SHORT NOTES

INVESTMENT ANALYSIS & PORTFOLIO MANAGEMENT

Code: KMBN FM01

UNIT-1
what is investment? explain its features, process, advantages and disadvantages.
What is Investment?
Investment refers to the act of allocating money or resources into assets or ventures with the expectation of
generating income or profit in the future. Individuals, businesses, and governments make investments in various
forms, such as stocks, bonds, real estate, or even business ventures, aiming for growth or financial returns over time.
Features of Investment
1. Risk and Return:
2. Time Horizon:
3. Liquidity:
4. Diversification:
5. Income Generation:
6. Capital Appreciation:
Process of Investment
1. Goal Setting:
2. Research and Planning:
3. Asset Allocation:
4. Investment Selection:
5. Execution:
6. Monitoring and Rebalancing:
Advantages of Investment
1. Wealth Creation:
2. Passive Income:
3. Inflation Hedge:
4. Tax Benefits:
5. Diversification of Income Sources:
Disadvantages of Investment
1. Risk of Loss:
2. Complexity
3. Liquidity Constraints:
4. Market Fluctuations:
5. Time Commitment:
TYPES OF INVESTMENT
1. Stocks (Equities)
2. Bonds (Fixed Income Securities)
3. Mutual Funds
4. Exchange-Traded Funds (ETFs)
5. Real Estate
6. Commodities
7. Certificates of Deposit (CDs)
8. Precious Metals
9. Private Equity and Venture Capital
Overview of Capital Market
The capital market is a financial market where long-term debt or equity-backed securities are bought and sold. It
plays a crucial role in the economy by enabling companies, governments, and other organizations to raise funds to
finance operations, expansion, and growth projects. The capital market is vital for economic development, as it helps
in the efficient allocation of capital from investors to businesses and government entities that need it.
Key Components of the Capital Market
1. Primary Market

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 o Description: This is where new securities (stocks and bonds) are issued and sold for the first time.
When a company issues its shares for the first time through an Initial Public Offering (IPO), it
happens in the primary market.
2. Secondary Market
o Description: After securities are issued in the primary market, they are traded between investors in
the secondary market. This includes stock exchanges like the New York Stock Exchange (NYSE) or
Nasdaq.

Types of Capital Market Instruments

1. Equity Instruments (Stocks)
2. Debt Instruments (Bonds)
3. Hybrid Instruments
Major Participants in Capital Markets
1. Issuers: Corporations, governments, and other entities that issue stocks or bonds to raise capital.
2. Investors: Includes institutional investors (mutual funds, pension funds, hedge funds) and retail investors
(individuals).
3. Intermediaries: Investment banks, brokerage firms, and other financial institutions facilitate transactions
between issuers and investors.
4. Regulatory Bodies: In most countries, capital markets are regulated by government agencies like the
Securities and Exchange Commission (SEC) in the United States or Securities and Exchange Board of India
(SEBI) in India. These agencies ensure that the markets operate fairly and transparently.
Functions of Capital Market
1. Mobilization of Savings:
2. Capital Formation:
3. Investment Opportunities:
4. Liquidity:
5. Efficient Allocation of Resources:
Types of Capital Markets
1. Stock Market
o Where shares of publicly traded companies are bought and sold. It includes major stock exchanges
like the NYSE, Nasdaq, and London Stock Exchange (LSE).
2. Bond Market
o Where participants buy and sell debt securities, primarily bonds. It includes government bonds,
municipal bonds, and corporate bonds.
3. Derivatives Market
o Where financial instruments like futures and options, which derive their value from underlying assets
(stocks, bonds, commodities), are traded. These are often used for hedging risks or speculating.
4. Foreign Exchange Market (Forex)
o Where currencies are traded. Though primarily a separate entity, the forex market intersects with the
capital market for international investments and financial instruments.
Advantages of Capital Markets
1. Efficient Capital Allocation:
2. Liquidity:
3. Price Discovery:
4. Wealth Creation:
5. Corporate Governance:
Disadvantages of Capital Markets
1. Volatility:
2. Risk of Loss:
3. Complexity:
4. Inequality:
5. Regulatory Risks:
Market of securities, Stock Exchange and New Issue Markets - their nature, structure, functioning and
limitations
Market of Securities
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The market of securities refers to a broad platform where financial instruments such as stocks, bonds, and other
securities are issued, bought, and sold. It is a crucial part of the financial system, enabling the allocation of capital to
productive sectors of the economy. This market consists of two main components:
1. Primary Market (New Issue Market)
2. Secondary Market (Stock Exchange)

Comparison: New Issue Market (Primary) vs. Stock Exchange (Secondary)

Aspect Primary Market (New Issue Market) Secondary Market (Stock Exchange)
Nature Initial issuance of new securities Trading of existing securities
Issuer Involvement Direct involvement of the issuer No involvement of the issuer
Price Setting Set by the issuer or through book-building Determined by market supply and demand
Participants Issuers, institutional investors, underwriters Individual and institutional investors, brokers
Purpose Raising capital for companies Providing liquidity and price discovery
Liquidity Low, as securities are newly issued High, as securities are actively traded
Risk Limited information, risk of mispricing Market volatility, speculation risks
Regulation Stringent due to first-time issuance Regulated to ensure fair trading

Limitations of the Securities Market

1. Market Manipulation:
2. Volatility:
3. Systemic Risk:
4. Access to Information:
5. Regulatory Delays:

Trading of securities: equity and debentures/ bonds.

Trading of Securities: Equity and Debentures/Bonds
Trading in securities, including equities (stocks) and debentures/bonds, is a critical activity within the capital
markets..

Key Differences Between Equity and Bonds/Debentures

Aspect Equity (Stocks) Debentures/Bonds
Nature Represents ownership in a company Represents a loan to a company or government
Fixed interest payments (coupons) and principal
Returns Dividends and capital gains
repayment
Low to medium risk (dependable but subject to
Risk Level High risk (volatile, potential for loss)
interest rate and credit risk)
Variable (depends on company profits and
Income Fixed income through coupon payments
stock performance)
Priority in Last priority; shareholders are paid after Higher priority; bondholders are paid before
Liquidation debt holders shareholders in case of liquidation
Ownership Yes (voting rights in some cases) No ownership, only creditor rights
Mostly traded OTC, but some bonds are traded on
Market Traded on stock exchanges
exchanges
Liquidity High, with active markets and daily trading Medium to low liquidity, depending on the bond type

Securities trading - Types of orders

In securities trading, different types of orders allow investors to execute trades based on their specific preferences,
risk tolerance, and market conditions. Understanding these types of orders is essential for effectively managing
investments in the stock market. Orders vary in terms of how they execute trades, control prices, or respond to
specific market conditions.
1. Market Order

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  Description: A market order is an order to buy or sell a security immediately at the best available current
price.
2. Limit Order
 Description: A limit order specifies the maximum price (for buying) or minimum price (for selling) at which
an investor is willing to execute the trade.
o Buy Limit Order: Specifies the maximum price at which the investor is willing to buy.
o Sell Limit Order: Specifies the minimum price at which the investor is willing to sell.
3. Stop-Loss Order
 Description: A stop-loss order is an order to buy or sell a security once it reaches a specific price, called the
stop price. Once the stop price is reached, the stop order becomes a market order and is executed at the best
available price.
o Buy Stop Order: Used to buy a security if its price rises to a certain level, usually in anticipation of
further gains.
o Sell Stop Order: Used to sell a security if its price falls to a certain level, minimizing further losses.
4. Stop-Limit Order
 Description: A stop-limit order combines the features of a stop order and a limit order. Once the stop price is
reached, the stop-limit order becomes a limit order rather than a market order.
o Example: An investor may set a stop price of $50 and a limit price of $48. If the stock price falls to
$50, the order turns into a limit order to sell at $48 or higher.
5. Trailing Stop Order
 Description: A trailing stop order sets a stop price at a fixed percentage or dollar amount below (for a sell) or
above (for a buy) the current market price. As the price of the security moves in the investor's favor, the stop
price "trails" the market price by the specified amount.
o Example: If you own a stock priced at $100 and set a trailing stop at 10%, the stop price would be
$90. If the stock price rises to $120, the trailing stop would adjust to $108 (10% below $120).
6. Day Order
 Description: A day order is valid only for the trading day on which it is placed. If the order is not executed by
the end of the trading session, it is canceled.
7. Good 'Til Canceled (GTC) Order
 Description: A Good 'Til Canceled (GTC) order remains active until the order is filled or the investor cancels
it.
8. Fill or Kill (FOK) Order
 Description: A Fill or Kill (FOK) order is an order that must be executed immediately in its entirety, or it is
canceled. There is no partial execution.
9. Immediate or Cancel (IOC) Order
 Description: An Immediate or Cancel (IOC) order is similar to a Fill or Kill order but allows for partial
execution. If only part of the order can be filled immediately, the remainder is canceled.
10. All or None (AON) Order
 Description: An All or None (AON) order specifies that the entire order must be filled in a single transaction
or none of it will be executed. Unlike FOK orders, AON orders can remain open until they are completely
filled.
margin trading
1. What is Margin Trading?
In margin trading, investors borrow money from their broker to buy securities. The borrowed amount is secured by
collateral, typically the cash or securities already in the investor's account. Margin trading enables investors to take
larger positions than they could with just the cash available, thus increasing the potential returns or losses.
 Margin Account: To engage in margin trading, an investor must have a margin account with a broker. This is
different from a standard brokerage account, as it allows for borrowing funds.

2. Key Concepts in Margin Trading

Initial Margin
 The initial margin is the percentage of the purchase price of securities that the investor must pay for with
their own funds. The rest is borrowed from the broker.
o For example, if the initial margin requirement is 50%, the investor must put up 50% of the total trade
value, while the other 50% can be borrowed from the broker.
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Maintenance Margin
 The maintenance margin is the minimum equity the investor must maintain in the margin account. If the
value of the securities falls, the investor may need to deposit more funds or sell some assets to maintain this
margin level.
Margin Call
 A margin call occurs when the value of the securities in the margin account drops below the maintenance
margin. The broker then requires the investor to deposit more cash or sell assets to bring the account
balance back to the required level.

3. How Margin Trading Works

Step-by-Step Process:
1. Opening a Margin Account: The investor opens a margin account with a broker, which requires meeting
certain eligibility criteria.
2. Funding the Margin Account: The investor deposits a percentage of the purchase amount, usually a
minimum of 50% (depending on regulations and the broker).
3. Buying Securities: The investor buys securities using both their own funds and the borrowed funds from the
broker. This allows them to control a larger position than they could with just their cash.
4. Interest Payments: Since the investor is borrowing from the broker, they are required to pay interest on the
borrowed funds. This interest is typically charged daily and accumulates until the loan is repaid.
5. Holding or Selling: If the value of the securities increases, the investor can sell them at a profit, repay the
broker, and keep the excess returns. However, if the value decreases, the broker may issue a margin call.
6. Responding to a Margin Call: If the value of the securities falls below the maintenance margin, the investor
must either:
o Deposit more cash or securities into the account.
o Sell some of the securities to reduce the loan amount.

4. Advantages of Margin Trading

 Increased Buying Power
 Potential for Higher Returns
 Leverage

5. Risks of Margin Trading

 Amplified Losses
 Margin Calls
 Interest Costs
 Forced Liquidation

clearing and settlement procedures

Clearing and Settlement Procedures for Securities
The clearing and settlement process for securities ensures that after a trade is executed on an exchange, it is
accurately confirmed, cleared, and settled, leading to the transfer of ownership and funds between the buyer and
seller. These steps are crucial for maintaining trust, reducing risks, and ensuring the efficiency of financial markets.
The process generally involves multiple entities, including the stock exchange, clearinghouses, and depositories.
Clearing and settlement cycles vary across markets but often adhere to a T+2 system (trade day + 2 days).

1. Key Terminology
 Clearing: The process of reconciling purchase and sale orders, determining the obligations of the buyer and
the seller, and ensuring that both parties meet the trade's requirements.
 Settlement: The transfer of securities from the seller to the buyer and funds from the buyer to the seller,
marking the completion of the transaction.
 Clearinghouse: An intermediary that clears trades and guarantees the performance of counterparties in the
trade. It mitigates counterparty risk.
 Depository: An entity that holds securities electronically and facilitates the transfer of ownership during
settlement.

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  Custodian: A financial institution responsible for holding customers' securities and safeguarding them during
the clearing and settlement process.

2. Process of Clearing and Settlement

1. Trade Execution
 A trade is executed when a buy or sell order is matched on a securities exchange, like the New York Stock
Exchange (NYSE) or Nasdaq.
 The details of the trade, including the security, price, and quantity, are confirmed with the exchange.

2. Trade Confirmation
 After the trade is executed, it must be confirmed by both the buyer and the seller. This involves verifying the
transaction details.
 Brokers confirm the trade details to ensure accuracy. Errors at this stage can delay the entire process.

3. Clearing
 Clearing starts after trade confirmation. It involves:
1. Netting: The clearinghouse aggregates buy and sell orders to determine the net obligations of each
participant. Instead of transferring individual trades, the clearinghouse nets the transactions,
minimizing the number of transfers required.
2. Obligation Determination: The clearinghouse determines the financial obligations of both parties.
The buyer must deliver funds, and the seller must deliver securities.
4. Settlement
 Settlement is the final step, where ownership of the securities is transferred from the seller to the buyer, and
funds are transferred from the buyer to the seller.
 The settlement is done on a specific timeline, typically T+2 (trade date plus two business days), meaning the
settlement happens two days after the trade is executed.

Steps in Settlement:
1. Transfer of Securities:
o The securities are transferred electronically through a depository (such as The Depository Trust
Company (DTC) in the U.S.).
o The depository ensures that the securities move from the seller's account to the buyer's account.
2. Transfer of Funds:
o Simultaneously, the buyer's broker transfers funds through the clearinghouse to the seller’s broker,
which are credited to the seller’s account.
o Banks and custodians are involved in ensuring the safe and efficient transfer of funds.

3. Entities Involved in Clearing and Settlement

1. Clearinghouse
2. Depositories
3. Custodians
4. Clearing and Settlement Timelines
5. Risks in Clearing and Settlement
6. International Clearing and Settlement Systems

Regularity systems for equity markets

Regulatory Systems for Equity Markets
Regulatory systems for equity markets are essential to ensure transparency, fairness, investor protection, and the
efficient functioning of financial markets. These systems establish the legal and operational frameworks under which
equity markets operate, safeguarding market integrity and stability.

Main Regulatory Bodies in Equity Markets

1. Securities Regulators

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  Securities and Exchange Commission (SEC) – U.S.: The SEC is the primary regulatory authority for equity
markets in the U.S. It enforces federal securities laws, regulates securities exchanges, brokers, and public
companies, and oversees disclosures to ensure transparency.
 Financial Conduct Authority (FCA) – U.K.: The FCA regulates the financial markets in the United Kingdom,
including equity markets. It ensures that markets are fair, transparent, and operate efficiently.
 European Securities and Markets Authority (ESMA) – EU: ESMA is responsible for improving investor
protection and ensuring stable, orderly financial markets in the European Union.
 Securities and Exchange Board of India (SEBI) – India: SEBI oversees the regulation and supervision of
securities markets in India, ensuring fair practices and protecting investor interests.
3. Stock Exchanges
Stock exchanges, such as the New York Stock Exchange (NYSE), Nasdaq, London Stock Exchange (LSE), and Tokyo
Stock Exchange (TSE), also have self-regulatory functions. They set listing requirements, monitor trading, and ensure
compliance with market rules.
3. Central Banks
Central banks, such as the Federal Reserve in the U.S. or the European Central Bank (ECB), oversee macroprudential
policies that affect the equity markets, particularly in areas like interest rates and monetary policy.
4. International Organizations
 International Organization of Securities Commissions (IOSCO): IOSCO is a global organization of securities
regulators that sets international standards for securities regulation. It promotes collaboration between
member states and aims to develop and maintain efficient and well-regulated securities markets globally.

Type of investors
There are various types of investors, each with different goals, risk tolerance, and investment strategies. Broadly,
investors can be categorized based on factors such as the type of assets they invest in, their financial objectives, and
their level of involvement in the investment process. Below are the key types of investors:

1. Based on Investment Goals

1.1. Retail Investors
 Definition: Individual investors who buy and sell securities for their own personal accounts, rather than for
institutions.
1.2. Institutional Investors
 Definition: Large entities, such as pension funds, insurance companies, mutual funds, hedge funds, or
endowments, that invest on behalf of others.
1.3. Angel Investors
 Definition: Wealthy individuals who provide capital to early-stage startups, often in exchange for equity.
1.4. Venture Capitalists (VCs)
 Definition: Professional investors who manage pooled funds from individuals or institutions to invest in high-
growth startups.
1.5. Private Equity Investors
 Definition: Investors or firms that invest directly in private companies, often acquiring a significant portion of
the company.
1.6. Socially Responsible Investors (SRI)
 Definition: Investors who prioritize ethical, social, and environmental concerns alongside financial returns.
2. Based on Risk Tolerance
2.1. Conservative Investors
 Definition: Investors with a low risk tolerance who prioritize capital preservation over high returns.
2.2. Aggressive Investors
 Definition: Investors who seek higher returns and are willing to accept greater risk.
2.3. Moderate Investors
 Definition: Investors with a balanced approach, seeking a mix of growth and security.
3. Based on Investment Strategy
3.1. Active Investors
 Definition: Investors who take an active role in buying, selling, and managing their portfolio.
3.2. Passive Investors
 Definition: Investors who follow a buy-and-hold strategy and focus on long-term growth.
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3.3. Value Investors
 Definition: Investors who seek to buy undervalued stocks that are trading below their intrinsic value.
3.4. Growth Investors
 Definition: Investors who focus on companies with high potential for earnings growth.
3.5. Income Investors
 Definition: Investors who prioritize generating a steady income from their investments, usually through
dividends or interest.
4. Based on Level of Involvement
4.1. DIY (Do-It-Yourself) Investors
 Definition: Investors who manage their own portfolio without professional advice.
4.2. Professional Investors
 Definition: Investors who rely on financial advisors, brokers, or portfolio managers to manage their
investments.
Aim of Security Analysis
 Identify Investment Opportunities
 Assess Risk and Return
 Support Decision Making
 Monitor and Adjust Portfolio

Approaches of Security Analysis

1. Fundamental Analysis
Fundamental analysis focuses on evaluating a security’s intrinsic value based on various financial, economic, and
qualitative factors. This approach seeks to determine the underlying value of a security by examining the
fundamental factors that influence its performance.
Key Components:
 Financial Statements Analysis
 Valuation Ratios
 Economic and Industry Analysis

2. Technical Analysis
Technical analysis involves evaluating securities based on historical price and volume data to predict future price
movements. This approach relies on charts, patterns, and technical indicators rather than fundamental factors.
Key Components:
 Charts and Patterns
 Technical Indicators
 Volume Analysis
 Trend Analysis
 Approach:

KBNFM01
UNIT-2
Risk refers to the potential for an outcome or event to differ from what is expected, especially when it involves
negative consequences.
Here are key aspects of the concept of risk:
1. Uncertainty:
2. Probability:
3. Impact:
4. Perception of Risk:
5. Types of Risk:
o Financial Risk:
o Operational Risk:
o Strategic Risk:
o Reputational Risk:
o Health and Safety Risk:
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 6. Risk Management: This involves identifying, assessing, and mitigating risks. The goal is to minimize potential
negative impacts while maximizing potential gains.

COMPONENTS OF RISK
1. Risk Event
2. Probability (Likelihood)
3. Impact (Consequence or Severity)
4. Exposure
5. Vulnerability
6. Risk Tolerance
7. Control (Mitigation)

CLASSIFICATION OF RISK
1. Based on Nature of Risk
a. Pure Risk
b. Speculative Risk
2. Based on Controllability
a. Controllable Risk
b. Uncontrollable Risk
3. Based on Origin or Source
a. Internal Risk
b. External Risk
4. Based on Impact Area
a. Financial Risk
b. Operational Risk
c. Strategic Risk
d. Compliance Risk
e. Reputational Risk
f. Environmental Risk
g. Technology Risk
5. Based on Time Horizon
a. Short-term Risk
b. Long-term Risk
6. Based on Measurability
a. Quantifiable Risk
b. Non-Quantifiable Risk
7. Based on Industry or Sector
a. Business Risk
b. Political Risk
c. Project Risk
8. Based on Frequency
a. High-Frequency, Low-Impact Risk
b. Low-Frequency, High-Impact Risk
9. Other Special Types of Risk
a. Systematic Risk
b. Unsystematic Risk

What Are Risk Measures?

 Risk measures are statistical measures that are historical predictors of investment risk and volatility.
Types of Risk Measures
 Alpha
 Beta
 R-Squared
 Standard Deviation
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  Sharpe Ratio
Covariance
Covariance is a measure of the directional relationship between the returns on two risky assets.
Covariance evaluates how the mean values of two variables move together.
When an analyst has a set of data, a pair of x and y values, covariance can be calculated using five variables from that
data. They are:
xi = a given x value in the data set
xm = the mean, or average, of the x values
yi = the y value in the data set that corresponds with xi
ym = the mean, or average, of the y values
n = the number of data points
Given this information, the formula for covariance is: Cov(x,y) = SUM [(xi – xm) * (yi – ym)] / (n – 1)
Covariance Applications
Covariances have significant applications in finance and modern portfolio theory. For example, in the capital asset
pricing model (CAPM), which is used to calculate the expected return of an asset, the covariance between a security
and the market is used in the formula for one of the model’s key variables, beta. In the CAPM, beta measures the
volatility, or systematic risk, of a security in comparison to the market as a whole; it’s a practical measure that draws
from the covariance to gauge an investor’s risk exposure specific to one security.
Correlation coefficient is a statistical measure that calculates the strength of the relationship between the relative
movements of the two variables. The range of values for the correlation coefficient bounded by 1.0 on an absolute
value basis or between -1.0 to 1.0. If the correlation coefficient is greater than 1.0 or less than -1.0, the correlation
measurement is incorrect. A correlation of -1.0 shows a perfect negative correlation, while a correlation of 1.0 shows
a perfect positive correlation. A correlation of 0.0 shows zero or no relationship between the movements of the two
variables.
Correlation Coefficient Formulas
One of the most commonly used formulas in stats is Pearson’s correlation coefficient formula. If you’re taking a basic
stats class, this is the one you’ll probably use:

n(Σxy)−(Σx)(Σy)/
r=
√[nΣx2−(Σx)2][nΣy2−(Σy)2]
Where,
r = Pearson correlation coefficient
x = Values in first set of data
y = Values in second set of data
n = Total number of values.

Economic, Industry,Company Analysis,

EIC ANALYSIS
Economic Analysis
Economic analysis evaluates the broader economic environment in which industries and companies operate. It
includes studying key factors like GDP growth, inflation rates, unemployment, interest rates, exchange rates, and
consumer confidence. These factors help investors and businesses assess the overall health of an economy and its
potential to support business growth.
Key components of economic analysis:
1. GDP (Gross Domestic Product):
2. Inflation:
3. Interest Rates:
4. Exchange Rates:
5. Government Policies:
Industry Analysis
Industry analysis focuses on understanding the specific environment in which a group of companies
operates. This analysis examines the competitive landscape, market trends, and structural factors within the industry.
Key components of industry analysis:
1. Industry Life Cycle:
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 2. Porter’s Five Forces:
3. Regulation and Policy:
4. Technological Changes:
5. Demand and Supply Dynamics:
Company Analysis
Company analysis involves evaluating a specific company’s strengths, weaknesses, opportunities, and threats (SWOT)
to determine its performance and potential for growth. It focuses on the company’s financial performance,
competitive positioning, and management effectiveness.
Key components of company analysis:
1. Financial Performance
2. Competitive Positioning:
3. Management and Corporate Governance:
4. Growth Prospects:.
5. Risks:
Portfolio Risk and Return
Portfolio Risk and Return are fundamental concepts in investment management, driving the decision-making
process for constructing and managing a portfolio.
Portfolio Return:
Portfolio return refers to the overall gain or loss generated by the portfolio over a specific period.
Calculation of Portfolio Return:
The return of a portfolio is calculated as the weighted average of the returns of the individual assets within the
portfolio. The formula is:
Rp = ∑ (wi × Ri)
Where:
 Rp = Portfolio return
 wi = Weight of the individual asset in the portfolio (i.e., the proportion of total investment in that asset)
 Ri = Return of the individual asset
This formula shows that the portfolio return depends on both the returns of the individual assets and the proportion
of the portfolio invested in each asset.
Expected Return:
The expected return is the anticipated return on a portfolio based on the historical performance of the assets or
their expected future performance. Investors use it to gauge potential profitability.
E(Rp) = ∑(wi × E(Ri))
Where E(Ri)) is the expected return of asset i.
Portfolio Risk
Portfolio risk refers to the uncertainty or variability of returns associated with the portfolio. It reflects the potential
for the actual return to deviate from the expected return. Unlike individual asset risk, which can be mitigated
through diversification, portfolio risk considers how the various assets interact with each other.
Types of Portfolio Risk:
1. Systematic Risk:
2. Unsystematic Risk:

Measurement of Portfolio Risk:

1. Variance and Standard Deviation:
2. Covariance and Correlation:
3. Beta (β):
Risk-Return Tradeoff
The risk-return tradeoff is a fundamental principle in investing that suggests the potential return rises with an
increase in risk. Investors must balance the desire for higher returns with their tolerance for risk.
Efficient Frontier
In Modern Portfolio Theory (MPT), the efficient frontier represents the set of optimal portfolios that offer the highest
expected return for a given level of risk. Portfolios on the efficient frontier are considered efficient because no
additional return can be obtained without increasing risk.
Beta as a Measure of Risk

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 Beta is a key measure in finance used to assess the risk of a stock or a portfolio in relation to the broader
market. It specifically measures the sensitivity of an asset's returns to market movements, providing investors insight
into the asset's risk profile compared to the overall market.

Understanding Beta
 Definition: Beta (β\betaβ) quantifies the correlation between the returns of an individual asset (e.g., a stock)
or portfolio and the returns of the market as a whole (often represented by a benchmark like the S&P 500).
 Purpose: It helps investors understand how much risk they are taking by holding a particular asset relative to
the risk of the broader market.

Interpretation of Beta:
1. Beta = 1:
o The asset moves in lockstep with the market.
o If the market goes up by 10%, the asset's price is expected to increase by 10%, and if the market falls
by 10%, the asset's price is likely to decrease by 10%.
o The asset has average market risk.
2. Beta > 1:
o The asset is more volatile than the market.
o If Beta = 1.5, and the market rises by 10%, the asset is expected to rise by 15%. Similarly, if the
market drops by 10%, the asset will drop by 15%.
o High-beta assets are considered riskier but also have the potential for higher returns during bull
markets.
3. Beta < 1 (but greater than 0):
o The asset is less volatile than the market.
o If Beta = 0.5, and the market rises by 10%, the asset is expected to rise by only 5%. Likewise, a 10%
market drop might lead to only a 5% drop in the asset's value.
o Low-beta assets have lower risk, offering more stability, but they also tend to provide lower returns
in strong market conditions.
4. Beta = 0:
o The asset has no correlation with market movements.
o It is not influenced by the broader market and moves independently.
o Examples might include assets like cash or government bonds.
5. Negative Beta (< 0):
o The asset moves inversely to the market.
o If Beta = -1, and the market rises by 10%, the asset would drop by 10%. Conversely, if the market falls
by 10%, the asset would rise by 10%.
o Assets with negative beta are often considered good hedging instruments during market downturns
(e.g., gold or certain bonds).
Beta in the Capital Asset Pricing Model (CAPM) / CALCULATION OF BETA
In the Capital Asset Pricing Model (CAPM), beta is used to calculate the expected return of an asset based
on its risk relative to the market. The formula for CAPM is:
Ri=Rf+βi(Rm−Rf)
Where:
 Riis the expected return of the asset.
 Rf is the risk-free rate (e.g., return on government bonds).
 βi\beta is the beta of the asset.
 Rm is the expected market return.
Advantages of Beta
1. Risk Measurement:
2. Portfolio Construction:
3. Benchmarking:
Limitations of Beta
1. Backward-Looking:
2. Ignores Fundamental Factors:

12
 3. Assumes Market Efficiency:
4. Short-Term Fluctuations:

Portfolio Selection: A Comprehensive Guide

Portfolio selection is the process of choosing a mix of assets that aims to achieve the investor’s goals while
balancing risk and return. The key to portfolio selection is diversification and alignment with the investor’s risk
tolerance, time horizon, and investment objectives. The selection process often relies on financial theories such as
Modern Portfolio Theory (MPT) and tools like the Capital Asset Pricing Model (CAPM).
Here’s a step-by-step guide to the portfolio selection process:

1. Understand Investor Objectives and Constraints

Key Considerations:
 Investment Goals:
 Time Horizon:
 Risk Tolerance:
 Liquidity Needs:
 Tax Considerations:
2. Asset Classes in Portfolio Selection
1. Equities (Stocks):
2. Fixed Income (Bonds):
3. Cash and Cash Equivalents:
4. Real Estate:
5. Commodities:
6. Alternative Investments:

3. Diversification and Risk Management

 Across Asset Classes:
 Within Asset Classes:
 Risk Reduction:

4. Portfolio Allocation and Weights

Portfolio allocation refers to how the total capital is distributed among different asset classes and individual
assets. This step requires determining the appropriate weights of each asset class based on the investor’s objectives,
risk tolerance, and market outlook.
 Strategic Asset Allocation:
 Tactical Asset Allocation:

Asset Allocation Models:

1. Conservative Portfolio (low-risk, low-return):
2. Balanced Portfolio (moderate risk and return):
3. Aggressive Portfolio (high-risk, high-return):

5. Risk and Return Optimization

Efficient Frontier:
Sharpe Ratio:

6. Rebalancing the Portfolio

Rebalancing Strategies:
 Time-based Rebalancing:
 Threshold-based Rebalancing:
7. Monitoring and Adjusting the Portfolio
 Performance Review:
 Risk Assessment:
 Adjustments:

13
Markowitz’s Modern Portfolio Theory (MPT)
Markowitz’s Modern Portfolio Theory (MPT), introduced by Harry Markowitz in 1952, is a foundational concept in
finance that revolutionized the way investors think about risk, return, and diversification. MPT emphasizes the
importance of diversifying investments across different assets to achieve the best possible return for a given level of
risk. The theory’s main innovation is the quantification of the risk-return trade-off and the use of mathematical
models to construct optimal portfolios.

Key Concepts of Markowitz’s Theory

1. Risk and Return:
2. Diversification:
3. Efficient Frontier:
4. Correlation:

Assumptions of Modern Portfolio Theory

1. Rational Investors: Investors are risk-averse and make decisions rationally to maximize their utility.
2. Mean-Variance Optimization: Investors only care about the mean (expected return) and variance (risk) of
their portfolio’s returns.
3. Single-Period Investment Horizon: MPT is based on a single time period for analysis.
4. No Transaction Costs: It assumes no transaction costs, taxes, or other frictions.
5. Efficient Markets: All investors have access to the same information, and securities are priced fairly based on
available information.

Limitations of Markowitz’s Theory

1. Simplistic Assumptions:
2. Historical Data Limitations:
3. Single-Period Assumption:
4. Difficulties in Estimating Inputs:

Markowitz Theory in Practice

Despite its limitations, MPT remains widely used in finance and serves as the foundation for various
investment strategies. Asset managers, pension funds, and individual investors often use MPT principles when
constructing portfolios.
Practical applications include:
1. Index Funds and ETFs: Many passive investment strategies rely on the diversification principles of MPT.
2. Robo-Advisors: Automated investment platforms use algorithms based on MPT to construct and rebalance
portfolios for clients.
3. Risk-Return Trade-Off Analysis: MPT provides a clear framework for understanding the relationship between
risk and return, aiding in portfolio optimization.

Single Index Model (SIM)

The Single Index Model (SIM) is a simplified approach to portfolio management and risk assessment that builds on
Modern Portfolio Theory (MPT). Proposed by William Sharpe in 1963, it models the returns of a stock (or portfolio of
stocks) as a function of the return of a single market index (e.g., S&P 500), reducing the complexity of calculating
covariances between every pair of assets in a portfolio.

Key Components of the Single Index Model

1. Market Index:
2. Beta (β):
3. Alpha (α):
4. Stock-Specific Risk (Unsystematic Risk):
Formula of the Single Index Model
The Single Index Model expresses the return of an individual stock as a function of the market return, beta,
and stock-specific factors:
Ri=αi+βiRm+ei
14
 Where:
 Ri = Return of stock iii
 αi = Stock-specific return (independent of the market)
 βi = Sensitivity of stock iii to the market return (beta)
 Rm = Return of the market index
 ei = Stock-specific random error (unsystematic risk), which has an expected value of zero.

Total Risk in the Single Index Model

In the SIM, the total risk of a stock (or portfolio) is a combination of systematic risk (market risk) and
unsystematic risk (stock-specific risk).
Total Risk=σi2=βi2σm2+σe2
Where:
 σi2 = Total variance (risk) of the stock’s return.
 βi2σm2= Systematic risk (market risk).
 σe2 = Unsystematic risk (specific to the stock).
The total risk consists of:
1. Systematic Risk:
2. Unsystematic Risk:

Advantages of the Single Index Model

1. Simplification:
2. Practical and Intuitive:
3. Clear Segregation of Risk:
4. Use in Performance Attribution:

Limitations of the Single Index Model

1. Single Market Factor:
2. Market Efficiency Assumption:
3. Static Model:
4. Unsystematic Risk May Not Be Completely Eliminated:

Single Index Model in Portfolio Management

Portfolio Return under SIM:
The expected return of a portfolio can be computed as:
Rp=αp+βpRm
Where:
 Rp = Expected return of the portfolio.
 αp = Weighted average of the alphas of the individual stocks.
 βp= Weighted average of the betas of the individual stocks.
 Rm= Return of the market index.
Portfolio Risk under SIM:
The portfolio risk is calculated by aggregating the systematic risk and unsystematic risk of the individual
assets:
σp2=βp2σm2+∑wi2σei2
Where:
 σp2 = Portfolio variance.
 βp = Portfolio beta.
 σm2= Market variance.
 σei2 = Unsystematic risk of stock iii.

UNIT-3
Dow theory
Dow Theory is a foundational approach to technical analysis of the stock market, developed by Charles H. Dow, co-
founder of The Wall Street Journal and co-creator of the Dow Jones Industrial Average (DJIA). The theory was later
15
expanded upon by his successors, particularly William Hamilton and Robert Rhea. It remains a fundamental concept
in understanding market trends and is the basis for many modern technical analysis tools.
The core idea of Dow Theory is that the stock market moves in broad, predictable phases and that market trends can
be identified through the interaction of two indexes: the Dow Jones Industrial Average (DJIA) and the Dow Jones
Transportation Average (DJTA).

Key Tenets of Dow Theory

1. The Market Discounts Everything:
2. The Market Moves in Trends:
o Dow Theory asserts that the market moves in identifiable trends. These trends can be divided into
primary, secondary, and minor trends:
3. Primary Trends Have Three Phases::
o Bull Market Phases:
1. Accumulation Phase:
2. Public Participation Phase:
o Excess Phase (or Distribution Phase): Bear Market Phases:
1. Distribution Phase:
2. Public Participation Phase:
4. Panic Phase: Indexes Must Confirm Each Other:
5. Volume Confirms Trends:
6. Trends Continue Until Definite Signals Reverse Them:

Practical Application of Dow Theory

1. Identifying Market Trends:
2. Market Signals:
o Buy Signal:
o Sell Signal:
3. Volume Analysis:
4. Trend Reversals:

Limitations of Dow Theory

1. Lagging Indicator:
2. Limited Scope:
3. Not Suitable for Short-Term Trading:
4. Subjectivity:

Support and Resistance Levels

Support and resistance are fundamental concepts in technical analysis used to identify price levels on a chart
where the forces of supply and demand interact, leading to significant changes in price direction.
 Support Level: A price point where a downtrend tends to pause due to a concentration of buying interest.
 Resistance Level: A price point where an uptrend tends to pause due to a concentration of selling pressure.

Importance of Support and Resistance Levels

 Decision Points: Traders and investors use support and resistance levels as key decision points for entering or
exiting trades. When the price approaches support, they may buy, expecting the price to rebound. When the
price nears resistance, they may sell or prepare for a breakout.
 Stop-Loss and Take-Profit Levels: Traders often set stop-loss orders just below support levels and take-profit
orders near resistance levels to manage risk and lock in profits.
 Risk Management: Understanding these levels helps in setting effective stop-loss orders, reducing the risk of
significant losses if the market moves against a position.
Type of charts & its interpretations
1. Line Chart
16
  Description: A basic chart that plots a security's price movement over time.
 Usage: Track the closing price of a stock, commodity, or index over a period (e.g., days, months, or years).
2. Candlestick Chart
 Description: A chart where each "candlestick" represents the open, high, low, and close prices of a security
for a particular time frame.
 Usage: Identify patterns and predict future price movements.
3. Bar Chart (OHLC Chart)
 Description: Shows the open, high, low, and close prices for a security over a specific period, similar to
candlestick charts but with bars instead of candles.
 Usage: Analyze price ranges within a trading session.
4. Point and Figure Chart
 Description: Plots price movements without considering time. X’s represent rising prices, and O’s represent
falling prices.
 Usage: Identify significant price trends, breakouts, and reversals.
5. Volume Chart
 Description: Shows the trading volume (number of shares or contracts traded) over a period.
 Usage: Understand the strength behind price movements.
6. Moving Average (MA) Chart
 Description: A smoothed-out line chart that shows the average price of a security over a specified period
(e.g., 50-day MA, 200-day MA).
 Usage: Reduce noise from short-term fluctuations and highlight the underlying trend.
7. Relative Strength Index (RSI) Chart
 Description: An oscillator chart that measures the speed and change of price movements, typically ranging
between 0 and 100.
 Usage: Identify overbought or oversold conditions in a security.

Trend line
A trend line in security analysis is a straight line drawn on a chart to connect specific price points, either highs or
lows, to visually represent the general direction of the price movement over time.
Types of Trend Lines:
1. Uptrend Line (Bullish Trend Line):
2. Downtrend Line (Bearish Trend Line):
Significance of Trend Lines:
1. Identifying the Trend:
2. Support and Resistance:
3. Trend Reversals:
4. Entry and Exit Points:
5. Strength of the Trend:
Trend Line Limitations:
1. Subjectivity:
2. False Breakouts:
3. Need for Adjustment:
Gap Wave Theory,
Gap Wave Theory is a lesser-known concept in technical analysis that combines gap analysis and wave theory to
interpret and predict stock price movements.
Key Concepts in Gap Wave Theory:
1. Gaps in Technical Analysis:
o A gap occurs on a price chart when a security's price opens higher or lower than the previous closing
price, leaving a visible gap between the two prices. Gaps can provide valuable information about
market sentiment, volatility, and potential future price movements.
o Types of Gaps:
 Common Gaps:
 Breakaway Gaps:
 Runaway (Continuation) Gaps
 Exhaustion Gaps:
17
 2. Wave Theory (Elliott Wave Principles):
o Wave theory, most famously the Elliott Wave Theory, is based on the idea that markets move in
repetitive wave-like patterns. These patterns reflect investor psychology and market sentiment,
moving in predictable cycles of impulse (in the direction of the trend) and corrective waves (against
the trend).
o Elliott Wave Theory proposes that markets move in a 5-wave pattern in the direction of the trend,
followed by a 3-wave corrective pattern.
 Impulse waves (1, 3, 5): Move in the direction of the overall trend.
 Corrective waves (2, 4): Move against the overall trend, retracing some of the gains or
losses.
3. Combining Gaps and Waves: Gap Wave Theory posits that gaps often correspond with key points in a wave
pattern, either accelerating a move in the direction of the trend or signaling an impending reversal.
Application of Gap Wave Theory:
1. Identifying Gaps in Wave Cycles:
2. Gap Filling and Retracements:
3. Predicting Trend Strength with Gaps:
4. Confirming Wave Completion with Gaps:
Strengths and Limitations:
Strengths:
 Predictive Power:
 Clear Signals:
 Complementary to Other Analysis:
Limitations:
 Subjectivity in Wave Counting:
 Gap Frequency:
 False Gaps:
Relative strength analysis
Relative Strength Analysis (RSA) is a technical analysis tool used to evaluate the performance of one security relative
to another, or to a benchmark index, over a specified period. It helps traders and investors identify securities that are
outperforming or underperforming the market or their peers.
Key Concepts of Relative Strength Analysis:
1. Relative Strength (RS) Ratio:
2. Relative Strength Line:
3. Timeframes in RSA:
Applications of Relative Strength Analysis:
1. Comparing Individual Stocks to a Market Index:
2. Comparing Securities within a Sector:
3. Sector Rotation Strategy:
4. Portfolio Construction and Risk Management:
5. Momentum Trading:
Tools for Relative Strength Analysis:
1. Relative Strength Charts: Many charting platforms (e.g., TradingView, Bloomberg, MetaStock) provide the
ability to plot RS lines between two securities or between a security and a benchmark.
2. Performance Comparison Charts: Some platforms allow users to compare the percentage performance of
multiple assets over a defined period, giving a visual representation of relative strength.
3. Specialized Indicators: Certain indicators like the Mansfield Relative Strength indicator help visualize relative
strength in a more structured manner, emphasizing outperformance and underperformance more clearly.

Technical Versus Fundamental analysis

Key Differences Between Technical and Fundamental Analysis:

Aspect Technical Analysis Fundamental Analysis
Financial health, intrinsic value, and economic
Focus Price action and chart patterns
factors

18
Aspect Technical Analysis Fundamental Analysis
Time Horizon Short-term (e.g., days, weeks, months) Long-term (e.g., years)
Financial statements, economic data, qualitative
Primary Tools Charts, trend lines, technical indicators
factors
Identify short-term price movements and
Objective Determine the intrinsic value of a security
trends
Markets are sometimes inefficient, causing
Assumption Price reflects all available information
mispricing
Quantitative, relying on historical price Quantitative and qualitative, relying on company
Approach
and volume fundamentals
Day traders, swing traders, short-term
Best for Long-term investors, value investors
traders
Consideration of Strongly considered as part of a company’s
Limited, only if it affects price movement
News valuation

Nature of Stock Markets: EMH (Efficient Market Hypothesis) and its implications for investment decision
Efficient Market Hypothesis (EMH)
The Efficient Market Hypothesis (EMH) is a financial theory that suggests stock prices fully reflect all available
information at any given time. The concept was popularized by economist Eugene Fama in the 1960s. According
to the EMH, because all known information is already incorporated into stock prices, it is impossible to
consistently "beat the market" through stock selection or market timing.
Types of Market Efficiency in EMH:
The EMH is divided into three forms based on the type of information that is reflected in stock prices:
1. Weak Form Efficiency:
2. Semi-Strong Form Efficiency:
3. Strong Form Efficiency:
Key Assumptions of EMH:
1. Rational Investors:.
2. Information Availability
3. Price Adjustments:
Implications of EMH for Investment Decisions:
1. Active vs. Passive Investing:
2. Technical and Fundamental Analysis:
3. Market Timing:
4. Risk-Return Tradeoff:
5. Random Walk Theory:
Criticisms and Challenges to EMH:
While the EMH is a widely accepted theory, it has been met with significant criticism, especially in light of real-
world market behavior.
1. Behavioral Finance:
2. Anomalies and Market Inefficiencies:
3. Insider Trading:
4. Performance of Active Managers:
5. Market Reactions to News:

Capital market theorem, CAPM (Capital Asset Pricing Model) and Arbitrage Pricing Theory.
1. Capital Market Theorem
The Capital Market Theorem is a foundational concept in modern portfolio theory, closely related to the Capital
Asset Pricing Model (CAPM). It describes the relationship between risk and return in an efficient capital market,
where investors make decisions to maximize expected return for a given level of risk.
Implications:
 Investors can maximize their return by combining a risk-free asset with the market portfolio (the optimal mix
of all risky assets).

19
  The CML shows the relationship between the expected return of a portfolio and its total risk, measured by
standard deviation (total risk).
The Capital Market Theorem forms the basis of the CAPM, which focuses on individual securities instead of
portfolios.

2. Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between expected return and
risk of investing in a security. It shows that the expected return on a security is equal to the risk-free return plus a
risk premium, which is based on the beta of that security. Below is an illustration of the CAPM concept.
CAPM Formula and Calculation
CAPM is calculated according to the following formula:

20
Where:
Ra = Expected return on a
security Rrf = Risk-free
rate Ba = Beta of
the security Rm = Expected return of the market
Note: “Risk Premium” = (Rm – Rrf)

Why CAPM is Important

The CAPM formula is widely used in the finance industry by various professions such as investment
bankers, financial analysts, and accountants. It is an integral part of the weighted average cost of
capital (WACC) as CAPM calculates the cost of equity.
Assumptions of CAPM:
1. Investors are rational and risk-averse, seeking to maximize returns for a given level of risk.
2. Markets are efficient, meaning all available information is reflected in asset prices.
3. There is a risk-free rate at which investors can lend or borrow money.
4. All investors have homogeneous expectations about future returns.
5. Investors can hold a diversified portfolio (the market portfolio) that eliminates unsystematic risk.
Limitations of CAPM:
 Simplistic assumptions: In reality, investors may not behave rationally, and markets are not
always efficient.
 Beta as a sole risk measure: CAPM relies heavily on beta, but some studies suggest that beta
alone may not fully capture an asset’s risk.
 Single factor model: CAPM focuses only on the market as a source of risk, ignoring other
potential risk factors (e.g., interest rate risk, inflation risk, etc.).

3. Arbitrage Pricing Theory (APT)

The Arbitrage Pricing Theory (APT), developed by economist Stephen Ross in 1976, is a more flexible
and complex alternative to CAPM. APT is a multifactor model that describes the relationship between
an asset’s expected return and multiple sources of systematic risk. Unlike CAPM, APT does not rely on a
single factor (market risk) and does not assume a risk-free rate. Instead, APT uses multiple risk factors
that affect an asset's return.
Mathematical Model of the APT
The Arbitrage Pricing Theory can be expressed as a mathematical model:

Where:
E(rj) – Expected return on asset

21
rf – Risk-free rate
ßn – Sensitivity of the asset price to macroeconomic factor n
RPn – Risk premium associated with factor n
The beta coefficients in the APT are estimated by using linear regression. In general, historical
securities returns are regressed on the factor to estimate its beta.
Implications:
 APT suggests that the return on an asset is influenced by various macroeconomic factors, not
just the market. Therefore, investors should consider these factors when evaluating an asset’s
expected return.
 Unlike CAPM, APT is less restrictive because it does not require assumptions like market
efficiency or a single source of risk.
Advantages of APT:
 Flexibility: APT allows for multiple factors affecting asset returns, making it more flexible than
CAPM.
 No reliance on a market portfolio: APT does not assume that all investors hold the same market
portfolio, as CAPM does.
 Real-world application: APT can be adapted to real-world situations where multiple factors
influence asset prices, such as changes in interest rates, inflation, or other economic forces.
Limitations of APT:
 Choosing factors: APT does not specify which factors should be included, leaving it up to the
investor to decide. This can lead to inconsistent application across different securities.
 Complexity: APT is more complex to use than CAPM because it requires the identification and
estimation of several risk factors.
 Data availability: APT requires accurate historical data for each factor, which may not always be
available or reliable.

Comparing CAPM and APT:

Aspect CAPM APT
Number of Risk Multiple factors (e.g., interest rates, inflation,
Single factor (market risk)
Factors etc.)
More complex, requires identifying multiple
Simplicity Simpler, easier to use
factors
Assumes market efficiency, risk- Does not require market efficiency or a
Assumptions
free rate specific market portfolio
Focus Market as the primary risk source Multiple sources of risk (macro factors)
Suitable for portfolios with market
Application More adaptable to different types of risks
risk exposure
Based on arbitrage and no-arbitrage
Theoretical Basis Based on modern portfolio theory
conditions

UNIT-4(FM01)
Equity valuation is a blanket term and is used to refer to all tools and techniques used by investors to
find out the true value of a company’s equity.
Inputs in the Equity Valuation Process

22
The true value of any financial asset is thought to be a good indicator of how that asset will do in the
long run. In equity markets, a financial asset with a relatively high intrinsic value is expected to
command a high price, and a financial asset with a relatively low intrinsic value is expected to
command a low price.
The factors can be broadly classified into four categories.

1. Macroeconomic variables
2. Management of the business
3. Financial health of the business
4. Profits of the business
Discounted cash-flow Techniques
Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment
opportunity. DCF analyses use future free cash flow projections and discounts them, using a required
annual rate, to arrive at present value estimates.
Types of DCF Techniques:
There are mainly two types of DCF techniques viz… Net Present Value [NPV] and Internal Rate of
Return [IRR].
(A) Net Present Value Techniques [NPV]:

(B) Internal Rate of Return [IRR]:

The Internal Rate of Return may be defined as that rate of interest when used to discount the cash
flows of an investment, reduce its NPV to zero. Or it is the rate of discount, which equates the
aggregate discounted benefits with aggregate discounted costs.
IRR is also called as ‘Discounted Cash Flow Method’ or ‘Yield Method’ or ‘Time Adjusted Rate of Return

Method’.

BALANCE SHEET

The balance sheet is one of the three fundamental financial statements and is key to both financial
modeling and accounting. The balance sheet is based on the fundamental equation:

23
 Assets = Liabilities + Equity.
1. Current Assets
Cash and Equivalents
Accounts Receivable
Inventory
2. Non-Current Assets
Plant, Property and Equipment (PP&E)
Intangible Assets
3. Current Liabilities
Accounts Payable
Current Debt/Notes Payable
Current Portion of Long-Term Debt
4. Non-Current Liabilities
Bonds Payable
Long-Term Debt
5. Shareholders’ Equity
Share Capital
Retained Earnings
Dividend discount Model
The Dividend Discount Model (DDM) is a quantitative method of valuing a company’s stock price
based on the assumption that the current fair price of a stock equals the sum of all company’s future
dividends discounted back to their present value.
The dividend discount model was developed under the assumption that the intrinsic value of a stock
reflects the present value of all future cash flows generated by a security. At the same time, dividends
are essentially the positive cash flows generated by a company and distributed to the shareholders.
Generally, the dividend discount model provides an easy way to calculate a fair stock price from a
mathematical perspective with minimum input variables required.
Formula for the Dividend Discount Model
The dividend discount model can take several variations depending on the stated assumptions. The
variations include the following:
 Gordon Growth Model
The Gordon Growth Model (GGM) is one of the most commonly used variations of the dividend
discount model. The model is called after American economist Myron J. Gordon, who proposed the
variation.

Where:

 V0 – the current fair value of a stock

 D1 – the dividend payment in one period from now
 r – the estimated cost of equity capital (usually calculated using CAPM)

24
  g – the constant growth rate of the company’s dividends for an infinite time
1. One-period Dividend Discount Model
The one-period discount dividend model is used much less frequently than the Gordon Growth model.
The former is applied when an investor wants to determine the intrinsic price of a stock that he or she
will sell in one period from now. The one-period dividend discount model uses the following equation:

Where:

 V0 – the current fair value of a stock

 D1 – the dividend payment in one period from now
 P1 – the stock price in one period from now
 r – the estimated cost of equity capital

 Multi-period Dividend Discount Model

The multi-period dividend discount model is an extension of the one-period dividend discount model
wherein an investor expects to hold a stock for the multiple periods. The main challenge of the multi-
period model variation is that forecasting dividend payments for different periods is required. The
model’s mathematical formula is below:

Intrinsic value and Market Price

Intrinsic value
Intrinsic value is also known as the fundamental price of a share. You have number of ways to
calculate it. In general, its the amount calculated based on the money a company is expected to earn
over its lifetime. This means, it’s the estimated true value of a company regardless of the present
market price of a stock.
But, it’s not always right to avoid a stock which has lower intrinsic value than the current market price.
Market Value
Market value of a stock is the amount that investors have attached to a company at a particular point
of time. In simpler terms, it’s the price you pay now to buy stock of a publicly traded company.
When an investor sell a stock, it means there is another investor who has bought it because to him, the
selling price is attractive at that point of time.

Earning Multiplier Approach

The market value per share is the current trading price for one share in a company, a relatively
straightforward definition. However, earnings per share (EPS) may not be as intuitive for most

25
investors. The more traditional and widely used version of
Calculated as the following:
Earnings Multiplier = Market value per share / Earnings Per Share (EPS)

P/E Ratio
The Price Earnings Ratio (P/E Ratio) is the relationship between a company’s stock price and
earnings per share (EPS). It is a popular ratio that gives investors a better sense of the value of the
company. The P/E ratio shows the expectations of the market and is the price you must pay per
unit of current earnings (or future earnings, as the case may be).
Price Earnings Ratio Formula
P/E = Stock Price Per Share / Earnings Per Share
or
P/E = Market Capitalization / Total Net Earnings
or
Justified P/E = Dividend Payout Ratio / R – G
where;
R = Required Rate of Return G =
Sustainable Growth Rate
Price/Book Value
The price to book value ratio, or PBV ratio, compares the market and book value of the company.
Imagine a company is about to be liquidated. It sells of all its assets, and pays off all its debts.
Whatever is left over is the book value of the company. The PBV ratio is the market price per share
divided by the book value per share. For example, a stock with a PBV ratio of 2 means that we pay Rs 2
for every Rs. 1 of book value. The higher the PBV, the more expensive the stock.
PBV ratio = market price per share / book value per share
Price/Sales Ratio
Price to sales ratio compares the price of a share to the revenue per share. This ratio is usually used
for valuation of shares. It takes into account the past performance of a company for valuation of its
shares.
Price to sales ratio is calculated by dividing the price per share by the revenue per share.
Price/Sales Ratio = Price per Share / Revenue per Share
Economic Value Added
Economic value added (EVA) is a financial measurement of the return earned by a firm that is in excess
of the amount that the company needs to earn to appease shareholders. In other words, it is a
measure of an organization’s economic profit that takes into account the opportunity cost of invested
capital and ultimately measures whether organizational value was created or lost.
EVA compares the rate of return on invested capital with the opportunity cost of investing elsewhere.
This is important for businesses to keep track of, particularly those businesses that are capital intensive.
When calculating economic value added, a positive outcome means that the company is creating value
with its capital investments.
The EVA formula is calculated using the following equation:
EVA = NOPAT – ( capital x cost of capital ) EVA =
NOPAT – (WACC * capital invested) Where NOPAT

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 = Net Operating Profits After Tax WACC = Weighted
Average Cost of Capital
Capital invested = Equity + long-term debt at the beginning of the period and
(WACC* capital invested) is also known as finance charge
Nature of Bonds, Bond Valuation
A bond is an instrument of indebtedness of the bond issuer to the holders, as such it is often referred to
as a debt instrument. A bond is a debt security, under which the issuer owes the holders a debt and,
depending on the terms of the bond, is obliged to pay them interest (the coupon) and/or repay the
principal at a later date, termed the maturity. Interest is usually payable at fixed intervals (semiannual,
annual, sometimes monthly).
Valuation of Bonds
The method for valuation of bonds involves three steps as follows: Step 1: Estimate the expected cash
flows
Step 2: Determine the appropriate interest rate that should be used to discount the cash flows. & Step
3: Calculate the present value of the expected cash flows (step-1) using appropriate interest rate
(step- 2) i.e. discounting the expected cash flows
PRESENT VALUE FORMULA FOR BOND VALUATION
Present Value n = Expected cash flow in the period n/ (1+i) n
Here,
i = rate of return/discount rate on bond n = expected time to receive the
cash flow
By this formula, we will get the present value of each individual cash flow t years from now. The next
step is to add all individual cash flows.
Bond Value = Present Value 1 + Present Value 2 + ……. + Present Value n
Bond Theorem, Term Structure of Interest Rates
Bond Theorem
Bond valuation is a technique for determining the theoretical fair value of a particular bond. Bond
valuation includes calculating the present value of the bond’s future interest payments, also known as
its cash flow, and the bond’s value upon maturity, also known as its face value or par value. Because a
bond’s par value and interest payments are fixed, an investor uses bond valuation to determine what
rate of return is required for a bond investment to be worthwhile.
Understanding Bond Valuation
A bond is a debt instrument that provides a steady income stream to the investor in the form of
coupon payments. At the maturity date, the full face value of the bond is repaid to the bondholder.
The characteristics of a regular bond include:
Coupon rate:
Maturity date:
Current Price:
Term Structure of Interest Rates
The term structure of interest rates is the variation of the yield of bonds with similar risk profiles with
the terms of those bonds. The yield curve is the relationship of the yield to maturity (YTM) of bonds to
the time to maturity, or more accurately, to duration, which is sometimes referred to as the effective
maturity. The term structure of interest rates has 3 characteristics:

1. The change in yields of different term bonds tends to move in the same direction.

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 2. The yields on short-term bonds are more volatile than long-term bonds.
3. The yields on long-term bonds tend to be higher than short-term bonds.
The expectations hypothesis has been advanced to explain the 1st 2 characteristics and the premium
liquidity theory have been advanced to explain the last characteristic.
Market Segmentation Theory
Because bonds and other debt instruments have set maturities, buyers and sellers of debt usually have
preferred maturities. Bond buyers want maturities that will coincide with their liabilities or when they
want the money, while bond issuers want maturities that will coincide with expected income streams.
Market Segmentation Theory (MST) posits that the yield curve is determined by supply and demand
for debt instruments of different maturities. Generally, the debt market is divided into 3 major
categories in regard to maturities: short- term, intermediate-term, and long-term. The difference in the
supply and demand in each market segment causes the difference in bond prices, and therefore, yields.
There are many different factors that would cause differences in the supply and demand for bonds of a
certain maturity, but much of that difference will depend on current interest rates and expected future
interest rates

UNIT-5(FM01)
Portfolio Management and Performance Evaluation
A portfolio refers to a collection of investment tools such as stocks, shares, mutual funds, bonds, cash
and so on depending on the investor’s income, budget and convenient time frame.
Following are the two types of Portfolio:
 Market Portfolio
 Zero Investment Portfolio
The art of selecting the right investment policy for the individuals in terms of minimum risk and
maximum return is called as portfolio management.
Need for Portfolio Management
 best investment plan
 minimizes the risks
 provide customized investment solutions

Types of Portfolio Management

Portfolio Management is further of the following types:

 Active Portfolio Management:

 Passive Portfolio Management:
 Discretionary Portfolio management services:
 Non-Discretionary Portfolio management services:
The portfolio performance evaluation involves the determination of how a managed portfolio has
performed relative to some comparison benchmark.
 Performance evaluation methods generally fall into two categories, namely conventional and
risk-adjusted methods. The most widely used conventional methods include benchmark
comparison and style comparison.
 The major methods are the Sharpe ratio, Treynor ratio, Jensen’s alpha, Modigliani and
Modigliani, and Treynor Squared. The risk-adjusted methods are preferred to the
conventional methods.
 The portfolio performance evaluation primarily refers to the determination of how a particular

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 investment portfolio has performed relative to some comparison benchmark.

The evaluation of portfolio performance is important for several reasons. First, the investor, whose
funds have been invested in the portfolio, needs to know the relative performance of the portfolio.
Second, the management of the portfolio needs this information to evaluate the performance of the
manager of the portfolio and to determine the manager’s compensation, if that is tied to the portfolio
performance.

Performance Evaluation of existing Portfolio

Benchmark Comparison
The most straightforward conventional method involves comparison of the performance of an
investment portfolio against a broader market index.
Style Comparison
A second conventional method of performance evaluation called ”style- comparison” involves
comparison of return of a portfolio with that having a similar investment style.

Sharpe, Treynor and Jensen Measures

Portfolio Performance Evaluation Methods
The objective of modern portfolio theory is maximization of return or minimization of risk. In this
context the research studies have tried to evolve a composite index to measure risk based return. The
credit for evaluating the systematic, unsystematic and residual risk goes to Sharpe, Treynor and Jensen.
The portfolio performance evaluation can be made based on the following methods:

1. Sharpe’s Measure
2. Treynor’s Measure
3. Jensen’s Measure
1. Sharpe’s Measure
Sharpe’s Index measure total risk by calculating standard deviation. The method adopted by Sharpe is
to rank all portfolios on the basis of evaluation measure. Reward is in the numerator as risk premium.
Total risk is in the denominator as standard deviation of its return.
SI =(Rt – Rf)/σf
Where,

 SI = Sharpe’s Index
 Rt = Average return on portfolio
 Rf = Risk free return
 σf = Standard deviation of the portfolio return.
2. Treynor’s Measure
The Treynor’s measure related a portfolio’s excess return to non-diversifiable or systematic risk. The
Treynor’s measure employs beta. The Treynor based his formula on the concept of characteristic line.
Tn =(Rn – Rf)/βm

Where,
 Tn = Treynor’s measure of performance
 Rn = Return on the portfolio
 Rf = Risk free rate of return
 βm= Beta of the portfolio ( A measure of systematic risk)
3. Jensen’s Measure

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Jensen attempts to construct a measure of absolute performance on a risk adjusted basis. This
measure is based on Capital Asset Pricing Model (CAPM) model. It measures the portfolio manager’s
predictive ability to achieve higher return than expected for the accepted riskiness.:
Rp = Rf + (RMI – Rf) x β

Where,
 Rp = Return on portfolio
 RMI= Return on market index
 Rf= Risk free rate of return

Finding alternatives and revision of Portfolio

Portfolio revision involves changing the existing mix of securities. This may be effected either by
changing the securities currently included in the portfolio or by altering the proportion of funds
invested in the securities.
Portfolio Revision Strategies
There are two types of Portfolio Revision Strategies.
 Active Revision Strategy
Active Revision Strategy involves frequent changes in an existing portfolio over a certain period of time
for maximum returns and minimum risks.
 Passive Revision Strategy
Passive Revision Strategy involves rare changes in portfolio only under certain predetermined rules.
These predefined rules are known as formula plans.
According to passive revision strategy a portfolio manager can bring changes in the portfolio as per the
formula plans only.
Constraints in Portfolio Revision:
Portfolio revision is the process of adjusting the existing portfolio in accordance with the changes in
financial markets and the investor‘s position so as to ensure maximum return from the portfolio with
the minimum of risk. Some of these are as under:

1. Transaction cost:
2. Taxes:
3. Statutory stipulations:
4. Intrinsic difficulty:
Portfolio Revision Strategies
 Active revision strategy involves frequent and sometimes substantial adjustments to the
portfolio. Investors who undertake active revision strategy believe that security markets are
not continuously efficient.
 Passive revision strategy, in contrast, involves only minor and infrequent adjustment to the
portfolio over time. The practitioners of passive revision strategy believe in market efficiency
and homogeneity of expectation among investors.

Formula Plans in Passive Revision Strategy

There are different formula plans for implementing passive portfolio revision; some of them are as
under:

1. Constant Rupee Value Plan:

This is one of the most popular or commonly used formula plans. In this plan, the investor

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constructs two portfolios, one aggressive, consisting of equity shares and the other, defensive,
consisting of bonds and debentures.
2. Constant Ratio plan
This is a variation of the constant rupee value plan. Here again the investor would construct two
portfolios, one aggressive and the other defensive with his investment funds. The ratio between the
investments in aggressive portfolio and the defensive portfolio would be predetermined such as 1:1 or
1.5:1 etc.

3. Dollar cost averaging

This is another method of passive portfolio revision. All formula plans assume that stock prices
fluctuate up and down in cycles. Dollar cost averaging utilizes this cyclic movement in share prices to
construct a portfolio at low cost.

Portfolio Management and Mutual Fund Industry

Portfolio management services (PMS) and mutual funds (MF) are avenues to invest in stocks or bonds.
Even though both of them are indirect ways of investing in the markets, there is a lot of difference
between the two.
Mutual Funds (MF)
Meaning of Mutual Funds
A mutual fund is a type of investment vehicle that pools money from multiple investors to purchase
a diversified portfolio of securities, such as stocks, bonds, or other assets.
Key Features:
 Professional Management: Managed by experienced investment professionals.
 Diversification: Exposure to a wide range of assets, reducing individual asset risk.
 Liquidity: Investors can buy or sell mutual fund shares at the fund's Net Asset Value (NAV),
typically calculated at the end of each trading day.
 Accessibility: Mutual funds are available to all types of investors, from beginners to experienced
individuals, and can be purchased through various financial institutions.

Types of Mutual Funds

Mutual funds can be categorized based on various factors such as the asset class they invest in,
their investment objectives, and how they are managed.
1. Based on Asset Class:
 Equity Funds (Stock Funds):
 Bond Funds (Fixed-Income Funds):
 Money Market Funds:
 Balanced/Hybrid Funds:
 Sector Funds:
 Index Funds:
 International/Global Funds:
2. Based on Structure:
 Open-End Mutual Funds:
 Closed-End Mutual Funds:
 Exchange-Traded Funds (ETFs):
3. Based on Investment Objective:
 Growth Funds:

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 Income Funds:
 Balanced Funds:
 Target-Date Funds:

 Advantages of Mutual Funds

 Diversification:
1. Professional Management:
2. Liquidity:
3. Affordability:
4. Convenience:
5. Transparency:
Disadvantages of Mutual Funds
1. Fees and Expenses:
2. Lack of Control:
3. Dilution:
4. Tax Inefficiency:
5. Market Risk:

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