business cycles,
technological changes, etc.
Financial or credit risk
 Financial risk is also known as credit risk. It arises
due to change in the capital structure of the
organization.
 The capital structure mainly comprises of three ways
by which funds are sourced for the projects.
Operational risk
 Operational risks are the business process risks failing

due to human errors. This risk will change from

industry to industry.
 It occurs due to breakdowns in the internal

procedures, people, policies and systems.

 MINIMIZING RISK EXPOSURE
◦ Protection against market risk
◦ Protection against interest rate risk
Holding the investment till maturity
Buying T bill or bond of short maturity
Investing in bonds with different maturity dates
◦ Protection against inflation
Identify real rate of return
Investment diversification
◦ Protection against business and financial risk
Swot analysis
Business life cycle and trend of profitability
Capital structure
Beta – A systematic Risk
 Systematic risk, or market risk, is the volatility that
affects many industries, stocks and assets. Systematic
risk affects the overall market and is difficult to
predict.

 Unlike unsystematic risk, diversification cannot help

to smooth systematic risk, because it affects a wide
range of assets and securities. For example, the Great
Recession was a form of systematic risk; the
economic downturn affected the market as a whole.
 Beta is a measure of a stock's volatility in relation to the
market. It measures the exposure of risk a particular stock or
sector has in relation to the market. If you want to know the
systematic risk of your portfolio, you can calculate its beta.
 A beta of 0 indicates that the portfolio is uncorrelated with
the market.

 A beta less than 0 indicates that it moves in the opposite

direction of the market.

 A beta between 0 and 1 signifies that it moves in the same

direction as the market, with less volatility.
 A beta of 1 indicates that the portfolio will move in
the same direction, have the same volatility and is
sensitive to systematic risk.

 A beta greater than 1 indicates that the portfolio will

move in the same direction as the market, with a
higher magnitude, and is very sensitive to systematic
risk.

 Assume that the beta of an investor's portfolio is 2 in

relation to a broad market index, such as the S&P
500. If the market increases by 2%, then the portfolio
will generally increase by 4%. Likewise, if the market
decreases by 2%, the portfolio generally decreases by
4%. This portfolio is sensitive to systematic risk, but
the risk can be reduced by hedging.
 Diversification is a risk management technique that mixes a wide
variety of investments within a portfolio.

 The rationale behind this technique contends that a portfolio of

different kinds of investments will, on average, yield higher
returns and pose a lower risk than any individual investment found
within the portfolio.

 Diversification strives to smooth out unsystematic risk events in a

portfolio so that the positive performance of some investments will
neutralize the negative performance of others.

 Therefore, the benefits of diversification will hold only if

the securities in the portfolio are not perfectly correlated.
Expected rate of return
 Probability value to all possible returns is assigned, based on
their past historical returns and future expectation about the
returns, which again depends upon the economic conditions.
 Expected returns, E(Ri) = PiRi
 Risk can be defined in terms of variability of returns.
 An investment whose returns are fairly stable is considered to
be a low risk investment, whereas an investment with
fluctuate returns is considered to be a high risk investment.
Measuring the risk of expected rate of
return
 2 possible measures of risk have received support in
theoretical work on portfolio theory
◦ Variance
Variance = Pi(Ri –Eri)2
The larger the variance for an expected rate of return, the greater the
dispersion of expected returns and the greater the uncertainty, or risk
of investments.
◦ Standard Deviation

◦ A relative measure of risk:

 In some cases, an unadjusted variance or standard deviation can
be misleading.
If conditions for two or more investment alternatives are not
similar; i.e if there are major differences in the expected rates of
return, it is necessary to use a measure of variability, which is
coefficient of variation.
Determinants of required rates of return
 Factors to be considered while selecting securities for
an investment portfolio
◦ The time value of money during the period of investment
◦ The expected rate of inflation during the period
◦ The risk involved
 The summarization of the above components is called
the required rate of return.
 This is the minimum rate of return that one should
expect from an investment to compensate for
deferring consumption.
Factors affecting recent investment
trends
• Increase in working population, large family income.
• Provision of tax incentive in respect of investment
• Increase in tendency of people to hedge against inflation.
• Attractive investment alternative
• Increase in investments related publicity
• Ability of investments to provide income and capital
INTRODUCTION TO STOCK MARKET

OPERATIONS OF INDIAN STOCK MARKET

Stock Exchange means any body of individuals,
whether incorporated or not, constituted for the
purpose of regulating or controlling the business of
buying, selling or dealing in securities.
These securities includes:

1.Shares, bonds, debenture or other marketable

securities.
2.Government Securities.
 NATURE AND FUNCTION OF STOCK EXCHANGE

 The scope for acquisition an  Provide information promptly

ownership of capital by private and widely
individuals also
 The opportunity for stock market to
render the service of stimulating  To secure the working capital
private saving and channeling such from the banks, individuals,
saving in to productive investment businessmen, partnership and
exits on vastly great scale. corporation provide the stock and
 Market that mobilizes and distributes shares of companies
the nation’s savings
 The stock exchange ensures the flow
of saving is utilized
 REGULATORY FRAMEWORK FOR SECURITIES
MARKET
 Legislations  Depositories Act 1996
 Capital issues Act 1947 making securities of public limited
 Securities contract Act 1956 company's freely transferable
provide direct and indirect control of dematerialized the securities
virtually, all aspects of securities maintain the record of ownership
trading
 Companies Act 1956
 SEBI Act 1992

protect the interest of investor in

securities
promoting the development of securities.
regulating the securities market
 BOMBAY STOCK EXCHANGE (BSE)

 History ● TRADING SYSTEM OF BSE

 The origin of the BSE dates back to 1875.  In March 1995, BSE introduced screen
 It was organized under the name of “The Native based trading called BOLT ( BSE On Line
Stock & Share Brokers Association” as a Trading).
voluntary & non-profit making association.  BOLT has a nation wide network.
 It was recognized on a permanent basis in 1957.  Trading Work Stations are connected with
the main computer at Mumbai through
● OBJECTIVES OF BSE WAN.
1. To safeguard the interest of investing public
having dealings on the exchange.
2. To establish & promote honorable & just practices
in securities’ transactions.
3. To promote, develop & maintain well regulated
market for dealing in securities.
4. To promote industrial development in the country
through efficient sources.
 NATIONAL STOCK EXCHANGE (NSE)
● RECENT DEVELOPMENTS
 Regulation of Intermediaries
 The NSE of India became operational in capital  Insistence of quality securities
market segment on 3rd November 1994 in  Prohibition of insider trading
Mumbai.  Transparency of accounting practices
 The genesis of the NSE lies in the  Strict supervision of stock market operations
recommendations of the Pherwani Committee  Prevention of price rigging
(1991).
 Protection of investors’ interest
 Committee pointed out five major defects in the  Free pricing of securities
Indian Stock market.
● THE MAIN DEFECTS ARE -  Setting up of credit rating agencies

1. Lack of liquidity in most of the markets in terms

 Introduction of electronic trading
of depth & breadth.  Establishment of NSE
2. Lack of ability to develop market for debt.  Introduction of depository system
3. Lack of infrastructure facilities & outdated  Buy back of shares
trading system.  Disinvestment of shares of public sector units
4. Lack of transparency in the operations that  Stock watch system
affects investors’ confidence.  Trading in derivatives
5. Outdated settlement systems that are inadequate  Stock Lending Mechanism
to cater to the growing volume, leading delays.
 International Listing
 Rolling Settlement
 PROCESS OF TRADING
 Choice of a broker  Limit orders
 Placement of order  Anyone placing a limit order
 At best order
specifies the buy or sell price.
 Limit order
 Suppose you submit a order at
 Discretionary order
 Immediate or cancel order
50 per share when the current
market price is 60/60.10, with
 Limited discretionary order
the expectation that the stock
 Open order
will decline to 50 in the near
 Stop loss order
future.
 Execution of orders  Time till order will be
 Preparation of contract notes outstanding should be
 Settlement of transactions specified.
 Spot delivery settlement  It can be fill or kill, , part of
 Hand delivery settlement the day, full day, several days,
 Clearing settlement week, month etc.
 Short sales  Special Orders
 Sell overpriced stock that you  Stop loss
don’t own and purchase it back  Conditional order to sell stock
later (at a lower price) if it drops to a given price
 Borrow the stock from another  Does not guarantee price you
investor (through your broker) will get upon sale
 Can only be made on an uptick  Market disruptions can cancel
trade, means the price of the short such orders
sale must be higher than the last  Stop buy order
trade price.
 Investor who sold short may
 This is because, the exchanges do
want to limit loss if stock
not want trades to force a profit increases in price
on short sale by pushing the price
down through continually selling
short.
 Margin requirements apply
 MARGIN TRANSACTIONS ● TYPES OF ORDERS
 When investors buy stock, they can pay for the  Market orders
stock with cash or borrow part of the cost,  This is the most frequent type of order
leveraging the transaction. to buy or sell a stock at the best current
 On any type order, instead of paying 100% cash, price.
borrow a portion of the transaction, using the stock  An investor who enters a market sell
as collateral order indicates a willingness to sell
 Interest rate on margin credit may be below prime immediately at the highest bid available
rate and buy order indicates the investor is
 Regulations limit proportion borrowed
willing to pay the lowest offering price
available at the time on the exchange.
 Margin requirements are from 50% up
 Eg: Suppose the price of BPCL is 360
 Changes in price affect investor’s equity, which is
– 361; first one is the bid price that any
equal to the market value of the collateral stock
minus the amount borrowed. one has offered to pay for BPCL and
 Maintenance margin
second is the ask price which is the
 Requirement proportion of equity to stock lowest any one is willing to accept to
 Protects broker if stock price declines sell the stock.
 Minimum requirement is 25%  There fore an order can be placed and
 Margin call on under margined account to purchased at the lowest ask price i.e;
meet margin requirement 361 and can be sold at 360.
 If margin call not met, stock will be sold to
pay off the loan
 Efficient Capital Markets ●Why Should Capital Markets
Be Efficient?
● In an efficient capital market, security The premises of an efficient market
prices adjust rapidly to the arrival of new ○ A large number of competing profit-
maximizing participants analyze and
information. Therefore, the current
value securities, each independently
prices of securities reflect all information of the others
about the security ○ New information regarding securities
● Whether markets are efficient has been comes to the market in a random
extensively researched and remains fashion
controversial ○ Profit-maximizing investors adjust
● There are deviations in market, but they security prices rapidly to reflect the
are random, hence it is not possible to effect of new information
● As security prices adjust to all new
identify over or under valued security.
information, these security prices should
● The concept of efficient capital market
reflect all information that is publicly
has been one of the dominant themes available at any point in time.
since 60s ● Therefore, these security prices should be
● According to Elton and Gruber: an unbiased reflection of all currently
● When someone refers to efficient capital available information, including the risk
market they mean that security prices involved in owing the security.
fully reflect all available information ● In efficient markets, the expected returns
comparison between FA, TA and EMT implicit in the current price of the security
should reflect its risk.
Conclusion: In an efficient market, the
expected returns implicit in the current
price of a security should reflect its risk
EFFICIENT MARKET HYPOTHESIS
(EMH):- Strong-Form EMH
● Stock prices fully reflect all information
Weak-Form EMH from public and private sources
●Current prices reflect all security-market ●This implies that no group of investors
information, including the historical should be able to consistently derive
sequence of prices, rates of return, trading above-average risk-adjusted rates of
volume data, and other market-generated return
information ●This assumes perfect markets in which
●This implies that past rates of return and all information is cost-free and available to
other market data should have no everyone at the same time
relationship with future rates of return
●Tests and Results of Weak-Form EMH
This is formulated in 2 groups
Semi strong-Form EMH Statistical Tests of Independence: which is
●Current security prices reflect all public the independence between rates of return
information, including market and non- ○ Autocorrelation tests
market information ○ Runs tests
●This implies that decisions made on new Tests of Trading Rules: this is the
information after it is public should not comparison of risk-return results for
lead to above-average risk-adjusted profits trading rules that make investment
from those transactions decisions based on past market
information
● Autocorrelation tests
The independence or randomness between price Filter tests
movements can be tested by calculation the ●Filter tests have been developed as direct
correlation between price changes in one period tests of specific mechanical trading strategies
and changes for the same stock in other period. to examine their validity and usefulness.
● Does the rate of return on day t correlate with the ●When new information comes in the market,
rate of return on day t-1, t-2 or t-3. a new equilibrium price will be determined.
● Positive value indicates a direct relation and ●If the news is favorable, then the price
negative value implies an inverse relationship should move up to a new equilibrium above
● Thus if r is close to 0, the price changes can be the old price.
considered to be serially independent. ●If the investors purchase at this point, they
will be benefited from the price increase to
Run tests
the new equilibrium level.
● In this test, the absolute value of price changes are
●Same goes when the news received is
ignored, only the direction of change is considered.
● An increase in represented by (+) sign and unfavorable.
decrease in value is represented by (-) sign and ●Technicians set up trading strategies based
when there is no change in price, it is represented on such patterns to earn excess returns. The
by 0. strategy is called filter rule.
● A consecutive sequence of the same sign is ●The rule is usually stated in the foll way:
considered as a run, for eg. +++---000++-- = 5  Purchase the stock when it rise by X
runs. % from the previous low and sell it
● In a run test, the actual number of runs observed in when it declines by X% from the
a series of stock price movements is compared subsequent high.
with the number of runs in a randomly generated  The filer may range from 1% to 50%
series. or even more.trt
● If no significant difference is found, then the
security price changes are considered to be
random in nature.
 Quarterly Earnings Reports
Tests and Results of Weak-Form EMH ○ Large Standardized Unexpected Earnings
●Testing constraints
(SUEs) result in abnormal stock price
○ Use only publicly available data
changes, with over 50% of the change
○ Include all transactions costs
happening after the announcement
○ Adjust the results for risk
○ Unexpected earnings can explain up to 80%
●Only better-known technical trading rules have
of stock drift over a time period
been examined
●These results suggest that the earnings surprise is
○ Too much subjective interpretation of data
○ Almost infinite number of trading rules not instantaneously reflected in security prices
The January Anomaly
Tests of the Semi strong Form of Market ○ Stocks with negative returns during the prior
Efficiency year had higher returns right after the first of
Two sets of studies the year
●Time series analysis of returns or the cross ○ Tax selling toward the end of the year has
section distribution of returns for individual stocks been mentioned as the reason for this
●Event studies that examine how fast stock prices phenomenon
adjust to specific significant economic events ○ Such a seasonal pattern is inconsistent with
Adjustment for Market Effects the EMH
○ Test results should adjust a security’s rate Other calendar effects
of return for the rates of return of the ○ All the market’s cumulative advance
overall market during the period occurs during the first half of trading
considered months
Abnormal rate of return ○ Monday/weekend returns were
ARit = Rit - Rmt significantly negative
where: ○ For large firms, the negative Monday
ARit = abnormal rate of return on security i during effect occurred before the market opened
period t (it was a weekend effect), whereas for
Rit = rate of return on security i during period t smaller firms, most of the negative
Rmt =rate of return on a market index during period t Monday effect occurred during the day on
Monday (it was a Monday trading effect)
Price-earnings ratios and returns ● Insiders must report to the SEC each
○ Low P/E stocks experienced superior risk- month on their transactions in the stock of
adjusted results relative to the market, the firm for which they are insiders
whereas high P/E stocks had significantly ● These insider trades are made public
inferior risk-adjusted results about six weeks later and allowed to be
○ Publicly available P/E ratios possess valuable studied
information regarding future returns ● Corporate insiders generally experience
○ This is inconsistent with semistrong efficiency above-average profits especially on
purchase transactions
Tests and Results of Strong-Form EMH ● This implies that many insiders had private
●Strong-form EMH contends that stock prices fully
information from which they derived
reflect all information, both public and private
●This implies that no group of investors has access to above-average returns on their company
private information that will allow them to consistently stock
earn above-average profits ● Studies showed that public investors who
traded with the insiders based on
Testing Groups of Investors announced transactions would have
●Corporate insiders enjoyed excess risk-adjusted returns (after
●Stock exchange specialists commissions), but the markets now seems
●Security analysts to have eliminated this inefficiency (soon
●Professional money managers after it was discovered)
Corporate Insider Trading ● Other studies indicate that you can
Insiders include major corporate officers, directors, and increase returns from using insider trading
owners of 10% or more of any equity class of securities
information by combining it with key
Corporate insiders include major corporate officers,
financial ratios and considering what group
directors, and owners of 10% or more of any equity
class of securities of insiders is doing the buying and selling
● Stock Exchange Specialists ● Professional Money Managers
● Specialists have monopolistic access to ● Trained professionals, working full time at
information about unfilled limit orders investment management
● You would expect specialists to derive above- ● If any investor can achieve above-
average returns from this information average returns, it should be this group
● The data generally supports this expectation ● If any non-insider can obtain inside
information, it would be this group due to
● Security Analysts the extensive management interviews that
● Tests have considered whether it is possible they conduct
to identify a set of analysts who have the ● Individual analyst recommendations seem
ability to select undervalued stocks to contain significant information
● The analysis involves determining whether, ● Performance of professional money
after a stock selection by an analyst is made managers seem to provide support for
known, a significant abnormal return is strong-form EMH
available to those who follow their
recommendations

● Analysts Recommendations
● There is evidence in favor of existence of
superior analysts who apparently possess
private information
 Fundamental Analysis
● A fundamental analyst believes that analyzing  FA tend to look first into the national
the economy, strategy, management, product, economy before analyzing industry
financial status and other related information will performance and then individual
help choose shares that will outperform the companies within an industry.
market and provide consistent gains to the  This method is called a top-down
investors. approach to fundamental analysis.
● FA is the examination of the underlying forces  The problem in FA is the evaluation of
that effect the interests of the economy, industry economic indicators as they need to be
sectors, and companies. compared over a period of time to assess
● FA requires an examination of the market from a the favourable climate.
broader perspective. The ACTUAL value of an equity share
● FA focuses on the economic data to evaluate depends on a multitude of factors. The
the present and future growth of the nation. earning of the company, the growth rate
● It usually compares one economy with similar or and the risk exposure of the company
superior national economies. have a direct bearing on the price of the
● At industry level, there is an examination of the share.
supply and demand forces for the products Fundamental analysis consist of the
offered, substitute product/industry, industry following analysis.
cycles and so on.  Economic analysis
● At the company level, FA examines financial  Industry analysis
data, mgmt policies, business vision,  Company analysis
competitive strength and so on.
● Thus to forecast future share prices, FA
combines economic, industry, and company
analysis to derive a share’s current fair value
and forecast its future value from this info.
The level of economic activity has an impact on ● Major components of GDP are:
investment in many ways. if the economy
grows rapidly, the industry can also be ● Consumption Spending
expected to show rapid growth. ● Investment Spending
when the level of economic activity is low ,stock ● Govt Expenditure
price are low, and the vice versa. the analysis ● Goods and Services produced
of macro economic environments is essential to domestically for export
understand the behavior of the stock prices. ● The production of goods and services
● Hence, an investor has to spend some time consumed in the process of distributing
exploring the forces operating in the overall imports to the domestic consumer.
economy. Consumption Spending:
● A macro economy has 2 components ● It classified into:
○ The national economy ● Durable Goods. Car, Furniture and
○ The international economy on the national house hold appliances which are used
economy for several yrs.
● The growth of national economy is mainly ● Non durable Goods. Food, clothing
determined by the domestic consumption and disposable products which are
pattern. used for a short time.
The economic analysis factors ● Services include the rent paid on
premises air plane tickets, legal advice
Gross Domestic Product and medical treatment.
● GDP is the total amount of goods and services ● An increase in consumption spending
produced in a country in a year. leads to an immediate increase in
● It is calculated by adding all the market values capacity utilization, in turn increasing
of all the final goods and services produced in a the profitability of companies.
year.
● GDP has several components. A component is
helpful to investors
● Investment Spending ● Exports:
● Non Residential fixed invt ● Exports are items produced in a country and
It is the creation of tools and equipment to use purchased by foreigners. It lead to an
in the production of other goods and services. exchange of productive goods and services
E.g., the establishment of factories, installation for an equivalent foreign currency.
of new machines and computers for business
use are non – residential fixed invt. ● Consumption in the process of Import
Residential invt is the building of a new house or Distribution
apartment ● It also lead to the local productivity.
● Inventory changes consist of changes in the ● Imports are the items produces by foreigners
level of stocks of goods necessary for and purchased by the local consumers.
● For the purpose of computing GDP,
production, and finished goods ready to be
expenditures involving localization or
sold.
internalizations of the imported goods are
● Investment spending does not necessarily
considered.
lead to an immediate release of productive Monetary Policy
goods and services. There is a time lag before ● If the monetary policy is very tight & banks
which investment spending results in have little excess reserves to lend, the
increased profitability for companies sources of capital become scarce and
● Govt Expenditure: economic activity may slow down or decline.
● It consist of spending by the Central, state and ● Although a good monetary policy and
local govt on goods and services such as liquidity is essential for the economy, excess
infrastructure, research, roads, defense, liquidity can be harmful. Excess money
school and police and fire dept. supply growth can lead to inflation, higher
● Govt expenditure as a % of GDP will be more interest rates and higher risk premiums
in regulated mkt and less in a liberalized leading to costly sources of capital and slow
economy. growth
Inflation International Influence:
●It can be defined as a trend of rising prices caused ●One imp measure of influence of international
by demand exceeding supply. economies is the exchange rate – the rate at
●In other words, if prices rise steadily, after a no. of which one currency may be converted into
yrs, consumers will be able to buy only fewer goods another.
and services assuming income level does not change ●Rapid growth in overseas market can create
with inflation. surges in demand for exports, leading to growth
●It increases the uncertainty of future business and in export sensitive industries and overall GDP.
●Erection of trade barriers can hinder the free
invt decisions, which in turn , increase risk premiums.
flow of currency, goods and services and can
●It also affects the investment, as reduces the value harm the export sector of an economy
of fixed income securities.
●A constant inflationary situation in an economy will Consumer Sentiments
be foreseen as a positive influence on the investors ●It usually expressed in terms of future
and hence market prices are likely to go up under expenditures planned and the feeling about the
such circumstances. future economy.
●CS can affect both cash flow i.e. higher or
Interest Rates: lower sales and operating incomes.
●It is the price of credit. It is the percentage fee
received or paid by individuals or organizations when
they lend or borrow money.
●In general IR caused by inflation, govt policy, rising
risk premiums or other factors will lead to reduced
borrowing and an economic slowdown.
●Rising IR lead to a decline in bond prices and
typically lead to a fall in share price
●When interest rates rise, investors required rate of
return on shares rise as well, causing the price of
securities to fall.
●Bank prime lending rate influences business
demand for loans.
● Industry analysis ● Tools For Industry analysis
● Standard Industry Classification: ● Cross-sectional Industry Performance
● It’s a common method of classifying business or ● Industry Performance over time
industries by type is the Standard Industry ● Differences in industry risk
Classification System, commonly referred to as ● Prediction about market behavior
the SIC Code. ● Competition over the industry life cycle
● It divides virtually all economic activity into
divisions that are further broken up into Cross-sectional Industry Performance
numbered, major groups. ● It aimed at finding out if the rates or return
● SIC codes get progressively more specific as the among different industries varied during a
no. of digits increases. given period of time.
● A 2 digit SIC code indicates the broad industry ● Analysts usually compare the performance
category (e.g., Furniture) measured in terms of growth in sales, profits,
● Adding 3rd digit might further specify a type of market capitalization and the dividend of
furniture (e.g., home furniture or office furniture) various industries.
● Adding 4th digit might further specify wooden Industry Performance over Time
household furniture or metal household furniture) ● Analysts also perform a detailed exploration
● A full listing of SIC codes is an imp tool in industry of industry performance over time, to identify
analysis. the stage of product life cycle that the industry
Factors to be considered in industry life cycle is expected to face.
analysis ● Usually a time duration of 3 to 5 yrs is
● Growth of industry considered to determine whether industries
● Cost structure and profitability that perform well in one time period would
● Nature of the product continue to perform well in subsequent time
● Nature of the competition periods.
● Government policy ● In many economies, the forecast of industrial
● Labor performance has been the most difficult task.
● Research and development
 ● Analysis of Industry Competition
Difference in Industry Risk
Competition and Expected Industry Returns
●Industry risk specifically investigates 2 questions: ○ Porter’s concept of competitive strategy
1. Does risk differ across industries in a given time is described as the search by a firm for a
period? favorable competitive position in an
2. Are industry risk measures stable over time? industry
Risk is measured in terms of variability in return/ ○ To create a profitable competitive
productive value. strategy, a firm must first examine the
basic competitive structure of its industry
○ The potential profitability of a firm is
Prediction about Market Behavior
heavily influenced by the profitability of its
●Prediction about Market Behavior industry
●Predicting Market behavior can be through a ● Competitive Structure of an Industry
qualitative assessment of strengths and weaknesses of ● Porter’s Competitive Forces
the industry on the whole. ○ Rivalry among existing competitors
●SWOT Analysis ○ Threat of new entrants
●SWOT Analysis can also applied in industrial analysis ○ Threat of substitute products
as well as in evaluating individual organisations ○ Bargaining power of buyers
○ Bargaining power of suppliers
Structural Economic Changes and Alternative Estimating the Required Rate of Return
Industries ● Influenced by the risk-free rate
●Social Influences ● Expected inflation rate
○ Demographics ● Risk premium for the industry versus the
○ Lifestyles market
●Technology ○ business risk (BR)
●Politics and regulations ○ financial risk (FR)
○ Economic reasoning ○ liquidity risk (LR)
○ Fairness ○ exchange rate risk (ERR)
○ Regulatory changes affect numerous ○ country political risk (CR)
industries ● Or compare systematic risk (beta) for the
○ Regulations affect international commerce industry to the market beta of 1.0
● Industry Valuation Using the Free Cash Flow Qualitative Factors
to Equity (FCFE) Model ●Business Model
FCFE is defined as follows: ●Management
Net income
○ Sources of Management Analysis
+ Depreciation
- Capital expenditures ■ Conference Calls
-  in working capital ■ Management Discussions
- Principal debt repayments ■ Management Ownership of
+ New debt issues equity

Industry Profit Margin Forecast ●Corporate Governance

● Industry’s operating profit margin
○ Areas of CG
(EBITDA / Sales)
○ Depreciation expense ■ Structure of BOD
○ interest expense ■ Financial and information
○ tax rate transparency
■ Stakeholder rights
Company analysis ■ Corporate culture
In the company analysis the investor assimilate
the several bits of information related to the
company and evaluates the present and
future value of the stock.
The risk and return associated with the
purchase of the stock is analyzed to take
better investment decisions.
Quantitative Factors

Earnings of the company (EAT) Return on Equity (ROE)

●The key element all investors look after is earnings. ○ This ratio is a measure of how efficient
Before investing in a company you want to know how a company is in generating its profits.
much the company is making in profits. Future It is a ratio of revenue and profits to
earnings are a key factor as the future prospects of owners' equity (shareholders are the
the company's business and potential growth owners). Specifically it is:  ROI = Net
opportunities are determinants of the stock price. income / Shareholder’s equity
●Factors determining earnings of the company are
such as sales, costs, assets and liabilities. A simplified Price-to-Earnings (P/E)
view of the earnings is earnings per share (EPS). ●When taking the current market price into
This is a figure of the earnings which denotes the consideration, the most popular ratio is the
amount of earnings for each outstanding share. Price-to-Earnings (P/E) ratio. As the name
●EPS = PAT / No of shares outstanding suggest it is the current market price divided by
Profit Margins its earnings per share (EPS). It is an easy way
○ The profit margin measures how much the to get a quick look of a stock's value.
company keeps in earnings out of every ●A high P/E indicates that the stock is priced
rupee of their revenues. This measure is relatively high to its earnings, and companies
therefore very useful for comparing similar with higher P/E therefore seem more expensive.
companies, within the same industry. However, this measure, as well as other
○ Higher profit margin indicates that the financial ratios, needs to be compared to similar
company has better control over its costs companies within the same sector or to its own
than its competitors. Profit margin is historical P/E. This is due to different
displayed in percentages and a 10 percent characteristics in different sectors and changing
profit margin denotes that the company has markets conditions.
a net income of 10 cents for each rupee of
their revenues.
○ Net profit margin = Net profit / Revnue
 BALANCED SCORECARD
Financial analysis
The best source of financial information about a The balanced scorecard is a framework for
company is its own financial statements. this is tracking important aspects of company strategy
primary source of information for evaluating the and for facilitating organizational improvement
investment prospects in the particular company's or change.
stock. ●Revenues
●Earnings
●The balance sheet
●Profit and loss account ●Market share
●Comparative financial statement ●Quality
●Trend analysis ●Employee morale
●Common size statement ●Customer satisfaction metrics
●Fund flow analysis THE BCG GROWTH-SHARE MATRIX
●Cash flow analysis This quadrant matrix, developed by Boston
●Ratio analysis Consulting Group (BCG), is a tool companies
use to assess the relative strength of product
BENCHMARKING lines within their portfolios.
●Benchmarking is the process of comparing your ●Product lines are assigned to one of four
company metrics to the metrics of your industry quadrants:
competitors or to those of innovative companies ●Cash cows
outside the industry. ●Stars
●Common metrics for benchmarking include: ●Question marks
●Revenues ●Dogs
●Production costs
●Employee turnover
●Process cycle time
● THE GE-MCKINSEY NINE-BOX MATRIX Price is determined solely by the interaction of
● This matrix was developed by McKinsey & supply & demand
Company in the 1970s to help General Electric (2) Supply and demand are governed by
prioritize its investments in its numerous business numerous factors both rational and
units. It’s widely used to help companies assess the irrational. The market continually and
relative merits of various opportunities. automatically weighs all these factors. (A
● Business units or opportunities are categorized as random walker would have no qualms about
“high,” “medium,” or “low” within the two axes of the this assumption either. He would point out that
matrix, which are “industry attractiveness” and any irrational factors are just as likely to be one
“competitive strength of the business unit.” side of the market as on the other.)
(3) Disregarding minor fluctuations in the
● CORE COMPETENCIES market, stock prices tend to move in trends
● The process of identifying your company’s core which persist for an appreciable length of
competencies helps you define your company’s time. ( Random walker would disagree with
positioning and competitive advantage. this statement. For any trend to persist there
has to be some collective 'irrationality')
TECHNICAL ANALYSIS (4) Changes in trend are caused by shifts in
demand and supply. These shifts no matter
why they occur, can be detected sooner or
later in the action of the market itself. (In the
financial economist's view the market (through
the price) will instantaneously reflect any shifts
in the demand and
Dow Theory
●Introduction
○ Charles Dow and his partner Edward Jones
founded Dow Jones & Company in 1882
○ Dow published his ideas in a series of
editorials he wrote for the Wall Street
Journal.
○ On July 3, 1884, Dow published the first
stock market average
○ By 1928 the industrial index had grown to
include 30 stocks, the number at which it
stands today
●Basic Tenets
1. The Averages Discount Everything
2. The Market Has Three Trends
■ Primary – More than a year and
possibly for several years
■ Secondary – 3 weeks to 3 months
■ Minor – Less than 3 weeks
3. Major Trends Have Three Phases
■ An accumulation phase
■ A public participation phase
■ A distribution phase
● Candlestick Chart ● Candlestick Patterns
Another kind of chart used in the technical analysis ● Japanese Candlesticks form patterns that
is the candlestick chart, so-called because the main traders use to analyze price movement. Some
component of the chart which represents prices examples of candlestick patterns include:
looks like a candlestick, with a thick ‘body’ and ● Doji: This is a candlestick formed when the
usually, a line extending above and below it, called opening and closing prices are the same, or
the upper shadow and lower shadow, respectively. very close to each other. The shadows may
● The closing price of the security have different lengths.
being traded determines whether ● Gravestone Doji: This pattern resembles a
the candlestick is bullish or bearish. gravestone, hence the name. It is formed
when the open and the close occur at the low
of the period.
● Dragonfly Doji: This pattern is formed when
The real body is usually white if the the opening and the closing prices of a
candlestick closes at a higher price security are at the high of the period. It
than it opened. In such a case, includes a long lower shadow and signals a
the closing price is located at the reversal of an uptrend.
top of the real body and the opening price is located at ● Bearish Engulfing Pattern: This pattern
the bottom. indicates bears in control of the market. It
● If the security being traded closed at a lower price consists of a large body that completely
than it opened for the time period, the body is engulfs the body of the previous candlestick.
usually filled up or black in color. The closing price It is a “down” candlestick, one where the
is located at the bottom of the body and the opening closing price is below the opening price.
price is located at the top. Modern candlesticks now When it appears, it signals a bearish reversal.
replace the white and black colors of the body with ● Bullish Engulfing Pattern: The pattern is
more colors, such as red, green, and blue. Traders often formed at the end of a downtrend. It is
can choose among the colors when using electronic comprised of a smaller down candlestick
trading platforms. whose body is engulfed by a larger up
candlestick.
● The key to P&F charts is the establishment of
the unit of price, which is the unit measurement
of a price movement plotted on the graph. On
P&F charts, there is no time axis, only a price
axis. Rising stock prices are shown with X's and
falling prices are shown with O's. These points
appear on the chart only if the price moved at
least one unit of price in either direction.
● So say the closing prices of a stock moved up
one price unit three times. This would appear as
a column of three X's. If the price
movement reverses direction, the chart shows a
new column of O's, wherein an O is plotted for
each unit of price movement. X's and O's never
appear in the same column. The chartist,
however, must establish how many price units
make up a box, which is how much the price
must move in the opposite direction for the
chart to begin a new column.

● If the issue is rising in price and we have

an uptrend in place with at least three X's, we
believe that demand has overcome supply.
● The reverse, when that chart gives us three O's,
indicates supply has overcome demand. P&F
charts show us the establishment of trends,
trend reversals and the supply and demand of
charted issues.
 ● Head & Shoulders
● Support & Resistance ● A head and shoulders pattern is a technical
● The support and resistance (S&R) are specific indicator with a chart pattern described by three
price points on a chart which are expected to peaks, the outside two are close in height and the
attract maximum amount of either buying or middle is highest.
selling. The support price is a price at which one ● A head and shoulders pattern describes a specific
can expect more buyers than sellers. Likewise chart formation that predicts a bullish-to-bearish
the resistance price is a price at which one can trend reversal.
expect more sellers than buyers. ● The head and shoulders pattern is believed to be
● On a standalone basis traders can use S&R to one of the most reliable trend reversal patterns.
identify trade entry points as well. ● What Does A Head And Shoulders Pattern Tell
● Support occurs where a downtrend is expected You?
to pause due to a concentration of demand. ● A head and shoulders pattern is comprised of three
● Resistance occurs where an uptrend is expected component parts:
to pause temporarily, due to a concentration of ● After long bullish trends, the price rises to a peak
supply.  and subsequently declines to form a trough.
● Market psychology plays a major role as traders ● The price rises again to form a second high
and investors remember the past and react to substantially above the initial peak and declines
changing conditions to anticipate future market again.
movement. ● The price rises a third time, but only to the level of
● Support and resistance areas can be identified the first peak, before declining once more.
on charts using trendlines and moving averages. ● The first and third peaks are shoulders, and the
second peak forms the head. The line connecting
the first and second troughs is called the neckline.
● The opposite of a head and shoulders chart is
the inverse head and shoulders, also called a head
and shoulders bottom, is inverted with the head
and shoulders top used to predict reversals in
downtrends.
● Double top and bottom ● Breadth of the market
● A double bottom occurs when the price of a stock Measure: This is a measure of the number of stocks
hits a particular low price level and rebounds back in the market which have advanced relative to
with a quick recovery. Following the price recovery those that have declined. The broader the
the stock trades at a higher level, after which the market, the stronger the demand.
stock attempts to hit back to the low price previously Related measures:
made. If the stock holds up once again and (1) Divergence between different market indices
rebounds, then a double bottom is formed. (BSE 30 Vs NSE 50)
● A double bottom formation is considered bullish, (2) Advance/Decline lines
and hence one should look at buying opportunities ● Market breadth is a technique used in technical
analysis that attempts to gauge the direction of
the overall market by analyzing the number of
companies advancing relative to the number
declining.
● Positive market breadth occurs when more
companies are moving higher than are moving
lower, and it is used to suggest that the bulls are
in control of the momentum. Conversely, a
disproportional number of declining securities is
used to confirm bearish momentum.
● A large number of advancing issues is a sign of
bullish market sentiment and is used to confirm
a broad market uptrend. Traders will specifically
look at the number of companies that have
created a 52-week high relative to the number
that created a 52-week low because this data
can provide longer term information about
whether the bullish or bearish trend will
continue.
● Moving Average and Exponential Moving ● Application of averages
Average ● The moving average can be used to identify
● A moving average (MA) is a trend-following buying and selling opportunities with its own
or lagging indicator because it is based on past merit. When the stock price trades above its
prices. The two basic and commonly used MAs are average price, it means the traders are willing
the simple moving average (SMA), which is the to buy the stock at a price higher than its
simple average of a security over a defined number average price. This means the traders are
of time periods, and the exponential moving optimistic about the stock price going higher.
average (EMA), which gives bigger weight to more Therefore one should look at buying
recent prices. opportunities.
● As it is evident, the moving average changes as ● Likewise, when the stock price trades below
and when the closing price changes. A moving its average price, it means the traders are
average as calculated above is called a ‘Simple willing to sell the stock at a price lesser than
Moving Average’ (SMA). Since we are calculating it its average price.
as per the latest 5 days of data it is called referred ● Rule 1) Buy (go long) when the current
to as 5 Day SMA. market price turns greater than the 50 day
● The averages for the 5 day (or it could be anything EMA. Once you go long, you should stay
like 5, 10, 50, 100, 200 days) are then joined to invested till the necessary sell condition is
form a smooth curving line known as the moving satisfied
average line, and it continues to move as the time ● Rule 2) Exit the long position (square off)
progresses. when the current market price turns lesser
● An exponential moving average (EMA) is a type than the 50 day EMA
of moving average that is similar to a simple ● The primary difference between an EMA and
moving average, except that more weight is an SMA is the sensitivity each one shows to
given to the latest data. It's also known as the changes in the data used in its calculation.
exponentially weighted moving average. This ● SMA calculates the average of price data,
type of moving average reacts faster to while EMA gives more weight to current data.
The newest price data will impact the moving
recent price changes than a simple moving
average more, with older price data having a
average.
lesser impact
 ● The relative strength index is calculated
using the following formula:
● RSI = 100 - 100 / (1 + RS)
● Moving average ● Where RS = Average gain of up periods
convergence divergence (MACD) is a trend- during the specified time frame / Average
following momentum indicator that shows the loss of down periods during the specified
time frame/
relationship between two moving averages of
● The RSI provides a relative evaluation of the
prices. The MACD is calculated by subtracting strength of a security's recent price
the 26-day exponential moving average (EMA) performance, thus making it a momentum
from the 12-day EMA. A nine-day EMA of the indicator. RSI values range from 0 to 100.
MACD, called the "signal line", is then plotted The default time frame for comparing up
on top of the MACD, functioning as a trigger for periods to down periods is 14, as in 14
buy and sell signals trading days.
Markowitz Portfolio Theory ● Using these five assumptions, a single
●Quantifies risk asset or portfolio of assets is considered to
●Derives the expected rate of return for a be efficient if no other asset or portfolio of
portfolio of assets and an expected risk measure assets offers higher expected return with
●Shows that the variance of the rate of return is a the same (or lower) risk, or lower risk with
meaningful measure of portfolio risk the same (or higher) expected return.
●Derives the formula for computing the variance Alternative Measures of Risk
of a portfolio, showing how to effectively diversify ● Variance or standard deviation of expected
return
a portfolio ● Range of returns
● Returns below expectations
Assumptions of Markowitz Portfolio Theory ○ Semivariance – a measure that only
1.Investors consider each investment alternative as considers deviations below the mean
being presented by a probability distribution of expected ○ These measures of risk implicitly
returns over some holding period. assume that investors want to
minimize the damage from returns
2.Investors maximize one-period expected utility, and
less than some target rate
their utility curves demonstrate diminishing marginal
utility of wealth.
Expected Rates of Return
3.Investors estimate the risk of the portfolio on the basis ● For an individual asset - sum of the
of the variability of expected returns.
potential returns multiplied with the
4.Investors base decisions solely on expected return
corresponding probability of the returns
and risk, so their utility curves are a function of expected ● For a portfolio of assets - weighted
return and the expected variance (or standard deviation)
average of the expected rates of return for
of returns only.
the individual investments in the portfolio
5.For a given risk level, investors prefer higher returns to
lower returns. Similarly, for a given level of expected
returns, investors prefer less risk to more risk.
Variance (Standard Deviation) of Returns for Portfolio Standard Deviation
an Individual Investment Calculation
Standard deviation is the square root of the ●Any asset of a portfolio may be
variance described by two characteristics:
Variance is a measure of the variation ○ The expected rate of return
of possible rates of return R i, from the expected ○ The expected standard deviations
rate of return [E(Ri)] of returns
●The correlation, measured by
Covariance of Returns covariance, affects the portfolio standard
A measure of the degree to which two variables deviation
“move together” relative to their individual mean ●Low correlation reduces portfolio risk
values over time while not affecting the expected return

Covariance and Correlation Combining Stocks with Different

The correlation coefficient is obtained by Returns and Risk
standardizing (dividing) the covariance by the ●Assets may differ in expected rates of
product of the individual standard deviations return and individual standard deviations
●Negative correlation reduces portfolio
Correlation Coefficient risk
It can vary only in the range +1 to -1. A value of ●Combining two assets with -1.0
+1 would indicate perfect positive correlation. correlation reduces the portfolio standard
This means that returns for the two assets move deviation to zero only when individual
together in a completely linear manner. A value of standard deviations are equal
–1 would indicate perfect correlation. This means
that the returns for two assets have the same
percentage movement, but in opposite directions
● Estimation Issues ● If all the securities are similarly related to the
● Results of portfolio allocation depend on accurate market and a bi derived for each one, it can
statistical inputs be shown that the correlation coefficient
● Estimates of between two securities i and j is given as:
○ Expected returns
○ Standard deviation
 m2
○ Correlation coefficient rij  b i b j
■ Among entire set of assets  i j
■ With 100 assets, 4,950 correlation

●
estimates
Estimation risk refers to potential errors
where  m2  the variance of returns for the
● With assumption that stock returns can be aggregate stock market
described by a single market model, the number of
correlations required reduces to the number of
assets
● Single index market model:

R i  a i  biR m   i
● bi = the slope coefficient that relates the returns for
security i to the returns for the aggregate stock
market
● Rm = the returns for the aggregate stock market
The Efficient Frontier
●The efficient frontier represents that set of
portfolios with the maximum rate of return for
every given level of risk, or the minimum risk for
every level of return
●Frontier will be portfolios of investments rather
than individual securities
○ Exceptions being the asset with the
highest return and the asset with the
lowest risk.

The Efficient Frontier and Investor Utility

●An individual investor’s utility curve specifies the
trade-offs he is willing to make between expected
return and risk
●The slope of the efficient frontier curve
decreases steadily as you move upward
●These two interactions will determine the
particular portfolio selected by an individual
investor
●The optimal portfolio has the highest utility for a
given investor
●It lies at the point of tangency between the
efficient frontier and the utility curve with the
highest possible utility