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MS 44
SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT
 TABLE OF
CONTENTS

01 LONG IMP QUESTIONS

02 EXTRA LONG QUESTIONS

03 VERY IMP SHORT NOTES

04 EXTRA SHORT NOTES

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MS 44- : SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

FIRST PRIORITY MOST IMPORTANT QUESTIONS
Answer any 5 questions from OUT OF 8
Q1- What are the premises of technical analysis ? What are the differences between technical and
fundamental analysis.? (v v v v v imp).
ANS- MEANING OF TECHNICAL ANALYSIS -- Technical Analysis is concerned with a critical study of
the daily or weekly price and volume data of the Index comprising several shares, like Bombay Stock
Exchange Sensitive Index (SENSEX), or of a particular Stock, like Infosys or Hindustan Lever. The
objective of the technical analysis is to predict or forecast the short, intermediate and long term
price movements. It uses only the data generated from the market. Such market generated data
includes price, volume, number of trades, 52-week high or low price, intra-day spread, dealers buy-
sell quote spread, number of advances and declines, number of Stocks hitting the new high and low,
open interest, etc. Some of the basic assumptions of the technical analysis are:

FUNDAMENTAL ANALYSIS Vs TECHNICAL ANALYSIS-

The price of most of the Indices and the Stocks keep on varying in a seemingly erratic fashion, so
much so that the difference between the high and the low during a year may exceed by a ratio of
two or more, even though the fundamentals do not change much. For instance, in spite of the daily
variation of price, the earnings of the company do not vary during the year, the book value, the
loans, the profit margin, the taxes and other charges, depreciation, etc. may not change from one
annual report to the other. Hence the fundamentals dictate the price horizon of the shares of a
company, but are not able to say what would be the price at a particular point of time. Technical
analysis incorporates techniques to determine when 'an equity is overbought, or is oversold so that
they can sell and buy the stocks at such levels. According to a firm offering technical analysis
services, the technical analyst or technician believes that the price movements, whatever their
cause, once in force persist for some period of time and form a particular pattern which can be
detected. He further believes that by critical study of these patterns of price and volume of trading,
he can predict whether price are moving higher or lower and even by how much. In sum and
substance, technician believes that the forces of supply and demand, guided by logical as well as
emotional factors, reflect in the price and volume movements and by carefully examining the
pattern of these movements, future price of stock can be reliably predicted. And the whole process
involves much less time and data analysis, compared with fundamental analysis, it facilitates timely
decision.
Timing of Trade is the Important Thing
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Investment analysts following fundamental. analysis advise to invest in a fundamentally strong

company i.e., one, which has high reserves, large profits, low debt, and pays high dividends. But if
you buy such a share at the wrong time and then the price moves down, you lose your wealth in
spite of the strong fundamentals. Technical analysis can be used to avoid this pitfall because it tells
the appropriate time to buy a share and the appropriate time to sell the same. Many investors thus
use technical analysis as supplement to fundamental analysis.

Q2- Define Markowitz diversification and also explain the statistical method used by Markowitz to
reduce the risks..? (v v v v v imp).
ANSIt is easy to see that the Markowitz's approach to trace efficient set is extremely demanding i n
its input data needs and computation requirements. This has been probably best expressed by
Markowitz himself : "...it is reasonable to ask security analysts to summarize their researches in 100
carefully considered variances of returns. It is not reasonable, however, to ask for almost 5000
carefully and individually considered covariances" . Indeed, while analysts and portfolio managers
are accustomed to thinking about expected rates of return, they are much less comfortable in
assessing the possible ranges of variation in their expectations, and are usually, not at all
accustomed to estimating covariance of returns among assets.
The problem is made more complex by the number of estimates of covariance (or correlation)
required. For a set of 200 shares, for example, we need to compute [200 (200-1)/ 2] = 19,900
covariance. It is unlikely that the analysts will be able to directly estimate such a staggering number
of inputs. Obviously, what we need is an alternate formula for portfolio variance, that lends itself to
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easy computation even when we are dealing with a large set of assets. However, an understanding
of Markowitz process would sharpen your understanding on the portfolio theory and management
though you may not use in your day to day life Markowitz method of portfolio construction
SINGLE-INDEX MODEL
We get such a capability with the `single-index model' developed by a student of Markowitz named
William Sharpe (1963). In the 1950s, after techniques for estimating the required inputs to this
model were perfected, packaged, and marketed as computer software, modern portfolio really took
off in terms of practical applications. Now the single-index model is widely employed to allocate
investments iii the portfolio between individual equity shares, while the original more general model
of Markowitz is widely used to allocate investments between types of assets, such as bonds, shares,
and real estate. In the discussion that follows, we present the basic tenets of the `single-index
model', with reference to investment in equity shares.
The Assumptions and the Model
Essentially, the single-index model assumes that the returns of various securities are related only
through common relationships with some basic underlying factor. In the words of Sharpe, this factor
"may be the level of the stock market as a whole, the gross national product, some price index, or
any other factor thought to be the most important single influence on the returns from securities". A
casual observation of share-price movements, at least, tends to support this line of argument. There
is considerable evidence that when the stock market goes down, most shares tend to decrease in
price. For instance, on the date of budget, several stocks move in the same direction depending on
the assessment of the budget on the economy and industry. It appears, therefore, that one reason
share returns might be correlated is because of a common response to market changes as measured
by the movements in, say, share price index. To understand the above assumption of the single-
index model more precisely, consider Figure , where we have related the returns of a hypothetical
share to the returns on the market index.

It is further assumed that the residuals are not correlated across shares of different companies; that
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is, ei, is independent of ej for all values of i and j. This is an important assumption; it implies that the
only reason shares vary together, systematically, is because of a common co-movement with the
market. Thus, single-index model assumes away all other possible effects on shares' returns, such as
industry effects
At this stage, it would be appropriate to contrast the procedure for computing portfolio variance as
outlined above with that of the Markowitz model. We have mentioned earlier that for a portfolio of
200 shares, Markowitz model requires 19,900 estimates of covariance. Under the single-index model
we need, however, only 200 estimates of beta, 200 estimates of residual variance, and one estimate
for the variance of returns on market index. Indeed, this is a dramatic reduction in the input data for
computing portfolio variance. But how accurate is the portfolio variance estimate as provided by the
single-index model's simplified formula? If it is the Markowitz formula, we know that the variance
number of perfectly accurate, given, of course, the accuracy of the covariance estimates. Besides,
the formula makes no assumptions regarding the return generating process. On the other hand, the
single-index model assumes that the market factor solely determines the shares' returns and
residuals. are not correlated across different shares. Thus, the accuracy of the single-index model's
formula for portfolio variance is as good as the accuracy of underlying assumptions. Quite obviously,
the assumptions are not strictly accurate. Many researchers have found that there are influences
beyond the market that cause shares to move together. In addition, empirical evidence suggests that
residuals are correlated to some degree, which is not altogether unexpected. After all, if something
(good or bad) happens to a company, some other companies, such as its suppliers and competitors,
would be affected simultaneously. The residuals that appear for the shares of these other company
would not, therefore, be independent of each other. However, one can always expect that the
degree of correlation would not be large enough to impair the relative efficiency with which the
single-index model estimate the portfolio variance.

Q3- What do you mean by Portfolio Revision ? Describe the major constraints in portfolio
revision.? When is portfolio revision needed ? (v v v v v imp).
ANS-- MEANING OF PORTFOLIO REVISION- Most investors are comfortable with buying securities
but spend little effort in revising portfolio or selling stocks. In that process they lose opportunities to
earn good return. In the entire process of portfolio management, portfolio revision is as important
as portfolio analysis and selection. Keeping in mind the risk-return objective, an investor selects a
mix of securities from the given investment universe. In a dynamic world of investment, it is only
natural that the portfolio may not perform as desired or opportunities might arise turning the
desired into less than desired. Further, some of the risk and return estimation might change over a
period of time. In every such situation, a portfolio revision is warranted. Portfolio revision involves
changing the existing mix of securities. The objective of portfolio revision is similar to the objective
of portfolio selection i.e., maximizing the return for a given level of risk or minimising the risk for a
given level of return. The process of portfolio revision is also similar to the process of portfolio
selection. This is particularly true where active portfolio revision strategy is followed. It calls for
reallocation of funds between bond and stock market through economic analysis, reallocation of
funds among different industries through industry analysis and finally selling and buying of stocks
within the industry through company analysis. Where passive portfolio revision strategy is followed,
use of mechanical formula plans may be made. What are these formula plans? We shall discuss
these and other aspects of portfolio revision in this Unit. Let us begin by highlighting the need for
portfolio revision.
NEED FOR PORTFOLIO REVISION
No plan can be perfect to the extent that it would not need revision sooner or later. Investment
Plans are certainly not. In the context of portfolio management the need for revision is even more
because the financial markets are continually changing. Thus the need for portfolio revision might
simply arise because market witnessed some significant changes since the creation of the portfolio.
Further, the need for portfolio revision may arise because of some investor-related factors such as (i)
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availability of additional wealth, (ii) change in the risk attitude and the utility function of the
investor, (iii) change in the investment goals of the investors and (iv) the need to liquidate a part of
the portfolio to provide funds for some alternative uses. The other valid reasons for portfolio
revision such as short-term price fluctuations in the market do also exist. There are thus numerous
factors, which may be broadly called market related and investor related.
CONSTRAINTS IN PORTFOLIO REVISION

Q4- What are the various types of mutual fund schemes available in India ? Explain their features?
(v v v v v imp).
ANS-- WHY MUTUAL FUNDS - Mutual funds can survive and thrive only if they can live up to the
hopes and trust of their individual members. These hopes and trust echo the peculiarities which
support the emergence and growth of such institution irrespective of the nature of economy where
these are to operate. Mutual funds come to the rescue of those people who do not excel at stock
market due to certain mistakes they commit which can be minimised with mutual funds. Such
mistakes can be viz., lack of sound investment strategies, unreasonable expectations of making
money, untimely decisions of investing of disinvesting, acting on the advise given by others, putting
all their eggs in one basket, i.e. failure to diversify. Mutual funds are characterised by many
advantages that they share with other forms of investments and what they possess uniquely
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themselves. The primary objectives of an investment proposal would fit into one or combination of
the two broad categories i.e. income and Capital gains. How mutual fund is expected to be over and
above an individual in achieving these two said, objectives, is what attracts investors to opt for
mutual funds. Mutual fund route offer several important benefits. Some of these are:
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SCHEMES OF MUTUAL FUNDS

Schemes of mutual funds refer to the products they offer to investors. Investors are to choose out of
such schemes as per their objectives of earnings. Mutual funds adopt different strategies to achieve
these objectives and accordingly offer different schemes of investments as per the need of investors.
Schemes can be grouped as under:
1--Operational Classification

2 --Return-Based Classification
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3-- Investment-Base Classification

Mutual funds may also be classified on the basis of securities in which they invest. Basically, it is
renaming the sub-categories of return-base classification. Equity Fund: Such funds, as the name
implies, invest most of their investible funds in equity shares of companies and undertake the risk
associated with the investment in equity shares. Such funds are clearly expected to outdo other
funds in a rising market, because these have almost all their capital in equity. A special type of equity
fund is known as 'Index Fund' or 'Never beat market fund'. These are known as Index funds since
these funds transact only those scrips which are included in any specific index e.g. the scrips which
constitute the BSE-30 Sensex or 100 shares National index. Due to the overall poor performance of
managed funds this type of fund has emerged. The fund consists of a portfolio designed to reflect
the composition of some broad based market index and it is done by holding securities in the, same
proportion as the index itself. The portfolio of the index fund is constructed in exactly the same
proportion with respect to rupees involved. The value of such index linked funds will go up
whenever the market index goes up and conversely, it will come down when the market index
comes down. Such fund is not to beat a specific index but is to match that index. These funds have
comparatively lower operating costs. Bond Fund: Such funds have their portfolio consisted of bonds,
debentures, etc. This type of fund is expected to be very secure with a steady income but with little
or no chance of capital appreciation. Obviously risk is low in such funds. In this category we may
come across the funds called Liquid funds which specialise in investing short-term money market
instruments. The emphasis is on liquidity and is associated with lower risks and low returns.
Balanced Fund: The funds which have in their portfolio a reasonable mix of equity and bonds are
known as balanced funds. Such funds will put more emphasis on equity share investments when the
outlook is bright and will tend to switch to debentures when the future is expected to be poor for
shares majority of funds fall in this category, of course, their mix- proportion varies.
Fund of funds (FOF): It is a mutual fund scheme that invests in other mutual funds schemes instead
of investing in securities. Such schemes are prevalent in international markets. These schemes can
have different investment patterns and investment strategies as disclosed in offer documents. The
investors may invest their funds in those FOF schemes which meet their investment objectives
instead of investing in different schemes of a mutual fund and keeping track of their NAVs. Such FOF
schemes may invest in other sector specific schemes or those schemes which have more weightage
of certain stocks and can exit from those schemes when growth prospects of those sectors are not
good. The investors putting their money in one sector specific scheme may not be able to decide
when to exit.
4-- Sector- based Classification
There are number of funds that direct investing in. a specified sector of an economy. While such
funds do have the disadvantage of low diversification by putting all their eggs in one basket, the
policy of specialising has the advantage of developing in the fund managers an intensive knowledge
of the specific sector in which they are investing. The specialised sectors can be (i) gold and silver, (ii)
real estate, (iii) specific industry say oil and gas companies, (iv) off-shore investments, etc.
5-- Leverage-Based Classification
Some mutual funds broad base their investible funds by borrowings from the market and then make
investments thereby making leverage benefits available to the mutual fund investors. Such funds are
known as 'leveraged funds'. It depends on the regulating provisions in a country whether borrowings
are allowed or not. Normally leverage funds use short sale, which allows the management of the
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fund to avail the advantage of declining markets in order to realise gains in the portfolio. Leverage
funds also use options specifically call options.
6-- Other Funds
There are some other types of schemes which do not fit into the above given classifications. Some of
such funds are mentioned here. There are 'load funds' and 'no-load funds'. In load funds, the mutual
funds charge a fee over and above the net asset value from the purchaser. In No load funds no load-
fee is charged because little sales efforts are made to promote the fund’s sales except through direct
advertising. Mutual funds schemes can also be designed to offer some tax exemption. Besides these,
there are money market mutual funds which interact only in money market. Off-shore mutual funds
(also known as regional or country funds) are the funds mobilising funds abroad for deployment in
local market. Many mutual funds abroad have floated property funds, art funds, commodity funds,
energy funds, etc. One point needs to be viewed that irrespective of classification of schemes, every
scheme will be either an open ended scheme or a close ended scheme.
MUTUAL FUNDS IN INDIA-
In India mutual fund concept took root only in the nineteen sixties, after a century old history
elsewhere in the world. Reacting to the need for a more active mobilisation of household savings to
provide investible resources to industry, the idea of first mutual fund in India i.e. UTI born out of the
far sighted vision of Sri T. T. Krishnamachari, the then Finance Minister. UTI in 1964 started with a
unit scheme popular as "US-64". Since Unit Trust of India was the result of a special enactment, no
other open end mutual fund activities could emerge because of restrictive conditions of Indian
Companies Act, 1956. Of course, close end investment companies existed for in-house investments
as well as portfolio investment for a long time. But their activities were again on restricted scale. In
1987 the monopoly of UTI came to an end when Government of India by amending Banking
Regulation Act enabled commercial banks in Public sector to set up mutual funds as their
subsidiaries. First of all State Bank of India got a nod from RBI. Next to follow was Canara Bank. It
was the Abid Hussain Committee’s unequivocal support to the concept that could be accepted as
something of a landmark. It called for a greater number of mutual fund players. LIC and GIC also
entered the field of mutual funds. During 1987-92, nine mutual funds came to be set up with
invertible resources Rs. 37000 crores. This .amount was only 4563 crores up to June 1987. Major
share was of UTI.
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Q5- What do you understand by Trading System of Stock Exchanges ? Explain the various features
of National Exchange for Automated Trading (NEAT) system? (v v v v v imp).
ANS-- Trading System of Stock Exchanges - Trading system differ from exchange to exchange. In the
next few pages, the trading system followed by the National stock Exchange is described. Students
desire to know more about the trading system of other exchanges in India as well as outside India
can visit respective web sites of stock exchanges. NSE operates on the 'National Exchange for
Automated Trading' (NEAT) system, a fully automated screen based trading system, which adopts
the principle of an order driven market. NSE consciously opted in favour of an order driven system as
opposed to a quote driven system. This has helped reduce jobbing spreads not only on NSE but in
other exchanges as well, thus reducing transaction costs. Till the advent of NSE, an investor wanting
to transact in a security not traded on the nearest exchange had to route orders through a series of
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correspondent brokers to the appropriate exchange. This resulted in a great deal of uncertainty and
high transaction costs. NSE has made it possible for an investor to access the same market and order
book, irrespective of location, at the same price and at the same cost.
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Q6- Elucidate how company analysis is performed through fundamental analysis.? (v v v v v imp).
ANS-- FUNDAMENTAL ANALYSIS- Investment decision-making being continuous in nature should be
attempted systematically. Broadly, two approaches are suggested in the literature. These are: (i)
Fundamental Analysis, and (ii) Technical Analysis. In the first approach, the investor attempts to look
at fundamental factors that affect risk return characteristic of the security. In the second approach,
the investor tries to identify the price trends, which reflect these characteristics. The technical
analysis concentrates on demand and supply of security and prevalent trend in share price measured
by various market indices in the stock market. Economic and industry analyses are part of
fundamental analysis. In the fundamental approach, various fundamental or basic factors that affect
the risk-return of the securities are examined. Effort, here, is to identify those securities, which are
perceived to be mispriced in the stock market. The assumption in this case is that the `market price'
of the security and the price as justified by its fundamental factors called `intrinsic value' are
different and the market place provides an opportunity for a discerning investor to detect such
discrepancy. The moment such a discrepancy is identified the decision to invest or disinvest is taken.
The decision rule under this approach is as follows:
If the price of a security at the market place is higher than the one, which is justified by the security's
fundamentals, sell that security. This is because, it is expected that the market will sooner or later
realise its mistake and reduce its price. Therefore, before the market realise its mistake and price
that security properly, a deal to sell this security should be struck in order to reap the profits. But, if
the price of that security is lower than what it should be based on its fundamental, it should be
bought before the market corrects its mistake by increasing the price of security in question. The
price prevailing in the market is called `market price' (MP) and the one justified by its fundamental is
called `intrinsic value' (IV)
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Q7- Explain the logic of the Arbitrage Pricing Theory (APT). How does it compare and c,ontrast
with the Capital Asset Pricing Model (CAPM).? (v v v v v imp).
ANS-- As noted above, at the core of APT is the recognition that several systematic factors affect
security returns. It is possible to see that the actual return, R, on any security or portfolio may be
broken down into three constituent parts, as follows:

The CAPM
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Security Market Line (SML)

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Limitations
You may be now interested in knowing whether security returns is in fact directly related to beta, as
the CAPM asserts. Research results suggest that the CAPM does not reflect the world well at least
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when tested using ex-post data. Critics have pointed out that the inadequacy of the model is due to
its austerity. The market, in principle includes all stocks, a variety of other financial instruments, and
even non-marketable assets such as an individual's investment in education; to which no market
index like the SP 500 Index in US or Bombay Stock Exchange National Index (or any other index used
to represent the market) can be a perfect proxy. And when we measure market risk using an
imperfect proxy, we may obtain a quite imperfect estimate of market sensitivity. Secondly, the
CAPM asserts that only a single number- market return - is required to measure risk. The actual
returns depend upon a variety of anticipated an unanticipated events. Thus, while systematic factors
are the major sources of risk in portfolio return, different portfolios have different sensitivities to
these factors. It is the recognition of this phenomenon which lies at the core of an alternative-pricing
model called Arbitrage Pricing Theory (APT). Let us briefly discuss APT in the following section.

SECOND PRIORITY MOST IMPORTANT QUESTIONS

Q8- Explain the concept of Efficient Frontier in the context of Portfolio Selection.? (v v v v v imp).
ANS- The process discussed above can be repeated to find as many points as desired on the efficient
frontier, each time starting with a specified target expected rate-of return. In actual practice,
standard computer packages are available which can find solutions quickly and accurately. For our
example case of three equity shares. Table shows ten efficient portfolios identified by the
application of such a package.
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Q9- What do you understand by ‘‘Order Books’’ ? Explain in detail the order matching rules
followed to execute trades on Indian Stock Exchanges..? (v v v v v imp).
ANS- The NSE trading system provides complete flexibility to members in the kinds of orders that
can be placed by them. Orders are first numbered and time-stamped on receipt and then
immediately processed for potential match. Every order has a distinctive order number and a unique
time stamp on it. If a match is not found, then the orders are stored in different `books'. Orders are
stored in price-time priority in various books in the following sequence:
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Q10- Define market efficiency. Describe the various forms of market efficiency and discuss the
different tests of the weak form of efficient market hypothesis? (v v v v v imp).
ANS- DEFINITIONS OF MARKET EFFICIENCY- distinguished statistician. Kendell had been looking for
regular price cycles, but to his surprise he could not find any. He came to a finding that there exists
no pattern in the movement of share prices and that the change in prices is a random event. To
quote Maurice Kendell himself "As if once a week the demon of chance drew a random number and
added it to the current price to determine the next weeks price." Initially, this result disturbed many
economists because they interpreted the random behaviour of stock prices as an outcome of erratic
market psychology and it follows no logical rules. However, over a period of time, they started
appreciating that in a well functioning or efficient market, prices will indeed change randomly
reflecting the impact of new information. The Efficient Market Hypothesis slowly evolved in the
1960s from the Ph.D. dissertation of Eugene Fama. Fama persuasively made the argument that in an
active market that includes many well-informed and intelligent investors, securities will be
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appropriately priced and reflect all available information. If a market is efficient, no information or
analysis can be expected to result in out performance of an appropriate benchmark
An efficient market is defined as a market where there are large numbers of rational, profit-
maximizers actively competing, with each trying to predict future market values of individual
securities, and where important current information is almost freely available to all participants. In
an efficient market, competition among the many intelligent participants leads to a situation where,
at any point in time, actual prices of individual securities already reflect the effects of information
based both on events that have already occurred and on events which, as of now, the market
expects to take place in the future. In other words, in an efficient market at any point in time the
actual price of a security will be a good estimate of its intrinsic value. William Sharpe stated that "a
perfectly efficient market is one in which every security price equal its market value at all times". An
efficient capital market is a market that is efficient in processing information. The prices of securities
observed at any time are based on "correct" evaluation of all information available at that time. In
an efficient market, prices fully reflect all available information. Substantial evidence has been
presented by empirical studies regarding the validity of EMH. Conclusion of these studies is not that
superior performance is impossible, but that consistently superior performance for a given risk level
is extremely rare. The random walk theory asserts that price movements will not follow any patterns
or trends and that past price movements cannot be used to predict future price movements. Much
of the theory on these subjects can be traced to French mathematician Louis Bachelier whose Ph.D.
dissertation titled "The Theory of Speculation" (1900) included some remarkably insights and
commentary. Bachelier came to the conclusion that “ The mathematical
expectation of the speculator is zero" and he described this condition as a "fair game."
Unfortunately, his insights were so far ahead of the times that they went largely unnoticed for over
50 years until his paper was rediscovered and eventually translated into English and published in
1964 62 India Market efficiency has implications for corporate managers as well as for investors. This
takes a lot of the "gamesmanship" out of corporate management. If a market is efficient, it is difficult
to fool the public for long. For instance, only genuine "news" can move the stock price. It is hard to
pump-up the stock price by claims that are not verifiable by investors. "Fake" news will not move the
price, or if it does, the price will quickly revert to the pre-announcement value when the news
proves hollow. Publicly available information is probably already impounded in the price. This is hard
for some managers to believe. An example is the Sears' attempt to sell the Sears Tower in Chicago in
the late 1950's. The company believed that since it carried the property on its balance sheet at
greatly depreciated values, the public did not credit the company with the full market price of the
building and thus Sears's stock was underpriced. This proved to be false. In fact, it seems that Sears
was overestimating the value of the building and the stock price was relatively efficient!
Another lesson: accounting tricks don't fool anybody. Don't worry about timing accounting charges
and don't worry about whether information is revealed in the footnotes or in the statements. An
efficient market will quickly figure out the meaning of the information, once it is made public.
Rationale investors seek to maximize returns at a given level of risk. If a security is underpriced,
investors will quickly identify it and rush to pick it up. Competition for the underpriced security
drives the price up. Hence it would be difficult to consistently achieve superior performance. Most
securities are corr ectly priced and it should be possible to earn a normal return by randomly
choosing securities of a given risk level. Notion of financial market efficiency is in fact akin to the
concept of profit in a perfectly competitive market. Abnormal or excess profits, in such a market are
competed away. In an efficient market new information is discounted as it arrives. Price
instantaneously adjusts to a new and correct level. An investor cannot consistently earn abnormal
profits by undertaking fundamental analysis (to identify undervalued/overvalued securities) or by
studying the behaviour of share prices with a view to discerning definite patterns. Isolated instance
of windfall gains from the stock market does not negate the theory that markets are efficient.
Paradox of the efficient market is that it is efficient because of the organized and systematic efforts
of thousands of analyst to evaluate intrinsic values. It ceases to be efficient the moment such efforts
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are abandoned by the investing community and analyst firms. Market prices will promptly and fully
reflect what is known about the companies whose shares are traded only if investors seek superior
returns and analyze information promptly and.. perceptively. If the efforts were abandoned, the
efficiency of the market would diminish rapidly. In order for EMH to be true, it is necessary for many
investors to disbelieve it!
EMPIRICAL TESTS OF EMH
What is the degree of efficiency witnessed in, the stock market? Is it efficient of the weak form or
semi-strong form or strong form? In order to be able to answer these questions, certain empirical
tests have been devised. This section would discuss in detail some of the tests used:
Tests of Weak Form
Weak form efficiency should be the simplest type of efficiency to prove, and for a time it was widely
accepted that the U.S. stock market was at least weak form efficient. Recall that weak form
efficiency only requires that you cannot make money using past price history of a stock (or index) to
make excess profits. Recall the intuition that, if people know the price will rise tomorrow, then they
will bid the price up today in order to capture the profit. Researchers have been testing weak form
of efficiency using daily information since the 1950's and typically they have found some daily price
patterns, e.g. momentum. However, it appears difficult to exploit these short-term patterns to make
money. Interestingly, as you increase the horizon of the return, there seems to be evidence of
profits through trading. Buying stocks that went down over the last two weeks and shorting those
that went up appears to have been profitable. When you really increase the horizons, stock returns
look even more predictable. Eugene Fama and Ken French for instance, found some evidence that 4-
year returns tend to revert towards the mean. Unfortunately, this is a difficult rule to trade on with
any confidence, since the cycles are so long that in fact, they are as long as the patterns conjectured
by Charles Henry Dow some 100 years ago! Does this all lend credence to the chartists, who look for
cryptic patterns in security prices - perhaps. But in all likelihood there is no easy money in charting,
either. Prices for widely trades securities are pretty close to a random walk, and if they were not,
then they would quickly become so, as arbitrageurs moved in to buy the stock when it is underpriced
and short (sell) it when it is overpriced. But who knows. May be a retired rocket scientist playing
around with fractal geometry and artificial intelligence will hit upon something. Of course, if he or
she did, it wouldn't become common knowledge, at least for a while! There have been empirical
tests of weak-form market efficiency for equities, bonds and futures contracts. Random walk
hypothesis suggests that even bond price changes should be essentially random or unpredictable.
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Tests of Semi-Strong Form

Semi-Strong form contends that all public information is fully reflected in security prices. Public
information includes company financial statements, earnings and dividends, bonus announcements
and macro-economic data. The most obvious indication that the market is not always and
everywhere semistrong form efficient is that money managers frequently use public information to
take positions in stocks. While there is no evidence that they beat the market on a risk-adjusted
basis, it is hard to believe that an entire industry of information production and analysis is for
naught. It seems likely that there is value to publicly available information, however there are
probably degrees to which information really is public knowledge. What is surprising is that recent
studies have shown some evidence that excess returns can be made by trading upon very public
information. These tests usually take the form of "backtesting" trading strategies. That is, you play a
"what-if' game with past stock prices, and pretend you followed some rule, using information
available only at the time of the pretend trade. One common rule that seems to perform well
historically is to buy stocks when the dividend yield is high. This apparently has made money in the
past, even though the information about which of the stocks have high yields and which of them
have low yields is widely available. Another rule that generates positive excess returns in back-tests
is to buy stocks when the earnings announcement is higher than expected. This seems simple, since
current announcements and even forecasts are widely available as well.
Does this mean that it is easy to become rich in stock market? Hardly! The profitability of these
simple trading rules depends upon the liquidity of the stocks involved and trading costs ("frictions" ).
Sometimes the costs outweigh the benefits. While many investment managers explain that they
pursue a strategy of buying "Value" stocks (such as low PIE firms) few of these managers have
consistently superior track records. The assumption of semi-strong form efficiency is a good first
approximation for a market with as many sharp traders and with as much publicly available
information as the U.S. equity market. Fama, Fischer, Jensen and Roll have tested the speed of the
market's reaction to a company's announcements of a stock split and with respect to a change in
dividend policy. They estimated the abnormal returns using `residual analysis". Security returns were
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regressed against the returns on a market index and the error term in the following linear equation
represented the residual or abnormal return. Fama, Fischer, Jensen and Roll examined 940 Stock
Splits on the New York Stock Exchange from 1927 to 1959. Price of the Stocks was examined for a
period of 29 months before the date of the split and 20 months after the split. The actual act of
splitting did not have any impact on the wealth of shareholders. Further, buying stocks after a stock
split did not appear to produce abnormal returns.
Ball and Brown did an analysis of the stock market's ability to absorb the informational content of
reported annual earnings per share. They found that those companies which reported "good"
earnings experienced price increases and those with "bad" earnings reports experienced price
declines. Nearly 85 per cent of the informational content of the earnings announcements was
reflected in stock price movements, prior to the release of the actual figure.
Tests of Strong Form
Strong form argues that all information is fully reflected in security prices. The top management has
access to corporate and financing strategies. In the same way specialists have access to the book
limit orders for any share. Knowledge of the price and quantities of the limit order represent private
information. Professional portfolio managers who have large research database and also access to
top management may also have access to such private. Merchant banking firms, for example, may
have private information on a new company that has not yet been disclosed to the public. To
disprove strong form EMH, one has to find an insider who has profited from inside information.
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FIRST PRIORITY MOST IMPORTANT SHORT QUESTIONS

Q1- Odd-lot trading.? (v v v v v imp).
ANS- which can be measured by constructing an odd-lot index by relating odd-lot purchase to odd-
lot sales (Purchase + Sales), can indicate the direction of the market, as technicians feel that the odd
lotters are inclined to do the wrong thing at critical turns in the market. Rising index indicates rising
market and falling index indicates falling market which, in effect, mean selling proportionately less at
or near the market peak and selling proportionately more before a rise in the market. Mutual-funds
Cash as a Percentage of Net Assets on a daily or weekly or monthly basis has been a popular market
indicator. The theory is that a low cash ratio, say about 5%.

Q2- Market Risk.? (v v v v v imp).

ANS- You would have observed that the market moves upward at some point of time and then
moves downward at some other point of time. Such movements may happen despite the good or
bad performance of the companies. Often, company management and its employees will be puzzled
why the market is behaving like this. Finance Ministers and economic advisors have gone on record
stating that they don't understand the behavior of the market when it takes a beating after the
presentation of budget. Irrespective of our understanding, the reality is the market move in one of
the two directions (upward or downward) and once such trend starts, it exists for a time. There are
several reasons behind such movements. Changes in economy or expectation about the future of
the economy may cause such widespread movement. Company specific news may also cause such
movement and if the company is a major one like Reliance or Infosys or Hindustan Lever, a positive
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or negative development may generally affect several other stocks in the market. Similarly, a shock
in the U.S. market will have an impact on domestic stock prices. Investors' psychology will also often
contribute to the market risk. For instance, negative news may create a panic in the market and
everyone would like to sell the stock without any buyer in the market. In this process, the market
will decline more than the desired level. Market risk is demonstrated by the increased variability of
investor returns due to alternating bouts to bull and bear phases. Efforts to minimize this
component of total investment risk require a fair anticipation of a particular phase. This needs an
understanding of the basic cause for the two market phases. It has been found that business cycles
are a major determinant of the timing and extent of the bull and bear market phases. This would
suggest that the ups and downs in securities markets would follow the cycle of expansion and
recession in the economy. A bear market triggers pessimism and price falls on an extensive scale.
There is empirical evidence, which suggests that it is difficult for investors to avoid losing in bear
markets. Of course, there could be exceptions.
The question of protection against market risk naturally arises. Investors can protect their portfolios
by withdrawing invested funds before the onset of the bear market. A simple rule to follow would
be: `buy just before the security prices rise in a bull market and sell just before the onset of the bear
market', that is, buy low and sell high. This is called good investment timing but often difficult to
practice. Market risk as pointed out earlier is also classified as systematic and non-systematic. When
combinations of systematic forces cause the majority of shares to rise during a bull market and fall
during a bear market, a situation called systematic market risk is already noted, a minority of
securities would be negatively correlated to the prevailing market trend. These unsystematic
securities face diversifiable market risk. For example, firms granted a valuable patent of obtaining a
profitable additional market share might find its share prices rising even when overall gloom prevails
in the market. Such unsystematic price fluctuations are diversifiable and the securities facing them
can be combined with some other shares so that the resulting diversified portfolio offsets the non-
systematic losses by gains from other -systematic securities.

Q3- SINGLE-INDEX MODEL.? (v v v v v imp).

ANS- We get such a capability with the `single-index model' developed by a student of Markowitz
named William Sharpe (1963). In the 1950s, after techniques for estimating the required inputs to
this model were perfected, packaged, and marketed as computer software, modern portfolio really
took off in terms of practical applications. Now the single-index model is widely employed to allocate
investments iii the portfolio between individual equity shares, while the original more general model
of Markowitz is widely used to allocate investments between types of assets, such as bonds, shares,
and real estate. In the discussion that follows, we present the basic tenets of the `single-index
model', with reference to investment in equity shares. Essentially, the single-index model assumes
that the returns of various securities are related only through common relationships with some basic
underlying factor. In the words of Sharpe, this factor "may be the level of the stock market as a
whole, the gross national product, some price index, or any other factor thought to be the most
important single influence on the returns from securities". A casual observation of share-price
movements, at least, tends to support this line of argument. There is considerable evidence that
when the stock market goes down, most shares tend to decrease in price. For instance, on the date
of budget, several stocks move in the same direction depending on the assessment of the budget on
the economy and industry. It appears, therefore, that one reason share returns might be correlated
is because of a common response to market changes as measured by the movements in, say, share
price index.

Q4- Elliot Wave Theory.? (v v v v v imp).

ANS- Primary, Secondary and Minor. Elliot Ware Theory is the most popular depiction of this
principle. It states that the market moves up in five waves i.e., five up or down, eg., three moves up
and two down, while it moves down in three to five waves. These waves are primary, secondary and
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tertiary superposed on each other, and it takes experience to separate the three movements. For
instance, an upward movement of a primary wave comprises five secondary waves, and so o n . This
applies well to stocks in USA where the market movement is free from all constraints, and the public
takes part freely in investment as well as options trading. However, in India the market suffers
frequent upheavals because of the frequent changes in the government policy, as well as speculative
activity indulged in by brokers, and it is not unusual to see the market gain by 25% post-budget, and
the individual stocks may jump up or down by 50% within a few weeks due to speculation. Hence in
India it is not clear to what extent this theory applies, though some analysts persist in trying to fit the
market movements to this theory.

Q5- Arbitrage Pricing Theory.? (v v v v v imp).

ANS- Discussed later.

Q6- Capital Market Line (CML).? (v v v v v imp).

ANS- With the identification of M as market portfolio, we may define the straight line from Rf
through M, as `capital market line' (CML). This line represents the risk premium as a 40 result of
taking on extra risk. James Tobin added the notion of leverage to Modern Portfolio Theory by
incorporating into the analysis an asset, which pays a risk-free rate of return. By combining a risk-
free asset with risky assets, it is possible to construct portfolios whose risk-return profiles are
superior to those of portfolios on the efficient frontier. Consider the diagram below:
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Q7- Portfolio revision strategies.? (v v v v v imp).

ANS- Broadly speaking investors may, depending on their investment objectives skill and resources,
follow `active' or `passive' strategies for portfolio revision. Active strategy of portfolio revision
involves a process similar to portfolio analysis and selection as described, which is based on an
analysis of fundamental factors covering economy, industries and companies as well as technical
factors as described.
Active revision strategy seeks `beating the market by anticipating' or reacting to the perceived
events or information. Passive revision strategy, on the other hand, seeks `performing as the
market'. The followers of active revision strategy are found among believers in the "market
inefficiency" whereas passive revision strategy is the choice of believers in the `market efficiency'.
However, some of the formula strategies are on the premise of market inefficiency. The frequency of
trading transactions, as is obvious, will be more under active revision strategy than under passive
revision strategy and so will be the time, money and resources required for implementing active
revision strategy than for passive revision strategy. In other words, active and passive revision
strategies differ in terms of purpose, process and cost involved. The choice between the two
strategies is certainly not very straight forward. One has to compare relevant costs and benefits. On
the face of it, active revision strategy might appear quite appealing but in actual practice, there exist
a number of constraints in undertaking portfolio revision itself

Q8- Dow theory.? (v v v v v imp).

ANS- Technical Analysis evolved in 1900-1902 when Charles H. Dow presented the celebrated `Dow
Theory' in a series of editorials in the Wall Street Journal in USA. The Classical Technical Analysis
evolved gradually in the early part of the 20th century, and deals with a detailed study of price bar
charts of the indices as well as the individual stocks.
Dow Theory and its Basic Tenets
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Q9- Security Market Line (SML).? (v v v v v imp).

ANS- Given the capital market line (CML) and the dominance of the market portfolio, the relevant
risk measure for an individual risky asset is its covariance with the market portfolio (Covi,M), or what
is known as its `systematic risk'. When this covariance is standardized by the covariance for the
market portfolio, we obtain the well-known `beta' measure. of systematic risk and a security market
line (SML) that relates the expected return for an asset to its beta. Under the CAPM, the postulated
relationship is such that higher an asset's beta, the higher its expected return. To understand the
CAPM and computation of beta, let us examine the whole issue intuitively. If the concept of CML is
clear, you will agree that it is not possible for any stock to offer a risk-return relationship below or
above the CML. If it is below the CML, such stocks are known as overpriced stocks (meaning they
offer lower return for a given level of risk and there is an alternative portfolio on the line of CML,
which offer higher return) and investors will start selling the stock until its return increases to the
level of CML. The same applies if there is a stock above CML in terms of risk and return and investors
will buy such stocks by offering higher price until its return declines to CML. In CML, you can observe
only two points namely Rf and M. Since M is an efficient portfolio, we assume that the risk
associated with the M is the least. Further it is also a diversified portfolio and hence one can expect
no unsystematic risk (Recall the discussion in Unit 9 on how diversification beyond a point fails to
yield further results in reducing the risk). Suppose a stock lies beyond M in the CML line and it means
that the stock's risk is higher and hence offer higher return. Now, it is possible to quantify how much
that the stock is riskier than M and such a measure is called beta of the stock. If the stock falls on the
CML line, it's return (Rs) should satisfy the following equation.
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So now we'll have a series of 60 returns on the stock and the index (1 to 61). Plot the returns on a
graph and fit the best-fit line (visually or using least squares process). In Figure 12.4, you can see the
monthly return of BSE Sensex and ITC over 60 months period (January 1997 - December 2001). In
Table , the beta of stocks forming part of BSE Sensex along with return and total risk measures are
listed. You may observe that many new economy stocks like Satyam, Zee Tele have high beta
whereas multinational companies like Nestle, Castrol, HLL, Colgate have shown low beta. You may
also observe that returns of the new economy stocks were also high compared to other low beta
stocks. You may have to periodically revise the beta values since the risk of the stock changes over
time based on changes in the economy and industry characteristics.