ASSIGNMENT

Course Code : MS-44

Course Title : Security Analysis and Portfolio Management

Assignment No. : MS-44/TMA/Sem-II/2020

Coverage : All Blocks

Note: Attempt all the questions and submit this assignment to the Coordinator of your Study
Centre on or before 31st October, 2020.

1. Define investment. Describe the steps involved in the investment process. Explain the
various types of risks involved in investment.

2. Explain the logic of the Arbitrage - Pricing Theory (APT). How does it compare and
contrast with CAPM ?

3. (a) "Fundamental analysis provides an analytical framework for rational investment

decision making". Discuss.
(b) What is technical analysis ? Explain the techniques and limitations of technical
analysis

4. What do you mean by Formula plans ? Critically examine the formula plans and
discuss their limitations.

5. Define the Efficient Market Hypothesis. What kinds of empirical evidence were
produced to reject the efficient market hypothesis ?
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ASSIGNMENT REFERENCE MATERIAL (July20 to Dec20)

MS-44
Security Analysis and Portfolio Management

Q1. Define investment. Describe the steps involved in the investment process. Explain
the various types of risks involved in investment.

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Ans.: An investment involves the choice by an individual or an organization such as a
pension fund, after some analysis or thought, to place or lend money in a vehicle, instrument
or asset, such as property, commodity, stock, bond, financial derivatives (e.g. futures or
options), or the foreign asset denominated in foreign currency, that has certain level of risk
and provides the possibility of generating returns over a period of time.

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When an asset is bought or a given amount of money is invested in the bank, there is
anticipation that some return will be received from the investment in the future.
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The investor decision process is concerned with as to how an investor should proceed in
making decision about

(i) What marketable securities to invest in?

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(ii) How diversified the investment should be?

(iii) When the investment should be made?

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There is a well-knit investment decision process involved therein.

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Steps:-
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A typical investment decision undergoes a five-step procedure, which in turn forms the basis
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of the investment process. These steps are:

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(1) Determine the investment objectives and policy

(2) Security Analysis

(3) Portfolio Construction

(4) Portfolio Revision

(5) Portfolio Performance Evaluation

(1) Determine the investment objectives and policy

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The investor will have to work out his investment objectives first and then evolve a policy
with the amount of investible wealth at his command.

The objective should be in clear and specific terms. It can be expressed in terms of expected
return or expected risk. Suppose, an investor can aim to earn 12% return against the risk-free
rate of 9%.

The investor can set her or his preference on risk by stating that the risk of investment should
be below market risk. It is desirable to set one of the two parameters (risk or return) and find
the other one from the market. If necessary, an investor can revise the objective if sheik finds
the risk is too high for her/him to bear a desired return.

The next step in formulating the investment policy of an investor would be the identification

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Of categories of financial assets he/she would be interested in. It would depend on the
objectives, amount of wealth and the tax status of the investor.

(2) Security Analysis

After defining the investment objective and broadly setting the proportion of wealth to be

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invested under different categories, the next step is selecting individual securities under each
category. For instance, a long-term government bond is much riskier than short-term bonds.
Similarly, investment in equities requires identification of companies stocks, in Which the
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investment can be made. Security analysis is often performed in two or three stages. The first
stage, called economic analysis, would be useful to set broad investment objective. If the
economy is expected to do well, investor can invest more in stocks. On the other hand, if the

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economic slowdown is expected to continue, investor can invest less in stocks and more in
bonds. In stage two, investors typically examine the industries and identify the industries, in
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which investment can be made.

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The issue is an analysis of broad trends of industry and future outlook is essential to proceed
further on security analysis.
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At the last step, one has to look into the fundamentals of specific companies and find whether
the stock is desirable for investment and investors need to match the risk-return objective
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she/he has set in the previous stage. Company specific analysis includes examination of
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historical financial information as well as future outlook.

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Through such analysis, analysts quantify the intrinsic value of the stock and compare the
same with current market price. If the intrinsic value is greater than the current market price,
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the stock qualifies for investment.

(3) Portfolio Construction

Under portfolio construction stage, the investor has to allocate the wealth to different stocks.
A couple of principles guide such allocation of wealth. Investors need to appreciate that the
risk of portfolio comes down if the portfolio is diversified. Diversification here doesn't mean
more than one stock but stocks whose future performance are not highly correlated. Further,
too much diversification or too many stocks may also create problem in terms of monitoring.

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While including stocks in the portfolio, the investor has to watch its impact on the overall
portfolio return and risk and also examine whether it is consistent with the initial investment
objective.

Since investors saving take place over a period of time, portfolios are also constructed over a
period of time. It is a continuous exercise. Sometime, timing of investment may be critical.
For instance, if an investor saves Rs. 30,000 during the first quarter and the desired portfolio
includes both bonds and stocks, the issue before the investor is whether the amount has to be
used for bonds or stocks or both.

Q2. Explain the logic of the Arbitrage - Pricing Theory (APT). How does it compare
and contrast with CAPM ?

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Ans. The APT is motivated by the empirical failure of the CAPM. The CAPM has only one
factor (Excess return of market portfolio) to explain the excess return of the asset. The
systematic risk of an asset is then given by the correlation with this factor. But in reality
returns are affected by many different macroeconomic factors other than the market portfolio
like

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-Surprises in Inflation.

-Surprises in GNP.
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-Surprises default risk premiums for bonds (measures investors confidence)

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-Surprises in shifts in yield curve (where \surprise" means \realized minus expected" have
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been shown to have predictive power for excess returns.)

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Difference in Methodology

-CAPM is an equilibrium model and derived from individual portfolio optimization.

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-APT is a statistical model which tries to capture sources of systematic risk.

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Relation between sources determined by no Arbitrage condition.

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Difference in Application
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-APT difficult to identify appropriate factors.

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-CAPM difficult to find good proxy for market returns.

-APT shows sensitivity to different sources. Important for hedging in portfolio information.

-CAPM is simpler to communicate, since everybody agrees upon.

-CAPM model is better for pricing risky assets. APT is an improved version of the CAPM,
but why do we still use CAPM as well? Because, in practise, APT does not work better than
CAPM. That happens because of estimation error. APT does not tell us how many factors we
should use and it does not tell us what the factors are.

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-The CAPM is more simple-minded model but we can estimate Bi and RM a lot more
precisely, so the required return is reasonably accurate. The APT may be more advanced
conceptually, but this is cancelled out by the greater estimation error. In practise, the required
return we come up with is not more accurate than the CAPM.

-The CAPM is simpler to understand, easier to use. The APT is more difficult to understand
much harder to use. APT is rarely used for computing required return, but it has useful
applications in investment management.

3. (a) "Fundamental analysis provides an analytical framework for rational investment

decision making". Discuss.

Ans. The analysis of economy, industry and company fundamental is the main ingredient of

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fundamental approach. The analysis should take into account all the three constituents which
form different stage in the investment decision making process and are depicted graphically
with three concentric circles as shown in fig. below. The process of investment analysis starts
with an evaluation of economic outlook. After getting some confidence on economic outlook,
the analysis is moved to industry specific to identify industries, which are worth for further
analysis to pick up good stocks. The last stage is identifying specific stocks from selected

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industry. Operationally, to base the investment decision on various fundamentals, all the three
stages must be taken into account.
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Econom
An nalysi
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Company
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Analysis
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All investment decisions are made within the economic environment after taking into account
the economic prospect of the country. This environment varies as the economy goes through
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stages of prosperity. When the economy is booming, companies over invest in projects and
create excess capacity and thus lead to slow down of the economy. Further, government
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policies and external pressures also create complications to the economy. Different stages of
economic prosperity are also referred to as the business cycle. The cycle moves on without
any definite length of time between the stages because government and other agencies would
like to extend the expansion stage while trying to cut down the recession or speed up the
recovery phase. Figure illustrates the common characteristics that are applicable to different
business cycles.

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National
Output
Recovery/Expansion

Peak

Recovery/Expansion
Expansion

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Trough Time
t1 t2 t3

Economists all over the world have developed a fair amount of understanding on factors

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leading to different phases of the economy and also developed necessary monetary and fiscal
policies to speed up the process of recovery and extend the period of expansion. Despite such
efforts, the government fails to achieve desired results because of new factors emerging in the
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economy and ever-changing social and political events.

(b) What is technical analysis ? Explain the techniques and limitations of technical
analysis

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Ans.: Technical Analysis is concerned with a critical study of the daily or weekly price and
volume data of the Index comprising several shares, like Bombay Stock Exchange Sensitive
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Index (SENSEX), or of a particular Stock, like Infosys or Hindustan Lever. The objective of
the technical analysis is to predict or forecast the short, intermediate and long term price
movements. It uses only the data generated from the market. Such market generated data
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includes price, volume, number of trades, 52-week high or low price, intra-day spread,
dealers buy-sell quote spread, number of advances and declines, number of Stocks hitting the
new high and low, open interest, etc.
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Technical analysis assumes that there is a sufficient lag between the arrival of information
and its ultimate impact on the Stock prices. The analysis fails if the information never
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incorporated in the prices (inefficient market) or instantaneously reflected in the prices

investors or analysts are able to understand the impact of information on prices and entering
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into the Stock.

In finance, technical analysis is a security analysis methodology for forecasting the direction
of prices through the study of past market data, primarily price and volume. Behavioral
economics and quantitative analysis use many of the same tools of technical analysis, which,
being an aspect of active management, stands in contradiction to much of modern portfolio
theory. The efficacy of both technical and fundamental analysis is disputed by the efficient-
market hypothesis which states that stock market prices are essentially unpredictable.

Determining the trend of a share is the most important purpose for technical analysis. When a
trend has been identified, the possible upward or downward space of a share can be

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determined. The risk and return can be extracted from this movement space of a share. To be
complete: when a trend shows a lot of space for downward movement, the risk and possible
return can be turned around by going short. Lots of downward movement space can result in
a positive return.

Not all types of technical analysis are useful. To understand technical analysis well, I make a
division of different types of methods for technical analysis. I also discuss the usefulness of
the technical analysis and the goal of for which the method can be used.

The first division that can be made, is the division between objective and subjective technical
analysis. Looking at a chart of a share and trying to make something up from this chart is
subjective (or interpretative) technical analysis. The interpretation of the chart depends fully
on the person who is looking at the chart. One technical analyst trying to interpret the chart

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can draw a totally other conclusion from the chart than his colleague who sits next to him (or
her). An example of 'chart-viewing' and a possible conclusion is the head-shoulder pattern.
An analyst can see this pattern, while another analyst can interpret the same chart as an up-
going trend. Both can be right, but not at the same time for the same chart.

Objective (or mathematical) technical analysis cannot be interpreted in a different way by

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different persons. The basis of objective technical analysis are fixed numbers, like the price,
or fixed calculation models, like the moving average. Formulas for objective technical
analysis are agreed upon by scientists and investors, so no difference in interpretation
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between different technical analysts should be possible.

Q4. What do you mean by Formula plans ? Critically examine the formula plans and

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discuss their limitations.
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Ans. Formula plan : The buying and/or selling of securities according to a predetermined
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formula. This approach to investment decisions is intended to eliminate the investor’s
emotions and instead to follow a mechanical set of rules. A huge number of formula plans
have been developed over the years.
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Formula plans are mechanical methods of portfolio management that try to take advantage of
price changes in securities that result from cyclical price movements. Formula plans, part of a
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conservative strategy, are designed primarily for investors who do not wish to take excessive
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risk but wish to quickly and favorably adjust their portfolio in response to cyclical security
price changes.
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Mechanical portfolio revision techniques have been developed to ease the problem of
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whether and when to revise to achieve the benefits of buying stocks when price are low and
selling stocks when prices are high. These techniques are referred to as formula plans. There
are three popular formula plans namely, Constant-Dollar-Value Plan, Constant Ratio Plan
and Variable Ratio Plan.

The formula plans are based on the following assumptions :–

1) The stock prices move up and down in cycles.

2) The stock prices and the high grade bond prices move in the opposite directions.

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3) The investors cannot or are not inclined to forecast direction of the next fluctuation in
stock prices which may be due to lack of skill and resources or their belief in market
efficiency or both.

The use of formula plans call for the investor to divide his investment funds into two
portfolios, one aggressive and the other conservative or defensive. The aggressive portfolio
usually consists of stocks while conservative portfolio consists of bonds. The formula plans
specify pre-designated rules for the transfer of funds from the aggressive into the
conservative and vice-versa such that it automatically causes the investor to sell stocks when
their prices are rising and buy stocks when their prices are falling.

Q5. Define the Efficient Market Hypothesis. What kinds of empirical evidence were
produced to reject the efficient market hypothesis ?

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Ans. The Efficient Market Hypothesis (EMH) has been consented as one of the cornerstones
of modern financial economics. Fama first defined the term “efficient market” in financial
literature in 1965 as one in which security prices fully reflect all available information. The
market is efficient if the reaction of market prices to new information should be instantaneous
and unbiased. Efficient market hypothesis is the idea that information is quickly and

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efficiently incorporated into asset prices at any point in time, so that old information cannot
be used to foretell future price movements. Consequently, three versions of EMH are being
distinguished depends on the level of available information.
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The weak form EMH stipulates that current asset prices already reflect past price and volume
information. The information contained in the past sequence of prices of a security is fully

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reflected in the current market price of that security. It is named weak form because the
security prices are the most publicly and easily accessible pieces of information. It implies
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that no one should be able to outperform the market using something that “everybody else
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knows”. Yet, there are still numbers of financial researchers who are studying the past stock
price series and trading volume data in attempt to generate profit. This technique is so called
technical analysis that is asserted by EMH as useless for predicting future price changes.
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The semi strong form EMH states that all publicly available information is similarly already
incorporated into asset prices. In another word, all publicly available information is fully
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reflected in a security’s current market price. The public information stated not only past
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prices but also data reported in a company’s financial statements, company’s announcement,
economic factors and others. It also implies that no one should be able to outperform the
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market using something that “everybody else knows”. This indicates that a company’s
financial statements are of no help in forecasting future price movements and securing high
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investment returns.

The strong form EMH stipulates that private information or insider information too, is
quickly incorporated by market prices and therefore cannot be used to reap abnormal trading
profits. Thus, all information, whether public or private, is fully reflected in a security’s
current market price. That’s mean, even the company’s management (insider) are not able to
make gains from inside information they hold. They are not able to take the advantages to
profit from information such as take over decision which has been made ten minutes ago. The
rationale behind to support is that the market anticipates in an unbiased manner, future
development and therefore information has been incorporated and evaluated into market price
in much more objective and informative way than insiders.

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The random walk model of asset prices is an extension of the EMH, as are the notions that
the market cannot be consistently beaten, arbitrage is impossible, and “free lunches” are
generally unavailable.

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