Teacher’s Material

BASICS OF STOCK SELECTION

When selecting stocks, key economic indicators provide essential insights into the broader
economy and help investors make informed decisions. Here's a detailed breakdown of each
indicator you've listed and how it affects stock investing:

i. Indices (e.g., Nifty, Sensex)

These are benchmark indices that reflect the performance of a group of major companies
listed on a stock exchange.

 Nifty 50: Tracks the top 50 companies on the NSE (National Stock Exchange) in India.
  Sensex: Tracks 30 prominent companies on the BSE (Bombay Stock Exchange).

Why it matters:

 Acts as a barometer of overall market sentiment.

 Helps investors gauge if the market is bullish or bearish.

 Can serve as a comparative benchmark for your stock’s performance.

ii. Gross Domestic Product (GDP)

GDP measures the total value of all goods and services produced within a country over a
specific period.

Why it matters:

 A growing GDP indicates a healthy economy and can boost corporate earnings.

 High GDP growth often correlates with rising stock markets.

 Sectoral insights: e.g., rising GDP from manufacturing may benefit industrial stocks.

iii. Unemployment Rate

This is the percentage of the labor force that is jobless and actively seeking employment.

Why it matters:

 High unemployment can reduce consumer spending and hurt business revenues.

 Lower unemployment often leads to increased spending, higher demand, and

potentially higher stock prices.

 Influences central bank decisions on interest rates, which in turn affect stock
markets.

iv. Inflation Rate

Measured by indices like the Consumer Price Index (CPI) and Wholesale Price Index (WPI),
it reflects the rate at which prices are rising.

Why it matters:

 Moderate inflation suggests healthy demand and economic growth.

 High inflation can erode purchasing power and increase costs for companies, hurting
profits.
  Central banks may raise interest rates to control inflation, which can lead to lower
stock valuations.

v. Consumer Confidence Index (CCI)

This gauges consumer sentiment toward the economy, based on their spending and
financial outlook.

Why it matters:

 High consumer confidence signals increased spending and potential sales growth for
businesses.

 Low confidence may lead to reduced spending, especially in discretionary sectors

(e.g., retail, automotive).

vi. Purchasing Managers' Index (PMI)

A monthly survey of business activity in the manufacturing and services sectors.

 A PMI > 50 indicates expansion.

 A PMI < 50 indicates contraction.

Why it matters:

 Provides forward-looking insight into business conditions.

 A rising PMI suggests stronger business investment and growth.

 A falling PMI can be an early warning signal of economic slowdown.

Bonus Tip: How to Use These Indicators in Stock Selection

1. Macro Alignment: If GDP and PMI are rising, consider cyclicals like banks, real estate,
and industrials.

2. Sector Sensitivity: Inflation-sensitive sectors (e.g., FMCG, energy) may be affected by

rising costs.

3. Defensive Strategy: In times of high unemployment or low consumer confidence,

lean toward defensive stocks (e.g., healthcare, utilities).

4. Interest Rate Outlook: Many of these indicators influence interest rates, which
heavily affect banking, real estate, and bond-yield-sensitive sectors.
 BONDS – COMMON STOCK – WARRANTS – PUTS AND CALLS – FUTURES

BETA

Academic Account on Beta (β) in Finance

Definition of Beta (β):

In finance, Beta (β) is a measure of a security's systematic risk relative to the overall market.
It represents the sensitivity of a stock’s returns to movements in the market portfolio’s
returns, typically proxied by a broad market index like the S&P 500 (US) or Nifty/Sensex
(India).

In the Capital Asset Pricing Model (CAPM), beta is a central component used to estimate the
expected return of an asset.

Empirical Estimation (Linear Regression Form):

 

How Beta Is Used:

1. Capital Asset Pricing Model (CAPM):

o Helps estimate expected return based on market risk.

o Inputs into cost of equity in valuation models.

2. Portfolio Management:

o Helps in constructing portfolios with desired risk levels.

o Weighted average beta of a portfolio determines its sensitivity to market.

3. Risk Assessment:

o Used in Value at Risk (VaR) and stress testing.

o Helps classify stocks into defensive or aggressive based on their beta.

Limitations of Beta:

 Historical Nature: Beta is backward-looking; future risk may differ.

 Non-linearity: Assumes linear relationship between asset and market returns.

 Beta Instability: Can change over time based on firm fundamentals or market
conditions.

 Ignores Unspecific (Idiosyncratic) Risk: Only captures systematic (market-wide) risk.

Absolutely — let’s build deeper context around that statement and how it ties into financial
theory, investment behavior, and real-world implications.

🔍 Expanding the Context of the Statement:

“If beta is a measure of risk, then investors who hold stocks with higher betas should expect
a higher return for taking on that risk.”

1. Rooted in CAPM (Capital Asset Pricing Model)

This idea is central to CAPM, a Nobel Prize–winning framework developed by William

Sharpe, John Lintner, and Jan Mossin (building on Markowitz’s portfolio theory). CAPM
formalized the tradeoff between risk and return using beta as a single, quantifiable risk
metric.

It argues that:

 Investors are rational and risk-averse.

 Markets are efficient, and all relevant information is priced in.

 There is a linear relationship between expected return and beta.

This is visually shown by the Security Market Line (SML):

Y-axis: Expected return,X-axis: Beta\text{Y-axis: Expected return}, \quad \text{X-axis: Beta}

2. Systematic vs. Unsystematic Risk

 Systematic risk = Market-wide risk (e.g., inflation, recession, interest rate changes).

 Unsystematic risk = Firm-specific (e.g., a CEO scandal, product failure).

Beta measures only systematic risk — the kind of risk that cannot be diversified away.
CAPM assumes that since investors can eliminate unsystematic risk by diversification, they
shouldn't be rewarded for it.

So, higher beta = more exposure to market swings = more required return.

3. Theoretical Foundations: Utility Theory and Efficient Frontier

From utility theory:

 A rational investor chooses portfolios that maximize expected utility (not just
return).
  Higher beta increases the volatility of returns, reducing utility unless offset by higher
expected returns.

The Efficient Frontier (from Markowitz) shows that adding risk must push expected return
higher, or else investors won’t accept the tradeoff.

4. In Practice: Do High Beta Stocks Always Outperform?

Not necessarily. Research and real-world data show several nuances:

 Fama-French Three-Factor Model (1992) demonstrated that beta does not fully
explain returns. Size and value factors also play a role.

 Low-Beta Anomaly: Empirical evidence shows that low-beta stocks sometimes

outperform high-beta stocks on a risk-adjusted basis.

 Behavioral Finance suggests investors often overpay for high-beta stocks, hoping for
lottery-like payoffs — creating inefficiencies.

5. Relevance in Portfolio Construction

A portfolio manager might:

 Choose high-beta stocks during a bull market to capture more upside.

 Rotate to low-beta or defensive stocks during volatility or downturns.

 Use beta to align a portfolio’s overall sensitivity to market conditions.

Summary Table:

Concept Relation to Statement

Provides the formal model where higher beta leads to higher

CAPM
expected return.

Systematic Risk Beta isolates the risk investors can’t diversify away.

Security Market Line

Graphically shows the return-beta relationship.
(SML)

Explains why higher risk requires higher return to maintain investor

Utility Theory
satisfaction.

Empirical Challenges Real-world data shows inconsistencies, prompting new models

Concept Relation to Statement

beyond CAPM.

💼 WACC – Weighted Average Cost of Capital

Definition:

The Weighted Average Cost of Capital (WACC) is a firm’s average cost of raising capital from
all sources — equity, debt, and sometimes preferred stock — weighted by their proportion
in the firm's capital structure. It represents the minimum return a company must earn on
its asset base to satisfy its capital providers (investors and lenders).

Why WACC Matters:

1. Investment Decision-Making:
 o WACC is used as a discount rate in Net Present Value (NPV) and Discounted
Cash Flow (DCF) models.

o If the expected return on a project > WACC, the project creates value.

2. Valuation:

o WACC is crucial in valuing firms or projects via DCF valuation.

o Lower WACC increases firm valuation (higher present value of future cash
flows).

3. Capital Structure Optimization:

o Firms try to minimize WACC to maximize firm value.

o Debt is cheaper than equity (due to tax shield), but too much debt increases
risk and ReR_e.
Limitations of WACC:

 Assumes constant capital structure, which may not hold over time.

 Market values of debt/equity can be difficult to determine precisely.

 Sensitive to input assumptions (especially ReR_e via CAPM).

 Doesn’t account for project-specific risk — sometimes a project-specific discount

rate is better.

✅ Summary:

Term Role

WACC Minimum required return from operations

Used for Valuation, project analysis, capital budgeting

Key inputs Cost of debt, cost of equity, capital structure, tax

Goal Lower WACC → Higher firm value

UNDERSTANDING DIFFERENT ASSET CLASSES
The image titled "Factors Affecting Asset Allocation" presents four key elements that
influence how investors distribute their capital among various asset classes. Let’s break
down and discuss each factor, along with the concluding insight about hybrid assets.

🔹 1. Time Horizon

Definition: The length of time an investor expects to hold an investment before needing the
funds.

 Short-term investors (e.g., 1–3 years) typically prefer low-risk, liquid investments like
bonds or savings accounts.

 Long-term investors (e.g., 10+ years) can afford to take more risk for higher returns,
favoring equities and real estate.

Implication: Time horizon directly affects risk capacity. Longer timeframes allow for
recovery from market downturns, enabling more aggressive allocation.

🔹 2. Risk Tolerance

Definition: An investor’s emotional and financial ability to handle losses.

 High risk tolerance: More exposure to volatile assets (e.g., small-cap stocks,
emerging markets).
  Low risk tolerance: Safer investments like fixed income or blue-chip stocks.

Implication: This is subjective and can differ even for investors with similar financial profiles.
It shapes portfolio volatility and return expectations.

🔹 3. Risk vs. Reward

Definition: The trade-off between the potential return of an investment and the risk of loss.

 Higher returns typically require accepting higher volatility or risk.

 Investors must weigh the expected return against potential downside.

Implication: This is an optimization problem in modern portfolio theory — to find the mix of
assets that offers the highest expected return for a given level of risk (efficient frontier).

🔹 4. Tax Saving

Definition: The impact of taxation on investment returns.

 Certain investments offer tax benefits (e.g., municipal bonds in the US, ELSS in India).

 Asset allocation may be tilted to exploit tax-deferral or tax-exempt opportunities.

Implication: Tax efficiency can significantly affect net returns, especially for high-income
individuals. Hence, tax-planning must be integrated into allocation decisions.

🌀 Hybrid Assets – Key Takeaway from the Image

“In real life, there are many assets which can not be fit into a single Asset Class, meaning
they are Hybrid Assets.”

Hybrid assets combine characteristics of multiple asset classes. Examples:

 Convertible bonds: Fixed-income + equity upside

 Balanced funds: Mix of debt and equity

 REITs: Real estate + stock market exposure

Implication: Asset allocation is not always a clean-cut division (e.g., 60% equity, 40% debt).
Investors and advisors must understand the underlying risk/return dynamics rather than
rely solely on labels.

✅ Summary Table
Factor Influences

Time Horizon Asset duration & liquidity

Risk Tolerance Volatility exposure

Risk vs. Reward Allocation efficiency & diversification

Tax Saving After-tax returns & investment selection

VALUATION OF SHARES
MARKET INDICES
The image titled "Challenges Facing Fixed Income Index Construction" illustrates the
complexities involved in creating a reliable fixed income index, using a funnel diagram.
Let’s break down the key issues shown and why they matter in practice:

🔄 Context: What Is a Fixed Income Index?

A fixed income index tracks the performance of a group of debt securities (such as
government or corporate bonds) and serves as a benchmark for passive investment
products (like bond index funds or ETFs).

Unlike equity indices (e.g., S&P 500), which are based on well-known and liquid stocks, fixed
income indices face unique structural and data-related issues.

📌 Challenges Highlighted in the Diagram:

1. Number of Securities

 Explanation: The bond market is fragmented and much larger than the stock market.

 Thousands of issuances exist, with varying terms (maturity, coupon, issuer,

covenants).

 Many bonds are not standardized and are often tailored for specific buyers.

Implication: Constructing a representative index becomes extremely complex due to the

sheer volume and variety of bonds.

2. Illiquid Securities

 Many bonds don’t trade frequently, especially:

o Corporate bonds

o Municipal bonds

o Emerging market debt

 Price discovery becomes difficult when trades are infrequent.

Implication: Indexes may include securities that are hard to price and even harder to
replicate, limiting investability for passive products.

3. Lack of Pricing Data

 Infrequent trades = limited real-time data.

 Often, pricing relies on estimates or dealer quotes, not actual trades.

 Some instruments may only be priced monthly or quarterly.

Implication: This undermines index accuracy and makes it harder to value index funds or
ETFs tied to these benchmarks.
📥 Funnel Shape – Why It Matters

The funnel visualization implies:

 A wide set of challenges enter the index construction process (top of the funnel).

 But the output — the fixed income index — is a narrowed, filtered representation
of the market.

 This filtering may introduce bias, reduce transparency, and impair trackability.

⚠️Broader Implications for Investors

 Tracking error: Bond index funds might not exactly follow the index due to liquidity
constraints.

 Construction bias: Index rules may favor large issuers or more liquid debt, leading to
credit or interest rate concentration.

 Passive not so passive: Unlike equity indices, fixed income indices often require
active decisions in their construction.

✅ Summary Table

Challenge Why It Matters

Number of securities Too many to include all; complexity increases

Illiquid securities Hard to price and buy/sell; lowers transparency

Lack of pricing data Impairs accuracy of index valuation

Hedge Fund Indices

1. Hedge funds are private investment vehicles that typically use leverage and long and
short investment strategies.

2. Research organizations maintain databases of hedge fund returns and summarize

these returns into indices.

3. Most indices reflect performance on a broad global level or on a strategy level.

4. Most indices are equal weighted.

VALUATION OF SECURITIES