Investment

Management
MBA 2 Semester 4

Tinkesh Gyamalani / MBA Dept. / KPMIM

 Investment Management / Tinkesh Gyamalani / MBA Dept. / KPMIM

Module no 1- Introduction to Investment

and it’s Avenues

Investment
Investment is the employment of funds on assets with the aim of earning income
or capital appreciation Investment has two attributes namely time and risk.
Present consumption is sacrificed to get a return in the future. The sacrifice that
has to be borne is certain but the return in the future may be uncertain. This
attribute of investment indicates the risk factor. The risk is undertaken with a view
to reap some return from the investment.
For a layman, investment means some monetary commitment. A person’s
commitment to buy a flat or a house for his personal use may be an investment
from his point of view. This cannot be considered as an actual investment as it
involves sacrifice but does not yield any financial return.

Characteristics / Nature of Investment

Tax Benefits Safety

Stability of Income Concealability

Return
Investment Capital Growth

Marketability Risk

Liquidity Purchasing Power

Stability

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Risk
Risk refers to the loss of principal amount of an investment. It is one of the major
characteristics of an investment.

Return
Return refers to expected rate of return from an investment
Return is an important characteristics of investment. Return is the major factor
which influences the pattern of investment that is made by the investor. Investor
always prefers to high rate of return for his investment.
Safety
Safety refers to the protection of investor principal amount and expected rate of
return.
Safety is also one of the essential and crucial elements of investment. Investor
prefers safety about his capital. Capital is the certainty of return without loss of
money or it will take time to retain it. If investor prefers less risk securities, he
chooses Government bonds. In the case, investor prefers high rate of return
investor will choose private Securities and Safety of these securities is low.
Liquidity
Liquidity refers to an investment ready to convert into cash position. In other
words, it is available immediately in cash form. Liquidity means that investment is
easily realisable, saleable or marketable. When the liquidity is high, then the
return may be low. For example, UTI units.
An investor generally prefers liquidity for his investments, safety of funds through
a minimum risk and maximisation of return from an investment.
Marketability
Marketability refers to buying and selling of Securities in market. Marketability
means transferability or saleability of an asset. Securities are listed in a stock
market which are more easily marketable than which are not listed. Public Limited
Companies shares are more easily transferable than those of private limited
companies.

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Concealability
Concealability is another essential characteristic of the investment. Concealability
means investment to be safe from social disorders, government confiscations or
unacceptable levels of taxation, property must be concealable and leave no
record of income received from its use or sale. Gold and precious stones have long
been esteemed for these purposes, because they combine high value with small
bulk and are readily transferable
Capital Growth
Capital Growth refers to appreciation of investment. Capital growth has today
become an important character of investment. It is recognising in connection
between corporation and industry growth and very large capital growth. Investors
and their advisers are constantly seeking ‘growth stock’ in the right industry and
bought at the right time.
Purchasing Power Stability
It refers to the buying capacity of investment in market. Purchasing power
stability has become one of the import traits of investment. Investment always
involves the commitment of current funds with the objective of receiving greater
amounts of future funds.
Stability of Income
It refers to constant return from an investment. Another major characteristic
feature of the Investment is the stability of income. Stability of income must look
for different path just as security of principal. Every investor always considers
stability of monetary income and stability of purchasing power of income.
Tax Benefits
Tax benefits is the last characteristic feature of the investment. Tax benefits refer
to plan an investment Programme without regard to one’s status may be costly to
the investor.

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Objectives of Investment
An investor has various alternative avenues of investment for his savings to flow
to. Savings kept as cash are barren and do not earn anything. Hence, savings are
invested in assets depending on their risk and return characteristics. The
objectives of the investor are minimizing the risk involved in investment and
maximize the return from the investment.
Thus, the objectives of an investor can be stated as:

1. Maximization of return.
2. Minimization of risk
3. Hedge against inflation.

Investors, in general, desire to earn as large returns as possible with the minimum
of risk. Risk here may be understood as the probability that actual returns realized
from an investment may be different from the expected return. If we consider the
financial assets available for investment, we can classify them into different risk
categories.
Government securities would constitute the low risk category as they are
practically risk free. Debentures and preference shares of companies may be
classified as medium risk assets. Equity shares of companies would form the high
risk category of financial assets. An investor would be prepared to assume higher
risk only if he expects to get proportionately higher returns. There is a trade-off
between risk and return. The expected return of an investment is directly
proportional to its risk. Thus, in the financial market, there are different financial
assets with varying risk-return combinations.

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 Investment Management / Tinkesh Gyamalani / MBA Dept. / KPMIM

Investment Vs Speculation
Investment and speculation are two terms which are closely related. Both involve
purchase of assets like shares and securities. Traditionally, investment is
distinguished from speculation with respect to three factors, viz.

(1) Risk,
(2) Capital gain and
(3) Time period.

Risk
It refers to the possibility of incurring a loss in a financial transaction. It arises
from the possibility of variation in returns from an investment. Risk is invariably
related to return. Higher return is associated with higher risk.
No investment is completely risk free. An investor generally commits his funds to
low risk investment, whereas a speculator commits his funds to higher risk
investments. A speculator is prepared to take higher risks in order to achieve
higher returns.

Capital Gain
The speculator’s motive is to achieve profits through price charges, i.e. he is
interested in capital gains rather than the income from the investment. If
purchase of securities is preceded by proper investigation and analysis to receive
a stable return and capital appreciation over a period of time, it is investment.
Thus, speculation is associated with buying low and selling high with the hope of
making large capital gains. A speculator consequently engages in frequent buying
and selling transactions.

Time Period
Investment is long-term in nature, whereas speculation is short-term. An investor
commits his funds for a longer period and waits for his return. But a speculator is

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interested in short-term trade gains through buying and selling of investment

instruments.
An investor is interested in a good rate of return earned on a rather consistent
basis for a relatively longer period of time. He evaluates the worth of a security
before investing in it. A speculator seeks opportunities promising very large
returns earned rather quickly. He is interested in market action and price
movements. Consequently, speculation is more risky than investment.

Showing Difference between Investment and Speculation

Basis of Difference Investor Speculator
Time Horizon Plans for a longer time horizon. Plans for very short period.
Holding period may be from one Holding period varies from
year to few years few days to months.
Risk Assumes moderate risk Willing to undertake high
risk.
Return Likes to have moderate rate of Like to have high returns
return associated with limited risk for assuming high risk
Decision Considers fundamental factors Considers inside
and evaluates the performance of information, hearsays and
company regularly market behaviour
Funds Uses his own funds and avoids Uses borrowed funds to
borrowed funds supplement his personal
resources

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 Investment Management / Tinkesh Gyamalani / MBA Dept. / KPMIM

Investment Vs Gambling

What is Gambling?
Gambling is fundamentally different from investment and speculation in following
respects.
1. Quick Outcome: Normally Outcome of gambling is know very quickly. The
outcome of rolling a dice or the turn of a dice is almost known quickly.
2. Results don’t depend on Economic activity: Normally results of gambling
are not dependent on any economic activity. For example when you create
position in futures or commodities the prices of stocks or commodities are
some where dependent upon economic activity but when you play card and
bet on that the outcome of that doesn’t depend upon any economic
activity.
3. Lack of significant Economic benefit: Generally gambling doesn’t provide
significant economic outcome. Whereas, investment and speculation can
provide significant economic outcome.
4. Gambling should be for fun: Normally rational people do gambling for fun
and not for making money. So it is clear that gambling should be more done
for fun and not for making money.

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Avenues of Investment

Investment avenues mean various types of investment opportunities available to

park the savings as per the requirement of the investors. Generally investors park
their funds either in real assets like gold, silver, land, etc. or financial assets like
equity shares, debentures, government bonds etc. A brief discussion of different
type of investment avenues are

Financial Assets Physical Assets

• Cash •House, Land, Buildings,

Flats
• Consumer Durables
• Bank Deposits
Investor
• Gold, Silver and Metals
• PF, LIC Schemes

• Pension Schemes

PO certificates
and Deposits

Marketable Non Marketable

Bank Deposits, Post

Shares Bonds,
Securities etc. office Deposits etc.

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 Investment Management / Tinkesh Gyamalani / MBA Dept. / KPMIM

On the Basis of Physical Investments

Examples of Physical investments are:
 House
 Land
 Building
 Gold and Silver
 Precious stones

On the Basis of Financial Investment

Financial investments further classified on the basis of:
1. Marketable and Transferable investments
2. Non-Marketable Investments

Examples of Marketable investments are:

 Shares
 Debentures of Public Limited Companies, particularly the listed company in
Stock Exchange
 Bonds of Public Sector Units
 Government Securities, etc.

Examples of Non-marketable investments are:

 Bank Deposits
 Provident and Pension Funds
 Insurance Certificates
 Post office Deposits
 National Saving Certificates
 Company Deposits
 Private Companies Shares etc.

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 Investment Management / Tinkesh Gyamalani / MBA Dept. / KPMIM

NON-MARKETABLE FINANCIAL ASSETS

The financial instruments which are not transferable or saleable are known as
non-marketable financial assets. The investors can invest in these instruments but
they cannot transfer or sell the instruments.
A good portion of the financial assets of individual is held in the form of non-
marketable financial assets like bank deposits, post office deposits, company
deposits, and provident fund deposits. A distinguishing feature of these assets is
that they represent personal transactions between the investor and the issuer.
For example, when you open a savings bank account at a bank you deal with the
bank personally. In contrast when you buy equity shares in the stock market you
do not know who the seller is and you do not care.

The important non-marketable financial assets held by investors are briefly

described below.

Bank Deposits
Bank deposits are a savings product that customers can use to hold an amount of
money at a bank for a specified length of time. In return, the financial institution
will pay the customer the relevant amount of interest, based on how much they
choose to deposit and for how long

Fixed deposits with Companies

A company FD, also known as a company term deposit, is a kind of fixed
deposit provided by corporations such as finance companies, home finance firms,
or other types of NBFCs.
For many businesses, company FDs are an excellent means to raise capital from
the general public. A number of rating agencies, including ICRA, CARE, and CRISIL,
evaluate the credibility of these term deposits.

PPF - Public Provident Fund

PPF full form is Public Provident Fund. It is a popular investment scheme among
investors courtesy of its multiple investor-friendly features and associated
benefits.
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PPF meaning can be simply stated as a long-term investment scheme, popular

among individuals who want to earn high but stable returns. Proper safekeeping
of the principal amount is the prime target of individuals opening a PPF account.
When a PPF scheme is opened, the PPF account is scheduled for the applicant
where the money is deposited every month and interest is compounded.
Post Office Investment-Savings Schemes
The Post Office Saving Schemes include several reliable products and offer risk-
free investment returns. Around 1.54 lakh post offices spread all over the country
operate these schemes. For example, the government operates the PPF scheme
via 8200 public sector banks and post offices in each city. These investments are
government-backed and thus provide guaranteed returns.
Investments in post office schemes help to create a corpus for emergency
purposes and achieve goals. They also offer tax benefits up to Rs.1.5 lakh under
Section 80C of the Income Tax Act. The various schemes offered by the post office
are discussed below.
National Saving certificate
It is a fixed income-generating investment scheme, whereby account can be
opened at any post office both individually and jointly. This savings plan was
launched to encourage small and mid-income groups to mobilise their savings
through investments while encouraging tax saving.
Typically, the investment option does not have any maximum limit on investment
and comes with two distinct maturity period – 5 and 10 years. Also, the NSC can
be used as collateral to avail substantial loan from financial institutions. However,
NRIs, HUFs and trusts are not allowed to invest in this savings scheme.

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MARKETABLE FINANCIAL ASSETS

Shares
Shares are units of stocks issued by a corporation that represent ownership. They
are sold to investors and traders to raise capital for the company. Many
businesses issue stocks and shares when they need funds for research and
development, expansion, or other growth opportunities.

FCD
A fully convertible debenture (FCD) is a type of debt security in which the entire
value is convertible into equity shares at the issuer's notice. The ratio of
conversion is decided by the issuer when the debenture is issued. Upon
conversion, the investors enjoy the same status as ordinary shareholders of the
company.

NCD
Non-convertible debentures fall under the debt category. They cannot be
converted into equity or stocks. NCDs have a fixed maturity date and the interest
can be paid along with the principal amount either monthly, quarterly, or annually
depending on the fixed tenure specified. They benefit investors with their
supreme returns, liquidity, low risk and tax benefits when compared to that of
convertible debentures.

Bond
A bond is a fixed-income instrument that represents a loan made by an investor to
a borrower (typically corporate or governmental). A bond could be thought of as
an I.O.U. between the lender and borrower that includes the details of the loan
and its payments. Bonds are used by companies, municipalities, states, and
sovereign governments to finance projects and operations. Owners of bonds are
debtholders, or creditors, of the issuer.

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Bond details include the end date when the principal of the loan is due to be paid
to the bond owner and usually include the terms for variable or fixed
interest payments made by the borrower.

Gilt-edged Securities
Gilts are bonds issued by certain national governments. The term is of British
origin, and originally referred to the debt securities issued by the Bank of England,
which had a gilt (or gilded) edge. Hence, they are called gilt-edged securities, or
gilts for short. The term is also sometimes used in Ireland and some British
Commonwealth countries, South Africa and India. When a reference is made to
gilts, what is generally meant is British gilts unless otherwise specified. The
description below applies to the UK gilt market. The data reveal that about two-
thirds of all gilts are held by insurance companies and pension funds. During 2009,
large quantities of gilts were created and purchased by the Bank of England under
its policy of quantitative easing.
The term “Gilt Account” is also a term used by the Reserve Bank of India to refer
to a constituent account maintained by a custodian bank for maintenance and
servicing of dematerialized Government Securities owned by a retail customer.

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Other Avenues of Investment

Mutual Fund units

Mutual Fund units represent an investor's ownership in a Mutual Fund scheme.
When you invest in a Mutual Fund, you are essentially buying units of the fund.
These units represent your share of the overall holdings of the Mutual Fund
scheme. The number of units you own is determined by the amount of money you
invest and the fund's Net Asset Value (NAV) at the time of your investment. For
example, if you invested Rs. 1,500 in a Mutual Fund and the NAV of the fund is Rs.
10 per unit, you will be allotted 150 units of the Mutual Fund.

Life Insurance investment plans

Investing in life insurance offers a dual purpose. It offers financial protection but
also helps you achieve long-term financial goals. Life insurance policies often
come with insurance and investment components that allow you to accumulate
funds over time.

Real Estate
Real estate investing involves the purchase, management and sale or rental of real
estate for profit. Someone who actively or passively invests in real estate is called
a real estate entrepreneur or a real estate investor. Some investors
actively develop, improve or renovate properties to make more money from
them.

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Module no 2- Risk and Return Analysis

CONCEPT OF RETURN AND RISK

There are different motives for investment. The most prominent among all is to
earn a return on investment. However, selecting investments on the basis of
return in not enough. The fact is that most investors invest their funds in more
than one security suggest that there are other factors, besides return, and they
must be considered. The investors not only like return but also dislike risk. So,
what is required is:
Clear understanding of what risk and return are
 What creates them, and
 How can they be measured?

Return:
The return is the basic motivating force and the principal reward in the
investment process. The return may be defined in terms of
 Realized return, i.e., the return which has been earned, and
 Expected return, i.e., the return which the investor anticipates to earn over
some future investment period.
The expected return is a predicted or estimated return and may or may not occur.
The realized returns in the past allow an investor to estimate cash inflows in terms
of dividends, interest, bonus, capital gains, etc, available to the holder of the
investment. The return can be measured as the total gain or loss to the holder
over a given period of time and may be defined as a percentage return on the
initial amount invested. With reference to investment inequity shares, return is
consisting of the dividends and the capital gain or loss at the time of sale of these
shares.

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Risk:
Risk in investment analysis means that future returns from an investment are
unpredictable. The concept of risk may be defined as the possibility that the
actual return may not be same as expected. In other words, risk refers to the
chance that the actual outcome (return) from an investment will differ from an
expected outcome.
With reference to a firm, risk may be defined as the possibility that the actual
outcome of a financial decision may not be same as estimated. The risk may be
considered as a chance of variation in return. Investments having greater chances
of variations are considered more risky than those with lesser chances of
variations. Between equity shares and corporate bonds, the former is riskier than
latter. If the corporate bonds are held till maturity, then the annual interest
inflows and maturity repayment. Investment management is a game of money in
which we have to balance the risk and return.
The risks associated with investment are:-
 Inflation risk: Due to inflation, the purchasing power of money gets
reduced.
 Interest rate risk: Due to an economic situation prevailing in the country,
the interest rate may change.
 Default risk: The risk of not getting investment back. That is, the principal
amount invested and / or interest.
 Business risk: The risk of depression and other uncertainties of business.
 Socio-political risk: The risk of changes in government, government
policies, social attitudes, etc.

The returns on investment usually come in the following forms:-

 The safety of the principal amount invested.
 Regular and timely payment of interest or dividend.
 Liquidity of investment. This facilitates premature encashment, loan
facilities, marketability of investment, etc.
 Chances of capital appreciation, where the market price of the investment
is higher, due to issue of bonus shares, right issue at a lower premium, etc.
 Problem-free transactions like easy buying and selling of the investment,
encashment of interest or dividend warrants, etc.

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The simple rule of investment management is that:-

1. The higher the risk, the greater will be the returns.
2. Similarly, lesser the risk, the lower will be the returns.
This rule of investment management is depicted in the following diagram:-

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Types of Risk
In finance, different types of risk can be classified under two main groups

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The meaning of systematic and unsystematic risk in finance:

 Systematic risk is uncontrollable by an organization and macro in nature.
 Unsystematic risk is controllable by an organization and micro in nature.

Systematic Risk
Systematic risk is due to the influence of external factors on an organization. Such
factors are normally uncontrollable from an organization's point of view.
It is a macro in nature as it affects a large number of organizations operating
under a similar stream or same domain. It cannot be planned by the organization.
The types of systematic risk are depicted and listed below.

Interest rate risk

Interest-rate risk arises due to variability in the interest rates from time to time. It
particularly affects debt securities as they carry the fixed rate of interest.
The types of interest-rate risk are depicted and listed below.

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 Price risk arises due to the possibility that the price of the shares,
commodity, investment, etc. may decline or fall in the future.
 Reinvestment rate risk results from fact that the interest or dividend earned
from an investment can't be reinvested with the same rate of return as it
was acquiring earlier.

Market risk
Market risk is associated with consistent fluctuations seen in the trading price of
any particular shares or securities. That is, it arises due to rise or fall in the trading
price of listed shares or securities in the stock market.
The types of market risk are depicted and listed below.

 Absolute risk is without any content. For e.g., if a coin is tossed, there is fifty
percentage chance of getting a head and vice-versa.
 Relative risk is the assessment or evaluation of risk at different levels of
business functions. For e.g. a relative-risk from a foreign exchange
fluctuation may be higher if the maximum sales accounted by an
organization are of export sales.

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 Directional risks are those risks where the loss arises from an exposure to
the particular assets of a market. For e.g. an investor holding some shares
experience a loss when the market price of those shares falls down.
 Non-Directional risk arises where the method of trading is not consistently
followed by the trader. For e.g. the dealer will buy and sell the share
simultaneously to mitigate the risk
 Basis risk is due to the possibility of loss arising from imperfectly matched
risks. For e.g. the risks which are in offsetting positions in two related but
non-identical markets.
 Volatility risk is of a change in the price of securities as a result of changes in
the volatility of a risk-factor. For e.g. it applies to the portfolios of derivative
instruments, where the volatility of its underlying is a major influence of
prices.

Purchasing power or inflationary risk

Purchasing power risk is also known as inflation risk. It is so, since it emanates
(originates) from the fact that it affects a purchasing power adversely. It is not
desirable to invest in securities during an inflationary period.
The types of power or inflationary risk are depicted and listed below.

 Demand inflation risk arises due to increase in price, which result from an
excess of demand over supply. It occurs when supply fails to cope with the
demand and hence cannot expand anymore. In other words, demand
inflation occurs when production factors are under maximum utilization.
 Cost inflation risk arises due to sustained increase in the prices of goods and
services. It is actually caused by higher production cost. A high cost of
production inflates the final price of finished goods consumed by people.

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Unsystematic Risk
Unsystematic risk is due to the influence of internal factors prevailing within an
organization. Such factors are normally controllable from an organization's point
of view.
It is a micro in nature as it affects only a particular organization. It can be planned,
so that necessary actions can be taken by the organization to mitigate (reduce the
effect of) the risk. The types of unsystematic risk are depicted and listed below.

Business or liquidity risk

Business risk is also known as liquidity risk. It is so, since it emanates (originates)
from the sale and purchase of securities affected by business cycles, technological
changes, etc.
The types of business or liquidity risk are depicted and listed below.

 Asset liquidity risk is due to losses arising from an inability to sell or pledge
assets at, or near, their carrying value when needed. For e.g. assets sold at a
lesser value than their book value.

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 Funding liquidity risk exists for not having an access to the sufficient-funds
to make a payment on time. For e.g. when commitments made to
customers are not fulfilled as discussed in the SLA (service level
agreements).

Financial or credit risk

Financial risk is also known as credit risk. It arises due to change in the capital
structure of the organization. The capital structure mainly comprises of three
ways by which funds are sourced for the projects. These are as follows:
Owned funds. For e.g. share capital.
Borrowed funds. For e.g. loan funds.
Retained earnings. For e.g. reserve and surplus.

The types of financial or credit risk are depicted and listed below.

 Exchange rate risk is also called as exposure rate risk. It is a form of financial
risk that arises from a potential change seen in the exchange rate of one
country's currency in relation to another country's currency and vice-versa.
For e.g. investors or businesses face it either when they have assets or
operations across national borders, or if they have loans or borrowings in a
foreign currency.
 Recovery rate risk is an often neglected aspect of a credit-risk analysis. The
recovery rate is normally needed to be evaluated. For e.g. the expected
recovery rate of the funds tendered (given) as a loan to the customers by
banks, non-banking financial companies (NBFC), etc.
 Sovereign risk is associated with the government. Here, a government is
unable to meet its loan obligations, reneging (to break a promise) on loans
it guarantees, etc.
 Settlement risk exists when counterparty does not deliver a security or its
value in cash as per the agreement of trade or business.

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Operational risk
Operational risks are the business process risks failing due to human errors. This
risk will change from industry to industry. It occurs due to breakdowns in the
internal procedures, people, policies and systems.
The types of operational risk are depicted and listed below.

 Model risk is involved in using various models to value financial securities. It

is due to probability of loss resulting from the weaknesses in the financial-
model used in assessing and managing a risk.
 People risk arises when people do not follow the organization’s procedures,
practices and/or rules. That is, they deviate from their expected behavior.
 Legal risk arises when parties are not lawfully competent to enter an
agreement among themselves. Furthermore, this relates to the regulatory-
risk, where a transaction could conflict with a government policy or
particular legislation (law) might be amended in the future with
retrospective effect.
 Political risk occurs due to changes in government policies. Such changes
may have an unfavorable impact on an investor. It is especially prevalent in
the third-world countries.

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What is Alpha / Beta in Stock Market?

Every investment involves two important aspects – returns and risk. And every
investor wants to get the maximum returns with minimum risk. In this post is
described the significance of Alpha and beta parameters of the stock portfolio
that are used to describe the two main risks inherent in investing in stocks. Alpha
relates to factors affecting the performance of an individual stock or the fund
manager’s skill in selecting the stocks while beta relates to market risks.
Alpha:-
Alpha is the risk-adjusted return on an investment. It is excess return of a stock
portfolio or fund over a given benchmark and hence is usually used to measure
the performance of fund manager in managing the fund portfolio. So usually an
investor’s strategy should be to buy securities with positive alpha as these may be
undervalued.
If an investment outperformed the benchmark, that means more reward for a
given amount of risk. In that case α > 0.
If an investment underperformed the benchmark; that means the investment has
earned too little for its risk. In that case α < 0. For efficient markets, the expected
value of the alpha is zero. i.e α = 0 and the investment has earned a return
adequate for the risk taken. Fund managers are rated according to how much
alpha their fund generates. It is thus a measure of the fund manager’s ability to
generate profits in excess of market returns. Fund managers are usually paid in
accordance to how much alpha their fund generates. Higher the alpha, the higher
is their fees.
Beta:-
Beta is a measure of a volatility of a stock and expresses the relation of movement
of stock with the movement of market as a whole. The S & P 500 Index is assigned
a Beta of 1. So a stock can have positive or negative value of beta.
If Beta = 1; that means security’s price will move in sync with the market.
If Beta is positive; that means stock moves more than the market and is more
volatile. If Beta is negative; that means stock moves less than the market and is
less volatile.

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High-beta stocks are generally riskier being more volatile but provide a potential
for higher returns as these are in the early stages of growth. On other side low-
beta stocks pose less risk and hence lower returns. Usually utilities stocks have a
beta of less than 1 while high-tech stocks have a beta of greater than 1.
Having gone through the fundamentals of alpha and beta; it can be inferred that
low beta and high alpha stocks are good. But blindly following this concept is not
desirable because these parameters are calculated based on historical data and
history is never the indicator of future performance of a stock portfolio.

Correlation
Correlation can be defined as: “…what is known as the correlation coefficient,
which ranges between -1 and +1. Perfect positive correlation (a correlation co-
efficient of +1) implies that as one security moves, either up or down, the other
security will move in lockstep, in the same direction. Alternatively, perfect
negative correlation means that if one security moves in either direction the
security that is perfectly negatively correlated will move in the opposite direction.
If the correlation is 0, the movements of the securities are said to have no
correlation; they are completely random.”
Correlation simply describes how two things are similar or dissimilar to each
other. Specifically how two investments move in relation to each other, how
tightly they are linked or opposed. Correlation between historically dissimilar
investments (think stocks and bonds) is never static, it’s not uncommon for the
correlation of investments to change, especially during volatile or crashing
markets. In fact, seemingly the only thing that goes up in a down market is in fact
correlation. I use correlation measurements in advanced portfolio management to
better manage risk. To me, higher correlation theoretically means higher risk to
the bottom line. The higher the correlation of your investments the higher of the
“doubling-down” effect you get, in other words you have a greater opportunity
for gains or financial ruin. One particular ripe investment class for high correlation
are mutual funds because both bond funds AND stock funds trade on the stock
market, thus your bond funds become more correlated with stock funds during
volatile markets.

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Measuring Expected Return

Expected return is calculated using the following formula:
Expected Return (%) = Σ (Pi * Ri)
Where:
Pi: The probability of each possible outcome.
Ri: The return associated with each outcome.

Investors use this formula to assess the potential return of an investment based
on the likelihood of various outcomes.
Example
Suppose you are considering investing in a stock. There are two possible
outcomes:
A 60% chance of a 15% return.
A 40% chance of a 5% return.
To calculate the expected return:
Expected Return (%) = (0.60 * 15%) + (0.40 * 5%)
Expected Return (%) = (9%) + (2%)
Expected Return (%) = 11%
In this example, the expected return on your investment is 11%.

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MEASURING RISK
The risk associate with the stock refers to the variability of its rate of return. The
investors should be able to quantify and measure the risk. The risk probability
distribution of the possible returns on the investments represents an investment’s
total risk.

Range
The simplest measure of the dispersion of a distribution is the range of returns.
The range is equal to the highest value that the variable can be less to the lowest
possible value.
Example: Monthly holding returns is
Months Returns
January 0.026
February –0.050
March –0.109
April 0.053
May –0.058
June –0.076
July –0.057

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August 0.241
September –0.063
October 0.125
November 0.161
December –0.053
Range = 0.35
Thus, the higher the range of returns, the riskier the security.
The advantage of the range as a measure of risk lies in its simplicity.

Variance
Variance is the better measure of risk than the range. It takes into account the
derivation of all possible returns from their mean or expected value. The
statistical measure that accomplishes this purpose is the variance of returns. The
formula used for variance is as follows:

Where:
Ri – the return observed in one period (one observation in the data set)
Ravg – the arithmetic mean of the returns observed
n – the number of observations in the dataset
The above equation defines the variance as the weighted average of the squared
deviation of the returns from their mean.

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Standard deviation:
One of the most common measures of risk is the standard deviation, which
quantifies the dispersion or volatility of an investment’s returns. Higher standard
deviation values indicate greater risk.
Computation of the variance of returns makes use of the squared deviation of
returns from the mean and therefore the resulting variance is stated in squared
terms. The standard deviation of a set of numbers is the average variability
around the mean. The following formula can be used to calculate standard
deviation.

Where:
Ri – the return observed in one period (one observation in the data set)
Ravg – the arithmetic mean of the returns observed
n – the number of observations in the dataset

Example
An investor wants to calculate the standard deviation experience by his
investment portfolio in the last four months. Below are some historical return
figures:

The first step is to calculate Ravg, which is the arithmetic mean:

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The arithmetic mean of returns is 5.5%.

Next, we can input the numbers into the formula as follows:

The standard deviation of returns is 10.34%.

Thus, the investor now knows that the returns of his portfolio fluctuate by
approximately 10% month-over-month. The information can be used to modify
the portfolio to better the investor’s attitude towards risk.
If the investor is risk-loving and is comfortable with investing in higher-risk,
higher-return securities and can tolerate a higher standard deviation, he/she may
consider adding in some small-cap stocks or high-yield bonds. Conversely, an
investor that is more risk-averse may not be comfortable with this standard
deviation and would want to add in safer investments such as large-cap stocks or
mutual funds.

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What is Mean-Variance Analysis?

Mean-Variance Analysis is a technique that investors use to make decisions about
financial instruments to invest in, based on the amount of risk that they are willing
to accept (risk tolerance). Ideally, investors expect to earn higher returns when
they invest in riskier assets.
When measuring the level of risk, investors consider the potential variance (which
is the volatility of returns produced by an asset) against the expected returns of
that asset. Mean-variance analysis essentially looks at the average variance in the
expected return from an investment.

The mean-variance analysis is a component of Modern Portfolio Theory

(MPT). This theory is based on the assumption that investors make rational
decisions when they possess sufficient information. One of the theory’s
assumptions is that investors enter the market to maximize their returns while at
the same time avoiding unnecessary risk.
When choosing a financial asset to invest in, investors prefer the asset with lower
variance when given choosing between two otherwise identical investments. An
investor can achieve diversification by investing in securities with varied variances
and expected returns. Proper diversification creates a portfolio where a loss in
one security is counter-balanced by a gain in another.
Main Components of Mean-Variance Analysis
Mean-variance analysis is comprised of two main components, as follows:
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1. Variance
Variance measures how distant or spread the numbers in a data set are from
the mean, or average. A large variance indicates that the numbers are further
spread out. A small variance indicates a small spread of numbers from the mean.
The variance may also be zero, which indicates no deviation from the mean. When
analyzing an investment portfolio, variance can show how the returns of a security
are spread out during a given period.
2. Expected return
The second component of mean-variance analysis is expected return. This is the
estimated return that a security is expected to produce. Since it is based on
historical data, the expected rate of return is not 100% guaranteed.
If two securities offer the same expected rate of return, but one comes with a
lower variance, most investors prefer that security.
Similarly, if two securities show the same variance, but one of the securities offers
a higher expected return, investors opt for the security with the higher return.
When trading multiple securities, an investor can choose securities with different
variances and expected returns.
Mean-Variance Analysis – Example: Calculating Expected Return
Assume a portfolio comprised of the following two stocks:
Stock A: Rs 200,000 with an expected return of 5%.
Stock B: Rs 300,000 with an expected return of 7%.
The total value of the portfolio is Rs 500,000, and the weight of each stock is as
follows:
Stock A = Rs 200,000 / Rs 500,000
= 40%
Stock B = Rs 300,000 / Rs 500,000
= 60%
The expected rate of return is obtained as follows:
= (40% x 5%) + (60% x 7%)
= 2% + 4.2%
= 6.2%

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Risk Return Trade Off

Risk may be defined as the likelihood that the actual return from an investment
will be less than the forecast return. Stated differently, it is the variability of
return form an investment.
Financial decisions incur different degree of risk. Your decision to invest your
money in government bonds has less risk as interest rate is known and the risk of
default is very less. On the other hand, you would incur more risk if you decide to
invest your money in shares, as return is not certain. However, you can expect a
lower return from government bond and higher from shares. Risk and expected
return move in one behind another.
The greater the risk, the greater the expected return. Financial decisions of a firm
are guided by the risk-return trade off. These decisions are interrelated and jointly
affect the market value of its shares by influencing return and risk of the firm.
The relationship between return and risk can be simply expressed as:
Return = Risk free rate + Risk Premium

Risk free rate is a rate obtainable from a default risk free government security. An
investor assuming risk from his investment requires a risk premium above the risk
free rate. Risk free rate is a compensation for time and risk premium for risk.
Higher the risk of an action, higher will be the risk premium leading to higher
required return on that action. A proper balance between return and risk should
be maintained to maximize the market value of a firms share. Such balance is
called risk-return trade off and every financial decision involves this trade off.

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Module no 3 - Investment Management Framework

This framework encompasses several critical steps that guide investors and fund
managers in making informed decisions. Here’s a comprehensive overview:

Investment
Avenues

Performance Investment
Evaluation Objectives

Selection of Investment
Securities Strategy

Review of Investment Avenues

Before making investment decisions, it’s essential to understand the available
investment options. These avenues include:
 Equities (Stocks): Ownership in companies.
 Bonds (Fixed Income): Debt securities issued by governments or
corporations.
 Real Estate: Physical properties or real estate investment trusts (REITs).
 Commodities: Precious metals, agricultural products, energy, etc.
 Alternative Investments: Hedge funds, private equity, venture capital, etc.

A thorough review helps identify the most suitable asset classes based on risk-
return profiles.

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Specification of Investment Objectives

Specific investment objectives based on individual or institutional requirements.
Objectives should be SMART:
 Specific: Clearly defined.
 Measurable: Quantifiable criteria.
 Achievable: Realistic given constraints.
 Relevant: Aligned with overall financial goals.
 Time-bound: Set within a specific timeframe.

Investment Objectives usually are

 Capital Appreciation: Seeking growth in the investment portfolio.

 Income Generation: Focusing on regular income through dividends or
interest.
 Wealth Preservation: Safeguarding capital against inflation and market
risks.

Formulation of Investment Strategy

The investment strategy outlines how the portfolio will achieve the specified
objectives. Key considerations include:
 Asset Allocation: Determining the mix of different asset classes.
 Diversification: Spreading risk across various investments.
 Active vs. Passive Management: Choosing between actively managed funds
and index-based funds.
 Market Timing: Deciding when to buy or sell.
 Sector and Industry Selection: Focusing on specific sectors or industries.

Selection of Securities/Assets
This step involves choosing specific investments within each asset class. Factors to
consider:
 Fundamental Analysis: Assessing financial health, growth prospects, and
valuation.
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 Technical Analysis: Analyzing price trends and patterns.

 Risk-Return Tradeoff: Balancing potential returns with associated risks.
 Liquidity: How easily an investment can be bought or sold.
 Costs: Transaction fees, management fees, etc.

Performance Evaluation
Regularly assessing the portfolio’s performance against benchmarks and
objectives include:
 Return on Investment (ROI): Actual returns achieved.
 Benchmarking: Comparing portfolio performance against relevant
benchmarks.
 Risk-adjusted Performance: Considering volatility. (Sharpe ratio, Treynor
ratio, etc.).
 Sharpe Ratio: Risk-adjusted return.
 Tracking Error: Deviation from the benchmark.
 Portfolio Rebalancing: Adjusting allocations as needed.
 Regular Monitoring: Continuously assessing portfolio performance and
making necessary adjustments.

Remember, investment management is both an art and a science. It requires a

blend of analytical skills, market understanding, and adaptability to changing
conditions

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Module no 4-
Analytical Framework for Investment in Shares

Fundamental Analysis
The intrinsic value of an equity share depends on a multitude of factors. The
earnings of the company, the growth rate and the risk exposure of the company have a
direct bearing on the price of the share. These factors in turn rely on the host of other
factors like economic environment in which they function, the industry they belong
to, and finally companies’ own performance.
The fundamental school of thought appraised the intrinsic value of shares through

1. Economic Analysis
2. Industry Analysis
3. Company Analysis

Economy Analysis

The performance of a company depends on the performance of the economy. If

the economy is booming, incomes rise, demand for goods increases, and hence the
industries and companies in general tend to the prosperous. On the other hand, if
the economy is in recession, the performance of companies will be generally bad.

Investors are concerned with those variables in the economy which affect
the performance of the company in which they intend to invest. A study of these
economic variables would give an idea about future corporate earnings and the payment
of dividends and interest part of his fundamental analysis.
 Growth Rates of National Income
 Inflation
 Interest Rates
 Government Revenue, Expenditure and Deficits
 Exchange Rates
 Infrastructure
 Monsoon
 Economic and Political Stability

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Industry Analysis
An industry is a group of firms that have similar technological structure of
production and produce similar products. Companies are distinctly classified to
give a clear picture about their manufacturing process and products. The table
gives the industry wise classification given in Reserve Bank of India Bulletin.

For Example the major industries in the Indian Economy are Iron & Steel, Textiles,
Jute, Sugar, Cement, Paper, Petrochemical, Automobile, Information Technology
(IT), and Banking & Insurance.

These industries can be classified on the basis of the business cycle i.e., classified
according reactions to the different phases of the business cycle. They are
classified into growth, cyclical, defensive and cyclical growth industry.

1. Growth Industry
The growth industries have special features of high rate of earnings and growth in
expansion, independent of the business cycle. The expansion of the industry
mainly depends on the technological change. For instance, inspite of the recession
in the Indian economy in 1997-98, there was a spurt in the growth of information
technology. It defied the business cycle and continued to grow. Like wise in every
phase of the history certain industries like colour televisions, pharmaceutical and
telecommunication industries have shown remarkable growth.
2. Cyclical Industry
The growth and the profitability of the industry move along with the business
cycle. During the boom period they enjoy growth and during depression they
suffer a set back. For example, the white goods like fridge, washing machine and
kitchen range products command a good market in the boom period and the
demand for them slackens during the recession
3. Defensive Industry
Defensive industry defies the movement of the business cycle. For example, food
and shelter are the basic requirements of humanity. The food industry withstands
recession and depression. The stocks of the defensive industries can be held by
the investor for income earning purpose. They expand and earn income in the

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depression period too, under the government’s umbrella of protection and are
counter cyclical in nature.
4. Cyclical Growth Industry
This is new type of industry that is cyclical and at the same time growing. For
example, the automobile industry experiences periods of stagnation, decline but
they grow tremendously. The change in technology and introduction of new
models help the automobile industry to resume their growth path.

Industry Life Cycle

The life cycle of the industry is separated into four well defined stages such as
 Pioneering stage
 Rapid growth stage
 Maturity and stabilization stage
 Declining stage

➢ Pioneering Stage

The prospective demand for the product is promising in this stage and the
technology of the product is low. The demand for the product attracts many
producers to produce the particular product. There would be severe competition
and only fittest companies survive this stage. The producers try to develop brand
name, differentiate the product and create a product image. This would lead to
non-price competition too. The severe competition often leads to the change of
position of the firms in terms of market shares and profit. In this situation, it is
difficult to select companies for investment because the survival rate is unknown.

➢ Rapid Growth Stage

This stage starts with the appearance of surviving firms from the pioneering stage.
The companies that have withstood the competition grow strongly in market
share and financial performance. The technology of the production would have
improved resulting in low cost of production and good quality products. The
companies have stable growth rate in this stage and they declare dividend to the
share holders. It is advisable to invest in the shares of these companies. The
pharmaceutical industry has improved its technology and the top companies in
this sector are giving dividend to the shareholders. Likewise power industry and
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telecommunication industry can be cited as examples of expansion stage. In this

stage the growth rate is more than the industry’s average growth rate.

➢ Maturity and Stabilization Stage

In the stabilization stage, the growth rate tends to moderate and the rate of
growth would be more or less equal to the industrial growth rate or the gross
domestic product growth rate. Symptoms of obsolescence may appear in the
technology. The keep going, technological innovations in the production process
and products should be introduced. The investors have to closely monitor the
events that take place in the maturity stage of the industry.

➢ Declining Stage

In this stage, demand for the particular product and the earnings of the
companies in the industry decline. Now-a-days very few consumers demand black
and white T.V.
Innovation of new products and change in consumer preferences lead to this
stage. The specific feature of the declining stage is that even in the boom period;
the growth of the industry would be low and decline at a higher rate during the
recession. It is better to avoid investing in the shares of the low growth industry
even in the boom period. Investment in the shares of these types of companies
leads to erosion of capital
Factors to be considered to analyse Industry
Apart from industry life cycle analysis, the investor has to analyse some other
factors too. They are as listed below
 Growth of the industry
 Cost structure and profitability
 Nature of the product
 Nature of the competition
 Government policy
 Labor
 Research and development

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Company Analysis

In the company analysis the investor assimilates the several bits of information
related to the company and evaluates the present and future values of the stock.
The risk and return associated with the purchase of the stock is analysed to take
better investment decisions. The valuation process depends upon the investors’
ability to elicit information from the relationship and inter-relationship among the
company related variables. The present and future values are affected by a
number of factors and they are given in fig

Factors to consider to do a company analysis

Like-wise in all industries, some companies rise to the position of eminence and
dominance. The large companies are successful in meeting the competition. Once
the companies obtain the leadership position in the market, they seldom lose it.
Over the time they would have proved their ability to withstand competition and
to have a sizeable share in the market. The competitiveness of the company can
be studied with the help of
 The market share
 The growth of annual sales
 The stability of annual sales
 Sales Forecast
 Earnings of the Company
 Capital Structure
 Preference Shares
 Debt
 Management
 Operating Efficiency
 Operating Leverage

 Financial Analysis of a company

The best source of financial information about a company is its own
financial statements. This is a primary source of information for evaluating
the investment prospects in the particular company’s stock. Financial
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statement analysis is the study of a company’s financial statement from

various viewpoints. The statement gives the historical and current
information about the company’s operations. Historical financial statement
helps to predict the future. The current information aids to analyse the
present status of the company.

Analysis of Financial Statement

The analysis of financial statements reveals the nature of relationship

between income and expenditure, and the sources and application of funds.
The investor determines the financial position and the progress of the
company through analysis. The investor is interested in the yield and safety
of his capital. He cares much about the profitability and the management’s
policy regarding the dividend.

 Comparative financial statements

 Trend analysis
 Common size statements
 Fund flow analysis
 Cash flow analysis
 Ratio analysis

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Technical Analysis

It is a process of identifying trend reversals at an earlier stage to formulate the

buying and selling strategy. With the help of several indicators they analyzed the
relationship between price - volume and supply-demand for the overall market and the
individual stock. Volume is favorable on the upswing i.e. the number of shares traded
is greater than before and on the downside the number of shares traded dwindles
If it is the other way round, trend reversals can be expected.

History of Technical Analysis

The technical analysis is based on the doctrine given by Charles H. Dow in

1884, in the Wall Street Journal. He wrote a series of articles in the Wall Street
Journal A.J. Nelson, a close friend of Charles Dow formalized the Dow Theory for
economic forecasting.
The analysts used charts of individual stocks and moving averages in the
early 1920’s. Later on, with the aid of calculators and computers, sophisticated
techniques came into vogue.

Technical Tools

Generally used technical tools are analyzed.

Trend
Trend is the direction of movement. The share prices can either increase or
fall or remain flat. The three directions of the share price movements are called as
rising, falling and flat trends. The point to be remembered is that share prices do not rise
or fall in a straight line. Every rise or fall in price experiences a counter move. If a share
price is increasing, the countermove will be a fall in price and vice-versa. The share
prices move in zigzag manner.
The trend lines are straight lines drawn connecting either the tops or bottoms of
the share price movement. To draw a trend line, the technical analyst should have
at least two tops or bottoms. The following figure shows the trend lines.

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Support and Resistance Level

Anybody interested in the technical analysis should know the support and
resistance level. A support level exists at a price where considerable demand for that
stock is expected to prevent further fall in the price level. The fall in the price may
be halted for the time being or it may result even in price reversal. In the support
level, demand for the particular scrip is expected.

In the resistance level, the supply of scrip would be greater than the
demand and further rise in price is prevented. The selling pressure is greater and
the increase in price is halted for the time being.

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Technical Indicators

There are a number of market indicators which are divided into five categories:

1. Moving Average Indicators

 Simple Moving Average (SMA)
 Exponential Moving Average (EMA)
 Weighted Moving Average (WMA)
 Volume Weighted Moving Average (VWMA)
 Double Exponential Moving Average (DEMA)

2. Trend Indicators
 Moving Average Convergence Divergence Indicators(MACD)
 Average Directional Index (ADX)
 Traders Dynamic Index (TDI)
 Aroon Indicator
 Vertical Horizontal Filter (VHF)

3. Momentum Indicators
 Stochastic Indicator
 Relative Strength Index(RSI)
 Stochastic Momentum Indicator (SMI)
 Williams Percentage Range (WPR)
 Chande Momentum Indicator (CMO)
 Commodity Channel Index Indicator (CCI)

4. Volatility Indicators
 Bollinger Bands
 Average True Range (ATR)
 Dochain Channel

5. Volume Indicators
 On-Balance Volume(OBV)
 Money Flow index (MFI)
 Chaikin Money Flow(CMF)
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All these tools of technical analysis are based the four factors:
 Price: The changes in the price of the stock are always driven by the two
forces of demand and supply.
 Time: The degree of price movement is a function of time. High price
changes are observed when a stock takes long time for trend reversal.
 Volume: The degree of price movement reflects on the number of
transactions i.e. the volume.
 Width: The width is the measure of changes in the price of the stock
determining whether it reflects across most sectors or just on a few stocks
for a trend to set

Technical indicators are used to find out the direction of the overall market.
The overall market movements affect the individual share price. Aggregate
forecasting is considered to be more reliable than the individual forecasting. The
indicators are price and volume of trade. The volume of trade is influenced by the
behavior of price.

Moving Average

The market indices do not rise or fall in straight line. The upward and
downward movements are interrupted by counter moves. The underlying trend
can be studied by smoothening of the data. To smooth the data moving average
technique is used.

The word moving means that the body of data moves ahead to include the
recent observation. If it is five day moving average, on the sixth day the body of
data moves to include the sixth day observation eliminating the first day’s
observation. Likewise it continues. In the moving average calculation, closing price
of the stock is used.
The moving averages are used to study the movement of the market as well
as the individual scrip price. The moving average indicates the underlying trend in
the scrip. The period of average determines the period of the trend that is being
identified. For identifying short-term trend, 10 day to 30 day moving averages are
used. In the case of medium term trend 50 day to 125 day are adopted. 200 day moving
average is used to identify long term trend.
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Index and Stock Price Moving Average

Individual stock price is compared with the stock market indices. The
moving average of the stock and the index are plotted in the same sheet and trends are
compared. If NSE or BSE index is above stock’s roving average line the particular stock
has bullish trend. The price may increase above the market average. If the Sensex or
Nifty is below the stock’s moving average, the bearish market can be expected for the
particular stock. If the moving average of the stock penetrates the stock market index
from above, it generates sell signal. Unfavorable market condition prevails for the
particular scrip. If the stock line pushes up through the market average, it is a buy
signal.

Stock Price and Stock Prices Moving Average

Buy and sell signals are provided by the moving averages. Moving averages are
used along with the price of the scrip. The stock price ma intersects the moving
average at a particular point. Downward penetration of the rising average
indicates the possibility of a further fall. Hence sell signal is generated in the figure
Upward penetration of a falling average would indicate the possibility of the
further rise and gives the buy signal. As the average indicates the underlying trend,
its violation may signal trend reversal that is shown in Figure

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Comparison of the Two Moving Averages

When long term and short term moving averages are drawn, the intersection of
two moving averages generates buy or sell signal. When the scrip price is falling and if the
short term average intersects the long term moving average from above and falls below
it, the sell signal is generated.

If the scrip price is rising, the short term average would be above the long
term average. The short term average intersects the long term average from below
indicating a further rise in price, gives a buy signal. The sell and buy signals are
given in figures.

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Oscillators

Oscillators indicate the market momentum or scrip momentum. Oscillator

shows the share price movement across a reference point from one extreme to
another. The momentum indicates:

➢ Overbought and oversold conditions of the scrip or the market.

➢ Signaling the possible trend reversal.
➢ Rise or decline in the momentum.

Generally, oscillators are analyzed along with the price chart. Oscillators
indicate trend reversals that have to be confirmed with the price movement of the
scrip. Changes in the price should be correlated to changes in the momentum, and
then only buy and sell signals can be generated. Actions have to be taken only when
the price and momentum agree with each other. With the daily, weekly or monthly
closing prices oscillators are built. For short term trading, daily price oscillators are
useful.

Relative Strength Index (RSI)

Relative strength index (RSI) RSI was developed by Wells Wilder. It is an

oscillator used to identify the inherent technical strength and weakness of a particular
scrip or market. RSI can be calculated for scrip by adopting the following formula.
The broad rule is, if the RSI crosses seventy there may be downturn and it is
time to sell. If the RSI falls below thirty it is time to pick up the scrip. The figure show
the buy and sell signals of a RSI chart.

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Technical Analysis and Fundamental Analysis

1. Fundamental analysts’ analyses the stock based on the specific goals of the
investors. They study the financial strength of corporate, growth of sales,
earnings and profitability. They also take into account the general industry
and economic conditions.
2. The technical analysts mainly focus the attention on the past history of
prices. Generally technical analysts choose to study two basic market data-price
and volume.
3. The fundamental analysts estimate the intrinsic value of the shares and
purchase them when they are undervalued. They dispose the shares when they
are overpriced and earn profits. They try to find out the long term value of
shares.

Compared to fundamental analysts, technical analysts mainly predict the short

term price movement rather than long term movement. They are not committed to buy
and hold policy.

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RANDOM WALK THEORY

Random Walk Theory is a concept in finance that suggests that changes in asset
prices, such as stock prices, follow a random and unpredictable pattern. Let’s
delve into the details:
Definition:
Random walk theory posits that past prices of an asset cannot accurately predict
future prices. In other words, stock prices move unpredictably, and historical data
alone cannot be used to forecast future movements.
Key Points:
 Unpredictable Movement: Stock prices exhibit a random walk, making it
impossible to predict their future direction based solely on past trends.
 Efficient Market Hypothesis (EMH): Random walk theory aligns with the
semi-strong form of EMH, which argues that it’s impossible to consistently
outperform the market.
 Investment Strategy: The theory suggests that buying and holding a
diversified portfolio (such as an index fund) may be the best long-term
investment strategy.
 Criticism: While some believe stock prices can be predicted using
techniques like technical analysis, random walk theory remains widely
accepted in financial economics.
Origin:
 Economist Burton Malkiel popularized random walk theory in his 1973
book, A Random Walk Down Wall Street.
 Malkiel argued that trying to time the market or predict stock prices using
fundamental or technical analysis is futile and can lead to
underperformance.
Takeaway:
 Investors should focus on long-term planning, remain disciplined, and avoid
rash decisions based on short-term market movements.
 Accepting the unpredictability of stock prices can lead to better investment
outcomes.
Remember, while random walk theory has its critics, understanding its
implications can guide investors toward prudent decision-making in the ever-
changing financial landscape

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EFFICIENT MARKET HYPOTHESIS (EMH)

The Efficient Market Hypothesis (EMH) is a fundamental concept in finance that
sheds light on how financial markets operate. Let’s explore it in detail:
Definition:
The EMH posits that current stock prices reflect all available information. In other
words, market prices are fairly valued based on existing knowledge.
Assumptions of EMH:
 Information Efficiency: The market processes and reflects all available
information with minimal waste.
 No Predictable Patterns: Past price movements or patterns cannot predict
future prices.
 No Arbitrage Opportunities: There are no opportunities to earn risk-free
profits by exploiting price discrepancies.
 Universal Information: All investors have access to the same information
simultaneously.
Forms of EMH:
 Weak Form: Prices already incorporate all past trading data, including
historical prices and trading volumes. Technical analysis (e.g., chart
patterns) is ineffective.
 Semi-Strong Form: Prices reflect all publicly available information, including
news, financial statements, and economic data. Fundamental analysis
cannot consistently beat the market.
 Strong Form: Prices account for all information, including private or insider
information. Even insider trading cannot yield consistent outperformance.
Criticism and Implications:
 Critics argue that EMH doesn’t account for market bubbles or irrational
behavior.
 Despite criticism, understanding EMH guides investors toward long-term
strategies and discourages attempts to time the market.

In summary, EMH suggests that stock prices are efficient and reflect all
relevant information, making it challenging to consistently beat the market
based on publicly available data

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The Markowitz Model

The Markowitz Model, also known as the Markowitz Portfolio Theory or Modern
Portfolio Theory (MPT), is a fundamental concept in finance. Let’s delve into its
details:
Definition and Purpose:
The Markowitz Model aims to maximize returns while managing risk within an
investment portfolio.
It facilitates practical application, making it popular among new investors in
capital markets
Key Points:
 Diversification: Markowitz emphasizes portfolio diversification to minimize
risk. By spreading investments across different assets, investors can reduce
exposure to individual stock volatility.
 Risk and Return: The model balances the trade-off between risk and return.
It seeks to achieve the highest possible return for a given level of risk.
 Mean-Variance Optimization: Markowitz’s approach involves mathematical
calculations to construct an optimal portfolio that balances risk and return.
Two Types of Stocks:
 Low-risk, low-return stocks: These provide stability but lower potential
gains.
 High-risk, high-return stocks: These offer greater profit potential but come
with higher volatility.
Systematic and Unsystematic Risk:
Systematic risk: Market-wide factors affecting all stocks (e.g., economic
conditions, interest rates).
Unsystematic risk: Stock-specific risks (e.g., company-specific events).
Ideal Portfolio: The Markowitz model builds an ideal portfolio by combining
assets to achieve the best risk-return trade-off.
Assumptions:
 Overreliance on Historical Data: The model relies on historical data, which
may not always reflect current market conditions.
 Irrelevant Assumptions: Some assumptions become irrelevant, especially
during volatile market periods.

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 Mean-Variance Approach: Markowitz uses mean-variance analysis, which

doesn’t fully capture all potential risks.
Advantages:
 Educates new investors about diversification.
 Highlights the importance of managing systematic risks.
Disadvantages:
 Overreliance on assumptions.
 Mean-variance focus may not account for all risks.
In summary, the Markowitz Model provides a framework for constructing
portfolios that balance risk and return. While it has limitations, understanding its
principles guides investors toward informed decision-making

Simple Diversification
Portfolio risk can be reduced by the simplest kind of diversification. Portfolio
means the group of assets an investor owns. The assets may vary from stocks to
different types of bonds. Sometimes the portfolio may consist of securities of
different industries. When different assets are added to the portfolio, the total risk
tends to decrease. In the case of common stocks, diversification reduces the
unsystematic risk or unique risk. Analysts opine that if 15 stocks are added in a
portfolio of the investor, the unsystematic risk can be reduced to zero. But at the same
time if the number exceeds 15, additional risk reduction cannot be gained. But
diversification cannot reduce systematic or undiversifiable risk.
The simple random diversification reduces the total risk. The reason
behind this is that the unsystematic price fluctuations are not correlated with the
market’s systematic fluctuations. The figure shows how the simple diversification
reduces the risk. The standard deviations of the portfolios are given in Y axis and the
number of randomly selected portfolio securities in the X axis.

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Markowitz Efficient Frontier

The Markowitz Efficient Frontier, introduced by Nobel Laureate Harry
Markowitz in 1952, is a fundamental concept within Modern Portfolio Theory
(MPT). Let’s explore it in detail:
Definition:
The efficient frontier represents the set of optimal portfolios that offer
the highest expected return for a defined level of risk or the lowest risk for a given
level of expected return.
Portfolios lying below the efficient frontier are suboptimal because they don’t
provide enough return for the risk taken, while those to the right of the frontier
have higher risk for a given rate of return.

Key Takeaways:
 Risk and Return: The efficient frontier balances the trade-off between risk
and return. It helps investors find portfolios aligned with their risk tolerance
and investment goals.
 Diversification: Optimal portfolios on the efficient frontier typically exhibit
a higher degree of diversification. Diversification reduces risk by spreading
investments across different assets.
 Mathematical Representation: The efficient frontier graphically rates
portfolios based on return (y-axis) versus risk (x-axis). It uses the compound
annual growth rate (CAGR) as the return component and standard
deviation (annualized) as the risk metric.

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 Risk Synchronization: Ideally, an investor aims to construct a portfolio with

securities offering exceptional returns while maintaining a combined
standard deviation lower than that of individual securities. Lower
covariance (less synchronization) among securities leads to lower portfolio
standard deviation.
 Benefit of Diversification: The curvature of the efficient frontier reveals how
diversification improves a portfolio’s risk-reward profile. It also highlights
diminishing marginal returns to risk—adding more risk doesn’t necessarily
yield an equal increase in return.
Criticisms:
 The efficient frontier and MPT rely on several assumptions that may not
perfectly represent reality. These assumptions include market efficiency,
normal distribution of returns, and constant correlations.
 Real-world markets may deviate from these assumptions due to factors like
behavioral biases, market frictions, and non-normal return distributions.
In summary, the Markowitz Efficient Frontier guides investors toward
constructing portfolios that optimize the balance between risk and return. By
understanding this concept, investors can make informed decisions in the
complex world of finance

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Approaches in Portfolio Construction

Commonly, there are two approaches in the construction of the portfolio of

securities viz, traditional approach and Markowitz efficient frontier approach

The Traditional Approach

The traditional approach basically deals with two major decisions. They are:

(a) Determining the objectives of the portfolio.

(b) Selection of securities to be included in the portfolio.

Normally, this is carried out in four to six steps. The flow chart 4.5 explains this

Steps in Traditional Approach

Analysis of constraints

Determination of Objectives

Selection of Portfolio

Bond and Common Stock

Assessment of risk and return

Diversification

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Modern Approach

The traditional approach is a comprehensive financial plan for the individual. It

takes into account the individual needs such as housing, life insurance and
pension plans. But these types of financial planning approaches are not done in
the Markowitz approach. Markowitz gives more attention to the process of
selecting the portfolio. His planning can
be applied more in the selection of common stocks portfolio than the bond
portfolio. The stocks are not selected on the basis of need for income or
appreciation. But the selection is based on the risk and return analysis. Return
includes the market return and dividend. The investor needs return and it may be
either in the form of market return or dividend. They are assumed to be
indifferent towards the form of return.

Feasible set of portfolios

A feasible portfolio refers to a group of investments selected from available

alternatives within an investor’s capital resources limits, investment goals,
and risk tolerance.
In simpler terms, it represents a portfolio that an investor can construct using the
assets they have available.
Each feasible portfolio has its own risk and reward profile, and investors can
choose from a range of feasible portfolios.
Key Points:
 Resource Constraints: Feasible portfolios take into account an investor’s
financial resources. If an investor has limited capital, their feasible portfolio
will be shaped accordingly.
 Risk Balancing: Constructing a feasible portfolio involves balancing risk and
allocation. Investors aim to optimize their portfolio given their constraints.
 Not Always Efficient: While feasible portfolios are practical, they may not
always be the most efficient in terms of risk-adjusted returns.
 Opportunity Set: Feasible portfolios are part of the broader opportunity set,
which includes all possible combinations of investment portfolios drawn
from risky assets.
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Application:
Investors use feasible portfolios to create a diversified mix of assets that align with
their financial situation and risk preferences.
Managing a portfolio involves assessing strengths, weaknesses, and opportunities
within the feasible set.
Remember, constructing a feasible portfolio is about making informed choices
based on available resources and risk tolerance. It’s a crucial step in achieving
investment objectives.

Selection of the Optimal Portfolio

Definition and Purpose:

An optimal portfolio is one that strikes a balance between generating returns and
managing risk.
It aims to achieve the best possible combination of assets to maximize returns
while minimizing risk.
The optimal portfolio considers an investor’s risk tolerance, financial goals, and
investment horizon.
Components of an Optimal Portfolio:
 Risk-Free Asset: Usually government-issued bonds with minimal risk.
 Risky Assets: These include stocks, real estate, commodities, etc.
 Capital Allocation Line (CAL): Combines the risk-free asset with the best
risky portfolio on a graph.
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Two-Fund Separation Theorem:

All investors, regardless of preferences or wealth, use two funds:
 A risk-free asset.
 A portfolio of risky assets.
The first step is to select the best mix of risky assets based on their characteristics.
The second step involves deciding how much to allocate to the risk-free asset
based on the investor’s risk preference.
Utility and Indifference Curves:
 Utility measures the relative satisfaction an investor derives from different
portfolios.
 The utility function depends on the portfolio’s expected return, variance,
and a measure of risk aversion.
 An indifference curve shows combinations of risk and returns that an
investor would accept for a given level of utility.
 For risk-averse investors, indifference curves slope upward (higher returns
require more risk).
 Risk-seeking investors have flatter indifference curves.
Objective:
The goal is to construct a portfolio that lies on the efficient frontier—the set of
portfolios offering the best expected returns for each level of risk.
The efficient frontier represents the optimal trade-off between risk and return.
Remember, an optimal portfolio is tailored to an individual’s risk appetite and
investment objectives. It’s about finding the right balance to achieve financial
goals while managing risk

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CAPITAL ASSET PRICING MODEL (CAPM)

The Capital Asset Pricing Model (CAPM) is a financial model that calculates the
expected rate of return for an asset or investment. Let’s explore its key aspects:
Purpose and Relationship:
CAPM describes the relationship between the 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 security1.
Components of CAPM:
 Risk-Free Rate (Rf): Represents the return on a risk-free asset (typically
government bonds). It accounts for the time value of money.
 Beta (β): Measures the sensitivity of an asset’s returns to overall market
movements. A beta greater than 1 indicates higher volatility than the
market, while a beta less than 1 implies lower volatility.
 Market Risk Premium (ERm - Rf): The expected return on the market minus
the risk-free rate. It reflects the additional return investors expect for taking
on market risk.
CAPM Formula:
The expected return of an investment ((ER_i)) can be calculated using the
following formula:
[ER_i = R_f + \beta_i (ER_m - R_f)]
where:
(ER_i) = Expected return of the investment.
(R_f) = Risk-free rate.
(\beta_i) = Beta of the investment.
((ER_m - R_f)) = Market risk premium.

Interpreting CAPM:
CAPM helps evaluate whether a stock is fairly valued when considering its risk and
the time value of money.
By understanding the individual components of CAPM, investors can assess
whether the current stock price aligns with its expected return.
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Limitations:
CAPM relies on certain assumptions, such as market efficiency and linear risk-
return relationships.
Real-world markets may deviate from these assumptions due to behavioral
factors and non-normal return distributions.
In summary, CAPM provides a framework for understanding the relationship
between risk, expected return, and market dynamics. Despite its limitations, it
remains widely used for investment analysis and comparisons

THE CAPITALMARKET LINE

The figure shows the efficient frontier of the investor. The investor prefers any
point between B and C because, with the same level of risk they face on line BA,
they are able to get superior profits. The ABC line shows the investor’s, portfolio
of risky assets. The investors can combine riskless asset either by lending or
borrowing. The line RfS represents all possible combination of riskless and risky
asset.
The ‘S’ portfolio does not represent any riskless asset but the line RS gives the
combination of both. The portfolio along the path RS is called lending portfolio
that is some money is invested in the riskless asset or may be deposited in the
bank for a fixed rate of interest. If it crosses the point S, it becomes borrowing
portfolio. Money is borrowed and invested in the risky asset. The straight line is
called capital market line (CML). Thus, all efficient portfolios will lie on the capital
market line.
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Arbitrage Pricing Theory

Definition:
The APT is an economic model used to estimate the expected return of a
particular asset.
It offers an efficient alternative to the traditional Capital Asset Pricing Model
(CAPM).
Unlike CAPM, which considers only one factor (market risk), APT takes into
account multiple macroeconomic factors associated with an asset’s risks.
Key Points:
Systematic Risk Factors: APT considers various macroeconomic factors, such as:
 Inflation
 Gross Domestic Product (GDP)
 Yield Curve Changes
 Interest Rate Fluctuations
Linear Relationship: APT estimates the price of an asset by holding a linear
function between expected return and these factors.
Accurate Pricing: APT provides more accurate and reliable asset pricing results
compared to CAPM.
Arbitrage and APT:
To understand APT, let’s first look at arbitrage. It involves finding discrepancies in
asset prices across different markets and profiting from the price differences.
APT helps investors determine the fair value of financial assets, including stocks,
bonds, and derivatives, by exploiting short-term profit opportunities.
Example:
Imagine Tata Power’s stock is trading at 120 on the NSE and 120.50 on the BSE
An investor can exploit this price difference through arbitrage, buying on the NSE
and selling on BSE for a profit of 0.50 per share.
In summary, APT provides a robust framework for estimating asset returns by
considering multiple risk factors. It’s a valuable tool for investors seeking accurate
pricing and understanding market dynamics.
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APT and CAPM

APT is more general and less restrictive than CAPM. In APT, the investor has no
need to bold the market portfolio because it does not make use of the market
portfolio concept. The portfolios are constructed on the basis of the factors to
eliminate arbitrage profits. APT is based on the law of one price to hold for all
possible portfolio combinations.
The APT model takes into account of the impact of numerous factors on the
security. The macro economic factors are taken into consideration and it is closer
to reality than CAPM.
The market portfolio is well defined conceptually. In APT model, factors are not
well specified. Hence the investor finds it difficult to establish equilibrium
relationship. The well-defined market portfolio is a significant advantage of the
CAPM leading to the wide usage of the model in the stock market.
The factors that have impact on one group of securities may not affect another
group of securities. There is a lack of consistency in the measurements of the APT
model. Further, the influences of the factors are not independent of each other. It
may be difficult to identify the influence that corresponds exactly to each factor.
Apart from this, not all variables that exert influence on a factor are measurable.

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Module no 5-Bond Valuation

Bonds are fixed-income securities that enable entities (such as companies,
governments, and municipalities) to raise funds by borrowing from individual
investors
Features of Bonds

1. Face Value:
o The face value (also known as principal or nominal value) represents the price of a
single unit of a bond issued by an enterprise.
o Issuers are legally obligated to return this value to the investor after a specified
period.
o For example, if an investor purchases a corporate bond at a face value of ₹6,500,
the issuing company must return ₹6,500 plus interest to the investor upon
maturity.

2. Interest or Coupon Rate:

o Bonds accrue fixed or floating interest rates across their tenure, payable
periodically to creditors.
o These interest rates are also referred to as coupon rates, harking back to the
tradition of claiming interest on paper bonds in the form of coupons.
o The interest earned on a bond depends on factors such as tenure and the issuer’s
reputation in the public debt market.

3. Tenure of Bonds:
o The tenure (or term) refers to the period after which bonds mature.
o Bonds are financial debt contracts between issuers and investors, and their
obligations are valid only until the end of the specified tenure.
o Different categories include:
 Short-term bonds: Maturity periods below 5 years.
 Intermediate-term bonds: Tenure of 5-12 years.
 Long-term bonds: Terms exceeding 12 years.

4. Credit Quality:
o The credit quality of a bond reflects the consensus among creditors regarding a
company’s long-term asset performance.
o It indicates the issuer’s ability to repay the debt.

In summary, bonds are negotiable instruments issued in relation to borrowing

arrangements, signifying indebtedness. Investors provide credit to the company
issuing the bond, and the bond’s value is equal to the present value of expected
cash flows from it
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Types of Bonds

On the Basis of Coupon rate

1. Plain Vanilla Bonds:

o Also known as straight bonds or bullet bonds, plain vanilla bonds are
straightforward and common.
o Key Features:
 Fixed Coupon: These bonds pay a fixed interest (coupon) periodically throughout
their tenure.
 Defined Maturity: They have a specific maturity date when the face value is
returned to the bondholder.
 Issuance and Redemption: Plain vanilla bonds are usually issued and redeemed
at face value.
 Tradability: They are tradable and can change hands before maturity.
 Example: Imagine a company issuing a bond with a fixed coupon rate of 6% and a
maturity of 5 years. Investors receive regular interest payments until the bond
matures, at which point they get back the face value.

2. Zero-Coupon Bonds:
o Also called pure discount bonds, zero-coupon bonds do not make periodic coupon
payments.
o Key Features:
 No Coupons: Zero-coupon bonds do not issue any interest payments during their
tenure.
 Discounted Issuance: They are issued at a discount to their face value.
 Face Value at Maturity: Bondholders receive the face value (principal) at
maturity.
 Investment Strategy: These bonds are suitable for long-term investors seeking
capital appreciation.
 Example: Suppose an investor buys a zero-coupon bond with a face value of
₹10,000 at a discounted price of ₹7,000. At maturity, they receive ₹10,000,
earning a profit of ₹3,000.

In summary, plain vanilla bonds offer regular coupon payments, while zero-
coupon bonds provide a lump-sum payment at maturity without any interim
interest payments.

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On the Basis of Issuer

1. Government Securities (G-Sec):

o These bonds are issued by the Government of India to finance national
developmental activities.
o G-Secs are considered the safest bonds and are often referred to as “risk-free.”
o They form the largest segment of outstanding bonds in India

2. State Development Loans (SDLs):

o SDLs are bonds issued by state governments for their developmental needs.
o While they have an implied guarantee from the central government, they
offer higher interest rates than G-Secs.
o Different SDLs have varying credit ratings based on the strength of each state

3. State Guaranteed Bonds:

o These are government bonds guaranteed by a state for specific developmental
activities, such as establishing infrastructure for electricity, roads, highways,
towns, and agriculture.
o Their credit rating depends on both the state’s financial strength and that of the
standalone state operating company

4. Public Sector Bonds (PSUs):

o PSU bonds are issued by national companies where the majority equity ownership
is held by the Government of India.
o These companies are involved in growth activities in sectors such as power,
agriculture, housing, infrastructure, and education.
o Each PSU has a separate credit rating based on its financial strength. However, it’s
important to note that PSU bonds do not have any explicit guarantee from the
government

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5. Corporate Bonds:
o These bonds are issued by private companies and are also referred to as Non-
Cumulative Debentures or NCDs.
o In India, bonds issued by private companies have been called NCDs, implying they
are not equity and do not have the ability to ‘cumulate’ interest coupons that may
be missed

6. Bank Bonds:
o These bonds are issued by banks in India, whether private or owned by the
Government of India.
o Bank bonds serve as a way for banks to raise capital and manage liquidity.
o They offer varying interest rates and risk profiles

Remember that each type of bond has its own risk-reward trade-off, and investors
should choose based on their financial goals and risk tolerance. If you’re
interested in exploring different bond options, you can browse through our Bond
Directory and invest online with ease

Concept of Bond Valuation

Bond valuation is a technique used to determine the theoretical fair value of a
specific bond. Let’s explore its key aspects:
Purpose of Bond Valuation:
Bond valuation helps investors understand the intrinsic worth of a bond.
It involves calculating the present value of a bond’s expected future cash flows.
Components of Bond Valuation:
 Coupon Payments: Bonds provide a steady income stream through coupon
payments (interest).
 Face Value (Par Value): At maturity, the bond issuer repays the investor the
full face value of the bond.

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Understanding Bond Characteristics:

 Coupon Rate: Some bonds have an interest rate (coupon rate) paid semi-
annually.
 Maturity Date: All bonds have specific maturity dates.
 Current Price: Depending on interest rates, bonds may be purchased at par,
below par (trading at a discount), or above par (trading at a premium).
Calculation of Fair Value:
Bond valuation involves discounting the future value of coupon payments by an
appropriate discount rate.
The goal is to determine the rate of return required for the bond investment to be
worthwhile.
In summary, bond valuation helps investors assess whether a bond is a suitable
addition to their portfolio based on its expected returns over time

Bond Yields

Current Yield:
The current yield represents the annual income (including interest payments)
relative to the current market value of the bond.
It provides a straightforward measure of the bond’s return based on its current
price.
The formula for current yield is

For instance, consider a bond with an annual coupon payment of Rs. 80 and a
current market value of Rs. 900. The current yield would be approximately 8.88%
per annum.

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Yield to Maturity (YTM):

YTM is a more comprehensive metric that considers the total return expected
from a bond if held until maturity.
It accounts for the entire cash flow stream, including coupon payments and
principal repayment at maturity.
YTM assumes that all coupon payments are reinvested back into the bond until
maturity.
The formula for YTM is:

Let’s illustrate this with an example:

Suppose ABC Ltd. issues 8% annual bonds with the following details:
Coupon rate: 8%
Face value: Rs. 2,000
Date of issue: August 17, 2020, Maturity: Five years
If an investor buys the bond at face value (Rs. 2,000), the YTM would be
approximately 10.52% per annum1. However, if the bond is selling at a different
price (higher or lower), the YTM will adjust accordingly.
If the bond is selling below face value (e.g., Rs. 1,800), YTM will be higher than the
coupon rate.
If the bond is selling above face value (e.g., Rs. 2,100), YTM will be lower than the
coupon rate.
YTM provides a more accurate picture of the bond’s potential return when
considering reinvestment of coupon payments and price fluctuations in the
market.

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Risk in Debt

1. Credit Risk (Default Risk):

o Credit risk refers to the possibility that a borrower (such as a company or
government) may default on interest payments or fail to repay the principal
amount.
o Credit risk is measured by credit ratings, which agencies like CRISIL, ICRA, and
CARE assign to bond issuers based on their financial health.
o Higher credit risk typically leads to higher expected returns. If a bond claims
exceptionally high returns, check its credit risk profile.
o Credit ratings can change over time, affecting a bond’s market price. Downgrades
decrease prices, while upgrades increase a fund’s value

2. Interest Rate Risk:

o Interest rate risk arises due to the inverse relationship between bond prices and
interest rates.
o When interest rates rise, bond prices fall, impacting existing bondholders.
o Conversely, falling interest rates lead to rising bond prices.
o Understanding a bond’s duration helps assess its sensitivity to interest rate
changes

3. Reinvestment Risk:
o Reinvestment risk occurs when bondholders must reinvest coupon payments at
lower rates.
o Callable bonds add complexity; if called early, investors may struggle to reinvest at
comparable rates

4. Inflation Risk:
o Inflation risk refers to the erosion of purchasing power due to rising prices.
o Fixed-income investments may not keep pace with inflation, leading to reduced
real returns.
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o Investors should consider inflation when choosing debt instruments .

Remember, understanding these risks helps investors make informed decisions

based on their financial goals

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Bond Portfolio Management

Let’s delve into the strategies for managing a bond portfolio. There are several
approaches, each with its own risk-reward tradeoffs. Here are the four principal
strategies:
Passive Strategy (Buy and Hold):
 In this approach, investors aim to maximize the income-generating
properties of bonds.
 The strategy involves purchasing individual bonds and holding them until
maturity.
 Bonds are considered a safe and predictable source of income.
 There are no assumptions made about future interest rate directions, and
changes in bond value due to yield shifts are not critical.
 Reinvestment of coupon payments contributes to total return.
 This strategy works best with high-quality, non-callable bonds like
government or investment-grade corporate or municipal bonds
Index Matching (Quasi-Passive):
 Investors mimic specific bond indices by constructing portfolios that closely
match the index composition.
 The goal is to achieve returns similar to the index.
 It combines some predictability with flexibility, as it doesn’t require
frequent adjustments.
 Typically used for passive bond funds or exchange-traded funds (ETFs) that
track specific bond indices.
Immunization (Quasi-Active):
 Immunization aims to reduce the impact of interest rate changes on a
portfolio’s value.
 It balances the need for predictable income with some protection against
rate fluctuations.
 By matching the duration of assets (bonds) with the duration of liabilities
(future cash flows), investors can minimize interest rate risk.
 Suitable for those seeking stability while still allowing for some
adjustments.

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Dedicated and Active Strategies:

 Dedicated: Investors allocate funds to specific bond sectors (e.g., corporate
bonds, municipal bonds) based on their objectives.
 Active: Portfolio managers actively adjust holdings based on market
conditions, economic outlook, and interest rate expectations.
 Active strategies involve more frequent adjustments and may seek to
outperform the market.
 Requires staying ahead of interest rate movements and making informed
decisions.
Remember that bond portfolio management involves balancing risk, return, and
income objectives. The choice of strategy depends on individual preferences,
market conditions, and investment goals

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Concept of present Value

Present Value Definition: Present value is the current value of a future sum of
money or stream of cash flows, given a specified rate of return. In simpler terms,
it answers the question: "How much is a future amount of money worth today?"
Here are the key points about present value:
Time Value of Money:
Present value takes into account the time value of money. This means that money
received today is generally worth more than the same amount received in the
future.
Why? Because an investor can invest the money received today and potentially
earn a rate of return over time.
Discounting Future Cash Flows:
To calculate present value, we discount future cash flows at a specified discount
rate.
The higher the discount rate, the lower the present value of future cash flows.
Determining the appropriate discount rate is crucial for valuing future cash flows,
whether they are earnings or debt obligations.
Example:
Suppose you receive 1,000 today and can earn a rate of return of 5% per year. The
present value of that 1,000 today is certainly worth more than receiving 1,000 five
years from now.
Waiting for 1,000 in the future would involve an opportunity cost, as you would
miss out on the rate of return during those five years.
In summary, present value accounts for the time value of money and helps us
determine the worth of future cash flows in today’s terms. It’s a fundamental
concept used in various financial analyses and investment decisions

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Share Valuation Models, Multiplier Approach to share valuation

Let’s explore the share valuation models and focus on the multiplier approach for
valuing shares:
Present Value Models (Discounted Cash Flow Models):
These models estimate the intrinsic value of a company’s equity based on
expected future benefits.
The fundamental idea is that the value of an investment today should be
equivalent to the present value of expected future benefits.
Two common approaches within this category are:
 Dividend Discount Model (DDM): It estimates intrinsic value based on
expected dividends.
 Free Cash Flow to Equity (FCFE) Models: These models estimate intrinsic
value based on expected free cash flows.

Multiplier Models (Market Multiple Models):

Multiplier models estimate intrinsic value based on a multiple of some
fundamental variable.
These models rely on share price multiples or enterprise value multiples.
Key points about multiplier models:
 Price Multiples: These ratios compare a stock’s price to some measure of
value per share. They are commonly used in the method of comparables.
 Enterprise Value Multiples: These ratios use enterprise value (market
capitalization + market value of debt and preferred shares – cash
equivalents) divided by EBITDA (EV/EBITDA) or total revenue (EV/Sales)12.
The method assumes that similar companies (or assets) should be valued similarly,
using financial data from other companies to help determine a company’s value.

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Asset-Based Valuation Models:

These models estimate intrinsic value based on the estimated value of a
company’s assets minus its liabilities.
Adjustments are often made to the book value of assets.
Theoretically, the value of a business should be equal to the sum of the value of
its assets.
In summary, the multiplier approach considers relative valuation by comparing a
company’s metrics to those of similar companies. It helps analysts assess whether
an asset is undervalued, fairly valued, or overvalued in relation to benchmark
values.

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Module no 6 – Investment Plans for Individuals at

various life cycle stages

Investment Planning:

Investment planning is the process of identifying your financial goals and creating
a strategic roadmap to achieve them.

It involves aligning your goals with your financial resources and risk tolerance to
select the best investment products. Investment planning doesn’t end with
making investments; it also includes monitoring those investments at regular
intervals.

Importance of Investment Planning:

1. Inculcates the Habit of Saving:

 An investment plan helps instill the habit of saving.
 Regularly scheduling investments promotes financial discipline.
2. Offers Financial Security:
 Having an investment plan provides security for the future.
 In adverse situations, you can rely on your investments to support you and
your family.
3. Increases Financial Awareness:
 Investment planning enhances your understanding of your current financial
situation.
 It helps you evaluate your position and choose suitable investment products.
4. Maintains and Improves Standard of Living:
 During emergencies (like job loss), your investments can be a lifeline.
 Even without emergencies, investment returns can fund goals like buying a car
or a house.
5. Efficient Income and Expenditure Management:
 An investment plan allows you to manage your income and expenses
effectively.
 Creating a budget helps plan expenditures and savings ahead of time.

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Steps in Financial Planning Process

1. Gathering Financial Information:

o Begin by collecting relevant financial data. This includes details about income,
expenses, assets, liabilities, investments, and insurance.
o Understanding your current financial situation is crucial for effective planning.
2. Setting Financial Goals:
o Define clear and realistic financial objectives. These goals can vary from short-
term (like saving for a vacation) to long-term (such as retirement planning or
paying off a mortgage) 1.
3. Analyzing the Financial Situation:
o Evaluate your financial health. Consider factors like income stability, debt levels,
and risk tolerance.
o Identify areas that need improvement or adjustment.
4. Developing a Financial Plan:
o Create a comprehensive plan that aligns with your goals.
o Address aspects such as budgeting, investment strategies, tax planning, and risk
management.
5. Implementing the Plan:
o Put your financial plan into action. Allocate resources according to your priorities.
o Execute strategies like saving, investing, and debt reduction.
6. Monitoring the Plan:
o Regularly review your progress. Monitor changes in income, expenses, and
investment performance.
o Adjust your plan as needed to stay on track.
7. Making Adjustments as Needed:
o Life circumstances change, and so do financial goals. Be flexible.
o Modify your plan based on new information or shifts in priorities.

Remember, financial planning is an ongoing process. Regularly revisit your plan to

ensure it remains relevant and effective in achieving your desired outcomes.
Whether you do it independently or with the guidance of a financial planner,
thoughtful planning can significantly impact your financial well-being

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Financial Planning for Lifetime

Financial planning is a crucial aspect of our lives, akin to charting a course for a
long journey. Let’s delve into the different life stages and how financial planning
plays a pivotal role:

1. Youth Stage (Ages 13 to 17):

o During these teenage years, it’s a time of discovery. Teens often juggle part-time
jobs, which introduce them to managing budgets and personal finances.
o Learning to distinguish between needs and wants is foundational. Teens grapple
with choices like saving versus spending on the latest gadgets or trendy fashion.
2. Blossoming Adulthood (Ages 18 to 25):
o Young adults step into the world, striving for fiscal autonomy.
o Key decisions include career paths and financial choices that impact the decades
ahead. Questions arise: How much of my income should go toward housing?
What about savings and investments.
3. Family and Foundations (Ages 26 to 45):
o This phase involves building a family, establishing a career, and accumulating
wealth.
o Priorities include saving for education, buying a home, and planning for children’s
futures.
o It’s essential to strike a balance between short-term needs and long-term goals.
4. Pre-Retirement (Ages 45 to 64):
o As you approach retirement age, focus shifts to wealth consolidation.
o Maximize savings, invest wisely, and prepare for the transition from active work to
retirement.
o Consider estate planning and ensure your financial house is in order.
5. Retirement (Age 65 and older):
o Retirement marks the culmination of decades of work and planning.
o Enjoy the fruits of your labor while maintaining financial stability.
o Strategies include managing retirement accounts, Social Security, and estate
distribution.

Remember, financial planning is a marathon, not a sprint. Each life stage presents
unique challenges and opportunities. By proactively shaping your financial future,
you can navigate life’s unpredictable turns with confidence.

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Planning Environment and determinants of personal Income

Financial planning is a dynamic process influenced by various individual factors.

Let’s explore these determinants and how they shape our financial decisions:

1. Income:
o Earnings play a pivotal role in financial planning. The amount of money you make
directly impacts your ability to save, invest, and achieve financial goals.
o Factors affecting income include education, career choices, and market
demand for specific skills.
2. Income Needs:
o Your lifestyle, family size, and personal preferences determine your income
needs.
o Consider expenses like housing, education, healthcare, and leisure
activities. Balancing needs and wants is crucial.
3. Risk Tolerance:
o Risk appetite varies from person to person. Some individuals are comfortable with
high-risk investments, while others prefer safety.
o Factors influencing risk tolerance include age, financial stability, and investment
knowledge.
4. Wealth Accumulation:
o Savings, investments, and assets contribute to wealth.
o Factors affecting wealth accumulation include discipline, investment choices,
and inheritance.
5. Life Stages:
o Different life stages impact financial decision-making:
 Youth Stage: Teens learn about budgeting and financial responsibility.
 Blossoming Adulthood: Young adults make career choices and manage finances.
 Family and Foundations: Prioritize savings, home buying, and children’s
education.
 Pre-Retirement: Focus on wealth consolidation and retirement planning.
 Retirement: Enjoy retirement while managing finances.
6. Sound Financial Planning:
o Goals: Define short-term and long-term objectives.
o Budgeting: Allocate income wisely.
o Investments: Diversify and consider risk.
o Emergency Fund: Prepare for unexpected expenses.
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o Estate Planning: Ensure smooth wealth transfer .

Remember, financial planning is unique to each individual. Tailor your plan to your
circumstances, aspirations, and external factors
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Preparation of financial plan considering different investment avenues

Financial planning involves thoughtful consideration of various investment

avenues to achieve your financial goals. Let’s explore some key steps and different
investment options:

1. Set Clear Goals:

o Define your financial objectives. Are you saving for retirement, education, or a
major purchase?
o Consider the time horizon for each goal.
2. Risk Assessment:
o Understand your risk tolerance. Some investments carry higher risks but offer
potential for greater returns.
o Diversify your portfolio to manage risk.
3. Investment Avenues:
o Here are some common investment options:
 Equity Stocks: Invest in shares of publicly traded companies. These can yield
substantial returns but come with market volatility.
 Mutual Funds: Pooled investments managed by professionals. They offer
diversification across various assets.
 Debentures / Bonds: Fixed-income securities issued by corporations or
governments. They provide regular interest payments.
 Fixed Deposits: Low-risk investments with fixed interest rates offered by banks.
 PPF (Public Provident Fund): A long-term savings scheme with tax benefits.
 EPF (Employee Provident Fund): A mandatory retirement savings plan for
employees.
 NPS (National Pension Scheme): A voluntary pension system with tax advantages.
 Property / Real Estate: Investment in land, residential, or commercial properties.
 Gold: A tangible asset that can act as a hedge against inflation.
 Life Insurance & General Insurance: While not direct investments, they provide
financial protection.
4. Research and Analysis:
o Thoroughly research each avenue. Understand historical performance, risks, and
costs.
o Consider factors like liquidity, tax implications, and ease of exit.

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5. Create a Portfolio:
o Allocate funds across different avenues based on your goals and risk tolerance.
o Regularly review and rebalance your portfolio.
6. Emergency Fund:
o Set aside funds for unforeseen expenses. Aim for 3-6 months’ worth of living
expenses.
7. Tax Planning:
o Understand the tax implications of each investment.
o Utilize tax-saving instruments like PPF, EPF, and ELSS (Equity-Linked Savings
Scheme).

Remember, financial planning is a personalized journey. Seek professional advice

if needed, and adapt your plan as circumstances change

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