Investment Management LT

Investment Management
Unit-I: Introduction to Investment

INTRODUCTION TO INVESTMENT MANAGEMENT
Security analysis is a pre-requisite for making investments. In the present day
financial markets, investment has become complicated. Investment may be defined
as an activity that commits funds in any financial/physical form in the present with
an expectation of receiving additional return in the future.
Types of investments
Investments may be classified as financial investments or economic investments. In
the financial sense, investment is the commitment of funds to derive future income
in the form of interest, dividend, premium, pension benefits, or appreciation in the
value of the initial investment. Economic investments are undertaken with an
expectation of increasing the current economy’s capital stock that consists of goods
and services.
Objectives
The main objective of an investment process is to minimize risk while
simultaneously maximizing the expected returns from the investment and assuring
safety and liquidity of the invested assets.
REAL VS. FINANCIAL ASSETS

Investment in financial assets differs from investment in physical assets in those
important aspects:
 Financial assets are divisible, whereas most physical assets are not. An asset
is divisible if investor can buy or sell small portion of it. In case of financial assets it
means, that investor, for example, can buy or sell a small fraction of the whole
company as investment object buying or selling a number of commonstocks.
 Marketability (or Liquidity) is a characteristic of financial assets that is not
shared by physical assets, which usually have low liquidity. Marketability (or
liquidity) reflects the feasibility of converting of the asset into cash quickly and
without affecting its price significantly. Most of financial assets are easy to buy or to
sell in the financial markets.
 The planned holding period of financial assets can be much shorter than
the holding period of most physical assets. The holding period for investments is
defined as the time between signing a purchasing order for asset and selling the
asset. Investors acquiring physical asset usually plan to hold it for a long period,
but investing in financial assets, such as securities, even for some months or a year
can be reasonable. Holding period for investing in financial assets vary in very wide
interval and depends on the investor’s goals and investment strategy.
INVESTMENT DECISION PROCESS

Investment management process is the process of managing money or funds. The
investment management process describes how an investor should go about
making decisions.
Investment management process can be disclosed by five-step procedure, which
includes following stages:
1. Setting of investment policy.
2. Analysis and evaluation of investment vehicles.
3. Formation of diversified investment portfolio.
4. Portfolio revision
5. Measurement and evaluation of portfolio performance.
Setting of investment policy is the first and very important step in investment
management process. Investment policy includes setting of investment objectives.
The investment policy should have the specific objectives regarding the investment
return requirement and risk tolerance of the investor. For example, the investment
policy may define that the target of the investment average return should be 15 %
and should avoid more than 10 % losses. Identifying investor’s tolerance for risk is
the most important objective, because it is obvious that every investor would like to
earn the highest return possible. But because there is a positive relationship
between risk and return, it is not appropriate for an investor to set his/ her
investment objectives as just “to make a lot of money”. Investment objectives should
be stated in terms of both risk and return.
Setting of investment objectives for individual investors is based on the assessment

of their current and future financial objectives. The required rate of return for
investment depends on what sum today can be invested and how much
investor
needs to have at the end of the investment horizon. Wishing to earn higher income
on his / her investments investor must assess the level of risk he /she should take
and to decide if it is relevant for him or not. The investment policy can include the
tax status of the investor. This stage of investment management concludes with the
identification of the potential categories of financial assets for inclusion in the
investment portfolio. The identification of the potential categories is based on the
investment objectives, amount of investable funds, investment horizon and tax
status of the investor. From the section 1.3.1 we could see that various financial
assets by nature may be more or less risky and in general their ability to earn
returns differs from one type to the other. As an example, for the investor with low
tolerance of risk common stock will be not appropriate type of investment.
Analysis and evaluation of investment vehicles. When the investment policy is

set up, investor’s objectives defined and the potential categories of financial assets
for inclusion in the investment portfolio identified, the available investment types
can be analyzed. This step involves examining several relevant types of
investment
vehicles and the individual vehicles inside these groups. For example, if the common
stock was identified as investment
vehicle relevant for investor, the analysis will be concentrated to the common stock
as an investment. The one purpose of such analysis and evaluation is to identify
those investment vehicles that currently appear to be mispriced. There are many
different approaches how to make such analysis. Most frequently two forms of
analysis are used: technical analysis and fundamental analysis.
Technical analysis involves the analysis of market prices in an attempt to predict

future price movements for the particular financial asset traded on the market.
This analysis examines the trends of historical prices and is based on the
assumption that these trends or patterns repeat themselves in the future.
Fundamental analysis in its simplest form is focused on the evaluation of intrinsic

value of the financial asset. This valuation is based on the assumption that
intrinsic
value is the present value of future flows from particular investment. By

comparison of the intrinsic value and market value of the financial assets those
which are under priced or overpriced can be identified. Fundamental analysis will
be examined in Chapter 4.
This step involves identifying those specific financial assets in which to invest and
determining the proportions of these financial assets in the investment portfolio.
Formation of diversified investment portfolio is the next step in investment
management process. Investment portfolio is the set of investment vehicles, formed
by the investor seeking to realize its’ defined investment objectives. In the stage of
portfol io formation the issues of selectivity, timing and diversification need to be
addressed by the investor. Selectivity refers to micro forecasting and focuses on
forecasting price movements of individual assets. Timing involves macro forecasting
of price movements of particular type of financial asset relative to fixed-income
securities in general. Diversification involves forming the investor’s portfolio for
decreasing or limiting risk of investment. 2 techniques of diversification:
1. random diversification, when several available financial assets are put to
the portfolio at random;
2. objective diversification when financial assets are selected to the portfolio
.
Investment management theory is focused on issues of objective portfolio
diversification
and professional investors follow settled investment objectives then constructing
and managing their portfolios.
Portfolio revision. This step of the investment management process concerns the
periodic revision of the three previous stages. This is necessary, because over time
investor with long-term investment horizon may change his / her investment
objectives and this, in turn means that currently held investor’s portfolio may no
longer be optimal and even contradict with the new settled investment objectives.
Investor should form the new portfolio by selling some assets in his portfolio and
buying the others that are not currently held. It could be the other reasons for
revising a given portfolio: over time the prices of the assets change, meaning that
some assets that were attractive at one time may be no longer be so. Thus investor
should sell one asset ant buy the other more attractive in this time according to his/
her evaluation. The decisions to perform changes in revising portfolio depend, upon
other things, in the transaction costs incurred in making these changes. For
institutional investors portfolio revision is continuing and very important part of
their activity. But individual investor managing portfolio must perform portfolio
revision periodically as well. Periodic re-evaluation of the investment objectives
and portfolios based on them is necessary, because financial markets change, tax
laws and security regulations change, and other events alter stated investment
goals.
Measurement and evaluation of portfolio performance. This the last step in
investment management process involves determining periodically how the
portfolio performed, in terms of not only the return earned, but also the risk of the
portfolio. For evaluation of portfolio performance appropriate measures of return
and risk and benchmarks are needed. A benchmark is the performance of
predetermined set of assets, obtained for comparison purposes. The benchmark
may be a popular index of appropriate assets – stock index, bond index. The
benchmarks are widely used by institutional investors evaluating the performance
of their portfolios.
SOURCES OF INVESTMENT INFORMATION

Types of Investment Information:
i. World Affairs:
International factors, which influence domestic income, output and employment
and for investment in the domestic market by F.F.I.s, O.C.B.s, etc. Also foreign
political affairs, wars, and the state of foreign markets affect our markets.
ii. Domestic Economic and Political Factors:

Gross domestic products, agricultural output, monsoon, money supply, inflation,
Govt. policies, taxation, etc., affect our markets.
iii. Industry Information:

Market demand, installed capacity, competing units, capacity utilisation, market
share of the major units, market leaders, prospects of the industry, international
demand for exports, inputs and capital goods abroad, import competing products,
labour problems and Govt. policy towards the industry are all relevant factors to be
considered in investment decision-making.
iv. Company Information:

Corporate data, annual reports, Stock Exchange publications, Dept. of company
affairs and their circulars, press releases on corporate affairs by Govt., industry
chambers or associations of industries etc. are also relevant for security price
analysis.
v. Security Market Information:

The Credit rating of companies, data on market trends, security market analysis and
market reports, equity research reports, trade and settlement data, listing of
companies and delisting, record dates and book closures etc., BETA factors, etc. are
the needed information for investment management.
vi. Security Price Quotations:

Price indices, price and volume data, breadth, daily volatility, range and rate of
changes of these variables are also needed for technical analysis.
vii. Data on Related Markets:

Such as Govt., securities, money market, forex market etc. are useful for deciding on
alternative avenues of investment.
viii. Data on Mutual Funds:

Their schemes and their performance, N A V and repurchase prices etc. are needed
as they are also investment avenues.
ix. Data on Primary Markets/New Issues, etc.

Need for Investment Information:

Investors and Market Analysts depend on the timely and correct information for
making investment decisions. In the absence of such information, their decisions
will depend on hearsay and hunches. In order to enable the correct investment
decisions to be made, investors need to know the sources of information. In the fast
expansion of the markets, and increasing complexity of economies, the amount of
information is also fast growing.
The collection of information and its analysis is time consuming and expensive.
Besides analysis of the information also requires expertise which all investors may
not have. The available books on the subject deal with the theoretical aspects and
not much practical analysis and down to earth operational aspects. As such the
investors are left to make decisions by hunches and intuition and not on scientific
analysis of the data. Those who have better information use it to make extra mileage
on such information.
It is also possible that insiders who have the information before it becomes public
take advantage of it called Insider trading. At present the SEBI has acquired powers
to control insider trading, malpractices and rigging up of prices in the secondary
markets in India, and penalise the offenders.
World Affairs:
The day-to-day developments abroad are published in Financial Journals like
Economic Times, Financial Express, Business Line, etc. Some foreign Journals, like
London Economist, Far East Economic Review and Indian Journals like, Business
India, Fortune India etc., also contain developments of economic and financial
nature in India and abroad. IMF News Survey, World Bank and IMF Quarterly
Journal (namely, Finance and Development), News Letters of Foreign Banks like
those of Grindlays, Standard, etc., contain all the needed information on world
developments.
National Economic Affairs:

The daily news papers particularly financial papers referred to above contain all the
national information; Besides Journals like Economic and Political Weekly, Business
India, Dataline Business, Business Today and Fortune India contain the material on
economic developments. RBI’s Annual Reports, Reports on currency and finance
and monthly reports and CMIE reports all contain a wealth of information on the
economy and the country. The Economic Survey of the govt. of India and reports of
C.S.O., D.G.T.D. and Dept. of companies, etc. do provide the information on, economy,
industry, trade sectors of the country. The reports of the Planning Commission and
annual reports of various ministries also contain a lot of information.
Industry Information:
There are various Associations — Chambers of Commerce, Merchants’ Chamber and
other agencies who publish Industry data. The reports of Planning Commission,
govt. of India, publications from Industry and Commerce Ministries also contain a
lot of information. The CMIE publishes various volumes and update them from time
to time containing data on various sectors of the economy and industries, and the
subscribers get these volumes and reports.
Directory of Information published by the B.S.E. also contains information on

industries and companies and this is updated from time to time. Many Daily
financial papers bring out regularly studies on various Industries and their
prospects. Industry data at micro level is available in Govt., publications, industry
wise, but in view of a large time lag involved in their reports, the monthly reports of
various Associations of Industries give more up-to-date and timely information.
Company Information:
The information on various Companies listed on Stock Exchanges is readily
available in daily financial papers. Besides the Fort- nightly Journals of Capital
Market, Dalai Street, Business India contain a lot of information on the industries
and companies, listed on stock exchanges. Results of equity and Market Research
are also published in these Journals.
The B.S.E. (Mumbai Stock Exchange) publishes Directory of Information on

Industries and Companies, which are listed on Stock Exchanges, and the Journals of
Capital Market and Dalai Street also publish these data. Computer software on these
data are available with a number of software companies. The B.S.E. also publishes
weekly Reviews, monthly Reviews giving data on various aspects of listed
companies.
The Annual Reports of companies and their half-yearly unaudited results are
another source of information on the companies. The financial journalists give write
ups on various companies after interviewing their executives and these are
published in Economic Times and other financial Dailies, like Business Line and
Financial Express.
Security Market Information:

A number of big Broker Firms who have equity research are sending newsletters on
Market Information with Fundamental and Technical analysis, combined in those
reports. The Capital Market, Dalai Street, Business India and few other Stock Market
Journals like Fortune India, Investment Week, etc., contain the information on
security markets. The ICFAI also publishes a monthly called Chartered Financial
Analyst, which contains economic data, company information, and market
information, Security analysis, Beta factors and a host of other items, useful for
security analysis.
The data on Trade cycles and settlements, record dates, book closures etc., are
contained in financial papers like Economic Times, Business Line, Financial Express
etc., after they are released by stock exchanges and companies. While the newsletter
of Merchant Bankers, brokers’ firms, Investment Analysts, are available to
subscribers or their own clients, others are available for all at stipulated prices.
1. The collection of information is thus costly and time consuming.
2. Security Price Quotations:
3. The daily quotations on various Stock Exchanges OTCEI, NSE are published
in the daily papers. Each Stock Exchange is publishing its own daily quotations list,
giving out opening, high, low and closing quotations of all traded securities. They
also publish volume of trade for individual securities and also the total for all
securities traded on a daily basis, in terms of shares and value of trades.

4. The Price indices, for all securities, industry wise, region wise etc., are
published by the RBI, B.S.E. and major Stock Exchanges, in the country. Besides each
financial Daily has its own Index published in its paper. All these indices, daily
volumes, highs, lows, advances, declines etc., of well traded Companies, Gainers and
Losers and such similar information, useful for both technical and fundamental
analysis is available from all Stock Exchanges and published in financial Dailies and
Journals. The Capital Market and Dalai Street journals also give Company
information regarding their fundamentals, P/E, EPS, GPM, etc., along with the price
data. Daily highs and lows, can be seen as against yearly highs/lows for each of the
securities in financial Dailies.
5. The patterns of shareholding, distribution schedule, floating stock, past
price data are available in all software and B.S.E. Directory. B.S.E. publishes all the
data useful for technical analysis and these data are compiled by the computer
specialists and floppies are available on official Daily quotations and Technical
charts of each of the major companies listed on Stock Exchanges. The computer
software data are also sold by software companies for those who have computer
facility. For others, these data can be collected from daily papers, weekly and
fortnightly Journals on Stock Markets, like Dalai Street and Capital Market.
6. Data on Money Market, Govt. Securities Market are available in the
publications of RBI and D.F.H.I., Indian Banks Association, Securities Trading
Corporation and banks and NSE. These data are published on a daily basis on the
financial Dailies and journals. The publications who deal with these markets are
however fewer in number compared to those on stock and capital markets.
7. The information on Forex Market is available in RBI publications, Foreign
Exchange Dealers Association (FEDAI) and foreign banks. These data are published
in the form of exchange rates and cross Currency rates in Financial Dailies regularly.
The developments in these markets are reviewed in the Dailies or weekly and
fortnightly Journals.
8. The data on Bullion market and rates for gold and silver are available on a
Daily basis in the financial press. These data are published in RBI Bulletins and are
also available in CMIE reports. Many of these data on Forex Markets in countries
abroad can be obtained from London Economist, Far Eastern Economic Review, and
Wall Street Journal.
Data on Mutual Funds, UTI etc.:

These are published in the Daily financial papers — at least once in a week in the
Investment Weekly or Investors’ Guide. They give the Current Schemes, NAV of each
scheme if quoted as against the Market price, if traded, repurchase price,
redemption rate, etc. in respect of close ended funds and daily purchase and sale
prices for open ended funds. Besides, however all the journals, magazines and
reports on Stock Markets also contain the relevant information on Mutual funds, as
many of their schemes are quoted and traded on the Stock Exchanges. Thus, the
Capital Market, Dalai Street and Business India also contain information on Mutual
Funds.
Data on Primary Market:

New Issues in the Pipeline are first known to the SEBI as they get the Draft
Prospectus for vetting and even before that, they would come to know of them from
Merchant bankers’ reports. But consolidation and publications of this information is
done by a Magazine called “PRIME” publication. Prime publishes all information of
new issues in the pipe line — industry wise and size wise analysis and public over
subscription and under subscription etc. The performance of companies, Merchant
bankers, underwriters and brokers etc., in the New Issue Market are also analysed
by them. Geographical and centre-wise collection of new issues and other relevant
company information is given by them.
Steps to be followed:
(a) Pattern of ownership of shares
(b) Proportion of public holding
(c) Floating stock for trading
(d) High/Low prices for the year
(e) Daily volatility of prices – Opening, High, Low and Closing
(f) Breadth of the Market
(g) No. of shares traded and their volumes vis-a-vis the total volume for all
companies
(h) Declines/Advances among scrips
(i) Chart of Daily price trends, moving average trends — to get signals of buy/sell
etc.
(j) Trace out the intrinsic value of the share by Fundamental Analysis —
Adjust for the expectations and sentiment in the Market to take a decision whether
the price in the market is fair price or not. Study of the company through financial
variables (BV, EPS, P/e, etc.), visit the plant and interview the chief executives of the
company for knowing the expectations, as also of the merchant bankers and
financial institutions, are the further steps. Scrips chosen on all these counts are
properly timed through Technical Analysis for a proper investment decision-
making. An analysis of risk in terms of variability of returns (standard deviation) of
each company vis-a-vis the Market, use of Beta factor for risk which is systematic
and diversification of investments into various industries and companies to reduce
the unsystematic risks are the further steps in portfolio management.
Investment Vs Speculation
The capacity to bear risk distinguishes an investor from a speculator. An investor
prefers low risk investments, whereas a speculator is prepared to take higher risks
for higher returns. speculation is associated with buying low and selling high with
the hope of making large capital gains. Investors are careful while selecting
securities for trading. Investments, in most instances, expect an income in addition
to the capital gains that may accrue when the securities are traded in the market.
Investment is long term in nature. An investor commits funds for a longer period in
the expectation of holding period gains. However, a speculator trades frequently;
hence, the holding period of securities is very short.
MEASUREMENT OF RISK-RANGE, STANDARD DEVIATION & CO-EFFICIENT OF

VARIATION.
Relationship between risk and return
The expected rate of return and the variance or standard deviation provide investor
with information about the nature of the probability distribution associated with a
single asset. However all these numbers are only the characteristics of return and
risk of the particular asset. But how does one asset having some specific trade-off
between return and risk influence the other one with the different characteristics of
return and risk in the same portfolio? And what could be the influence of this
relationship to the investor’s portfolio? The answers to these questions are of great
importance for the investor when forming his/ her diversified portfolio. The
statistics that can provide the investor with the information to answer these
questions are covariance and correlation coefficient. Covariance and correlation are
related and they generally measure the same phenomenon – the relationship
between two variables. Both concepts are best understood by looking at the math
behind.
Covariance
Two methods of covariance estimation can be used: the sample covariance and the
population covariance.
The sample covariance is estimated than the investor hasn‘t enough information
about the underlying probability distributions for the returns of two assets and then
the sample of historical returns is used.
Sample covariance between two assets - A and B is defined in
∑ [( rA,t - ŕA ) . ( rB,t - ŕB)] t=1

Cov (ŕA, ŕB) = , (2.9)
n–1
here rA,t , rB,t - consequently, rate of return for assets A and B in the time period t,
when t varies from 1 to n;
ŕA, ŕB - sample mean of rate of returns for assets A and B consequently.
As can be understood from the formula, a number of sample covariance can range
from “–” to “+” infinity. Though, the covariance number doesn’t tell the investor
much about the relationship between the returns on the two assets if only this pair
of assets in the portfolio is analysed. It is difficult to conclud if the relationship
between returns of two assets (A and B) is strong or weak, taking into account the
absolute number of the sample variance. However, what is very important using the
covariance for measuring relationship between two assets – the identification of the
direction of this relationship. Positive number of covariance shows that rates of
return of two assets are moving to the same direction: when return on asset A is
above its mean of return (positive), the other asset B is tend to be the same
(positive) and vice versa: when the rate of return of asset A is negative or bellow its
mean of return, the returns of other asset tend to be negative too. Negative number
of covariance shows that rates of return of two assets are moving in the
contrariwise directions: when return on asset A is above its mean of return
(positive), the returns of the other asset - B is tend to be the negative and vice
versa. Though, in analyzing relationship between the assets in the same portfolio
using covariance for portfolio formation it is important to identify which of the
three possible outcomes exists:
positive covariance (“+”),
negative covariance (“-”) orzero covariance (“0”).
If the positive covariance between two assets is identified the common

recommendation for the investor would be not to put both of these assets to the
same portfolio, because their returns move in the same direction and the risk in
portfolio will be not diversified.
If the negative covariance between the pair of assets is identified the common
recommendation for the investor would be to include both of these assets to the
portfolio, because their returns move in the contrariwise directions and the risk in
portfolio could be diversified or decreased.
If the zero covariance between two assets is identified it means that there is no
relationship between the rates of return of two assets. The assets could be included
in the same portfolio, but it is rare case in practice and usually covariance tends to
be positive or negative.
For the investors using the sample covariance as one of the initial steps in analyzing
potential assets to put in the portfolio the graphical method instead of analytical
one (using formula 2.9) could be a good alternative. In figures 2.1, 2.2 and 2.3 the
identification of positive, negative and zero covariances is demonstrated in

graphical way. In all these figures the horizontal axis shows the rates of return on
asset A and vertical axis shows the rates of return on asset B. When the sample
mean of return for both assets is calculated from historical data given, the all area of
possible historical rates of return can be divided into four sections (I, II, III and IV)
on the basis of the mean returns of two assets (ŕA, ŕB consequently). In I section
both asset A and asset B have the positive rates of returns above their means of
return; in section II the results are negative for asset A and positive for asset B; in
section III the results of both assets are negative – below their meansof return and
in section IV the results are positive for asset A and negative for assetB.
When the historical rates of return of two assets known for the investor are marked
in the area formed by axes ŕA, ŕB, it is very easy to identify what kind of relationship
between two assets exists simply by calculating the number of observations in each:
if the number of observations in sections I and III prevails over the number of
observations in sections II and IV, the covariance between two assets is
positive (“+”);
if the number of observations in sections II and IV prevails over the number of

observations in sections I and III, the covariance between two assets is
negative(“-”);
if the number of observations in sections I and III equals the number of

observations in sections II and IV, there is the zero covariance between two assets
(“0”).
The population covariance is estimated when the investor has enough information
about the underlying probability distributions for the returns of two assets and can
identify the actual probabilities of various pairs of the returns for two assets at the
same time.
Similar to using the sample covariance, in the population covariance case the
graphical method can be used for the identification of the direction of the
relationship between two assets. But the graphical presentation of data in this case
is more complicated because three dimensions must be used (including the
probability). Despite of it, if investor observes that more pairs of returns are in the
sections I and III than in II and IV, the population covariance will be positive, if the
pairs of return in II and IV prevails over I and III, the population covariance is
negative.
Correlation and Coefficient of determination.
Correlation is the degree of relationship between two variables.
The correlation coefficient between two assets is closely related to their

covariance.
The correlation coefficient between two assets A and B (kAB) can be calculated
using the next formula:
Cov(rA,rB)
kA,B = ------------------- ,
δ(rA) . δ(rB)
here δ (rA) and δ(rB) are standard deviation for asset A and
B consequently.
Very important, that instead of covariance when the calculated number is

unbounded, the correlation coefficient can range only from -1,0 to +1,0. The more
close the absolute meaning of the correlation coefficient to 1,0, the stronger the
relationship between the returns of two assets. Two variables are perfectly
positively correlated if correlation coefficient is +1,0, that means that the returns of
two assets have a perfect positive linear
relationship to each other , and perfectly negatively correlated if correlation

coefficient is - 1,0, that means the asset returns have a perfect inverse linear
relationship to each other . But most often correlation between assets returns is
imperfect . When correlation coefficient equals 0, there is no linear relationship
between the returns on the two assets .Combining two assets with zero correlation
with each other reduces the risk of the portfolio. While a zero correlation between
two assets returns is better than positive correlation, it does not provide the risk
reduction results of a negative correlation coefficient.
It can be useful to note, that when investor knows correlation coefficient, the
covariance between stocks A and B can be estimated, because standard deviations

of the assets’ rates of return will already are available:
Therefore, as it was pointed out earlier, the covariance primarily provides

information to the investor about whether the relationship between asset returns is
positive, negative or zero, because simply observing the number itself without any
context with which to compare the number, is not very useful. When the covariance
is positive, the correlation coefficient will be also positive, when the covariance is
negative, the correlation coefficient will be also negative. But using correlation
coefficients instead of covariance investor can immediately asses the degree of
relationship between assets returns.
The coefficient of determination (Det.AB) is calculated as the square of
correlation coefficient:
Det.A, B = k²A,B (2.13)
The coefficient of determination shows how much variability in the returns of one
asset can be associated with variability in the returns of the other. For example, if
correlation coefficient between returns of two assets is estimated + 0,80, the
coefficient of determination will be 0,64. The interpretation of this number for the
investor is that approximately 64 percent of the variability in the returns of one
asset can be explained by the returns of the other asset. If the returns on two assets
are perfect correlated, the coefficient of determination will be equal to 100 %, and
this means that in such a case if investor knows what will be the changes in returns
of one asset he / she could predict exactly the return of the other asset.
Relationship between the return on stock and market portfolio
When picking the relevant assets to the investment portfolio on the basis of their
risk and return characteristics and the assessment of the relationship of their
returns investor must consider to the fact that these assets are traded in the market.
The characteristic line and the Beta factor
Before examining the relationship between a specific asset and the market portfolio
the concept of “market portfolio” needs to be defined. Theoretical interpretation of
the market portfolio is that it involves every single risky asset in the global
economic system, and contains each asset in proportion to the total market value of
that asset relative to the total value of all other assets (value weighted portfolio).
But going from conceptual to practical approach - how to measure the return of the
market portfolio in such a broad its understanding - the market index for this
purpose can be used. Investors can think of the market portfolio as the ultimate
market index. And if the investor following his/her investment policy makes the
decision to invest, for example, only in stocks, the market portfolio practically can
be presented by one of the available representative indexes in particular stock
exchange.
characteristic line Stock’s characteristic line: describes the relationship between

the stock and the market; shows the return investor expect the stock to produce,
given that a particular rate of return appears for the market; helps to assess the risk
characteristics of one stock relative to the market. Stock’s characteristic line as a
straight line can be described by its slope and by point in which it crosses the
vertical axis – intercept.
The slope of the characteristic line is called the Beta factor. Beta factor for the stock
J and can be calculated using following formula:
Cov (rJ,rM)
βJ =--------------------,
δ²(rM)
here: Cov(rJ,rM) – covariance between returns of stock J and the market portfolio;
δ²(rM) - variance of returns on market portfolio.
The Beta factor of the stock is an indicator of the degree to which the stock reacts to
the changes in the returns of the market portfolio. The Beta gives the answer to the
investor how much the stock return will change when the market return will
change by 1 percent.
Further in Chapter 3 the use of Beta factor in developing capita asset pricing model
will be discussed.
Intercept AJ (the point where characteristic line passes through the vertical axis)
can be calculated using following formula:
AJ = rJ - βJ . rM,
here: rJ - rate of return of stock J;
βJ - Beta factor for the stock J; rM - rate of return of the market.
The intercept technically is a convenient point for drawing a characteristic line. The
interpretation of the intercept from the investor’s point of view is that it shows
what would be the rate of return of the stock, if the rate of return in the market is
zero.
Residual variance
The characteristic line isa line-of-best-fit through some data points. A characteristic
line is what in statistics is called astime-series regression line. But in
reality the stock produce returns that deviate from the characteristic line In
statistics this propensity is called the residual variance.
To calculate residual variance the residual in every period of observations must be
identified. Residual is the vertical distance between the point which reflect the pair
of returns (stock J and market) and the characteristic line of stock J.
It is useful for the interpretation of residual to investor to accentuate two
components in formula of residual
• Component 1 reflects the return actually generated by the stock J

during period t;
• Component 2 (in the bracket) represents investor’s expectations for

the
stock’s return, given its characteristic line and market’s returns.Note the difference
between the variance and the residual variance:
The variance describes the deviation of the asset returns from its expected value ;
The residual variance describes the deviation of the asset returns from its
characteristic line.
The return of any investment has an average, which is also the expected return, but
most returns will be different from the average: some will be more, others will be
less. The more individual returns deviate from the expected return, the greater the
risk and the greater the potential reward. The degree to which all returns for a
particular investment or asset deviate from the expected return of the investment is
a measure of its risk.
Standard Deviation: Measure of Absolute Risk
If you recorded the returns of a sample population of investors who invested in 5-
year Treasury notes (T-notes), you would note that everyone received a constant
rate of return that didn't deviate, since, once bought, T-notes pay a constant rate of
interest with no credit risk. On the other hand, if you had recorded the returns of a
sample of investors who had invested in small stocks at the same time, you would
see a much wider variation in their returns — some would have done much better
than the T-note investors, while others would have done worse, and each of their
returns would vary over time. This variability can be measured with statistical
methods, because investment returns generally follow a normal distribution, which
shows the probability of each deviation from the mean, which is the average return,
or the expected return, for a particular asset.
The sum of the deviations, both positive and negative, forms a normal
distribution about the mean. The normal distribution describes the variation of
many natural quantities, such as height and weight. It also describes the distribution
of investment returns. The normal distribution has the property that small
deviations from the mean are more probable than larger deviations. When graphed,
it forms a bell-shaped curve.
The mean is subtracted from each deviation, then squared to ensure that all
deviations are positive numbers, then divided by the number of returns minus 1,
which is the degrees of freedom for a small sample. This is called the variance.
The
square root of the variance is the standard deviation, which is simply the average
deviation from the expected return. Standard deviations can measure the
probability that a value will fall within a certain range. For normal distributions,
68% of all values will fall within 1 standard deviation of the mean, 95% of all values
will fall within 2 standard deviations, and 99.7% of all values will fall within 3
standard deviations.
A normal distribution can be completely described by its mean and standard
deviation. The extent of the deviation of investment returns is the volatility,
measured by the standard deviation of the investment returns for a particular asset.
Volatility differs according to the type of asset, such as stocks and bonds. Individual
assets also differ in volatility, such as the stocks of different companies and bonds
by different issuers. Volatility is commensurate with the investment's risk, and this
risk can be quantified by calculating the standard deviation for particular
investments, which is done by measuring the historical variation in the investment
returns of particular assets or classes of assets. The greater the standard deviation,
the greater the volatility, and, therefore, the greater the risk. More volatile assets
have a wider bell-shaped curve, reflecting a greater dispersion in their returns.
Likewise, 1 standard deviation will cover a wider dispersion of investment returns
for a volatile asset than for a nonvolatile asset. Hence, more volatile assets are more
likely to outperform or underperform less volatile assets.
Standard Deviation Formula for Investment Returns
s = Standard Deviation
rk = Specific Return
rexpected = Expected Return
n = Number of Returns (sample size).
Coefficient of Variation: Measure of Relative Risk
The greater the standard deviation, the greater the risk of an investment. However,
the standard deviation cannot be used to compare investments unless they have the
same expected return. For instance, consider the following table.
On the left hand side, you have an investment with an expected return of $5 where
each specific return deviates by $1 from the expected return. On the right hand side,
the specific returns also deviate by $1, but the expected return is $10. Because the
difference between the expected returns and the specific returns for each sample is
1, the standard deviation is the same, but, nonetheless, the risk is not the same,
because $1 is only 10% of $10, but 20% of $5.
The coefficient of variation is a better measure of risk, quantifying the dispersion
of an asset's returns in relation to the expected return, and, thus, the relative risk of
the investment. Hence, the coefficient of variation allows the comparison of
different investments.
Coefficient of Variation = Standard Deviation / Average Return
APPROACHES TO INVESTMENT ANALYSIS

1. Value Investing
The strategy of value investing is to find stocks that are under-priced and good
value. Warren Buffet is a fan of this investment strategy. This strategy requires
detailed fundamental analysis of the company. Value investors look at stocks which
have a market price (stock price) which is lower than the intrinsic value of the
company. Intrinsic value is defined as the discounted value of the cash that can be
taken out of a business during its remaining life. This value is an estimate which is
dependant on interest rate movements or forecasted cash flow. A stock price is
more than the intrinsic value when there is strong demand, driving the prices up.
This strategy is more suited to the long term investor as these value stocks may take
a long time before their stock prices rise. Stocks with lower P/E ratios will be more
favourable under value investing. A cheaper stock does not always mean a
profitable stock as the business may have serious issues. Hence research on the
company is necessary when evaluating a value stock.
2. Income Investing
This strategy involves buying securities that generate income for the investor.
Stocks which have a high dividend yield are selected as investors are looking for
income producing stocks. Bond proxies have been popular in income investing. Such
stocks include real estate trusts (REITs) and listed infrastructure. These are
defensive stocks but have a higher dividend yield compared to the bond market.
Stocks that have a high dividend rate may not have as much capital growth
appreciation as a stock that pays no dividends. The reason is that companies which
forgo dividend payouts reinvest those earnings into the business for expansion. The
strategy of finding companies that pay high dividends is appropriate for investors
who are living off their investment portfolio to fund their living expenses. This
strategy is suited to the conservative investor as companies who can pay large
dividends tend to be established stable companies.
3. Growth Investing
This strategy involves selecting companies which have potential to grow rapidly
in the future. These stocks may be expensive in comparison to what the company
is
earning currently as the market has already priced in future growth in these
companies. Growth companies reinvest their earnings to grow the business further
and hence may not pay a dividend at all. This strategy is more suited to the risk
seeking investor as these stocks are more volatile than average. Growth stocks have
the possibility of large capital growth gains if stocks are selected well. It is suited to
the investor who does not need income from their investment portfolio and is
willing to sacrifice income for capital growth.
4. Small Cap Investing
Another strategy for the risk seeking investor is small cap investing. This strategy is
suited to an investor who does not need access to their capital for a while. A small
cap stock is defined as company with a market capitalisation between $300million
and $2billion. Small cap stocks have historically performed well when there are
interest rate rises and the economy is strong. However large cap stocks perform
better during periods of recessions. These stocks are chosen for their potential for
future growth, but with a small market cap their volatility is higher. Unlike growth
investing, small cap stocks tend to be priced cheaply as the business is still in its
infancy. The reason why small cap stocks have a higher propensity for capital
growth than stocks in the top 20 is because they are still in the growth phase of the
business cycle. It’s easier for a company with market cap of 300m to double in size
than a stock in the top 20
5. Active Investing
This strategy involves frequent buying and selling of stocks to take advantage of
stock volatility and stock mispricing. An active investor typically holds positions
within hours, days or months. Technical analysis is more of a focus than
fundamental analysis as the investor is not investing in the stock for the long-term
frame. Active investors change stocks in the portfolio depending on market,
economic and company conditions. These investors will cut stocks that aren’t
performing or are stagnate rather than hold the stock long term anticipating the
stock will appreciate in value. The purpose of active investing is to beat the market
and outperform the index.
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6. Passive Investing
Passive investors believe the market is priced efficiently and they hold shares which
track an index. The is strategy is to match the returns of the market. These investors
buy and hold securities for the long term and there less frequent trading. Stocks are
only sold and brought when companies leave and enter the indices. If there are
large share price drops, passive investors hold onto the stock in the hope that over
time it will recover. The returns with passive investing tend me to be smaller than
active investing as it seeks to track the index and not beat it. However, transaction
costs are lower due to less trading.
THE EFFICIENT MARKET HYPOTHESIS (EMH)
Efficient market theory states that the price fluctuations are random and do not
follow any regular pattern. Fama suggested that efficient market hypothesis can be
divided into three categories.
They are: (1) the weak form,
(2) The semi strong form,
(3) The strong form.
The level of information being considered in the market is the basis for this
segregation.
Weak form of EMH
The weak form hypothesis says that the current prices of stocks already fully reflect
all the information that is contained in the historical sequence of prices. Therefore,
there is no benefit in examining the historical sequence of prices forecasting the
future. This weak form of the efficient market hypothesis is popularly known as the
random-walk theory. Clearly, if this weak form of the efficient market hypothesis is
true, it is a direct repudiation of technical analysis. If there is no value in studying
past prices and past price changes, there is no value in technical analysis. As we saw
in the preceding chapter, however, technicians place considerable reliance on the
charts of historical prices that they maintain even though the efficient-market
hypothesis refutes this practice.
Empirical tests of the weak form
Over the years an impressive literature has been developed describing empirical
tests of random walk (Paul H. Cootner, 1967). This research has been aimed at
testing whether successive or lagged price changes are independent. In this section
we will review briefly some of the major categories of statistical techniques that
have been employed in this research, and we will summarize their major
conclusions. These techniques generally fall
into two categories: those that test for trends in stock prices and thus infer whether
profitable trading systems could be developed and those that test such mechanical
systems directly. Although certain of these studies were conducted many years ago,
they are the basis upon which research on the efficient-market theory has been
based, and are included here to provide the necessary conceptual basis for the
theory and its evolution.
SEMI STRONG FORM OF EMH
The semi strong form of the efficient-market hypothesis says that current prices of
stocks not only reflect all informational content of historical prices but also reflect
all publicly available knowledge about the corporations being studied. Further-
more, the semi strong form says that efforts by analysts and investors to acquire
and analyze public information will not yield consistently superior returns to the
analyst.
Examples of the type of public information that will not be of value on a consistent
basis to the analyst are corporate reports, corporate announcements, information
relating to corporate dividend policy, forthcoming stock splits, and so forth. In
effect, the semi strong form of the efficient market hypothesis maintains that as
soon as information becomes publicly available, it is absorbed and reflected in stock
prices. Even if this adjustment is not the correct one immediately, it will in a very
short time be properly analyzed by the market. Thus the analyst would have great
difficulty trying to profit using fundamental analysis Strong form of EMH
we have seen that the weak\ form of the efficient-market hypothesis maintains that
past prices and past price changes cannot be used to forecast future price changes
and future prices. Semi strong form of the efficient-market hypothesis says that
publicly available information cannot be used to earn consistently superior
investment returns. Some studies that tend to support the semi strong theory of the
efficient-market hypothesis were cited. Finally, the strong form of the efficient-
market hypothesis maintains that not only is publicly available information useless
to the investor or analyst but all information is useless. Specifically, no information
that is available, be it public or ‘inside’, can be used to earn consistently superior
investment returns. The semi strong form of the efficient-market hypothesis could
only be tested indirectly- namely, by testing what happened to prices on days
surrounding announcements of various types, such as earnings announcements,
dividend announcements, and stock-split announcements. To test the strong form

of
efficient-market hypothesis, even more indirect methods must be used. For the
strong form, as has already been mentioned, says that no information is useful. This
implies that not even security analysts and portfolio managers who have access to
information more quickly than the general investing public are able to use this
information to earn superior returns. Therefore, many of the tests of the strong
form of the efficient market hypothesis deal with tests of mutual-fund performance.
The efficient-market hypothesis and mutual-fund performance
It has often been said that large investors such as mutual funds perform better in
the market than the small investor does because they have access to better
information. Therefore, it would be interesting to observe if mutual funds earned
above-average returns, where these are defined as returns in excess of those that
can be earned by a simple buy-and-hold strategy. The results of such an
investigation would have interesting implications for the efficient market
hypothesis.
Researchers have found that mutual funds do not seem to be able to earn greater
net returns (after sales expenses) than those that can be earned by investing
randomly in a large group of securities and holding them. Furthermore, these
studies indicate, mutual funds are not even able to earn gross returns (before sales
expenses) superior to those of the native buy-and-hold strategy. These results occur
not only because of the difficulty in applying fundamental analysis in a consistently
superior manner to a large number of securities in an efficient market but also
because of portfolio over diversification and its attendant problems- two of which
are high book-keeping and administrative costs to monitor the investments, and
purchases of securities with less favorable risk-return characteristics. Therefore, it
would seem that the mutual-fund studies lend some credence to the efficient-
market hypothesis.
BEHAVIOURAL FINANCE AND HEURISTIC DRIVEN BIASES.

Behavioral finance, first developed in the late 1970s, demonstrates the pitfalls of
economic theory that result from the assumption of rationality
“Irrational” human behavior can be categorized and modeled

By learning about how these behaviors impact investors, financial professionals can
help their clients mitigate and prevent errors
The behavioral economist’s replacement for expected utility theory is known

as prospect theory, which demonstrates cognitive shortcuts and their impact on
decision-making
Loss aversion, an aspect of prospect theory, asserts that losses loom larger than
gains
Example: Investors are prone to keep losing stocks, hoping they will rebound, and
are more likely to sell gaining stocks, afraid of a potential downturn
Individuals tend to make decisions based on how outcomes compare to a reference

point, typically the status quo
Example: An investor who sees his portfolio fall to $2 million from $3 million
considers himself worse off than an investor who sees his portfolio rise from $1
million to $1.5 million, even though the first investor still has more wealth
Cognitive errors, which cause a person’s decisions to deviate from rationality, fall
into two subcategories
Belief preservation errors refer to the tendency to cling to one’s initial belief even
after receiving new information that contradicts it
Information processing errors refer to mental shortcuts
Emotional errors arise as a result of attitudes or feelings that cause one to deviate
from rationality
The important heuristic-driven biases and cogniive errors that impair judgement
are:
 Representativeness
 Overconfidence
 Anchoring
 Aversion to ambiguity
 Innumeracy
1. Representativeness
Representativeness refers to the tendency to form judgements based on
stereotypes.
For example, you may form an opinion about how a student would perform
academically in college on the basis of how he has performed academically in
school. While representativeness may be a good rule of thumb, it can also lead
people astray.
For example: Investors may be too quick to detect patterns in data that are in
fact random.
Investors may believe that a healthy growth of earnings in the past may be
representative of high growth rate in future. They may not realise that there is a lot
of randomness in earnings growth rates.
Investors may be drawn to mutual funds with a good track record because such
funds are believed to be representative of well-performing funds. They may forget
that even unskilled managers can earn high returns by chance.
Investors may become overly optimistic about past winners and overly
pessimistic about past losers.
Investors generally assume that good companies are good stocks, although
the opposite holds true most of the time.
2. Overconfidence
People tend to be overconfident and hence overestimate the accuracy of their

forecasts. Overconfidence stems partly from the illusion of knowledge.
The human mind is perhaps designed to extract as much information as possible
from what is available, but may not be aware that the available information is not
adequate to develop an accurate forecast in uncertain situations.
Overconfidence is particularly seductive when people have special
information or experience - no matter how insignificant - that persuades them
to think that they have an investment edge. In reality, however, most of the so
called sophisticated and knowledgeable investors do not outperform the
market consistently.
Another factor contributing to overconfidence is the illusion of control. People
tend to believe that they have influence over future outcomes in an uncertain
environment. such an illusion may be fostered by factors like active involvement
and positive early outcomes. Active involvement in a task like online investing gives
investors a sense of control. Positive early outcomes, although they may be purely
fortuitous, create a illusion of control.
People perhaps remain overconfident, despite failures, because they

remember their successes and forget their failures.
Harvard psychologist Langer describes this phenomenon as "head I win, tail it's
chance". Referred to as self-attribution bias, it means that people tend to
ascribe their success to their skill and their failure to bad luck. Another reason
for persistent overconfidence and optimism is the human tendency to focus on
future plans rather than on past experience.
Overconfidence manifests itself in excessive trading in financial markets. It

also explains the dominance of active portfolio management, despite the
disappointing performance of many actively managed funds.
1. Anchoring
After forming an opinon, people are often unwilling to change it, even though
they receive new information that is relevant.
Suppose that investors have formed an opinion that company A has above-average
long-term earnings prospect. Suddenly, A reports much lower earnings than
expected. Thanks to anchoring (also referred to as conservatism), investors will
persist in the belief that the compny is above-average and will not react sufficiently
to the bad news. So, on the day of earnings announcement the stock price would
move very little. Gradually, however, the stock price would drift downwards
over a period of time as investors shed their initial conservatism.
Anchoring manifests itself in a phenomenon called the "post-earnings
announcement drift," which is well-documented empirically.
Companies that report unexpectedly bad (good) earnings news generally produce
unusually low (high) returns after the announcement
Unit-II : Capital Market

What Are Capital Markets?
Capital markets are venues where savings and investments are channeled between
the suppliers who have capital and those who are in need of capital. The entities
that have capital include retail and institutional investors while those who seek
capital are businesses, governments, and people.
Capital markets are composed of primary and secondary markets. The most
common capital markets are the stock market and the bond market.
Capital markets seek to improve transactional efficiencies. These markets bring

those who hold capital and those seeking capital together and provide a place
where entities can exchange securities.
urchasers, non-financial companies, and governments financing infrastructure

investment and operating expenses.
Capital markets are used to sell financial products such as equities and debt
securities. Equities are stocks, which are ownership shares in a company. Debt
securities, such as bonds, are interest-bearing IOUs.
These markets are divided into two different categories: primary markets—where
new equity stock and bond issues are sold to investors—and secondary markets,
which trade existing securities. Capital markets are a crucial part of a functioning
modern economy because they move money from the people who have it to
those who need it for productive use.
Primary vs. Secondary Markets

Capital markets are composed of primary and secondary markets. The majority of
modern primary and secondary markets are computer-based electronic
platforms.
Primary markets are open to specific investors who buy securities directly from the
issuing company. These securities are considered primary offerings or initial public
offerings (IPOs). When a company goes public, it sells its stocks and bonds to large-
scale and institutional investors such as hedge funds and mutual funds.
The secondary market, on the other hand, includes venues overseen by a regulatory
body like the Securities and Exchange Commission (SEC) where existing or already-
issued securities are traded between investors. Issuing companies do not have a
part in the secondary market. The New York Stock Exchange (NYSE) and Nasdaq are
examples of the secondary market.
Capital Markets Expanded

Capital markets can refer to markets in a broad sense for any financial asset.
Corporate Finance
In this realm, the capital market is where investable capital for non-financial
companies is available. Investable capital includes the external funds included in a
weighted average cost of capital calculation—common and preferred equity, public
bonds, and private debt—that are also used in a return on invested capital
calculation. Capital markets in corporate finance may also refer to equity funding,
excluding debt.
Financial Services
Financial companies involved in private rather than public markets are part of the
capital market. They include investment banks, private equity, and venture
capital (VC) firms in contrast to broker-dealers and public exchanges.

Public Markets
Operated by a regulated exchange, capital markets can refer to equity markets in
contrast to debt, bond, fixed income, money, derivatives, and commodities markets.
Mirroring the corporate finance context, capital markets can also mean equity as
well as debt, bond, or fixed income markets.
Capital markets may also refer to investments that receive capital gains
tax treatment. While short-term gains—assets held under a year—are taxed as
income according to a tax bracket, there are different rates for long-term
gains.1
These rates are often related to transactions arranged privately through investment
banks or private funds such as private equity or venture capital.
Unit III: Fundamental and Technical analysis
Fundamental Analysis
Introduction So, you want be a stock analyst? Perhaps not, but since you're reading
this we'll assume that you at least want to understand stocks. Whether it's your
burning desire to be a hotshot analyst on Wall Street or you just like to be hands-on
with your own portfolio, you've come to the right spot. Fundamental analysis is the
cornerstone of investing. In fact, some would say that you aren't really investing if
you aren't performing fundamental analysis. Because the subject is so broad,
however, it's tough to know where to start. There are an endless number of
investment strategies that are very different from each other, yet almost all use the
fundamentals. The goal of this tutorial is to provide a foundation for understanding
fundamental analysis. It's geared primarily at new investors who don't know a
balance sheet from an income statement. While you may not be a "stock-picker
extraordinaire" by the end of this tutorial, you will have a much more solid grasp of
the language and concepts behind security analysis and be able to use this to further
your knowledge in other areas without feeling totally lost. The biggest part of
fundamental analysis involves delving into the financial statements. Also known as
quantitative analysis, this involves looking at revenue, expenses, assets, liabilities
and all the other financial aspects of a company. Fundamental analysts look at this
information to gain insight on a company's future performance. A good part of this
tutorial will be spent learning about the
Technical Analysis
The methods used to analyze securities and make investment decisions fall into two
very broad categories: fundamental analysis and technical analysis. Fundamental
analysis involves analyzing the characteristics of a company in order to estimate its
value. Technical analysis takes a completely different approach; it doesn't care one
bit about the "value" of a company or a commodity. Technicians (sometimes called
chartists) are only interested in the price movements in the market. Despite all the
fancy and exotic tools it employs, technical analysis really just studies supply and
demand in a market in an attempt to determine what direction, or trend, will
continue in the future. In other words, technical analysis attempts to understand the
emotions in the market by studying the market itself, as opposed to its components.
If you understand the benefits and limitations of technical analysis, it can give you a
new set of tools or skills that will enable you to be a better trader or investor.
The Basic Assumptions What Is Technical Analysis? Technical analysis is a method

of evaluating securities by analyzing the statistics generated by market activity,
such as past prices and volume. Technical analysts do not attempt to measure a
security's intrinsic value, but instead use charts and other tools to identify patterns
that can suggest future activity. Just as there are many investment styles on the
fundamental side, there are also many different types of technical traders. Some rely
on chart patterns, others use technical indicators and oscillators, and most use some
combination of the two. In any case, technical analysts' exclusive use of historical
price and volume data is what separates them from their fundamental counterparts.
Unlike fundamental analysts, technical analysts don't care whether a stock is
undervalued - the only thing that matters is a security's past trading data and what
information this data can provide about where the security might move in the
future.
The field of technical analysis is based on three assumptions: 1. The market
discounts everything. 2. Price moves in trends. 3. History tends to repeat itself. 1.
The Market Discounts Everything A major criticism of technical analysis is that it
only considers price movement, ignoring the fundamental factors of the company.
However, technical analysis assumes that, at any given time, a stock's price reflects
everything that has or could affect the company - including fundamental factors.
Technical analysts believe that the company's fundamentals, along with broader
economic factors and market psychology, are all priced into the stock, removing the
need to actually consider these factors separately. This only leaves the analysis of
price movement, which technical theory views as a product of the supply and
demand for a particular stock in the market. 2. Price Moves in Trends In technical
analysis, price movements are believed to follow trends. This means that after a
trend has been established, the future price movement is more likely to be in the
same direction as the trend than to be against it. Most technical trading strategies
are based on this assumption.
2. History Tends To Repeat Itself Another important idea in technical analysis

is that history tends to repeat itself, mainly in terms of price movement.
The repetitive nature of price movements is attributed to market
psychology; in other words, market participants tend to provide a
consistent reaction to similar market stimuli over time. Technical analysis
uses chart patterns to analyze market movements and understand trends.
Although many of these charts have been used for more than 100 years,
they are still believed to be relevant because they illustrate patterns in
price movements that often repeat themselves. Not Just for Stocks
Technical analysis can be used on any security with historical trading data.
This includes stocks, futures and commodities, fixed-income securities,
forex, etc. In this tutorial, we'll usually analyze stocks in our examples, but
keep in mind that these concepts can be applied to any type of security. In
fact, technical analysis is more frequently associated with commodities and
forex, where the participants are predominantly traders. Now that you
understand the philosophy behind technical analysis, we'll get into
explaining how it really works. One of the best ways to understand what
technical analysis is (and is not) is to compare it to fundamental analysis.
We'll do this in the next section.
By looking at the balance sheet, cash flow statement and income statement, a
fundamental analyst tries to determine a company's value. In financial terms, an analyst
attempts to measure a company's intrinsic value. In this approach, investment decisions
are fairly easy to make - if the price of a stock trades below its intrinsic value, it's a good
investment. Although this is an oversimplification (fundamental analysis goes beyond
just the financial statements) for the purposes of this tutorial, this simple tenet holds true.
Technical traders, on the other hand, believe there is no reason to analyze a company's
fundamentals because these are all accounted for in the stock's price. Technicians believe
that all the information they need about a stock can be found in its charts. Time Horizon
Fundamental analysis takes a relatively long-term approach to analyzing the market
compared to technical analysis. While technical analysis can be used on a timeframe of
weeks, days or even minutes, fundamental analysis often looks at data over a number of
years. The different timeframes that these two approaches use is a result of the nature of
the investing style to which they each adhere. It can take a long time for a company's
value to be reflected in the market, so when a fundamental analyst estimates intrinsic
value, a gain is not realized until the stock's market price rises to its "correct" value. This
type of investing is called value investing and assumes that the short-term market is
wrong, but that the price of a particular stock will correct itself over the long run. This
"long run" can represent a timeframe of as long as several years, in some cases. (For more
insight, read Warren Buffett: How He Does It and What Is Warren Buffett's Investing
Style?) Furthermore, the numbers that a fundamentalist analyzes are only released over
long periods of time. Financial statements are filed quarterly and changes in earnings per
share don't emerge on a daily basis like price and volume information. Also remember
that fundamentals are the actual characteristics of a business. New management can't
implement sweeping changes overnight and it takes time to create new products,
marketing campaigns, supply chains, etc. Part of the reason that fundamental analysts use
a long-term timeframe, therefore, is because the data they use to analyze a stock is
generated much more slowly than the price and volume data used by technical analysts.
Trading Versus Investing Not only is technical analysis more short term in nature that
fundamental analysis.
A More Formal Definition Unfortunately, trends are not always easy to see. In other words,
defining a trend goes well beyond the obvious. In any given chart, you will probably notice
that prices do not tend to move in a straight line in any direction, but rather in a series of highs
and lows. In technical analysis, it is the movement of the highs and lows that constitutes a
trend. For example, an uptrend is classified as a series of higher highs and higher lows, while a
downtrend is one of lower lows and lower highs.
Unit IV : Mutual Funds

A Mutual Fund is a trust that collects money from investors who share a common financial
goal, and
invest the proceeds in different asset classes, as defined by the investment objective. Simply
put,
mutual fund is a financial intermediary, set up with an objective to professionally manage the
money
pooled from the investors at large.
By pooling money together in a mutual fund, investors can enjoy economies of scale and can
purchase
stocks or bonds at a much lower trading costs compared to direct investing in capital
markets. The
other advantages are diversification, stock and bond selection by experts, low costs,
convenience and
flexibility.
An investor in a mutual fund scheme receives units which are in accordance with the
quantum of
money invested by him. These units represent an investor’s proportionate ownership into
the assets of
a scheme and his liability in case of loss to the fund is limited to the extent of amount
invested by him.
The pooling of resources is the biggest strength for mutual funds. The relatively lower
amounts
required for investing into a mutual fund scheme enables small retail investors to enjoy the
benefits
of professional money management and lends access to different markets, which they
otherwise may
not be able to access. The investment experts who invest the pooled money on behalf of
investors
of the scheme are known as 'Fund Managers'. These fund managers take the investment
decisions
pertaining to the selection of securities and the proportion of investments to be made into
them.
However, these decisions are governed by certain guidelines which are decided by the
investment
objective(s), investment pattern of the scheme and are subject to regulatory restrictions. It is
this
investment objective and investment pattern which also guides the investor in choosing the
right
fund for his investment purpose.
Today, there are a variety of schemes offered by mutual funds in India, which cater to
different categories
of investors to suit different financial objectives e.g. some schemes may provide capital
protection for
the risk-averse investor, whereas some other schemes may provide for capital appreciation
by investing
in mid or small cap segment of the equity market for the more aggressive investor.
The diversity in investment objectives and mandates has helped to classify and sub-classify
the schemes
accordingly. The broad classification can be done at the asset class levels. Thus we have
Equity Funds,
Bond Funds, Liquid Funds, Balanced Funds, Gilt Funds etc. These can be further sub-
classified into
different categories like mid cap funds, small cap funds, sector funds, index funds etc.
2. How are Mutual Funds set up?
A mutual fund is set up in the form of a trust, which has Sponsor, Trustees, Asset
Management
Company (AMC) and Custodian. The trust is established by a sponsor or more than one
sponsor who
is like a promoter of a company and registered with Securities and Exchange Board of India
(SEBI). The
trustees of the mutual fund hold its property for the benefit of the unit holders. Asset
Management
Company (AMC) approved by SEBI manages the funds by making investments in various
types of
securities. Custodian, who is registered with SEBI, holds the securities of various schemes of
the fund
(2)
in its custody. The trustees are vested with the general power of superintendence and
direction over
the AMC. They monitor the performance and compliance of SEBI regulations by the mutual
fund.
SEBI Regulations require that at least two thirds of the directors of trustee company or board
of trustees
must be independent i.e. they should not be associated with the sponsors. Also, 50% of the
directors
of AMC must be independent.
3. Types of Mutual Fund Schemes
Mutual Fund schemes can be classified into different categories and subcategories based on
their
investment objectives or their maturity periods.
Mutual Fund schemes can be classified into three categories based on their maturity periods.
Open-ended funds : An open-ended fund or scheme is one that is available for subscriptions
and
redemptions on a continuous basis. Investors can conveniently buy and sell units at Net
Asset Value
(NAV) related prices which are declared on a daily basis.
Close-ended funds : A close-ended fund or scheme has a stipulated maturity period which
can range
from a few months to a few years, e.g. 6 months, 5 years or 7 years. i.e. fund is open for
subscription
only during a specified period at the time of launch of the scheme which is the New Fund
Offer (NFO).
Investors can invest in the scheme at the time of the NFO and thereafter, they can buy or sell
the units
of the scheme on the stock exchanges where the units have to be mandatorily listed.
Interval funds : These schemes are a cross between an open-ended and a close-ended
structure.
These schemes are open for both purchase and redemption during pre-specified intervals
(viz.
monthly, quarterly, annually etc.) at the prevailing NAV based prices. Interval funds are very
similar to
close-ended funds, but differ on the following points:-
• They are not required to be listed on the stock exchanges, as they have an in-built
redemption
window.
• They can make fresh issue of units during the specified interval period, at the prevailing
NAV based
prices.
• Maturity period is not defined.
Exchange Traded Funds : Exchange Traded Funds or ETFs are essentially Index Funds that
are listed
and traded on exchanges like stocks. They enable investors to gain broad exposure to indices
on stock
markets in India and in some cases in other countries as well. These indices, if based on
certain specific
sectors/themes would thus provide exposure to such sectors with relative ease, on a real-
time basis
and at a lower cost than many other forms of investing. For example there are ETFs that
track S&P
CNX Nifty, BSE Sensex etc. Gold ETF are mutual fund schemes where the underlying
investment is in
physical gold.
Fund of Funds : Fund of Funds (FoF) as the name suggests are schemes which invest in other
mutual
fund schemes. The concept is popular in markets where there are number of mutual fund
offerings
and choosing a suitable scheme according to one’s objective is tough. Just as a mutual fund
scheme
(3)
invests in a portfolio of securities such as equity, debt etc.,the underlying investments for a
FoF is the
units of other mutual fund scheme(s), either from the same fund family or from other fund
houses or
from funds domiciled outside the home country (known as overseas feeder fund or fund of
fundsexplained
in detail under section types of equity funds).
4. Classification based on investment objective
Apart from the above classification, mutual fund schemes can also be classified based on
their
investment objectives.
Equity Funds : Growth/ Equity oriented schemes are those schemes which predominantly
invest in
equity and equity related instruments. The objective of such schemes is to provide capital
appreciation
over the medium to long term. These types of schemes are generally meant for investors with
a longterm
investment horizon and with a higher risk appetite.
Type of Equity Funds
a) Diversified Funds
• Multi-Cap Funds : These funds invest across the market capitalization i.e. in large, mid and
small cap companies.
• Large Cap : These funds invest predominantly in large companies. Generally, large cap
companies experience a slower growth rate and have much lower risk than mid cap
companies
due to their size. They are also known as blue chip companies.
• Mid Cap : These funds invest predominantly in mid cap companies. Most mid cap
companies
experience higher growth than a large cap company.
• Small Cap : Small cap refers to a company that it is relatively new and has lower market
capitalisation. Of the three, small cap companies represent the most investment risk but also
the highest return potential.
• Tax Saving Fund : These funds are also known as Equity Linked Savings Schemes (ELSS). In
case
of ELSS schemes investment upto Rs. 1 lakh qualify for deductions under Section 80C of the
Income tax Act, 1961, however, these schemes have a lock in period of 3 years.
• Equity–International : These funds invest in companies of foreign country. The investment

could be specific to a country (like the China, US fund etc.) or diversified across countries/
region (like Europe, Asia etc.). By seeking exposure to foreign stocks in portfolio one can
spread
investment risk and achieve diversification. AMCs generally tie up with a foreign fund (called
‘Underlying Fund’) and in India they launch a ‘Feeder Fund’. The money collected in the
feeder
fund is invested in the underlying fund. Sometimes AMCs also launch schemes investing
directly
in equity securities of international companies. In such schemes, the local investors invest in
rupees for buying the units. The rupees are converted into foreign currency for investing
abroad.
Thus, there is an element of foreign currency risk while investing in such schemes. Also, it
should
be noted that tax treatment of international equity funds is similar to debt funds.
• Equity Income / Dividend Yield Schemes : Dividend yield schemes generally invest in a
welldiversified
portfolio of companies with relatively high dividend yield, which provides a steady
stream of cash flows by way of dividend.
(4) (4)
b) Sector Funds : Sector funds invest in companies in a particular sector. For example, a
banking
sector fund will invest only in shares of banking companies.
c) Thematic funds : Thematic Funds invest in line with an investment theme. For example, an
infrastructure thematic fund will invest in shares of companies that are directly or indirectly
related
to the infrastructure sector.
d) Arbitrage Funds : These funds exploit arbitrage opportunities such that the risk is
neutralized, but
a return is earned. The arbitrage is sought by taking advantage of a price differential of the
same
asset between two or more markets, say, taking advantage of the mispricing between the
cash
and derivatives market. These funds generally have low risk-return trade-off.
Index Funds : Index Funds invests in companies that constitute the index and in the same
proportion,
in order to replicate a specific market index and provide a rate of return over time that will
approximate
or match that of the market which they are mirroring subject to tracking error.
Income/ Debt Oriented Funds : Such schemes generally invest in debt securities like
Treasury Bills,
Government Securities, Bonds and Debentures etc. They are considered less risky than
equity schemes,
but also offer lower returns.
Gilt Funds : These funds invest exclusively in Government securities. Government securities
have no
default risk. NAVs of these schemes also fluctuate due to changes in interest rates and other
economic
factors as is the case with income or debt oriented schemes.
Money Market/Liquid Funds : These funds aim to provide easy liquidity, preservation of
capital
and moderate income. They invest in safer short-term instruments such as certificates of
deposit,
commercial paper, etc. These schemes are used mainly by institutions and individuals to
park their
surplus funds for short periods of time. These funds are more or less insulated from changes
in the
interest rate in the economy and capture the current yields prevailing in the market.
Hybrid Funds
Balanced Funds : These are the funds that aim at allocating the total assets with it in the
portfolio
mix of debt and equity instruments. Balanced funds provide investor with an option of single
mutual
fund that combines both growth and income objectives, by investing in both stocks (for
growth) and
bonds (for income). Balanced funds are also called equity oriented funds and their tax
treatment is
similar to an equity fund. Their average returns and risk profile fall somewhere in between
growth and
debt funds.
Monthly Income Plans : These plans seek to provide regular income by declaring dividends. It
therefore invests largely in debt securities. However, a small percentage is invested in equity
shares
to improve the scheme’s yield. Monthly Income Plan are also called debt oriented hybrid
schemes.
‘Monthly Income’ is however not assured and depends on the distributable surplus of the
scheme.
Capital Protection Oriented Schemes : These are mutual fund schemes which endeavour to
protect
the capital invested therein through suitable orientation of its portfolio structure. The
orientation
towards protection of capital originates from the portfolio structure of the scheme and not
from any
bank guarantee, insurance cover etc. SEBI stipulations require these type of schemes to be
close-
(5) (5)
ended in nature, listed on the stock exchange and the intended portfolio structure would
have to
be mandatory rated by a credit rating agency. A typical portfolio structure could be to set
aside
major portion of the assets for capital safety and could be invested in highly rated debt
instruments.
The remaining portion would be invested in equity or equity related instruments to provide
capital
appreciation. Capital Protection Oriented schemes should not be confused with ‘Capital
Guaranteed’
schemes.
5. Investment Plans/Options available to investors
Investment Plans
Direct Plan : Under direct plan investors can invest directly with a fund house where in no
agent or
distributor is involved and thus they can save on costs. The direct plan has a separate NAV,
which is
generally higher than normal or regular plan as direct plan charges lower expenses because
it does not
entail paying any commission to agent/distributor and thus gets reflected in the form of
higher NAV.
Regular or Normal Plan : Under regular or normal plan investors can invest through an agent
or
distributor in order to avail their investment advice/services. The regular plan too has a
separate NAV,
which is generally lower than direct plan as former charges higher expenses in order to pay
commission
to an intermediary involved.
Investment Options
Growth Option : Under growth option, dividends are not paid out to the unit holders. Income
attributable to the unit holders continues to remain invested in the scheme and is reflected in
the NAV
of units under this option. Investors can realize capital appreciation if any, by way of an
increase in NAV
of their units by redeeming them.
Dividend Payout Option : Dividends are paid out to the unit holders under this option.
However, the
NAV of the units falls to the extent of the dividend paid out and applicable statutory levies.
Dividend Re-investment Option : The dividend that accrues on units under option is re-
invested
back into the scheme at ex-dividend NAV. Hence investors receive additional units on their
investments in lieu of dividends.
6. Benefits of Mutual Fund
There are two major reasons why most people around the globe are afraid to take
investment decisions
on their own. One of them is the lack of time to study the pros and cons of different
investment
opportunities and the other being lack of financial know-how. Apart from that, some financial
markets
have a steep entry barrier, which prevents a small ticket investor from participating in the
growth of
that sector. Investment needs across different category of investors are also not common.
While some
may settle for safety of capital, others may chase returns. There may be others who would
want their capital to grow at a steady pace, while some may want to save for retirement or
child’s education. The need and objective of the investors are truly diverse and one financial
product can’t fulfill all of them.
The emergence of mutual funds in the past decade as a popular investment vehicle is due to
the fact
that it serves broadly all categories of investors through the plethora of schemes that it
offers. The benefits provided by mutual funds far outweigh its shortcomings, and has thus
gained wide-spread acceptance.
Following are the key benefits of investing in mutual funds:
• Professional Management: Mutual funds provide the benefit of professional management as
people’s money is managed by experienced fund managers. Investors, who do not have time,
inclination and the know-how to manage their investments, can look towards mutual funds
as an
alternative. It is inexpensive and is ideal for a small ticket investor.
• Economies of scale: The way mutual funds are structured gives it a natural advantage. The
“pooled” money from a number of investors ensures that mutual funds enjoy economies of
scale; it is cheaper compared to investing directly in the capital markets which involves
higher charges.
This also allows retail investors access to high entry level markets like real estate, and also
there is
a greater control over costs.
• Diversification: Mutual funds provide investors with the benefit of diversification across
different
companies and sectors. Diversification in simple terms means to spread your portfolio across
different instruments, sectors, industries, companies and countries so that the overall
portfolio
is relatively safeguarded from downturns in one or more sectors, companies or countries.
Since
small investors do not have enough money to make meaningful investments across different
assets, a mutual fund does the job for them.
• Liquidity: Open ended mutual funds provide easy liquidity and investors can buy or sell
units
anytime, at the prevailing NAV based prices. Close-ended schemes are listed on a stock
exchange
where investors can redeem their units at the prevailing market price. Interval funds which
are a
cross between a close-ended and an open ended structure also provide periodic liquidity
option
to its investors.
• Flexibility: There are a lot of features in a regular mutual fund scheme, which imparts
flexibility to
the scheme. An investor can opt for a Systematic Investment Plan (SIP), Systematic
Withdrawal Plan
(SWP), Systematic Transfer Plan (STP)etc. to plan his cash flow requirements as per his
convenience.
The wide range of schemes being launched in India by different mutual funds also provides
an
added flexibility to the investor to build his portfolio accordingly.

• Convenience: Mutual fund companies offer convenient routes to investing in their schemes.
Investors can invest through the internet or mobile phone in addition to the conventional
option
of physically filling up an application form and submitting it. Further, as bank details are
required
to be submitted at the time of investment, redemptions become very convenient as an
investor
directly receives the proceeds in the bank account.
• Transparency: The mutual fund industry in India works on a very transparent basis, and
various
kind of information is available to their investors through fact sheets, offer documents,
annual
reports etc.
• Well Regulated: Indian Mutual Fund industry is well regulated by the Securities and
Exchange
Board of India (SEBI). This helps to instill confidence and provides comfort to the investors.
The regulatory environment in India is quite healthy, and ensures transparency in the
processes and
transactions.
The best practices adopted by the industry in India have helped them win investors’
confidence over
the years. The ease and convenience which mutual funds offer and the different variety of
schemes
made available to the investors creates popularity for mutual funds, which cuts across
investor classes
and creates a favourable appeal.
7. Mutual Fund Myths
There are few myths and misconceptions associated with investing in mutual fund schemes.
Some
of these notions have faded over time, as investor awareness has increased but some
continue to
hold strong. It is imperative to dispel these myths as investments should not be made under
wrong
impressions. It can throw the best laid out financial plan out of control, and the situation can
be
avoided with a little bit of caution.
Lower NAV is cheaper : The most common myth that is prevalent among mutual fund
investors is
that of associating a scheme with a lower NAV being a better buy compared to a scheme with
a higher
NAV. This stems from the mind set of equating mutual fund units with equity shares of a
company. NAV
of a scheme is irrelevant and irrespective of whether we are investing into a fund having a
low NAV or
a fund with a higher NAV, the amount of investment remains the same.
Let’s look at a hypothetical investment into two schemes A and B. Scheme A has a NAV of Rs
10
whereas scheme B has a NAV of Rs 200. We made equal amount of investment of Rs. 1 lakh
each in
both the schemes. Scheme A would come across as a cheaper buy because we got 10,000
units as
against 500 units in scheme B. Now, let us assume that both the scheme returns 10 % in a
month. The
NAV for scheme A is Rs 11 and Scheme B has a NAV of Rs 220. The value of your investment
in both
the case is Rs 1,10,000. Therefore, we see that the NAV of a scheme is irrelevant, as far as
generating
returns is concerned. The only difference being in case of the former, the investor gets more
units and
in the latter, he gets lesser units. For two schemes with identical portfolio and other things
remaining
constant, the difference in NAV will hardly matter and both the schemes will grow at the
same rate.
Regular dividends means good performance : Another popular myth which emerges due to
the
linkages we make between the concepts of a stock markets and mutual funds is the dividend
payout
mechanism. When a company pays dividend, in effect it is transferring acerta in portion of its
surplus
to its shareholders. Therefore a generous dividend payout policy could be considered
favourable in
case of a company. However, in case of mutual funds, dividends are declared out of the
distributable
surplus which is included in calculation of net asset value. In effect it is paying back a certain
portion
of net assets from our own investments. Therefore, dividends from mutual fund units don’t
make us
any richer, as there are no additional gains to be made. The NAV of the scheme falls to the
extent of the
dividend payout, when a scheme pays dividend. Thus, a scheme with a high dividend payout
record
does not necessarily mean that it is performing well. Dividend option may prove important
to plan
cash flows, especially in the case of tax savings scheme which have a lock-in period and also
for tax
incidence.
Demat account is required for MF investments : Except in case of schemes which are listed on
the
stock exchange and are available on their platforms, demat account is not required to own
units in a
mutual fund scheme.
Past performers are the best funds to buy : Despite the disclaimers, mutual fund investors
tend to
invest in the top performing scheme of the last year, hoping that past performance will
ensure that
the scheme continues to stay at the top. Therefore, instead of chasing the top performer in
the short
term, it is advisable to invest in a scheme which features in the top quartile consistently over
a longer
period of time. In addition to past performance, the investors should also consider other
factors viz.
professional management, service standards etc.
Fees and Expenses : As is the case with any other business, running a mutual fund business
also
involves costs. The various costs incurred by a mutual fund could be associated with
transactions
made by investors, operating costs, marketing and distribution expenses etc. Expenses borne
by the
mutual fund investor can be broadly classified into two categories: - (i) The load which may
be charged
to the investor at the time of redemption (ii) The recurring expenses which are charged to
the fund.
Loads or Sales Charges : Loads are charges which investors incur when they redeem units in
a mutual
fund scheme. A load charged at the time of redemption is known as ‘Exit Load or Back End
Load’. Asset
management companies charge these loads to defray the selling and distribution expenses
including
commission paid to the agents/distributors.
Since August 1, 2009 entry load has been banned and therefore purchase/subscription of
mutual
funds happen at a price which is equal to the NAV. However, an investor is required to pay an
exit load
(if any) if he chooses to redeem units. This happens at a price linked to the NAV. This re-
purchase price
price may differ from NAV to the extent of exit load charged, if any.
Further, expenses related to New Fund Offer (NFO) are borne by the AMC / Trustee /
Sponsor.
Recurring Expenses : These are costs incurred for day to day operation of a scheme. These
expenses
inter alia include investment management and advisory fees, trustee fees, registrar’s fees,
custodian’s
fees, Audit fees, marketing and selling expenses including agents’ commission etc. Expenses
exceeding
the specified limit are to borne by the AMC.
The recurring expenses (including investment management fees) that can be charged to the
scheme
are subject to following limits (as a percentage of daily net assets):-
First Rs. 100 crores Next Rs. 300 crores Next Rs. 300 crores Balance
2.50% 2.25% 2.00% 1.75%
In addition to TER within the limits specified under regulation 52 (6) of the Regulations (as
specified
above), the AMC may charge expenses not exceeding 0.20% of daily net assets of the scheme,
towards
investment & advisory fees as specified under regulation 52(2) of the Regulations and/or
towards
recurring expenses as specified under 52(4) of the Regulations.
(9)
Additional Distribution Expenses in case of new inflows from specified cities
In addition to total expenses ratio (TER) as specified above, the AMC will charge expenses
not exceeding
0.30% of daily net assets if the new inflows in the scheme from such cities, as specified by
SEBI from
time to time, are at least:
(i) 30% of gross new inflows in the scheme, or;
(ii) 15% of the average assets under management (year to date) of the scheme, whichever is
higher.
In case, inflows from such cities is less than the higher of (i) or (ii) of above, such expenses on
daily
net assets of scheme will be charged on proportionate basis in accordance with SEBI Circular
vide
reference no. CIR/IMD/DF/21/2012 dated September 13, 2012. The additional expenses on
account
of inflows from such cities charged will be credited back to the scheme in case the said
inflows are
redeemed within a period of one year from the date of investment. The additional expenses
charged
in case of inflows from such cities will be utilized for distribution expenses incurred for
bringing inflows
from such cities.
Brokerage and Transaction Cost: In addition to limits specified in regulation 52 (6) of the
Regulations,
brokerage and transaction costs incurred for the purpose of execution of trade not exceeding
0.12%
of value of trade in case of cash market transaction and 0.05% of value of trade in case of
derivative
transactions (inclusive of service tax) will be capitalised.
Any payment towards brokerage and transaction cost for execution of trade, over and above
the said
limit of 0.12% for cash market transactions and 0.05% for derivatives transactions may be
charged to
the scheme within the maximum limit of TER as prescribed under regulation 52 of the
Regulations.
The total expenses of the scheme(s) including the Investment Management and Advisory Fee
shall
not exceed the limits stated in Regulation 52 of the SEBI (MF) Regulations. Any expenditure
in excess
of the prescribed limit (including brokerage and transaction cost, if any) will be borne by the
AMC/ the Trustee /Sponsors. The Mutual Funds needs to update the current expense ratios
on its website within two working days mentioning the effective date of change.
Mutual Fund investments are subject to market risks, read all scheme related documents
carefully.
Unit V Derivatives
Introduction
The objective of an investment decision is to get required rate of return

with minimum risk. To achieve this objective, various instruments, practices
and strategies have been devised and developed in the recent past. With the
opening of boundaries for international trade and business, the world trade
gained momentum in the last decade, the world has entered into a new phase
of global integration and liberalisation. The integration of capital markets
world-wide has given rise to increased financial risk with the frequent
changes in the interest rates, currency exchange rate and stock prices. To
overcome the risk arising out of these fluctuating variables and increased
dependence of capital markets of one set of countries to the others, risk
management practices have also been reshaped by inventing such
instruments as can mitigate the risk element. These new popular
instruments are known as financial derivatives which, not only reduce
financial risk but also open us new opportunity for high risk takers.
Defining derivatives
Literal meaning of derivative is that something which is derived. Now
question arises as to what is derived? From what it is derived? Simple one
line answer is that value/price is derived from any underlying asset. The term
‘derivative’ indicates that it has no independent value, i.e., its value is
entirely derived from the value of the underlying asset. The underlying asset
can be securities, commodities, bullion, currency, livestock or anything else.
The Securities Contracts (Regulation) Act 1956 defines ‘derivative’ as under:
‘Derivative’ includes–
Security derived from a debt instrument, share, loan whether secured
or unsecured, risk instrument or contract for differences or any other form of
security.
A contract which derives its value from the prices, or index of prices of
underlying securities.
There are two types of derivatives. Commodity derivatives and
financial derivatives. Firstly derivatives originated as a tool for managing
risk in commodities markets. In commodity derivatives, the underlying asset
is a commodity. It can be agricultural commodity like wheat, soybeans,
rapeseed, cotton etc. or precious metals like gold, silver etc. The term
financial derivative denotes a variety of financial instruments including
stocks, bonds, treasury bills, interest rate, foreign currencies and other hybrid
securities. Financial derivatives include futures, forwards, options, swaps,
etc. Futures contracts are the most important form of derivatives, which are
in existence long before the term ‘derivative’ was coined. Financial derivatives
can also be derived from a combination of cash market instruments or other
financial derivative instruments. In fact, most of the financial derivatives are
not new instruments rather they are merely combinations of older generation
derivatives and/or standard cash market instruments.
Evolution of derivatives
It is difficult to trace out origin of futures trading since it is not clearly
established as to where and when the first forward market came into
existence. Historically, it is evident that futures markets were developed after
the development of forward markets. It is believed that the forward trading
was in existence during 12th century in England and France. Forward trading
in rice was started in 17th century in Japan, known as Cho-at-Mai a kind
(rice trade-on-book) concentrated around Dojima in Osaka, later on the trade
in rice grew with a high degree of standardization. In 1730, this market got
official recognition from the Tokugawa Shogurate. As such, the Dojima rice
market became the first futures market in the sense that it was registered on
organized exchange with the standardized trading norms.
The butter and eggs dealers of Chicago Produce Exchange joined hands
in 1898 to form the Chicago Mercantile Exchange for futures trading.
The
exchange provided a futures market for many commodities including pork
bellies (1961), live cattle (1964), live hogs (1966), and feeder cattle (1971). The
International Monetary Market was formed as a division of the Chicago
Mercantile Exchange in 1972 for futures trading in foreign currencies. In
1982, it introduced a futures contract on the S&P 500 Stock Index. Many
other exchanges throughout the world now trade futures contracts. Among
these are the Chicago Rice and Cotton Exchange, the New York Futures
Exchange, the London International Financial Futures Exchange, the

Toronto Futures Exchange and the Singapore International Monetary
Exchange.
During 1980’s, markets developed for options in foreign exchange,
options on stock indices, and options on futures contracts. The Philadelphia
Stock Exchange is the premier exchange for trading foreign exchange options.
The Chicago Board Options Exchange trades options on the S&P 100 and the
S&P 500 stock indices while the American Stock Exchange trades options on
the Major Market Stock Index, and the New York Stock Exchange trades
options on the NYSE Index. Most exchanges offering futures contracts now
also offer options on these futures contracts. Thus, the Chicago Board of
Trades offers options on commodity futures, the Chicago Mercantile
Exchange offers options on live cattle futures, the International Monetary
Market offers options on foreign currency futures, and so on.
The basic cause of forward trading was to cover the price risk. In
earlier years, transporting goods from one market to other markets took
many months. For example, in the 1800s, food grains produced in England
sent through ships to the United States which normally took few months.
Sometimes, during this time, the price trembled due to unfavourable events
before the goods reached to the destination. In such cases, the producers had
to sell their goods at loss. Therefore, the producers sought to avoid such price
risk by selling their goods forward, or on a “to arrive” basis. The basic idea
behind this move at that time was simply to cover future price risk. On the
opposite side, the speculator or other commercial firms seeking to offset their
price risk came forward to go for such trading. In this way, the forward
trading in commodities came into existence.
In the beginning, these forward trading agreements were formed to
buy and sell food grains in the future for actual delivery at the predetermined
price. Later on these agreements became transferable, and during
the American Civil War period, Le., 1860 to 1865, it became common place to
sell and resell such agreements where actual delivery of produce was not
necessary. Gradually, the traders realized that the agreements were easier to
buy and sell if the same were standardized in terms of quantity, quality and
place of delivery relating to food grains. In the nineteenth century this
activity was centred in Chicago which was the main food grains marketing
centre in the United States. In this way, the modern futures contracts first
came into existence with the establishment of the Chicago Board of Trade
(CBOT) in the year 1848, and today, it is the largest futures market of the
world. In 1865, the CBOT framed the general rules for such trading which
later on became a trendsetter for so many other markets.
In 1874, the Chicago Produce Exchange was established which
provided the market for butter, eggs, poultry, and other perishable
agricultural products. In the year 1877, the London Metal Exchange came
into existence, and today, it is leading market in metal trading both in spot as
well as forward. In the year 1898, the butter and egg dealers withdrew from
the Chicago Produce Exchange to form separately the Chicago Butter and
Egg Board, and thus, in 1919 this exchange was renamed as the Chicago
Mercantile Exchange (CME) and was reorganized for futures trading. Since
then, so many other exchanges came into existence throughout the world
which trade in futures contracts.
Although financial derivatives have been is operation since long, but
they have become a major force in financial markets in the early 1970s. The
basic reason behind this development was the failure of Brettonwood System
and the fixed exchange rate regime was broken down. As a result, new
exchange rate regime, i.e., floating rate (flexible) system based upon market
forces came into existence. But due to pressure or demand and supply on
different currencies, the exchange rates were constantly changing, and often,
substantially. As a result, the business firms faced a new risk, known as
currency or foreign exchange risk. Accordingly, a new financial instrument
was developed to overcome this risk in the new financial environment.
Another important reason for the instability in the financial market
was fluctuation in the short-term interests. This was mainly due to that most
of the government at that time tried to manage foreign exchange fluctuations

through short-term interest rates and by maintaining money supply targets,
but which were contrary to each other. Further, the increased instability of
short-term interest rates created adverse impact on long-term interest rates,
and hence, instability in bond prices, because they are largely determined by
long-term interest rates. The result is that it created another risk, named
interest rate risk, for both the issuers and the investors of debt instruments.
Interest rate fluctuations had not only created instability in bond
prices, but also in other long-term assets such as, company stocks and shares.
Share prices are determined on the basis of expected present values of future
dividend payments discounted at the appropriate discount rate. Discount
rates are usually based on long-term interest rates in the market. So

increased instability in the long-term interest rates caused enhanced
fluctuations in the share prices in the stock markets. Further volatility in
stock prices is reflected in the volatility in stock market indices which causes
systematic risk or market risk.
In the early 1970s, it is witnessed that the financial markets were
highly instable, as a result, so many financial derivatives have been emerged
as the means to manage the different types of risks stated above, and also for
taking advantage of it. Hence, the first financial futures market was the
International Monetary Market, established in 1972 by the Chicago
Mercantile Exchange which was followed by the London International
Financial Futures Exchange in 1982. The Forwards Contracts (Regulation)
Act, 1952, regulates the forward/futures contracts in commodities all over
India. As per this the Forward Markets Commission (FMC) continues to have
jurisdiction over commodity forward/futures contracts. However when
derivatives trading in securities was introduced in 2001, the term ‘security’ in
the Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to
include derivative contracts in securities. Consequently, regulation of
derivatives came under the preview of Securities Exchange Board of India
(SEBI). We thus have separate regulatory authorities for securities and
commodity derivative markets.

Features of financial derivatives
It is a contract: Derivative is defined as the future contract between
two parties. It means there must be a contract-binding on the underlying
parties and the same to be fulfilled in future. The future period may be short
or long depending upon the nature of contract, for example, short term
interest rate futures and long term interest rate futures contract.
7
Derives value from underlying asset: Normally, the derivative
instruments have the value which is derived from the values of other
underlying assets, such as agricultural commodities, metals, financial assets,
intangible assets, etc. Value of derivatives depends upon the value of
underlying instrument and which changes as per the changes in the
underlying assets, and sometimes, it may be nil or zero. Hence, they are
closely related.
Specified obligation: In general, the counter parties have specified
obligation under the derivative contract. Obviously, the nature of the
obligation would be different as per the type of the instrument of a derivative.
For example, the obligation of the counter parties, under the different
derivatives, such as forward contract, future contract, option contract and
swap contract would be different.
Direct or exchange traded: The derivatives contracts can be
undertaken directly between the two parties or through the particular
exchange like financial futures contracts. The exchange-traded derivatives
are quite liquid and have low transaction costs in comparison to tailor-made
contracts. Example of exchange
traded derivatives are Dow Jons, S&P 500,
Nikki 225, NIFTY option, S&P Junior that are traded on New York Stock
Exchange, Tokyo Stock Exchange, National Stock Exchange, Bombay Stock
Exchange and so on.
Related to notional amount: In general, the financial derivatives
are carried off-balance sheet. The size of the derivative contract depends upon
its notional amount. The notional amount is the amount used to calculate the
payoff. For instance, in the option contract, the potential loss and potential
payoff, both may be different from the value of underlying shares, because the
payoff of derivative products differ from the payoff that their notional amount
might suggest.
8
Delivery of underlying asset not involved: Usually, in derivatives
trading, the taking or making of delivery of underlying assets is not involved,
rather underlying transactions are mostly settled by taking offsetting
positions in the derivatives themselves. There is, therefore, no effective limit
on the quantity of claims, which can be traded in respect of underlying
assets.
May be used as deferred delivery: Derivatives are also known as
deferred delivery or deferred payment instrument. It means that it is easier
to take short or long position in derivatives in comparison to other assets or
securities. Further, it is possible to combine them to match specific, i.e., they
are more easily amenable to financial engineering.
Secondary market instruments: Derivatives are mostly secondary
market instruments and have little usefulness in mobilizing fresh capital
by
the corporate world, however, warrants and convertibles are exception in this
respect.
Exposure to risk: Although in the market, the standardized, general
and exchange-traded derivatives are being increasingly evolved, however, still
there are so many privately negotiated customized, over-the-counter (OTC)
traded derivatives are in existence. They expose the trading parties to
operational risk, counter-party risk and legal risk. Further, there may also be
uncertainty about the regulatory status of such derivatives.
Off balance sheet item: Finally, the derivative instruments,
sometimes, because of their off-balance sheet nature, can be used to clear up
the balance sheet. For example, a fund manager who is restricted from taking
particular currency can buy a structured note whose coupon is tied to the
performance of a particular currency pair.

9
Types of financial derivatives

Derivatives are of two types: financial and commodities.
Derivatives
Financial Commodity
Basic Complex
Forward Futures Option Warrants &
Convertibles
Swaps Exotics
Fig. 1.1: Classification of Derivatives
One form of classification of derivative instruments is between
commodity derivatives and financial derivatives. The basic difference between
these is the nature of the underlying instrument or asset. In a commodity
derivative, the underlying instrument is a commodity which may be wheat,
cotton, pepper, sugar, jute, turmeric, corn, soyabeans, crude oil, natural gas,
gold, silver, copper and so on. In a financial derivative, the underlying
instrument may be treasury bills, stocks, bonds, foreign exchange, stock
index, gilt-edged securities, cost of living index, etc. It is to be noted that
financial derivative is fairly standard and there are no quality issues whereas
in commodity derivative, the quality may be the underlying matter. However,
despite the distinction between these two from structure and functioning
point of view, both are almost similar in nature.
The most commonly used derivatives contracts are forwards, futures
and options.
10
Forwards: A forward contract is a customised contract between two
entities, where settlement takes place on a specific date in the future at
today’s pre-agreed price. For example, an Indian car manufacturer buys auto
parts from a Japanese car maker with payment of one million yen due in 60
days. The importer in India is short of yen and suppose present price of yen is
Rs. 68. Over the next 60 days, yen may rise to Rs. 70. The importer can hedge
this exchange risk by negotiating a 60 days forward contract with a bank at a
price of Rs. 70. According to forward contract, in 60 days the bank will give
the importer one million yen and importer will give the banks 70 million
rupees to bank.
Futures: 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 standardised exchange-traded contracts. A speculator expects an increase
in price of gold from current future prices of Rs. 9000 per 10 gm. The market
lot is 1 kg and he buys one lot of future gold (9000 × 100) Rs. 9,00,000.
Assuming that there is 10% margin money requirement and 10% increase
occur in price of gold. the value of transaction will also increase i.e. Rs. 9900
per 10 gm and total value will be Rs. 9,90,000. In other words, the speculator
earns Rs. 90,000.
Options: Options are of two types– calls and puts. Calls give the buyer
the right but not the obligation to buy a given quantity of the underlying
asset, at a given price on or before a given future date. Puts give the buyer
the right, but not the obligation to sell a given quantity of the underlying
asset at a given price on or before a given date.
Warrants: Options generally have lives of upto one year, the majority
of options traded on options exchanges having maximum maturity of nine
11
months. Longer-dated options are called warrants and are generally traded
over-the-counter.
Leaps: The acronym LEAPS means long term equity anticipation
securities. These are options having a maturity of upto three years.
Baskets: Basket options are options on portfolios of underlying assets.
The index options are a form of basket options.
Swaps: Swaps are private agreements between two parties to
exchange cash flows in the future according to a prearranged formula. They
can be regarded as portfolios of forward contracts. The two commonly used
swaps are:
• Interest rate swaps: These entail swapping only the interest

related cash flows between the parties in the same currency
• Currency Swaps: These entail swapping both principal and

interest on different currency than those in the opposite
direction.
Swaptions: Swaptions are options to buy or sell a swap that will
become operative at the expiry of the options. Thus a swaptions is an option
on a forward swap. Rather than have calls and puts, the swaptions market
has receiver swaptions and payer swaptions. A receiver swaption is an option
to receive fixed and pay floating. A payer swaption is an option to pay fixed
and receive floating.
Uses and functions of derivatives
Generally derivatives are used as risk management tools. Here is the
brief description of their uses and functions.
12
Uses of derivatives
Derivatives are supposed to provide the following services:
Risk aversion tools: One of the most important services provided by
the derivatives is to control, avoid, shift and manage efficiently different
types of risks through various strategies like hedging, arbitraging, spreading,
etc. Derivatives assist the holders to shift or modify suitably the risk
characteristics of their portfolios. These are specifically useful in highly
volatile financial market conditions like erratic trading, highly flexible
interest rates, volatile exchange rates and monetary chaos.
Prediction of future prices: Derivatives serve as barometers of the
future trends in prices which result in the discovery of new prices both on the
spot and futures markets. Further, they help in disseminating different
information regarding the futures markets trading of various commodities
and securities to the society which enable to discover or form suitable or
correct or true equilibrium prices in the markets. As a result, they assist in
appropriate and superior allocation of resources in the society.
Enhance liquidity: As we see that in derivatives trading no
immediate full amount of the transaction is required since most of them are
based on margin trading. As a result, large number of traders, speculators
arbitrageurs operate in such markets. So, derivatives trading enhance

liquidity and reduce transaction
costs in the markets for underlying assets.
Assist investors: The derivatives assist the investors, traders and
managers of large pools of funds to devise such strategies so that they may
make proper asset allocation increase their yields and achieve other
investment goals.
Integration of price structure: It has been observed from the
derivatives trading in the market that the derivatives have smoothen out
13
price fluctuations, squeeze the price spread, integrate price structure at
different points of time and remove gluts and shortages in the markets.
Catalyse growth of financial markets: The derivatives trading
encourage the competitive trading in the markets, different risk taking
preference of the market operators like speculators, hedgers, traders,
arbitrageurs, etc. resulting in increase in trading volume in the country. They
also attract young investors, professionals and other experts who will act as
catalysts to the growth of financial markets.
Brings perfection in market: Lastly, it is observed that derivatives
trading develop the market towards ‘complete markets’. Complete market
concept refers to that situation where no particular investors can be better off
than others, or patterns of returns of all additional securities are spanned by
the already existing securities in it, or there is no further scope of additional
security.
Functions of derivatives markets
The following functions are performed by derivative markets:
Discovery of price: Prices in an organised derivatives market reflect
the perception of market participants about the future and lead the prices of
underlying assets to the perceived future level. The prices of derivatives
converge with the prices of the underlying at the expiration of the derivative
contract. Thus derivatives help in discovery of future as well as current
prices.
Risk transfer: The derivatives market helps to transfer risks from

those who have them but may not like them to those who have an appetite for
them.
14
Linked to cash markets: Derivatives, due to their inherent nature,
are linked to the underlying cash markets. With the introduction of
derivatives, the underlying market witnesses higher trading volumes because
of participation by more players who would not otherwise participate for lack
of an arrangement to transfer risk.
Check on speculation: Speculation traders shift to a more controlled
environment of the derivatives market. In the absence of an organised
derivatives market, speculators trade in the underlying cash markets.
Managing, monitoring and surveillance of the activities of various
participants become extremely difficult in these kind of mixed markets.
Encourages entrepreneurship: An important incidental benefit that
flows from derivatives trading is that it acts as a catalyst for new
entrepreneurial activity. Derivatives have a history of attracting many bright,
creative, well-educated people with an entrepreneurial attitude. They often
energize others to create new businesses, new products and new employment
opportunities, the benefit of which are immense.
Increases savings and investments: Derivatives markets help
increase savings and investment in the long run. The transfer of risk enables
market participants to expand their volume of activity.
Futures contracts
Suppose a farmer produces rice and he expects to have an excellent
yield on rice; but he is worried about the future price fall of that commodity.
How can he protect himself from falling price of rice in future? He may enter
into a contract on today with some party who wants to buy rice at a specified
future date on a price determined today itself. In the whole process the
farmer will deliver rice to the party and receive the agreed price and the other
party will take delivery of rice and pay to the farmer. In this illustration,
15
there is no exchange of money and the contract is binding on both the parties.
Hence future contracts are forward contracts traded only on organised
exchanges and are in standardised contract-size. The farmer has protected
himself against the risk by selling rice futures and this action is called short
hedge while on the other hand, the other party also protects against-risk by
buying rice futures is called long hedge.
Features of financial futures contract
Financial futures, like commodity futures are contracts to buy or sell,
financial aspects at a future date at a specified price. The following features
are there for future contracts:
• Future contracts are traded on organised future exchanges.
These are forward contracts traded on organised futures
exchanges.
• Future contracts are standardised contracts in terms of
quantity, quality and amount.
• Margin money is required to be deposited by the buyer or sellers
in form of cash or securities. This practice ensures honour of the
deal.
• In case of future contracts, there is a dairy of opening and
closing of position, known as marked to market. The price
differences every day are settled through the exchange clearing
house. The clearing house pays to the buyer if the price of a
futures contract increases on a particular day and similarly
seller pays the money to the clearing house. The reverse may
happen in case of decrease in price.
Types of financial future contracts
Financial futures contracts can be categorised into following types:
16
Interest rate futures: In this type the futures securities traded are
interest bearing instruments like T-bills, bonds, debentures, euro dollar
deposits and municipal bonds, notional gilt-contracts, short term deposit
futures and treasury note futures.
Stock index futures: Here in this type contracts are based on stock
market indices. For example in US, Dow Jones Industrial Average, Standard
and poor's 500 New York Stock Exchange Index. Other futures of this type
include Japanese Nikkei index, TOPIX etc.
Foreign currency futures: These future contracts trade in foreign
currency generating used by exporters, importers, bankers, FIs and large
companies.
Bond index futures: These contracts are based on particular bond
indices i.e. indices of bond prices. Municipal Bond Index futures based on
Municipal Bonds are traded on CBOT (Chicago Board of Trade).
Cost of living index future: These are based on inflation measured
by CPI and WPI etc. These can be used to hedge against unanticipated
inflationary pressure.
Forward contract
A forward contract is a simple customized contract between two parties
to buy or sell an asset at a certain time in the future for a certain price.
Unlike future contracts, they are not traded on an exchange, rather traded in
the over-the-counter market, usually between two financial institutions or
between a financial institution and one of its client.
In brief, a forward contract is an agreement between the counter
parties to buy or sell a specified quantity of an asset at a specified price, with
17
delivery at a specified time (future) and place. These contracts are not
standardized, each one is usually customized to its owner’s specifications.
Features of forward contract
The basic features of a forward contract are given in brief here as
under:
Bilateral: Forward contracts are bilateral contracts, and hence, they
are exposed to counter-party risk.
More risky than futures: There is risk of non-performance of
obligation by either of the parties, so these are riskier than futures contracts.
Customised contracts: Each contract is custom designed, and hence,
is unique in terms of contract size, expiration date, the asset type, quality,
etc.
Long and short positions: In forward contract, one of the parties
takes a long position by agreeing to buy the asset at a certain specified future
date. The other party assumes a short position by agreeing to sell the same
asset at the same date for the same specified price. A party with no obligation
offsetting the forward contract is said to have an open position. A party with a
closed position is, sometimes, called a hedger.
Delivery price: The specified price in a forward contract is referred to
as the delivery price. The forward price for a particular forward contract at a
particular time is the delivery price that would apply if the contract were
entered into at that time. It is important to differentiate between the forward
price and the delivery price. Both are equal at the time the contract is entered
into. However, as time passes, the forward price is likely to change whereas
the delivery price remains the same.
18
Synthetic assets: In the forward contract, derivative assets can often
be contracted from the combination of underlying
assets, such assets are
oftenly known as synthetic assets in the forward market.
The forward contract has to be settled by delivery of the asset on
expiration date. In case the party wishes to reverse the contract, it has to
compulsorily go to the same counter party, which may dominate and
command the price it wants as being in a monopoly situation.
Pricing of arbitrage based forward prices: In the forward
contract, covered parity or cost-of-carry relations are relation between the
prices of forward and underlying assets. Such relations further assist in
determining the arbitrage-based forward asset prices.
Popular in forex market: Forward contracts are very popular in
foreign exchange market as well as interest rate bearing instruments. Most of
the large and international banks quote the forward rate through their
‘forward desk’ lying within their foreign exchange trading room. Forward
foreign exchange quotes by these banks are displayed with the spot rates.
Different types of forward: As per the Indian Forward Contract Act-
1952, different kinds of forward contracts can be done like hedge contracts,
transferable specific delivery (TSD) contracts and non-transferable specific
delivery (NTSD) contracts. Hedge contracts are freely transferable and do not
specify, any particular lot, consignment or variety for delivery. Transferable
specific delivery contracts are though freely transferable from one party to
another, but are concerned with a specific and predetermined consignment.
Delivery is mandatory. Non-transferable specific delivery contracts, as the
name indicates, are not transferable at all, and as such, they are highly
specific.
19
Distinction between futures and forwards contracts
Forward contracts are often confused with futures contracts. The
confusion is primarily because both serve essentially the same economic
functions of allocating risk in the presence of future price uncertainty.
However futures are a significant improvement over the forward contracts as
they eliminate counterparty risk and offer more liquidity. Table 1.1 lists the
distinction between the two.
TABLE 1.1: DISTINCTION BETWEEN FUTURES AND FORWARDS
Futures Forwards
Trade on an organised exchange OTC in nature
Standardised contract terms Customised contract terms
Hence more liquid Hence less liquid
Requires margin payments No margin payment
Follows daily settlement Settlement happens at end of period
Summary
During the last decade, derivatives have emerged as innovative
financial instruments for their risk aversion capabilities. There are two types
of derivatives: commodity and financial. Basically derivatives are designed for
hedging, speculation or arbitrage purpose. Derivative securities are the
outcome of future and forward market, where buying and selling of securities
take place in advance but on future dates. This is done to mitigate the risk
arising out of the future price movements. Future contracts are standardised
having more liquidity and less margin payment requirements while viceversa
is the case of forward contracts. Based on the nature of complexity,
these are of two types: basic and complex.
20
In basic financial derivatives, the focus is only on the simplicity of
operation i.e. forward, future, option, warrants and convertibles. A forward
contract is an agreement between two parties to buy or sell an asset at a
certain time in the future for a certain price, whereas a futures contract is an
agreement between two parties to buy or sell a specified quantity of assets at
a predetermined price at a specified time and place. Futures contracts are
standardised and are traded on an exchange. Option is a contract between
two parties which gives the right (not obligations) to buy or sell a particular
asset, at a specified price, on or before, a specified date. Option holder is the
person who acquires the right to buy (hold), while option seller/writer is the
person who confers the right. In a call option, the holder has the right to buy
an asset at a specified price and time, while in case of a put option, the holder
has the right to sell an asset at specified time and price. The price at which
an option is exercised is known as exercise price or strike price and the date is
known as expiration date. In case of an American option, option can be
exercised on or before the expiration data but European option can be
exercised only on date of expiration, warrants are also options which give the
holders right to purchase a specified number of shares at a fixed price in a
fixed time period. On the other hand, convertibles are hybrid securities which
are also called equity derivative securities with features of fixed as well as
variable return attributes. Swaps are latest derivatives which can be
exchanged for something. There are two types of swaps: interest rate swaps
and currency swaps. In interest rate swap, one party agrees to pay the other
party interest at a fixed rate on a notional principal amount and in return
receives interest as a floating rate on the same principal notional amount for
a specified period. Currency swap involves an exchange of cash payment in
one currency for cash payments in another currency. Future value of cash
flows are required for calculation purposes.
21
Key words
Derivatives are the financial instruments whose pay-off is derived
from some other underlying asset.
Forward contract is an agreement between two parties to exchange
an asset for cash at a predetermined future date for a price specified today.
Future contracts are forward contracts traded on organized
exchanges in standardized contract size.
Option is the right (not obligation) to buy or sell an asset on or before
a pre-specified date at a predetermined price.
Call option is the option to buy an asset.
Put option is the option to sell an asset.
Exercise price is the price at which an option can be exercised. It is
also known as strike price.
European option can be exercised only on the expiration date of
option.
American option can be exercised on or before the expiration date of
option.
In-the-money: An option is called in-the-money if it benefits the
investor when exercised immediately.
Out-of-the money: An option is said to be out-of-the money if it is not
advantageous for the investor to exercise it.
At-the-money: When holder of an option neither gains nor looses
when the exercises the option.
22
Option premium is the price that the holder of an option has to pay
for obtaining a call or put option.

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Investment Management

Unit-I: Introduction to Investment

REAL VS. FINANCIAL ASSETS

INVESTMENT DECISION PROCESS

Setting of investment objectives for individual investors is based on the assessment

Analysis and evaluation of investment vehicles. When the investment policy is

Technical analysis involves the analysis of market prices in an attempt to predict

Fundamental analysis in its simplest form is focused on the evaluation of intrinsic

value is the present value of future flows from particular investment. By

SOURCES OF INVESTMENT INFORMATION

ii. Domestic Economic and Political Factors:

iii. Industry Information:

iv. Company Information:

v. Security Market Information:

vi. Security Price Quotations:

vii. Data on Related Markets:

viii. Data on Mutual Funds:

ix. Data on Primary Markets/New Issues, etc.

Need for Investment Information:

National Economic Affairs:

Directory of Information published by the B.S.E. also contains information on

The B.S.E. (Mumbai Stock Exchange) publishes Directory of Information on

Security Market Information:

securities traded on a daily basis, in terms of shares and value of trades.

Data on Mutual Funds, UTI etc.:

Data on Primary Market:

MEASUREMENT OF RISK-RANGE, STANDARD DEVIATION & CO-EFFICIENT OF

Sample covariance between two assets - A and B is defined in

∑ [( rA,t - ŕA ) . ( rB,t - ŕB)] t=1

ŕA, ŕB - sample mean of rate of returns for assets A and B consequently.

negative covariance (“-”) orzero covariance (“0”).

If the positive covariance between two assets is identified the common

identification of positive, negative and zero covariances is demonstrated in

if the number of observations in sections II and IV prevails over the number of

if the number of observations in sections I and III equals the number of

Correlation and Coefficient of determination.

Correlation is the degree of relationship between two variables.

The correlation coefficient between two assets is closely related to their

Very important, that instead of covariance when the calculated number is

relationship to each other , and perfectly negatively correlated if correlation

covariance between stocks A and B can be estimated, because standard deviations

Therefore, as it was pointed out earlier, the covariance primarily provides

Relationship between the return on stock and market portfolio

characteristic line Stock’s characteristic line: describes the relationship between

can be calculated using following formula:

here: rJ - rate of return of stock J;

βJ - Beta factor for the stock J; rM - rate of return of the market.

• Component 1 reflects the return actually generated by the stock J

• Component 2 (in the bracket) represents investor’s expectations for

APPROACHES TO INVESTMENT ANALYSIS

THE EFFICIENT MARKET HYPOTHESIS (EMH)

(2) The semi strong form,

(3) The strong form.

Weak form of EMH

Empirical tests of the weak form

SEMI STRONG FORM OF EMH

dividend announcements, and stock-split announcements. To test the strong form

BEHAVIOURAL FINANCE AND HEURISTIC DRIVEN BIASES.

“Irrational” human behavior can be categorized and modeled

The behavioral economist’s replacement for expected utility theory is known