INTRODUCTION SECURITY ANALYSIS: The term investment is a word of many meanings. The investment refers to net additions to the capital stock of the community. Investment decision is a part of our economic life. Everybody takes such decisions in different context and at different times. The investor deploys money in specific investment channels with the objective of better returns. The investor has various alternative investment avenues. Savings are invested in assets depending on their risky. An intelligent investor with skills of management can reduce the risk and maximize returns. CONCEPT OF SECURITY ANALYSIS : Security analysis refers to the analysis of trading securities. It analyses the share price returns and the risk involved in the investment. Every investment involves the risk and the expected return is related to risk. The security analysis will help in understanding 1
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
INTRODUCTION
SECURITY ANALYSIS:
The term investment is a word of many meanings. The investment refers to
net additions to the capital stock of the community. Investment decision is a part of
our economic life. Everybody takes such decisions in different context and at
different times. The investor deploys money in specific investment channels with the
objective of better returns. The investor has various alternative investment avenues.
Savings are invested in assets depending on their risky. An intelligent investor with
skills of management can reduce the risk and maximize returns.
CONCEPT OF SECURITY ANALYSIS:
Security analysis refers to the analysis of trading securities. It analyses the
share price returns and the risk involved in the investment. Every investment
involves the risk and the expected return is related to risk. The security analysis will
help in understanding the behavior of security prices, market and decision making
for investment. If the analysis includes scrip the analysis of a market with various
securities it is known as macro picture of the behavior of the market. The entire
process of estimating return and risk of a security is known as security analysis.
This traditional investment analysis when applied to securities emphasizes the
projection of prices ad dividends are known as security analysis. It involves the
potential price of a share and future dividend stream is forecast, then discounted
back to the present value. Such value is called as ‘’intrinsic value’’. Then the
intrinsic value is compared with the securities market price, If the current market
price is lower than the intrinsic value, then purchase is recommended. Further, the
1
security analysis is built around the idea that investors are concerned with two
principal properties inherent in securities, the return that can be expected from
holding a security, and risk that is achieved will be less than the return that was
expected.
Generally, the investors are interested primarily in selling a security for more than
they pay for it. The investor hopes to achieve a higher reward than simply placing
the money in a saving account. An investor who seeks reward that exceeds those
available on savings account forces the real risk. There is no return without risk. The
process of estimating return and risk for individual securities is known as ‘’security
analysis’’. Security analysis is the essence of valuation of financial instruments. The
value of financial asset depends upon their return and risk. The universal fact is that
everyone must recognize the risk component in risk situation
OBJECTIVES OF SECURITY ANALYSIS:
The following are the objectives of security analysis:
1. To estimate the risk and return related to a particular security.
2. To find out the intrinsic value of the security with a view to make a buy/sell
decision
3. To identify the under valued securities to buy or over value securities to sell.
4. To analyze the stock market trends to understand the stock market pattern
and behavior.
5. To forecast the future earning and dividends along with the price of the
securities.
6. To find out the key determinants of the intrinsic value.
7. To analyse and point out the position of economy industry and the company
with a view to select the possible company for investment.
2
APPROACHES TO SECURITY ANALYSIS:
The security analysis aimed at identifying under securities to buy and over
valued securities to sell. It involves the entire process of estimating return and risk
for an individual security.
It is deeply rooted in fundamental concepts to measure the risk and return of
security. It emphasizes on the return and risk estimates rather than mere price and
dividend estimates. However, the return and risk estimates are dependent on share
prices and accompanying dividend stream.
Any forecast of security must necessarily consider the prospects of the
economy. The economic sets greatly influence the prospects of certain industries as
well as the psychological aspect of investing public.
The approaches for security analysis are broadly grouped into the following
categories.
1) Fundamental analysis
2) Technical analysis
3) Efficient market hypothesis.
1) FUNDAMENTAL ANALYSIS :
The first major analysis of securities analysis is the fundamental analysis. A
Fundamental analysis is a time honored value based approach depending. Upon a
careful assessment of the fundamental of an economy, industry and the company.
The fundamental analysis studies the general economic situation makes an
evaluation of an industry and finally does an in-depth analysis of both financial and
the non financials of the company of choice. The fundamental analysis is aimed at
3
analyzing the various fundamentals or basic factors that effect the risk return of the
securities. The fundamental analysis involves the analysis of the following:
A) THE ECONOMIC ANALYSIS
B) THE INDUSTRY ANALYSIS
C) THE COMPANY ANALYSIS
A) THE ECONOMIC ANALYSIS:
In the economic analysis the investor has to analyse the economic factor to
forecast of the economy in order to identify the growth of the economy and its trend.
Further based on the economic analysis the investor will identify the industry groups
which are promising in the coming years in order to choose the best company in
such industry group. The economic analysis provides the investor to develop a
sound economic understand and be able to interpret the impact of important
economic indicators on the markets.
B) INDUSTRY ANALYSIS:
The object of the industry analysis is to assess the prospects of various
industrial groupings. The industry analysis helps to identify the industries with a
potential for future growth and to select companies from such industry to invest in
its securities. The industry analysis involves industry life cycle analysis, investment
implication, structure and characteristics of an industry.
C) THE COMPANY ANALYSIS:
Company analysis is the last leg in the economy, industry and company analysis
sequence. The company analysis is a study of variable that influence the future of a
firm both qualitatively and quantitatively. The purpose of company analysis is to
know the intrinsic value of a share of a company.
4
2) THE TECHNICAL ANALYSIS :
As an approach to investment analysis, technical analysis is radically
different from fundamental analysis. The technical analysis is frequently used as a
supplement to fundamental analysis is, concerned with a critical study of the daily or
weekly price volume data of index comprising several shares. The technical analysis
analyses the buying and selling pressure, which govern the price trend. It helps the
investors to buy cheap and sell high, regardless of the type of company the investor
choose. The technical analysis complies a study of the market itself and not of the
various external factors which effect the market. According to technical analyst, all
relevant factors get gets reflected in the volume of the stock exchange transaction
and the level of the share prices
3) EFFICIENT MARKET HYPOTHSIS:
The efficient market hypothesis is also called as “RANDOM WALK
THEORY”. It is the extension of fundamental and technical analysis to equity
investment decisions. Efficient market theory says that no investors can out perform
the market for the simple reason that there are numerous knowledgeable analysts
and investors who would not allow the market price to deviate from the intrinsic
value due to their active buying and selling. Therefore the current market price
incorporates all fundamental information. According to “WILLIAM SHARPE” A
perfectly efficient market is one in which every security price equalizes market
value at all times. EUGEN FAMA expressed that “An efficient capital market is a
market that is efficient in processing in information. The prices of securities
observed at any time are based on “correct evaluation” of all information available
at that time. In an efficient market, prices fully reflect all available information.
The efficient market theory has the following three forms of efficiency:
5
1. Weak form of efficiency:
2. Prices reflect in all information found in the record of past prices and
volumes.
3. Semi-strong- form of efficiency:
4. Prices reflect not only all information found in the records of past and
volumes but also other publicity available information.
5. Strong form of efficiency:
6. Prices reflect all available information, public as well as private.
CONCEPT OF PORTFOLIO MANAGEMENT:
Portfolio is the collection of financial or real assets such as equity
shares, debentures, bonds, treasury, bills and property etc. in a more general sense
the term portfolio may be used synonymous with the expression “collection of
assets” which can even include physical assets (gold, silver, real estate, etc).
Portfolio means a collection of combination of financial assets (securities) such as
shares, debentures, government securities. Portfolios are a combination of assets.
Portfolio will consist of collection of securities. What is to be borne in mind is that,
in portfolio context, assets are held for investment purposes and not for consumption
purposes. These holding are the result of individual preferences and decisions of the
holders regarding risk and return an a host of other considerations.
Portfolio is the investment of funds in different securities in which the total
risk of the portfolio is minimized while expecting maximum return from it. Portfolio
management takes the ingredients of risk and returns for individual securities and
considers the mixing of these securities. The portfolio management in total includes
the planning, super vision, forming rationalism and conservatism involved in the
collection of securities to meet investor’s objectives. In entails choosing the one best
6
portfolio to suit the risk-return preferences of the investors. It also encompasses the
evaluation and revising the portfolio in view of changing risk, return and investors
risk preferences
STATEMENT OF THE PROBLEM
It is a service activity which is associated with providing quantitative
information primarily financial in nature and that which may needed for making
economic decisions regarding reasoned choice among different alternative course of
action. Financial management is a process of identifying management, accumulation
analysis, preparation, interpretation and communication of financial information to
plan evaluate and control. Financial management is that specialized function of
general management which is related to the procurement of finance and its effective
utilization for the achievement of the common goal of the organization.
Security Analysis refers to the analysis of trading securities. It analysis
the share price returns and the risk involved in the statement. The security analysis
aimed at identifying under valued securities to buy and over valued securities to sell.
With the reasonable review of the literature a thorough work in studying
the effective functioning of the Security analysis and Portfolio management in Inter-
connected Stock Exchange, is felt a necessary in the explained circumstances, it is
chosen for the studying in Inter-connected Stock Exchange, Hyderabad.
7
NEED FOR THE STUDY :
The investor today is looking at investing in securities, which would
give him better returns that an ordinary savings bank account or fixed deposits
though at a certain amount of risk. Every person save money by post poning
consumption because future is uncertain. So, they have to search out for efficient
opportunities. Due to fast changing development in economic and industries
scenario improving the performance of the organization is essential. As a result
undertaking an academic study on Security Analysis and Portfolio Management will
be a welcome step. This study will be defiantly help full in achieving the
organization effectiveness.
OBJECTIVES:
1) To study the investment pattern and it’s related risks and returns.
2) To understand, analyze and select the best Portfolio.
3) To find out the intrinsic value of security with a view to make a buy/ sell
decision.
HYPOTHESIS:
1) Effective Security Analysis and Portfolio Management have a bearing on
company.
2) Effective Security Analysis and Portfolio Management contribute to increase
the efficiency of the company.
SCOPE:
Even though there are number of techniques for Portfolio analysis,
Markowitz Model has been choosing for the analysis. The scope of study has
been restricted to Hyderabad Stock Exchange. SEBI role and guidelines has been
8
covered study, at large Indian stock market tendencies also has been considered
in the study.
METHODOLOGY
In attempting to pursue this research study topic qualitative as well as
quantitative approaches are undertaken.
Sources of Information:-
Both primary and secondary data were gathered and utilized for the study of
Security Analysis and Portfolio Management.
The statements cover the aspects of Security Analysis and Portfolio
Management the and associated issues. Personal interviews are taken with
respondents to strengthen the information.
Data collection tools, to obtain the data for the purpose of present study the
following tools used;
a) The data has been collected through HSE staff, the project guide and stock
brokers.
b) The data has been collected through journals, news papers and internet.
Data analysis are analyzed using basic parametric techniques such as percentages
and averages etc, where ever they are required.
LIMITATIONS OF THE STUDY:
1) Limited access to company information.
2) Detailed study of the topic was not possible due to limited size of the project.
9
REVIEW OF LITERATURE
The securities available to an investor for investment are numerous and of
various types. The shares of over 7000 companies are listed in the stock exchanges
of the country. Traditionally, the securities were classified into ownership securities
such as equity shares and preference shares and creditorship security such as
debentures and Bonbs.Recently a number of new securities with innovative features
are being issued by companies to raise funds for their projects.
Securities analysis is the initial phase of the portfolio management process.
This step consists of examining the risk-return characteristics of individual
securities. A basic strategy in securities investment is to buy under priced securities
and sell over priced securities.
There are two alternative approaches to security analysis, namely,
fundamental analysis and technical analysis. They are based on different premises
and follow different techniques fundamental analysis, the order of the two
approaches, concentrates on the fundamental factors affecting the company such as
the EPS of the company the dividend pay-out ratio, the competition faced by the
company, the market share, quality of management,etc
According to this approach, the share price of a company is determined by
these fundamental factors. The fundamental analyst works out the true worth or
intrinsic value of a security based on its fundamentals: if the current market price is
higher than the intrinsic value, the share is set to be over priced and vice versa.
Fundamental analysis helps to identify fundamentally strong companies
whose share are worthy to be included in the investor’s portfolio.
10
The alternative approach to security analysis is Technical analysis. The
technical analyst believes that share price movements are systematic and exhibit
certain consistent patterns. He there fore studies past movements in the prices of
shares to identify trends and patterns. He then tries to predict the future piece
movements. Technical analysis is an approach which concentrates on price
movements and ignores the fundamentals of the shares.
A more recent approach to security analysis is the efficient market
hypothesis according to the school of thought; the financial market is efficient in
pricing securities. The efficient market hypothesis holds the market prices
instantaneously and fully reflect all relevant available information. It means that the
market prices of securities will always equal its intrinsic value.
Efficient market hypothesis is a direct repudiation of both fundamental
analysis and technical analysis. An investor cannot consistently earn abnormal
returns by undertaking fundamental analysis or technical analysis. According to
efficient market hypothesis it is possible for an investor to earn normal returns by
normally choosing securities of a given risk level.
In literature Beinhocker say that evaluation provide a powerful and effective
recipe for salving problems and creating strategies in an predictable environment.
Fitness landscapes demonstrates how evolutionary search creates robustness and
adaptability through constant experimentation, parallel search , and mix of adaptive
walks and long jumps .by creating and cultivating evolving portfolios of strategies,
managers can make it more likely that there company will stay out of the strategy
wilderness and enjoy the high fitness peaks.
In view of Korczak adopts a different approach in the portfolio optimization
problem. He identified problems trading rules in stock market using genetic
11
algorithms. Technical analysis assumes that future trends can be identified as a
more or less complicated function of past prices. Using a trade rule is a practical
way of identifying trends, which, in terms generate buying, and selling signals. on
the basis of past prices, each rule generates a signal: to sell, to hold, or to buy. To
ensure simplicity in the computing these decision.
In literature of Vieire, he is present a method for finding the optimal portfolio using
genetic algorithm matching the parameters defined by the analyst and the desired
beta of the portfolio. The analysis done by using functions that provides the most
important information on the financial health of a company. In this work, the
parameter used for the analysis is the following indices: current ration, quick ratio
and market value/ patrimony value. Binary codification is used to represent the
portfolio. The representation not only includes the share held in the portfolio, but
also it is proportion. The implementation was run for more than 4000 generations
and the fitness the value reached very close to the maximum.
In view of M.Sitaram Venugopal, S.Subramanian and U.S.Rao the
dynamic portfolio consisting of both debt and equity that has been selected for each
month for out performed the Sensex throughout the testing period. In addition, it
also dynamically switches from debt to equity during bull phase and vice versa in
bear phase automatically. thus the model is able to identify the portfolio of equity
and debt securities mix dynamically without human intervention and obtain
consistently good results in both phases. It could used by investors-both individual
and institutional for decision making.
12
PROFILE OF INTER-CONNECTED STOCK EXCHANGE
13
INTRODUCTION
Inter-connected stock exchange of India limited [ISE] has been promoted by 14 Regional
stock exchanges to provide cost-effective trading linkage/connectivity to all the members
of the participating Exchanges, with the objective of widening the market for the securities
listed on these Exchanges. ISE aims to address the needs of small companies and retail
investors with the guiding principle of optimizing the existing infrastructure and
harnessing the potential of regional markets, so as to transform these into a liquid and
vibrant market through the use of state-of-the-art technology and networking.
The participating Exchanges of ISE in all about 4500 stock brokers, out of
which more than 200 have been currently registered as traders on ISE. In order to leverage
its infrastructure and to expand its nationwide reach, ISE has also appointed around 450
Dealers across 70 cities other than the participating Exchange centers. These dealers are
administratively supported through the regional offices of ISE at Delhi [north], kolkata
[east], Coimbatore, Hyderabad [south] and Nagpur [central], besides Mumbai.
ISE has also floated a wholly-owned subsidiary, ISE securities and services
limited [ISS], which has taken up corporate membership of the National Stock Exchange
of India Ltd. [NSE] in both the Capital Market and Futures and Options segments and The
Stock Exchange, Mumbai In the Equities segment, so that the traders and dealers of ISE
can access other markets in addition to the ISE markets and their local market. ISE thus
provides the investors in smaller cities a one-stop solution for cost-effective and efficient
trading and settlement in securities.
With the objective of broad basing the range of its services, ISE has started
offering the full suite of DP facilities to its Traders, Dealers and their clients.
14
OBJECTIVES:
1. Create a single integrated national level solution with access to multiple markets
for providing high cost-effective service to millions of investors across the country.
2. Create a liquid and vibrant national level market for all listed companies in general
and small capital companies in particular.
3. Optimally utilize the existing infrastructure and other resources of participating
Stock Exchanges, which are under-utilized now.
4. Provide a level playing field to small Traders and Dealers by offering an
opportunity to participate in a national markets having investment-oriented
business.
5. Reduce transaction cost.
6. Provide clearing and settlement facilities to the Traders and Dealers across the
Country at their doorstep in a decentralized mode.
7. Spread demat trading across the country
METHODOLOGY OF THE STUDY
OBJECTIVES OF THE STUDY:
The objectives of the study are as follows:
To know the on-line screen based trading system adopted by ISE and about its
communication facilities for the appropriate configuration to set network. This
would link the ISE to individual brokers/members.
To study about the back up measures with respect to primary communication
facilities, in order to achieve network availability and connectivity back-up
options.
Study about Clearing & Settlements in the stock exchanges for easy transfer and
error prone system. Also study about computerization demand process.
To know about the settlement procedure involved in ISE and also NSDL
operations.
Clearing defining each and every term of the stock exchange trading procedures.
SCOPE OF STUDY:
15
The scope of the project is to study and know about Online Trading and
Clearing & Settlements dealt in Inter-Connected Stock Exchange.
By studying the Online Trading and Clearing & Settlements, a clear option of
dealing in stock exchange is been Understood. Unlike olden days the concept of trading
manually is been replaced for fast interaction of shares of shareholder. By this we can
access anywhere and know the present dealings in shares.
DATA COLLECTION METHODS
The data collection methods include both the primary and secondary collection methods.
Primary collection methods : This method includes the data collection from the
personal discussion with the authorized clerks and members of the exchange.
Secondary collection methods: The secondary collection methods includes the
lectures of the superintend of the department of market operations and so on., also
the data collected from the news, magazines of the ISE and different books issues
of this study
LIMITATIONS OF THE STUDY
The study confines to the past 2-3 years and present system of the trading procedure in the
ISE and the study is confined to the coverage of all the related issues in brief. The data is
collected from the primary and secondary sources and thus is subject to slight variation
than what the study includes in reality.
Hence accuracy and correctness can be measured only to the extend of what the sample
group has furnished.
SAILENT FEATURES
Network of intermediaries:
16
As at the beginning of the financial year 2003-04, 548 intermediaries (207
Traders and 341 Dealers) are registered on ISE. A broad of members forms the bedrock
for any Exchange, and in this respect, ISE has a large pool of registered intermediaries
who can be tapped for any new line of business.
Robust Operational Systems:
The trading, settlement and funds transfer operations of ISE and ISS are
completely automated and state-of-the-art systems have been deployed. The
communication network of ISE, which has connectivity with over 400 trading members
and is spread across46 cities, is also used for supporting the operations of ISS. The trading
software and settlement software, as well as the electronic funds transfer arrangement
established with HDFC Bank and ICICI Bank, gives ISE and ISS the required operational
efficiency and flexibility to not only handle the secondary market functions effectively,
but also by leveraging them for new ventures.
Skilled and experienced manpower:
ISE and ISS have experienced and professional staff, who have wide
experience in Stock Exchanges/ capital market institutions, with in some cases, the
experience going up to nearly twenty years in this industry. The staff has the skill-set
required to perform a wide range of functions, depending upon the requirements from time
to time.
Aggressive pricing policy
The philosophy of ISE is to have an aggressive pricing policy for the various
products and services offered by it. The aim is to penetrate the retail market and strengthen
the position, so that a wide variety of products and services having appeal for the retail
market can be offered using a common distribution channel. The aggressive pricing policy
also ensures that the intermediaries have sufficient financial incentives for offering these
products and services to the end-clients.
Trading, Risk Management and Settlement Software Systems:
17
The ORBIT (Online Regional Bourses Inter-connected Trading) and AXIS
(Automated Exchange Integrated Settlement) software developed on the Microsoft NT
platform, with consultancy assistance from Microsoft, are the most contemporary of the
trading and settlement software introduced in the country. The applications have been built
on a technology platform, which offers low cost of ownership, facilitates simple
maintenance and supports easy up gradation and enhancement. The soft wares are so
designed that the transaction processing capacity depends on the hardware used; capacity
can be added by just adding inexpensive hardware, without any additional software work.
Vibrant Subsidiary Operations:
ISS, the wholly owned subsidiary of ISE, is one of the biggest Exchange
subsidiaries in the country. On any given day, more than 250 registered intermediaries of
ISS traded from 46 cities across the length and breadth of the country.
1. Prof. P. V. Narasimham Public Interest Director
2. Shri V. Shankar Managing Director
3. Dr. S. D. Israni Public Interest Director
4. Dr. M. Y. Khan Public Interest Director
5. Mr. P. J. Mathew Shareholder Director
6. M. C. Rodrigues Shareholder Director
7. Mr. M. K. Ananda Kumar Shareholder Director
8. Mr. T.N.T Nayar Shareholder Director
9. Mr. K. D. Gupta Shareholder Director
10. Mr. V. R. Bhaskar Reddy Shareholder Director
11. Mr. Jambu Kumar Jain Trading Member Director
18
LIMITATIONS OF THE STUDY:
This study has been conducted purely to understand Portfolio Management for investors.
Construction of Portfolio is restricted to two companies based on Markowitz model.
Very few and randomly selected scripts / companies are analysed from BSE listings.
Data collection was strictly confined to secondary source. No primary data is associated with the project.
Detailed study of the topic was not possible due to limited size of the project.
There was a constraint with regard to time allocation for the research study i.e. for a period of two months.
19
PORTFOLIO MANAGEMENT PROCESS
Portfolio management is a complex activity which may be broken down into
following steps;
1) Specification of investment objectives and constraints;
The typical objectives sought by investors are current income,
capital appreciation, and safety of principal. The relative importance of these
objectives should be specified. Further, the constraints arising from liquidity, tome
horizon, tax, and special circumstances must be identified.
2) choice of asset mix:
The most important decision in portfolio management is the
asset mix Decision. Very broadly, this is concerned with the proportions of ‘stocks’
(equity shares and units / shares of equity // oriented mutual funds) and ‘bonds’
(fixed income investment vechiles in general) in the portfolio. The appropriate
‘stock bond’ mix depends mainly on the risk tolerance and investment tolerance
horizon of the investor.
3) Formulation of portfolio strategy:
Once a certain asset mix is chosen, an appropriate portfolio
strategy has to be hammered out. Two broad choices are available: an active
portfolio strategy or a passive portfolio strategy. An active portfolio strategy strives
to earn superior risk-adjusted returns by resorting to market timing, or sector
rotation, or security selection, or some combination of these. A passive portfolio
20
strategy, on the other hand involves holding a broadly diversified portfolio and
maintaining a pre-determined level of risk exposure.
4) Selection of securities
Generally, investors pursue an active stance with respect to
security selection. For stock selection, investors commonly go by fundamental
analysis and / or technical analysis. The factors that are considered in selecting
bonds (or fixed income instruments) are yield to maturity, credit rating, term to
maturity, tax shelter, and liquidity.
5) Portfolio execution:
This is the phase of portfolio management which is concerned with
implementing the portfolio plan by buying and/ or selling specified securities in
given amounts. Though often glossed over in portfolio management discussions, this
is an important practices step that has a bearing on investment results.
6) Portfolio revision:
The value of a portfolio as well as its composition the relative proportions of stock
and bond components may change as stocks and bonds fluctuate. Of course the
fluctutations of stocks is often the dominant factor underlying this change. In
response to such changes, periodic rebalancing of the portfolio is required. This
primarily involves a shift from stocks to bonds or vice versa. In addition, it may call
for sector rotation as well as security switches.
7) Performance evaluation:
The performance of a portfolio should be evaluated periodically. The key
dimensions of portfolio performance return are commensurate with its risk exposure.
21
Such a review may provide useful feedback to improve the quality of the portfolio
management process on a continuing basis.
Sources of investment risk:
As an investor you are exposed to may variety of risks. Among these there are three
major ones: business risk, interest rate risk. While a detailed discussion of these is
woven in the entire book, at this juncture a brief idea may be given.
1) Business risk:
As a holder of corporate securities (equity shares or debentures), you are
exposed to the risk of poor business performance. This may be caused by a variety
of factors like heightened competition, emergence of new technologies,
development of substitute products, shifts in consumer preferences. Inadequate
supply of essential inputs, changes in government policies, and so on. Often, of
course, the principal factor may be inept and in component management. The poor
business performance definitely affects the interest of share holders, who have a
residual claim on the income and wealth of the firm. It can also affect the interest of
debenture holders if the ability of the firm to meet its interest and principal interest
payment obligation is impaired. In such a case, debenture holders face the prospect
of default risk.
2) Interest rate risk:
The changes in interest have a bearing on the welfare of the investors. As the
interest rate goes up., the market price of existing fixed income securities falls, and
vice versa. This happens because the buyer of a fixed income security would not buy
it at its par value of share value if its fixed interest rate ids lower than the prevailing
22
rate interest rate on a similar security. For example, a debenture that has a face value
of Rs 100anda fixed rate of 12% will sell at discount if the interest rate moves up,
say, 12% to 14%. While changes in interest rate will have a direct bearing on the
prices of fixed income securities, they affect equity prices too, albeit some what
indirectly. The changes in the relative yields of debentures and equity shares
influence equity prices.
3) Market risk:
Even if the power of the corporate sector and the interest rate structure remain
more or less unchanged, prices of securities, equity shares in particular, tend to
fluctuates. While there can be several reasons for fluctuation, the main cause appears
to be the changing psychology of the investors. There are periods when investors
become bullish and their investments horizons lengthen. Investor optimism, which
may border on euphoria, during such periods drives share prices to great heights.
The buoyancy created in the wake of this development is pervasive, affecting all
most ass the shares. On the others hand, when a wave of pessimism (which often is
an exaggerated response to some unfavorable political or economic development)
sweeps the market, investors turn bearish and myopic prices of all most all equity
shares register as decline as fear and uncertainly pervade the market. The market
tends to move in cycles. As john says: “you need to get deeply in to your bones the
sense that any market, and certainly the stock market, moves in cycles, so that you
will infallibly wonderful bargains every few years, and have a chance to sell again at
ridiculously high prices a few years later.”
The cycles are caused by mass psychology. As john train explains:
“the ebb and flow of mass emotion quite regular: panic is followed by relief, and
relief by optimism; then comes enthusiasm, then euphoria and rapture, then the
23
bubble bursts, and public feeling slides off again into concern, desperation ,and
finally a new panic.” One would expect large participation of institutions to dampen
the price fluctuations in the market. After all institutional investors have core
professional expertise to de fundamental analysis and greater financial resources to
act on fundamental analysis. However nothing of this kind has happened. On the
contrary, price fluctuation seen to have become wider after the arrival of the
institutional investors in larger numbers. Why? Perhaps the institutions and their
analysis have not displayed more presence and rationality than the general investing
public and have succumbed in equal measure to the temptation to the speculation.
As john Maynard Kenyes has argued, factors that contribute to the volatility of the
market are not likely to diminish when expert professionals possessing best
judgement and knowledge compete in the market place. Why? According to Kenyes,
even these people are concerned with speculation (the activity of forecasting the
psychology of the market) and not the enterprise (the activity of forecasting the
prospective yield of assets over their whole life).
PORTFOLIO THEORY THE BUSINESS OF DIVERSIFICATION:
Very broadly speaking the investment process consists of two types. The first task is
security analysis which focuses on assessing the risk and risk returns characteristic
of the available investment vehicles. The second task is portfolio selection, which
involves portfolio selection, which involves choosing the best portfolio from the set
of feasible portfolios.
We begin our discussion with the second task with the help of portfolio theory.
Portfolio theory, originally proposed by ‘’HARRY MARKOEITZ’’ in the 1950s,
was the first formal attempt to quantify the risk of aportfolio and develop a
24
methodology for determining the optimal portfolio. Prior to the development of
portfolio theory, investors dealt with the concepts of return and risk somewhat
loosely. Intuitively smart investors knew the benefit of diversification which is
reflected in the traditional adage: ‘’do not put all your eggs in one basket. ‘’HARRY
MARKOWITY’’ was the first person to show quantitively why and how
diversification reduces risk. In recongnition of his seminal contribution in the field
was awarded the Nobel prize in Economic in 1990.
PORTFOLIO RETURNS:
Measuring actual portfolio return
The actual (or realized) return of a portfolio of assets over some specific time period
is calculated as follows:
Rp = W1R1+W2R2+.......Wn Rn
Where Rp = rate on return on portfolio
Ri = rate on return of assest I (I = 1,….n)
Wi = weight of assest i in the portfolio ( I =1,….n)
N = number of assests in the portfolio
Equation can be expressed succinctly as follows:
Rp = ∑ Wi Ri
Equation (2) says that return on a portfolio of assests is equal to the weighted
average of the returns on various assests on the portfolio.
25
n
i = 1
For example consider a portfolio consisting of five assests: