CONTENTS

CHAPTER 1: OBJECTIVES OF INVESTMENT DECISIONS .........................................1

1.1 Introduction ...............................................................................................1

1.2 Types of investors .......................................................................................1

1.2.1 Individuals.............................................................................................1

1.2.2 Institutions ............................................................................................2

1.2.2.1 Mutual funds .................................................................................2

1.2.2.2 Pension funds................................................................................2

1.2.2.3 Endowment funds ..........................................................................3

1.2.2.4 Insurance companies (Life and Non-life) .............................................3

1.2.2.5 Banks .............................................................................................3

1.3 Constraints.................................................................................................4

1.3.1 Liquidity
................................................................................................4

1.3.2 Investment horizons

...............................................................................4

1.3.3 Taxation

................................................................................................5 1.4 Goals of

Investors .......................................................................................5 CHAPTER 2:

FINANCIAL MARKETS ........................................................................6

2.1 Introduction ...............................................................................................6

2.2 Primary and Secondary Markets ....................................................................6

2.3 Trading in Secondary Markets .......................................................................7

2.3.1 Types of Orders......................................................................................7

2.3.2 Matching of Orders .................................................................................8

2.4 The Money Market .......................................................................................9

2.4.1 T-Bills ...................................................................................................9

2.4.2 Commercial Paper ..................................................................................9

2.4.3 Certificates of Deposit ........................................................................... 10

2.5 Repos and Reverses................................................................................... 10

2.6 The Bond Market ....................................................................................... 11

2.6.1 Treasury Notes (T-Notes) and T-Bonds.................................................... 11

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 2.6.2 State and Municipal Government bonds................................................... 11

2.6.3 Corporate Bonds .................................................................................. 11

2.6.4 International Bonds .............................................................................. 12

2.6.5 Other types of bonds ............................................................................ 12

2.7 Common Stocks........................................................................................ 13

2.7.1 Types of shares.................................................................................... 14

CHAPTER 3 FIXED INCOME SECURITIES .............................................................15

3.1 Introduction: The Time Value of Money ........................................................ 15

3.2 Simple and Compound Interest Rates .......................................................... 15

3.2.1 Simple Interest Rate ............................................................................. 15

3.2.2 Compound Interest Rate ....................................................................... 16

3.3 Real and Nominal Interest Rates ................................................................. 18

3.4 Bond Pricing Fundamentals......................................................................... 19

3.4.1 Clean and dirty prices and accrued interest.............................................. 20

3.5 Bond Yields .............................................................................................. 20

3.5.1 Coupon yield........................................................................................ 20

3.5.2 Current Yield........................................................................................ 20

3.5.3 Yield to maturity................................................................................... 21

3.5.4 Yield to call .......................................................................................... 23

3.6 Interest Rates........................................................................................... 24

3.6.1 Short
Rate........................................................................................... 24

3.6.2 Spot Rate

............................................................................................ 24

3.6.3 Forward Rate

....................................................................................... 25

3.6.4 The term structure of interest rates

........................................................ 26 3.7 Macaulay Duration and Modified

Duration ..................................................... 28 CHAPTER 4 CAPITAL MARKET

EFFICIENCY..........................................................32

4.1 Introduction ............................................................................................. 32

4.2 Market Efficiency....................................................................................... 32

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 4.2.1 Weak-form Market
Efficiency.................................................................. 32

4.2.2 Semi-strong Market

Efficiency................................................................ 32

4.2.3 Strong Market

Efficiency........................................................................ 33 4.3 Departures from

the EMH ........................................................................... 33

CHAPTER 5: FINANCIAL ANALYSIS AND VALUATION..........................................35

5.1 Introduction ............................................................................................. 35

5.2 The Analysis of Financial Statement............................................................. 35

5.2.1 Income Statement (Profit & Loss)........................................................... 36

5.2.2 The Balance Sheet ................................................................................ 36

5.2.3 Cash Flow Statement ............................................................................ 37

5.3 Financial Ratios (Return, Operation and, Profitability Ratios).......................... 38

5.3.1 Measures of Profitability: RoA, RoE ......................................................... 39

5.3.2 Measures of Liquidity ............................................................................ 39

5.3.3 Capital Structure and Solvency Ratios ..................................................... 39

5.3.4 Operating Performance ......................................................................... 39

5.3.5 Asset Utilization ................................................................................... 39

5.4 The valuation of common stocks ................................................................. 40

5.4.1 Absolute (Intrinsic) Valuation ................................................................. 40

5.4.2 Relative Valuation................................................................................. 44

5.5 Technical Analysis ..................................................................................... 49

5.5.1 Challenges to Technical Analysis............................................................. 50

CHAPTER 6: MODERN PORTFOLIO THEORY ......................................................... 51

6.1 Introduction ............................................................................................. 51

6.2 Diversification and Portfolio Risks ................................................................ 51
6.2.1 Portfolio variance - General case ............................................................
56

6.3 Equilibrium Module: The Capital Asset Pricing Module .................................... 57

6.3.1 Mean-Variance Investors and Market Behaviour

....................................... 58

6.3.2 Estimation of Beta

................................................................................ 63 6.4 Multifactor Modules

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 ................................................................................... 64 CHAPTER 7:

VALUATION OF DERIVATIVES ......................................................... 66

7.1 Introduction ............................................................................................. 66

7.2 Forwards and Futures ................................................................................ 66
7.3 Call and Put Options .................................................................................. 68

7.4 Forward and Future Pricing......................................................................... 68

7.4.1 Cost-of carry and convenience yield........................................................ 69

7.4.2 Backwardation and Contango................................................................. 70

7.5 Option Pricing ........................................................................................... 70

7.5.1 Payoffs from option contracts................................................................. 70

7.5.2 Put-call parity relationship ..................................................................... 72

7.6 Black-Scholes formula...................................................................................... 73

CHAPTER 8: INVESTMENT MANAGEMENT ............................................................75

8.1 Introduction ............................................................................................. 75

8.2 Investment Companies .............................................................................. 75

8.2.1 Benefits of investments in managed funds............................................... 76

8.3 Active vs. Passive Portfolio Management ...................................................... 76

8.4 Costs of Management: Entry/Exit Loads and Fees.......................................... 78

8.5 Net Asset Value......................................................................................... 78

8.6 Classification of funds ................................................................................ 79

8.6.1 Open ended and closed-ended funds....................................................... 79

8.6.2 Equity funds ........................................................................................ 79

8.6.3 Bond funds .......................................................................................... 80

8.6.4 Index funds ......................................................................................... 80

8.6.5 Money market funds ............................................................................. 80

8.6.6 Fund of funds....................................................................................... 80

8.7 Other Investment Companies ..................................................................... 80

8.7.1 Unit Investment Trusts (UTI) ................................................................. 80

8.7.2 REITS (Real Estate Investment Trusts).................................................... 81

8.7.3 Hedge Funds........................................................................................ 81

8.8 Performance assessment of managed funds ................................................. 81

8.8.1 Sharpe
Ratio........................................................................................ 82

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 8.8.2 Treynor
Ratio....................................................................................... 82

8.8.3 Jensen measure or (Portfolio

Alpha)........................................................ 82 MODEL TEST

.................................................................................................82 Distribution

of weights in the

Investment Analysis and Portfolio Management Module Curriculum

Chapter Title Weighs (%)

No
1 Objectives of Investment Decisions 9
2 Financial Markets 13
3 Fixed Income Securities 12
4 Capital Market Efficiency 8
5 Financial Analysis and Valuation 23
6 Modern Portfolio Theory 10
7 Valuation of Derivatives 12
8 Investment Management 13
Note: Candidates are advised to refer to NSE's website: www.nseindia.com, click on 'NCFM'
link and then go to 'Announcements' link, regarding revisions/updations in NCFM modules or
launch of new modules, if any.

Copyright © 2018 by NSE Academy Ltd.

National Stock Exchange of India Ltd. (NSE)
Exchange Plaza, Bandra Kurla Complex,
Bandra (East), Mumbai 400 051 INDIA

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All content included in this book, such as text, graphics, logos, images, data compilation etc.
are the property of NSE. This book or any part thereof should not be copied, reproduced,
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any means, electronic, mechanical, photocopying, recording or otherwise.

CHAPTER 1 : Objectives of Investment

Decisions
1.1 Introduction
In an economy, people indulge in economic activity to support their consumption
requirements. Savings arise from deferred consumption, to be invested, in anticipation of
future returns. Investments could be made into financial assets, like stocks, bonds, and similar
instruments or into real assets, like houses, land, or commodities.

Our aim in this book is to provide a brief overview of three aspects of investment: the various
options available to an investor in financial instruments, the tools used in modern finance to
optimally manage the financial portfolio and lastly the professional asset management industry
as it exists today.

Returns more often than not differ across their risk profiles, generally rising with the expected
risk, i.e., higher the returns, higher the risk. The underlying objective of portfolio management
is therefore to create a balance between the trade-off of returns and risk across multiple asset
classes. Portfolio management is the art of managing the expected return requirement for the
corresponding risk tolerance. Simply put, a good portfolio manager’s objective is to maximize
the return subject to the risk-tolerance level or to achieve a pre-specified level of return with
minimum risk.

In our first chapter, we start with the various types of investors in the markets today, their
return requirements and the various constraints that an investor faces.

1.2 Types of investors

There is wide diversity among investors, depending on their investment styles, mandates,
horizons, and assets under management. Primarily, investors are either individuals, in that
they invest for themselves or institutions, where they invest on behalf of others. Risk appetites
and return requirements greatly vary across investor classes and are key determinants of the
investing styles and strategies followed as also the constraints faced. A quick look at the broad
groups of investors in the market illustrates the point.

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1.2.1 Individuals

While in terms of numbers, individuals comprise the single largest group in most markets, the
size of the portfolio of each investor is usually quite small. Individuals differ across their risk
appetite and return requirements. Those averse to risk in their portfolios would be inclined
towards safe investments like Government securities and bank deposits, while others may be
risk takers who would like to invest and / or speculate in the equity markets. Requirements of
individuals also evolve according to their life-cycle positioning. For example, in India, an
individual in the 25-35 years age group may plan for purchase of a house and vehicle, an
individual belonging to the age group of 35-45 years may plan for children’s education and
children’s marriage, an individual in his or her fifties would be planning for post-retirement
life. The investment portfolio then changes depending on the capital needed for these
requirements.

1.2.2 Institutions

Institutional investors comprise the largest active group in the financial markets. As mentioned
earlier, institutions are representative organizations, i.e., they invest capital on behalf of
others, like individuals or other institutions. Assets under management are generally large and
managed professionally by fund managers. Examples of such organizations are mutual funds,
pension funds, insurance companies, hedge funds, endowment funds, banks, private equity
and venture capital firms and other financial institutions. We briefly describe some of them
here.

Box No. 1.1:

The Indian financial markets are also witnessing active participation by institutions with
foreign institutional investors, domestic mutual funds, and domestic insurance companies
comprising the three major groups, owning more than a third of the shareholding in listed
companies, with the Government and promoters another 50%. Over the years the share of
institutions has risen in share ownership of companies.

1.2.2.1 Mutual funds

Individuals are usually constrained either by resources or by limits to their knowledge of the
investment outlook of various financial assets (or both) and the difficulty of keeping abreast
of changes taking place in a rapidly changing economic environment. Given the small portfolio
size to manage, it may not be optimal for an individual to spend his or her time analyzing
various possible investment strategies and devise investment plans and strategies accordingly.
Instead, they could rely on professionals who possess the necessary expertise to manage thier

7
funds within a broad, pre-specified plan. Mutual funds pool investors’ money and invest
according to pre-specified, broad parameters. These funds are managed and operated by
professionals whose remunerations are linked to the performance of the funds. The profit or
capital gain from the funds, after paying the management fees and commission is distributed
among the individual investors in proportion to their holdings in the fund. Mutual funds vary
greatly, depending on their investment objectives, the set of asset classes they invest in, and
the overall strategy they adopt towards investments.

1.2.2.2 Pension funds

Pension funds are created (either by employers or employee unions) to manage the retirement
funds of the employees of companies or the Government. Funds are contributed by the
employers and employees during the working life of the employeesand the objective is to
provide benefits to the employees post their retirement. The management of pension funds
may be in-house or through some financial intermediary. Pension funds of large organizations
are usually very large and form a substantial investor group for various financial instruments.

1.2.2.3 Endowment funds

Endowment funds are generally non-profit organizations that manage funds to generate a
steady return to help them fulfill their investment objectives. Endowment funds are usually
initiated by a non-refundable capital contribution. The contributor generally specifies the
purpose (specific or general) and appoints trustees to manage the funds. Such funds are
usually managed by charitable organizations, educational organization, non-Government
organizations, etc. The investment policy of endowment funds needs to be approved by the
trustees of the funds.

1.2.2.4 Insurance companies (Life and Non-life)

Insurance companies, both life and non-life, hold large portfolios from premiums contributed
by policyholders to policies that these companies underwrite. There are many different kinds
of insurance polices and the premiums differ accordingly. For example, unlike term insurance,
assurance or endowment policies ensure a return of capital to the policyholder on maturity,
along with the death benefits. The premium for such poliices may be higher than term policies.
The investment strategy of insurance companies depends on actuarial estimates of timing and
amount of future claims. Insurance companies are generally conservative in their attitude
towards risks and their asset investments are geared towards meeting current cash flow needs
as well as meeting perceived future liabilities.

1.2.2.5 Banks

8
Assets of banks consist mainly of loans to businesses and consumers and their liabilities
comprise of various forms of deposits from consumers. Their main source of income is from
what is called as the interest rate spread, which is the difference between the lending rate
(rate at which banks earn) and the deposit rate (rate at which banks pay). Banks generally do
not lend 100% of their deposits. They are statutorily required to maintain a certain portion of
the deposits as cash and another portion in the form of liquid and safe assets (generally
Government securities), which yield a lower rate of return. These requirements, known as the
Cash Reserve Ratio (CRR ratio) and Statutory Liquidity Ratio (SLR ratio) in India, are stipulated
by the Reserve Bank of India and banks need to adhere to them.

In addition to the broad categories mentioned above, investors in the markets are also
classified based on the objectives with which they trade. Under this classification, there are
hedgers, speculators and arbitrageurs. Hedgers invest to provide a cover for risks on a
portfolio they already hold, speculators take additional risks to earn supernormal returns and
arbitrageurs take simultaneous positions (say in two equivalent assets or same asset in two
different markets etc.) to earn riskless profits arising out of the price differential if they exist.

Another category of investors include day-traders who trade in order to profit from intra-day
price changes. They generally take a position at the beginning of the trading session and
square off their position later during the day, ensuring that they do not carry any open position
to the next trading day. Traders in the markets not only invest directly in securities in the
socalled cash markets, they also invest in derivatives, instruments that derive their value from
the underlying securities.

1.3 Constraints
Portfolio management is usually a constrained optimization exercise: Every investor has some
constraint (limits) within which she wants the portfolio to lie, typical examples being the risk
profile, the time horizon, the choice of securities, optimal use of tax rules etc. The professional
portfolio advisor or manager also needs to consider the constraint set of the investors while
designing the portfolio; besides having some constraints of his or her own, like liquidity,
market risk, cash levels mandated across certain asset classes etc.

We provide a quick outline of the various constraints and limitations that are faced by the
broad categories of investors mentioned above.

9
1.3.1 Liquidity

In investment decisions, liquidity refers to the marketability of the asset, i.e., the ability and
ease of an asset to be converted into cash and vice versa. It is generally measured across two
different parameters, viz., (i) market breadth, which measures the cost of transacting a given
volume of the security, this is also referred to as the impact cost; and (ii) market depth, which
measures the units that can be traded for a given price impact, simply put, the size of the
transaction needed to bring about a unit change in the price. Adequate liquidity is usually
characterized by high levels of trading activity. High demand and supply of the security would
generally result in low impact costs of trading and reduce liquidity risk.

1.3.2 Investment horizons

The investment horizon refers to the length of time for which an investor expects to remain
invested in a particular security or portfolio, before realizing the returns. Knowing the
investment horizon helps in security selection in that it gives an idea about investors’ income
needs and desired risk exposure. In general, investors with shorter investment horizons prefer
assets with low risk, like fixed-income securities, whereas for longer investment horizons
investors look at riskier assets like equities. Risk-adjusted returns for equity are generally
found to be higher for longer investment horizon, but lower in case of short investment
horizons, largely due to the high volatility in the equity markets. Further,certain securities
require commitment to invest for a certain minimum investment period, for example in India,
thePost Office savings or Government small-saving schemes like the National Savings
Certificate (NSC) have a minimum maturity of 3-6 years.

Investment horizon also facilitates in making a decision between investing in a liquid or

relatively illiquid investment. If an investor wants to invest for a longer period, liquidity costs
may not be a significant factor, whereas if the investment horizon is a short period (say 1
month) then the impact cost (liquidity) becomes significant as it could form a meaningful
component of the expected return.

1.3.3 Taxation

The investment decision is also affected by the taxation laws of the land. Investors are always
concerned with the net and not gross returns and therefore tax-free investments or
investments subject to lower tax rate may trade at a premium as compared to investments
with taxable returns. The following example will give a better understanding of the concept:

Table 1.1:

10
 Asset Type Expected Return Net Return

A 10% taxable bonds (30% tax) 10% 10%*(1-0.3) = 7 %

B 8% tax-free bonds 8% 8%

Although asset A carries a higher coupon rate, the net return for the investors would be higher
for asset B and hence asset B would trade at a premium as compared to asset A. In some
cases taxation benefits on certain types of income are available on specific investments. Such
taxation benefits should also be considered before deciding the investment portfolio.

1.4 Goals of Investors

There are specific needs for all types of investors. For individual investors, retirement,
children’s marriage / education, housing etc. are major event triggers that cause an increase
in the demands for funds. An investment decision will depend on the investor’s plans for the
above needs. Similarly, there are certain specific needs for institutional investors also. For
example, for a pension fund the investment policy will depend on the average age of the plan’s
participants.

In addition to the few mentioned here, there are other constraints like the level of requisite
knowledge (investors may not be aware of certain financial instruments and their pricing) ,
investment size (e.g., small investors may not be able to invest in Certificate of Deposits) ,
regulatory provisions (country may impose restriction on investments in foreign countries)
etc. which also serve to outline the investment choices faced by investors.

CHAPTER 2: Financial Markets

2.1 Introduction
There are a wide range of financial securities available in the markets these days. In this
chapter, we take a look at different financial markets and try to explain the various instruments
where investors can potentially park their funds.

Financial markets can mainly be classified into money markets and capital markets.
Instruments in the money markets include mainly short-term, marketable, liquid, low-risk
debt securities. Capital markets, in contrast, include longer-term and riskier securities, which
include bonds and equities. There is also a wide range of derivatives instruments that are
traded in the capital markets.

Both bond market and money market instruments are fixed-income securities but bond market
instruments are generally of longer maturity period as compared to money market

11
instruments. Money market instruments are of very short maturity period. The equities market
can be further classified into the primary and the secondary market. Derivative market
instruments are mainly futures, forwards and options on the underlying instruments, usually
equities and bonds.

2.2 Primary and Secondary Markets

A primary market is that segment of the capital market, which deals with the raising of capital
from investors via issuance of new securities. New stocks/bonds are sold by the issuer to the
public in the primary market. When a particular security is offered to the public for the first
time, it is called an Initial Public Offering (IPO). When an issuer wants to issue more securities
of a category that is already in existence in the market it is referred to as Follow-up Offerings.

Example: Reliance Power Ltd.’s offer in 2008 was an IPO because it was for the first time
that Reliance Power Ltd. offered securities to the public. Whereas, BEML’s public offer in
2007 was a Follow-up Offering as BEML shares were already issued to the public before 2007
and were available in the secondary market.

It is generally easier to price a security during a Follow-up Offering since the market price of
the security is actually available before the company comes up with the offer, whereas in the
case of an IPO it is very difficult to price the offer since there is no prevailing market for the
security. It is in the interest of the company to estimate the correct price of the offer, since
there is a risk of failure of the issue in case of non-subscription if the offer is overpriced. If the
issue is underpriced, the company stands to lose notionally since the securities will be sold at
a price lower than its intrinsic value, resulting in lower realizations.
The secondary market (also known as ‘aftermarket’) is the financial market where securities,
which have been issued before are traded. The secondary market helps in bringing potential
buyers and sellers for a particular security together and helps in facilitating the transfer of the
security between the parties. Unlike in the primary market where the funds move from the
hands of the investors to the issuer (company/ Government, etc.), in case of the secondary
market, funds and the securities are transferred from the hands of one investor to the hands
of another. Thus the primary market facilitates capital formation in the economy and
secondary market provides liquidity to the securities.

There is another market place, which is widely referred to as the third market in the investment
world. It is called the over-the-counter market or OTC market. The OTC market refers to all
transactions in securities that are not undertaken on an Exchange. Securities traded on an
OTC market may or may not be traded on a recognized stock exchange. Trading in the OTC
market is generally open to all registered broker-dealers. There may be regulatory restrictions

12
on trading some products in the OTC markets. For example, in India equity derivatives is one
of the products which is regulatorily not allowed to be traded in the OTC markets. In addition
to these three, direct transactions between institutional investors, undertaken primarily with
transaction costs in mind, are referred to as the fourth market.

2.3 Trading in Secondary Markets

Trading in secondary market happens through placing of orders by the investors and their
matching with a counter order in the trading system. Orders refer to instructions provided by
a customer to a brokerage firm, for buying or selling a security with specific conditions. These
conditions may be related to the price of the security (limit order or market order or stop loss
orders) or related to time (a day order or immediate or cancel order). Advances in technology
have led to most secondary markets of the world becoming electronic exchanges.
Disaggregated traders across regions simply log in the exchange, and use their trading
terminals to key in orders for transaction in securities. We outline some of the most popular
orders below:

2.3.1 Types of Orders

Limit Price/Order: In these orders, the price for the order has to be specified while entering
the order into the system. The order gets executed only at the quoted price or at a better
price (a price lower than the limit price in case of a purchase order and a price higher than the
limit price in case of a sale order).

Market Price/Order: Here the constraint is the time of execution and not the price. It gets
executed at the best price obtainable at the time of entering the order. The system
immediately executes the order, if there is a pending order of the opposite type against which
the order can match. The matching is done automatically at the best available price (which is
called as the market price). If it is a sale order, the order is matched against the best bid (buy)
price and if it is a purchase order, the order is matched against the best ask (sell) price. The
best bid price is the order with the highest buy price and the best ask price is the order with
the lowest sell price.

Stop Loss (SL) Price/Order: Stop-loss orders which are entered into the trading system,
get activated only when the market price of the relevant security reaches a threshold price.
When the market reaches the threshold or pre-determined price, the stop loss order is
triggered and enters into the system as a market/limit order and is executed at the market
price / limit order price or better price. Until the threshold price is reached in the market the
stop loss order does not enter the market and continues to remain in the order book. A sell

13
order in the stop loss book gets triggered when the last traded price in the normal market
reaches or falls below the trigger price of the order. A buy order in the stop loss book gets
triggered when the last traded price in the normal market reaches or exceeds the trigger price
of the order. The trigger price should be less than the limit price in case of a purchase order
and vice versa.

Time Related Conditions

Day Order (Day): A Day order is valid for the day on which it is entered. The order, if not
matched, gets cancelled automatically at the end of the trading day. At the National Stock
Exchange (NSE) all orders are Day orders. That is the orders are matched during the day and
all unmatched orders are flushed out of the system at the end of the trading day.

Immediate or Cancel order (IOC): An IOC order allows the investor to buy or sell a security
as soon as the order is released into the market, failing which the order is removed from the
system. Partial match is possible for the order and the unmatched portion of the order is
cancelled immediately.

2.3.2 Matching of orders

When the orders are received, they are time-stamped and then immediately processed for
potential match. The best buy order is then matched with the best sell order. For this purpose,
the best buy order is the one with highest price offered, also called the highest bid, and the
best sell order is the one with lowest price also called the lowest ask (i.e., orders are looked
at from the point of view of the opposite party). If a match is found then the order is executed
and a trade happens. An order can also be executed against multiple pending orders, which
will result in more than one trade per order. If an order cannot be matched with pending
orders, the order is stored in the pending orders book till a match is found or till the end of
the day whichever is earlier. The matching of orders at NSE is done on a price-time priority
i.e., in the following sequence:

• Best Price

• Within Price, by time priority

Orders lying unmatched in the trading system are ‘passive’ orders and orders that come in to
match the existing orders are called ‘active’ orders. Orders are always matched at the passive
order price. Given their nature, market orders are instantly executed, as compared to limit
orders, which remain in the trading system until their market prices are reached. The set of
such orders across stocks at any point in time in the exchange, is called the Limit Order Book
(LOB) of the exchange. The top five bids/asks (limit orders all) for any security are usually
visible to market participants and constitute the Market By Price (MBP) of the security.

14
2.4 The Money Market
The money market is a subset of the fixed-income market. In the money market, participants
borrow or lend for short period of time, usually up to a period of one year. These instruments
are generally traded by the Government, financial institutions and large corporate houses.
These securities are of very large denominations, very liquid, very safe but offer relatively low
interest rates. The cost of trading in the money market (bid-ask spread) is relatively small due
to the high liquidity and large size of the market. Since money market instruments are of high
denominations they are generally beyond the reach of individual investors. However, individual
investors can invest in the money markets through money-market mutual funds. We take a
quick look at the various products available for trading in the money markets.

2.4.1 T-Bills

T-Bills or treasury bills are largely risk-free (guaranteed by the Government and hence carry
only sovereign risk - risk that the government of a country or an agency backed by the
government, will refuse to comply with the terms of a loan agreement), short-term, very liquid
instruments that are issued by the central bank of a country. The maturity period for T-bills
ranges from 3-12 months. T-bills are circulated both in primary as well as in secondary
markets. T-bills are usually issued at a discount to the face value and the investor gets the
face value upon maturity. The issue price (and thus rate of interest) of T-bills is generally
decided at an auction, which individuals can also access. Once issued, T-bills are also traded
in the secondary markets.

In India, T-bills are issued by the Reserve Bank of India for maturities of 91-days, 182 days
and 364 days. They are issued weekly (91-days maturity) and fortnightly (182-days and
364days maturity).

2.4.2 Commercial Paper

Commercial papers (CP) are unsecured money market instruments issued in the form of a
promissory note by large corporate houses in order to diversify their sources of short-term
borrowings and to provide additional investment avenues to investors. Issuing companies are
required to obtain investment-grade credit ratings from approved rating agencies and in some
cases, these papers are also backed by a bank line of credit. CPs are also issued at a discount
to their face value. In India, CPs can be issued by companies, primary dealers (PDs), satellite
dealers (SD) and other large financial institutions, for maturities ranging from 15 days period
to 1-year period from the date of issue. CP denominations can be Rs. 500,000 or multiples
thereof. Further, CPs can be issued either in the form of a promissory note or in dematerialized
form through any of the approved depositories.

15
2.4.3 Certificates of Deposit

A certificate of deposit (CD), is a term deposit with a bank with a specified interest rate. The
duration is also pre-specified and the deposit cannot be withdrawn on demand. Unlike other
bank term deposits, CDs are freely negotiable and may be issued in dematerialized form or as
a Usance Promissory Note. CDs are rated (sometimes mandatory) by approved credit rating
agencies and normally carry a higher return than the normal term deposits in banks (primarily
due to a relatively large principal amount and the low cost of raising funds for banks). Normal
term deposits are of smaller ticket-sizes and time period, have the flexibility of premature
withdrawal and carry a lower interest rate than CDs. In many countries, the central bank
provides insurance (e.g. Federal Deposit Insurance Corporation (FDIC) in the U.S., and the
Deposit Insurance and Credit Guarantee Corporation (DICGC) in India) to bank depositors up
to a certain amount (Rs. 100000 in India). CDs are also treated as bank deposit for this
purpose.

In India, scheduled banks can issue CDs with maturity ranging from 7 days – 1 year and
financial institutions can issue CDs with maturity ranging from 1 year – 3 years. CD are issued
for denominations of Rs. 1,00,000 and in multiples thereof.

2.5 Repos and Reverse Repos

Repos (or Repurchase agreements) are a very popular mode of short-term (usually overnight)
borrowing and lending, used mainly by investors dealing in Government securities. The
arrangement involves selling of a tranche of Government securities by the seller (a borrower
of funds) to the buyer (the lender of funds), backed by an agreement that the borrower will
repurchase the same at a future date (usually the next day) at an agreed price. The difference
between the sale price and the repurchase price represents the yield to the buyer (lender of
funds) for the period. Repos allow a borrower to use a financial security as collateral for a cash
loan at a fixed rate of interest. Since Repo arrangements have T-bills as collaterals and are
for a short maturity period, they virtually eliminate the credit risk.

Reverse repo is the mirror image of a repo, i.e., a repo for the borrower is a reverse repo for
the lender. Here the buyer (the lender of funds) buys Government securities from the seller (
a borrower of funds) agreeing to sell them at a specified higher price at a future date.

2.6 The Bond Market

Bond markets consist of fixed-income securities of longer duration than instruments in the
money market. The bond market instruments mainly include treasury notes and treasury
bonds, corporate bonds, Government bonds etc.

16
2.6.1 Treasury Notes (T-Notes) and T-Bonds

Treasury notes and bonds are debt securities issued by the Central Government of a country.
Treasury notes maturity range up to 10 years, whereas treasury bonds are issued for maturity
ranging from 10 years to 30 years. Another distinction between T-notes and T-bonds is that
Tbonds usually consist of a call/put option after a certain period. In order to make these
instruments attractive, the interest income is usually made tax-free.

Interest on both these instruments is usually paid semi-annually and the payment is referred
to as coupon payments. Coupons are attached to the bonds and each bondholder has to
present the respective coupons on different interest payment date to receive the interest
amount. Similar to T-bills, these bonds are also sold through auction and once sold they are
traded in the secondary market. The securities are usually redeemed at face value on the
maturity date.

2.6.2 State and Municipal Government bonds

Apart from the central Government, various State Governments and sometimes municipal
bodies are also empowered to borrow by issuing bonds. They usually are also backed by
guarantees from the respective Government. These bonds may also be issued to finance
specific projects (like road, bridge, airports etc.) and in such cases, the debts are either repaid
from future revenues generated from such projects or by the Government from its own funds.
Similar to T-notes and T-bonds, these bonds are also granted tax-exempt status.

In India, the Government securities (includes treasury bills, Central Government securities
and State Government securities) are issued by the Reserve Bank of India on behalf of the
Government of India.

2.6.3 Corporate Bonds

Bonds are also issued by large corporate houses for borrowing money from the public for a
certain period. The structure of corporate bonds is similar to T-Notes in terms of coupon
payment, maturity amount (face value), issue price (discount to face value) etc. However,
since the default risk is higher for corporate bonds, they are usually issued at a higher discount
than equivalent Government bonds. These bonds are not exempt from taxes. Corporate bonds
are classified as secured bonds (if backed by specific collateral), unsecured bonds (or
debentures which do not have any specific collateral but have a preference over the equity
holders in the event of liquidation) or subordinated debentures (which have a lower priority
than bonds in claim over a firms’ assets).

17
2.6.4 International Bonds

These bonds are issued overseas, in the currency of a foreign country which represents a large
potential market of investors for the bonds. Bonds issued in a currency other than that of the
country which issues them are usually called Eurobonds. However, now they are called by
various names depending on the currency in which they are issued. Eurodollar bonds are US
dollar-denominated bonds issued outside the United States. Euro-yen bonds are
yendenominated bonds issued outside Japan.

Some international bonds are issued in foreign countries in currency of the country of the
investors. The most popular of such bonds are Yankee bond and Samurai Bonds. Yankee
bonds are US dollar denominated bonds issued in U.S. by a non-U.S. issuer and Samurai bonds
are yen-denominated bonds issued in Japan by non-Japanese issuers.

2.6.5 Other types of bonds

Bonds could also be classified according to their structure/characteristics. In this section, we

discuss the various clauses that can be associated with a bond.

Zero Coupon Bonds

Zero coupon bonds (also called as deep-discount bonds or discount bonds) refer to bonds
which do not pay any interest (or coupons) during the life of the bonds. The bonds are issued
at a discount to the face value and the face value is repaid at the maturity. The return to the
bondholder is the discount at which the bond is issued, which is the difference between the
issue price and the face value.

Convertible Bonds

Convertible bonds offer a right (but not the obligation) to the bondholder to get the bond
converted into predetermined number of equity stock of the issuing company, at certain,
prespecified times during its life. Thus, the holder of the bond gets an additional value, in
terms of an option to convert the bond into stock (equity shares) and thereby participate in
the growth of the company’s equity value. The investor receives the potential upside of
conversion into equity while protecting downside with cash flow from the coupon
payments.The issuer company is also benefited since such bonds generally offer reduced
interest rate. However, the value of the equity shares in the market generally falls upon issue
of such bonds in anticipation of the stock dilution that would take place when the option (to
convert the bonds into equity) is exercised by the bondholders.
Callable Bonds

18
In case of callable bonds, the bond issuer holds a call option, which can be exercised after
some pre-specified period from the date of the issue. The option gives the right to the issuer
to repurchase (cancel) the bond by paying the stipulated call price. The call price may be
more than the face value of the bond. Since the option gives a right to the issuer to redeem
the bond, it carries a higher discount (higher yield) than normal bonds. The right is exercised
if the coupon rate is higher than the prevailing interest rate in the market.

Puttable Bonds

A puttable bond is the opposite of callable bonds. These bonds have an embedded put option.
The bondholder has a right (but not the obligation) to sell back the bond to the issuer after a
certain time at a pre-specified price. The right has a cost and hence one would expect a lower
yield in such bonds. The bondholders generally exercise the right if the prevailing interest rate
in the market is higher than the coupon rate.

Since the call option and the put option are mutually exclusive, a bond may have both option
embedded.

Fixed rate and floating rate of interest

In case of fixed rate bonds, the interest rate is fixed and does not change over time, whereas
in the case of floating rate bonds, the interest rate is variable and is a fixed percentage over
a certain pre-specified benchmark rate. The benchmark rate may be any other interest rate
such as T-bill rate, the three-month LIBOR rate, MIBOR rate (in India), bank rate, etc. The
coupon rate is usually reset every six months (time between two interest payment dates).

2.7 Common Stocks

Simply put, the shareholders of a company are its owners. As owners, they participate in the
management of the company by appointing its board of directors and voicing their opinions,
and voting in the general meetings of the company. The board of directors have general
oversight of the company, appoints the management team to look after the day-to-day
running of the business, set overall policies aimed at maximizing profits and shareholder value.
Shareholders of a company are said to have limited liability. The term means that the liability
of shareholders is limited to the unpaid amount on the shares. This implies that the maximum
loss of shareholder in a company is limited to her original investment. Being the owners,
shareholders have the last claim on the assets of the company at the time of liquidation, while
debt- or bondholders always have precedence over equity shareholders.

19
At its incorporation, every company is authorized to issue a fixed number of shares, each
priced at par value, or face value in India. The face value of shares is usually set at nominal
levels (Rs. 10 or Re. 1 in India for the most part). Corporations generally retain portions of
their authorized stock as reserved stock, for future issuance at any point in time.

Shares are usually valued much higher than the face value and this initial investment in the
company by shareholders represents their paid-in capital in the company. The company then
generates earnings from its operating, investing and other activities. A portion of these
earnings are distributed back to the shareholders as dividend, the rest retained for future
investments. The sum total of the paid-in capital and retained earnings is called the book value
of equity of the company.

2.7.1 Types of shares

In India, shares are mainly of two types: equity shares and preference shares. In addition to
the most common type of shares, the equity share, each representing a unit of the overall
ownership of the company, there is another category, called preference shares. These
preferred shares have precedence over common stock in terms of dividend payments and the
residual claim to its assets in the event of liquidation. However, preference shareholders are
generally not entitled to equivalent voting rights as the common stockholders.

In India, preference shares are redeemable (callable by issuing firm) and preference dividends
are cumulative. By cumulative dividends, we mean that in case the preference dividend
remains unpaid in a particular year, it gets accumulated and the company has the obligation
to pay the accrued dividend and current year’s dividend to preferred stockholders before it
can distribute dividends to the equity shareholders. An additional feature of preferred stock in
India is that during such time as the preference dividend remains unpaid, preference
shareholders enjoy all the rights (e.g. voting rights) enjoyed by the common equity
shareholders. Some companies also issue convertible preference shares which get converted
to common equity shares in future at some specified conversion ratio.

In addition to the equity and fixed-income markets, the derivatives market is one of India’s
largest and most liquid. We take a short tour of derivatives in the 5th chapter of this module.

CHAPTER 3: Fixed Income Securities

3.1 Introduction: The Time Value of Money
Fixed-income securities are securities where the periodic returns, time when the returns fall
due and the maturity amount of the security are pre-specified at the time of issue. Such

20
securities generally form part of the debt capital of the issuing firm. Some of the common
examples are bonds, treasury bills and certificates of deposit.

3.2 Simple and Compound Interest Rates

In simple terms, an interest payment refers to the payment made by the borrower to the
lender as the price for use of the borrowed money over a period of time. The interest cost
covers the opportunity cost of money, i.e., the return that could have been generated had the
lender invested in some other assets and a compensation for default risk (risk that the
borrower will not refund the money on maturity). The rate of interest may be fixed or floating,
in that it may be linked to some other benchmark interest rate or in some cases to the inflation
in the economy.

Interest calculations are either simple or compound. While simple interest is calculated on the
principal amount alone, for a compound interest rate calculation we assume that all interest
payments are re-invested at the end of each period. In case of compound interest rate, the
subsequent period’s interest is calculated on the original principal and all accumulated interest
during past periods.

In case of both simple and compound interest rates, the interest rate stated is generally
annual. In case of compound interest rate, we also mention the frequency for which
compounding is done. For example, such compounding may be done semi-annually, quarterly,
monthly, daily or even instantaneously (continuously compounded).

3.2.1 Simple Interest Rate

The formula for estimating simple interest is :

I = P *R *T

Where,

P = principal amount

R = Simple Interest Rate for one period (usually 1 year)

T = Number of periods (years)

Example 3.1

What is the amount an investor will get on a 3-year fixed deposit of Rs. 10000 that pays 8%
simple interest?

Answer: Here we have

P = 10000, R = 8% and T = 3 years

21
I = P *R *T = 10000*8% *3 = 2400

Amount = Principal + Interest = 10000+2400 = 12400.

3.2.2 Compound Interest Rate

In addition to the three parameters (Principal amount (P), Interest Rate (R), Time (T)) used
for calculation of interest in case of simple interest rate method, there is an additional
parameter that affects the total interest payments. The fourth parameter is the compounding
period, which is usually represented in terms of number of times the compounding is done in
a year (m). So for semi-annual compounding the value for m = 2; for quarterly compounding,
m = 4 and so on.

Let us consider an interest rate of 10% compounded semi-annually and an investment of Rs.
100 for a period of 1 year. The investment will become Rs. 105 in 6 months and for the second
half, the interest will be calculated on Rs. 105, which will come to 105*5% = 5.25. The total
amount the investor will receive at the end of 1 year will become 105 + 5.25 = 110.25. The
equivalent interest rate, if compounded annually becomes

m
+
1 R –1.
((110.25-100)/100)*100 = 10.25%. The equivalent annual interest rate is
m

The formula used for calculating total amount under this method is as under:

A=P 1+R T *m –P
m
Where

A = Amount on maturity R

= interest rate

m = number of compounding in a year

T = maturity in years

Example 3.2

What is the amount an investor will get on a 3-year fixed deposit of Rs. 10000 that pay 8 %
interest compounded half yearly?
Answer:

Here P = 10000, R = 8% and T = 3, m = 2. The total interest income comes to:

22
Interest P 1+R T *m
–P

0. 08
10000* 1+ 2 2*3
–10000 = Rs.2653.20

Amount = Principal + Interest = 10000+2653.20 = 12653.20.

Example 3.3

Consider the same investment. What is the amount if the interest rate is compounded
monthly?

Answer:

Here P = 10000, R = 8% and T = 3, m = 12. The total interest income comes to:

Interest P 1+R T *m –P

10000* 1 + 0.08 12*3 –10000 = Rs.2702.37

12

Amount = Principal + Interest = 10000+2702.37 = 12702.37.

Continuous compounding

Consider a situation, where instead of monthly or quarterly compounding, the interest rate is
compounded continuously throughout the year i.e. m rises indefinitely. If m approaches
R
infinity, the equivalent annual interest rate is 1 + ∞
–1, which can be shown (using

tools from

differential calculus), to tend to [2.718r –1] or er –1 in the limit, (where e=2.71828… is the
base for natural logarithms). Further, for convenience, we use ‘r’ (in small letters) to represent
continuously compound interest rate.

Thus, an investment of Re. 1 at 8% continuously compounded interest becomes e0.08 =1.0833

after 1 year and the equivalent annual interest rate becomes 0.0833 or 8.33%. If the
investment is for T years, the maturity amount is simply 1* erT , where e = 2.718.

23
Continuous compounding is widely assumed in finance theory, and used in various asset
pricing models—the famous Black-Scholes model to price a European option is an illustrative
example. Example 3.4

Consider the same investment (Rs. 10000 for 3 years). What is the amount received on
maturity if the interest rate is 8% compounded continuously?

Answer:

Here P = 10000, e = 2.718, r = 8% and T = 3

The final value of the investment is P *erT .

It comes to 10000* e0.08*3 = 12712.50.

3.3 Real and Nominal Interest Rates

The relationship between interest rates and inflation rates is very significant. Normally, the
cash flow from bonds and deposits are certain and known in advance. However, the value of
goods and services in an economy may change due to changes in the general price level
(inflation). This brings an uncertainty about the purchasing power of the cash flow from an
investment. Take a small example. If inflation (say 12%) is rising and is greater than the
interest rate (say 10% annually) in a particular year, then an investor in a bond with 10 %
interest rate annually stands to lose. Goods worth Rs. 100 at the beginning of the year are
worth Rs. 112 by the end of the year but an investment of Rs. 100 becomes only Rs. 110 by
end of the year. This implies that an investor who has deposited money in a risk-free asset
will find goods beyond his reach.

An economist would look at this in terms of nominal cash flow and real cash flows. Nominal
cash flow measures the cash flow in terms of today’s prices and real cash flow measures the
cash flow in terms of its base year’s purchasing power, i.e., the year in which the asset was
bought/ invested. If the interest rate is 10%, an investment of Rs. 100 becomes Rs. 110 at
the end of the year. However, if inflation rate is 5% then each Rupee will be worth 5% less
next year. This means at the end of the year, Rs. 110 will be worth only 110/1.05 = Rs. 104.76
in terms of the purchasing power at the beginning of the year. The real payoff is Rs. 104.76
and the real interest rate is 4.76%. The relationship between real and nominal interest rate
can be established as under:

Nominal Cash Flow

Real Cash Flow = (1 + inflation rate)

And

24
 1 + nominal interest rate
(1 + realinterest rate =
1 + inflation rate

In our example, the real interest rate can be directly calculated using the formula:

1 + 0 .10
Real interest rate = 1 + .05 –1 = 0.0476 or 4.76 %
3.4 Bond Pricing Fundamentals
The cash inflow for an investor in a bond includes the coupon payments and the payment on
maturity (which is the face value) of the bond. Thus the price of the bond should represent
the sum total of the discounted value of each of these cash flows (such a total is called the
present value of the bond). The discount rate used for valuing the bond is generally higher
than the risk-free rate to cover additional risks such as default risk, liquidity risks, etc.

Bond Price = PV (Coupons and Face Value)

Note that the coupon payments are at different points of time in the future, usually twice each
year. The face value is paid at the maturity date. Therefore, the price is calculated using the
following formula:

C(t)

∑
Bond Price = t (1)

t (1 + y)

Where C(t) is the cash flow at time t and y is the discount rate. Since the coupon rate is
generally fixed and the maturity value is known at the time of issue of the bond, the formula
can be re-written as under:

T
Coupon FaceValue

∑
Bond Price = t t + (1 +y)T (2) (1 +y)

Here t represents the time left for each coupon payment and T is the time to maturity. Also
note that the discount rate may differ for cash flows across time periods.

Example 3.5

25
Calculate the value of a 3-year bond with face value of Rs. 1000 and coupon rate being 8%
paid annually. Assume that the discount rate is 10%.

Here:

Face value = Rs. 1000

Coupon Payment = 8% of Rs. 1000 = Rs. 80

Discount Rate = 10 % t=1 to 3

T=3

Bond Price = + + + = 950.26

Now let us see what happens if the discount rate is lower than the coupon rate:
Example 3.6

Calculate the bond price if the discount rate is 6%.

Bond Price = + + = 1053.46

Since the discount rate is higher than the coupon rate, the bond is traded at a discount. If the
discount rate is less than the coupon rate, the bond trades at a premium.

3.4.1 Clean and dirty prices and accrued interest

Bonds are not traded only on coupon dates but are traded throughout the year. The market
price of the bonds also includes the accrued interest on the bond since the most recent coupon
payment date. The price of the bond including the accrued interest since issue or the most
recent coupon payment date is called the ‘dirty price’ and the price of the bond excluding the
accrued interest is called the ‘clean price’. Clean price is the price of the bond on the most
recent coupon payment date, when the accrued interest is zero.

Dirty Price = Clean price + Accrued interest

For reporting purpose (in press or on trading screens), bonds are quoted at ‘clean price’ for
ease of comparison across bonds with differing interest payment dates (dirty prices ‘jump’ on
interest payment dates). Changes in the more stable clean prices are reflective of
macroeconomic conditions, usually of more interest to the bond market.

3.5 Bond Yields

Bond yield are measured using the following measures:

26
3.5.1 Coupon yield

It is calculated using the following formula:

Coupon Payment
CouponYield =
FaceValue

3.5.2 Current Yield

It is calculated using the following formula:

Coupon Payment
CouponYield =

Current Market Priceof the Bond

The main drawback of coupon yield and current yield is that they consider only the interest
payment (coupon payments) and ignore the capital gains or losses from the bonds. Since they
consider only coupon payments, they are not measurable for bonds that do not pay any
interest, such as zero coupon bonds. The other measures of yields are yield to maturity and
yield to call. These measures consider interest payments as well as capital gains (or losses)
during the life of the bond.

3.5.3 Yield to maturity

Yield to maturity (also called YTM) is the most popular concept used to compare bonds. It
refers to the internal rate of return earned from holding the bond till maturity. Assuming a
constant interest rate for various maturities, there will be only one rate that equalizes the
present value of the cash flows to the observed market price in equation (2) given earlier.
That rate is referred to as the yield to maturity.

Example 3.7

What is the YTM for a 5-year, 8% bond (interest is paid annually) that is trading in the market

for Rs. 924.20 ? Here, t= 1 to 5

T=5

Face Value = 1000

Coupon payment = 8% of Rs. 1,000 = 80

Putting the values in equation (1), we have:

27
Solving for y, which is the YTM, we get the yield to maturity for the bond to be 10%.

Yield and Bond Price:

There is a negative relationship between yields and bond price. The bond price falls when yield
increases and vice versa.

Example 3.8

What will be the market price of the above bond (Example 3 7) if the YTM is 12%.

t= 1 to 5

T=5

Face Value = 1000

Coupon payment = 8% of 1,000 = 80

Putting the values in equation (1), the bond price comes to:
Bond Price

Further, for a long-term bond, the cash flows are more distant in the future and hence the
impact of change in interest rate is higher for such cash flows. Alternatively, for short-term
bonds, the cash flows are not far and discounting does not have much effect on the bond price.
Thus, price of long-term bonds are more sensitive to interest rate changes.

Bond equivalent yield and Effective annual yield: This is another important concept that is of
importance in case of bonds and notes that pay coupons at time interval which is less than 1
year (for example, semi-annually or quarterly). In such cases, the yield to maturity is the
discount rate solved using the following formula, wherein we assume that the annual discount
rate is the product of the interest rate for interval between two coupon payments and the
number of coupon payments in a year:

T
Coupon Face Value

Bond Price = ∑ t 1+y t 1+y T (3)

2 2

YTM calculated using the above formula is called bond equivalent yield.

However, if we assume that one can reinvest the coupon payments at the bond equivalent
yield (YTM), the effective interest rate will be different. For example, a semi-annual interest
rate of 10% p.a. in effect amounts to

28
 0.10
1+ 2
= 1.1025 or 10.25%.

Yield rate calculated using the above formula is called effective annual yield.

Example 3.9

Calculate the bond equivalent yield (YTM) for a 5-year, 8% bond (semi-annual coupon

payments) , that is trading in the market for Rs. 852.80? What is the effective annual yield

for the bond? Here, t= 1 to 10

T = 10

Face Value = 1000

Coupon payment = 4% of 1,000 = 40

Bond Price = 852.80

Putting the values in equation (3), we have:

10
40 1000

852.80 = ∑
1 1+y t 1+y 10

2 2

Solving, we get the Yield to Maturity (y) = 0.12 or 12%.

The effective yield rate is

1+y 2 –1 1 + 0.12 2 –1 = 0.1236 or 12.36%

2 2

3.5.4 Yield to call

Yield to call is calculated for callable bond. A callable bond is a bond where the issuer has a
right (but not the obligation) to call/redeem the bond before the actual maturity. Generally
the callable date or the date when the company can exercise the right, is pre-specified at the
time of issue. Further, in the case of callable bonds, the callable price (redemption price) may
be different from the face value. Yield to call is calculated with the same formula used for
calculating YTM (Equation 2), with an assumption that the issuer will exercise the call option
on the exercise date.

Example 3.10

29
Calculate the yield to call for a 5-year, 7% callable bond (semi-annual coupon payments), that
is trading in the market for Rs. 877.05. The bond is callable at the end of 3rd year at a call
price of Rs. 1040.

Here: t=

1 to 6

T=6

Coupon payment = 3.5% of 1,000 = 35

Callable Value = 1040

Bond Price = 877.05

Putting the values in the following equation:

T
Coupon

∑
CallableValue Bond Price = t

1+ t + 1+y T y

2 2

we have:
6
35 1000

877.05 = ∑ 1
1 t y 6 y
1

2 2

Solving for y, we get the yield to call = 12 %

3.6 Interest Rates

While computing the bond prices and YTM, we assumed that the interest rate is constant
across different maturities. However, this may not be true for different reasons. For example,
investors may perceive longer maturity periods to be riskier and hence may demand higher
interest rate for cash flow occurring at distant time intervals than those occurring at short time
intervals. In this section, we account for the fact that the interest demanded by investors also
depends on the time horizon of the investment. Let us first introduce certain common
concepts.

30
3.6.1 Short Rate

Short rate for time t, is the expected (annualized) interest rate at which an entity can borrow
for a given time interval starting from time t. Short rate is usually denominated as rt.

3.6.2 Spot Rate

Yield to maturity for a zero coupon bond is called spot rate. Since zero coupon bonds of varying
maturities are traded in the market simultaneously, we can get an array of spot rates for
different maturities.

Relationship between short rate and spot rate:

Investors discount future cash flows using interest rate applicable for that period. Therefore,
the PV of an investment of T years is calculated as under:

(Initial Investment)
PV (Investment) =
(1 + r1)(1 + r2)...(1+ rT )

Example 3.11

If the short rate for a 1-year investment at year 1 is 7% and year 2 is 8%, what is the present
value of a 2-year zero coupon bond with face value Rs. 1000 :

P= = = 865.35

1.
For a 2-year zero coupon bond trading at 865.35, the YTM can be calculated by solving the
following equation:

865.35 =

The resulting value for y is 7.4988%, which is nothing but the 2-year spot rate.
3.6.3 Forward Rate

One can assume that all bonds with equal risks must offer identical rates of return over any
holding period, because if it is not true then there will be an arbitrage opportunity in the
market. If we assume that all equally risky bonds will have identical rates of return, we can
calculate short rates for a future interval by knowing the spot rates for the two ends of the
interval. For example, we can calculate 1-year short rate at year 3, if we have the 3-years
spot rate and 4-years spot rate (or in other words are there are 3-year zero coupon and a 4-
year zero coupon treasury bonds trading in the market). This is because, the proceeds from
an investment in a 3-year zero coupon bond on the maturity day, reinvested for 1 year should

31
result in a cash flow equal to the cash flow from an investment in a 4-year zero coupon bond
(since the holding period is the same for both the strategies).

Example 3.12

If the 3-year spot rate and 4-year spot rates are 8.997% and 9.371% respectively, find the
1-year short rate at end of year 3.

Given the spot rates, proceeds from investment of Re. 1 in a 3-year zero coupon bond will be
1* 1.089973 = 1.2949.

If we reinvest this (maturity) amount in a 1-year zero coupon bond, the proceeds at year 4
will be 1.2949*(1+r3).

This should be equal to the proceeds from an investment of Rs. 1 in a 4-year zero coupon
bond, assuming equal holding period return.

Proceeds from investment of Re. 1 in a 4-year zero coupon bond is 1*1.093714 = 1.4309

Solving,

1.2949 * (1+ r3)=1.4309 r3= 0.11 or 11%, which is nothing but the 1 year short

rate at the end of year 3.

Future short rates computed using the market price of the prevailing zero coupon bonds’ price
(or prevailing spot rates) are called forward interest rates. We use the notation fi to represent
the 1-year forward interest rate starting at year i. For example, f2 denotes the 1-year forward
interest rate starting from year 2.

3.6.4 The term structure of interest rates

We have discussed various interest rates (spot, forward, discount rates), and also seen their
behaviour, and connections with each other. The term structure of interest rates is the set of
relationships between rates of bonds of different maturities. It is sometimes also called the
yield curve. Formally put, the term structure of interest rates defines the array of discount
factors on a collection of default-free pure discount (zero-coupon) bonds that differ only in
their term to maturity. The most common approximation to the term structure of interest rates
is the yield to maturity curve, which generally is a smooth curve and reflects the rates of
return on various default-free pure discount (zero-coupon) bonds held to maturity along with
their term to maturity.

32
The use of forward interest rates has long been standard in financial analysis such as in pricing
new financial instruments and in discovering arbitrage possibilities. Yield curves are also used
as a key tool by central banks in the determination of the monetary policy to be followed in a
country. The forward interest rate is interpreted as indicating market expectations of the
timepath of future interest rates, future inflation rates and future currency depreciation rates.
Since forward rates helps us indicate the expected future time path of these variables, they
allow a separation of market expectations for the short, medium and long term more easily
than the standard yield curve.

The market expectations hypothesis and the liquidity preference theory are two important
explanations of the term structure of interest in the economy. The market expectation
hypothesis assumes that various maturities are perfect substitutes of each other and that the
forward rate equals the market expectation of the future short interest rate i.e. fi = E(ri ), where
i is a future period. Assuming minimal arbitrage opportunities, the expected interest rate can
be used to construct a yield curve. For example, we can find the 2-year yield if we know the
1-year short rate and the futures short rate for the second year by using the following formula:

(1 + y2)2 = (1+r1)*(1 +f2)

Since, as per the expectation hypothesis − f2 =E(R2), the YTM can be determined solely b
current and expected future one-period interest rates.

Liquidity preference theory suggests that investors prefer liquidity and hence, a short-term
investment is preferred to a long-term investment. Therefore, investors will be induced to hold
a long-term investment, only by paying a premium for the same. This premium or the excess
of the forward rate over the expected interest rate is referred to as the liquidity premium.
Therefore, the forward rate will exceed the expected short rate, i.e. f2 > E(r2), where f2 – E(r2)
represent the liquidity premium. The liquidity premium causes the yield curve to be upward
sloping since long-term yields are higher than short-term yields.

Example 3.13

Calculate the YTM for year 2-5 if the 1-year short rate is 8% and the future rates for years 2-
5 is 8.5% (f2), 9% (f3), 9.5% (f4) and 10%(f5) respectively.
Answer: y1

= r1 = 8%

(1 +y2)2 + (1 + r1)*(1 +f2);y2 = 2 (1.08 *1.085) =1.0825, i.e. y2 = 8.25 %

33
(1 +y3)3 + (1 + y2)2 *(1 +f3);y3 = 3 (1.08252 *1.09) =1.0850, i.e. y3 = 8.50 %

(1 +y4)4 + (1 + y3)3 *(1 +f4);y4 = 4(1.08503 *1.095) =1.0875, i.e. y4 = 8.75 %

(1 +y5)5 + (1 + y4)4 *(1 +f5);y5 = 5 (1.08754 *1.10) =1.09, i.e. y5 = 9.00 %

It can be seen that because of the liquidity premium, the future interest rate increases with
time and this causes the yield curve to rise with time.

Box No. 3.1:

Relationship between spot, forward, and discount rates

Recall that discount factors are the interest rates used at a given point in time to
discount cash flows occurring in the future, in order to obtain their present value. So
how do spot rates, forward rates, and discount rates relate to each other?

A discount function (dt,m) is the collection of discount factors at time t for all maturities
m. Spot rates (st,m), i.e., the yields earned on bonds which pay no coupon, are related
to discount factors according to:

d
t,m = em*–S1m and

1
–
St,m = m 1ndt,m

The estimation of a zero coupon yield curve is based on an assumed functional

relationship between either par yields, spot rates, forward rates or discount factors on
the one hand and maturities on the other. Par yield curves are those that reflect return
on bonds that are priced at par, which just means that the redemption yield is equal to
the coupon rate of the bond.

There is a different forward rate for every pair of maturity dates. The relation between
the yield-to-maturity (YTM) and the implied forward rate at maturity is analogous to the
relation between average and marginal costs in economics. The YTM is the average cost
of borrowing for m periods whereas the implied forward rate is the marginal cost of
extending the time period of the loan, i.e. it describes the marginal one-period interest
rate implied by the current term structure of spot interest rate. Because spot interest
rates depend on the time horizon, it is natural to define the forward rates f t,m as the
instantaneous rates which when compounded continuously up to the time to maturity,
yield the spot rates (instantaneous forward rates are thus rates for which the difference
between settlement time and maturity time approaches zero).

m
1 34
= –
m ∫f (u)
 S du ,
t,m or we can say

dt,m = exp ∫ 0 f(u)du

Thus, knowing any of the four means that the other four can be readily computed. However,
the real problem is that neither of these curves is easily forecast able.

3.7 Macaulay Duration and Modified Duration

The effect of interest rate risks on bond prices depends on many factors, but mainly on coupon
rates, maturity date etc. Unlike in case of zero-coupon bonds, where the cash flows are only
at the end, in the case of other bonds, the cash flows are through coupon payments and the
maturity payment. One needs to average out the time to maturity and time to various coupon
payments to find the effective maturity for a bond. The measure is called as duration of a
bond. It is the weighted (cash flow weighted) average maturity of the bond.

Duration = ∑t *w t

t=1

The weights (Wt) associated for each period are the present value of the cash flow at each
period as a proportion to the bond price, i.e.

CFt
PV of cashflow (1+y) t

W t= =
Bond Price BondPrice

This measure is termed as Macaulay’s duration1 or simply, duration. Higher the duration of
the bond, higher will be the sensitivity towards interest rate fluctuations and hence higher the
volatility in the bond price.

This tool is widely used in fixed income analysis. Banks and other financial institutions
generally create a portfolio of fixed income securities to fund known liabilities. The price
changes for fixed income securities are dependent mainly on the interest rate changes and
the average maturity (duration). In order to hedge against interest rate risks, it is essential
for them to match the duration of the portfolio of fixed income securities with that of the

1
The method was designed by Frederick Macaulay in 1856 and hence named as Macaulay Duration.

35
liabilities. A bank thus needs to rebalance its portfolio of fixed-income securities periodically
to ensure that the aggregate duration of the portfolio is kept equal to the time remaining to
the target date. One should note that the duration of a short-term bond declines faster than
the duration of the long-term bond. When interest rates fall, the reinvestment of interests
(until the target date) will yield a lower value but the capital gain arising from the bond is
higher. The increase or decrease in the coupon income arising from changes in the
reinvestment rates will offset the opposite changes in the market values of the bonds in the
portfolios. The net realized yield at the target date will be equal to the yield to maturity of the
original portfolio. This is also called bond portfolio immunization.

Example 3.14

What is the duration for a 5-year maturity, 7% (semi-annual) coupon bond with yield to
maturity of 12%?

Here: t = 1
to 10

T = 10
Coupon payment = 3.5% of 1,000 = 35 YTM
= 12 % or 6% for half year.

Period Time till Cash PV of Cash Flow (discount Weights (b)*( e )

payment Flow = 6% per period)

(a) (b) (c ) (d) (e) (f)

(33.02/816)

1 0.5 35 33.02 = 0.0405 0.0202

2 1 35 31.15 0.0382 0.0382

3 1.5 35 29.39 0.0360 0.0540

4 2 35 27.72 0.0340 0.0679

5 2.5 35 26.15 0.0321 0.0801

6 3 35 24.67 0.0302 0.0907

7 3.5 35 23.28 0.0285 0.0998

36
 8 4 35 21.96 0.0269 0.1076

9 4.5 35 20.72 0.0254 0.1142

10 5 1035 577.94 0.7083 3.5413

Sum 816.00 1.0000 4.2142

The selling price of the bond as calculated from column (d) is Rs. 816.00. The duration of the
bond is 4.2142 years.

Since for a zero coupon bond, the cash flow is only on the maturity date, the duration equals
the bond maturity. For coupon-paying bonds, the duration will be less than the maturity
period. Since cash flows at each time are used as weights, the duration of a bond is inversely
related to the coupon rate. A bond with high coupon rate will have lower duration as compared
to a bond with low coupon rate.

Example 3.15

What is the duration for a 5-year maturity zero coupon bond with yield to maturity of 12%?

Answer: One does not need to do any calculation for answering this question. All cash flows
are only on the maturity date and hence the duration for this bond is the maturity date.

Although duration helps us in measuring the effective maturity of the bond, investors are
concerned more about the bond price sensitivity with respect to change in interest rates. In
order to measure the price sensitivity of the bond with respect to the interest rate movements,
we need to find the so-called modified duration (MD) of the bond. Modified duration is
calculated from duration (D) using the following formula:

D
MD =
y ,1
+
n

Where,

y = yield to maturity of the bond n =

number of coupon payments in a year.

The price change sensitivity of modified duration is calculated using the following formula:

37
Price Change(%) = (–) MD *Yield Change

Note the use of minus (-) term. This is because price of a bond is negatively related to the
yield of the bond.

Example 3.16

Refer to the bond in Example 3 14 i.e. 5-year maturity, 7% (semi-annual) coupon bond with
yield to maturity of 12%. Calculate the change in bond price if the YTM falls to 11%.

Answer: In Example 3 14, we calculated the duration to be 4.2142 and the bond price to be
816. The modified duration of the bond is:
D 4.2142 4.2142
MD = = = = 3.976
.12
n 2
1+y 1+ 1.06

The price change will -3.976*1 = 3.976% or Rs. 816 * 3.976% = 32.45

New Price = 816 + 32.45 = 848.45

Check: The actual market price of a 5-year maturity, 7% (semi-annual) coupon bond with
YTM = 11% would be:

T
Coupon FaceValue 10
35 1000

∑
Bond Price = ∑ t 1+y t 1+y T =t =1 1 + 0.11 t 1 + 0.11 10 = 849.25

2 2 2 2

Note that there is still some minor differences in the actual price and the bond price calculated
using the modified duration formula, due to what is called ‘convexity’. However, we would not
be covering the concept in this chapter.

38
CHAPTER 4: Capital Market Efficiency
4.1 Introduction
The Efficient Markets Hypothesis (EMH) is one of the main pillars of modern finance theory,
and has had an impact on much of the literature in the subject since the 1960’s when it was
first proposed and on our understanding about potential gains from active portfolio
management. Markets are efficient when prices of securities assimilate and reflect information
about them. While markets have been generally found to be efficient, the number of
departures seen in recent years has kept this topic open to debate.

4.2 Market Efficiency

The extent to which the financial markets digest relevant information into the prices is an
important issue. If the prices fully reflect all relevant information instantaneously, then market
prices could be reliably used for various economic decisions. For instance, a firm can assess
the potential impact of increased dividends by measuring the price impact created by the
dividend increase. Similarly, a firm can assess the value of a new investment taken up by
ascertaining the impact on its market price on the announcement of the investment decision.
Policymakers can also judge the impact of various macroeconomic policy changes by assessing
the market value impact. The need to have an understanding about the ability of the market
to imbibe information into the prices has led to countless attempts to study and characterize
the levels of efficiency of different segments of the financial markets.

The early evidence suggests a high degree of efficiency of the market in capturing the price
relevant information. Formally, the level of efficiency of a market is characterized as belonging
to one of the following (i) weak-form efficiency (ii) semi-strong form efficiency (iii) strongform
efficiency.

4.2.1 Weak-form Market Efficiency

The weak-form efficiency or random walk would be displayed by a market when the
consecutive price changes (returns) are uncorrelated. This implies that any past pattern of
price changes are unlikely to repeat by itself in the market. Hence, technical analysis that uses
past price or volume trends do not to help achieve superior returns in the market. The weak-
form efficiency of a market can be examined by studying the serial correlations in a return
time series. Absence of serial correlation indicates a weak-form efficient market.

39
4.2.2 Semi-strong Market Efficiency

The semi-strong form efficiency implies that all the publicly available information gets reflected
in the prices instantaneously. Hence, in such markets the impact of positive (negative)
information about the stock would lead to an instantaneous increase (decrease) in the prices.
Semi-strong form efficiency would mean that no investor would be able to outperform the
market with trading strategies based on publicly available information.

The hypothesis suggests that only information that is not publicly available can benefit
investors seeking to earn abnormal returns on investments. All other information is accounted
for in the stocks price and regardless of the amount of fundamental and technical analysis one
performs, above normal returns will not be had.

The semi-strong form efficiency can be tested with event-studies. A typical event study would
involve assessment of the abnormal returns around a significant information event such as
buyback announcement, stock splits, bonus etc. Here, a time period close to the selected
event including the event date would be used to examine the abnormal returns. If the market
is semi-strong form efficient, the period after a favorable (unfavorable) event would not
generate returns beyond (less than) what is suggested by an equilibrium pricing model (such
as CAPM, which has been discussed later in the book).

4.2.3 Strong Market Efficiency

The level of efficiency ideally desired for any market is strong form efficiency. Such efficiency
would imply that both publicly available information and privately (non-public) available
information are fully reflected in the prices instantaneously and no one can earn excess
returns. A test of strong form efficiency would be to ascertain whether insiders of a firm are
able to make superior returns compared to the market. Absence of superior return by the
insiders would imply that the market is strongly efficient. Testing the strong-form efficiency
directly is difficult. Therefore, the claim about strong form efficiency of any market at the best
remains tenuous.

In the years immediately following the proposal of the market efficiency, tests of various forms
of efficiency had suggested that the markets are reasonably efficient. Over time, this led to
the gradual acceptance of the efficiency of markets.

4.3 Departures from the EMH

Evidence accumulated through research over the past two decades, however, suggests that
during many episodes the markets are not efficient even in the weak form. The returns are

40
found to be correlated both for short as well as long lags during such episodes. The downward
and upward trending of prices is well documented across different markets (momentum
effect). Then there is a whole host of other documented deviations from efficiency. They
include, the predictability of future returns based on certain events and high volatility of prices
compared to volatility of the underlying fundamentals. All these evidences have started to
offer a challenge to the earlier claim of efficiency of the market. The lack of reliability about
the level of efficiency of the market prices makes it less reliable as a guideline for decision-
making.
Alternative prescriptions about the behaviour of markets are widely discussed these days.
Most of these prescriptions are based on the irrationality of the markets in either processing
the information related to an event or based on biased investor preferences. For instance, if
the investors on an average are overconfident about their investment ability, they would not
pay close attention to new price relevant information that arises in the market. This leads to
inadequate price response to the information event and possibly continuation of the trend due
to the under reaction. This bias in processing information is claimed to be the cause of price
momentum. Biased investor preferences include aversion to the realization of losses incurred
in a stock. This again would lead to under reaction.

The market efficiency claim was based on the assumption that irrational (biased) investors
would be exploited by the rational traders, and would eventually lose out in the market, leading
to their exit. Therefore, even in the presence of biased traders the market was expected to
evolve as efficient. However, more recent evidence suggest that the irrational traders are not
exiting the market as expected, instead at many instances they appear to make profits at the
expense of the rational traders.

Some of the well-known anomalies—or departures from market efficiency—are calendar

effects like the January effect and various day-of-the-week effects and the so-called size
effect. The January effect was first documented in the US markets—stock returns were found
to be higher in January than in any other month. Since then, it has been empirically tested in
a number of international markets, like Tokyo, London, and Paris among others. While the
evidence has been mixed, the fact that it exists implies a persistent deviation from market
efficiency.

Stock returns are generally expected to be independent across weekdays, but a number of
studies have found returns on Monday to be lower than in the rest of the week. One of the
reasons put forward to explain this anomaly is that returns on Monday are expected to be
different, given that they are across Friday-end-to-Monday-morning, a much longer period

41
than any other day, and hence with more information. This is why this departure from market
efficiency is also sometimes called the weekend effect.

The alternative prescriptions about the behaviour of markets based on various sources and
forms of investor irrationality are collectively known as behavioral finance. It implies that (i)
the estimation of expected returns based on methods such as the capital asset pricing model
is unreliable, and (ii) there could be many profitable trading strategies based on the collective
irrationality of the markets.

Departures from market efficiency, or the delays in markets reaching equilibrium (and thus
efficiency) leave scope for active portfolio managers to exploit mispricing in securities to their
benefit. A number of investment strategies are tailored to profit from such phenomena, as we
would see in later chapters.

CHAPTER 5: Financial Analysis and Valuation

5.1 Introduction
Investments in capital markets primarily involve transactions in shares, bonds, debentures,
and other financial products issued by companies. The decision to invest in these securities is
thus linked to the evaluation of these companies, their earnings, and potential for future
growth. In this chapter we look at one of the most important tools used for this purpose,
Valuation. The fundamental valuation of any asset (and companies are indeed assets into
which we invest) is an examination of future returns, in other words, the cash flows expected
from the asset. The ‘value’ of the asset is then simply what these cash flows are worth today,
i.e., their present discounted value. Valuation is all about how well we predict these cash flows,
their growth in future, taking into account future risks involved.

5.2 The Analysis of Financial Statements

A company’s financial statements provide the most accurate information to its management
and shareholders about its operations, efficiency in the allocation of its capital and its earnings
profile. Three basic accounting statements form the backbone of financial analysis of a
company: the income statement (profit & loss), the balance sheet, and the statement of cash
flows. Let us quickly summarize each of these.

5.2.1 Income Statement (Profit & Loss)

A profit & loss statement provides an account of the total revenue generated by a firm during
a period (usually a financial year or a quarter), the expenses involved and the money earned.
In its simplest form, revenue generation or sales accrues from selling the products

42
manufactured, or services rendered by the company. Operating expenses include the costs of
these goods and services and the costs incurred during the manufacture. Beyond operating
expenses are interest costs based on the debt profile of the company. Taxes payable to the
Government are then debited to provide the Profit After Tax (PAT) or the net income to the
shareholders of the company.

Actual P&L statements of companies are usually much more complicated than this, with
socalled ‘other income’ (income from non-core activities), ‘negative’ interest expenses (from
cash reserves with the company), preferred dividends, and non-recurring, exceptional income
or expenses. The example given below is that of a large company in the Pharmaceutical sector
over the period 2006-2008.
Illustration 5.1

Income Statement (US$M) 2006 2007 2008

Net sales 16,380 21,340 33,565

Cost of sales (5,332) (6,584) (8,190)

SG&A (1,408) (1,771) (2,738)

Research & development (1,534) (2,440) (2,725)

Other operating items (3,650) (4,620) (5,369)

EBIT 4,457 5,926 14,543

Total other non-operating items 543 1,336 305

Associates 0 0 0

Net interest income/expense 869 1,072 1,146

Exceptional items 0 0 0

Pretax profit 5,869 8,334 15,994

Taxation (239) 67 (485)

Minority interest 3 (559) (640)

Preferred dividends 0 0 0

Net extraordinary items 100 0 0

Reported net income 5,733 7,843 14,869

43
5.2.2 The Balance Sheet

Assets owned by a company are financed either by equity or debt and the balance sheet of a
company is a snapshot of this capital structure of the firm at a point in time; the sources and
applications of funds of the company.

A company owns fixed assets (machinery, and other infrastructure), current assets
(manufacturing goods in progress, money it expects to receive from business partners—
receivables, inventory etc.), cash and other financial investments. In addition to these three,
a company could also own other assets which carry value, but are not directly marketable,
like patents, trademarks, and ‘goodwill’—value not linked to assets, but realized from
acquisitions.

These assets are financed either by the company’s equity (investments by shareholders) or
by debt. The illustrative example shown below is the balance sheet of a large Pharmaceutical
company.
Illustration 5.2

Balance Sheet (US$m) 2006 2007 2008

Cash and marketable securities 15,628 14,106 17,290

Accounts receivable 3,609 6,789 14,177

Inventory 5,117 6,645 7,728

Other current assets 2,471 2,653 5,079

Current assets 26,826 30,192 44,274

Net tangible fixed assets 8,977 10,122 11,040

Total financial assets 3,237 2,239 2,659

Net goodwill 507 697 1,729

Total assets 39,547 43,250 59,701

Accounts payable 2,279 2,966 3,722

Short-term debt 0 0 0

Total other current liabilities 1,236 80 2,651

Current liabilities 3,515 3,046 6,373

Long-term debt 18,747 11,144 1,436

Total other non-current liabilities 1,053 895 92

44
 Total provisions 0 0 0

Total liabilities 23,314 15,085 7,901

Minority interest – accumulated 332 438 1,886

Shareholders’ equity 15,902 27,728 49,915

Shareholders’ funds 16,233 28,166 51,800

Liabilities and shareholders’ funds 39,547 43,250 59,701

5.2.3 Cash Flow Statement

The cash flow statement is the most important among the three financial statements,
particularly from a valuations perspective. As the name implies, such a statement is used to
track the cash flows in the company over a period. Cash flows are tracked across operating,
investing, and financing activities. Cash flows from operations include net income generation
adjusted for changes in working capital (like inventories, receivables and payables), and non-
core accruals (like depreciation, etc). A firm’s investment activities comprise fixed, and current
assets (capitaland operating expenditure), sometimes into other firms (like an acquisition),
and generally represent negative cash flows. Cash flows in financing activities are the net
result of the firm’s borrowing, and payments during the period. The sum total of cash flows
from these three heads represents the net change in cash balances of the firm over the period.
Cash generation from operating activities of the firm, when adjusted for its capital expenditure
represent the ‘free cash’ available to it, for potential investment activities, acquiring other
firms or businesses, or distribution among its shareholders. As we will see in later topics, free
cash flows are the key to calculating the so-called intrinsic value of an asset in any discounted
valuation model. Our illustrative example below shows the cash flow statement (and free cash
flows) of a large pharmaceutical company over the period 2006-2008.

Illustration 5.3

Cash Flow (US$M) 2006 2007 2008

Reported net income 5,733 7,843 14,869

Preferred dividends 0 0 0

Minority interest (3) 559 640

Depreciation and amortization 610 813 969

Cash tax adjustment 75 (511) (1,337)

Total other operating cash flow (1,365) (2,156) (753)

Net change in working capital (3,177) (4,154) (9,340)

45
 Cash from operations 1,872 2,394 5,048

Capital expenditure (3,387) (2,000) (1,995)

Net acquisitions/disposals 3,511 1,367 (5,242)

Total other investing cash flows 634 1,272 1,177

Cash from investing activities 758 639 (6,060)

Change in borrowings 805 (1,742) 768

Equity raised/share buybacks 0 0 0

Dividends paid (793) (2,629) (18)

Total other financing cash flows (156) (127) (88)

Cash from financing activities (144) (4,498) 661

Change in cash 3,518 (1,465) (352)

Free cash flow (1,514) 394 3,052

5.3 Financial Ratios (Return, Operating and, Profitability Ratios)

Financial ratios are meaningful links between different entries of financial statements, as by
themselves the financial entries offer little to examine a company. In addition to providing
information about the financial health and prospects of a company, financial ratios also allow
a company to be viewed, in a relative sense, in comparison with its own historical performance,
others in its sector of the economy, or between any two companies in general. In this section
we examine a few such ratios, grouped into categories that allow comparison of size, solvency,
operating performance, growth profile and risks. The list below is by no means exhaustive,
and merely serves to illustrate a few of the important ones.

5.3.1 Measures of Profitability: RoA, RoE

Return on Assets (RoA) in its simplest form denotes the firm’s ability to generate profits
given its assets :

RoA = (Net Income + Interest Expenses)*(1- Tax Rate) / Average Total Assets Return
on Equity (RoE) is the return to the equity investor :

RoE = Net Income / Shareholder Funds

Sometimes this ratio is also calculated as RoAE, to account for recent capital raising by the
firm

Return on Average Equity = Net Income / Average Shareholder Funds

Return on Total Capital = Net Income + Gross Interest Expense / Average total capital

46
5.3.2 Measures of Liquidity
Short-term liquidity is imperative for a company to remain solvent. The ratios below get
increasingly conservative in terms of the demands on a firm to meet near-term payables.

Current ratio = Current Assets / Current Liabilities

Quick Ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities
Acid test ratio = (Cash + Marketable Securities) / Current Liabilities
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities

5.3.3. Capital Structure and Solvency Ratios

Total debt to total capital = (Current Liabilities + Long-term Liabilities) /
(Equity + Total Liabilities)
Long-term Debt-Equity = Long-term Liabilities / Equity

5.3.4 Operating Performance

Gross Profit Margin = Gross Profit / Net Sales
Operating Profit Margin = Operating Income / Net Sales
Net Profit Margin = Net Income / Net Sales

5.3.5 Asset Utilization

These ratios look at the effectiveness of a firm to utilize its assets, especially its fixed assets.
A high turnover implies optimal use of assets. In addition to the two below there are others
like Sales to inventories, and Sales to Working capital.

Total Asset Turnover = Net Sales / Average Total Assets

Fixed Asset Turnover = Net Sales / Average Net Fixed Assets
There are many other categories, like the ‘common size’ ratios, which serve to present the
company in terms of one of its own denominators, like Net Sales, or the market capitalization;
and others that specifically look at the risk aspect of things (business, financial, and liquidity).
We shall take a look at another two categories, the market measures, and valuation ratios,
after the discussion on valuations.

5.4 The valuation of common stocks

In chapter 3, we examined a few of the major valuation methods for fixed income-generating
assets. Using financial statements and ratios, we now examine some of the concepts relating
to share valuations and to be more specific, we will deal with valuation of common stocks.
Common shareholders are the owners of the firm, and as such are the final stakeholders in its
growth, and risks; they appoint the management to run its day-to-day affairs and the Board
of Directors to oversee the management’s activities. The cash flows (return) to common
shareholders from the company are generally in the form of current and future dividends
distributed from the profits of the firm. Alternatively, an investor can always sell her holdings

47
in the market (secondary market), get the prevailing market price, and realize capital
appreciation if the returns are positive.

We now examine the valuation of common shares in some detail. As mentioned above, the
valuation of any asset is based on the present value of its future cash flows. Such a
methodology provides what is called the ‘intrinsic’ value of the asset—a common stock in our
case. The problem of valuing the stock then translates into one of predicting the future free
cash flow profile of the company, and then using the appropriate discount factor to measure
what they are worth today. The appropriately named discounted-cash flow technique is also
referred to as absolute valuation, particularly when compared to another widely-followed
approach in valuation, called relative valuation.

Relative valuation looks at pricing assets on the basis of the pricing of other, similar assets—
instead of pricing them independently—the core assumption being that assets with similar
earnings and growth profile, and facing the same risks ought to be priced comparably. Two
stocks in the same sector of the economy could thus be compared, and the same sector (and
its stocks) across countries. The discussion on relative valuation follows that of absolute or
intrinsic valuation.

5.4.1 Absolute (Intrinsic) Valuation

Intrinsic value or the fundamental value refers to the value of a security, which is intrinsic to
or contained in the security itself. It is defined as the present value of all expected cash flows
to the company. The estimation of intrinsic value is what we would be dealing with in details
in this chapter.

5.4.1.1 Discounted Cash Flows

The discounted cash flow method values the share based on the expected dividends from the
shares. The price of a share according to the discounted cash flow method is calculated as
under:

P0 = ∑ ∞
Div t t

t =1 (1 + r)

Since the profits of the firm are not certain, the actual future dividends are not known in
advance. However, the market forms an expectation of the future dividends and the value of
a share is the present value of expected future dividends of the company. It can be shown
+
that the formula can be seen as an extension of the formula P0 = D(iv11+ r)P 1 .

48
As explained above, we can write the share price at the end of the year 1 as a function of the
2nd year dividend and price of share at the end of the year 2. Or,

P1 = Div 2 +P2

(1+ r)
Similarly,

+ P
P2 = D(iv 13+ r) 3 and so on.

Putting the values of P1, P2, P3, P4, we can write:

P0 = D(iv 11++r)P1 = 1D+ivr1 + (1D+ivr2)2 + (1D+ivr3)3 + .... + (1D+ivrN)N + (1 +PN r)N

Now when N tends to infinity, (1+ r) and therefore may be ignored. So the current

share price (P0) can be written as:

N tends to infinity and the value of (1+PN r)N tends to zero

∞
Div

P0 = ∑(1 +r ) t t

t =1

5.4.1.2 Constant Dividend Growth

Let us see a special case of the above model when it is assumed that amount paid as
dividends grows at a constant rate (say g) every year. In this case, the cash flows in various
years will be as under: Year Cash Flow

0 -P0
1 Div1
2 Div2 = Div1*(1+g)

49
3 Div3 = Div2*(1+g) = Div1*(1+g)2
4 Div4 = Div3*(1+g) = Div2*(1+g)2= Div1*(1+g)3

In this circumstance, where the dividend amount grows at a constant rate, the constant
dividend growth model states that the share price can be obtained using the simple formula:

Div 1
P 0 =

r–g

This formula can be used only when the expected rate of return (r) is greater than the growth
rate (g). Otherwise, the present value of the growing perpetuity will reach infinite. This is even
true in real world. It is not possible for a stock’s dividend to grow at a rate g, which is greater
than r for infinite period. It can only be for a limited number of years. This model is not
applicable in such cases.

Example: RNL has paid a dividend of Rs. 10 per share last year (D 0) and it is expected to grow
at 5% every year. If an investor’s expected rate of return from RNL share is 7%, calculate the
market price of the share as per the dividend discount model.

Answer: The following are given:

Div0 = 10; g = 5% or 0.05; r = 7% or 0.07.

Div1 + Div0 *(1+ g)=10*1.05 = 10.50

Div 1 = 10.50 = 10.50 = 525

P0 =

r– g 0.07 – 0.05 0.02

The market price of RNL share as per the dividend discount model with constant growth rate
is Rs. 525.

If we know the market price of the share, the dividend amount and the dividend growth rate,
then we can compute the expected rate of return (r) by using the following formula:

Div 1 + g
r=
P0

5.4.1.3 Present Value of Growth opportunities (PVGO)

One can split the value of the shares as computed in the constant growth model into two parts
– the present value of the share assuming level stream of earnings (a level stream of earnings

50
is simply the current income extrapolated into the future, with no growth; in which case,
there’s no need to retain any of the earnings) and the present value of growth opportunities.
The value of growth opportunities is positive if the firm (and the market) believes that the firm
has avenues to invest which will generate a return that is more than the market expected rate
of return. Now when the firm’s income potential from additional investment is more than the
market expected rate of return, then for every penny re-invested (plowbacked rather than
distributed as dividend) will generate a return that is higher than the market expectation. The
value of such excess return is referred to as present value of growth opportunities.

PVGO =Share Price – Present value of level stream of earnings

=Share price– EPS / r

The growth in the future dividend arises because the firms, instead of distributing 100% of
the earnings as dividends, plowbacks and invests certain portion of the current year profit on
projects whose yield will be greater than the market expected rate of return.

The growth rate in dividend (g), equals, the Plowback ratio * ROE.

5.4.1.4 Discounted Free-cash flow valuation models

Using the above concepts, we are now in a position to look at valuation using cash flows, with
the discounted free cash flow model. We first determine the value of the enterprise and then
value the equity by deducting the debt value from the firm value. Thus:

Market value of equity (V0) = Value of the firm + Cash in hand – Debt Value

The price of the share (P0) is the market value of the equity divided by the number of shares
outstanding.

It is simple to calculate the debt value since the payments to be made to debt holders is
predetermined and certain. However, the real problem lies with determining the value of the
firm. As per the discounted free cash flow model, the value of a firm is the present value of
the future free cash flow of the firm. The discounting rate is the firms weighted average cost
of capital (WACC) and not the market expected rate of return on equity investment. WACC is
the cost of capital that reflects the risk of the overall business and not the risk associated with
the equity investment alone. WACC is calculated using the following formula:

D E
WACC = rD (1–T)* + r E * D+ E D+ E

where

rD and rE is the expected rate of return on debt and equity

51
T = Income Tax Rate
D = the market value of debt ; E = the market value of equity The
firm value (V0) is calculated using the following formula:

V0 = 1 FCF + rw1acc + (1+FCFrwa2cc )2 + (1+FCFrwa3cc )3 + ....+ (1+FCFrwaNcc )N +

(Ter(m1+inalrwaVcc a)luN eN )

The terminal value at year N is often computed by assuming that the FCF will grow at a
constant growth rate beyond year N, i.e.
Terminal ValueN = FCF N+1 = FCF *(1+ gFCF )

((r) WACC – gFCF ) ((r)WACC – gFCF )

where gFCF is the expected growth rate of the firms free cash flow

What is free cash flow (FCF)? The free cash measures the cash generated by the firm that can
be distributed to the equity shareholders after budgeting for capital expenditure and working
capital requirements. While computing FCF, we assume that the firm is a 100% equity owned
company and hence we do not consider any payment to debt or equity holders while calculating
the free cash flow. Thus the formula for computing FCF is:

Terminal VFCF = EBIT* (1– T)+ Depn – Capital Expenditure –IncreaseinWorkingCapital

where T in the tax rate.

We start with EBIT since we do not consider cash outflow in the form of interest payments.
Depreciation lowers the EBIT but is added back since it is a non-cash expenditure (does not
result in cash payments). Since the firm has to incur any planned capital expenditure and has
to finance any working capital requirement before distributing the profits to the shareholders
the same is deducted while calculating the free cash flows.

5.4.2 Relative Valuation

Relative valuation models do calculate the share price but they are generally based on the
valuation of comparable firms in the industry. Various valuation multiples such as price-
earning ratio, enterprise value multiples, etc. are used by the finance professionals which
depends on the industry, current economic scenario, etc. Most of these models are generally
used for evaluation purpose as to whether a particular stock is overvalued or undervalued and
less for actual valuation of the shares.

52
As discussed in the first chapter, the face value or nominal value of a share is the price printed
on the share certificate. One should not confuse a share’s nominal value with the price at
which the company issues shares to the public. The price at which a company issues shares
may be more or less than the face value. The issue price is generally more than the face value
and the difference between the issue price and the face value is called as share premium.

Market price is the price at which the share is traded in the market. It is determined by the
demand and supply of the share in the market and depends on the market (buyers and sellers)
estimation of the present value of all future cash flows to the company. In an efficient market,
we assume that the market is able to gather all information about the company and price
accordingly. Market capitalization of a company is the total value of all shares of the company
and is calculated by multiplying the market price per share with the number of shares
outstanding in the market.
The book value or carrying value in accounting, is the value of an asset according to its
balance sheet account balance. For assets, the value is based on the original cost of the asset
less any depreciation, amortization or impairment costs made against the asset. Book value
per share is calculated by dividing the net assets of the company with the number of shares
outstanding. The net asset of the company is the values of all assets less values of all liabilities
outstanding in the books of accounts.

5.4.2.1 Earning per Share (EPS)

Earning per share is the firms’ net income divided by the average number of shares
outstanding during the year.

Calculated as:
Net Proift – DividendonPreference Shares
EPS = Averagenumberof shares outstandingduring the year

5.4.2.2 Dividend per Share ( DPS )

Dividends are a form of profit distribution to the shareholders. The firm may not distribute the
entire income to the shareholders, but decide to retain some portion of it for financing growth
opportunities. Alternatively, a firm may pay dividends from past years profit during years
where there is insufficient income. In this case, the dividends amount will be higher than the
earnings. The dividend per share is the amount that the firm pays as dividend to the holder of
one share i.e. total dividend / number of shares in issue.

53
The dividend payout ratio (DPR) measures the percentage of income that the company pays
out to the shareholders in the form of dividends. The formula for calculating DPR is:

Dividends DPS
DPR = =
Net Income EPS

Retention ratio is the opposite of dividend payout ratio and measures the percentage of net
income not paid to the shareholders in the form of dividends. It is nothing but (1-DPR).

Example: The following is the figure for Asha International during the year 2008-09:

Net Income: Rs. 1,000,000

Number of equity shares (2008): 150,000 Number

of equity shares (2009): 250,000

Dividend paid: Rs. 400,000

Calculate the earnings per share (EPS), dividend per share (DPS), dividend payout ratio and
retention ratio for Asha International.

Answer:
Opening + closing 150,000 + 250,000
Average number of shares = = = 200,000
2 2

Net Income 1,000,0000

EPS = = =5
AverageNumber of shares 200,000

Dividends 4,00,000
DPS = = = 2

54
 AverageNumber of shares 200,000

DPS 2
DPR = = = 0.4 or 40%
EPS 5

Retention Ratio = 1- DPR = 0.6 or 60 %

5.4.2.3 Price-earnings ratio (P/E Ratio)

Price earning ratio for a company is calculated by dividing the market price per share
with the earnings per share (EPS).

Market priceper share

PriceEarnings Ratio =
Annual earningper share

The earning per share is usually calculated for the last one year. Sometimes, we also
calculate the PE ratio using the expected future one-year return. In such case, we call
forward PE or estimated PE ratio.

Example: Stock XYZ, whose earning per share is Rs. 50 is trading in the market at Rs.
2000. What is the price to earnings ratio for XYZ?

Answer:
Market priceper share 2000
PriceEarnings Ratio = = = 40 Annual earningper share 50

We cannot draw any conclusion as to whether a stock is undervalued or overvalued in

the market by just considering the PE ratio. A higher PE ratio implies that the investors
are paying more for each unit of net income, which implies that the investors are
optimistic about the future performance (or future growth rate) of the company.
Stocks with higher PE ratio are also called growth firms and stocks with lower PE ratio
are called as income firms.

5.4.2.4 Price-Book Ratio

The price-book ratio is widely used as a conservative measure of relative valuation of

an asset, where the assets of the firm are valued at book. Investors also widely use
the ratio to judge whether the stock is undervalued or overvalued, as it’s less
susceptible to fluctuations than the PE ratio. The formula to calculate the ratio is:
Price-book ratio = Market price of the share / Book Value per share.

5.4.2.5 Return on Equity

Return on equity measures profitability from the equity shareholders point of view. It
is the return to the equity shareholders and is measured by the following formula:

Net Incomeafter Tax– Preferred Dividends

ROE = AverageShareholder EquityExcluding Preferred
ShareCapital

Example: XYZ Company net income after tax for the financial year ending 31 st March,
2009 was Rs. 10 million and the equity share capital as on 31 st March, 2008 and 31st
March 2009 was Rs. 80 million and Rs. 120 million respectively. Calculate the return
on equity of XYZ company for the year 2008-09.

Answer:
Opening Equity + Closing Equity 80 + 120
Average Equity = = = 100 million 2 2

Net Profit after Tax 10

ReturnonEquity= = = 0.10 or10% Average Equity 100

5.4.2.6 The DuPont Model

The Du Pont model is widely used to decide the determinants of return profitability of
a company, or a sector of the economy. Returns on shareholder equity are expressed
in terms of a company’s profit margins, asset turn, and its financial leverage.

DuPont Model breaks the Return on equity as under:

RoE = Return on Equity

= Net Profits/Equity

= Net Profits/Sales * Sales/Assets * Assets/Equity

= Profit Margin * Asset Turnover * Financial Leverage

The first component measures the operational efficiency of the firm through its net
margin ratio. The second component, called the asset turnover ratio, measures the
efficiency in usage of assets by the firm and the third component measures the
financial leverage of the firm through the equity multiplier. The analysis reflects a
firms’ efficiency in different aspects of business and is widely used now for control
purpose. It shows that the firm could improve its RoE by a combination of profitability
(higher profit margins), raising leverage (by raising debt) , by using its assets better
(higher asset turn) or a combination of all three.
The DuPont analysis could be easily extended to ascertain a sector’s profitability
metrics for comparability, or, for that matter, an entire market.

5.4.2.7 Dividend Yield

Dividend yield is the ratio between the dividend paid during the last 1-year period and
the current price of the share. The ratio could also be used with the forward dividend
yield instead— expected dividends, for either the next 12 months, or the financial
year.

Example: ABC Company paid a dividend of Rs. 5 per share in 2009 and the market
price of ABC share at the end of 2009 was Rs. 25. Calculate the dividend yield for ABC
stock.

Answer:

Last year dividend 5

DividendYield= = = 0.20 or20% CurrentPrice
per share 25

5.4.2.8 Return to Investor

The return what the investor earns during a year by holding the share of a company
is not equal to the dividend per share or the earnings per ratio. An investor’s earning
is the sum of the dividend amount that he received from the company and the change
in the market price of the share. The investment amount is equal to the market price
of the share at the beginning of the year. An investor’s return can be calculated using
the following formula:

Dividends+ Δ(market priceof theshare)

Expected Return(r) =
OpeningMarket Price
Example: The share price of PQR Company on 1st April 2008 and 31st March 2009 is
Rs. 80 and Rs. 84 respectively. The company paid a dividend of Rs. 6 for the year
2008-09. Calculate the return for a shareholder of PQR Company in the year 2008-09.

Answer:

Dividends+ ∆(market priceof theshare) 6 + (84– 80) 10

Expected Return(r) = = = = 12.5% OpeningMarket Price 80
80

If we write the dividends during the year as Div1, the price of the share at the beginning
and at the end of the year as P0 and P1 respectively, we can write the above formula
as:

r = Div 1 + P1 – P0

P0

This can be re-written as:

P0 = Div 1 – P1

(1+ r)
This implies that given the expected rate of return for an investor, the price of a share
can be calculated based on the investor expectation of the future dividends and the
future share price. We have already learned in the previous chapter about the factors
that affect the expected rate of returns and how one can calculate the expected rate
of returns (e.g. using CAPM). Now the question arises what determines the next year
price (P1) of a share.

5.5 Technical Analysis

Our final approach to valuation is also considered the most controversial, with the
numbers of believers balancing those who find fault with the methodology. Technical
analysis involves making trading decisions by studying records or charts of past stock
prices and volume, and in the case of futures, open interest.

The technical analysts do not attempt to measure a security’s intrinsic value but
believe in making short-term profit by analyzing the volume and price patterns and
trends. Technical analysts use statistical tools like time series analysis (in particular
trend analysis), relative strength index, moving averages, regressions, price
correlations, etc. The field of technical analysis is based on the following three
assumptions.

a) The market discounts everything: Technical analysts believe that the market
price takes into consideration the intrinsic value of the stocks along with
broader economic factors and the market psychology. Therefore, what is
important is an analysis of the price movement that reflects the demand and
supply of a stock in the short run.

b) Price moves in trends: Trends are of three types, viz. uptrend, downtrend and
horizontal trend. Technical analysts believe that once trends are established
in the prices, the price moves in the same direction as the trends suggests.

c) History tends to repeat itself: This assumption leads to a belief that current
investors repeat the behavior of the investors that preceded them and
therefore recognizable price patterns can be observed if a chart is drawn.

There are various concepts that are used by technical analysts like support prices,
resistance levels, breakouts, momentum, etc. These concepts can be heard very often
in business channels and business newspapers. Supports refer to the price level
through which a stock price seldom falls and resistance is the price level through which
a stock seldom surpasses. Breakout refers to situation when the price actually falls
below the support level or rises above the resistance level. Once a breakout occurs,
the role is reversed. If the price increases beyond the resistance level, the resistance
level becomes the support level and when the price falls below the support level, the
support level becomes the new resistance level for the stock. Momentum refers to
the rate at which price of a stock changes.
5.5.1 Challenges to Technical Analysis

There are many questions, primarily raised by fundamental analysts, about the
assumptions of technical analysis. While it is understandable that price movements
are caused by the interaction of supply and demand of securities and that the market
assimilates this information (as mentioned in the first assumption), there is no
consensus on the speed of this adjustment or its extent. In other words, while prices
may react to changes in demand-supply and other market dynamics, the response
could easily differ across securities, both in the time taken, and the degree to which
prices change. Other objections to technical analysis arise from Efficient Markets
Hypothesis, which we have seen in Chapter 4. Proponents of the EMH aver that market
efficiency would preclude any technical trading patterns to repeat with any predictable
accuracy, rendering the profitability of most such trading rules subject to chance.
Further, the success of a trading rule could also make it crowded, in the sense that
most technical traders follow a small set of rules (albeit with possibly different
parameterizations) , speeding up the adjustment of the market, and thus reducing the
potential gains. Finally, technical analysis involves meaningful levels of subjectivity-
interpretations may vary widely on the same pattern of stock, or index prices-which
also hinders systematic reasoning and extensibility across different securities.
CHAPTER 6: Modern Portfolio Theory
6.1 Introduction
Understanding the risky behaviour of asset and their pricing in the market is critical
to various investment decisions, be it related to financial assets or real assets. This
understanding is mostly developed through the analysis and generalization of the
behaviour of individual investors in the market under certain assumptions. The two
building blocks of this analysis and generalization are (i) theory about the risk-return
characteristics of assets in a portfolio (portfolio theory) and (ii) generalization about
the preferences of investors buying and selling risky assets (equilibrium models). Both
these aspects are discussed in detail in this chapter, where our aim is to provide a
brief overview of how finance theory treats stocks (and other assets) individually, and
at a portfolio level. We first examine the modern approach to understanding portfolio
management using the trade-off between risk and return and then look at some
equilibrium asset-pricing models. Such models help us understand the theoretical
underpinning and (hopefully predict) the dynamic movement of asset prices.

6.2 Diversification and Portfolio Risks

The age-old wisdom about not putting “all your eggs in one basket” applies very much
in the case of portfolios. Portfolio risk (generally defined as the standard deviation of
returns) is not the weighted average of the risk (standard deviation) of individual
assets in the portfolio. This gives rise to opportunities to eliminate the risk of assets,
at least partly, by combining risky assets in a portfolio. To give an example, consider
a hypothetical portfolio with say, ten stocks. Each of these stocks has a risk profile, a
simple and widely used indicator of which is the standard deviation of its returns.
Intuitively, the overall risk of the portfolio simply ought to be an aggregation of
individual portfolio risks, in other words, portfolio risk simply ought to be a weighted
average of individual stock risks. Our assertion here is that the risk of the portfolio is
usually much lower. Why? As we shall see in the discussion here, this is largely due to
the interrelationships that exist between stock price movements. These so-called
covariances between stocks, could be positive, negative, or zero. An example of two
IT services stocks, reacting favourably to a depreciation in the domestic currency—as
their export realizations would rise in the domestic currency—is one of positive
covariance. If however, we compare one IT services company with another from the
metals space, say steel, which has high foreign debt, then a drop in the share price of
the steel company (as the falling rupee would increase the debt-service payments of
the steel firm) and rise in share price of the IT services company, would provide an
example of negative covariance. It follows that we would expect to have zero
covariance between stocks whose movements are not related.
Figure 6.1 : Portfolio Risk and Return for Assets with Different Correlations

Note: the portfolio sigma is the standard deviation. The portfolios are created by using
actual return data and assumed correlations, except 0.4, which is the actual correlation
between the two stocks.

With these insights we can now examine the behaviour of portfolios with a larger
number of assets.

6.3 Equilibrium Models: The Capital Asset Pricing Model

The most important insight from the analysis of portfolio risk is that a part of the
portfolio variance can be diversified away (unsystematic or diversifiable risk) by
selecting securities with less than perfect correlation. This along with the other insights
obtained from the analysis would help us to understand the pricing of risky assets in
the equilibrium for any asset in the capital market, under certain assumptions.
These additional assumptions required are as follows:
 • All investors are mean-variance optimizers. This implies that investors are
concerned only about the mean and variance of asset returns. Investors
would either prefer portfolios which offer higher return for the same level
of risk or prefer portfolios which offer minimum risk for a given level of
return (the indirect assumption of mean-variance investors is that all
other characteristics of the assets are captured by the mean and
variance).

• Investors have homogenous information about different assets. The well-

organized financial markets have remarkable ability to digest information
almost instantaneously (largely reflected as the price variation in
response to sensitive information).

• Transaction costs are absent in the market and securities can be bought
and sold without significant price impact.

• Investors have the same investment horizon.

Given these assumptions, it is not impossible to see that substantive arbitrage

opportunities would not exist in the market. For instance, if there is a portfolio which
gives a higher return for same level of risk, investors would prefer that portfolio
compared to the existing one.

In light of the behaviour of portfolio risk and the above assumptions, let us try to
visualize what would be the relationship between risk and return of assets in the
equilibrium.

6.3.1 Mean-Variance Investors and Market Behaviour

We can use a so-called mean-variance space to examine the aggregate behaviour of

the market (as all investors are mean-variance optimizers, these are the only variables
that matter). Evidently, all the assets in the market can be mapped on to a return-
standard deviation space as follows.

Figure 6.2 : Return and Risk of Some of the Nifty stocks

All these stocks (in figure 6.2) have correlations between 0 and 1. Therefore, their
combination could theoretically be characterized as given in figure 6.3.

Figure 6.3 : Feasible Set of Portfolios

All the feasible portfolio combinations can be represented by the space enclosed by
the curved line and the straight-line. The curved line represents combinations of stocks
or portfolios where correlations are less than 1, whereas portfolios along the straight-
line represent combinations of stocks or portfolios with the maximum correlation
(+1.0) (no portfolios would lie to the right of the straight-line).

Obviously, a mean-variance investor would prefer portfolio A to B, given that it has

lower risk for the same level of return offered by B. Similarly, portfolio A would be
preferred to portfolio C, given that it offers higher return for the same level of risk. D
is the minimum variance portfolio among the entire feasible set. A close examination
of the feasible set of portfolios reveals that portfolios that lie along D-E represent the
best available combination of portfolios. Investors with various risk tolerance levels
can choose one of these portfolios. These portfolios offer the maximum return for any
given level of risk. Therefore, these are called the efficient portfolios (and the set of
all such portfolios, the efficient frontier), as represented in Figure 6.4.
Figure 6.4: Efficient Frontier

Ordinarily, the investor also has the opportunity to invest in a risk-free asset.
Practically, this could be a bank deposit, treasury bills, Government securities or
Government guaranteed bonds. With the availability of a risk-free security, the choice
facing the mean-variance investor can be conveniently characterised as follows:

Figure 6.5 : Efficient Portfolio in the Presence of a Risk-Free Asset

As given in figure 6.5, with the presence of the risk-free asset, that has no correlation
with any other risky asset, the investor also gets an added opportunity to combine
portfolios along the efficient frontier with the risk-free asset. This would imply that the
investor could partly put the money in the risky security and the remaining in any of
the risky portfolios.

Apparently, the portfolio choice of the mean-variance investor is no more the securities
along the efficient frontier (D-E). If an investor prefers less risk, then rather than
choosing D by going down the efficient frontier, he can choose G, a combination of
risky portfolio M and the risk-free asset. G gives a higher return for the level of risk of
D. In fact, the same applies for all the portfolios along the efficient frontier that lie
between D and M (they offer only lower returns compared to those which lie along the
straight-line connecting the risk-free asset and risky portfolio M).

This gives the powerful insight that, with the presence of the risk-free security, the
most preferred portfolio along the efficient frontier would be M (portfolios to the right
of M along the straight line indicates borrowing at the risk-free rate and investing in
M).

An investor who does not want to take the risk of M, would be better off by combining
with the risk-free security rather than investing in risky portfolios with lower standard
deviation (that lie along the M-D).

Identification of M as the optimal portfolio, combined with the assumptions (1) that all
investors have the same information about mean and variance of securities and (2)
they all have the same investment horizon, suggest that all the investors would hold
only the following portfolios depending on the risk appetite.

1. The portfolio purely of risky assets, which would be M.

2. The portfolio of risky assets and risk-free asset, which would be a combination
of M and RF.

All other portfolios are inferior to these choices, for any level of risk preferred by the
investors. Let us examine what would be the nature of the portfolio M. If all investors
are mean-variance optimizers and have the same information, their portfolios would
invariably be the same. Then, all of them would identify the same portfolio as M.
Obviously, it should be a combination of all the risky stocks (assets) available in the
market (somebody should be willing to hold all the assets available on the market).
This portfolio is referred to as the market portfolio. Practically, the market portfolio
can be regarded as one represented by a very liquid index like the NIFTY. The line
connecting the market portfolio to the risk-free asset is called the Capital Market
Line (CML). All points along the CML have superior risk-return profiles to any portfolio
on the efficient frontier.

With the understanding about the aggregate behaviour of the investors in the
securities market, we can estimate the risk premium that is required for any asset.
Understanding the risk premium dramatically solves the asset pricing problem through
the estimation of the discounting factor to be applied to the expected cash flows from
the asset. With the expected cash flows and the discounting rate, the price of any risky
asset can be directly estimated.

Let RM be the required rate of return on the market (market portfolio, M), RF be the
required rate of return on the risk free asset and σM be the standard deviation of the
market portfolio. From Figure 6.5, the rate of risk premium required for unit variance
of the market is estimated as,
RM – RF
σ2M (6)

In a very liquid market (where assets can be bought and sold without much hassles),
investor has the opportunity to hold stocks as a portfolio rather than in isolation. If
investors have the opportunity to hold a well-diversified portfolio, the only risk that
matters in the individual security is the incremental risk that it contributes to a well-
diversified portfolio. Therefore, the risk relevant to the prospective investor (or firm)
is the covariance risk. Then, one can compute the risk premium required on the
security as follows

Risk premium on stock = RMσ–M R F × Cov (i, M)

2

where, Cov(i,M), is the covariance between the returns of stock i and the market
returns
Cov (i, M)
(returns on portfolio M). The quantity represented by σ2M is popularly called the beta

(β). This measures the sensitivity of the security compared to the market. A beta of

2.0 indicates that if the market moves down (up) by 1%, the security is expected to
move down (up) 2%. Therefore, we would expect twice the risk premium as compared
to the market. This implies that the minimum expected return on this stock is 2 x (Rm
–Rf ). In general, the risk premium on a security is β times (Rm –Rf ). Obviously, the

market portfolio will have a beta of 1.0 (covariance of a stock with itself is variance).

Now by combining the risk-free rate and the risk premium as estimated above, the
total required rate of return on any risky asset is,

Ri = RF + (RM –RF )βi (7)

This approach to the estimation of the required return of assets (cost of equity, in case
of equity) is called the Capital Asset Pricing Model (CAPM, pioneered by William
Sharpe).

If CAPM holds in the market, all the stocks would be priced according to their beta.
This would imply that the stock prices are estimated by the market by discounting the
expected cash flows by applying a discounting rate as estimated based on equation
(7).

Hence, all the stocks can be identified in the mean return-beta space, as shown below
and relationship between beta and return can be estimated. The line presented in the
following figure is popularly called the Securities Market Line (SML).
Figure 6.6 : Security Market Line
Note: this figure is not based on any real data.

Prices (returns) which are not according to CAPM shall be quickly identified by the
market and brought back to the equilibrium. For instance, stocks A and B given in the
following figure (6.7) shall be brought back to the equilibrium through market
dynamics.

This works as follows. Stock A, currently requires a lower risk premium (required rate
of return) than a specified by CAPM (the price is higher). Sensing this price of A as
relatively expensive, the mean-variance investors would sell this stock. The decreased
demand for the stock would push its price downwards and restore the return back to
as specified by CAPM (will be on the line). The reverse happens in case of stock B,
with increased buying pressure.

Figure 6.7 : Arbitrages around SML

6.3.2 Estimation of Beta

The beta of a stock can be estimated with the formula discussed above. Practically,
the beta of any stock can be conveniently estimated as a regression between the
return on stock and that of the market, represented by a stock index like NIFTY (the
dependent variable is the stock return and the independent variables is the market
return).

Accordingly, the regression equation is,

Ri = αi + βi RM + ei , (8)

where the regression coefficient βi represents the slope of the linear relationship

between the stock return and the market return and αi denote the risk-free rate of
return. The SLOPE function in MS-Excel is a convenient way to calculate this coefficient
from the model.

The beta of an existing firm traded in the market can be derived directly from the
market prices. However, on many occasions, we might be interested to estimate the
required rate of return on an asset which is not traded in the market. For instances
like, pricing of an IPO, takeover of another firm, valuation of certain specific assets
etc.. In these instances, the required rate of return can be estimated by obtaining the
beta estimates from similar firms in the same industry.

The beta can be related to the nature of the assets held by a firm. If the firm holds
more risky assets the beta shall also be higher. Now, it is not difficult to see why
investors like venture capitalists demand higher return for investing in start-up firms.
A firm’s beta is the weighted average of the beta of its assets (just as the beta of a
portfolio is the weighted average of the beta of its constituent assets).

6.4 Multifactor Models: The Arbitrage Pricing Theory (APT)

The CAPM is founded on the following two assumptions (1) in the equilibrium every
mean variance investor holds the same market portfolio and (2) the only risk the
investor faces is the beta. Evidently, these are strong assumptions about the market
structure and behaviour of investors. A more general framework about asset pricing
should allow for relaxation of these strong and somewhat counterfactual assumptions.
A number of alternative equilibrium asset pricing models, including the general
arbitrage pricing theory (APT), attempt to relax these assumptions to provide a better
understanding about asset pricing.

The arbitrage pricing theory assumes that the investor portfolio is exposed to a
number of systematic risk factors. Arbitrage in the market ensures that portfolios with
equal sensitivity to a fundamental risk factor are equally priced. It further assumes
that the risk factors which are associated with any asset can be expressed as a linear
combination of the fundamental risk factors and the factor sensitivities (betas).
Arbitrage is then assumed to eliminate all opportunities to earn riskless profit by
simultaneously selling and buying equivalent portfolios (in terms of risk) which are
overpriced and underpriced.
Under these assumptions, all investors need not have the same market portfolio as
under CAPM. Hence, APT relaxes the assumption that all investors in the market hold
the same portfolio. Again, as compared to CAPM, which has only one risk dimension,
under the APT characterization of the assets, there will be as many dimensions as
there are fundamental risks, which cannot be diversified by the investors. The
fundamental factors involved could for instance be the growth rate of the economy
(GDP growth rate), inflation, interest rates and any other macroeconomic factor which
would expose the investor’s portfolio to systematic risk.

In the lines of the assumptions of arbitrage pricing theory, a number of multifactor

asset pricing models have been proposed. One such empirically successful model is
the so-called Fama-French three-factor model. The Fama-French model has two more
risk factors, viz., size, and book-to-market ratio as the additional risk factors along
with the market risk as specified by CAPM. The size risk factor is the difference
between the expected returns on a portfolio of small stocks and that of large stocks.
And the book-to-market ratio is the difference in the expected return of the portfolio
of high book-to market-ratio stocks and that of low book-to market-ratio stocks.

Theoretical and empirical evidence suggests that in the real market, expected returns
are probably determined by a multifactor model. Against this evidence, the most
popular and simple equilibrium model, CAPM, could be regarded as a special case
where all investors hold the same portfolio and their only risk exposure is the market
risk.

CHAPTER 7: Valuation of Derivatives

7.1 Introduction
Derivatives are a wide group of financial securities defined on the basis of other
financial securities, i.e., the price of a derivative is dependent on the price of another
security, called the underlying. These underlying securities are usually shares or
bonds, although they can be various other financial products, even other derivatives.
As a quick example, let’s consider the derivative called a ‘call option’, defined on a
common share. The buyer of such a product gets the right to buy the common share
by a future date. But she might not want to do so—there’s no obligation to buy it, just
the choice, the option. Let’s now flesh out some of the details. The price at which she
can buy the underlying is called the strike price, and the date after which this option
expires is called the strike date. In other words, the buyer of a call option has the
right, but not the obligation to take a long position in the underlying at the strike price
on or before the strike date. Call options are further classified as being European, if
this right can only be exercised on the strike date and American, if it can be exercised
any time up and until the strike date.

Derivatives are amongst the widely traded financial securities in the world. Turnover
in the futures and options markets are usually many times the cash (underlying)
markets. Our treatment of derivatives in this module is somewhat limited: we provide
a short introduction about of the major types of derivatives traded in the markets and
their pricing.
7.2 Forwards and Futures
Forward contracts are agreements to exchange an underlying security at an agreed
rate on a specified future date (called expiry date). The agreed rate is called forward
rate and the difference between the spot rate, the rate prevailing today, and the
forward rate is called the forward margin. The party that agrees to buy the asset on a
future date is referred to as a long investor and is said to have a long position.
Similarly, the party that agrees to sell the asset in a future date is referred to as a
short investor and is said to have a short position.

Forward contracts are bilateral (privately negotiated between two parties), traded
outside a regulated stock exchange (traded in the OTC or ‘Over the Counter’ market)
and suffer from counter-party risks and liquidity risks. Here counter-party risk refers
to the default risk that arises when one party in the contract defaults on fulfilling its
obligations thereby causing loss to the other party.

Futures contracts are also agreements to buy or sell an asset for a certain price at a
future time. Unlike forward contracts, which are traded in the over-the-counter market
with no standard contract size or delivery arrangements, futures contracts are
standardized contracts and are traded on recognized and regulated stock exchanges.
They are standardized in terms of contract sizes, trading parameters and settlement
procedures, and the contract or lot size (no. of shares/units per contract) is fixed.

Since futures contracts are traded through exchanges, the settlement of the contract
is guaranteed by the exchange or a clearing corporation (through the process of
novation) and hence there is no counter-party risk. Exchanges guarantee execution
by holding a caution amount as security from both the parties (buyers and sellers).
This amount is called as the margin money, and is adjusted daily based on price
movements of the underlying till the contract expires.

Compared to forward contracts, futures also provide the flexibility of closing out the
contract prior to the maturity by squaring off the transaction in the market.
Occasionally the fact forward contracts are bilateral comes in handy—two parties could
suit a contract according to their needs; such a futures may not be traded in the
market. Primary examples are long-term contracts—most futures contracts have short
maturities of less than a few months.
The table here draws a comparison between a forward and a futures contract.

Table 7.1 : Comparison of Forward and Futures Contracts

Forward Contract Futures Contract

Nature of Contract Standardized contract

Non-standardized/
Customized contract

Trading Private contract between Traded on an exchange

parties – Informal, Over-
the-Counter market

Settlement Set by the parties. Final Settlement date is

Pre-specified in the fixed by the exchange. In

contract. addition, there is a provision

of daily settlement, known as
daily mark to market
settlement.

Risk Counterparty risk exists, Exchange provides the

no independent guarantee. guarantee of settlement and

hence no counter party risk.

7.3 Call and Put Options

Like forwards and futures, options are derivative instruments that provide the
opportunity to buy or sell an underlying asset on a future date. As explained in the
introduction, an option contract is a contract written by a seller that conveys the
buyers a right, but not an obligation to either sell (put option) or buy (call option) a
particular asset at a specified price in the future. In case of call options, the option
buyer has a right to buy and in case of put options, the option buyer has a right to sell
the security at the agreed upon price (called strike rate or exercise price). In return
for granting the option, the party (seller) granting the option collects a payment from
the other party. This payment collected is called the “premium” or price of the option.

Options are like insurance contracts. Unlike futures, where the parties are denied of
any favorable movement in the market, in case of options, the buyers are protected
from downside risks and in the same time, are able to reap the benefits from any
favorable movement in the exchange rate. The buyer of the option has a right but no
obligation to enforce the execution of the option contract and hence, the maximum
loss that the option buyer can suffer is limited to the premium amount paid to enter
into the contract. The buyer would exercise the option only when she can make some
profit from the exercise, otherwise, the option would not be exercised, and be allowed
to lapse. Recall that in case of American options, the right can be exercised on any
day on or before the expiry date but in case of a European option, the right can be
exercised only on the expiry date.

Options can be used for hedging as well as for speculation purposes. An option is used
as a hedging tool if the investor already has (or is expected to have) an open position
in the spot market. For example, in case of currency options, importers buy call options
to hedge against future depreciation of the local currency (which would make their
imports more expensive) and exporters could buy put options to hedge against
currency appreciation. There are other methds of hedging too—using forwards,
futures, or combinations of all three—and the choice of hedging is determined by the
costs involved.

7.4 Forward and Futures Pricing

Forwards/ futures contract are priced using the cost of carry model. The cost of carry
model calculates the fair value of futures contract based on the current spot price of
the underlying asset. The formula used for pricing futures is given below:

F = SerT Where:

F = Futures Price

S = Spot price of the underlying asset

R = Cost of financing (using a continuously compounded interest rate)

T = Time till expiration in years

E = 2.71828 (The base of natural logarithms)

Example: Security of ABB Ltd trades in the spot market at Rs. 850. Money can be
invested at 11% per annum. The fair value of a one-month futures contract on ABB is
calculated as follows:
 1
F = SerT = 850* e0.11 12 = 857.80

The presence of arbitrageurs would force the price to equal the fair value of the asset.
If the futures price is less than the fair value, one can profit by holding a long position
in the futures and a short position in the underlying. Alternatively, if the futures price
is more than the fair value, there is a scope to make a profit by holding a short position
in the futures and a long position in the underlying. The increase in demand/ supply
of the futures (and spot) contracts will force the futures price to equal the fair value
of the asset.

7.4.1 Cost-of-carry and convenience yield

The cost of carry is the cost of holding a position. It is usually represented as a

percentage of the spot price. Generally, for most investment, we consider the risk-
free interest rate as the cost of carry. In case of commodities contracts, cost of carry
also includes storage costs (also expressed as a percentage of the spot price) of the
underlying asset until maturity.

Futures prices being lower than spot price (backwardation) is also explained by the
concept of convenience yield. It is the opposite of carrying charges and refers to the
benefit accruing to the holder of the asset. For example, one of the benefits to the
inventory holder is the timely availability of the underlying asset during a period when
the underlying asset is otherwise facing a stringent supply situation in the market.
Convenience yield has a negative relationship with inventory storage levels (and
storage cost). High storage cost/high inventory levels lead to negative convenience
yield and vice versa.

The cost of carry model expresses the forward (future) price as a function of the spot
price and the cost of carry and convenience yield.

F = [S + PV (storagecost)]* e(r – c)t

Where F is the forward price, S is the spot price, r is the risk-free interest rate, c is
the convenience yield and t is the time to delivery of the forward contract (expressed
as a fraction of 1 year).
7.4.2 Backwardation and Contango

The theory of normal backwardation was first developed by J. M. Keynes in 1930. The
theory suggests that the futures price is a biased estimate of the expected spot price
at the maturity. The underlying principle for the theory is that hedgers use the future
market to avoid risks and pay a significant amount to the speculators for this
insurance. When the future price is lower than the current spot price, the market is
said to be backwarded and the opposite is called as a contango market. Since future
and spot prices have to converge on maturity (this is sometimes called the law of one
price), in the case of a backwarded market, the future price will increase relative to
the expected spot price with passage of time, the process referred to as
backwardation. In case of contango, the future price decreases relative to the
expected spot price.

Backwardation and contango is easily explained in terms of the seasonal nature of

commodities. Commodity futures with expiration dates falling in post harvest month
would face backwardation, as the expected spot price would be lower. When hedgers
are net short (farmers willing to sell the produce immediately after harvest), or the
risk aversion is more for short hedgers than the long hedgers, the futures price would
be a downward biased estimate of the expected spot price, resulting into a backwarded
market.

7.5 Option Pricing

Our brief treatment of options in this module initially looks at pay-off diagrams, which
chart the price of the option with changes in the price of the underlying and then
describes how call and option prices are related using put-call parity. We then briefly
describe the celebrated Black-Scholes formula to price a European option.

7.5.1 Payoffs from option contracts

Payoffs from an option contract refer to the value of the option contract for the parties
(buyer and seller) on the date the option is exercised. For the sake of simplicity, we
do not consider the initial premium amount while calculating the option payoffs.

In case of call options, the option buyer would exercise the option only if the market
price on the date of exercise is more than the strike price of the option contract.
Otherwise, the option is worthless since it will expire without being exercised.
Similarly, a put option buyer would exercise her right if the market price is lower than
the exercise price.

The payoff of a call option buyer at expiration is:

Max [(Market price of theshare – Exercise Price), 0]

The following figures shows the payoff diagram for call options buyer and seller
(assumed exercise price is 100)

The payoff for a buyer of a put option at expiration is:

Max [(Exerciseprice –Market price of theshare), 0]

The payoff diagram for put options buyer and seller (assumed exercise price is 100)
From the pay-off diagrams it’s apparent that a buyer of call options would expect the
market price of the stock to rise, and buying the call option allows him to lock in the
benefits of such a rise, and also cap the downside in the event of a fall. The price of
course is the premium. On the other side, a seller of call options has a contrarian view,
and hopes to profit from the premium of the call options sold that would expire
unexercised. It’s clear from the vertical axis of the payoff diagram (which provides the
payoff the contract), that while the downside of a call option buyer is limited, it is not
so for the seller.

In a similar sense, a buyer of put options would expect the market to fall, and profit
from it, with an insurance, or a hedge (in the event of an unexpected rise in the
market), to cap the downside. The price of the hedge is the put option premium.
7.5.2 Put-call parity relationship

The put-call parity relationship gives us a fundamental relationship between European

call options and put options. The relationship is derived by noticing that the payoff
from the following two strategies is the same irrespective of the stock price at
maturity. The two strategies are:

Strategy 1: Buy a call option and investing the present value of exercise price in risk-
free asset.

Strategy 2: Buy a put option and buying a share.

This can be shown in the form of the following diagram:

Strategy 1:

Strategy 2:

Since the payoff from the two strategies is the same therefore:
Value of call option (C) + PV of exercise price Ke–rt ( ) = value of put option (P) +
Current share price (S0), i.e.

C + Ke– rt =P + S0
7.6 Black-Scholes formula
The main question that is still unanswered is the price of a call option for entering
into the option contract, i.e. the option premium. The premium amount is dependent
on many variables. They are:

- Share Price (S0)

- Exercise Price (K)

- The time to expiration i.e. period for which the option is valid (T)

- Prevailing risk-free interest rate ( r )

- The expected volatility of the underlying asset (σ)

One of the landmark inventions in the financial world has been the Black-Scholes
formula to price a European option. Fischer Black and Myron Scholes2 in their seminal
paper in 1973 gave the world a mathematical model to value the call options and put
options. The formula proved to be very useful not only to the academics but also to
practitioners in the finance world. The authors were later awarded The Sveriges
Riksbank Prize in Economic Sciences in Memory of Alfred Nobel in 1997. The Black-
Scholes formula for valuing call options (c) and value of put options (p) is as under:

c(S,t) = SN (d1)–ke –r(T –t)

N(d2)

and p(S,t) = Ke–r(T –t)

N(–d2)–

SN(–d1) Where

S σ
d 1 = ln K + r + 22 (T – t)

σ T –t

d = d1 – σ T – t 2
Where,

N(.) is the cumulative distribution function (cdf) of the standard normal distribution

T-t is the time to maturity

S is the spot price of the underlying asset K is

the strike price r is the continuously

compounded annual risk-free rate σ is the

volatility in the log returns of the underlying.

Example: Calculate the value of a call option and put option for the following contract:

Stock Price (S) = 100

Exercise Price (K) = 105

Risk-free, continuously compounded interest Rate (r) = 0.10 (10%)

Time to expiration (T-t) = 3 month = 0.25 years

Standard deviation (σ) = 0.30 per year

S σ 100 0.32
ln + r + 22 (T – t) ln
d1 = K = 105 0.10 + 2 (0.25) = – 0.0836
σ T –t 0.3 * 0.25

d = d1 – σ T – t = 0.0836 – 0.3 0.25 = – .0236 2

N(d1) = N(–0.0836) =

0.4667 N(d2) = N(–0.0236)

= 0.4076 N(–d1) =

N(0.0836) = 0.5333

N(–d2) = N(0.0236) = 0.5924

2
Black, Fischer; Myron Scholes (1973). "The Pricing of Options and Corporate Liabilities". Journal of Political
Economy 81 (3): 637-654
Value of call option (c) =

c (S,t) = SN (d1)–ke–r(T −t) N(d2) = 100*0.4667–105*e–.10*0.25 *0.4076 = 4.9225

Value of Put option (p) = p(S,t) = Ke–r(T–t) N(–d2)– SN(–d1) = 105*e–0.10*0.25 *

0.5924–100* 0.5333 = 7.33

CHAPTER 8: Investment Management

8.1 Introduction
In the final chapter of this module we take a brief look at the professional asset
management industry. Worldwide, the last few decades have seen an increasing trend
away from direct investment in the markets, with the retail investor now preferring to
invest in funds or the index, rather than direct exposure into equities. This has
naturally led to a sharp increase in the assets under management of such firms.

The asset management industry primarily consists of two kinds of companies, those
engaged in investment advisory or wealth management activities, and those into
investment management. In the first category, investment advisory firms recommend
their clients to take positions in various securities, and wealth management firm either
recommend, or have custody of their clients’ funds, to be invested according to their
discretion. In both cases, the engagement with clients is at an account level, i.e., funds
are separately managed for each client. In contrast, investment management
companies combine their clients’ assets towards taking positions in a single portfolio,
usually called a fund (or a mutual fund). A unit of such a fund then represents positions
in each of the securities owned in the portfolio. Instead of tracking returns on their
own portfolios, clients track returns on the net asset value (NAV) of the fund. In
addition to the perceived benefits of professional fund management, the major reason
of investment into funds is the diversification they afford the investor. For instance,
instead of owning every large-cap stock in the market, an investor could just buy units
of a large-cap fund.

In this chapter, we shall examine the various types of such funds, differentiated by
their investment mandates, choice of securities, and of course, investment
performance, where we would outline a few of the key metrics used to measure
investment performance of funds.

8.2 Investment Companies

Investment companies pool funds from various investors and invest the accumulated
funds in various financial instruments or other assets. The profits and losses from the
investment (after repaying the management expenses) are distributed to the investors
in the funds in proportion to the investment amount. Each investment company is run
by an asset management company who simultaneously operate various funds within
the investment company. Each fund is managed by a fund manager who is responsible
for management of the portfolio.

Investment companies are referred to by different names in different countries, such

as mutual funds, investment funds, managed funds or simply funds. In India, they are
called mutual funds. Our treatment would use these names interchangeably, unless
explicitly stated.
8.2.1 Benefits of investments in managed funds

The main advantages of investing through collective investment schemes are:

- Choice of Schemes: There are various schemes with different investment

themes. Through each scheme an investor has an opportunity to invest in a
wide range of investable securities.

- Professional Management: Professionally managed by team of experts.

- Diversification: Scope for better diversification of investment since mutual

fund assets are invested across a wide range of securities.

- Liquidity: Easy entry and exit of investment: investors can with ease buy
units from mutual funds or redeem their units at the net asset value either
directly with the mutual fund or through an advisor / stock broker.

- Transparency: The asset management team has to on a regular basis publish

the NAV of the assets and broad break-up of the instruments where the
investment is made.
 - Tax benefits: Dividends received on investments held in certain schemes,
such as equity based mutual funds, are not subject to tax.

8.3 Active vs. Passive Portfolio Management

If asset prices always reflect their equilibrium values (expected returns equal to the
value specified by an asset pricing model), then an investor is unlikely to benefit from
actively searching for mispriced (overpriced/underpriced) opportunities in assets. In
other words, the investor is better off by simply investing in the market, or a
representative benchmark. For instance, under such assumptions, an Indian equity
investor would achieve the best possible outcome by trying to replicate the Nifty 50
by investing in the constituent stocks in the same proportion as they are in the index.

Such investment assumes that gains in the market are those of the benchmark, and
not in the choice of individual securities, as opportunities in their selection, or timing
of entry/exit are too short to be taken advantage of. This, passive approach to
investment rests upon the theory of market efficiency, which we saw in chapter 4.
Recall that the EMH postulates that prices always fully reflect all the available
information and any deviation from the full information price would be quickly
arbitraged away. In an efficient market, information about fundamental factors related
to the asset, or its market price, volume or any other related trading data related has
little value for the investor.
Passive fund managers try to replicate the performance of a benchmark index, by
replicating the weights of its constituent stocks. Given daily price movement in stock
prices, the challenge for such managers is to minimize the so-called ‘tracking error’ of
the fund, which is calculated as the deviation in its returns from that of the index. The
choice of the index further differentiates between the funds, for example, an equity
index fund would simply try to maintain the return profile of the benchmark index,
say, the NIFTY 50; but if investments are allowed across asset classes, then the
‘benchmark’ could well consist of a combination of a equity and a debt index.

Recent evidence of systematic departures of asset prices in the from equilibrium

values, as envisaged under the market efficiency, has renewed interest in ‘active’ fund
management, which entails that optimal selection of stocks, and the timing of
entry/exit could lead to ‘marketbeating’ returns.
This represents an opportunity for investors to engage in active strategies based on
their objective views about the assets. In a generic sense, such views are about the
relative under pricing or over pricing of an asset. Over pricing presents an opportunity
to engage in short selling, under pricing an opportunity to take a long position, and
combinations of the two are also possible, across stocks, and portfolios.

The objective of an active portfolio manager is to make higher profits from investing,
with similar, or lower risks attached. The risk of a portfolio, as noted in an earlier
chapter, is usually measured with the standard deviation of its assets. A good portfolio
manager should have good forecasting ability and should be able to do two things
better than his competitors: market timing and security selection.

By market timing, we refer to the ability of the portfolio manager to gauge at the
beginning of each period the profitability of the market portfolio vis-à-vis the risk-free
portfolio of Government bonds. The strength of such a signal would indicate the level
of investment required in the market.

By security selection, we refer to ability of a portfolio manager in identifying mispricing

in individual securities and then investing in securities with the maximum mispricing,
which maximizes the so-called alpha. The alpha of a security refers to the expected
excess return of the security over the expected rate of return (for example, estimated
by an equilibrium assetpricing model like the CAPM). The mispricing may be either
way: If the portfolio manager believes that a security is going to generate negative
return, his portfolio should give a negative weight for the same i.e. short the security
and vice versa. The tradeoff for the active investor is the presence of nonsystematic
risk in the portfolio. Since the portfolio of an active investor is not fully diversified,
there is some nonsystematic (firm-specific) risk that is not diversified away. Active
fund management is a diverse business—there are many ways to make money in the
market—almost all the investment styles we would examine further in the chapter are
illustrative examples.

Active and passive fund management are not always chalk and cheese—there are
techniques that utilize both, like portfolio tilting. A tilted portfolio shifts the weights of
its constituents towards one or more of certain pre-specified market factors, like
earnings, valuations, dividend yields, or towards one or more specific sectors.
By their very nature of operations, active and passive investments differ meaningfully
in terms of their costs to the investors. Passive investment is characterized by low
transaction costs (given their low turnover), management expenses, and the risks
attached. Active fund management is understandably more expensive, but has seen
costs falling over the years on competitive pricing and increased liquidity of the
markets, which reduced transaction costs.

8.4 Costs of Management: Entry/Exit Loads and Fees

Running a mutual fund involves certain costs (e.g. remuneration to the management
team, advertising expenses etc.) which may be recurring or non-recurring in nature.
These costs are recovered by the fund from the investors (e.g. from redemption fees)
or from charges on the assets (transaction fees, management fees and commission
etc.) of the funds.

Generally, the management team is paid a fixed percentage of the asset under
management as their fees.

Investment management companies can be broadly classified on the basis of the

securities they invest in and their investment objectives. Before we look at either, we
define the core measure of return for a fund, the NAV, and so-called open, and closed-
ended funds.

8.5 Net Asset Value

The net asset value NAV is the most important and widely followed metric of a fund’s
performance. It is calculated per share using the following formula:

MarketValue of Assets– MarketValue of liabilities

NAV (per share) =
Number of shares outstandign

Net asset value (NAV) is a term used to describe the per unit value of the fund’s net
assets (assets less the value of its liabilities). Hence the NAV for a fund is

Fund NAV = (Market Value of the fund portfolio – Fund Expenses) / Fund Shares
Outstanding
Just like the share price of a common stock, the NAV of a fund would rise with the
value of the fund portfolio, and is instantly reflective of the value of investment.

8.6 Classification of funds

8.6.1 Open ended and closed-ended funds

Funds are usually open or closed-ended. In an open-ended fund, the units are issued
and redeemed by the fund, at any time, at the NAV prevalent at the time of issue /
redemption. The fund discloses the NAV on a daily basis to facilitate issue and
redemption of units. Unlike open-ended funds, closed-ended funds sell units only at
the outset and do not redeem or sell units once they are issued. The investors can sell
or purchase units to (or from) other investors and to facilitate such transactions, such
units are traded on stock exchanges. Price of closed ended schemes are determined
based on demand and supply for the units at the stock exchange and can be more or
less than the NAV of the units.

We now examine the different kind of funds on the basis of their investments. While
we had earlier mentioned mutual fund investments represented as units in a single
portfolio, in real life, fund houses float various schemes from time-to-time, each a
constituting a portfolio where inputs translate into units. These schemes are
differentiated by their charter which mandates their investment into asset classes.

Beyond the type of instruments they invest in, fund houses are also differentiated in
terms of their investment styles. The approaches to equity investing could be
diversified or undiversified, growth, income, sector rotators, value, or market-timing
based.

Each mutual fund scheme has a particular investment policy and the fund manager
has to ensure that the investment policy is not breached. The policy is laid right at the
outset when the fund is launched and is specified in the prospectus, the ‘Offer
Document’ of the scheme. The investment policy determines the instruments in which
the money from a specific scheme will be primarily invested. Based on these securities,
mutual funds can be broadly classified into equity funds (growth funds and income
funds), bond funds, money market funds, index funds, etc. Generally, fund houses
have dozens of schemes floating in the market at any given time, with separate
investment policies for each scheme.
8.6.2 Equity funds

Equity funds primarily invest in common stock of companies. Equity funds can be
growth funds or income funds. Growth funds focus on growth stocks, i.e., companies
with strong growth potential, with capital appreciation being the major driver, while
income funds focus on companies that have high dividend yields. Income funds focus
on dividend income or coupon payments from bonds (if they are not pure equity).

Equity funds may also be sector-specific wherein the investment is restricted to stocks
from a specific industry. For example, in India we have many funds focusing on
companies in power sector and infrastructure sector.
8.6.3 Bond funds

Bond funds invest primarily in various bonds that were described in the earlier
segment. They have a stable income stream and relatively lower risk. They could
potentially invest in corporate bonds, Government. bonds, or both.

8.6.4 Index funds

Index funds have a passive investment strategy and they try to replicate a broad
market index. A scheme from such a fund invests in components of a particular index
proportionate to their representation in the benchmark. It is possible that a scheme
tracks more than one index (in some pre-specified ratio), in either equity, or across
asset classes.

8.6.5 Money market funds

Money market mutual funds invest in money market instruments, which are short-
term securities issued by banks, non-bank corporations and Governments. The various
money market instruments have already been discussed earlier.

8.6.6 Fund of funds

Fund of funds add another layer of diversification between the investor and securities
in the market. Instead of individual stocks, or bonds, these mutual funds invest in
units of other mutual funds, with the fund managers’ mandate being the optimal choice
across mutual fund schemes given extant market conditions.
8.7 Other Investment Companies
In addition to the broad categories mentioned here, there are many other kinds of
funds, depending on market opportunities, and investor appetite. Total return funds
look at a combination of capital appreciation and dividend income. Hybrid funds invest
in a combination of equity, bonds, convertibles, and derivative instruments. These
funds could be further distributed as ‘asset allocation’, ‘balanced’, or ‘flexible portfolio’
funds, based on the breadth of their investment in different asset classes, and the
frequency of modifying the allocation.

Global, regional, or emerging market funds recognize investment opportunities across

the world, and accordingly base their investment focus. Such funds could again
comprise either, or a combination of equity, debt, or hybrid instruments. We mention
some other, specific types of investment vehicles below.

8.7.1 Unit Investment Trusts (UIT)

Similar to mutual funds, UITs also pool money from investors and have a fixed portfolio
of assets, which are not changed during the life of the fund. Although the portfolio
composition is actively decided by the sponsor of the fund, once established the
portfolio composition is not changed (hence called unmanaged funds).
The way an UIT is established is different from that of other mutual funds. UITs are
usually created by sponsors, who first make investment in the portfolio of securities.
The entire portfolio is then transferred to a trust and the trustees issue trust
certificates to the public, which is similar to shares. The trustees distribute the incomes
from the investment and the maturity (capital) amount to the shareholders on
maturity of the scheme.

8.7.2 REITS (Real Estate Investment Trusts)

REITS are also similar to mutual funds, but they invest primarily in real estates or
loans secured by real estate. REIT can be of three types – equity, mortgage or hybrid
trusts. Equity trusts invest in real estate assets, mortgage trusts invest in loans backed
by mortgage and hybrid trusts invest in either.
8.7.3 Hedge Funds

Hedge funds are generally created by a limited number of wealthy investors who agree
to pool their funds and hire experienced professionals (fund managers) to manage
their portfolio. Hedge funds are private agreements and generally have little or no
regulations governing them. This gives a lot of freedom to the fund managers. For
example, hedge funds can go short (borrow) funds and can invest in derivatives
instruments which mutual funds cannot do.

Hedge funds generally have higher management fees than mutual funds as well as
performance based fees. The management fee (paid to the fund managers), in the
case of hedge funds is dependent on the assets under management (generally 2 - 4%)
and the fund performance (generally 20% of the excess returns over the market return
generated by the fund).

8.8 Performance assessment of managed funds

Prior to the development of the modern portfolio theory (MPT), portfolio managers
were evaluated by comparing the return generated by them with some broad
yardstick. The risk borne by the portfolio managers or the source of performance such
as market timing, market volatility, the security selections and valuations were not
considered. With the development of the MPT, the goal of performance evaluation is
to study whether the portfolio has provided superior returns compared to the risks
involved in the portfolio or compared to an equivalent passive benchmark.

The performance evaluation approach tries to attribute the performance to the

following:
- Risk
- Timing: market or volatility
- Security selection – of industry or individual stocks
Therefore:

a) The focus of evaluation should be on excess returns

b) The portfolio performance must account for the difference in the risk

c) It should be able to distinguish the timing skills from the security selection
skills.
The assessment of managed funds involves comparison with a benchmark. The
benchmark could be based on the Capital Market Line (CML) or the Security Market
Line (SML). When it is based on capital Market Line, the relevant measure of the
portfolio risk is σ and when based on Security Market Line, the relevant measure is β.

Various measures are devised to evaluate portfolio performance, viz. Sharpe Ratio,
Treynor Ratio and Jensen Alpha.

8.8.1 Sharpe Ratio

Sharpe ratio or ‘excess return to variability’ measures the portfolio excess return over
the sample period by the standard deviation of returns over that period. This ratio
measures the effectiveness of a manager in diversifying the total risk (σ). This
measure is appropriate if one is evaluating the total portfolio of an investor or a fund,
in which case the Sharpe ratio of the portfolio can be compared with that of the
market. The formula for measuring the Sharpe ratio is:

Sharpe Ratio = (rp – rf ) / σp

This will be compared to the Shape ratio of the market portfolio. A higher ratio is
preferable since it implies that the fund manager is able to generate more return per
unit of total risks. However, managers who are operating specific portfolios like a value
tilted or a style tilted portfolio generally takes a higher risks, and therefore may not
be willing to be evaluated based on this measure.

8.8.2 Treynor Ratio

Treynor’s measure evaluates the excess return per unit of systematic risks ( β) and not

total risks. If a portfolio is fully diversified, then β becomes the relevant measure of
risk and the performance of a fund manager may be evaluated against the expected
return based on the SML (which uses β to calculate the expected return). The formula

for measuring the Treynor Ratio is:

Theynor Ratio = (rp – rf ) / βp

8.8.3 Jensen measure or (Portfolio Alpha)

The Jensen measure, also called Jensen Alpha, or portfolio alpha measures the
average return on the portfolio over and above that predicted by the CAPM, given the
portfolio’s beta and the average market returns. It is measured using the following
formula:
αp = rp –[rf + βp (rM – rf )]

The returns predicted from the CAPM model is taken as the benchmark returns and is
indicated by the formula within the brackets. The excess return is attributed to the
ability of the managers for market timing or stock picking or both. This measure
investigates the performance of funds and especially the ability of the managers in
stock selection in terms of these contributing aspects.

This measure is widely used in evaluating mutual fund performance. If αP is positive

and significant, it implies that the fund managers are able to identify stocks with high
potential for excess returns. Market timing would refer to the adjustment in the beta
of the portfolio in tandem with market movements. Specifically, timing skills call for
increasing the beta when the market is rising and reducing the beta, when the market
declines, for example through futures position. If the fund manager has poor market
timing ability, then the beta of the portfolio would not have been significantly different
during a market decline compared to that during a market increase.

Example: The data relating to market portfolio and an investor ‘P’ portfolio is as under:

Investor P’s Portfolio Market Portfolio (M)

Average Return 28% 18 %

Beta (β) 1.4 1

Standard Deviation (σ) 30% 20 %

Assuming that the risk-free rate for the market is 8%, calculate (a) Sharpe Ratio (b)
Treynor Ratio and (c) Jensen Alpha for the investor P and the market.

Answer:

Investor P Portfolio Market Portfolio (M)

Sharpe Ratio = (rp – rf ) / σp (28% - 8%)/30% = 0.67 (18% - 8%)/20% = 0.5

Treynor Ratio = (rp – rf ) / βp (28% - 8%)/1.4 = 5 (18% - 8%)/1 = 10

Jensen Alpha 28% - [8% + 1.4*(18% - 8%)] 18% - [8% + 1

(αp) = rp –[ rf + βp (rM – rf )] = 28% - 22% = 6% (18% - 8%)] = 0

***