UNIT-2

SECURITIES ANALYSIS

Contents:
Analysis of variable income securities, fundamental analysis – analysis of economy, industry
analysis, company analysis – financial and non – financial, Equity valuation models, Options,
futures, forwards, warrants, and their valuations, Technical analysis – Dow’s theory, charts –
Efficient market hypothesis and its implications, Tax aspects of investment, Securities
Trading procedure. A Critical Survey of software packages for security analysis.

INTRODUCTION TO VARIABLE INCOME SECURITIES

The term variable-income security refers to investments that provide their owners with a rate
of return that is dynamic and determined by market forces. It provides investors with both
greater risks as well as rewards. It is also known as variable-rate securities, are typically
valued by investors looking for higher returns than those offered by fixed-income securities.
For instance: Common stock (Equity shares), which can offer investors virtually unlimited
up-side growth as well as the complete loss of principal. In exchange for this risk, investors
in these securities demand higher returns than their fixed-income counterparts.
• Security analysis is the basis for rational investment decisions.
• If a security’s estimated value is above the market price, the security analyst will
recommend buying the stock and vice-versa.

Analysis of Variable Income Securities

Active portfolio managers undertake different types of analysis to select outperforming
equities for the portfolios they manage. The two extremes approaches are:
1. Fundamental analysis; and
2. Technical Analysis

FUNDAMENTAL ANALYSIS
Fundamental analysis focuses on the economic strengths & weaknesses of the market and on
the individual features of the stocks within the market. This is primarily concerned with
determining the intrinsic value or true value of a security.
It is to evaluate lot information about the past performance and the expected future
performance of companies, industries and the economy as a whole before taking the
investment decision. Such evaluation or analysis is called fundamental analysis. This analysis
is really a logical and systematic approach to estimating the future dividends and share price.
Fundamental analysis is performed on historical and present data, but with the goal of making
financial forecasts.

Objectives of Fundamental Analysis

1. To conduct company’s stock evaluation and to identify the under-priced and over-
priced securities.
2. To make a projection on its business performance in the long run.
3. To evaluate its management and make internal investment decisions.
4. To calculate its risk to beat the market.

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 FUNDAMENTAL ANALYSIS FRAMEWORK OR EIC FRAMEWORK
A basic assumption of Fundamental Analysis is that intrinsic value and market price can
differ from time to time. Those investors, who can perform good fundamental analysis & spot
discrepancies between market price and intrinsic value, are able to realize profits by taking
suitable decisions before the discrepancy is eliminated by the market. According to
Grahamand Dodd, “Intrinsic Value of a security is that value which is justified by the facts
e.g. assets, earnings, dividends, definite prospects including the factor of management of the
company.”
Fundamental analysis uses two types of approaches:
1. Top down Approach, and
2. Bottom Up Approach

The top-down investor starts their analysis with global economics, including both
international and national economic indicators. These may include GDP growth rates,
inflation, interest rates, exchange rates, productivity, and energy prices. They subsequently
narrow their search to regional/ industry analysis of total sales, price levels, the effects of
competing products, foreign competition, and entry or exit from the industry. Only then do
they refine their search to the best business in the area being studied.
The bottom-up investor starts with specific businesses, regardless of their industry/region,
and proceeds in reverse of the top-down approach.
Economic Analysis:

(I) ECONOMIC ANALYSIS:

The status of economic activity has a major impact on overall stock prices. Four stages of
economy or economic cycle i.e. depression, recovery, boom and recovery of economy of
nation also impact on security performance.

 Depression: At this stage demand is low and declining inflation often high and so are
interest rate, companies usually reduce activities and securities performance is poor.
 Recovery: Economy begins to revive after depression, demand pick up leading,
production and activities increase.
 Boom: High demand with high investment and production, companies earn more
profit.
 Recession: Companies slowly begins downturn in demand, production and
employment, profits are also decline.

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The performance of a company depends much on the performance of the economy if the
economy is in Boom, the industries and companies in general said to be prosperous. On the
other hand, if the economy is in Recession, the performance of companies will be generally
poor.
Key economic variables that an investor must monitor as a part of the fundamental
analysis: the analysis of macroeconomic environment is essential to understand the
behaviour of the stock prices. The commonly analyzed macro-economic factors are as
follows:
1. GNP/GDP: GNP (Gross national product), NNP (Net national product) and GDP
(Gross domestic product) are the different measures of the total income or total
economic output of the country as a whole. The growth rates of these measures
indicate the growth rate of the economy. The estimated growth rates are made
available by the government from time to time. An economy typically passes through
different phases of prosperity known as the different stages of the economic or
business cycle.
2. Savings & Investment: Stock Market is a channel through which the savings of the
investors are made available to the corporate bodies. Savings are distributed over
various assets like equity shares, deposits, mutual fund units, real estate and bullion.
The savings and investment patterns of the public affect the stock to a great extent.
3. Inflation: Inflation prevailing in the economy has considered impact on the
performance of companies. Higher rates of inflation upset business planes, lead to
cost escalation and result in a squeeze on profit margins. On the other hand inflation
leads to erosion of purchasing power in the hands of consumers. This will result lower
demand for products. Thus higher inflation in an economy are likely to affect the
performance of companies adversely. Industries and companies prosper during times
of low inflation
4. Agriculture: agriculture is a major part of the Indian economy. Some companies are
using agricultural raw material as inputs and some others are supplying inputs to
agriculture. Hence, the increase/decrease in agricultural production has a significant
bearing on the industrial production & corporate performance.
5. Interest Rates: Interest rates determine the cost and availability of credit for
companies operating in an economy. A low interest rate stimulates investment by
making credit available easily and cheaply. Moreover it implies lower cost of finance
for a company which assures higher profitability. On the contrary, higher interest rates
result in higher cost of production which may lead to lower profitability and lower
demand. The interest rates in the organised financial sector of the economy are
determined by the monetary policy of the government and the trends in the money
supply.
6. Government Revenue, expenditure & deficits: As the government is the largest
investor and spender of money, the trends in government revenue, expenditure and
deficits have a signifying impact on the performance of industries and companies.
Expenditure by government stimulates the economy by creating jobs and generating
demand. Since a major portion of demand in the economy is generated by
government. spending, the nature of government spending is of great importance in
determining the fortunes of many an industry. However, when the government
expenditure exceeds its revenue, there occurs a fiscal deficit. All developing countries
suffer from fiscal deficits as government spend large amounts of money to build up
infrastructure.

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7. Political stability: A stable political environment is necessary for steady and
balanced growth. No industry or company can grow and prosper in the midst of
political turmoil. Stable long term economic policies are what needed for industrial
growth. Stable government with clear cut long term economic policies will be
conducive to good performance of the economy
8. Infrastructure: The development of an economy depends very much on the
infrastructure available. The availability of infrastructural facilities such as power,
transportation and communication systems affects the performance of companies. An
investor should assess the status of the infrastructural facilities available in the
economy before finalising his investment plans.
9. Monsoon: The Indian economy essentially an agrarian economy and agriculture
forms a very important sector of Indian economy. Because of the strong forward and
backward linkages between agriculture and industry, performance of several
companies and industries are dependent on the performance of agriculture. Moreover,
as agriculture incomes rise, the demand for industrial products and services will be
good and industry will prosper.
10. Exchange rates: The performance and profitability of industries and companies that
are major importers and exporters are considerably affected by the exchange rates of
the rupee against major currencies of the world. A depreciation of rupee improves the
competitive position of Indian products in foreign markets, thereby stimulating
exports. But it would also make imports more expensive. The exchange rates of the
rupee are influenced by the balance of trade deficit, the balance of payments deficit
and also the foreign exchange reserves of the country. The excess of imports over
exports is called balance of trade deficit.

Economic Forecasting
“Economic Forecasting is a process to find out the future return of an investment.”

 Short-term periods (up to 3 years)

 Intermediate-term periods (3 to 5 years)
 Long-term periods (more than 5 years)

Techniques of Economic Forecasting are as follows:

1. Anticipatory Surveys: Anticipatory surveys are the surveys of intentions of people in
government, business, trade and industry regarding their construction activities, plant
and machinery expenditures, level of inventory, etc. Such surveys may also include
the future plans of consumers with regards to their spending on durables and non-
durables. It is based on the results of these surveys; the analyst can form his own
forecast of the future state of the economy.

2. Barometric or Indicator Approach: In this approach, various types of indicators are

studied to find out how the economy is likely to perform in the future. There are three
indicators which are as follows:
a) Leading indicators: The leading indicators indicate what is going to happen in
the economy. It helps the investor to predict the path of the economy. The popular
leading indicators are the fiscal policy, monetary policy, productivity, rainfall,
capital investment and the stock indices.
b) Coincidental Indicators: The coincidental indicators indicate what the economy
is. The coincidental indicators are gross national product, industrial production,

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 interest rates and reserve funds. GDP is the aggregate amount of goods and
services produced in the national economy. The gap between the budgeted GDP
and the actual GDP attained indicates the present situation.
c) Lagging Indicators: These are time series data of variables that lag behind in
their consequences vis-a-vis the economy. Lagging indicators are identified as
unemployment rate, consumer price index and flow of foreign funds.

3. Economic Model Building Approach: i9n this approach, the forecaster makes use of
various independent and dependent variables.
a) He must specify the relationship between these variables.
b) Assumptions should be clearly stated.
c) It yields a definite forecast figure based on precisely stated factors.
d) Gives the direction and also the magnitude.

(II) INDUSTRY ANALYSIS:

“Industry is defined as a group of productive or profit making enterprises or organizations
that have a similar technically substitutable goods, services or sources of income.” It is the
second stage of fundamental analysis of investments. Industry analysis involves reviewing
the economic, political and market forces that influence the industry developments. It
evaluates the relative strengths or weaknesses of particular industry.
Industry analysis is a type of investment research that begins by focusing on the status of an
industry or an industrial sector. A form of fundamental analysis involving the process of
making investment decisions based on the different stages an industry is at during a given
point in time. The type of position taken will depend on firm specific characteristics, as well
as where the industry is at in its life cycle.

Industry life Cycle

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 1. Development stage: In this stage the boundaries and range are set and the product
development and designing are into inclining phase.
2. Introduction stage: It is the introduction stage for the process innovation for the
industry and designing of the product starts declining.
3. Growth stage: At this stage the industry is in the growing phase in terms of process
innovation and product development. The industry is so developed that new player
find it so difficult to enter and small player finds difficulty in surviving.
4. Maturity stage: the industry is relatively stable in terms of growth rate and no new
innovation and development happens in this stage. The products are at their stage of
utilization and no further scope is left to increase the profit.
5. Decline stage: At this stage profit starts declining and maintaining the efficiency in
terms process and product development is not possible.

Porter’s Five Force Model:

This is a framework for industry analysis & business strategy development by Michael E.
Porter

1. Supplier power: An assessment of how easy it is for suppliers to drive up prices.

This is driven by the: number of suppliers of each essential input; uniqueness of their
product or service; relative size and strength of the supplier; and cost of switching
from one supplier to another.
2. Buyer power: An assessment of how easy it is for buyers to drive prices down. This
is driven by the: number of buyers in the market; importance of each individual buyer
to the organisation; and cost to the buyer of switching from one supplier to another. If
a business has just a few powerful buyers, they are often able to dictate terms.

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 3. Competitive rivalry: The main driver is the number and capability of competitors in
the market. Many competitors, offering undifferentiated products and services, will
reduce market attractiveness.
4. Threat of substitution: Where close substitute products exist in a market, it increases
the likelihood of customers switching to alternatives in response to price increases.
This reduces both the power of suppliers and the attractiveness of the market.
5. Threat of new entry: Profitable markets attract new entrants, which erodes
profitability. Unless incumbents have strong and durable barriers to entry, for
example, patents, economies of scale, capital requirements or government policies,
then profitability will decline to a competitive rate.

Industry Characteristics or Components of Industry Analysis:

1. Demand supply gap: The demand for the product usually trends to change at a
steady rate, whereas the capacity to produce the product tends to change at irregular
intervals, depending upon the installation of additional production capacity. As result
an industry is likely to experience under supply and over supply of capacity at
different times. Excess supply reduces the profitability of the industry through a
decline in the unit price realization.
2. Competitive conditions in the industry: The level of competition among various
companies in an industry is determined by certain competitive forces. These
competitive forces are: barriers to entry, the threat of substitution, bargaining power
of the suppliers and the rivalry among competitors.
3. Permanence: Permanence is the phenomenon related to the products and the
technology used by the industry. If an analyst feels that the need for a particular
industry will vanish in a short period, or that the rapid technological changes would
render the products obsolete within short period of time, it would be foolish to invest
such industry.
4. Labour conditions: In our country the labour unions are very power full .if the
labour in a particular industry is rebellious and is inclined to resort to strikes
frequently, the prospects of that industry cannot become bright.
5. Attitude of government: The government may encourage certain industries and can
assist such industries through favorable legislation. On the contrary, the government
may look with disfavour on certain other industries .in India this has been the
experience of alcoholic drinks and cigarette industries.
6. Supply of raw materials: This is also one of the important factor determine the
profitability of an industry. Some industry may have no difficulty in obtaining the
major raw materials as they may be indigenously available in plenty. Other industries
may have to depend on a few manufactures within the country or on imports from
outside the country for their raw material supply.
7. Cost structure: The cost structure that is the fixed and variable cost, affect the cost of
production and profitability of the firm. The higher the fixed cost component, higher
is the sales volume necessary to achieve breakeven point. Conversely, the lower the
proportion of fixed cost relative to variable cost, lower would be the breakeven point
provides higher margin of safety.
8. Sales trends and Earnings Performance: For forecasting the future trends,
historical sales records & earnings performance plays a very crucial role. The analyst
from the observation of present or past factors will be able to judge the stability of the
performance in terms of sales, earnings as well as growth rates.

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 9. Technology: Technology keeps on changing. An investor must carefully view the
technological changes. If analyst feels that the need for a particular industry will
vanish in an extremely short period of time, it would be foolish to invest funds in such
industry. An investor must keep a check on product with frequent technological
changes for his future investment.

(III) COMPANY ANALYSIS:

Company analysis is the final stage of fundamental analysis. The economy analysis provides
the investor a broad outline of the prospects of growth in the economy, the industry analysis
helps the investor to select the industry in which investment would be rewarding. Now he has
to decide the company in which he should invest his money. In company analysis, the analyst
tries to forecast the future earnings of the company because there is a strong evidence that the
earnings have a direct and powerful effect upon share prices. The level, trend and stability of
earnings of a company, however depend upon a number of factors concerning the operations
of the company.

“Company Analysis is a method of assessing the competitive position of a firm, its earning
and profitability, the efficiency with which it operates its financial position and its future
aspects with respect to the earnings of its shareholders.”

Financial Indicators: Financial parameters used in the Company analysis are as follows:

1. Balance Sheet: The financial condition of the business concern can be finding out by
preparing balance sheet. The various items of Balance sheet for two different periods
are used. The assets are classified as current assets and fixed assets for comparison.
Likewise, the liabilities are classified as current liabilities, long term liabilities and
shareholders’ net worth. The term shareholders’ net worth includes Equity Share
Capital, Preference Share Capital, Reserves and Surplus and the like.
2. Profit and Loss Statement: A P&L is a financial statement that summarizes the
revenues, costs and expenses incurred during a specific period of time, usually a fiscal
quarter or year. These records provide information about a company's ability or lack
thereof to generate profit by increasing revenue, reducing costs, or both. The P&L
statement is also referred to as "statement of profit and loss", "income statement,"
"statement of operations," "statement of financial results," and "income and expense
statement."
3. Comparative Financial Statement Analysis (Horizontal Analysis): Comparative
analysis provides a year-on-year review of the various financial statements. For
example, in the Income Statement, the Sales figure may be compared over a period of
consecutive years to understand how the sales figures have grown (or declined) over
the year. It compares the internal performance of the company.
4. Common-size Financial Statement Analysis (Vertical Analysis): Vertical analysis
is also put to use for comparison across companies as financial statements are
converted to common-size format, which can then be used to compare with
competitor or industry averages, highlighting key differences which can then be
analyzed. For example, Operating Expenses, Depreciation, Amortization, Profit
before tax, Tax, Profit after tax, etc. may be represented as a percentage of Sales in
the Income Statement.
5. Ratio Analysis: Ratio analysis is the most widely used tool of financial statement
analysis. A ratio gives relationship between two numbers, in this case items in the

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 financial statements. Ratios are popular because they readily allow internal evaluation
as well as comparison across firms. The ratios are categorized according to activities
or functions they perform or the information they provide. For example, profitability
ratios measure the profit making capability of the company.
6. Fund Flow Analysis: Fund flow analysis deals with detailed sources and application
of funds of the business concern for a specific period. It indicates where funds come
from and how they are used during the period under review. It highlights the changes
in the financial structure of the company.
7. Cash Flow Analysis: Cash flow analysis is based on the movement of cash and bank
balances. In other words, the movement of cash instead of movement of working
capital would be considered in the cash flow analysis. There are two types of cash
flows, i.e; actual and notional cash flows.
8. Trend Analysis: Trend analysis is used to reveal the trend of items with the passage
of time and is generally used as a statistical tool. It is used in conjunction with ratio
analysis, horizontal and vertical analysis to spot a particular trend, explore the causes
of the same and if required prepare future projections.

Non-Financial Indicators: The investor should also analyze non-financial parameters as

well which are mention below:
1. Business of the Company: the investor should know whether the company is a well-
established one, whether it has a good product range.
2. Management: the quality of top management team, the competence and the
commitment of CEO matters a lot in shaping the destiny of the company.
3. Market Share of the Company: The market share should be substantial. The larger
the share, the better the prospects of controlling the market & profit margins and
expanding the operations.
4. Product Range: Progressive companies like HUL & ITC create competition for their
existing products by launching new products with regular frequency. Hence, investor
must examine the company.
5. Expansion Policy: the company’s Policy of expansion should be consistency and
have a long term perspective.
6. Diversification: the company must be well diversified into the areas of growth
potential. To reduce the degree of business risk and improve profitability.
7. Foreign Collaboration: Where a company has entered into technical collaboration
with the foreign company, the investor must find out more about the nature of the
collaboration agreement.
8. Research and Development: Progressive companies spent substantial sums of
money on R & D to upgrade their existing product.
9. Government Policy: The government. must assess the implications of governmental
regulations such as licensing, entry barriers, patent registrations etc.
10. New Millennium Trends: the sectors which come to limelight the new millennium
are knowledge based industries like IT, E-Commerce, Robotics, Multimedia, Satellite
telecommunications, Biotech etc…….

EQUITY VALUATION MODELS

The valuation of equity shares is relatively difficult as compared to the bonds or preferred
stock. The cash flows are certain because the rate of interest on bonds and dividend rate on
preference shares are known. The cash flows expected by investors on common stock are

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uncertain. The earnings and dividends on equity shares are expected to grow. However, to
determine the value of earning shares certain models are as follows:

A. Capitalization of Dividend (basic Capitalization models) and

B. Capitalization of Earnings

Valuation Models (Theory & Problems covered in Class)

1. One-period Valuation Model
2. Two-period Valuation Model
3. n-period Valuation Model
4. Dividend Valuation Models:-
a. No Growth Case
b. Constant Growth Case
c. Supernormal Growth
5. Earnings Capitalization Model
6. Rate of return on Equity Share

FINANCIAL DERIVATIVES

A derivative is a financial contract that derives its value from an underlying asset. The buyer
agrees to purchase the asset on a specific date at a specific price. The most common
underlying assets include stocks, bonds, commodities, foreign currencies, loans interest rates
and market indexes etc. Derivatives can be used for a number of purposes, including insuring
against price movements (hedging), increasing exposure to price movements for speculation
or getting access to otherwise hard-to-trade assets or markets.

Need of Derivatives: The derivatives market performs a number of economic functions.

They help in the following:
 Transferring risks
 Discovery of future as well as current prices
 Catalyzing entrepreneurial activity
 Increasing saving and investments in long run.
 Participants in Derivative markets

Participants in Derivative markets:

a) Hedgers use futures or options markets to reduce or eliminate the risk associated with
price of an asset.
b) Speculators use futures and options contracts to get extra leverage in betting on
future movements in the price of an asset.
c) Arbitrageurs are in business to take advantage of a discrepancy between prices in
two different markets.

Types of Financial Derivatives

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(A) FORWARD CONTRACT:
Forward Contract is a contract between two parties to buy or sell an Asset on a pre
specified future date at a pre specified price. Forward contract is different from Spot Contract
as in spot contract settlement comes at the time of contract while in Forward Contract
Settlement comes on a pre specified future date.

Forward contracts are traded only in Over the Counter (OTC) Market and not in stock
exchanges. OTC Market is a private Market where individuals/institutions can trade through
negotiations on a one to one basis. Forwards are private contracts and their terms are
determined by the parties involved. The features of forward contracts:
 A contract has to be settled in delivery or cash on expiry date.
 It offers flexibility to the parties in terms of price, quality, quantity, delivery, time and
place.
 It is traded over the counter not on exchanges
 The parties to contract bear counterparty risk/default risk.
(B) FUTURES CONTRACT:
A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. Futures contracts are special types of forward
contracts in the sense that the former are standardized exchange-traded contracts.

As far as Indian Equity Market is Concern, NSE is having the most developed Equity
Derivatives Market. They have launched 3 Month series for Future Contracts i.e. Current
Month (1 month Expiry), Next Month (2-month Expiry) and Far Month (3-month Expiry).

Types of Future Contracts

1. Commodity Futures: In India, Commodity futures are mainly traded in two
exchanges MCX (Multi commodity exchange) and NCDEX (National commodities
and derivatives exchange).
2. Financial Futures are further divided into three categories:

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 a. Interest Rate Futures: Short Term interest rate futures transactions takes
place in Money Market and Long Term interest rate futures transactions in
Capital Market.
b. Stock Index Futures: Stock index futures are traded in the NSE (Nifty
Futures).
c. Currency Futures: Two currencies are exchanged in future at a previously
agreed exchange rate in the FOREX market.

Difference between Futures & Forwards

FUTURES FORWARDS

1. Futures are traded only on the organized Forwards are traded off the stock exchanges
and recognized exchanges. and OTC markets.

2. These are standardized instruments. These are special purpose instruments

designed to suit the specific needs of the
counter parties.

3. Futures are regulated by SEBI, RBI and Forwards are self-regulatory.

other agencies.

4. Futures don’t have flexibility of quantity Forwards have certain flexibility.

and quality of commodity to be
delivered.

5. Futures involve brokerage fees for all Transaction costs of forwards are based on
purchase and sale transactions. bids.

6. It is settled only on a specified date fixed Most of the contracts settled by the actual
by the exchanges. delivery on any date.

7. The profits and losses on futures are Forward contracts are settled on the maturity
settled daily via the Exchange Clearing date or any date agreed upon by the parties to
House. the contract.

8. Future contracts require margin or Margins or any collateral security is not

collateral from the parties to the contract. required in forward contracts.

(C) OPTIONS:
An Option is a contract between two party, where one party gives to the other the
right, but not the obligation, to buy from (or sell to) the First Party the underlying asset on or
before a specific day at an agreed price. In return for giving the right, the party giving the
right collects a payment from the other party. This payment collected is called the “premium”
or price of the Option.

Features of Options:
1. The buyer or owner has the right to exercise the option.
2. An option is created only when two parties strike a deal (buyer and seller/writer).

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 3. The buyer has a limited liability.
4. Option holders do not carry any voting rights and not entitled to receive any
dividend/interest.
5. It has high degree of risk to the option writers/sellers.
6. It allows the buyer to earn profit from favorable market conditions.
7. It provides flexibility to investors (buyers) who have every right to either purchase or
sell.
8. No certificates are issued by the company.

Types of Options:
1. Call Options: Call Option is an Option where buyer gets the right to purchase the
underlying but not any obligation. Buyer of the Call option expects the price to go up and
hence purchase right to buy at a specified rate by paying premium. Call Option buyer is
getting the right to purchase from Call Option seller and pays the premium to Call Option
seller. The Maximum loss to the buyer of the Option is limited up to premium paid.
For Example: Suppose X limited is at Rs.40 and you think X’s stock price is going to go up
to Rs.50 in the next few weeks. One way to profit from this expectation is to buy 100 shares
of X Ltd. today at Rs. 40 and sell it in a few weeks when it goes to Rs. 50. This would cost
Rs. 4,000 today and when you sold the shares in a few weeks you would receive Rs. 5,000 for
a Rs. 1,000 profit and a 25% return. Those sounds great, but watch how buying a call option
on X ltd. would have given you a 400% return (instead of the 25% return from buying the
stock!

Profits from buying a call:

Profits from writing a call:

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2. Put Options: Put Option is an Option where buyer gets the right to sell the Underlying but
not any obligation. Buyer of the Put Option expects the price to go down. The Maximum loss
to the buyer of the Option is limited up to premium paid. If prices falls than Put buyer earns
unlimited profit. Let us look at one example to make it clear.
For Example: Suppose you bought 100 shares of A Co. limited at Rs. 500 but wanted to
make sure you don't lose more than 10% on this investment. You could buy an put option
with a strike price of Rs. 450. If the price drops below Rs. 450 a share you will be able to sell
your stock for Rs. 450. Note down that you don't "HAVE TO" sell you’re A Co. shares at Rs.
450. If the price in the market is Rs. 475 then of course you can sell your shares in the
market. That is why it is called an option--it is a choice and not an obligation.

Pay-off from buying a call:

Pay-off from writing a call:

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Comparison between Call Option and Put Option

CALL OPTION PUT OPTION

Definition Buyer of a call option has the right, but Buyer of a put option has the right,
is not required, to buy an agreed but is not required, to sell an agreed
quantity by a certain date for a quantity by a certain date for the
certain/strike price. strike price.

Obligations Seller obligated to sell the underlying Seller obligated to buy the
asset to the option holder if the option underlying asset from the option
is exercised. holder if the option is exercised.

Value Increases as value of the underlying Decreases as value of the underlying

asset increases asset increases

Analogies Security deposit – allowed taking Insurance – protected against a loss

something at a certain price if the in value.
investor chooses.

Costs Premium paid by buyer Premium paid by buyer

(D) SWAPS
Swaps are private agreements between two parties to exchange cash flows in the future
according to a pre-agreed price. The two main types of swaps are:
a) Interest Rate Swaps: This swaps only the interest related cash flows between the
parties in the same currency.
b) Currency Swaps: This swaps both principal and interest between the parties, with the
cash flows in one direction being in a different currency than those in the opposite
direction.

(E) WARRANTS
A warrant is a derivative that confers the right, but not the obligation, to buy or sell a security
– normally equity – at a certain price before expiration. Warrants are long term options. The
price at which the underlying security can be bought or sold is referred to as the exercise
price or strike price.An American warrant can be exercised at any time on or before the
expiration date, while European warrants can only be exercised on the expiration date. It
confer the right to buy a security are known as call warrants; those that confer the right to sell
are known as put warrants.

TECHNICAL ANALYSIS

Technical analysis is based on the premise that "history repeats itself" and hence movement
in stock prices follow an established trend which can be gauged from past price and volume
data. It helps in answering the questions like "Is it the right time to buy a share?" or "Is it the
right time to sell a share?"Technical analysis is a method of evaluating securities that
involves a statistical analysis of market activity, such as price and volume.

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According to John J. Murphy, “Technical Analysis is the study of market action, primarily
through the use of charts, for the purpose of forecasting future price trends.”

Technical analysis is based on three Assumptions:

1. The market discounts everything: This analysis of price movements, which

technical analysts view as the product of supply and demand for a particular stock in
the market.
2. Price moves in trends: Technical analysts believe that prices move in short-,
medium-, and long-term trend. In other words, a stock price is more likely to continue
a past trend than move erratically. Most technical trading strategies are based on this
assumption.
3. History tends to repeat itself: The repetitive nature of price movements is often
attributed to market psychology, which tends to be very predictable based on
emotions like fear or excitement.

Tools and Techniques of Technical Analysis

1. Prices: Whenever there is change in prices of securities, it is reflected in the changes

in investor attitude and demand and supply of securities.
2. Time: The degree of movement in price is a function of time. The longer it takes for
a reversal in trend, greater will be the price change that follows.
3. Volume: The intensity of price changes is reflected in the volume of transactions that
accompany the change.
4. Width: The study of width of the market indicates the extent to which price changes
in accordance with a certain overall trends.

Difference between Fundamental and Technical Analysis

FUNDAMENTAL TECHNICAL
ANALYSIS ANALYSIS
Meaning Stock value calculated using economic Security price movements used
factors and company’s financial data. to predict future price
movements.
Methodology It examines financial data, industrial It examines price movements
trends, competitor’s performance and and market psychology.
economic outlook.
Time – Long term Approach Short term Approach
Horizon
Function Investing Trading

Data Gathered Financial Statements Charts

from
Concepts Used ROE – Return on Equity, ROA – Return Dow Theory, Price Data
on Assets
Main Goal It is to find the intrinsic value of the It is to find the right time to
stock. enter or exit based on the past
and current trend.

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Vision Looks backward as well as forward Looks backward

The two approaches are not used as substitutes but as complementary to each
other……………..

DOW THEORY

The Dow Theory, originally proposed by Charles Dow who was editor of Wall Street Journal
in 1900 is known for the oldest and best-known theory developed by him on technical
indicators.

According to Charles Dow, The market is always considered as having three movements, all
going at the same time.

 The "main movement", primary movement or major trend may last from less than a
year to several years. It can be bullish or bearish.
 The "medium swing", secondary reaction or intermediate reaction may last from ten
days to three months and generally retraces from 33% to 66% of the primary price
change since the previous medium swing or start of the main movement.
 The "short swing" or minor movement varies with opinion from hours to a month or
more.

Basic Tenets of Dow Theory: There are six fundamental principles of the Dow Theory that
fully explain its operation.

1. The Averages Discount everything (except “acts of God”):At the turn of the
twentieth century there was considerably less liquidity and regulation in the market;
therefore, manipulation was common. It reflects the combined market activities of
thousands of investors and brokers. It is the aggregate judgment of all market
participants.
2. Classifications of Trends: There are three classifications of trends: primary trends,
secondary swings, and minor day-to-day fluctuations. (Explained in definition).

Bull market: It is a financial market of a group of securities in which prices are rising or are
expected to rise. The term "bull market" is most often used to refer to the stock market but
can be applied to anything that is traded, such as bonds, currencies and commodities.

Bear market: It is a condition in which securities prices fall and widespread pessimism
causes the stock market's downward spiral to be self-sustaining. Investors anticipate losses as
pessimism and selling increases. Although figures vary, a downturn of 20% or more from a
peak in multiple broad market indexes over a two-month period is considered an entry into a
bear market.

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3. The Principle of Confirmation: For a bull or bear market to exist, two of the three
major averages (the Industrials, the Transportation, and the Utilities) must confirm the
direction.
a. When first created, the Dow Theory required the confirmation on only the
Utilities and the Railroads.
b. Although much has changed since Dow devised this rule, the purpose is to
assure that the bull or bear market is a widespread economic phenomenon and
not a narrower industry-related event.

4. Volume Goes with the Trend: Volume confirms the price move
a. Volume must increase as the trend develops, whether it is a bull or bear
market.
b. It is greatest at the peak of a bull market or during the panic phase of a bear
market.

5. Only Closing Prices Are Used: Dow had a strong belief that the closing price each
day was the most important price. It was the point of evening-up.
a. Not only do day traders liquidate all of their positions before the close of
trading, reversing their earlier impact, but many investors and hedge funds
execute at the close.
b. There is always high volume at the close of trading, when investors with short
and long time frames come together to decide the fair price.

6. The Trend Persists: A trend should be assumed to continue in effect until its reversal
has been signaled. This rule forms the basis of all trend-following principles.
a. It considers the trend as a long term price move, and positions are entered only
in the trend direction.
b. The Dow Theory does not express expectations of how long a trend will
continue.
c. It simply follows the trend until a signal occurs that indicates a change of
direction.

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CHARTING

Technical analysis is mainly based on charts, graphical representation of security prices. A

chart helps to study the share price movements which changes on same day. The different
types of charts are as follows:
1. Line chart: Line charts are the most basic and simplest type of chart because it
represents only the closing prices over a set period. While this type of chart doesn’t
provide much insight into intraday price movements, many investors consider the
closing price to be more important than the open, high, or low price within a given
period.

2. Bar chart: Bar charts expand upon the line chart by adding the open, high, low, and
close – or the daily price range. The chart is made up of a series of vertical lines that
represent the price range for a given period with a horizontal dash on each side that
represents the open and closing prices.

3. Point and Figure Charts: Point and figure charts are not very well known or used by
the average investor, but they have a long history of use dating back to the first
technical traders. It reflects price movements without time or volume concerns, which
helps remove noise – or insignificant price movements – that can distort a trader’s
view of the overall trend.

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 EFFICIENT MARKET HYPOTHESIS (EMH)

The efficient market hypothesis (EMH) is an investment theory that states it is impossible to
"beat the market" because stock market efficiency causes existing share prices to always
incorporate and reflect all relevant information. The EMH was developed in 1960’s by
Professor Eugene Fama and According to the EMH, stocks always trade at their fair value on
stock exchanges, making it impossible for investors to either purchase undervalued stocks or
sell stocks for inflated prices. This theory states that the price fluctuations are random and do
not follow any regular pattern.

Random Walk theory: It is that the market information and immediately and fully spread
so that all investors have the full knowledge of the information and changes price of the
security in the stock market, which all are independent of each other.
The hypothesis state that the capital market is efficient in processing information according to
the efficient market model market is actually concerned with the spread of information with
which information is incorporated into the security raises.
The technique before that the past price sequences contents the information about the future
price movements because all type of information is slowly incorporated in the security prices.
The efficient market has internal and external efficiency there are 3 forms of efficient
market hypothesis (EMH) which are as follows:
1. Weak Form EMH:It suggests that all past information is priced into securities.
Fundamental analysis of securities can provide an investor with information to
produce returns above market averages in the short term but there are no "patterns"
that exist. Therefore fundamental analysis does not provide long-term advantage and
technical analysis will not work.
2. Semi-Strong Form EMH:It implies that neither fundamental analysis nor technical
analysis can provide an advantage for an investor and that new information is
instantly priced in to securities.This form of market is testing whether publicly
available information is fully reflected in current stock prices.
3. Strong Form EMH:All information, both public and private, is priced into stocks
and that no investor can gain advantage over the market as a whole. Strong Form
EMH does not say some investors or money managers are incapable of capturing
abnormally high returns but that there are always outliers included in the averages.

Implications of Efficient Markets:

EMH and Technical Analysis: Technical analysis bases decisions on past results. EMH,
however, believes past results cannot be used to outperform the market. As a result, EMH
negates the use of technical analysis as a means to generate investment returns.
EMH and Fundamental Analysis:With respect to fundamental analysis, the EMH also
states that all publicly available information is reflected in security prices and as such,
abnormal returns are not achievable through the use of this information. This negates the use
of fundamental analysis as a means to generate investment returns.
EMH and Portfolio Management Process: Given EMH, the portfolio management process
should not focus on achieving above-average returns for the investor. The portfolio

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management process should focus purely on risks given that above average returns are not
achievable.A portfoliomanager's goal is to outperform a specific benchmark with specific
investment ideas. The EMH implies that this goal is unachievable.

TAX ASPECTS OF INVESTMENTS

All investment options should be assessed on seven key parameters – returns, safety,
flexibility, liquidity, costs, transparency and taxability of Income. Each parameter has given
equal weight-age and a composite score for the various tax saving options.

1. ELSS Funds: ELSS stands for Equity Linked Savings Scheme. These are tax saving
mutual funds that you can use to save income tax of up to Rs 1.5 lakh under Section
80C. ELSS funds have a lock--in period of 3 years and invest a majority of their
portfolio in the stock market. An ELSS investment can be started with a minimum
amount of Rs. 500 and there is no upper limit on how much you can invest in ELSS
funds.
2. ULIP: A Unit Linked Insurance Plan (ULIP) is a product offered by insurance
companies that unlike a pure insurance policy gives investors the benefits of both
insurance and investment under a single integrated plan. Money invested in ULIP can
be claimed as a deduction under section 80C (life insurance) or 80CCC (pension). A
maximum of Rs 1,50,000 is allowed under section 80C/ 80CCC.
3. NPS: New Pension Scheme (NPS) is a voluntary, defined contribution retirement
savings scheme designed to enable the investors help save for their retirement through
systematic savings during their working life. Investment up to Rs 1,50,000 into NPS
in a financial year is eligible for deduction under Section 80CCD.A subscriber need
not make contribution every month. Minimum contribution per year: Rs 6,000 and no
upper limit on contribution. A subscriber can make contributions to the NPS account
till the age of 60.
4. PPF: PPF refers to Public Provident Fund and is a Long Term Debt Scheme of the
Government. of India on which regular interest is paid. Any Individual can invest in
this scheme and can earn a handsome tax-free return on the same which is usually
higher than the return offered by Banks on Fixed Deposits.PPF allows a minimum
investment of Rs 500 and a maximum of Rs 1.5 lakh for each financial year under
section 80C. Investments can be made in lump sum or in a maximum of 12
installments.
5. EPF: TheEmployee Provident fund has tax treatment is EEE, which means your
money is exempt from taxes at the time of investment, accumulation and withdrawal.
At the time of investment, the tax deduction is under the limit of section 80C of the
Income-tax Act, which is currently Rs1.5 lakh. Partial withdrawals are also tax-free if
made after 5 years of continuous service. If withdrawals are made before 5 years of
service, 10% tax will be deducted at source.
6. Bank FD’s: Bank fixed deposits are known for giving risk free returns. Fixed
deposits for long have been one of the favourite avenues of investors in India who do
not trust the capital markets. In this, investor puts the money with the bank for a
specified tenure and bank repays the money with a specified interest rate. It is
regarded as one of the safest investments. The interest earned on the bank fixed
deposit is subjected to TDS, if it exceeds INR 10,000 in a financial year.
7. NSC: National Savings Certificates, popularly are instruments issued by the
Government of India under the small savings tier These can be purchased from any
postal office of India by an adult in his/her own name, on behalf of a minor, a trust

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 and two adults only. The denominations of such certificates range in INR 100, INR
500, INR 1000, INR 5000 and INR 10000. While investments of up to INR 150000
are qualified for income tax rebate and the maturity periods of NSCs can be 5 years or
10 years.
8. Sukanya Samriddhi Scheme: The Scheme was launched with an aim to bridge the
financial gap and prevented women from achieving their best. This small savings
scheme is the brainchild of Prime Minister Narendra Modi and has a vision to provide
for the education and marriage needs of a girl child, offering her adequate
opportunities to pursue her dreams. Investments made towards this scheme are
eligible for tax deduction under Section 80C of the Income Tax Act. This deduction is
subject to a maximum of Rs 1.5 lakh towards this scheme.
9. SCSS: The Senior Citizen Savings Scheme (SCSS) offers regular income, highest
safety and tax saving, making it a popular product for those over 60 years of age. The
tenure of the scheme is five years, which can be further extended for three more years.
Premature withdrawals are allowed, but only after one year and with premature
withdrawal charges. Tax benefit is under the overall current ceiling of Rs. 1.5 lakh per
annum fixed for all investments under Section 80C.
10. Insurance Policies: Section 80C and 80CC of the Income Tax Act lists out the
investments for which deduction is allowed for an individual taxpayers or a Hindu
Undivided Families (HUF). The deduction for purchase of life insurance can go right
up to the maximum Rs 1,50,000 allowed under these sections. Investment in a life
insurance has two benefits. One is by way of availing a deduction from your taxable
income and the other through gaining exemption from your total income.

SECURITIES TRADING PROCEDURE

1. Selection of a Broker: The first step is to select a broker, who will buy/sell securities
on behalf of the speculator/investor. This is necessary because trading of securities
can only be done through SEBI registered brokers, who are members of stock
exchange. Brokers may be individuals, partnership firms and corporate bodies.
2. Opening Demat Account with Depository: The next step is to open a demat
account. Demat (Dematerialised) account refers to an account which an Indian citizen
must open with the depository participant (banks and stock brokers) to trade in listed
securities in "electronic form.
The securities are held in the electronic form by a depository. ‘Depository’ is
an institution/organisation which holds securities (e.g. shares, debentures, bonds,
mutual funds, etc) in electronic form, in which trading is done.
3. Placing the Order: The next step is to place the order with the broker. The order can
be communicated to the broker either personally or through telephone, cell phone, e-
mail, etc. The instructions should specify the securities to be bought or sold and the
price range within which the order is to be executed. Only the securities of listed
companies can be traded on the stock exchange.
4. Making the Order: The broker or his authorized clear declared the purchase or sale
price of securities at that moment when the ordered price of the broker provides the
facilities for making a contract for the transaction.
5. Preparing the contract note: The broker prepares a contract not stating the number
and price of securities bought or sold the names of the buyers and sellers, brokerage
payable by the client, etc. Thereafter, the contract paper is prepared and signed.

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 6. Final settlement: The buyer deposits the estimated cost and the seller delivers the
securities in the same way in case of ready delivery contracts. But in the case of the
forward contract, the settlement is made within a fortnight.
7. Executing the Order: As per the Instructions of the investor, the broker executes the
order i.e. he buys or sells the securities. Broker prepares a contract note for the order
executed. The contract note contains the name and the price of securities, name of
parties and brokerage (Commission) charged by him. Contract note is signed by the
broker.
8. Settlement: This is the last stage in the trading of securities done by the brokers on
behalf of their clients. The mode of settlement depends upon the nature of the
contract. Equity spot markets follow a T + 2 rolling settlement. This means that any
trade taking place on Monday gets settled by Wednesday. Stock, exchange operates
from Monday to Friday between 9:55am and 3:30pm. Each exchange has its own
clearing house, which assumes all settlement risk.

CRITICAL SURVEY OF SOFTWARE PACKAGES

The software packages provide research and analysis of securities to help an investor to take
into consideration the past records of the security, its fundamentals and trends in prices. The
different kinds of packages that is available for Security Analysis which is as follows:

1. MetaStock Trader: This software helps in viewing the technical indicators of

single/individual shares in different stock markets around the world.
2. Wave59 Pro: This is highly technical software used especially for hive technology
and artificial intelligence modules.
3. eSignal: This software package provides data on bonds, shares, funds, derivatives &
forex. It gives information on trade management and technical indicators.
4. Ninja Trader: It is used for analyzing stock market fundamentals & making technical
analysis through charts. It provides data of past and future trends of stocks.
5. Worden TC2000: It provides a pictorial view of charts which shows data on
information of companies & any current trading new. It is also limited to shares and
funds of exchange traded.
6. ProfitSource Platform: Brokers & traders in stock market use this software to
provide technical indicators which is useful for trading in equities, options, futures
and global level funds.
7. Vector Vest: It is useful in assessing stocks and has a comprehensive coverage for
technical indicators for covering stock and charting tools.
8. EquityFeed Workstation: This software covers daily information on bid and asks
prices of stock. It also has filtering criteria to scan and select stocks.

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 PRACTICAL PROBLEMS

EQUITY VALUATION MODELS

Problem 1: One period Valuation Model

Mr. X is planning to buy an equity share, hold it for one year and then sell it. The expected
dividend at the end of year 1 is Rs. 7 and the expected sale precedes Rs. 200 after 1 year.
Determine the value of share to the investor assuming the discount rate of 15%.

Problem 2: Two period Valuation Model

Mr. X is planning to buy an equity share, hold it for two years and then sell it. The expected
dividend at the end of year 1 is Rs. 7 and Rs. 7.50 at the end of year2. The expected selling
price of the share at the end of year 2 is Rs. 220. Calculate the value of share today taking
15% discount rate.

Problem 3: n period Valuation Model

An investor expects a dividend of Rs. 5 per share for each of 10 years and a selling price of
Rs. 80 at the end of 10 years. Calculate the present value of share if his required rate of return
is 12%.

DIVIDEND VALUATION MODELS

Problem 4: No growth case

A company is presently paying a dividend of Rs. 6 per share and is expected not to deviate
from this in future. Calculate the value of the share if his required rate of return is 15%.

Problem 5: Constant growth case

A company is expected to pay a dividend of Rs. 6 per share next year. The dividends are
expected to grow perpetually at a rate of 9%. What is the value of its share if the required rate
of return is 15%?

Problem 6:

The current price of a company’s share is Rs. 75 and dividend per share is Rs. 5. Calculate
the dividend growth rate, if its capitalization rate is 12%.

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Problem 7:

The current price of a company’s share is Rs. 200. The company is expected to pay a
dividend of Rs. 5 per share next year with a annual growth rate of 10%. If an investor’s
required rate of return is 12%, should he buy the share?

Problem 8: Supernormal growth case

A company is presently paying a dividend of Rs. 4.24 per share. The dividend is expected to
grow at an 18% annual rate for five years and then at 12% forever. What is the present value
of the share, if its capitalization rate is 14%?

EARNINGSD VALUATION MODEL

Problem 9:

Calculate the price of an equity share from the following data:

Earnings per share (EPS) Rs. 20

Internal rate of return (r) 20%
Equity Capitalization rate (ke) 20%

Problem 10:

A company decides that it will not pay any dividends for 20 years. After that it is expected
that the company could pay dividend of Rs. 15 per share indefinitely. However, the company
at present could pay Rs. 3 per share. The required rate of his company’s shareholders is 10%.
What is the loss to the each shareholder as a result of the policy of the company? Calculate
the value of the equity share.

RATE OF RETURN ON EQUITY SHARE

Problem 11:

The equity share of a company is currently selling at Rs. 80. It is expected that the company
will pay a dividend of Rs. 4 at the end of one year and the share can be sold at a price of Rs.
88. Calculate the return on share. Should an investor buy it, if his capitalization rate is 12%?

Problem 12:

The current price of a company’s share is Rs. 60. The company is expected to pay a dividend
of Rs. 4.80 per share at the end of one year. The dividends are expected to grow perpetually
at a rate of 6%. If an investor’s required rate of return is 15%, should he buy the share?

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