bal reddy

8/7/2019 bal reddy

1/75

8/7/2019 bal reddy

2/75

Aurora School of Business Secundrabad 1

55726861.docSECURITY ANALYSIS & PORTFOLIO MANAGEMENT

Objectives of the Study:

How to analyze Securities.

How Portfolio Management is done.

To study the investment pattern and its related risks & returns.

To understand, analyze and select the best portfolio.

To help the investors to choose wisely between alternative investment.

To strike balance between Cost of funds, risk and returns.

Limitations of the Study:

This study has been conducted purely to understand Portfolio Management for investors and

is done for requirement of Certificate of MBA.

For study purpose 5 Companies have been taken for Calculations.

Study is limited to Portfolio consisting of only 2 companies.

Study is limited to period from 2000-2004.

Data Collection was strictly confined to secondary source. No primary data associated with

the project.

There was a constraint with regard to time allocated for the research study, a period of one

and a half month i.e. from March 14th to April 30 2005.

Study is limited to only first 3 steps or phases of Portfolio Management.

Detailed study of the topic was not possible due to limited size of the project.

The availability of information in the form of annual reports and price fluctuations of thecompanies was a big constraint to the study.

8/7/2019 bal reddy

3/75



(2). Research Methodology:

Sources of Data Collection: - The methodology adopted or employed in this study was mostly

on Secondary data collection i.e.,

Companies Annual Reports

Information from Internet

Publications

Information provided by Hyderabad Stock Exchange

Period of Study:

For different companies, financial data has been collected from the year 2000 2004.

Selection of Companies:

Companies selected for analysis are

Infosys

Indian Tobacco Corporation (ITC)

Satyam

Hero Honda

Reliance

8/7/2019 bal reddy

4/75



(3). STOCK EXCHANGE

History:

The only stock exchange operating in the 19th century wee those of Bombay set up in 1875

and Ahmedabad set up in 1894. These were organized as voluntary non-profit making association of

brokers to regulate and protect their interests. Before the control on securities trading became a

central subject under the constitution in 1950, it was a state subject and the Bombay securities

contracts (control) Act if 1925 used to regulate trading in securities. Under this Act, The Bombay

Stock Exchange was recognized in 1927 and Ahmedabad in 1937.

During the war boom, a number of stock exchanges were organized even in Bombay,

Ahmedabad and other centers, but they were not recognized. Soon after it became a central subject,

central legislation was proposed and a committee headed by A.D. Gorwala went into the bill for

securities regulation. On the basis of the committees recommendations and public discussion, the

securities contracts (regulation) Act became law in 1956.

DEFINITION OF STOCK EXCHANGE

Stock Exchange means any body or individuals whether incorporated or not, constituted for

the purpose of assisting, regulating or controlling the business of buying, selling or dealing in

securities.

It is an association of member brokers for the purpose of self-regulation and protecting the

interests of its members.

It can operate only if it is recognized by the Government under the securities contracts

(regulation) Act, 1956. The recognition is granted under section 3 of the Act by the central

government, ministry of Finance.

8/7/2019 bal reddy

5/75



BY LAWS:

Besides the above act, the securities contracts (regulation) rules were also made in 1957 to

regulate certain matters of trading on the stock exchanges. There are also bylaws of the exchanges,

which are concerned with the following subjects:

Opening/closing of the Stock Exchanges, timing of trading, regulation of blank transfers, regulation

of badla or carryover business, control of the settlement and other activities of the Stock Exchange,

fixation of margins, fixation of market prices or making up prices. Regulation of taravani business

(jobbing), etc., regulation of brokers trading, brokerage charges, trading rules on the exchange,

arbitration and settlement of disputes, settlement and clearing of the trading etc.

REGULATION OF STOCK EXCHANGE

The Securities contracts (regulation) act is the basis for operations of the Stock Exchanges in

India. No exchange can operate legally without the government permission or recognition. Stock

Exchanges are given monopoly in certain areas under section 19 of the anove Act to ensure that the

control and regulation are facilitated. Recognition can be granted to a Stock Exchange provided

certain conditions are satisfied and the necessary information is supplied to the government.

Recognition can also be withdrawn, if necessary where there is no Stock Exchange in its absence.

SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI)

SEBI was setup as an autonomous regulatory authority by the Government of India in 1988to protect the interests of investors in securities and to promote the development of and to regulate

the securities market and for matters connected therewith or incidental thereto. It is empowered by

two acts namely SEBI Act, 1992 and Securities contract (regulation) Act, 1956 to perform the

function of protecting investors rights and regulating the capital markets.

8/7/2019 bal reddy

6/75



BOMBAY STOCK EXCHANGE

The Stock Exchange, Mumbai popularly known as BSE was established in 1875 as The

Native share and stock brokers association, as a voluntary non-profit making association. It has

evolved over the years into its present status as the premiere Stock Exchange in the country. It may

be noted that the Stock Exchanges the oldest one in Asia, even older than the Tokyo Stock

Exchange, which was founded in 1878.

The exchange, while providing an efficient and transparent market for trading in securities,

upholds the interests of the investors and ensures redressed of their grievances, whether against the

companies or its own member brokers. It also strives to educate and enlighten the investors by

making available necessary informative inputs and conducting investor education programmers.

A governing board having 20 directors is the apex body, which decides the policies and

regulates the affairs of the exchange. The Governing body consists of 9 elected directors, 3 SEBInominees, 6 public representatives and an Executive director & Chief Executive Officer and a Chief

Operating Officer.

The Executive director as the chief executive officer is responsible for the day-to-day

administration of the exchange. The average daily turnover of the exchange during the year 2000-01

(April-March) was Rs. 3984.19 Crs and average number of daily trades 5.69 lacs.

However the average daily turn over of the exchange during the year 2001-02 has declined

to Rs. 1248.10 Crs and number of average daily trades during the period to 5.17 lacs.

The average daily turn over of the exchange during the year 2002-03 has declined and

number of average daily trades during the period is also decreased.

8/7/2019 bal reddy

7/75



The Ban on all deferral products like BLESS and ALBM in the Indian capital markets by

SEBI w.e.f July 2, 2001 abolition of account period settlements, introduction of compulsory rolling

settlements in all scrips traded on the exchanges w.e.f Dec 31,

2001 etc., have adversely impacted the liquidity and consequently there is a considerable

decline in the daily turn over at the exchange. The average daily turn over of the exchange present

scenario is 110363 (lacs) and number of average daily trades 1057 (lacs).

BSE INDICES

In order to enable the market participants, analysts etc., to track the various ups and downs inthe Indian stock market, the exchange has introduced in 1986 an equity stock index called BSE-

SENSEX that subsequently became the barometer of the moments of the share prices in the Indian

stock market. It is a Market capitalization-weighted index of 30 component stocks representing a

sample of large, well-established and leading companies. The base year of Sensex is 1978-79. The

Sensex is widely reported in both domestic and international markets through print as well as

electronic media.

Sensex is calculated using a market capitalization weighted method. As per this

methodology, the level of the index reflects the total market value of all 30-component stocks from

different industries related to particular base period. The total market value of a company is

determined by multiplying the price of its stock by the number of shares outstanding. Statiscians call

an index of a set of combined variables (such as price and number of shares) a composite Index. An

indexed number is used to represent the results of this calculation in order to make the value easier to

work with and track overtime. It is much easier to graph a chart based on Indexed values than one

based on actual values world over majority of the well-known Indices are constructed using Market

capitalization weighted method.

In practice, the daily calculation of SENSEX is done by dividing the

aggregate market value of the 30 companies in the Index by a number called the Index Divisor. The

divisor keeps the index comparable over a period of time and if the reference point for the entire

8/7/2019 bal reddy

8/75



Index maintenance adjustments. SENSEX is widely used to describe the mood in the Indian stock

markets. Base year average is changed as per the formula:

New base year average = old base year average*(new market value/old market value)

NATIONAL STOCK EXCHANGE

The organization

The National Stock Exchange of India Limited has genesis in the report of the High Powered

Study Group on Establishment of New Stock Exchanges, which recommended promotion of a

National Stock Exchange by financial institutions (Fis) to provide access to investors from all across

the country on an equal footing. Based on the recommendations, NSE was promoted by leading

Financial Institutions at the best of the Government of India and was incorporated in November

1992 as a tax paying company unlike other Stock Exchanges in the country.

On its recognition as a stock exchange under the Securities Contracts (Regulation) Act, 1956

in April 1993, NSE commenced operations in the Wholesale Debt Market (WDM) segment in June

1994. The Capital Market (Equities) segment commenced operations in November 1994 and

operations in Derivatives segment commenced in June 2000.

NSE NIFTY

The NSE on April 22,1996 launched a new equity Index. The NSE-50. The new Index which

replaces the existing NSE 100 Index, is expected to serve as an appropriate Index for the new

segment of futures and option. NIFTY means Nations Index for Fifty Stocks. The NSE-50

comprises 50 companies that represent 20 broad Industry groups with an aggregate market

capitalization of around Rs.1, 70,000crs. All companies included in the Index have a market

8/7/2019 bal reddy

9/75



capitalization excess of Rs.500crs each and should have traded for 85% of trading days at an impact

cost of less than 1.5%.

NSE MIDCAP INDEX

The NSE madcap Index or the Nifty comprises 50 stocks that represent 21 boards Industry

groups and will provide proper representation of the madcap segment of the Indian capital market.

All stocks in the Index should have market capitalization of greater than Rs.200crs and should have

traded 85% of the trading days at an impact cost of less 2.5%.

The base period for the index is Nov 4, 1996, which signifies two years for

completion of operations of the capital market segment of the operations. The base value of the

Index has been set at 1000.

Average daily turnover of the present scenario 258212 (Laces) and number of average

daily trades 2160 (Laces).

At present, there are 24 Stock Exchanges recognized under the Securities Contract

(Regulation) Act, 1956. They are: -

8/7/2019 bal reddy

10/75

8/7/2019 bal reddy

11/75



Bombay Stock Exchange

Ahmedabad share and Stock brokersAssociation

Calcutta Stock exchange Association Ltd

Delhi Stock Exchange Association Ltd

Madras Stock Exchange Association Ltd

Indore Stock Exchange Association

Bangalore Stock Exchange

Hyderabad Stock Exchange

Cochin Stock ExchangePune Stock Exchange Ltd

U.P Stock Exchange Association Ltd

Ludhiana Stock Exchange Association Ltd

Jaipur Stock Exchange Ltd

Gauhathi Stock Exchange Ltd

Mangalore Stock Exchange Ltd

Maghad Stock Exchange Ltd, Patna

Bhubaneshwar Stock Exchange Association Ltd

Over the counter exchange of India, Bombay

Saurasthra Kutch Stock Exchange Ltd

Vsdodara Stock Exchange ltd

Coimbatore Stock Exchange Ltd

The Meerut Stock Exchange Ltd

National Stock Exchange Ltd

Integrated Stock Exchange

1875

1957

1957

1957

1958

1968

1943

1978

19821982

1983

1983 84

1984

1985

1986

1989

1989

1990

1991

1991

1991

1991

1991

1999

(4). THE HYDERABAD STOCK EXCHANGE LIMITED

8/7/2019 bal reddy

12/75



ORIGIN

Rapid growth in industries in the erstwhile Hyderabad State saw efforts at starting the Stock

Exchange. In November 1941 some leading bankers and brokers formed the share and stock Brokers

Association. In 1942, Mr. Gulab Mohammed, the Finance Minister formed a Committee for the

purpose of constituting Rules and Regulations of the Stock Exchange. Sri Purushothamdas

Thakurdas, President and Founder Member of the Hyderabad Stock Exchange performed the

opening ceremony of the Exchange on 14.11.1943 under Hyderabad Companies Act; Mr. Kamal Yar

Jung Bahadur was the first President of the Exchange. The HSE started functioning under

Hyderabad Securities Contract Act of No. 21 of 1352 under H.E.H. Nizams Government as a

Company Limited by guarantee. It was the 6

th

Stock Exchange recognized under Securities ContractAct, after the Premier Stock Exchanges, Ahmedabad, Bombay, Calcutta, Madras and Bangalore

stock Exchange. All deliveries were completed every Monday or the next working day.

The Securities Contracts (Regulation) Act 1956 was enacted by the Parliament, passed into

Law and the rules were also framed in 1957. The Act and the Rules were brought into force from

20th February 1957 by the Government of India.

The HSE was first recognized by the Government of India on 29 th September 1958, as

Securities Regulation Act was made applicable to twin cities of Hyderabad and Secunderabad from

that date. In view of substantial growth in trading activities, and for the yeoman services rendered by

the Exchange, the Exchange was bestowed with permanent recognition with effect from 29th

September 1983.

The Exchange has a significant share in achievements of erstwhile State of Andhra Pradesh

to its present state in the matter of Industrial development.

OBJECTIVES

8/7/2019 bal reddy

13/75



The Exchange was established on 18th October 1943 with the main objective to create,

protect and develop a healthy Capital Market in the State of Andhra Pradesh to effectively serve the

Public and Investors interests.

The property, capital and income of the Exchange, as per the Memorandum and Articles of

Association of the Exchange, shall have to be applied solely towards the promotion of the objects of

the Exchange. Even in case of dissolution, the surplus funds shall have to be devoted to any activity

having the same objects, as Exchange or be distributed in Charity, as may be determined by the

Exchange or the High Court of judicature. Thus, in short, it is a Charitable Institution.

The Hyderabad Stock Exchange Limited is now on its stride of completing its 59 th year in the

history of Capital Markets serving the cause of saving and investments. The Exchange has made its

beginning in 1943 and today occupies a prominent place among the Regional Stock Exchanges in

India. The Hyderabad Stock Exchange has been promoting the mobilization of funds into the

Industrial sector for development of industrialization in the State of Andhra Pradesh.

GROWTH

The Hyderabad Stock Exchange Ltd., established in 1943 as a Non-profit making

organization, catering to the needs of investing population started its operations in a small way in

a rented building in Koti area. It had shifted into Aiyangar Plaza, Bank Street in 1987. In

September 1989, the then Vice-President of India, Honble Dr. Shankar Dayal Sharma had

inaugurated the own building of the Stock exchange at Himayathnagar, Hyderabad. Later in

order to bring all the trading members under one roof, the exchange acquired still a larger

premises situated 6-3-654/A ; Somajiguda, Hyderabad - 82, with a six storied building and a

constructed area of about 4,86,842 sft (including cellar of 70,857 sft). Considerably, there has

been a tremendous perceptible growth that could be observed from the statistics.

The number of members of the Exchange was 55 in 1943, 117 in 1993 and increased to 300

with 869 listed companies having paid up capital of Rs.19128.95 crores as on 31/03/2000. The

business turnover has also substantially increased to Rs. 1236.51 crores in 1999-2000. The Exchange

has got a very smooth settlement system.

8/7/2019 bal reddy

14/75



GOVERNING BOARD

At present, the Governing Board consists of the following:

MEMBERS OF THE EXCHANGE

Sri Hari Narayan Rathi

Sri Rajendra V. Naniwadekar

Sri K. Shiva Kumar

Sri R.D. Lahoti

Sri Ram Swaroop Agrawal

Sri Dattatray

SEBI NOMINEE DIRECTORS

Sri N.S. Ponnunambi -- Registrar of Companies [Govt. of India]

PUBLIC NOMINEE DIRECTORS

Justice V. Bhaskara Rao Retd. Judge High Court.

Sri P. Muralimohan Rao Mogili & Co. Chartered Accountants.

Dr B. Brahmaiah -- G.M. JNIDB

EXECUTIVE DIRECTOR

Sri S Sarveshwar Reddy

COMPUTERIZATION

8/7/2019 bal reddy

15/75

8/7/2019 bal reddy

16/75



The HOST provided the network for HSE to hook itself into the ISE. The ISE provided

the members of HSE and their investors, access to a large national network of Stock Exchanges.

The Inter-connected Stock Exchange is a National Exchange and all HSE Members could

have trading terminals with access to the National Market without any fee, which was a boon to the

Members of an Exchange/Exchanges to have the trading rights on

NationalExchange(NSE),withoutanyfeeorexpenditure.

ON-LINE SURVEILLANCE

HSE pays special attention to Market Surveillance and monitoring exposures of the

members, particularly the mark to market losses. By taking prompt steps to collect the margins

for mark to market losses, the risk of default by members is avoided. It is heartening that there

have been no defaults by members in any settlement since the introduction of Screen Based

Trading.

IMPROVEMENT IN THE VOLUMES

It is heartening that after implementing HOST, HSE's daily turnover has fairly stabilized

at a level of Rs. 20.00 crores. This should enable in improving our ranking among Indian StockExchanges for 14th position to 6th position. We shall continuously strive to improve upon this to

ensure a premier position for our Exchange and its members and to render excellent services to

investors in this region.

The number of transactions, turnovers of the Exchange, number of listed companies and the

paid up capital listed have grown up substantially as may be seen from the following figures.

8/7/2019 bal reddy

17/75



YEAR

NUMBER OF

TRANSACTIONSIN Thousands

TURNOVERSRs.IN Crores LISTEDCOMPANIES

MARKET

CAPITRs.IN Crores

1991-92 515.949 587.75 236 2740.56

1992-93 421.985 676.00 274 10228.48

1993-94 603.635 984.46 372 13156.15

1994-95 860.642 1160.48 668 18588.71

1995-96 720.521 1107.30 727 20159.31

1996-97 240.64 479.98 851 22050.69

1997-98 427.83 1860.86 852 18705.10

1998-99 513.168 1269.90 856 18753.93

1999-00 513.440 1236.51 869 19128.95

2000-01 427.205 977.83 934 14717.08

2001-02 34.326 41.26 932 13616.12

2002-03 4.203 4.58 .928 13974.12

2003-04 2.277 2.73 856 22126.65

2004-05 4.401 14.13 820 14456.95

8/7/2019 bal reddy

18/75



SETTLEMENT GUARANTEE FUND

The Exchange has introduced Trade Guarantee Fund on 25/01/2000. This will insulate

the trading member from the counter-party risks while trading with another member. In other

words, the trading member and his investors will be assured of the timely completion of the pay-

out of funds and securities notwithstanding the default, if any, of any trading member of the

Exchange. The shortfalls, if any, arising from the default of any member will be met out of the

Trade Guarantee Fund. Several pay-ins worth of crores of rupees in all the settlements have been

successfully completed after the introduction of Trade Guarantee Fund, without utilizing any

amount from the Trade Guarantee Fund.

The Trade Guarantee Fund will be a major step in re-building this confidence of the members

and the investors in HSE. HSE's Trade Guarantee Fund has a corpus of Rs. 2.00 crores initially

which will later be raised to Rs. 5.00 crores. At present Rs. 3.20 Crores is stood in the credit of SGF.

The Trade Guarantee Fund had strict rules and regulations to be complied with by the

members to avail the guarantee facility. The HOST system facilitated monitoring the compliance of

members in respect of such rules and regulations.

CURRENT DIVERSIFICATIONS

(A). DEPOSITORY PARTICIPANT

The Exchange has also become a Depository Participant with National Securities Depository

Limited (NSDL) and Central Depository Services Limited (CDSL). Our own DP is fully operational

and the execution time will come down substantially. The Exchange undertakes the depository

functions by opening the accounts at Hyderabad of investors, members of the Exchange and other

Exchanges. The trades of all the Exchanges having On-line trading which get into National

depository can also be settled at Hyderabad by this exchange itself. In short all the trades of all the

investors and members of any Exchange at Hyderabad in dematerialized securities can be settled by

the Exchange itself as a participant of NSDL and CDSL. The exchange has about 15,000 B.O.

accounts.

8/7/2019 bal reddy

19/75



B) FLOATING OF A SUBSIDIARY COMPANY FOR THE MEMBERSHIP OF MAJOR

STOCK EXCHANGES OF THE COUNTRY

The Exchange had floated a Subsidiary Company in the name and style of M/s HSE

Securities Limited for obtaining the Membership of NSE and BSE. The Subsidiary had obtained

membership of both NSE and BSE. About 113 Sub-brokers may register with HSES, of which about

75 sub-brokers are active. Turnover details are furnished here under.

C)FACILI

TY TO

TRADE

AT NSE,

DERIVATIVES TRADING, NET TRADING ETC

The Exchange has incorporated a Subsidiary "HSE securities Limited " with a paid up capital

of Rs. 2.50 crores initially to take NSE Membership, so that the members of the exchange will have

access to the NSE's Trading Screen as Sub-brokers, Derivatives Trading and Net Trading etc. The

Members of this Exchange will also have equal opportunity of participating in such trading like any

other NSE member.

(6). PORTFOLIO MANAGEMENT & ITS PHASES

YEARNSE CASH

Rs.In Lakhs

NSE F&O

Rs.In Lakhs

BSE

CASH

Rs.In Lakhs

2001-02 338236.81 -- --

2002-03 426143.50 16657.08 --

2003-04 617808.46 312203.56 17558.59

2004-05 484189.11 354370.71 39519.96

8/7/2019 bal reddy

20/75



Portfolio management is a process encompassing many activities aimed at optimizing the

investment of one funds, each phase is an integral part of the whole process and the success of

portfolio management depends up the efficiency in carrying out each phases. Five phases can be

identified: -

(1) Security analysis

(2) Portfolio analysis

(3) Portfolio selection

(4) Portfolio revision

(5) Portfolio evaluation

SECURITY ANALYSIS : It refers to the analysis of treading securities from the point of

view of their prices, return and risk. All invest are risky and the expected return is related to

risk

The securities available to an investor for investment are numerous and of various

types. The shares of over 7000 companies are listed in stock exchanges of the country. Securities

classified into ownership securities such as equity shares and preference shares and creditor shipsecurities such as debentures and bonds. Recently, a no. of new securities such as Convertible

debentures, Deep discount bonds, Zero coupon bonds, Flexi bonds, Floating rate bonds, Global

depository receipts, Euro currency bonds etc. are issued to raise funds for their projects by

companies from which investor has to choose those securities that is worthwhile to be included in his

investment portfolio. This calls for detailed analysis of the available securities.

Security analysis is the initial phase of the portfolio management process. It examines the

risk return characteristics of individual securities. A basic strategy in securities investment is to buy

under priced securities and sell over priced securities. But

the problem is how to identify such securities in other words mispriced securities. This is what

security analysis is all about.

8/7/2019 bal reddy

21/75



The security market emerges out of the new issues made by companies, government, local

bodies and public undertakings. All securities are in the form of IOUS except those of ownership

shares. Securities of more than one year come into categories of capital and stock market.

Trading: The market in securities is influenced by the forces of supply and demand that

determine volume of trading. Turnover and also the prices. The volume of trading is

reflected in the no. of deal per day or hours, no. of days in a year in which the company

share is treaded or the no. of share traded in a day or a year.

The Main constituents of and players in the market are as follows:

(a) Investments traded such as equity and preference shares in the category of ownership capital and

debentures, bonds and p.s.u bonds and government securities in the category of debt capital. A

no. of new investments like warrants, zero coupon bonds etc are also being issued at present

(b) The institution or players in the market are the issuers of capital namely corporate units,

government and semi-government bodies and public sector undertakings that are the major

borrowers, the investors and intermediaries such as bank, financial institution and brokers. More

recently, a no. of mutual funds, FFIS,NRIS,OCBS have also started as players in the market

(b) Intermediaries are brokers, merchant bankers, financial investment, financial and

investment consultancy firm etc. these are active both primary and secondary markets.

Market analysis : The security market analysis refers to the analysis of market and securities

traded price trends and other indicators.

Valuation: The basic objective of market analysis is to know the fair valuation of shares for

buying and selling. The market comprises of various securities whose price change from day

and from time to time. The investors should have information of fair prices for making their

decisions of buying and selling. It is, therefore Necessary to make security valuation an

important part of market analysis.

8/7/2019 bal reddy

22/75



The valuation analysis in particular has two components, namely, the market valuation at

macro level & the individual security valuation at micro level. The macro level analysis is done with

the help of suitable price indices of the leading scrips in the market and their price-earning ratio. The

BSE national index of securities price has 100 scrips in it and their P/E ratio. Represents the market

valuation of securities. These are published by the BSE on a daily basis. As regards the individual

security valuation. The intrinsic value is the basis on which over valuation or under valuation is

judged. It is determined by expected to the present time by a suitable discount rate. But in actual

practice this method is not followed.

The methods of valuation are(i) Discounted value of future income streams or dividends

(ii) No. of years of payback period. This method is used in the form of P/E ratio.

Return:

The term return from an investment refers to the benefits from that investment. In the field

of finance in general and security analysis in particular, the term return is almost invariably

associated with a percentage (say, return on investment of 12%) and not a mere amount (like, profit

of Rs. 150).

Theoretical framework:

(a) The first theoretical tool is the savings investment theory saving promote capital

formation and economic growth through increase in output and incomes of the country.

The mobilization of savings for capital formation is through capital market comprising the

new issues market and stock market.

(c) Secondly, market behavior depends on the player and their role in trading. Analysis of market

price behavior is thus possible though the no. of buyers and sellers available and information in

the market . The Capital Market Efficiency Theory, Random Walk Theory and many other

theories explain how prices behave in the market. To explain why share prices fluctuate and what

8/7/2019 bal reddy

23/75



are the fair prices, these theories are used. The theory of Trend Walkers explains the market

trends as set by a few trendsetters or leaders followed by a mass of trend walkers.

(d) Third theoretical tool in investment analysis is fundamental analysis that explains why prices are

what they are. The market price & individual share prices are explained by fundamental factors

namely. Economy, industry and company analysis. In security valuation the most important tool

is the ratio analysis or examination of balance sheet of a co. whose share is being examined. This

enables us to locate the undervalued shares and overvalued share and to decide what shares to

buy and what share to sell.

(e) Fourth theoretical tool is technical analysis, which is an analysis of the price behavior of

agg.marketand of individual share with help of charts on price. Trading volume and movingaverages. The Dow Theory & Elliot Wave Theory are some if the theories in this analysis, which

explain the price behavior.

(f) Lastly, Risk Return Analysis, which are two major characteristic of any investment. In this, the

choice of scrips is decided by an analysis of risks involved in relation to the return in the

background of market risk and market return. Portfolio theory provides the linkage of market to

investments. An efficient portfolio is to be developed by minimize the risks and maximize the

returns. The portfolio management helps the investment process by applying the principles of

portfolio theory to build up on efficient portfolio. Through a diversified basket of scrips. What

securities to buy and when to buy so as to build up an efficient portfolio are all liked to result in

the buying and selling of shares in the market and trading.

A brief explanation of these theories are given below:

Fundamental Analysis:

The primary motive of buying a shares to sell it 60 subsequently at a higher price. In many

case, dividends are also expected. Thus dividends and price changes constitute the retune from

investing in shares.

Fundamental analysis to is really a logical and systematic approach to estimating the future

dividends and share price this share price is based on no. of fundamental factors like economic

fundamental, industry fundamental and company fundamentals which have to be considered while

8/7/2019 bal reddy

24/75



analyzing a security for investment purpose. Its a detailed analysis of the fundamental factors

affecting the performance of companies.

The analysis of economy, industry and company fundamentals constitute the main activity in

the fundamental approach to security analysis. A company belongs to an industry and the industry

operates within the economy. As such industry and economy factors affect the performance of the

company. These factors are: -

Economy wide factors such as growth rate of the economy, inflation rate, and foreign exchange

rate etc. that affect all companies.

Industry wide factors such as demand. Supply gap in the industry the emergence of substitute

products, changes in government policy relating to industry.

Company specific factors such as age of its plant, the quality management, brand image of its

products etc.

Fundamental analysis involves 3 steps:

1) Economy analysis

2) Industry analysis

3) Company analysis

1) Economy analysis : The performance of a company depends on the performance of the

economy. If the economy is booming, income rise and demand for goods will increase, if the

economy is in recession, the performance of the company will be generally bad. Investors are

concerned with those variables in the economy, which affect the performance of the company

in which they tend to invest. Those are: -

Growth rates of national income :

The rate of growth of the national economy is an important variable. GNP (gross national

product), NNP (net national income) and GDP (gross domestic product) are the difference

measures indicate growth rate of the economy. These estimates are made available by

government. An economy typically passes through different phases, such as depression,

recovery, boom and recession.

8/7/2019 bal reddy

25/75



During a depression, demand is low and declining. Inflation is often high and so are

interest rate. During the recovery stage, the economy begins to revive after a depression. Demand

picks up lending to more investment in the economy. In the boom phase, investment and production

are maintained at a high level to satisfy high demand. In Recession stage, the economy slowly begins

to experience a downturn in demand, production, employment etc. The profits also decline.

Inflation:

Inflation prevailing in the economy has considerable impact. Higher rates of inflation upset

business plans, lead to cost escalation and result in a squeeze on profit margins. High rates of

inflation in an economy are likely to affect the performance of companies. Inflation is measured both

in terms of wholesale prices through wholesale price Index (WPI) and in terms of retail pricesthrough consumer price Index.

Interest rate :

Interest rate determine the cost and availability of credit for companies operating in an

economy. A low interest rate stimulates investment by making credit available easily and cheaply.

Higher interest rate result in higher cost of production, which may lead to lower profitability and

lower demand.

An investor has to evaluate and consider the other factors like government revenue,

expenditure, deficits, exchange rate, and infrastructure economic and political stability for a good

performance of the economy.

2) Industry analysis :

An investor ultimately invests his money in the securities of one or more specific

companies. The performance of companies would be influenced by the fortunes of the

industry to which it belongs. An industry is generally described as a homogenous group of

companies. An industry is defined as A group of firms products, which serve the same need

of a common set of buyers.

Market experts believe that each poll has a stage and the decline stage. Even industry has a

life cycle theory.

8/7/2019 bal reddy

26/75



(i) The Pioneering stage

(ii) The Expansion stage

(iii) The Stagnation stage

(iv) The Decay stage

Technological advances in one country can effect the growth of another Industry. All these

stages gives an insight into merits of invest in a given industry at a given time. An industry usually

exhibits low profitability in the pioneering stage, high profitability in the growth or expansion stage,

medium but steady profitability in the stagnation or maturity stage and declining profitability in thedecay stage.

3) Company analysis : It is the final stage of fundamental analysis. It deals with the

estimation of return and risk of individual shares. In company analysis, the analyst tries to

forecast the future earnings of the company. The level, trend and stability of earnings of a

company. However depend upon a no. of factors concerning the operations of the company.

8/7/2019 bal reddy

27/75



PORTFOLIO MANAGEMENT

Introduction: -

Many times the investors go on acquiring assets in an adhoc & unplanned manner & the result

is high risk, low return profile that they may face. All such assets of financial nature such as gold,

silver, real estate, building, insurance policies, Post office certificate, NSC or NSS would constitute

his portfolio & the wise investor not only plans his portfolio as per risk return profile or preferences

but manages his port folio efficiently so as to secure the highest return for the lowest risk possible at

that level of investment. This is in short the Portfolio Management.

The basic principle is that the higher the risk, the higher is the return & investor should have

clear perception of elements of risk & return when he makes investments. Risk return analysis is

essential for the investment & portfolio management. An investor considering investment in

securities is faced with the problem of choosing from among a large no of securities. His choice

depends upon the risk return characteristics of individual securities. He would attempt to choose the

most desirable securities & like to allocate his funds over group of securities. As the economic and

financial environment keep changing the risk return characteristics of individual securities as well as

portfolios also change.

An investor invests his funds in a portfolio expecting to get a good return consistent with the

risk that he has to bear. Portfolio management comprises all the processes involved in the creation &

maintainence of an investment portfolio. It deals specifically with Security Analysis, Portfolio

Analysis, Selection, Revision & Evaluation. Portfolio Management is a complex process, which triesto make investment activity more rewarding & less risky.

8/7/2019 bal reddy

28/75



Role of portfolio management:

There was a time when portfolio management was an exotic term. The scenario has changed

drastically. It is now a familiar term and is widely practiced in India. The theories and concepts

relating to portfolio management now find their way to the front pages of financial newspapers and

the cover pages of investment journals in India.

.

Indian capital markets have become active. The Indian stock markets are steadily

moving towards higher efficiency, with rapid computerization, increasing market transparency,

better infrastructure, better customer service etc. The markets are dominated by large institutional

investors with their diversified portfolios. A large no. of mutual funds have been set up the country

since 1987. With this development investment in securities has gained considerable momentum.

Professional portfolio management backed by competent research began to be practiced

by mutual funds, investment consultants and big brokers. The Securities Exchange Board of India

(SEBI), The Stock Market Regulatory body in India is supervising the whole process.

With the advent of computers the whole process of portfolio management has become

quite easy. The computer can absorb large volumes of data perform computations accurately and

quickly give out results in desired form.

The trend towards liberalization and globalization of the economy has promoted free flow of

capital across international border. Portfolio now include not only domestic securities but also

foreign securities such as Options and Futures in the field of investment management and trading in

derivative securities, their valuation etc have broadened its scope.

8/7/2019 bal reddy

29/75



(8). PORTFOLIO THEORIES

MARKOWITZ THEORY:

Markowitz approach determines for the investor the efficient set of portfolio through 3

important variables, i.e., Standard Deviation, Covariance and Co-efficient of Correlation.

Markowitz model is called the Full Covariance Model. Through this method, the investor can

with the use of computer, find out the efficient set of portfolio by finding out the trade off

between risk and return between the limits of zero to infinity. According to this theory, the

effects of one security purchase over the effects of the other security purchase are taken into

consideration and then the results are evaluated.

Assumption under Markowitz Theory:

Markowitz theory is based on the modern portfolio theory under several assumptions. The

assumptions are: -

(1) The market is efficient and all investors have in their knowledge all the facts about the

stock market and so on investor can continuously make superior returns either by

predicting past behavior of stocks through technical analysis or by fundamental analysis

of internal company management or by finding out the intrinsic value of shares. Thus all

investors are in equal category.

(2) All investors before making any investments have a common goal. This is the avoidance

of risk because they are risk averse.

(3) All investors would like to earn the maximum rate of return that they can achieve from

their investments.

(4) The investors base their decisions on the expected rate of return of an investment. Theexpected rate of return can be found out by finding out the purchase price of a security

divided by the income per year and by adding annual capital gains. It is also necessary to

8/7/2019 bal reddy

30/75



know the standard deviation of the rate of return, which is being offered on the investment.

The rate of return and

standard deviation are important parameters for finding out whether the

investment is worthwhile for a person.

(5) Markowitz brought out the theory that it was a useful insight to find out how the security

returns are correlated to each other. By combining the assets in such way that they give

the lowest risk maximum returns could be brought out by the investor.

(6) From the above it is clear that every investor assumes that while making an investment he

will combine his investments in such a way that he gets a maximum return and issurrounded by minimum risk.

(7) The investor assumes that greater or larger the return that he achieves on his investments,

the higher the risk factor that surrounds him. On the contrary when risks are low the

return can also be expected to be below.

(8) The investor can reduce his risk if he adds investments to his portfolio.

(9) An investor should be able to get higher return for each level of risk by determining the

efficient set of securities.

2. THE SHARPE INDEX MODEL

The investor always likes to purchase a combination of stock that provides the highest return

and has lowest risk. He wants to maintain a satisfactory reward to risk ratio. Traditionally analysis

paid more attention to the return aspect of the stocks. Now a days risk has received increased

attention and analysts are providing estimates of risk as well as return.

Sharp has developed a simplified model to analyze the portfolio. He assumed that the return

of a security is linearly related to a single index like the market index. Strictly speaking, the market

index should consist of all the securities trading on the exchange

In the absence of it, a popular index can be treated as a surrogate for the market index.

8/7/2019 bal reddy

31/75



SINGLE INDEX MODEL

Casual observation of the stock prices over a period of time reveals that most of the stock

prices move with the market index. When sensex increases, stock prices also

tend to increase and vice-versa. This indicates that some underlying factors affect the market index

as well as the stock prices. Stock prices are related to the market index and this relationship could be

used to estimate the return on stock. Towards this purpose, the following equation can be used:

Ri = i + i Rm + ei

Where R= expected return on security I

i =intercept of the straight line or alpha co-efficienti =slope of straight line or beta co-efficient

Rm = the rate of return on market index

ei = error team

CORNER PORTFOLIO

The entry or exit of a new stock in the portfolio generates a series of corner portfolio. In a

one stock portfolio, itself is the corner portfolio. In a two stock portfolio, the minimum attainable

risk (variance) and the lowest return would be the corner portfolio. As the member of stocks

increases in a portfolio, the corner portfolio would be the one with lowest return and risk

combination.

SHARPES OPTIMAL PORTFOLIO

Sharpe had provided a model for the selection of appropriate securities in a portfolio. The

selection of any stock is directly related to its excess return beta ratio.

RiRf / i

Where, Ri = the expected return on stock i

Rf = the return on a risk less asset

i = the expected change in the rate of return on stock I associated with one unit change in

the market return.

8/7/2019 bal reddy

32/75



The excess return is the difference between the expected return on the stock and the risk less

rate of interest such as the rate offered on the government security or treasury

bill. The excess return to beta ratio measures the additional return on s security (excess of the risk

less asset return) per unit of systematic risk or non-diversifiable risk. This ratio provides a

relationship between potential risk and reward.

The steps for finding out the stocks to be included in the optimal portfolio are given below:

1. Finding out the excess return to beta ratio for each stock under consideration.

2. Rank them from the highest to the lowest

3. Proceed to calculate C for all the stocks according to the ranked order using the following

formula,Ci = 2m N ((Ri Rf) i / 2ei)/1+ 2 N i / 2ei

4. The calculated values of Ci start declining after a particular Ci and that point is taken as the

cut-off point and that stock ratio is the cut-off ratio Ci.

CAPITAL ASSET PRICING THEORY:

We have seen that diversifiable risk can be eliminated by diversification. The remaining risk

portion is the undiversifiable risk i.e., market risk. As a result, investors are interested in

knowing the systematic risk when they search for efficient portfolios. They would like to have

assets with low beta coefficient i.e., systematic risk. Investors would opt for high beta co-

efficient only if they provide high rate of return. The risk were averse nature of the investors is

the underlying factor for this behavior. The capital asset pricing theory helps the investors top

understand and the risk and return relationship of the securities. It also explains how assets

should be priced in the capital market.

The CAPM Theory

Markowitz, William Sharpe, John Lintner and Jan Mossin provided the basis structure for the

CAPM model. It is a model of linear general equilibrium return. In the CAPM theory, the

required rate of return of an asset is having a linear relationship with assets beta value i.e.

undiversifiable or systematic risk.

8/7/2019 bal reddy

33/75



Assumptions:

1. An individual seller or buyer cannot affect the price of a stock. This assumption is the basic

assumption of the perfect competitive market.

2. Investors make their decisions only on the basis of the expected returns, standard deviations

and covariances of all pairs of securities.

3. Investors are assumed to have homogenous expectations during the decision-making period.

4. The investor can lend or borrow any amount of funds at the risk less rate of interest. The risk

less rate of interest is the rate of interest offered for the treasury bills or Government

securities.

5. Assets are infinitely divisible, according to this assumption, investor could buy and quantityof share i.e. they can even buy ten rupees worth of Reliance Industry shares.

6. There is no transaction cost i.e. no cost involved in buying and selling of stocks.

7. There is no personal income tax. Hence, the investor is indifferent to the form of return either

gain or dividend.

8. Unlimited quantum if short sales are allowed. Any amount of shares an individual can sell

short.

Lending and Borrowing

Here, it is assumed that the investor could borrow or lend any amount of money at risk less

rate of interest. When this opportunity is given to the investors, they can mix risk free assets with the

risk assets in a portfolio to obtain in desired rate of risk return combination.

The expected return on the combination of risky and risk free combination is

Rp = RfXf+ Rm (1-Xf)

Where, Rp = Portfolio return

Xf= the proportion of funds invested in risk free assets

1-Xf= the proportion of funds invested in risk assets

Rf = Risk free rate of return

Rm = Return on risky assets

8/7/2019 bal reddy

34/75



This formula can be used to calculate the expected returns for different situations like mixing

risk less assets with risky assets, investing only in the risky asset and mixing the borrowing with

risk assets.

The Concept

According to CAPM, all investors hold only the market portfolio and risk less securities. The

market portfolio is a portfolio comprised of all stocks in the market. Each asset is held in proportion

to its market value to the value of all risky assets. For example, if Reliance Industry share represents

20% of all risky assets, then the market portfolio of the individual investor contains 20% of Reliance

Industry shares. At this stage, the investor has the ability to borrow or lend any amount of money atthe risk less rate of interest. The efficient frontier of the investor is given in figure.

The figure shows the efficient frontier of the investor. The investor prefers any point between

B&C because; with the same level of risk they face on line BA, they are liable to get superior profits.

The ABC line shows the investors portfolio of risky assets. The investors can combine risk less

asset either by lending or borrowing. This is shown in figure,

Rp Rp

C

S CML

B

Rf

A

O p p

The line RfS represent all possible combination of risk less and risky asset. The S portfolio does

not represent any risk less asset but the line RfS gives the combination of both. The portfolio along

8/7/2019 bal reddy

35/75



the path RfS is called lending portfolio i.e. some money is invested in the risk less asset or may be

deposited in the bank for a fixed rate of interest If it crosses the point S, it becomes borrowing

portfolio. Money is borrowed and invested in the risky asset. The straight lines are called Capital

Market Line (CML). It gives the desirable set of investment opportunities between risk free and

risky investments. The CML represents linear relationship between the required rates of return for

efficient portfolio and their standard deviations.

E(Rp) = Rf + (Rm-Rf) x p

m

E(Rp) = portfolios expected rate of return

Rm = expected return on market portfolio

m = standard deviation of market portfolio

p = standard deviation of the portfolio

For a portfolio on the capital market line, the expected rate of return in excess of the risk free rate is

in proportion to the standard deviation of the market portfolio. The slope of the line gives the price

of the risk. The slope equals the risk premium for the market portfolio Rm-Rf divided by the risk orstandard deviation of the market portfolio. Thus, the expected return of an efficient portfolio is

Expected return = Price of time + (Price of risk X amount of risk)

Price of time is the risk free rate of return. Price of risk is the premium amount higher and above the

risk free return.

Security Market Line:

The Capital Market Line measures the risk-return relationship of an efficient portfolio. But, it

does not show the risk-return trade off for other portfolio and individual securities. Inefficient

portfolios lie below the capital market line and the risk-return relationship cannot be established with

the help of the capital market line. Standard deviation includes the systematic and unsystematic risk.

Unsystematic risk can be diversified and it is not related to the market. If the unsystematic risk is

eliminated, then the matter of concern is systematic risk alone. This systematic risk could be

8/7/2019 bal reddy

36/75



measured by beta. The beta analysis is useful for individual securities and portfolios whether

efficient or inefficient.

When an additional security is added to the market portfolio, an additional risk is also added

to it. The variance of a portfolio is equal to the weighted sum of the co-variances of the individual

securities in the portfolio. If we add an additional security to the market portfolio, its marginal

contribution to the variance of the market is the covariance between the securitys return and market

portfolios return. If the security is included, the covariance between the security and the market

measures the risk. Dividing it by standard deviation of market portfolio Cov 1m/M can standardize

covariance. This shows the systematic risk of the security, and then the expected return of the

security is given by the equation-Ri-Rf = Rm-Rf COVim/ m

m

This equation can be rewritten as follows:

Ri-Rf = COVim [Rm-Rf]

2m

The first term of the equation is nothing but the beta coefficient of the stock. The beta

coefficient of the equation of SML is same as the beta of the market (Single index) model. In

equilibrium, all efficient and inefficient portfolios lie along the security market line. The SML line

helps to determine the expected return for a given security beta. In other words, when betas are

given, we can generate expected returns for the given securities. This is explained in figure.

If we assume the expected market risk premium to be 8% and the risk free rate of return to

be 7%, we can calculate expected return for A, B, C and D securities using the formula,

E (Ri) = Rf+ 1 [E (Rm) Rf]

Market Imperfection and SML:

8/7/2019 bal reddy

37/75



Information regarding the share price and market condition may not be immediately available

to all investors; imperfect information may affect the valuation of securities. In a market with perfect

information, all securities should lie on SML. Market imperfections would lead to a band to SML

rather than a single line. Market imperfections after the width of the SML to a band, if imperfections

were more, the width also would be larger.

Empirical tests of the CAPM:

In the CAPM, beta is used to estimate the systematic risk of the security and reflects the

future volatility of the stock in relation to the market. Future volatility of the stock is estimated only

through historical data. Historical data are used to plot the regression line or the characteristics lineand calculate beta. If historical betas are stable over a period of time, they would be good proxy for

their ex-ante or expected risk.

Robert A. Levy, Marshall E. Blume and others studied the question of beta stability in-depth.

Levy calculated betas for the both individual securities and portfolios. His study results have

provided the following conclusions.

1. The betas of individuals stocks are unstable; hence the past betas for the individual securities

are not good estimators of future risk.

2. The betas of portfolios of ten or more randomly selected stocks are reasonably stable, hence

the past portfolio betas are good estimators of future portfolio volatility. This is because of

the errors in the estimates of individual securities betas tend to offset one another in a

portfolio.

Various researchers have attempted to find out the validity of the model by calculating

beta and realized rate of return. They attempted to test (1) whether the intercept is equal to Rf i.e. risk

free rate of interest or the interest for treasury bills (2) whether the line is linear and pass through the

beta = 1 being the required rate of return of the market. In general, the studies have showed the

following results:

1. The studies generally showed a significant positive relationship between the expected return

and the systematic risk. But the slope of the relationship is usually less than that of predicted

by the CAPM.

8/7/2019 bal reddy

38/75



2. The risk and return relationship appears to be linear. Empirical studies give no evidence of

significant curvature in the risk/return relationship.

3. The attempt of the researchers to access the relative importance of the market and company

risk has yielded results. The CAPM theory implies that unsystematic risk is not relevant, but

unsystematic and systematic risks are positively related to security returns. Higher returns are

needed to compensate both the risks. Most of the observed relationship reflects statistical

problems rather than the true nature of capital market.

4. According to Richard Roll, the ambiguity of the market portfolio leaves the CAPM

untestable. The practice of using indices, as proxies are loaded with problems. Different

indices yield different betas for the same security.5. If the CAPM were completely valid, it should apply to all financial assets including bonds.

But, when bonds are introduced into the analysis, they do not all on the security market line.

Present Validity of CAPM

The CAPM is greatly appealing at an intellectual level, logical and rational. The basic

assumptions on which the model is built raise, some doubts in the minds of the investors. Yet,

investment analysis has been more creative in adapting CAPM for their uses.

1. The CAPM focuses on the market risk, makes the investors to think about the risky ness of

the assets in general. CAPM provides basic concepts, which is truly fundamental value.

2. The CAPM has been useful in the selection of securities and portfolios. Securities with

higher returns are considered to be undervalued and attractive for buy. The below normal

expected return yielding securities are considered to be overvalued and suitable for sale.

3. In the CAPM, it has been assumed that investors consider only the market risk. Given the

estimate of the risk free rate, the beta of the firm, stock and the required market rate of return,

one can find out the expected returns for a firms security. This expected return could be used

as an estimate of the cost of retained earnings.

8/7/2019 bal reddy

39/75



4. Even though CAPM has been regarded as a useful tool to financial analysis, it has it won

critics too. They point out, when the model is ex-ante, the inputs also should be ex-ante, i.e.

based on the expectations of the future. Empirical tests and analysis have used ex-post i.e.

past data only.

5. The historical data regarding the market return, risk free rate of return and betas vary

differently for different periods. The various methods used to estimate these inputs also affect

the beta value. Since the inputs cannot be estimated precisely, the expected return found out

through the CAPM model is also subjected to criticism.

ARBITRAGE PRICING THEORY:

Arbitrage Pricing Theory is one of the tools used by the investors and portfolio managers.

The Capital Asset Pricing Theory explains the returns of the securities on the basis of their

respective betas. According to the previous models, the investor chooses the investment on the basis

of expected return and variance. The alternative model developed in Asset pricing by Stephen Ross

is known as Arbitrage Pricing Theory. The APT explains the nature of equilibrium in the asset

pricing in a less complicated manner with fewer assumptions compared to CAPM.

Arbitrage is a process of earning profit by taking advantage of differential pricing for the

same asset. The process generates risk less profit. In the security market, it is of selling security at a

high price and the simultaneous purchase of the same security at a lower price. Since the profit

earned through arbitrage is risk less, the investors have the incentive to undertake this whenever an

opportunity arises. In general, some investors indulge more in the type of activities than others,

however, the buying and selling activities of the arbitrageur reduces and eliminates the profit margin,

bringing the market price to the equilibrium level.

The Assumptions:

1. The Investors have homogenous expectations.

8/7/2019 bal reddy

40/75



2. The investors are risk averse and utility maxi misers.

3. Perfect competition prevails in the market and there is no transaction cost.

The APT theory does not assume (1) single period investment horizon, (2) no taxes (3) investors can

borrow and lend at risk free rate of interest and (4) the selection of the portfolio is based on the mean

and variance analysis. These assumptions are present in CAPM theory.

Arbitrage Portfolio

According to the APT theory an investor tries to find out the possibility to increase returns

form his portfolio without increasing the funds in the portfolio. He also likes to keep the risk at thesame level. For example, the investor holds A, B and C securities and he wants to change in

proportion of securities can be denoted by X, XB and XC. The increase in the investment in security

A could be carried out only if he reduces the proportion of investment either in B or C because it has

already stated that the investor tries to earn more income without increasing his financial

commitment. Thus, the changes in different securities will add up to zero. This is the basic

requirement of an Arbitrage portfolio. If X indicates the change in proportion,

XA + XB + XC = 0

The factor sensitivity indicates the responsiveness of a securitys return to a particular factor.

The sensitiveness of securities to any factor is the weighted average of the sensitivities of the

securities, weights being the changes made in the proportion. For example, b A, bB and bC are

sensitivities in an arbitrage portfolio the sensitivities become zero.

bA XA + bB XB +bC XC = 0

Effect on Price:

To buy stock A and B, the investor has to sell stock C. The buying pressure on stock A and B

would lead to increase in their prices. Conversely selling of stock C will result in fall in the price of

the stock C. With the low price there would be rise in the expected return of stock C. For example, if

the stock C price Rs.100 per share has earned 12% return, at Rs.80 per share the return would be

12/80 * 100 = 15%. At the same time, return rates would be declining in stock A and B with the rise

8/7/2019 bal reddy

41/75



in price. This buying and selling activity will continue until all arbitrage possibilities are eliminated.

At this juncture, there exists an approximate linear relationship between expected returns and

sensitivities.

The APT Model:

According to Stephen Ross, returns of the securities are influenced by a number of macro

economic factors. The macro economic factors are growth rate of industrial production, rate of

inflation, spread between long term and short-term interest rates and spread between low grade and

high-grade bonds.

The arbitrage theory is represented by the equation: -

R1 = 0 + 1 bi1 + j bij

R1 = average expected return

1 = sensitivity of return to bi1

bi1 = the beta co-efficient relevant to the particular factor

The equation is derived from the model

R1 = 1 + b11I1 + b12I2. + byIj +ej

The Constants of the APT Equation

The existence of the risk asset yields a risk free rate of return that is a constant. The asset

does not have sensitivity to the factor for example, the industrial production.

If bi = 0

R = 0 + i0

Ri = 0

Ri = I

In other words, 0 is equal to the risk free rate of return. If the single factor portfolios sensitivity is

equal to one i.e., bi = 1 then

Ri = 0 = 01

This can be written as

8/7/2019 bal reddy

42/75



Ri = 0 + I

Ri- 0 = I

Thus, i is the expected excess return over the risk free rate of return for a portfolio with

unit sensitivity to the factor. The excess return is known as Risk premium.

Factors affecting the Return:

The specification of the factors is carried out by much financial analysis, Chen, Roll and

Ross have taken four macro economic variables and tested them. According to them the factor are

inflation, the term structure of interest rates, risk premium and industrial production. Inflation affects

the discount rate or the required rate of return and the size of the future cash flows. The short-term

inflation is measured by monthly percentage changes in the consumer price index. The interest rates

on long-term bonds and short-term bonds differ. This difference affects the value of payments in

future relative to short-term payment. The difference between the return on the high-grade bonds and

low grade (more risky) bonds indicates the markets reaction to risk. The industrial production

represents the business cycle. Changes in the industrial production have an impact on the

expectations and opportunities of the investor. The real value of the cash flow is also affected by it.

Burmeister and McElroy have estimated the sensitivities with some other factors. They aregiven below: -

Default risk

Time premium

Deflation

Change in expected sales

The market returns not due to the first four variables.

The default risk is measured by the difference between the return on long term governmentbonds and the return on long term bonds issued by corporate plus one-half of one percent. Time

premium is measured by the return on long term government bonds minus one month Treasury bill

rate one month ahead. Deflation is measured by expected inflation at the beginning of the month

minus actual inflation during the month. According to them, the first four factors accounted 25% of

the variation in the standard and poor composite Index an all the four co-efficient were significant.

8/7/2019 bal reddy

43/75



Salmon Brothers identified five factors in their fundamental factor model. Inflation is the

only common factor identified by others. The other factors are given below: -

Growth rate in gross national product

Rate of interest

Rate of change in oil prices

Rate of change in defense spending

All the three sets of factors have some common characteristics. They all affect the macro

economic activities. Inflation and interest rate are identified as common factors. Thus, the stock

price is related to aggregate economic activity and the discount rate of future cash flow.

APT and CAPM

The simplest form of APT model is consistent with the simple form of the CAPM model,

when only one factor is taken into consideration, the APT can be stated as:

Ri 0 + bi I

It is similar to the capital market line equation

Ri = Rf i + (Rm Rf)

Which is similar to CAPM model.

APT is more general and less restrictive than CAPM. In APT, the investor has no need to

hold the market portfolio because it does not make use of the market portfolio concept. The

portfolios are constructed on the basis of the factors eliminate arbitrage profits. APT is based on the

law of one price to hold for all possible portfolio combinations.

The APT model takes in to account of the impact of numerous factors on the security. The

macro economic factors are taken into consideration and it is closer to reality then CAPM.

The market portfolio is well defined conceptually. In APT model, factors are not well

specified. Hence, the investor finds it difficult to establish equilibrium relationship. The well-defined

8/7/2019 bal reddy

44/75



market portfolio is a significant advantage of the CAPM leading to the wide usage of the model in

the stock market.

The factors that have impact on one group of securities may not affect another group

securities. There is a lack of constituency in the measurement of the APT model. Further, the

influences of the factors are not independent of each other. It may be difficult

to identify the influence corresponds exactly to each factor. Apart from this, not all variables that

exert influence on a factor are measurable.

9). PORTFOLIO CONSTRUCTION & ANALYSIS

8/7/2019 bal reddy

45/75



Portfolio analysis believes in the maximization of return through a combination of securities.

The modern portfolio theory discusses the relationship between different securities and then draws

inter-relationship of risks between them. It is not necessary to achieve success only by trying to get

all securities of minimum risk. The theory States that by combining a security of low risk with

another security of high risk, success can be achieved by an investor in making a choice of

investment outlets.

AVERAGE RETURNS OF THE COMPANIES

S.No Security Average Return1 INFOSYS 44.24

2 RELIANCE 43.05

3 HERO HONDA 34.54

4 SATYAM 32.40

5 ITC 5.76

AVERAGE RETURN= R = Ri/N

Where R = AVERAGE RETURN

Ri = Return of the security I for the year T

N = Number of years

INFERENCES:

Based on above Average return of securities Infosys is earning highest return

andITC (Indian Tobacco Corporation) is earning lowest return. Other securities are earning

medium range returns such are Reliance, Satyam and Hero Honda.

8/7/2019 bal reddy

46/75



Average Return

44.24 43.05

34.54 32.4

5.76

0

10

20

30

40

50

INFOSYS RELIANCE HEROHONDA

SATYAM ITC

STANDARD DEVIATION OF THE COMPANIES

S.D = 1/n-1 (R-R) 2

T=1

INFERENCES:

Based on above calculations Standard Deviations like this Satyam is highest and ITC

(Indian Tobacco Corporation) is lowest. Where as other securities are having medium Standard

Deviations.

S.No Security Standard Deviation

1 SATYAM 109.93

2 INFOSYS 108.37

3 HERO HONDA 107.53

4 RELIANCE 63.505 ITC 37.43

8/7/2019 bal reddy

47/75



Standard Deviation

109.93 108.37 107.53

63.5

37.43

0

20

40

60

80

100

120

SATYAM INFOSYS HERO

HONDA

RELIANCE ITC

CORRELATION COEFFICIENT BETWEEN THE SECURITIES

Security INFOSYS ITC SATYAM RELIANCE HERO HONDA

INFOSYS 1 -0.3306 0.9297 0.7686 -0.0039

ITC 1 -0.0706 0.2618 -0.4278SATYAM 1 0.8100 0.3490

RELIANCE 1 0.0606

HERO HONDA 1

FORMULA:

CORRELATION COEFFICIENT ( nab) = COV (ab) / a. b

Where COV (ab) = 1/n-1 (RA- RA)(RB-RB)

PORTFOLIO WEIGHTS

8/7/2019 bal reddy

48/75



S.No PORTFOLIO (A/B) CORRELATION WEIGHT of A WEIGHT of B

1 INFOSYS & ITC -0.3306 0.1773 0.8227

2 INFOSYS & SATYAM 0.9297 0.6000 0.4000

3 INFOSYS & RELIANCE 0.7686 -0.2418 1.24184 INFOSYS & HERO HONDA -0.0039 0.4961 0.5039

5 ITC & SATYAM -0.0706 0.8797 0.1203

6 ITC & RELIANCE 0.2618 0.8328 0.1672

7 ITC & HERO HONDA -0.4278 0.8096 0.1904

8 SATYAM & RELIANCE 0.8100 -0.3373 1.3373

9 SATYAM & HERO HONDA 0.3490 0.4830 0.5170

10 RELIANCE & HERO HONDA 0.0606 0.7549 0.2451

FORMULA:

WEIGHT of a (Wa) = b( b-nab a) / ( a2 + b2) (2nab. a. b)

WEIGHT of b (Wb) = 1 - Wa

PORTFOLIO RISK

S.No. COMBINATIONS PORTFOLIO RISK

1 SATYAM & RELIANCE 27.11

2 ITC & HERO HONDA 28.38

3 INFOSYS & ITC 30.43

4 ITC & SATYAM 34.60

5 ITC & RELIANCE 35.46

6 INFOSYS & RELIANCE 48.52

7 RELIANCE & HERO HONDA 56.07

8 INFOSYS & HERO HONDA 76.17

9 SATYAM & HERO HONDA 89.26

10 INFOSYS & SATYAM 107.13

Formula:

p = a2Wa2 + b2Wb2 + 2nab. a. b.WaWb

Where,

a = Standard deviation of Security a b = Standard deviation of Security b

Wa = Weight of Security a

Wb = Weight of Security b

nab = Correlation Coefficient between Security a & b

p = Portfolio Risk

8/7/2019 bal reddy

49/75



PORTFOLIO RISK

0

20

40

60

80

100

120

SATYAM

&RELIA

NCE

ITC&HE

ROHOND

A

INFO

SYS&ITC

ITC&SAT

YAM

ITC&RELI

ANCE

INFO

SYS&RELI

ANCE

RELIANCE&HEROH

OND

A

INFO

SYS&HERO

HO

NDA

SATYAM

&HEROHO

NDA

INFO

SYS&SAT

YAM

INFERENCES:

Based on above table shows that the compaines SATYAM & RELIANCE Consist

(27.11) risk, that mean, minimum when compare to INFOSYS & SATYAM (107.13) asmaximum risk.

PORTFOLIO RETURN

S.No. COMBINATIONS PORTFOLIO RETURN

1 ITC & SATYAM 8.96

2 ITC & HERO HONDA 11.23

3 ITC & RELIANCE 11.99

8/7/2019 bal reddy

50/75



4 INFOSYS & ITC 12.58

5 SATYAM & HERO HONDA 33.50

6 INFOSYS & HERO HONDA 39.357 INFOSYS & SATYAM 39.50

8 RELIANCE & HERO HONDA 40.95

9 INFOSYS & RELIANCE 42.74

10 SATYAM & RELIANCE 46.62

Formula:

Rp = (Ra*Wa) + (Rb*Wb)

Where,Ra = Average Return of Security a

Rb = Average Return of Security b

Wa = Weight of Security a

Wb = Weight of Security b

Rp = Portfolio Return

8/7/2019 bal reddy

51/75



PORTFOLIO RETURN

0

10

20

30

40

50

ITC&SATYAM

ITC&HE

ROHOND

A

ITC&RELIANCE

INFO

SYS&ITC

SATYA

M&HEROHOND

A

INFOS

YS&HEROHOND

A

IN

FOSYS&SATYAM

RELIAN

CE&HER

OHOND

A

INFO

SYS&RELIAN

CE

SA

TYAM

&RELIANC

E

INFERENCES:

The above table shows that the companies SATYAM & RELIANCE consist of

maximum returns (46.66) and ITC & SATYAM have minimum returns (8.66) comparatively.

PORTFOLIO RISK RETURN

S.No. COMBINATIONS PORTFOLIO RISK PORTFOLIO RETURN

1 SATYAM & RELIANCE 27.11 46.62

2 ITC & HERO HONDA 28.38 11.23

3 INFOSYS & ITC 30.43 12.58

4 ITC & SATYAM 34.60 8.96

5 ITC & RELIANCE 35.46 11.99

6 INFOSYS & RELIANCE 48.52 42.74

7 RELIANCE & HERO HONDA 56.07 40.95

8 INFOSYS & HERO HONDA 76.17 39.35

9 SATYAM & HERO HONDA 89.26 33.5010 INFOSYS & SATYAM 107.13 39.50

8/7/2019 bal reddy

52/75



PORTFOLIO RISK - RETURN

0

20

40

60

80

100

120

SATYAM

&RELIA

NCE

ITC&HE

ROHOND

A

INFO

SYS&ITC

ITC&SAT

YAM

ITC&RELI

ANCE

INFO

SYS&RELI

ANCE

RELIANCE&HER

OHOND

A

INFO

SYS&HERO

HOND

A

SATYAM

&HER

OHO

NDA

INFO

SYS&SAT

YAM

PORTFOLIO RISK

PORTFOLIO RETURN

INFERENCES:

The table shows that the SATYAM & RELIANCE companies and giving maximum

returns with minimum risk. When the INFOSYS &SATYAM have maximum risk while giving

minimum return.

(10). PORTFOLIO SELECTION:

8/7/2019 bal reddy

53/75



Portfolio analysis provides the input for next phase in portfolio management, which is

portfolio selection. The proper goal of portfolio construction is to generate a portfolio that provides

the highest returns at a given level of risk. The inputs from portfolio analysis can be used to identify

the set of efficient portfolios. From this the optimal portfolio must be selected for investment. Harry

markowitzis portfolio theory provides both the conceptual framework and analytical tools for

determining the optimal portfolio in a disciplined and objective way.

So, out of the various combinations (related to 5 companies), the optimal portfolio is Satyam

& Reliance, as this portfolio has minimum risk of 27.112% with maximum return of 46.63%. Hence,

we can say that it is better to invest in these portfolios.

PORTFOLIO REVISION :

Economy and financial markets are dynamic, changes take place almost daily. As time

passes securities which were once attractive may lease to be so. New securities with promises of

high return and low risk may emerge. The investor now has to revise his portfolio in the light of the

developments in the market. This leads to purchase of some new securities and sale of some of the

existing securities and their proportion in the portfolio changes as a result of the revision.

The revision has to be scientifically and objectively so as to ensure the optimality of

the revised portfolio, it important as portfolio analysis and selection.

PORTFOLIO EVALUATION

8/7/2019 bal reddy

54/75



The objective of constructing a portfolio and revising it periodically is to earn maximum

returns with minimum risk. Portfolio evaluation is the process, which is concerned with assessing the

performance of the portfolio over a selected period of time in terms of return and risk. This involves

quantitative measurement of actual return realized. Alternative measures of performance evaluation

have been developed by investor and portfolio managers for their use.

It provides a mechanism for identifying weaknesses in the investment process and improving

them. The portfolio management process is an on going process to portfolio construction, continues

with portfolio revision and evaluation. The evaluation provides the necessary feedback for betterdesigning of portfolio the next time around. Superior performance is achieved through continual

refinement of portfolio management skills.

8/7/2019 bal reddy

55/75



CONCLUSIONS & SUGGESTIONS

Before investing in shares you should look at the type of shares, you want to buy

and the way in which you want to deal on the stock

Date post:	08-Apr-2018
Category:	Documents
Upload:	manju-yanamala
View:	222 times
Download:	0 times

bal reddy

Documents