SECURITY ANALYS`IS AND PORTFOLIO MANAGEMENT

Module 1
Introduction to the landscape of Investment Indian Capital Markets World markets and various indices Risk and Return in Investment

Introduction to the landscape of Investment

Investment
Investment refers to the purchasing of securities or other financial assets from the capital market. It also means buying money market or real properties with high market liquidity. Some examples are gold, silver, real properties, and deposits.

Introduction of Investment
Financial investments are in stocks, bonds, and other types of security. Indirect financial investments can also be done with the help of mediators or third parties, such as pension funds, mutual funds, commercial banks, and insurance companies.

Modes of Investment
A. Security forms of Investment 1. 2. 3. 4. Corporate Bonds/Debentures Public Sector Bonds Preference Shares Equity Shares

Modes of Investment
B. Non-Security Forms of Investment 1. 2. 3. 4. 5. 6. 7. National Savings Scheme National Savings Certificates Provident Funds Corporate Fixed Deposits Life Insurance Policies Unit Schemes Post Savings Bank Accounts

Characteristics of Investment
Risk Return Safety Liquidity Marketability

Portfolio Management
Portfolios are combinations of assets held by the investors. Selection of such securities that would fit in well with the assets preferences, needs and choice of the investors.

Investment Alternatives
Real Estate Gold Shares Mutual Funds Bonds Fixed Deposits Insurance/ ULIP

Real Estate
Commercial Real Estate: Commercial real estate involves a real estate investment in properties for commercial purposes such as renting. Residential Real Estate: This is the most basic type of real estate investment, which involves buying houses as real estate properties.

Gold
Gold ETFs allow investment in gold in small denominations, which makes it easier for the retail investor to participate.

Physical Gold

Shares
Investment in Stock market for long term, trading with margins or doing short sales

Mutual Funds
passed back to

Investor

Pool their money with

Returns
Generates

Fund Manger
Invest In

Securities

Mutual Funds
A professionally managed type of collective investment scheme that pools money from many investors and invests it in stocks, bonds, short-term money market instruments, and/or other securities.

Bonds / Fixed Deposits

A fixed deposit account allows to deposit money for a set period of time, thereby earning a higher rate of interest in return.

Bonds are fixed interest bearing certificates issued by government or similar for a fixed period of time.

Insurance / ULIP
Unit linked Insurance plans provides safety for life as well as financial security for the old age, critical situations etc.

Stock Exchanges
Total stock exchanges -23 Regional Stock exchanges 21 NSE and BSE The over the counter Exchange of India (OTCEI) The Interconnected Stock Exchange of India (ICSE)

Players in the Market

1. 2. 3. 4. Merchant Bankers Registrars Collecting and Co-ordinating Bankers Underwriters and Brokers

Stock Market Intermediaries

1. 2. 3. 4. 5. Client Brokers Floor Brokers Jobbers and Market Makers Arbitraguers Badla Financiers

Primary Market
Primary Market New Issue Market

Public Issue through Prospectus

Private Placement

Offer of Sale

Rights Issue

Secondary Markets
1. Specified securities : Paid up capital 50 millions Market capitalization 100 millions 20000 shareholders 2. Non-Specified Securities 3. Permitted securities

Secondary Markets
Margin Payment 1. Scrip wise Margins 2. Turnover Margins 3. Adhoc Margins 4. Carry Forward Margins

The Process of Investment Trading

NSE Introduced a nation wide fully automated Screen Based Trading System (SBTS) BSE switched to fully automated trading on 14 march 1995, (known as BSE On Line Trading BOLT)

The Process of Investment Trading

NSE Member enter the price and shares he want to buy or sale Transaction gets executed as soon as the system finds matching sale or by order SBTS matches orders on strict price/time priority

The Process of Investment Trading

Delhi 11:05 Buy IOC @ 301 Pune 11:09 Buy IOC @ 300 Mumbai 11:08 Buy IOC @ 300 Agra 11:04 Buy IOC @ 302

Bhuj 11:00 Sell IOC @ 300

Goa 11:00 Sell IOC @ 301

The Process of Investment Trading

Trading in rolling settlement are settled on T + 2 basis
Activity Trading Clearing Rolling Settlement Trading Custodial Confirmation Delivery Generation Settlement Securities and Funds Pay in Day T T + 1 WD T + 1 WD T + 2 WD

Securities and Funds Pay out T + 2 WD

TYPES OF ORDERS

Types of Orders
1. Market Order Market orders are simply buy or sell orders that are to be executed immediately at current market price.

Types of Orders
2. Limit orders Investors specify prices at which they are willing to buy or sell a security. if the stock falls below the limit on a limit buy order then the trade is to be executed.

Limit Order Order Book

Buy Qty Buy Price Sell Price Sell Qty 300 237.25 237.70 400

100

237.20

237.90

100

200

237.15

238.00

200

500

237.10

238.20

500

Types of Orders
2. Limit orders
Condition Price Below the limit Price Above the Limit Limit Buy Order Buy Stop Loss Order Sell Limit Sell Order Stop-Buy Order

Types of Orders
2. Limit orders Investor placed a buy order for 50 shares of ABB at Rs. 345 as Limit buy order. If the price of ABB falls at 344.20, than the order is executed.

Types of Orders
3. Best orders Best orders are at the top of the list: the offers to buy at the lowest price and to sell at the highest price. The buy and sell orders at the top of the list Rs. 235 and Rs. 242

Types of Orders
4. Day Orders It expires at the close of the trading days. 5. Open or good till canceled Remain in force for up to 6 Months unless canceled by the customer

Types of Orders
6. Fill or Kill Orders expire if the broker cannot fill them immediately.

Margin Trading
The act of taking advantage of brokers loans is called buying on margins. In the US, the current margin requirement is 50% There may be for intra-day or weekly margin trading facility

Margin Trading
The percentage margin is defined as the ratio of the networth of the account to the market value of the securities.

Margin Trading
For 100 shares@100, If investors pay Rs. 6000 towards purchase of Rs. 10000, borrowing the remaining 4000 from the broker. The initial balance sheet looks like Assets Value 10000 Liability_____________ Loan from broker 4000 Equity trader 6000

Percentage of margin 60%

Margin Trading
If the stock price decline to Rs.70 per share, the account balance becomes: Assets Value 7000 Liability_____________ Margin 4000 Equity trader 3000

Percentage of margin 43%

Maintenance Margin
If the stock value fall below Rs.4000, equity would become negative. If margin falls below level, the broker will issue a Margin Call

Short Sales
A short sale allows investors to profit from a decline in a securitys price An investors borrows a share of stock from a borrower and sells it. Later the short seller must purchase the same stock in the market

 Consider the following Limit Order book of a specialist. The last trade in the stock took place at a price of Rs. 50
Limit Buy Orders Price Shares Limit Sell Orders Price Shares

49.75
49.50 49.25 49

500
800 500 200

50.25
51.50 52.75 53.25

100
100 300 100

If a market buy and market sell order for 100 shares comes in, at what price will it be filled? Would you desire to increase or decrease your inventory of this stock?

 Here is some price information

Shares Marriott Bid` 37.80 Asked 38.50

For Marriott, you have placed a stop-loss order to sell at Rs. 38. What are you telling your broker?

VARIOUS INDICES AND ITS CONSTRUCTION

World Markets
India Bombay Stock Exchange Limited: National Stock Exchange of India: United States American Stock Exchange Chicago Stock Exchange Nasdaq-Amex New York Stock Exchange

World Markets
Great Britain The London Stock Exchange

Japan Tokyo Stock Exchange (TSE):

NASDAQ
In 1971, the National Association of Securities Dealers Automated Quotation System (NASDAQ) began to offer immediate information on computer linked system of bid and asked prices for stocks offered by various dealers.

NASDAQ
Bid price is that at which a dealer is willing to purchase a security Asked price is that at which the dealers sell a security

NASDAQ
Nasdaq is divided into 2 sectors, 1. Nasdaq national market system 2. Nasdaq Small Cap Market

NASDAQ
Nasdaq has 3 levels of Subscribers I. Level I are not actively buying or selling security II. Level II tend to be brokerage firms III. Level III are making markets buying and selling stock actively

London Stock Exchange

Untill 1997, trading arrangements in London were similar to those on nasdaq. In 1997, LSE introduced an electronic trading system named SETS (Stock Exchage Electonic Trading Service).

Euronext
Euronext was formed in 2000 by a merger of the paris, Amsterdam and Brussels exchange. It uses an electronic trading system called NSC (New Quotation System)

Euronext
In 2001, it also purchased LIFFE, the London International Financial Futures and Options Exchange

Tokyo Stock Exchange (TSE)

TSE is the largest stock exchange in japan. A saitori maintains the operations of the stock exchange.

Tokyo Stock Exchange (TSE)

TSE organizes stock into two categories 1. The first sections consists of about 1200 of the most actively traded stock 2. Second section is for less actively traded stock.

Nifty - Sensex
It is constructed as a value-weighted index. Market capitalization of each stock is multiplied with a free float factor to arrive at the modified market capitalization of the stocks.

Nifty - Sensex
Total market cap of Infosys 59080 Cr Free float adjustment factor 0.8

Free float market cap of infosys = 59080 x 0.8 = 47264 cr.

Nifty - Sensex
Combine Free-float market cap of Sensex = 387067 Weight of infosys in sensex = 47264 = 12.21% 387067

 Types of Risk Real Return and Nominal Return

1. Systematic Risk 2. Unsystematic Risk

1. 2. 3. 4. 5.

Market Risk Interest Rate Risk Purchasing Power or Inflation Risk Credit Risk Economic Risk

1. 2. 3. 4.

Business Risk Financial Risk Management Risk Input Risk

 Portfolio Investors Portfolio are composed of diverse types of assets. Investing in an asset with a payoff pattern that offsets exposure to a particular source of risk is called Hedging.

 Portfolio Risk The risk that remains even after extensive diversification is called Portfolio risk. Such risk is also called systematic risk or non diversifiable risk.

 Portfolio Risk The risk that can be eliminated by diversification is called Unique risk or diversifiable risk

1. The supply funds from savers, primarily households 2. The demand for funds from businesses 3. The governments net supply or demand for funds as modified by actions of RBI.

 The growth rate of the money is known as Nominal rates of interest Suppose FD amount = 10000

FD rate of interest(Nominal)(R) = 10%

According to Nominal rates of Interest, interest amount received is 1000.

 The growth rate of the purchasing power is called real interest rate. Suppose rate of inflation (i) = 6%
Nominal rate of interest ( R) = 10%

Real rate (r) = 10 6

= 4%

 r =

1+R -1 1+I

r = Real Rate of Return R = Nominal rate of return I = Inflation Rate

Sum
X expects to earn a nominal rate of 10% with rate of inflation to be 6%, what is real rate of return he will earn

Sum
An equity share of Rs. 10 promises a dividend of 20% and it is expected that the price of the share rise from the current level of Rs. 60 to 80 in a year. Inflation rate is 14%, what is the real rate of return of the equity?

Expected Rate of Return

The expected rate of return is the weighted average of all possible returns multiplied by their respective probabilities

Expected Rate of Return

E(R) = Sum total of PiRi E (R) = Expected Return Pi = Probability of outcome Ri = Rate of Return

Expected Rate of Return

State of Economy Probability of growth Rate of Return

Boom

0.25

35

Normal Growth

0.50

20

Recession

0.25

10

R = Sum of RiPi E(R) = 8.75 + 10 + 2.5 = 21.25

Expected Return Equation

The formula for historical variance

Sum total ( R R)2 Pi

i

Ri = Possible return of the i year R = Expected rate of return Pi = Probability

Sum
Torent estimates the probability and the expected returns for the five observations
Probability 0.1 0.2 0.4 0.2 0.1

Possible Return

-10%

5%

20%

35%

50%

Portfolio Risk
Return on 2 Assets Move Together Covariance is Positive Risk is more on Portfolio

Returns Move Independently

Covariance is negative

Risk will be lower

Portfolio Risk
The covariance for portfolio risk = 1 Sum total ( Rx Rx) ( Ry Ry) N Rx = Return on Security X R = Expected rate of return N = Number of Observations

Portfolio Risk
Coeeficient of correlation of x and y are Y xy= Cov x y

xy

Portfolio Risk
Return I. Stock X I. Stock Y II. Stock X II. Stock Y 7 13 11 5 Expected Return 9 9 9 9 Variance -2 +4 +2 -4

Power of Diversification
Diversification into many more securities, continues to spread out exposure to firm-specific factors and portfolio volatility should continue to fall.

Power of Diversification
Portfolio risk does fall with diversification. However even extensive diversification cannot eliminate risk.

Power of Diversification
Finding by Obaidullah The total risk of an individual stock is on average 11.7%. It falls to about 9.5% when a second stock is added to create a two-stock portfolio.

Power of Diversification
Stock TCS Adani Quantity 100 100 Purchase price 550 900 Low Price 500 850 High Price 610 1000

Return @ Low price = Total Purchase price Risk at Low price

1,45,000 1,35,000 = 10000

Risk of Return Loss = (- 6.8%) Return @ High Price = Profit at High price - Total Purchase price 1,61,000 1,45,000 = 10000

Power of Diversification
Stock TCS Adani RPL Ultratech Quantity 100 100 100 100 Purchase price 550 900 900 400 Low Price 500 850 880 380

Return @ Low price = Total Purchase price Risk at Low price 2,75,000 2,61,000 = 14000

Risk of Loss = (- 5.09 %)

Power of Diversification
Average Portfolio Risk 50 40 30 20

10
0 10 20 30 40 50

Number of Stock in Portfolio

REVISION

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