Page 1 of82ABSTRACT This project had been initiated for the purpose of acquainting myself with, right from the basics of the financial terminology used in the stock markets, further up to gaining in depth knowledge of all the issues concerning the management of various risks faced by a stock brokerage company. This work is a detailed study of stock market and stocks. It¶s about the ways in which investors can invest in stock market. The initial phase of the document explains what I have understood about the functioning of stock market. I have tried to explain the entire cash and derivative market in detail with the help of live examples. All these calculations give a better insight to my work. After this I have tried to analyze the risk arising due to fluctuations of the shares in stockmarket. This risk arises due to number of reasons, which I have tried to put across. The focus in this project is on hedging risk in stock market. I have tried to fi nd out various ways to hedge risk, to minimize risk while maximizing returns. The entire work has not been done till date. Application of these ways to hedge risk in stock market is yet to be do ne, it¶s in progress. The first half of the project examines the working of a stock market and the role of the intermediaries i.e. brokers, the set up of the operational networks used by the company, the financial products offered by the company and the coordination between the risk management department and the ot her branches and functional departments of the co mpany. The second part of the project deals with exploring the statutory requirements provided by the various regulatory authorities in India and the compliance with these requirements by the company within the purview of risk management. At the same time I am trying to analyze some top notch companies to make sure that the companies selected for investing money are really worth to invest in a large amount. All this has been done with the help of Annual report Quarterly results and daily news. I have calculated various ratios that combined with some other factors will help me analyze and decide some good companies in which one can invest one¶s funds. The project had been carried out at the Risk Management Cell of Religare Securities Limited, New Delhi.
ABSTRACTThis project had been initiated for the purpose of acquainting myself with, right from the basics
of the financial terminology used in the stock markets, further up to gaining in depth knowledgeof all the issues concerning the management of various risks faced by a stock brokerage
company.
This work is a detailed study of stock market and stocks. It¶s about the ways in which investors
can invest in stock market. The initial phase of the document explains what I have understood
about the functioning of stock market. I have tried to explain the entire cash and derivative
market in detail with the help of live examples. All these calculations give a better insight to my
work. After this I have tried to analyze the risk arising due to fluctuations of the shares in stock
market. This risk arises due to number of reasons, which I have tried to put across. The focus in
this project is on hedging risk in stock market. I have tried to find out various ways to hedgerisk, to minimize risk while maximizing returns. The entire work has not been done till date.
Application of these ways to hedge risk in stock market is yet to be done, it¶s in progress.
The first half of the project examines the working of a stock market and the role of the
intermediaries i.e. brokers, the set up of the operational networks used by the company, the
financial products offered by the company and the coordination between the risk management
department and the other branches and functional departments of the company.
The second part of the project deals with exploring the statutory requirements provided by the
various regulatory authorities in India and the compliance with these requirements by the
company within the purview of risk management.
At the same time I am trying to analyze some top notch companies to make sure that the
companies selected for investing money are really worth to invest in a large amount. All this has
been done with the help of Annual report Quarterly results and daily news. I have calculated
various ratios that combined with some other factors will help me analyze and decide some good
companies in which one can invest one¶s funds.
The project had been carried out at the Risk Management Cell of Religare Securities Limited,
1. INTRODUCTION The time one talks about stock market, another word also clicks and that is risk. People have lost
their millions in this stock market. Stocks are just like gamble for those who don¶t know how to
invest. The market behaves differently to different people. For speculators it can be risky. They
are the speculators, who mostly lose the most. If I talk about wise people these are always
hedgers. Hedgers always keep risk involved in mind and try to minimize it using different
strategies. Though hedging doesn¶t always give good returns but it helps one to take out his
money with sufficient if not unlimited profits. This document tries to hedge that business risk
arising out of fluctuations in stock market. When I started to learn hedging at that time the stock
market was going through its bearish phase, it was a slow moving market, and market trend came
unexpectedly. So it's high time when everybody should hedge. Initially I have tried to show how
people suffer losses and make gains in the absence of hedging and then comes understanding
those strategies that would help one two hedge. For hedging, derivatives are best instruments and
I have tried to show all combinations that can be used for hedging. It also has detailed study of some companies that would help one to compare those companies and decide which is better to
invest in. The future prospects of a company can also seen using this analysis. For this some
ratios like PE ratio, price to sales, price to operating profits will be used, apart from that value at
risk is another factor that helps one in making decisions
For my understanding I referred to a book-NCFM derivatives market. This was that book that
actually helps me understanding the derivative market. For all the data collection
www.moneycontrol.com and NSE¶s site www.nse.india.com proved to be a great help for me.
It helps me track all the historic information about companies. The only limitation of this project
is that in initial phases I have chosen companies that were most actively being traded those days.And I have not been able to keep a track of all the companies listed. There are two reasons for
this
It's was really not possible to analyze 100 companies
The companies I have decided to chose for analysis are some top notch companies though
there are some midcaps too but they are very few..
Derivatives are a huge project to understand. I have tried to cover everything but due to time
constraint I have to limit its study. This may be a major limitation of this project.
The project begins with stock market its scenario and gives explanation why people prefer investing in Indian markets. And then it shifts to its major focus risk .with each step I have
understood it better. The following work is the detailed explanation of my work. But before I
give all the details it's important to know what are stocks.
2. ABOUT INDIA INFOLINE LIMITEDIt's one of the leading firms in financial services in India. Its business can be broadly categorized
under three major headings
Retail spectrumWealth spectrum
Institutional spectrum
I am working for India Infoline Limited which is one of the reknown companies in stock market.
So I would like you to have a look at the profile of the company
About India Infoline Limited
India Infoline Limited (IIFL)IIFL is a leading equity and securities firm in India. The company currently handles sizeable
volumes traded on NSE and in the realm of online trading and investments it currently holds a
reasonable share of the market. The major activities and offerings of the company are:
Equity broking
Commodity broking
Depository Participant Services
Portfolio Management Services
Institutional Brokerage & Research
International advisory
Investment Banking
Corporate Finance
IIFL is a member of the National Stock Exchange of India, Bombay Stock Exchange of India,
Depository Participant with National Securities Depository Limited and Central Depository
Services (I) Limited, and SEBI approved Portfolio Manager.
IIFL has three products for trading in equity
Equity Broking ProductsLIFE TIME ACCOUNT
Designed to provide world class experience and expertise to investors, Life Time Account is the perfect partner for savvy investors for Integrated Offline and Online Trading: Customers can
trade through Trader Terminal (Application & Web Based)
Features and USPs:
Dedicated Relationship Managers for assisting multiple investments needs.
Dedicated Dealers for facilitating trading and post trade needs.
Information on mutual funds and their performance along with forthcoming IPO tracker
F&O Strategy Report: On trading calls in futures and options
Daily and weekly technical reports
SMS service for research advice
Access to all your accounts through your Unique Login ID
Life Time Trading & Demat A/c: Rs. 555Initial Margin Cheque:Rs 10000Brokerage: Rs750 in advance (Refunded in 3 months)Install the ApplicationOnline Funds Transfer: ICICI / HDFC / UTI / BOB/ CITI/YES BANK Offline / Online MixRM / Dealer Based Service ModelPaper based (Cheques / DIS accepted) Negotiable Leverage / Margin Negotiable Brokerage Rates No Auto Squaring off Intra-Day Position
Brokerage chargedIIFL like other brokerage houses also charges some commission from their clients. Instead of
explaining all the details on the very outset I have tried to explain everything from very basic
together with my work, otherwise it would have been very troublesome for me.iam explaining
everything in the flow I have understood things while working with IIFL
Stock IndexA stock index is a number that represents change in value of a set of stocks that constitute the
index. It¶s a relative value because it is expressed relative to the weighted average of the prices
of pre defined equities. The starting value is usually set to be number like 100 or 1000.to define
it in one line I would say it's a barometer of the market behavior.
Significance of the movementsThey reflect the changing expectations of the stock market about the future dividends of
corporate sector. The index goes up if the market thinks that the prospective dividends in the
future will be better than previously thought and vice versa.
Stock MarketA stock market (also known as a stock exchange) has two main functions. The first function is to
provide companies with a way of issuing shares to people who want to invest in the company.
This can be illustrated by an example: Suppose a company has a mining lease over an area with
some rich ore deposits. It wants to exploit these deposits, but it doesn¶t have any equipment. To
buy the equipment it needs money. One way to raise money is through the stock market. The
company issues a prospectus, which is a sort of advertisement informing people about the
prospects of the company and inviting them to invest some money in it. When the company is
µfloated¶ (established) on the stock market, interested investors can become part-owners of the
company by buying µshares¶. If the company operates at a profit, shareholders benefit in two
ways ± through the issuing of dividends in the form of cash or more shares, and through growth
in the value of the shares. On the other hand, if the company does not operate at a profit (e.g., if
the price of the product dips), the shareholders will probably lose money. The second function of the stock market, related to the first, is to provide a venue for the buying and selling of shares.
Stock ExchangeAn exchange is an institution, organization, or association which hosts a market where stocks, bonds, options and futures, and commodities are traded. Buyers and sellers come together totrade during specific hours on business days. Exchanges impose rules and regulations on thefirms and brokers that are involved with them. If a particular company is traded on an exchange,it is referred to as "listed". Companies that are not listed on a stock exchange are sold OTC (shortfor Over-The-Counter). Companies that have shares traded OTC are usually smaller and riskier because they do not meet the requirements to be listed on a stock exchange.
What Is A Share?In finance a share is a unit of account for various financial instruments including stocks, bonds,mutual funds, limited partnerships. In simple Words, a share or stock is a document solely tostocks is so common that it almost replaces the word stock itself. It is issued by a company,which entitles its holder to be one of the owners of the company. A share is issued by a companyor can be purchased from the stock market. By owning a share you can earn a portion in the firmand by selling shares you get capital gain. So, your return is the dividend plus the capital gain.However, you also run a risk of making a capital loss if you have sold the share at a price belowyour buying price.
PR IMARY AND SECONDARY MARK ETSThere are two ways for investors to get shares from the primary and secondary markets. In
primary markets, securities are bought by way of public issue directly from the company. In
Secondary market share are traded between two investors.
Primary MarketMarket for new issues of securities, as distinguished from the Secondary Market, where
previously issued securities are bought and sold. A market is primary if the proceeds of salesgo to the issuer of the securities sold.
Secondary MarketThe market where securities are traded after they are initially offered in the primary market is
known as secondary market. Most trading is done in the secondary market. Generally, most
shares have a face value (i.e. the value as in a balance sheet) of Rs.10 though not always offered
to the public at this price. Companies can offer a share with a face value of Rs.10 to thepublic at a higher price. The difference between the offer price and the face value is called the
premium. As per the SEBI guidelines, new companies can offer shares to the public at a
premium provided:
1. The promoter company has a 3 years consistent record of profitable working.
2. The promoter takes up at least 50 per cent of the shares in the issue.
3. All parties applying to the issue should be offered the same instrument at the same terms,
especially regarding the premium.
4. The prospectus should provide justification for the propose premium.
On the other hand, existing companies can make a premium issue without the above restrictions.
A company¶s aim is to raise money and simultaneously serve the equity capital. As far as
accounting is concerned, premium is credited to reserves and surplus and it does not increase the
equity. Thus the companies seek to make premium issues. In a buoyant stock market when goodshares trade at very high prices, companies realize that it¶s easy to command a high premium.
The biggest difference between them is the length of time you hold onto the assets. An investor
is more interested in the long-term appreciation of his assets, counting on that historical rise in
market equity.
He¶s not generally concerned about short-term fluctuations in prices, because he¶ll ride them out
over the long haul. An investor relies mostly on Fundamental Analysis, which is the analytical
method of predicting long-term prospects of a particular asset. Most investors adopt a ³buy and
hold´ approach to assets, which simply means they buy shares of some company and hold onto
them for a long time. This approach can be dangerous, even devastating, in an extremely volatilemarket such as today¶s BSE or NSE Indexes Show. What most investors need to remember is
this: investing is not about weathering storms with your ³beloved´ company ± it¶s about making
money. Traders, on the other hand, are attempting to profit on just those short-term price
fluctuations. The amount of time an active trader holds onto an asset is very short: in many cases
minutes, or sometimes seconds. If you can catch just two index points on an average day, you
Risks Involved In Stock MarketTo make Money in the Stock Market, you must assume High Risks.
Tips to Lower your Risk:
1. Do not put more than 10% of your money into any one stock Do not own more than 2-3 stocks in any industry Buy your stocks over time, not all at once Buy stocks with consistent and predictable earnings growth Buy stocks with growth rates greater than the total of inflation and interest rates Use stop-loss orders to limit your risk
2. Buy Stocks on the Way Down and Sell on the Way Up.False: People believe that a falling stock is cheap and a rising stock is too expensive. But on the
way down, you have no idea how much further it may fall. If a stock is rising, especially if it has
broken previous highs, there are no unhappy owners who want to dump it. If the stock is fairly
valued, it should continue to rise.
3. You can Hedge Inflation with Stocks.When interest rates rise, people start to pull money out of the market and into bonds, so that
pushes prices down. Plus the cost of business goes up, so corporate earnings go down, along with
the stock prices.
even understanding what the company does.
Fundamental AnalysisFundamental analysis looks at a share¶s market price in light of the company¶s underlying
business proposition and financial situation. It involves making both quantitative and qualitative judgments about a company. Fundamental analysis can be contrasted with 'technical analysis¶,
which seeks to make judgments about the performance of a share based solely on its historic
price behavior and without reference to the underlying business, the sector it's in, or the economy
as a whole.
TER MS COMMONLY USED IN STOCK MARK ETSome day-to-day terms we hear in context to the stock market are discussed henceforth:
ACTIVE SHAR ES
Shares in which there are frequent and day-to-day dealings, as distinguished from partly active
shares in which dealings are not so frequent. Most shares of leading companies would be active,
particularly those which are sensitive to economic and political events and are, therefore, subject
to sudden price movements. Some market analysts would define active shares as those which are
bought and sold at least three times a week . These shares are easy to buy or sell.
BEAR (MANDIWALA)An investor who believes that a stock or the market in general will decline. A bear market is anextended period of falling prices in the overall market.
BULL (TEJIWALA)An investor who thinks the market or a specific security or industry will rise. A bull market is anextended period in which the market consistently rises.
STAGA cautious speculator, who applies for new securities in the anticipation that price will rise by
the time of allotment of shares, is known as stag speculator. This is why; he applies for new
shares with the intention that he will be selling these shares at higher price in future and earn
good profit.
LAME DUCK When a bear finds it difficult to fulfill his commitment, he is called struggling like a lame duck.
BONDSA bond is basically a promise note from the government or a private company. You agree to give
them a set amount of money as a loan and they keep it for a set number of years with a
predetermined amount of interest. This is typically a safe bet and one that is a good investment
for a first time investor because there is little risk of losing your money.
BOOK VALUE
Usually called as Book Value per Share and is calculated by dividing the Net Worth of a
Company (common stock plus retained earnings) by the number of shares outstanding. This is
the accounting value of a share of stock, the value of the company's assets a shareholder would
theoretically receive if a company were liquidated.
BROK ER Every transaction in the stock exchange is carried out through licensed members called brokers.
To trade in shares, you have to approach a broker However, since most stock exchange brokers
deal in very high volumes, they generally do not entertain small investors. These brokers have a
network of sub-brokers who provide them with orders.
The general investors should identify a sub-broker for regular trading in shares and place his
order for purchase and sale through the sub-broker. The sub/broker will transmit the order to his
broker who will then execute it. A stock broker is a person or a firm that trades on its clients
behalf, you tell them what you want to invest in and they will issue the buy or sell order. Some
stock brokers also give out financial advice that you are charged for.
It wasn¶t too long ago and investing was very expensive because you had to go through a full
service broker which would give you advice on what to do and would charge you a hefty fee for
Types of stock broker1. Full Service Broker - A full-service broker can provide a bunch of services such as
investment research advice, tax planning and retirement planning.
2. Discount Broker ± A discount broker let¶s you buy and sell stocks at a low rate but
doesn¶t provide any investment advice.
3. Direct-Access Broker- A direct access broker lets you trade directly with the electronic
communication networks (ECN¶s) so you can trade faster. Active traders such as day
traders tend to use Direct Access Brokers
So as you can tell there a few options for a stock broker and you really need to pick which ones suit you need.
BROK ER-DEALER A Broker-Dealer is a person or company in the business of both buying and selling securities.Also called an Agent when buying securities and a Principal when selling them, and may act aswither but not in the same transaction. Broker-Dealers must register with the Securities andExchange Commission as well as with states in which they do business.
BUSINESS CYCLE
The cycle of economic growth and decline is known as business cycle. There are four stages in
the business cycle: expansion, growth, contraction and recession.
BACKWARDATION Charges paid by the bear speculator for extending settlement date in case of rise in price of
security are known as backwardation.
CAPITAL GAIN / LOSSThe difference between the current market value of an asset and the original cost of the asset,
with cost adjusted for any improvement or depreciation in the asset.
CORPORATION A form of business organization in which the company is divided into shares of stock. Acorporation is ongoing and the owners face only limited liability.
CURR ENT ASSETS Appears on a company's balance sheet, representing cash, accounts receivable, inventory,marketable securities, prepaid expenses and other assets that can be converted to cash within oneyear.
CONTANGO Charges paid by bull speculator for extending settlement date in case of fall in price are knownas contango.
DIVIDENDIt is a profit earned by the company or the mutual fund, which is shared with the shareholders or unit-holders either partially or completely.
A measure of a company's financial leverage, calculated by dividing long term debt byshareholders' equity is called debt to equity ratio. A higher debt/equity ratio generally means thata company has been aggressive in financing its growth with debt, which can result in volatileearnings as a result of the additional interest expense.
DECLARATION DATE The date on which a company's Board of Directors meet to announce the date and amount of thenext dividend payment. Once the payment has been authorized, it is known as a DeclaredDividend, and becomes a legal liability that must be paid.
DEFERR ED INCOME TAXES On the balance sheet, deferred taxes are a liability that result from income already earned andrecognized for accounting purposes but not for tax purposes.
DEPR ECIATION An expense recorded regularly on a company's books to reduce the value of a long-term tangibleasset. Since it is a non-cash expense, it increases free cash flow while decreasing the amount of a
company's reported earnings.
DER IVATIVE A security, like an option or future, whose value is derived from another underlying security.
DEVALUATION A significant fall in the value of a currency, as compared to gold or another country's currency.
DILUTION Dilution is the effect on a company's earnings per share caused by the conversion of convertiblesecurities or the issuance of additional shares of stock. Dilution reduces earnings per share byincreasing the number of shares potentially outstanding.
EQUITY On the balance sheet, the value of the funds contributed by the owners (the stockholders) plus theretained earnings (or losses) is stated as equity. The balance sheet may list Owners' Equity or Shareholders' Equity.
FLOATThe total number of outstanding shares available on the market.
FIXED MATUR ITY PLAN The Fixed Maturity Plan or FMP has a portfolio investing in debt securities for fixed periods of time ranging from 3 months to 1 year, normally. Benefits range from having a quality portfolio,
to greater predictability of returns, to protection from interest rate movements and to tax-freedividends.
GOING PUBLIC The process of selling shares those were formerly privately-held to new investors for the firsttime.
INFLATION Inflation refers to the increase in cost of living over a period of time. It is measured by changesin the Wholesale Price Index for manufacturers and the Consumer Price Index for consumers.For example, a masala dosa, which would cost you Rs.4.50 in 1990, costs you Rs.30.00, today.
INITIAL PUBLIC OFFER ING In short known as an IPO, the first sale of stock by a company to the public. IPO¶s are oftensmaller, newer companies seeking equity capital to expand their businesses.
LIABILITY The legal obligation to pay a debt is called so. Current liabilities are debts payable within twelve
STOCKSStocks are a unique kind of investment because they allow you to take partial ownership in acompany. Because of this, the returns are potentially bigger and they have a history of being awise way to invest your money.
SHAR E In finance a share is a unit of account for various financial instruments including stocks, bonds,mutual funds, limited partnerships. In simple Words, a share or stock is a document solely tostocks is so common that it almost replaces the word stock itself.It is issued by a company, which entitles its holder to be one of the owners of the company. Ashare is issued by a company or can be purchased from the stock market.By owning a share you can earn a portion in the firm and by selling shares you get capital gain.So, your return is the dividend plus the capital gain. However, you also run a risk of making acapital loss if you have sold the share at a price below your buying price.
SHORT-TER M / LONG TER M CAPITAL GAIN / LOSSThe gain/loss occurring on or before one year of capital investment is termed as Short-term
capital gain/loss. If it exceeds one year then it is termed as Long-term capital gain/loss.
SECUR ITY According to the Securities Exchange Act of 1934, this is the definition of a security: "The term'security' means any note, stock, treasury stock, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease,any collateral-trust certificate, pre organization certificate or subscription, transferable share,investment contract, voting-trust certificate, certificate of deposit, for a security, any put, call,straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle,option, or privilege entered into on a national securities exchange relating to foreign currency, or
in general, any instrument commonly known as a 'security'; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribeto or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker's acceptance which has a maturity at the time of issuance of not exceedingnine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewiselimited.
In BSE jobbers are called Taraniwalas. They may work as broker also. In BSE authorizedassistant or agent of the Taraniwalas can purchase and sell securities on behalf of Taraniwalas.These agents are called half commission agents. They usually specialize in one or two securities.
SEBI (Securities and Exchange Board of India)In 1988 the Securities and Exchange Board of India (SEBI) was established by the Government
of India through an executive resolution, and was subsequently upgraded as a fully autonomous
body (a statutory Board) in the year 1992 with the passing of the Securities and Exchange Board
of India Act (SEBI Act) on 30th January 1992. In place of Government Control, statutory and
autonomous regulatory boards with defined responsibilities, to cover both development &
regulation of the market, and independent powers have been set up. Paradoxically this is a
positive outcome of the Securities Scam of 1990-91.
The basic objectives of the Board were identified as:
To protect the interests of investors in securities; To promote the development of Securities Market; To regulate the securities market and For matters connected therewith or incidental thereto.
Since its inception SEBI has been working targeting the securities and is attending to the
fulfillment of its objectives with commendable zeal and dexterity. The improvements in the
securities markets like capitalization requirements, margining, establishment of clearing
corporations etc. reduced the risk of credit and also reduced the market.
SEBI has introduced the comprehensive regulatory measures, prescribed registration norms, the
eligibility criteria, the code of obligations and the code of conduct for different intermediaries
like, bankers to issue, merchant bankers, brokers and sub-brokers, registrars, portfolio managers,
credit rating agencies, underwriters and others. It has framed bye-laws, risk identification and
risk management systems for Clearing houses of stock exchanges, surveillance system etc. which
has made dealing in securities both safe and transparent to the end investor.
Another significant event is the approval of trading in stock indices (like S&P CNX Nifty &
Sensex) in 2000. A market Index is a convenient and effective product because of the following
reasons:
It acts as a barometer for market behavior;
It is used to benchmark portfolio performance; It is used in derivative instruments like index futures and index options; It can be used for passive fund management as in case of Index Funds.
Two broad approaches of
SEBI is to integrate the securities market at the national level, and also to diversify the trading
products, so that there is an increase in number of traders including banks, financial institutions,
insurance companies, mutual funds, and primary dealers etc. to transact through the Exchanges.
In this context the introduction of derivatives trading through Indian Stock Exchanges permitted
by SEBI in 2000 AD is a real landmark.
SEBI appointed the L. C. Gupta Committee in 1998 to recommend the regulatory framework for
derivatives trading and suggest bye-laws for Regulation and Control of Trading and Settlement
of Derivatives Contracts. The Board of SEBI in its meeting held on May 11, 1998 accepted therecommendations of the committee and approved the phased introduction of derivatives trading
in India beginning with Stock Index Futures. The Board also approved the "Suggestive Bye-
laws" as recommended by the Dr LC Gupta Committee for Regulation and Control of Trading
and Settlement of Derivatives Contracts.
SEBI then appointed the J. R. Verma Committee to recommend Risk Containment
Measures (RCM) in the Indian Stock Index Futures Market. The report was submitted in
November 1998.
However the Securities Contracts (Regulation) Act, 1956 (SCRA) required amendment to
include "derivatives" in the definition of securities to enable SEBI to introduce trading in
derivatives. The necessary amendment was then carried out by the Government in 1999. The
Securities Laws (Amendment) Bill, 1999 was introduced. In December 1999 the new framework
was approved.
Derivatives have been accorded the status of `Securities'. The ban imposed on trading in
derivatives in 1969 under a notification issued by the Central
Government was revoked. Thereafter SEBI formulated the necessary regulations/bye-laws and
intimated the Stock Exchanges in 2000. The derivative trading started in India at NSE in 2000and BSE started trading in the year 2001.
NSE (National Stock Exchange)The National Stock Exchange of India Limited (NSE), is a Mumbai-based stock exchange. It
is the large stock exchange in India in terms daily turnover and number of trades, for both
equities and derivative trading. Though a number of other exchanges exist, NSE and the Bombay
Stock Exchange are the two most significant stock exchanges in India, and between them are
responsible for the vast majority of share transactions.
NSE is mutually-owned by a set of leading financial institutions, banks, insurance companiesand other financial intermediaries in India but its ownership and management operate as separate
entities. As of 2006, the NSE VSAT terminals, 2799 in total, cover more than 1500 cities across
India. In October 2007, the equity market capitalization of the companies listed on the NSE was
US$ 1.46 trillion, making it the second largest stock exchange in South Asia. NSE is the third
largest Stock Exchange in the world in terms of the number of trades in equities.[4]It is the second
fastest growing stock exchange in the world with a recorded growth of 16.6%.
Corporates may raise capital in the primary market by way of an initial public offer, rights issue
or private placement. An Initial Public Offer (IPO) is the selling of securities to the public in the
primary market. This Initial Public Offering can be made through the fixed price method, book
building method or a combination of both.
In case the issuer chooses to issue securities through the book building route then as per SEBIguidelines, an issuer company can issue securities in the following manner:100% of the net offer to the public through the book building route.75% of the net offer to the public through the book building process and 25% through the fixed price portion.
Under the 90% scheme, this percentage would be 90 and 10 respectively.
Difference between shares offered through book building and offer of shares throughnormal public issue:
Features Fixed Price process Book Building process
Pricing Price at which the securities are
offered/allotted is known in
advance to the investor.
Price at which securities will be offered/allotted
is not known in advance to the investor. Only an
indicative price range is known.
Demand Demand for the securities offered
is known only after the closure of
the issue
Demand for the securities offered can be known
everyday as the book is built.
Payment Payment if made at the time of subscription wherein refund is
given after allocation.
Payment only after allocation.
Book Building - Glossary
Bid A bid is the demand for a security that can be entered by the syndicate/sub-syndicate members inthe system. The two main components of a bid are the price and the quantity.
BidderThe person who has placed a bid in the Book Building process is called so.
Book R unning Lead ManagerA Lead Merchant Banker who has been appointed by the Issuer Company to work as the Book Running Lead Manager for the company is called so. The name of the Book Runner LeadManager is mentioned in the offer document of the Issuer Company.
The minimum offer price below which bids cannot be entered. The Issuer Company inconsultation with the Book Running Lead Manager fixes the floor price.
Merchant BankerAn entity registered under the Securities and Exchange Board of India (Merchant Bankers)Regulations, 1999.
Syndicate MembersSyndicate Members are the intermediaries registered with the Board and permitted to carry onactivity as underwriters. The Book Running Lead Managers to the issue appoints the SyndicateMembers.
Order Book It is an 'electronic book' that shows the demand for the shares of the company at various prices.
Demat Form Of SharesThere are two forms of shares physical or dematirialised (demat) shares. Though the company is
under obligation to offer the securities in both physical and demat mode, you have the choice toreceive the securities in either mode. If you wish to have securities in demat mode, you need to
indicate the name of the depository and also of the depository participant with whom you have
depository account in your application. It is, however desirable that you hold securities in demat
form as physical securities carry the risk of being fake, forged or stolen.
Just as you have to open an account with a bank if you want to save your money, make cheque
payments etc, Nowadays, you need to open a demat account if you want to buy or sell stocks So
it is just like a bank account where actual money is replaced by shares. You have to approach the
DPs (they are like bank branches), to open your demat account. Let's say your portfolio of
shares looks like this: 150 of Infosys, 50 of Wipro, 200 of HLL and 100 of ACC. All these will
show in your demat account. So you don't have to possess any physical certificates showing that
you own these shares. They are all held electronically in your account. As you buy and sell the
shares, they are adjusted in your account. Just like a bank passbook or statement, the DP will
provide you with periodic statements of holdings and transactions.
Is a demat account a must? Nowadays, practically all trades have to be settled in dematerialized
form. Although the market regulator, the Securities and Exchange Board of India (SEBI), has
allowed trades of up to 500 shares to be settled in physical form, nobody wants physical shares
any more. So a demat account is a must for trading and investing. Most banks are also DP
participants, as are many brokers.
Difference Between A Broker And A DPA broker is separate from a DP. A broker is a member of the stock exchange, who buys and
sells shares on his behalf and on behalf of his clients. A DP will just give you an account to hold
A derivative is a generic term for specific types of investments from which payoffs over time are
derived from the performance of assets (such as commodities, shares or bonds), interest rates,
exchange rates, or indices (such as a stock market index, consumer price index (CPI) or an index
of weather conditions). This performance can determine both the amount and the timing of the
payoffs. The diverse range of potential underlying assets and payoff alternatives leads to a huge
range of derivatives contracts available to be traded in the market. The main types of derivatives
are futures, forwards, options and swaps.
Types Of Derivatives- OTC And Exchange Traded
Broadly speaking there are two distinct groups of derivative contracts, which are distinguished
by the way that they are traded in market:
Over-the-counter (OTC) derivatives are contracts that are traded directly between two parties,
without going through an exchange or other intermediary. Products such as swaps, forward rateagreements, and exotic options are almost always traded in this way. The OTC derivatives
market is huge.
Exchange-traded derivatives are those derivatives products that are traded via Derivatives
exchanges. A derivatives exchange acts as an intermediary to all transactions, and takes Initial
margin from both sides of the trade to act as a guarantee. The world's largest derivatives
exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index
Futures & Options), Eurex (which lists a wide range of European products such as interest rate &
index products), Chicago Mercantile Exchange and the Chicago Board of Trade.
- Common Contract Types
There are three major classes of derivatives:
Futures/Forwards, which are contracts to buy or sell an asset at a specified future date.
Options which are contracts that give the buyer the right (but not the obligation) to buy or sell
an asset at a specified future date.
Swaps, where the two parties agree to exchange cash flows
ValuationMarket Price And Fair Value
Two common measures of value are:
Market price, i.e. the price at which traders are willing to buy or sell the contract
Fair value or the theoretical price, i.e. a rational and unbiased estimate of the contract's
fundamental value
Determining The Market Price
For exchange traded derivatives, market price is usually transparent (often published in real-time by the exchange, based on all the current bids and offers placed on that particular contract at any
one time).
Complications can arise with OTC or floor-traded contracts though, as trading are handled
manually, making it difficult to automatically broadcast prices. In particular with OTC contracts,
there is no central exchange to collate and disseminate prices.
Determining Fair Value
The fair value of a derivatives contract is often complex, partly because of the immense variation
in the contracts, and partly because there are often many different variables to consider.
Fair valuation of derivatives is a central topic of financial mathematics, where "fair" refers to the
absence of arbitrage, meaning that no risk less profits can be made by trading in assets. Crucial
to the valuation of derivatives is also the stochastic of the underlying assets, typically expressed
as a stochastic process.
UsagesInsurance And HedgingOne use of derivatives is as a tool to transfer risk. For example, farmers can sell futures contracts
on a crop to a speculator before the harvest. The farmer offloads (or hedges) the risk that the
price will rise or fall, and the speculator accepts the risk with the possibility of a large reward.
The farmer knows for certain the revenue he will get for the crop that he will grow; the
speculator will make a profit if the price rises, but also risks making a loss if the price falls.
It is not unknown for farmers to walk away smiling, when they have lost out in the derivatives
market, as the result of a hedge. In this case, they have profited from the real market from the
sale of their crops. Contrary to popular belief, financial markets are not always a zero-sum game.
This is an example of a situation where both parties in a financial markets transaction benefit.
Another example is the company General Electric. This company uses derivatives to "match
funding" (GE web cast on derivatives) to mitigate interest rate and currency risk, and to lock in
material costs. The program is strictly for forecasted and highly anticipated needs, and not a
means to generate non-operating revenues. 90% of all derivatives revenue produced by
derivatives sellers is for this kind of cost, cash, accounts receivable and accounts payable
4. FINANCIAL SECTOR IN INDIAThe financial sector is in a process of rapid transformation. Reforms are continuing as part of the
overall structural reforms aimed at improving the productivity and efficiency of the economy.
The role of an integrated financial infrastructure is to stimulate and sustain economic growth.
The US$ 28 billion Indian financial sector has grown at around 15 per cent and has displayed
stability for the last several years, even when other markets in the Asian region were facing a
crisis. This stability was ensured through the resilience that has been built into the system over
time. The financial sector has kept pace with the growing needs of corporate and other
borrowers. Banks, capital market participants and insurers have developed a wide range of
products and services to suit varied customer requirements. The Reserve Bank of India (RBI) has
successfully introduced a regime where interest rates are more in line with market forces.
Financial institutions have combated the reduction in interest rates and pressure on their margins by constantly innovating and targeting attractive consumer segments. Banks and trade financiers
have also played an important role in promoting foreign trade of the country.
BanksThe Indian banking system has a large geographic and functional coverage. Presently the total
asset size of the Indian banking sector is US$ 270 billion while the total deposits amount to US$
220 billion with a branch network exceeding 66,000 branches across the country. Revenues of
the banking sector have grown at 6 per cent CAGR over the past few years to reach a size of US$
15 billion. While commercial banks cater to short and medium term financing requirements,
national level and state level financial institutions meet longer-term requirements. Thisdistinction is getting blurred with commercial banks extending project finance. The total
disbursements of the financial institutions in 2001 were US$ 14 billion.
Banking today has transformed into a technology intensive and customer friendly model with a
focus on convenience. The sector is set to witness the emergence of financial supermarkets in the
form of universal banks providing a suite of services from retail to corporate banking and
industrial lending to investment banking. While corporate banking is clearly the largest segment,
personal financial services is the highest growth segment.
The recent favourable government policies for enhancing limits of foreign investments to 49 per cent among other key initiatives have encouraged such activity. Larger banks will be able to
mobilise sufficient capital to finance asset expansion and fund investments in technology.
Capital MarketThe Indian capital markets have witnessed a transformation over the last decade. India is now
placed among the mature markets of the world. Key progressive initiatives in recent years
The depository and share dematerialisation systems that have enhanced theefficiency of the transaction cycle Replacing the flexible, but often exploited, forward trading mechanism with rollingsettlement, to bring about transparency The infotech-driven National Stock Exchange (NSE) with a national presence (for the
benefit of investors across locations) and other initiatives to enhance the quality of financial disclosures. Corporatisation of stock exchanges. The Securities and Exchange Board of India (SEBI) has effectively been functioning asan independent regulator with statutory powers. Indian capital markets have rewarded Foreign Institutional Investors (FIIs) withattractive valuations and increasing returns. The Mumbai Stock Exchange continues to be the premier exchange in the country withan increase in market capitalisation from US$ 40 billion in 1990-1991 to US$ 203 billionin 1999-2000. The stock exchange has about 6,000 listed companies and an average dailyvolume of about a billion dollars
Many new instruments have been introduced in the markets, including index futures,index options, derivatives and options and futures in select stocks.
InsuranceWith the opening of the market, foreign and private Indian players are keen to convert untapped
market potential into opportunities by providing tailor-made products:
The presence of a host of new players in the sector has resulted in a shift in approachand the launch of innovative products, services and value-added benefits. Foreign majorshave entered the country and announced joint ventures in both life and non-life areas.Major foreign players include New York Life, Aviva, Tokio Marine, Allianz, StandardLife, Lombard General, AIG, AMP and Sun Life among others.
With competition, the erstwhile state sector companies have become aggressive in termsof product offerings, marketing and distribution. The Insurance Regulatory and Development Authority (IRDA) has played a proactiverole as a regulator and a facilitator in the sector¶s development. The size of the market presents immense opportunities to new players with only 20 per cent of the country¶s insurable population currently insured. The state sector Life Insurance Corporation (LIC), the largest life insurer in 2000, soldclose to 20 million new policies with a turnover of US$ 5 billion. The gross premia for the insurance sector was US$ 13 billion for 2001-02.There are four public sector and nine private sector insurance companies operating ingeneral/non-life insurance business with a premium income of over US$ 2.58 billion.
The market¶s potential has been estimated to have a premium income of US$ 80 billionwith a potential size of over 300 million people. The General Insurance Corporation(GIC) (which covers the non-life sector) had a total premium income of US$ 2 billion in2001-02. This has the potential to reach US$ 9 billion in the next five years.
Venture CapitalTechnology and knowledge have been and continue to drive the global economy. Given the
inherent strength by way of its human capital, technical skills, cost competitive workforce,
research and entrepreneurship, India is positioned for rapid economic growth in a sustainable
manner. To realise the potential, there is a need for risk finance and venture capital (VC) funding
to leverage innovation, promote technology and harness knowledge based ideas.
The Indian venture capital sector has been active despite facing a challenging external
environment in 2001 and a competitive market scenario. There were 34 VCFs and 2 Foreign VCFs registered with SEBI in March 2002. According to a survey conducted by Thomson Financial and Prime Database, Indiaranked as the third most active venture capital market in Asia Pacific (excluding Japan).It recorded 115 deals in 2001 with average investment per deal amounting to US$ 7.9million. 57 VCFs invested US$ 908 million in 101 Indian companies during 2001. Disbursements for 2002 are expected to be US$ 2 billion and are estimated to reachUS$ 10 billion by 2007. There is an increased interest in India: 70 VC funds operate in India with the total assetsunder management worth about US$ 6 billion. The amount has grown nearly twenty fold in the past five years. Most VCs believe that
2002-03 will be driven by a relatively stable economy and new initiatives that will boostthe e-commerce sector, particularly on-line trading and e-banking sectors.
Opportunities There is no tax on distributed income of VCFs. The income distributed by the funds isonly taxed at the hands of the investors. Increase in incomes with potentially high penetration of both banking and insurance products to increase the market size, will be the powerful drivers of growth in the sector. Continued de-regulation and increased competition is expected to result in the Indianfinancial services reach US$ 51 billion by 2007
5. UNDERSTANDING STOCK MARK ET R ISK As a long term investor, one needs to understand several different kinds of risk:
Market Risk Market risk is the risk associated with fluctuations in stock prices. This is the first risk many
people think of when they think of the stock market. Many factors can cause stock prices to
fluctuate. Examples include actual or anticipated developments within a particular company or
industry; changes in the outlook for the economy as a whole; or shifts in investor attitude toward
the stock market in general. Downward and upward trends in stock prices can occur over short or
extended periods, and can have a very significant affect on the value of an investment.
There are two ways to reduce market risk. One is to diversify your investments among different
kinds of assets: divide your money among fixed-income and growth investments, for example.
The second way is to steadily invest on a regular basis and ignore market ups and downs and
focus on long-term results.
Inflation Risk Inflation, defined as a persistent increase in prices, is a serious risk for any long-term investor.
Historically, inflation in the United States has averaged 3.1%, offsetting most of the returns from
investment in cash reserves and bonds, but less than half of that of stocks. Because stocks' real
returns are often generally higher than inflation, stocks offer a way to help protect your money
against inflation risk. If your principal doesn't grow, you can't possibly stay ahead of inflation. A
good way to reduce inflation risk is to invest in growth assets like stocks.
Business Risk Business risk is the risk of losing your money in an investment that seemed like a winner but
wasn't. It is the specific risk associated with the underlying business of the issuer of a particular
stock, bond, or other investment. If the company's product suddenly loses value, the value of
your investment declines. You can reduce business risk by diversifying your investments.
Currency Risk Currency risk is the risk associated with the price fluctuations in the dollar value of international
stocks due to changing currency exchange rates. To an American, the value of any stock heldinternationally is not what the stock is worth in its domestic market, but what the stock is worth
in terms of dollars.
BetaThis refers to how a stock moves vs. the market. If a stock moves more than the market, it has a
high beta. If it moves little vs. the market it has a low beta. Technology generally has a high beta
while Utilities have low betas. A portfolio of high beta stocks in a down market can create
extreme downward movements, while up-markets can cause tremendous performance. If a
market is demonstrating extreme risk, it is wise to raise cash, lower the beta of your portfolio,
and even consider some hedging of exposure.
All above are different types of risks that influence the stock market. After looking at all the risksone thing is very clear that controlling price fluctuations is not in our hand. Our major job is to
maximize our returns keeping all the above risks in mind. this is done by hedging funds in
market in way that maximizes the returns. Creating portfolios wisely is another method of risk
hedging, apart from that there are other methods with the help of which risk is minimized.
HedgingThe word hedge literally means to surround in a way as to provide complete protection.
A hedge is an investment that is taken out specifically to reduce or cancel out the risk in another
investment. Defining it in simple words µHedging¶ is a strategy designed to minimize exposureto an unwanted risk, while still allowing the business to profit from an investment activity. But
one thing has to be kept in mind hedging does not always make money. The best that can be
achieved using hedging is the removal of unwanted exposure. The hedged position will make
less profit than the no hedged position, half the time. One should not enter into the hedging
strategy hoping to make excess profits for sure.
Derivatives are an excellent tool to hedge risk.
Hedging using futures and options
Playing with f uturesLong security, sell f uturesI would explain it with the help of an example.iam discussing here the case of investor who holds
the share of a company and gets uncomfortable with the market movements in the short run. In
the absence of stock futures he would either suffer the discomfort of a price fall or sell the
security in anticipation of market. With security future he can minimize his price risk. All he
needs to do is to enter an offsetting stock future position, in this case take on a short future
position. As the price of stock will fall the value of his holdings would go down and value of his
future contract will rise. Both will move in opposite direction. This way he would not only be
able to minimize his loss but also make profits
Short security, buy f uturesThis is exactly opposite case. This will be explained later with the help of real examples.
Index portfolios can be very effective to get rid of market risk of a portfolio every portfolio
contains a hidden risk or market exposure. This is true for all portfolios. Most of the portfolio
risk is accounted by index fluctuations hence a position LONG PORTFOLIO +SHORT NIFTY
is one tenth risky as LONG portfolio position.
Playing with optionsBuy puts when market is expected to fall
as an owner of stocks or equity portfolio, sometimes one may have a view that market will fall innear future. To protect the value of stock from falling below a particular level, one has to buy
right number of puts at right strike price. If one is concerned only about the value of particular
stock one has to buy puts of only that particular stock, if it's about the entire portfolio it's better
to buy index puts. When the value of the stock falls it will lose value and the put options will
gain value. This is how hedging can be done through puts
Sell puts when market is risingThis is also done the way hedging has been done above.
Apart from derivatives there are some other ways using which hedging is done generally. Some
people feel that derivatives are risky. I won¶t say this is true for options, but when it comes to
futures I believe to an extent their statement is true.
Apart from derivatives there are two other ways to hedge risk and these are listed as under:
Short sell when you have holdings of a particular stock-say you have holdings of a particular
share, the market value of the share is expected to fall, and it¶s time to short sell your stock. It¶s
better to explain it with the help of an example. Say I have a stock worth rs.345 and its value fall
to340, at this price I short sell some amount of shares, if the value of a stock falls further buys it.
And then the entire stock can be sold, making profits, this would give an average buying price.
And in other case also it will release average value.
Average buying is another way ±if you decide to buy 100 shares of a company it's better to buy
them in shifts. By this I want to say that twenty at one time,20 next time and so on.
Hedging is not the only way to minimize risk. Its always said that prevention is better than cure,
by this I mean it's better to first look at the stock see it's market value and then buy it, one basic
thing is that one should invest wisely. Keeping that in mind I decided to do fundamental analysis
that begins with economy then comes industry, after that company and last one is ratio analysis.
This work is still in progress.
Economic analysisThis is in short and one will find all the details in final project.
Monetary policies, fiscal policies, inflation, business cycles all effect the company growth.
During periods of prosperity, there are more people employed which means the nation¶s income
is growing. With increased income there would be increased spending, which translates into
PortfolioA portfolio is an appropriate mix of or collection of investments held by an institution or a
private individual. In building up an investment portfolio a financial institution will typically
conduct its own investment analysis, whilst a private individual may make use of the services of
a financial advisor or a financial institution which offers portfolio management services. Holding
a portfolio is part of an investment and risk-limiting strategy called diversification. By owning
several assets, certain types of risk (in particular specific risk) can be reduced. The assets in the
portfolio could include stocks, bonds, options, warrants, gold certificates, real estate, futures
contracts, production facilities, or any other item that is expected to retain its value.
Portfolio ManagementPortfolio management involves deciding what assets to include in the portfolio, given the goals
of the portfolio owner and changing economic conditions. Selection involves deciding whatassets to purchase, how many to purchase, when to purchase them, and what assets to divest.
These decisions always involve some sort of performance measurement, most typically expected
return on the portfolio, and the risk associated with this return (i.e. the standard deviation of the
return). Typically the expected return from portfolios of different asset bundles are compared.
The unique goals and circumstances of the investor must also be considered. Some investors are
more risk averse than others.
Asset allocationThe different asset classes and the exercise of allocating funds among these assets (and among
individual securities within each asset class) is what investment management firms are paid for.
Asset classes exhibit different market dynamics, and different interaction effects; thus, the
allocation of monies among asset classes will have a significant effect on the performance of the
fund. Some research suggested that allocation among asset classes have more predictive power
than the choice of individual holdings in determining portfolio return. Arguably, the skill of a
successful investment manager resides in constructing the asset allocation, and separately the
individual holdings, so as to outperform certain benchmarks (e.g., the peer group of competing
funds, bond and stock indices).
Long-term returnsIt is important to look at the evidence on the long-term returns to different assets, and to holding
period returns (the returns that accrue on average over different lengths of investment). For
example, over very long holding periods (eg. 10+ years) in most countries, equities have
generated higher returns than bonds, and bonds have generated higher returns than cash.
According to financial theory, this is because equities are riskier (more volatile) than bonds
DiversificationDiversification in finance is a risk management technique, related to hedging, that mixes a wide
variety of investments within a portfolio. Because the fluctuations of a single security have less
impact on a diverse portfolio, diversification minimizes the risk from any one investment.
A simple example of diversification is this one. On a particular island the entire economyconsists of two companies: one that sells umbrellas and another that sells sunscreen. If a portfolio
is completely invested in the company that sells umbrellas, it will have strong performance
during the rainy season, but poor performance when the weather is sunny. The reverse occurs if
the portfolio is only invested in the sunscreen company, the alternative investment: the portfolio
will be high performance when the sun is out, but will tank when clouds roll in. To minimize the
weather-dependent risk in the example portfolio, the investment should be split between the
companies. With this diversified portfolio, returns are decent no matter the weather, rather than
alternating between excellent and terrible.
There are three primary strategies used in improving diversification:
1. Spread the portfolio among multiple investment vehicles, such as stocks, mutual funds, bonds,
and cash.
2. Vary the risk in the securities. A portfolio can also be diversified into different mutual fund
investment strategies, including growth funds, balanced funds, index funds, small cap, and large
cap funds. When a portfolio includes investments with varied risk levels, large losses in one area
are offset by other areas.
3. Vary your securities by industry, or even by geography. This will minimize the impact of
industry- or location-specific risks. The example portfolio above was diversified by investing in
both umbrellas and sunscreen. Another practical application of this kind of diversification is
mixing investments between domestic and international funds. By choosing funds in many
countries, events within any one country's economy have less effect on the overall portfolio.
7. R ISK ALLOCATION AND THE RATIOSIn a sense, ³risk allocation´ ± also referred to as ³risk budgeting´ ± is another step in the
evolution of investment management practices.
In the mi-1900¶s, the dominant investment style was ³asset selection´ (also known as ³pickingwinners´). Investors tried to select stocks and other assets with high expected returns and low
risk (ie, low variance or returns).
Modern portfolio theory revolutionized investing by making clear the importance of correlations
of asset returns, in addition to expected returns and the variance of returns. By the 1970¶s, the
dominant investment style had become ³asset allocations´. Investors tried to hold ³efficient
portfolios´ ± portfolios of assets with low correlations ± so that all but the market risk would be
diversified away. This gave rise to the common practice of managing to some benchmark
portfolio.
With the rise in benchmarking, the task of an active portfolio manager was to ³beat the index´.
Clearly, one way to beat the index was to take on more risk than in the index ± a tactic not
necessarily in line with the wishes of the investor.
Risk allocation emerged in the late 1990¶s, in response to concerns about the level or risk being
accepted in the portfolio and as a consequence of the development of risk measurement and
management tools. While the phrase ³risk allocation´ seems to mean different things to different
people, it can be defined broadly as an investment style where allocations are based on the
asset¶s risk contribution to the portfolio, as well as on the asset¶s expected return. In this regards,
it is a direct application of the original Markowitz (1952) perspective on portfolio construction,
where both risk and return expectations play explicit roles in the asset allocation process. Under
risk allocation, the task of the active portfolio managers is to ³beat the index´ without taking
more risk than the index.
Asset vs. Risk AllocationAs described by Rawls & Izakson (1999), differences between asset allocation and risk
allocation can be highlighted by examining the investment portfolio management process. In
the initial stages of the process, the differences between an asset allocator and a risk budgeter are
relatively limited. They are primarily related to different emphasis on, and measurement of, the
risk characteristics of the asset classes:
Defining the ³feasible set´ ± the set of asset classes that could be included in the portfolio.Both the asset allocator and the risk budgeter would determine the relevant characteristics ±
expected returns, expected volatilities and expected covariances ± for each asset class. While
both the asset allocator and the risk budgeter are interested in reliable estimates of expected
returns, the risk budgeter will have a stronger incentive to obtain careful estimates of the
volatilities and covariances of each of the asset classes.
For example, the two might differ with respect to the horizon over which the volatilities and
correlations are gauged. Since asset allocators often use a relatively long history to form a
baseline for expected return, they are likely to use this long history to form baseline estimates of
the volatility and covariance for each asset class. However, because volatility and covariance
tend to have strong autoregressive conditional heteroscedasticity characteristics, the risk
budgeter will put more weight on the recent behavior of the asset classes in estimating volatilities
and covariance.
Choosing initial asset allocations The initial asset allocation should be some optimization between risk and expected risk. Asset
allocators often centered the allocation around generally accepted allocations for a portfolio with
the desired level of risk (say, 40% debt and 60% equity). In contrast, the risk budgeter might use
something like a value-at-risk assessment to determine the risk tolerance.
Differences in Asset Allocation and Risk Allocation
Asset allocation Risk allocationGoal An allocation of assets
across a set of differentclasses such that the portfolio targets achieve adesired return on assets.The constraint is that theallocations weights sum toone
An allocation of risk acrossassets such that the portfolioachieves a desired return onthe risk taken. Theconstraint is that the total portfolio risk is limited
Inputs to decisionsMost emphasis on expectedreturn
More emphasis on volatilityand correlation
Monitoring the allocations Monitors actual dollar increase/decrease in portfolio value. Typicallyignores forecast errors onvolatility and correlation
Monitors forecast errors involatility and correlation inaddition to gains and losses
Rebalancing Rebalances when dollar values of positions deviatefrom target
Rebalances when total portfolio risk deviates fromtarget
Focus Focuses only on thecomposition of the parts of the portfolio
Focuses on overall portfolio, as total risk iswhat is important
Suppose the risk allocator determines that, at a 95% confidence level, the portfolio would lose no
more than 10% over a month horizon. The risk allocator them implicitly defines a 6% monthly
standard deviation as a risk tolerance for the portfolio.
Given the determination of the risk tolerance, the initial asset allocations are made to maximize
the return for this level of portfolio risk. Thus risk allocation makes it explicit that the initialasset allocation derives from a carefully defined risk tolerance of the investor. (While this may
be the case in asset allocation, it is generally implicit rather than explicit.)
More noticeable differences between the asset allocator and risk budgeter come in the
monitoring and rebalancing of the portfolio.
Monitoring. Over time, the asset allocator monitors risk exposures (increases and decreases in
the values of the positions). The risk budgeter worries not only about changes in risk exposures
but also about changes in the volatilities and correlations. The risk allocator recognizes that
volatilities and correlations often move faster than portfolio values, and can result in significantchanges in the riskiness of the portfolio, even if there are no significant changes in the
allocations.
Rebalancing. The asset allocator rebalances positions when return fluctuations cause them to
deviate too far from the original levels. As a result, with reasonably stable asset allocations,
fluctuations in volatilities and correlations of the asset classes will mean the riskiness (volatility)
of the portfolio fluctuates over time. Thus, the actual amount of risk that the investor is taking,
and the maximum loss they might incur, is fluctuation with market conditions. This exposes the
investor to more or less risk than was originally desired. The risk budgeter, on the other hand,
regards the allocations as the portfolio¶s exposures to risk and return, and will thereforerebalance in response to changes in the short-term conditional volatility and correlations of the
assets. The risk budgeter alters allocations to keep the overall portfolio risk at the level defined
as tolerable for the investor.
Suppose an initial allocation of 60% equities and 40% bonds produced the desired portfolio
standard deviation of 6% a month, as discussed above. Then suppose that market conditions
changed ± the conditional volatility of stocks increases and the correlation between stocks and
bonds increases slightly. Using these as new forecasts, the risk budgeter discovers that the
current asset allocation leads to an expected monthly standard deviation of the portfolio of 8%.
This results in an increase in the VAR to the investor for a one-in-20-month loss of 13.2% rather than the 10% they desired. Consequently, the risk budgeter changes the asset allocations to keep
the risk of the portfolio at an expected standard deviation of 6% a month. This would probably
involve shifting the allocation towards bonds, or possibly shifting some of the assets into cash.
Thus, an important difference between asset allocation and risk allocation is the direction of
causality: under risk allocation, maintaining the desired risk level drives the asset allocation, not
the other way around. The focus of the risk allocator is on earning an expected return on a
targeted level of risk for the portfolio, while the asset allocator focuses on earnings and expected
return on the assets.
Advantages of Risk AllocationA risk allocation strategy can free the manager to look for alternative investments that might
increase the expected return of the portfolio. Because the constraint is simply that the total risk of the portfolio must stay at or below a targeted level, increased attention is paid to low
correlation investments (eg, market-neutral strategies or currency and commodity plays). While
these investments may have reasonably high return variability, this risk is typically not correlated
with the equity market risk of a typical portfolio. Because of the low correlation, small
allocations to such investments can actually reduce the total risk of the portfolio through
diversification. Because risk budgeters focus on the risk of the total portfolio, rather than the
risk of each asset class, the risk budgeter may see low correlation investments in a different light
than another investor. Such investments are also attractive to the extent that they provide ³risk
room´ for the risk budgeter to search out additional small investments in a high-risk/high-return
class.
Measures used to evaluate risk-adjusted performance.
Sharpe ratioThe most widely used of the risk-adjusted performance measure, this ratio ± created by Nobellaureate and winner of Risk¶s Lifetime Achievement Award 2001, William Sharpe (1996) ±
provides a measure of the excess return earned relative to the risk accepted ± ³reward per unit of risk´. It is defined as the portfolio return (Rp) less the risk-free return (Rf) divided by the
standard deviation of the portfolio returns ( p):Rp± Rf
p
It is an ideal measure for looking at the risks of entire portfolios, but is less suited for looking atindividual asset classes within a portfolio, as it does not take into account the correlations.
Information ratioAlso suggested by Sharpe (1981), this measure of risk-adjusted performance compares the performance of a portfolio to that of its benchmark. It is defined as the excess return over some
selected benchmark (Rp ± RB) divided by the standard deviation of those excess returns ((P-B)):
Rp ± RB(P-B)
Thus it measures the extra return one earns over the benchmark relative to the extra risk taken. Itis analogous to a Sharpe ratio where the baseline is a predefined benchmark portfolio rather thanthe risk-free rate. While it forces managers to outperform a benchmark without taking muchrisk, it suffers in that it cannot highlight attractive opportunities to trade-off risk and return on thedownside.
M-squaredIn contrast to the unit less Sharpe and information ratios, the measure proposed by LeahModigliani and Nobel laureate Franco Modigliani (1997) expresses risk-adjusted performance asa return. M2 is the rate of return the portfolio (P) would have earned had it been leveraged or deleveraged to create a portfolio (P¶), the risk of which would match that of the appropriate
benchmark (B). Using the style of the preceding measures, the return per unit of risk beingconsidered in M2 is:
Rp¶ ± Rf B
Or, as shown by Coleman & Siegel (2000), M2 could be written as:
8. FINANCIAL RATIO ANALYSISIt is difficult to infer organizational performance from one or two simple numbers. Nevertheless,
in practice a number of different ratios are often calculated in strategic planning endeavors and,
taken as a whole and with some caution, these ratios do provide some information about the
relative performance of an organization. In particular, a careful analysis of a combination of
these ratios may help you to distinguish between firms that will eventually fail and those that will
continue to survive. Evidence suggests that, as early as five years before a firm fails, one may be
able to detect trouble from the value of these financial ratios.
In this note, the basic financial ratios are reviewed, and some of the caveats associated with using
them are highlighted. The ratios tend to be most meaningful when they are used to compare
organizations within the same broad industry, or when they are used to make inferences about
changes in a particular organization's structure over time.
Liquidity RatiosIn order to survive, firms must be able to meet their short-term obligations²pay their creditors
and repay their short-term debts. Thus, the liquidity of the firm is one measure of a firm's
financial health. Two measures of liquidity are in common:
Current ratio = current assets / current liabilities
Quick ratio = (cash + marketable securities + net receivables) / current liabilities
The main difference between the current ratio and the quick ratio is that the latter does not
include inventories, while the former does.
Which ratio is a better measure of a firm's short-term position? In some ways, the quick ratio is
a more conservative standard. If the quick ratio is greater than one, there would seem to be no
danger that the firm would not be able to meet its current obligations. If the quick ratio is less
than one, but the current ratio is considerably above one, the status of the firm is more complex.
In this case, the valuation of inventories and the inventory turnover are obviously critical.
A number of problems with inventory valuation can contaminate the current ratio. An obvious
accounting problem occurs because organizations value inventories using either of two methods,
last in, first out (LIFO) or first in, first out (FIFO). Under the LIFO method, inventories are
valued at their old costs. If the organization has a substantial quantity of inventory, some of itmay be carried at relatively low cost, assuming some inflation in overall prices. On the other
hand, if there has been technical progress in a market and prices have been falling, the LIFO
method will lead to an overvalued inventory. Under the FIFO method of inventory valuation,
inventories are valued at close to their current replacement cost. Clearly, if we have firms that
differ in their accounting methods, and hold substantial inventories, comparisons of current ratios
will not be very helpful in measuring their relative strength, unless accounting differences are
adjusted for in the computations.
A second problem with including inventories in the current ratio derives from the difference
between the inventory's accounting value, however calculated, and its economic value. A simple
example is a firm subject to business-cycle fluctuations. For a firm of this sort, inventories willtypically build during a downturn. The posted market price for the inventoried product will often
not fall very much during this period; nevertheless, the firm finds it cannot sell very much of its
inventoried product at the so-called market price. The growing inventory is carried at the posted
price, but there really is no way that the firm could liquidate that inventory in order to meet
current obligations. Thus, including inventories in current assets will tend to understate the
precarious financial position of firms suffering inventory buildup during downturns.
Might we then conclude that the quick ratio is always to be preferred? Probably not. If we
ignore inventories, firms with readily marketable inventories, appropriately valued, will be
undeservedly penalized. Clearly, some judicious further investigation of the marketability of theinventories would be helpful.
Low values for the current or quick ratios suggest that a firm may have difficulty meeting current
obligations. Low values, however, are not always fatal. If an organization has good long-term
prospects, it may be able to enter the capital market and borrow against those prospects to meet
current obligations. The nature of the business itself might also allow it to operate with a current
ratio less than one. For example, in an operation like McDonald's, inventory turns over much
more rapidly than the accounts payable become due. This timing difference can also allow a
firm to operate with a low current ratio. Finally, to the extent that the current and quick ratios
are helpful indexes of a firm's financial health, they act strictly as signals of trouble at extremerates. Some liquidity is useful for an organization, but a very high current ratio might suggest
that the firm is sitting around with a lot of cash because it lacks the managerial acumen to put
those resources to work. Very low liquidity, on the other hand, is also problematic.
LeverageFirms are financed by some combination o£ debt and equity. The right capital structure will
depend on tax policy²high corporate rates favor debt, high personal tax rates favor equity²on
bankruptcy costs, and on overall corporate risk. In particular, if we are concerned about
bankruptcy possibilities, the long-run solvency or leverage of the firm may be important. There
are two commonly used measures of leverage, the debt-to-assets ratio and the debt-equity ratio;
Debt-to-asset ratio = total liabilities / total assets
Debt-equity ratio = long-term debt / shareholder's equity
As with liquidity measures, problems in measurement and interpretation also occur in leverage
measures. The central problem is that assets and equity are typically measured in terms of the
carrying (book) value in the firm's financial statements. This figure, however, often has very
little to do with the market value of the firm, or the value that creditors could receive were the
firm liquidated.
Debt-to-equity ratios vary considerably across industries, in large measure due to other
characteristics of the industry and its environment. A utility, for example, which is a stable business, can comfortably operate with a relatively high debt-equity ratio. A more cyclical
business, like manufacturing of recreational vehicles, typically needs a lower D/E²a reminder
that cross-industry comparisons of these ratios is typically not very helpful.
Often, analysts look at the debt-equity ratio to determine the ability of an organization to
generate new funds from the capital market. An organization with considerable debt is often
thought to have little new-financing capacity. Of course, the overall financing capacity of an
organization probably has as much to do with the quality of the new product the organization
wishes to pursue as with its financial structure. Nevertheless, given the threat of bankruptcy and
the attendant costs, a very high debt-equity ratio may make future financing difficult. It has beenargued, for example, that railroads in the 1970s found it hard to find funds for new investments
in piggybacking, a large technical improvement in railroading, because the threat of bankruptcy
from prior poor investments was so high.
Rates Of ReturnThere are two measures of profitability common in the financial community, return on assets
(ROA) and return on equity (ROE).
ROA = net income / total average assets
ROE = net income / total stockholders equity
Assets and equity, as used in these two common indexes, are both measured in terms of book
value. Thus, if assets were acquired some time ago at a low price, the current performance of the
organization may be overstated by the use of historically valued denominators. As a result, the
accounting returns for any investment generally do not correlate well with the true economic
internal rate of return for that investment.
Difficulties with using either ROA and ROE as a performance measure can be seen in merger
transactions. Suppose we have an organization that has been earning a net income of $500 on
assets with a book value of $1000, for a hefty ROA of 50 percent. That organization is nowacquired by a second firm, which then moves the new assets onto its books at the acquisition
price, assuming the acquisition is treated using the purchase method of accounting. Of course,
the acquisition price will be considerably above the $1,000 book value of assets, for the potential
acquirer will have to pay handsomely for the privilege of earning $500 on a regular basis.
Suppose the acquirer pays $2,000 for the assets. After the acquisition, it will appear that the
returns of the acquired firm have fallen. The firm continues to earn $500, but the asset base is
now $2,000, so the ROA is reduced to 25 percent. Indeed, the ROA may be less as a result of
other factors, such as increased depreciation of the newly acquired assets. Yet in fact nothing
has happened to the earnings of the firm. All that has changed is its accounting, not its
performance.
Another fundamental problem with ROA and ROE measures comes from the tendency of analysts to focus on performance in single years, years that may be idiosyncratic. At a
minimum, one should examine these ratios averaging over a number of years to isolate
idiosyncratic returns and try to find patterns in the data.
Stock Market RatiosSeveral ratios are calculated not from the income statements and balance sheets of organizations,
but from data associated with their stock market performance. The three most common ratios are
earnings per share (EPS), the price-earnings ratio (P/E), and the dividend-yield ratio:
EPS = (net income - preferred dividends) /Common shares outstandingP/E = market price per share / earnings per share
Dividend yield = annual dividends / price per share
EPS is one of the most widely used statistics. Indeed, it is required to be given in the income
statements of publicly traded firms. As we can see, the ratio tells us how much the firm has
earned per share of stock outstanding. As it turns out, this is not generally a very helpful
statistic. It says nothing about how many assets a firm used to generate those earnings, and
hence nothing about profitability. Nor does it tell us how much the individual stockholder has
paid per share for the rights over that annual earning. Further, accounting practices in thecalculation of earnings may distort these ratios. And finally, the treatment of inventories is again
problematic.
The P/E is another ratio commonly cited. Indeed, P/Es are reported in daily newspapers. A high
P/E tends to indicate that investors believe the future prospects of the firm are better than its
current performance. They are in some sense paying more per share than the firm's current
earnings warrant. Again, earnings are treated differently in different accounting practices.
Finally, from the perspective of some stockholders at least, dividend policy may be important.
The dividend-yield ratio tells us how much of its earnings the firm pays out in dividends versusreinvestment. Rapidly growing firms in new areas tend to have low dividend-yield ratios; more
9. CONCLUSION All stocks can be analyzed and there relative study can be done using (Risk Factor),
(Intercept), (Standard Deviation), ² (Variance), R (Security Return), P/E Ratio (Priceearnings Ratio), r (Correlation Coefficient), and r² (Variation).
P/E Ratio was the primary ratio on which basis analysis of the company is done, StandardDeviation for the shortlisted companies was compared, after that analysis Retunes of the
respective company was compared and lastly short listing of company was completed after
comparing there respective Risks.
Further detailed study of market can be done using these ratios. Relative study can be done to
see, in which stock investor must invest, so there is minimum risk in investment in particular
stock/segment.
These ratios also help in industry analysis and in predicting market future, according to the
performance of the company. News about the company and the segment in which
company/industry is operating are also helpful in predicting company future and there return.
Financial modeling is one of the very helpful tool in evaluating all these ratios and industry
analysis can also be done very easily. Speculation might not be helpful every time, most of the
time losses occur because of these speculations done by people. Stock market is one of the most
volatile market and have very high risk in investment. Industry analysis and ratios comparison is
very important and essential tool for every investor, so that the risk involved can be identified
and accordingly investment decision is made so that risk will be minimized.
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