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Project 3
Investment Analysis and Portfolio Management
Aishwariya Sharma (2011010) | Avi Kathpalia (2011034) | Bhawna Singh (2011035) |
Nishtha Chopra (2011071) | Swati Gautam (2011115)
1
Contents
S.No.
Topic
Slide No.
1
Objectives of Investment Decisions
4
2
Financial Markets
33
3
Fixed Income Securities
89
4
Capital Market Efficiency
141
5
Financial Analysis and Valuation
156
6
Modern Portfolio Theory
213
7
Valuation of Derivatives
245
8
Investment Management
278
2
Objectives of this Module
Provide brief overview of three aspects of investments :
• Various options available to an investor in financial instruments
• Tools used in modern finance to optimally manage the financial portfolio
• Professional asset management industry, as it exists today
3
Chapter – 1
Objectives of Investment Decisions
4
Objectives of this Chapter
• Understanding types of Investors
• Constraints and Limitations faced by Investors
• Goals of Investors
5
Introduction
• Investments are made into :
• Financial assets, like, stocks, bonds, or similar instruments
• Real assets, like, houses, lands, or commodities
• Why portfolio management ?
• To create a balance between the trade-off of returns and risk across multiple
asset classes.
• To manage the expected returns requirement for the corresponding risk
tolerance.
• To maximize the return subject to the risk-tolerance level or to achieve a pre-
specified level of return with minimum risk.
6
Types of Investors
Diversity among investors depending on their investment styles,
mandates, horizons, and assets under management.
Investors
Mutual
Funds
Individual
Institutions
Pension
Funds
Endowment
Funds
Insurance
Companies
Banks
7
Investors : Individuals
• Single largest group in most markets, while portfolio size is quite small.
• Differ across risk appetite and return requirements in their portfolios:
• Averse to risk - Inclined towards safe investments, like Government securities
and bank deposits
• Risk takers – Invest and/or speculate in equity markets
• Requirements also dependent upon life-cycle positioning.
E.g.: In India, an individual in
25-35 yrs age group may plan for purchase of a house and vehicle,
35-45 yrs age group may plan for children’s education & children’s marriage,
50s would be planning for post-retirement life.
8
Investors : Institutions
• Largest active group in the financial markets.
• Are essentially representative organizations, i.e., invest capital on behalf
of others, like individuals or other institutions.
• Assets under management are large and managed professionally by
fund managers.
9
Investors : Institutions - Mutual Funds
• Problem - For an individual, management of small portfolio size, i.e.
spending time analyzing various possible investment strategies and
devising investment plans and strategies accordingly may not be optimal.
• Solution - Getting the funds handled by another professional.
Mutual funds :
• pool investors’ money and invest according to pre-specified, broad parameters
• are managed and operated by professionals whose remunerations are linked
to the performance of the funds
10
Investors : Institutions - Mutual Funds
• their profit or capital gain from funds (after paying management fees and
commission) is distributed among the individual investors in proportion of
their holding funds
• vary greatly, depending upon their
• investment objectives
• set of assets class they invest in
• overall strategy they adopt towards investment
11
Investors : Institutions - Pension Funds
• Created (either by employers or employee unions) to manage the
retirement funds of the employees of companies or the Government.
• Contributed by the employers and employees during the working life of
the employees.
• Objective: To provide benefits to the employees post their retirement.
• Managed either in-house or through some financial intermediary.
• Are very large for large organizations ,and form a substantial investor
group for various financial instruments.
12
Investors : Institutions - Endowment Funds
• Are (generally) non-profit organizations that manage funds to generate
a steady return to help them fulfill their investment objectives.
• (Usually) initiated by a non-refundable capital contribution.
• Contributor (generally) specifies the purpose (specific or general) and
appoints trustees to manage the funds.
• (Usually) managed by charitable organizations, educational organization,
non-Government organizations, etc.
• Trustees of fund approve its investment policy.
13
Investors : Institutions - Insurance Companies
(Both life and non-life Insurance Companies)
• Hold large portfolios from premiums contributed by policyholders to
policies that these companies underwrite.
• Premiums differ according to insurance policies.
E.g. Unlike term insurance, assurance or endowment policies ensure a return
of capital to the policyholder on maturity, along with the death benefits.
The premium for such policies may be higher than term policies.
• Their investment strategy depends on actuarial estimates of timing and
amount of future claims.
14
Investors : Institutions - Insurance Companies
• Resistant towards taking risk.
• Asset investments geared towards meeting current cash flow needs and
meeting perceived future liabilities.
15
Investors : Institutions - Banks
• Assets consist mainly of loans to businesses and consumers and their
liabilities comprise of various forms of deposits from consumers.
• Main source of income : interest rate spread (= lending rate - deposit
rate)
• Generally do not lend 100% of their deposits.
• Statutorily required to maintain a certain portion of the deposits as cash
and another portion in the form of liquid and safe assets (generally Govt.
securities), which yield a lower rate of return.
16
Investors : Institutions - Banks
• Statutory requirements, followed by all banks, are known as the Cash
Reserve Ratio (CRR ratio) and Statutory Liquidity Ratio (SLR ratio) in
India (stipulated by Reserve Bank of India).
17
Investors (Classification as per Trade Objective)
Investors
Hedgers
Invest to provide a
cover for risks on a
portfolio they
already hold
Speculators
Arbitrageurs
Day Traders
Take additional risks
to earn
supernormal
returns
Take simultaneous
positions (say in two
equivalent assets or
same asset in two
different markets
etc.) to earn riskless
profits arising out of
the price differential
if they exist
Trade in order to
profit from intra-day
price changes
Invest directly in
securities in cash
markets, and in
derivatives,
instruments that
derive their value
from the underlying
securities
18
Constraints
Every investor has some constraint (e.g. risk profile, the time horizon, the
choice of securities, optimal use of tax rules, etc.) within which he/she
wants the portfolio to lie.
Constraints
Liquidity
Investment
Horizons
Taxation
19
Constraints : Liquidity
• Refers to the marketability of the asset (i.e., the ability and ease of an
asset to be converted into cash and vice versa)
• Measured across 2 parameters :
1. market breadth (or, impact cost) - measures the cost of transacting a given
volume of the security
2. market depth - measures the units that can be traded for a given price
impact
• Adequate liquidity implies high levels of trading activity.
20
Constraints : Liquidity
• High demand and supply of the security results in low impact costs of
trading and reduce liquidity risk.
21
Constraints : Investment Horizons
• Refers to the length of time for which an investor expects to remain
invested in a particular security or portfolio, before realizing the returns.
• Helps in security selection by giving idea about investors’ income needs
and desired risk exposure.
• High demand and supply of the security results in low impact costs of
trading and reduce liquidity risk.
• Investors with shorter investment horizons prefer assets with low risk, like
fixed-income securities, whereas for longer investment horizons investors
look at riskier assets like equities.
22
Constraints : Investment Horizons
• Risk-adjusted returns for equity : higher for longer investment horizon,
and, lower for short investment horizons.
• Certain securities require commitment to invest for a certain minimum
investment period.
E.g. in India, the Post Office savings or Government small-saving schemes like
the National Savings Certificate (NSC) have a minimum maturity of 3-6 years.
• Facilitate in deciding between investing in a liquid or relatively illiquid
investment.
23
Constraints : Investment Horizons
E.g. If an investor wants to invest for a longer period, liquidity costs may not be
a significant factor, whereas if the investment horizon is a short period (say 1
month) then the impact cost (liquidity) becomes significant as it could form a
meaningful component of the expected return.
24
Constraints : Taxation
• Tax-free investments or investments subject to lower tax rate may trade
at a premium as compared to investments with taxable returns.
Asset
A
B
Type
10% taxable bonds (30% tax)
8% tax-free bonds
Expected Return
10%
8%
Net Return
10%*(1-0.3) = 7%
8%
(In the table, A carries higher coupon rate. But, net return for the
investors would be higher for asset B. Hence, asset B would trade at a
premium as compared to asset A.)
25
Constraints : Taxation
• Taxation benefits (if available on specific investments) must be
considered before deciding investment portfolio.
26
Goals of Investors
• Investment decisions depend upon investor’s plan as per needs.
• Other factors affecting an investor’s choice for investment :
• Level of requisite knowledge (investors may not be aware of certain financial
instruments and their pricing),
• Investment size (e.g., small investors may not be able to invest in Certificate
of Deposits),
• Regulatory provisions (country may impose restriction on investments in
foreign countries)
27
MCQs
Q1. An endowment fund is an institutional investor.
(a) FALSE
(b) TRUE
Q2. For longer investment horizons investors look at ______ .
(a) riskier assets like equities.
(b) low risk assets like government securities.
28
MCQs
Q3. Portfolio management is required to manage the expected _______
requirement for the corresponding ________.
(a) income, expenditure
(b) gain, losses
(c) profit, loss tolerance
(d) return, risk tolerance
29
MCQs
Q4. In investment decisions, _______ refers to the marketability of the
asset.
(a) value
(b) profitability
(c) price
(d) liquidity
30
MCQs
Q5. Banks and other financial institutions generally create a portfolio of
fixed income securities to fund known _______ .
(a) assets
(b) liabilities
31
Answer Key to MCQs
1) b
2) a
3) d
4) d
5) b
32
Chapter – 2
Financial Markets
33
Objectives of this Chapter
• Understand different financial markets
• Understand various instruments where investors can potentially
park their funds
34
Introduction
Financial
Markets
Money
Market
Primary
Market
Capital
Market
Secondary
Market
Third Market
(OTC Market)
Fourth
Market
35
Introduction
Money Market
Capital Market (Bond & Equity Market)
Instruments : mainly short-term,
Instruments : longer-term and riskier
marketable, liquid, low-risk debt
securities, which include derivative
securities
market instruments**.
Fixed-income securities, with very
Fixed-income securities, with longer
short maturity period.
maturity period as compared to money
market instruments.
** Derivative market instruments are mainly futures, forwards and options on the underlying
instruments, usually equities and bonds.
36
Primary Market
• Deals with the raising of capital from investors via issuance of new
securities.
• New stocks/bonds are sold by the issuer to the public.
• Funds move from investors to the issuer (Company/Govt., etc.)
• Initial Public Offering (IPO) : security is offered to the public for the
first time.
• Follow-up Offerings : issuer wants to issue more securities of a
category that is already in existence in the market
37
Primary Market
E.g. Reliance Power Ltd.’s offer in 2008 was an IPO because it was for the
first time that Reliance Power Ltd. offered securities to the public.
BEML’s public offer in 2007 was a Follow-up Offering as BEML shares were
already issued to the public before 2007 and wereavailable in the secondary
market.
• Pricing a security : Easier during Follow-up Offering, since the market
price of the security is available before the company comes up with
the offer.
No prevailing market for security in case of an IPO, hence difficult.
38
Primary Market
• Companies must estimate correct price of offer :
• Risk of failure of the issue in case of non-subscription if the offer is
overpriced.
• If the issue is underpriced, the company stands to lose notionally since the
securities will be sold at a price lower than its intrinsic value, resulting in
lower realizations.
• Facilitates capital formation in the economy
39
Secondary Market (Aftermarket)
• Market where securities, which have been issued before are traded.
• Helps in :
• bringing potential buyers and sellers for a particular security together
• facilitating the transfer of the security between the parties
• Funds and securities transferred from one investor to another.
• Provides liquidity to the securities
40
Third Market (Over-the-Counter Market)
• Refers to all transactions in securities that are not undertaken on an
Exchange.
• Securities traded may or may not be traded on a recognized stock
exchange.
• Trading generally open to all registered broker-dealers (regulatory
restrictions on trading some products).
• E.g., in India equity derivatives is one of the products which is
regulatorily not allowed to be traded in the OTC markets.
41
Fourth Market
• Direct transactions between institutional investors, undertaken
primarily with transaction costs in mind.
42
Trading in Secondary Market
Investors place orders (instructions provided by a customer to a brokerage firm,
for buying or selling a security with specific conditions**)
Orders match with counter order in trading system
**Conditions may be related to the price of the security (limit order or market order or stop
loss orders) or related to time (a day order or immediate or cancel order). Electronic
exchanges used now a days.
43
Types of Orders
• Limit Price/Order
• Market Price/Order
• Stop Loss (SL) Price/Order
• Day Order (Day) (Time related Conditions)
• Immediate or Cancel Order (IOC) (Time related Conditions)
44
Types of Orders : Limit Price/Order
• Price for the order has to be specified while entering the order into
the system.
• Order gets executed only at the quoted price or at a better price
(a price lower than the limit price in case of a purchase order and a
price higher than the limit price in case of a sale order).
45
Types of Orders : Market Price/Order
• Constraint : time of execution (not price)
• Gets executed at the best price obtainable at the time of entering the
order
• System immediately executes the order, if there is a pending order of
the opposite type against which the order can match
• Matching is done automatically at the best available price (market
price)
• For sale order : order matched against the best bid (buy) price
46
Types of Orders : Market Price/Order
• For purchase order : order is matched against the best ask (sell) price
• Best bid price : order with the highest buy price
• Best ask price : order with the lowest sell price
47
Types of Orders : Stop Loss(SL) Price/Order
Step 1 : Orders enter into trading system
Step 2 : Get activated only when market price of relevant security
reaches a threshold price
Step 3 : Stop loss order triggered when market reaches the threshold or
pre-determined price
Step 4 : Order enters into system as a market/limit order and is executed
at the market price/limit order price or better price.
(Until the threshold price is reached in the market the stop loss order does not enter
the market and continues to remain in the order book. )
48
Types of Orders : Stop Loss(SL) Price/Order
Step 5 : Sell order in the stop loss book triggered when the last traded
price in the normal market reaches or falls below the trigger price of
the order.
Step 6 : Buy order in the stop loss book triggered when the last traded
price in the normal market reaches or exceeds the trigger price of the
order.
(Trigger price should be less than the limit price in case of a purchase order and vice
versa.)
49
Types of Orders : Time Related Conditions
Day Order (Day) :
• Valid for the day on which it is entered
• If unmatched, gets cancelled automatically at the end of the trading
day
• All orders are Day Orders at the National Stock Exchange (NSE)
50
Types of Orders : Time Related Conditions
Immediate or Cancel Order (IOC):
• Allows the investor to buy or sell a security as soon as the order is
released into the market, failing which the order is removed from the
system.
• Partial match possible for the order and the unmatched portion of
the order is cancelled immediately.
51
Matching of Orders
Order received
Time Stamped
Processed for
potential match
Match found
Order executed and
trade happens
Match not found
Order is stored in
pending orders book
till a match is found
• For potential match,
Best buy order (highest price - highest bid) is matched with best sell
order (lowest price - lowest ask).
52
Matching of Orders
• Order can also be executed against multiple pending orders, resulting in
more than one trade per order.
• The matching of orders at NSE is done on a price-time priority i.e., in
the following sequence:
• Best Price
• Within Price, by time priority
• Orders lying unmatched : passive orders
• Orders matching existing orders : active orders
• Orders always matched at the passive order price
53
Matching of Orders
• Market orders : executed instantly
• Limit orders : remain in the trading system until their market prices are
reached
• Limit Order Book (LOB) of the exchange : orders across stocks at any point in
time in the exchange
• Top five bids/asks (limit orders all) for any security are usually visible to
market participants and constitute the Market By Price (MBP) of the security.
54
The Money Market
• Subset of fixed-income market
• Participants borrow or lend for short period of time, usually up to a
period of one year
• Instruments generally traded by the Government, financial institutions
and large corporate houses
• Securities are of very large denominations, very liquid, very safe but
offer relatively low interest rates (generally beyond the reach of
individual investors)
55
The Money Market
• Cost of trading in money market (bid-ask spread) relatively small
due to high liquidity and large size of the market
• Individual investors invest in the money markets through moneymarket mutual funds
• Products available for trading in money market :
• T-Bills
• Commercial Paper
• Certificates of Deposit
56
The Money Market - Treasury Bills
• Risk-free (carry only sovereign risk), short-term, very liquid instruments
that are issued by the central bank of a country
• Maturity period range : 3-12 months
• Circulated both in primary as well as in secondary markets
• Usually issued at a discount to the face value and the investor gets the
face value upon maturity
• Issue price (and thus rate of interest) of T-bills is generally decided at an
auction, which individuals can also access
57
The Money Market - Treasury Bills
• Traded in the secondary markets after getting issued
In India,
• Issued by the Reserve Bank of India for maturities of 91-days, 182 days and
364 days.
• Issued weekly (91-days maturity) and fortnightly (182-days and 364-days
maturity).
58
The Money Market - Commercial Paper
• Unsecured money market instruments issued in form of promissory note
by large corporate houses in order to diversify their sources of shortterm borrowings and to provide additional investment avenues to
investors
• Issuing companies required to obtain investment-grade credit ratings
from approved rating agencies (papers also backed by a bank line of credit)
• Also issued at a discount to their face value
59
The Money Market - Commercial Paper
• In India,
• Issued by companies, primary dealers (PDs), satellite dealers (SD) and other
large financial institutions, for maturities ranging from 15 days period to 1-year
period from the date of issue.
• Denominations can be Rs. 500,000 or multiples thereof.
• Issued either in form of promissory note or in dematerialized form through any
of the approved depositories.
60
The Money Market - Certificates of Deposit
• Is a term deposit with a bank with a specified interest rate
• Duration is also pre-specified and the deposit cannot be withdrawn on
demand
• Freely negotiable and may be issued in dematerialized form or as a
Usance Promissory Note
• Rated by approved credit rating agencies and normally carry a higher
return than the normal term deposits in banks
(Normal term deposits are of smaller ticket-sizes and time period, have the
flexibility of premature withdrawal and carry a lower interest rate than CDs)
61
The Money Market - Certificates of Deposit
• In many countries, the central bank provides insurance to bank
depositors up to a certain amount
E.g. Federal Deposit Insurance Corporation (FDIC) in the U.S.,
Deposit Insurance and Credit Guarantee Corporation in India (Rs. 100000).
(CDs also treated as bank deposit for this purpose.)
• In India,
• Scheduled banks can issue CDs with maturity ranging from 7 days - 1 year
• Financial institutions can issue CDs with maturity ranging from 1 year - 3 years
• CD are issued for denominations of Rs. 1,00,000 and in multiples thereof
62
Repos and Reverse Repos
• Mode of short-term (usually overnight) borrowing and lending, used
mainly by investors dealing in Government securities
• Tranche of Government securities sold by seller (a borrower
of funds) to buyer (the lender of funds), backed by an agreement
that the borrower will repurchase the same at a future date (usually the
next day) at an agreed price
• Yield to the buyer for the period : sale price – repurchase price
63
Repos and Reverse Repos
• Repos allow borrower to use a financial security as collateral for a cash
loan at a fixed rate of interest
• Reverse repo : mirror image of a repo, i.e., a repo for the borrower is a
reverse repo for the lender.
(The buyer (the lender of funds) buys Government securities from the seller (a
borrower of funds) agreeing to sell them at a specified higher price at a future
date.)
64
Bond Market
Instruments:
• Treasury Notes (T-Notes) and T-Bonds
• State and Municipal Govt. Bonds
• Corporate Bonds
• International Bonds
• Others : according to structure/ characteristics (Zero Coupon Bonds,
Convertible Bonds, Callable Bonds, Puttable Bonds, Fixed Rate and
Floating Rate of Interest Bonds)
65
Bond Market- T-Notes and T-Bonds
• Debt securities issued by the Central Government of a country
Treasury Notes
Treasury Bonds
maturity range : up to 10 years
maturity range : 10 years to 30 years
Do not consist call/put option
usually consist of a call/put option after
a certain period
• Interest on both paid semi-annually (referred as coupon payments)
• Coupons attached to bonds. Each bondholder presents respective
coupons on different interest payment date to receive interest amount
66
Bond Market- State and Municipal Govt. Bonds
• Issued to finance specific projects (like road, bridge, airports etc.) debts are either repaid from future revenues generated from such
projects or by the Government from its own funds.
• Granted tax-exempt status (like T-Notes and T-Bonds)
• In India,
Govt. securities (includes treasury bills, Central Govt. securities and State
Govt. securities) are issued by the Reserve Bank of India on behalf of GoI
67
Bond Market- Corporate Bonds
• For borrowing money from the public for a certain period
• Similar to T-Notes in terms of coupon payment, maturity amount (face
value), issue price (discount to face value) etc.
• Usually issued at a higher discount than equivalent Government bonds
(not exempt from taxes)
68
Bond Market- Corporate Bonds
• Three types :
1. secured bonds (backed by specific collateral)
2. unsecured bonds (or debentures having no specific collateral but
preference over the equity holders in the event of liquidation)
3. subordinated debentures (having lower priority than bonds in claim over a
firms’ assets)
69
Bond Market- International Bonds
• Issued overseas, in the currency of a foreign country which represents a
large potential market of investors for the bonds
• Eurobonds : Bonds issued in a currency other than that of the country
which issues them (E.g. Euro-Dollar bonds, Euro-Yen bonds)
• Bonds issued in foreign countries in currency of the country of the
investors. (E.g. Yankee bond - US dollar denominated bonds issued in
U.S. by a non-U.S. issuer, and Samurai Bonds - yen-denominated
bonds issued in Japan by non-Japanese issuers)
70
Bond Market- Zero Coupon Bonds
• Also called as deep-discount bonds or discount bonds
• Bonds which do not pay any interest (or coupons) during the life of the
bonds
• Issued at a discount to the face value and the face value is repaid at the
maturity
• Return to the bondholder : Discount at which the bond is issued
(= issue price - face value)
71
Bond Market- Convertible Bonds
• Offer a right to bondholder to get the bond converted into
predetermined number of equity stock of the issuing company, at
certain, pre-specified times during its life.
• Holder of the bond gets an additional value, in terms of an option to
convert the bond into stock (equity shares) and thereby participate in
the growth of the company’s equity value
• Investor receives the potential upside of conversion into equity while
protecting downside with cash flow from the coupon payments
72
Bond Market- Convertible Bonds
• Issuer company is also benefited since such bonds generally offer
reduced interest rate
• Value of equity shares in market falls upon issue of such bonds in
anticipation of the stock dilution that would take place when the option
(to convert the bonds into equity) is exercised by the bondholders
73
Bond Market- Callable Bonds
• Bond issuer holds a call option, which can be exercised after some prespecified period from the date of the issue
• Option gives the right to the issuer to repurchase (cancel) the bond by
paying the stipulated call price
• Call price may be more than face value of bond
• Carries a higher discount (higher yield) than normal bonds - option
gives a right to the issuer to redeem the bond
• Right exercised if coupon rate higher than the prevailing interest rate in
the market
74
Bond Market- Puttable Bonds
• Opposite of Callable Bond
• Have an embedded put option
• Bondholder has a right (but not the obligation) to sell back the bond to
the issuer after a certain time at a pre-specified price
• Lower yield in bond : right has a cost
• Bondholders exercise the right if prevailing interest rate in market
higher than the coupon rate
(Call option and the put option are mutually exclusive, implies bond may have both
option embedded.)
75
Bond Market- Fixed and Floating Rate Bonds
• Fixed Rate Bond : interest rate is fixed and does not change over time
• Floating Rate Bond : Interest rate is variable and is a fixed percentage
over a certain pre-specified benchmark rate
• Benchmark rate : T-bill rate, the three month LIBOR rate, MIBOR rate (in
India), bank rate, etc.
• Coupon rate : reset every six months (time between two interest payment
dates)
76
Common Stock
• Shareholders of a company have limited liability (liability of
shareholders is limited to the unpaid amount on the shares)
• Maximum loss of shareholder in a company is limited to her original
investment
• Shareholders have the last claim on the assets of the company at the
time of liquidation. Debt- or bondholders always have precedence over
equity shareholders
77
Common Stock
• Shares valued much higher than the face value
• Initial investment in the company by shareholders represents their
paid-in capital in the company.
• Company generates earnings from its operating, investing and other
activities, portion of which is distributed back to the shareholders as
dividend, the rest retained for future investments.
• The sum total of the paid-in capital and retained earnings is called the
book value of equity of the company
78
Common Stock – Types of Shares
Shares
Equity
Preference
• Equity shares : each representing a unit of the overall ownership of the
company
• Preference Shares : have precedence over common stock in terms of
dividend payments and the residual claim to its assets in the event of
liquidation
79
Common Stock – Types of Shares
• Preference shareholders are generally not entitled to equivalent voting
rights as the common stockholders
• In India, preference shares are redeemable (callable by issuing firm)
and preference dividends are cumulative.
• Cumulative dividends : In case the preference dividend remains unpaid in a
particular year, it gets accumulated and the company has the obligation to pay
the accrued dividend and current year’s dividend to preferred stockholders
before it can distribute dividends to the equity shareholders
80
Common Stock – Types of Shares
• In India, preference shareholders enjoy all the rights (e.g. voting rights)
enjoyed by the common equity shareholders in case preference
dividend remains unpaid
• Some companies also issue convertible preference shares which get
converted to common equity shares in future at some specified
conversion ratio.
81
MCQs
Q1. The issue price of T-bills is generally decided at an ______ .
(a) OTC market
(b) inter-bank market
(c) exchange
(d) Auction
82
MCQs
Q2. ______ orders are activated only when the market price of the
relevant security reaches a threshold price.
(a) Limit
(b) Market-loss
(c) Stop-loss
(d) IOC
83
MCQs
Q3. In India, Commercial Papers (CPs) can be issued by _____.
(a) Mutual Fund Agents
(b) Insurance Agents
(c) Primary Dealers
(d) Sub-Brokers
84
MCQs
Q4. New stocks/bonds are sold by the issuer to the public in the
________ .
(a) fixed income market
(b) secondary market
(c) money market
(d) primary market
85
MCQs
Q5. A ________, is a time deposit with a bank with a specified interest
rate.
(a) certificate of deposit (CD)
(b) commercial paper (CP)
(c) T-Note
(d) T-Bill
86
MCQs
Q6. In the case of callable bonds, the callable price (redemption price)
may be different from the face value.
(a) FALSE
(b) TRUE
87
Answer Key to MCQs
1) d
2) c
3) c
4) d
5) a
6) b
88
Chapter – 3
Fixed Income Securities
89
Objective of this Chapter
 Understanding the concept Interest rate and the types
 Understanding the concept of bond pricing
 To study Bond Portfolio Immunization
90
Introduction
 Fixed-income securities have some pre-specified values
 Pre-specified values can be:
1.Maturity amount
2.The time of the maturity due
For issuing firm- Such securities form debt capital
Examples are bonds, treasury bills and certificates of deposit
91
Interest
 Extra money paid by the borrower to the lender
 The price for the use of the borrowed amount over the given period
of time
 Interest cost covers the opportunity cost of the money
 The rate of interest may be fixed or floating
92
Interest Calculations
Two Types of Interest Calculations:
1. Simple Interest - Calculated on the principal amount alone.
2. Compound Interest - We assume that all interest payments are reinvested at the end of each period
Interest
Simple
Compound
93
Simple Interest
 Simple- it ignores the effects of compounding
 Simple Interest (S.I)= P×R×T
where:
P = Principal
R = Rate of Interest for one period (usually 1 year)
T= Number of periods (years)
94
Example
Que. What is the amount an investor will get on a 3-year fixed deposit
of Rs. 10000 that pays 8% simple interest?
Ans : Given:
P = 10000, R = 8% and T = 3 years
I = P × R × T = 10000 × 8%× 3 = 2400
Amount = Principal + Interest = 10000 + 2400
Therefore the amount an investor will get = 12400
95
Example
Que : Braun invested a certain sum of money at 8% p.a. simple interest
for ‘T' years. At the end of ‘T' years, Braun got back 4 times his original
investment. What is the value of T?
Ans : Let us say Braun invested $100.
Then, at the end of 'n' years he would have got back $400.
Therefore, the Simple Interest earned = 400 - 100 = $300
96
Example
Here P = $100 , I = $300 and R = 8%
We know , I = P × R × T
=> 300 = 100 ×8% ×T
T = 300/100 ×8% = 37.5 years
97
Compound Interest
 Apart from the normal P, R and T, there is a fourth factor “m”.
 “m” is the number of compounding in a year
where A= Amount of maturity
98
Example
Que. What is the amount an investor will get on a 3-year fixed deposit
of Rs. 10000 that pay 8% interest compounded half yearly?
Ans : Given P = 1000, R = 8% , T = 3 and m = 2
The total interest income is:
Interest=[P(1+R/m)ˆT×m]-P (where ˆ is raise to power)
Putting the value gives Interest = Rs 2653.2
Amount = Principal + Interest = 1000 + 2653.2 = 12653.2
99
Example
Que. What is the amount an investor will get on a 3-year fixed deposit
of Rs. 10000 that pay 8% interest compounded Monthly?
Ans : Given P=1000 , R=8% , T=3 and m=12
The total interest income is : Interest=[P(1+R/m)ˆT×m] - P
Putting the value gives Interest= Rs 2702.37
Amount = Principal + Interest = 1000 + 2702.37 = 12702.37
100
Continuous Compounding
 Sum of money is compounded infinitely throughout the year
Hence the formula becomes,
 Derived formula is:
A = Peˆrt ( where ˆ stands for raise to power)
where e is the mathematical constant
101
Example
Que. Consider the same investment (Rs. 10000 for 3 years). What is the
amount received on maturity if the interest rate is 8% compounded
continuously?
Ans : Here P= 10000 , e=2.718 , r=8% and T=3
The final value of the investment is P*eˆrt
It comes to 10000*2.718 ˆ0.08*3 = 12712.50
The amount received on maturity is Rs. 12712.50
102
Real and Nominal Interest Rates
 The interest rate and the inflation rate are related.
 The cash flow is known usually but the values of goods and services
may change due to inflation.
 The above scenario brings uncertainty about the purchasing power of
a cash flow.
 Formula:
(1+norminal rate) = (1+real interest rate)(1+inflation rate)
103
Nominal Interest rate
 It is the interest rate on an investment or loan without adjusting for
inflation
 It is the rates quoted in loan and deposit agreements
 Nominal cash flows measure the cash flow in terms of today’s prices
104
Real interest rate
 An interest rate that has been adjusted in order to remove the effects
of inflation
 Real cash flows measure the cash flow in terms of its base year’s
purchasing power
 Real Cash flow= Nominal Cash flow/(1+inflation rate)
105
Bond Pricing
 The cash inflow for an investor includes:
1.The coupon payments
2.Payment on maturity of the bond
 Thus the price of the bond should represent the sum total of the
discounted value of each of these cash flows.
 The discount rate is generally higher than the risk free rate
 It is higher in order to cover off the additional risks such as liquidity
risks, default risks etc.
106
Bond Pricing
 Bond Price = PV ( Coupons and Face Value)
 Coupon payment is different times throughout the year whereas face
value is paid at maturity.
C(t) = Cash flow at time T
T= time of maturity
y= discount rate
t = time left for each coupon payment
107
Example
108
Example
What happens if the discount rate is lower than the coupon rate?
109
Clean and Dirty Prices
 The market value of the bond includes the accrued interest on the bond.
 The price of the bond including the accrued interest rate is called as the
dirty price
 The price of the bond excluding accrued interest is called the clean price
 Simple formulation, Dirty Price = Clean Price + Accrued Interest
 For reporting purpose, bonds are quoted at ‘clean price’ for comparison
of bonds with different interest dates.
110
Bond Yields
 The amount of return an investor will realize on a bond
 Bond yields are measured using the following measures:
1) Coupon yield
2) Current yield
3) Yield to Maturity
4) Yield to Call
111
Coupon Yields
 It is simply the coupon payment C as a percentage of the face value F
 It is also called nominal yield
 Coupon yield = Coupon payment/Face Value
112
Current Yield
 It is simply the coupon payment C as a percentage of the current
bond price P
 It is closely related to the other bond concept
 Current Yield= Coupon Payment/current Market bond price
113
Example
Que. Monique Moneybags purchased one XYZ convertible mortgage
bond at 105. Two years later, the bond is trading at 98.If the coupon
rate of the bond 6%, what is the current yield of the bond?
Ans : The current market price is $980 ( 98% of $1000 per value)
The annual interest is $60 (6% coupon rate ×$1000 per value)
Current yield = Annual Interest/current Market bond price
Current yield = $60/$980 = 6.1%
114
Drawbacks
The main drawbacks of Coupon yield and Current Yield are:
1) They consider only the coupon (interest) payments
2) They ignore the capital loses or gains from the bond.
3) Do not work for bonds which do not pay any interest
115
Yield to maturity (YTM)
 A concept used to compare bonds
 Refers to the IRR earned from holding the bond till maturity
 It is a rate that equalizes the present value of the cash flows to the
observed market price.
116
Yield to maturity (YTM)
Q) What is the YTM for a 5-year, 8%bond (interest is paid annually) that is
trading in the market for Rs. 924.20?
117
Bond Equivalent Yield
 Very important concept
 Important in case of bonds and notes that pay coupons at time
interval which is less than 1 year
 The yield to maturity is the discount rate solved using the following
formula:
118
Yield to call
 It is calculated for callable bond
 Before the date of actual maturity , issuer has the right to call/redeem
the bond
 Calculated same way as YTM but with a presumption.
 Presumption- Issuer exercises the call option on the exercise date
119
Interest Rates
There are three types of common interests:
1. Short Rate - the expected rate at which an entity
can borrow for
a given time interval.
2. Spot Rate - Yield to maturity for a zero coupon bond.
3. Forward Rate – Rate applicable to a financial transaction that will
take place in future.
120
Interest Rates
 Relationship between spot rate and short rate
 We can calculate short rates for a future interval by knowing the
spot rates for the two ends of the interval.
121
Example
Que. If the short rate for 1-year investment at year 1 is 7% and year 2 is
8%,what is the present value of a 2-year zero coupon bond with face
value RS 1000 ?
Ans: P=1000/1.07×1.08 = 865.35
For a 2-year zero coupon bond trading at 865.35,the YTM can be
calculated by solving the equation: 865.35 = 1000/(1+y2)^2
=> y = 7.4988%,which is nothing but the 2-year spot rate.
122
Term Structure of Interest Rates
 It is the set of relationships between rates of bonds of maturities
 Also known as yield curve
 Defines the array of discount factors on a collection of default-free
pure discount bonds
 The most common approximation- yield to maturity curve
 Application- Yield curves are used as a key tool by central banks in the
determination of the monetary policy
123
Term Structure of Interest Rates
Two important explanations of the term structure of interest :
1. Market expectations hypothesis
2. Liquidity preference theory
124
Market Expectation Hypothesis
 Assumes that various maturities are perfect substitutes of each
other
 The forward rate equals the market expectation of the future short
interest rate i = E(ri ) where i is a future period
 The expected interest rate can be used to construct a yield curve
 The formula is:
125
Liquidity preference theory
 In this investors prefer liquidity and hence, a short-term investment is
preferred
 Investors will be induced to hold a long-term investment, only by
paying a premium for the same.
 The excess of the forward rate over the expected interest rate is
referred to as the liquidity premium
126
Macaulay & Modified Duration
 The effect of interest rate risks on bond prices depends on many factors,
but mainly on coupon rates, maturity date etc. One needs to average out
the time to maturity and time to various coupon payments to find the
effective maturity for a bond.
 The measure is called as duration of a bond. It is the weighted (cash flow
weighted) average maturity of the bond.
127
Macaulay & Modified Duration
 The weights (Wt) associated for each period are the present value of
the cash flow at each period as a proportion to the bond price, i.e.
 This measure is termed as Macaulay’s duration or simply, duration
128
Macaulay & Modified Duration
 Higher the duration of the bond, higher will be the sensitivity towards
interest rate fluctuations
 Higher the sensitivity implies higher the volatility in the bond price.
 Banks create a portfolio of fixed income securities to fund known
liabilities.
 The price changes for fixed income securities are dependent mainly on
the interest rate changes and the average maturity (duration).
129
Bond Portfolio Immunization
 When interest rates fall, the reinvestment of interests will yield a lower
value but the capital gain arising from the bond is higher.
 The increase or decrease in the coupon income arising from changes in
the reinvestment rates will offset the opposite changes in the market
values of the bonds in the portfolios.
 The net realized yield at the target date will be equal to the yield to
maturity of the original portfolio.
 This is also called bond portfolio immunization.
130
MCQs
Q1) Security of ABC Ltd. trades in the spot market at Rs 595. Money can
be invested at 10% per annum. The fair value of a one-month futures
contract on ABC Ltd. is (using continuously compounded method)
(a) 630.05
(b) 620.05
(c) 600.05
(d) 610.05
131
MCQs
Q2) In the case of callable bonds, the callable price (redemption price)
may be different from the face value.
(a) FALSE
(b) TRUE
132
MCQs
Q3) Term structure of interest rates is also called as the ______.
(a) term curve
(b) yield curve
(c) interest rate curve
(d) maturity curve
133
MCQs
Q4) ______ are a fixed income security
(a) Equities
(b) Forex
(c) Derivatives
(d) Bonds
134
MCQs
Q5) In a Bond the ____ is paid at the maturity date
(a) face value
(b) discounted value
(c) compounded value
(d) present value
135
MCQs
Q6) Security of ABC Ltd. trades in the spot market at Rs.525. Money
can be invested at 10% per annum. The fair value of a one-month
futures contract on ABC Ltd. is (using countinously compounded
method):
(a) 559.46
(b) 549.46
(c) 539.46
(d) 529.46
136
MCQs
Q7) One needs to average out the time to maturity and time to various
coupon payments to find the effective maturity for a bond. The
measure is called as _____ of a bond.
(a) duration
(b) IRR
(c) YTM
(d) yield
137
MCQs
Q8) In case of compound interest rate, we need to know the _______
for which compounding is done.
(a) period
(b) frequency
(c) time
(d) duration
138
MCQs
Q9) What is the amount an investor will get on a 1-year fixed deposit of
Rs. 10000 that pays 8% interest compounded quarterly?
(a) 12824.32
(b) 13824.32
(c) 10824.32
(d) 11824.32
139
Answer key to MCQs
1)
2)
3)
4)
5)
6)
7)
8)
9)
c
b
b
d
a
d
a
b
c
140
Chapter – 4
Capital Market Efficiency
141
Objectives of this Chapter
• What is Market Efficiency?
• Types of Market Efficiencies
• Weak-Form Market Efficiency
• Semi Strong Market Efficiency
• Strong Market Efficiency
• Departures from the EMH (Efficient Market Hypothesis)
142
Introduction
• What is Market Efficiency?
• Efficient Market Hypothesis (EMH) forms the basis of Modern
Financial Theory.
• Markets are said to be efficient when the prices of securities
assimilate and reflect information about them.
143
Market Efficiency
• Impact of Market Efficiency
• If the prices reflect all the information instantly, then the prices can be used
for various economic decisions.
• For instance, a firm can assess the potential impact of increased dividend by
measuring the price impact created by it.
• Policymakers can also judge the impact of various macro-economic policy
changes by assessing the market value.
144
Types of Market Efficiency
• There is high degree of efficiency of the market in capturing the price
relevant information.
• Characterization of level of efficiency of the market :
a) Weak-form Market Efficiency
b) Semi-Strong Market Efficiency
c) Strong Market Efficiency
145
Weak-form Market Efficiency
• (Also known as random walk) displayed by the market when
consecutive price changes are uncorrelated
• Means that any past price change pattern is unlikely to repeat
itself
• The technical analysis that uses past price or volume trends do not
achieve superior returns
• This market examined by studying the serial correlation in time
series and look for its absence
146
Semi-Strong Market Efficiency
• All the publicly available information gets reflected in the prices
instantaneously.
• Positive change would lead to a price increase and vice versa.
• This ensures that no trader would be able to out perform the market
by building strategies based on public information.
• If a trader wants to earn more or basically expects an abnormal
return, the only way to do that is through the non-public information.
147
Strong Market Efficiency
• Ideally, it is the level of efficiency desired for a market.
• This efficiency also means that both publicly and privately owned
information gets reflected in the prices and no one can earn in excess.
• Tested by checking if insiders of a firm are earning in excess compared
to the market, absence of any excess would imply the market to be
strongly efficient.
• Testing the strong-form efficiency is difficult, hence the claim of the
efficiency in the market remains the best option.
148
Departures from the EMH
• Challenges to the efficiency of the market:
• Studies have shown that the markets are very in-efficient even in the weak
form.
• The returns are found to be correlated for both short as well as long lags.
• There are a lots of deviations from the efficiency, which include,
1.Predictability of future returns based on certain events.
2.High volatility of prices compared to volatility of underlying fundamentals.
• The lack of reliability about the level of efficiency of the market prices
makes it less reliable as a guideline for decision-making.
149
Departures from the EMH
• There are alternative prescriptions about the behavior of the markets,
most of which are based upon irrationality of the markets.
• For instance, if the investors on an average are overconfident about
their investment ability, they would not pay close attention to new
price relevant information that arises in the market. This leads to,
1. Inadequate price response to the information event.
2. Continuation of the trend due to the under reaction.
• This bias in processing information : cause of price momentum
150
Calendar Effects in Market Efficiency
January Effect : Stock returns are generally found to be higher in
January than any other months of the year. This effect has been
observed in US markets, Tokyo, London and Paris.
Week-end effect : Returns on Monday are generally lower than other
days. This is explained by the fact that there is a large amount of time
between Friday-end to Monday morning. Hence there is much more
information available.
151
Conclusion
• The alternative prescriptions about the behaviour of markets based
on various sources and forms of investor irrationality are collectively
known as behavioural finance.
• This means that,
• The estimation of expected returns based on methods such as capital asset
pricing model is unreliable.
• There could be any profitable trading strategies based on collective
irrationality of the markets.
152
MCQs
Q1. If the market is _______, the period after a favorable (unfavorable)
event would not generate returns beyond (less than) what is
suggested by an equilibrium model such as CAPM.
(a) weak-form efficient
(b) strong form efficient
(c) semi-strong form efficient
153
MCQs
Q2. __________ would mean that no investor would be able to
outperform the market with trading strategies based on publicly
available information.
(a) Semi strong form efficiency
(b) Weak-form efficiency
(c) Strong form efficiency
154
Answer Key to MCQs
1) c
2) a
155
Chapter – 5
Financial Analysis and Valuation
156
Objectives of this Chapter
• Analysis of Financial statements
• Learning about Financial Ratios
• Valuation of common stocks
157
Introduction
• Decision to invest is linked to :
• Evaluation of companies
• Their Earnings and Potential for future growth
• What is Valuation ?
• Examination of future returns or the cash flows expected from an asset.
• Most important tool for making any decision to invest.
158
Analysis of Financial Statements
Provide the most accurate information about a company’s operations,
how efficiently the capital is allocated and its earnings profile.
Financial Analysis
Income
Statement (Profit
& Loss)
Balance Sheet
Cash Flow
Statement
159
Financial Statements : Income Statement
• Account of total revenue generated by a firm during a period.
• Covers expenses and money earned:
• Operating expenses – Cost of goods and services, cost during manufacture
• Interest cost – Based on Debt profile of company
• Other income – Income from non-core activities
• Negative interest expenses – From cash reserves with the company
160
Financial Statements : Balance Sheet
• Statement of the assets, liabilities, and capital of a business.
• Types of assets:
• Current assets – Manufacturing goods in progress, receivables, inventory
• Fixed assets – Machinery, other infrastructure
• Other assets – Carry value but not directly marketable like Patents, trademarks
161
Financial Statements : Cash Flow
• Track the cash flows in a company over a period and most important
from valuation’s perspective.
• Cash Flows : The total amount of money being transferred into and out
of a business across three activities :
• Operating – Net income generation, non-core accruals like depreciation
• Investing – Fixed and current assets, other firms
• Financing – Net result of firm’s borrowing and payments
162
Financial Statements : Example
Pharmaceutical Industry - Income statement, Balance sheet and Cash flow
163
Financial Ratios
• Meaningful links between different entries of financial statements.
• Provides information about:
• Financial health and prospects of company
• Relative sense : With itself and other companies
164
Financial Ratios : Measures of Profitability
• Return on assets(RoA): Firm’s ability to generate profits given its assets.
RoA = (Net Income + Interest Expenses)*(1- Tax Rate) / Average Total Assets
• Return on Equity(RoE) : Return to the equity investor.
RoE = Net Income / Shareholder Funds
• For recent capital raising by the firm, RoAE
Return on Average Equity = Net Income / Average Shareholder Funds
Return on Total Capital = Net Income + Gross Interest Expense / Average total capital
165
Financial Ratios : Measures of Liquidity
• Short-term liquidity is imperative for a company to remain solvent.
• Ratios :
• Current ratio = Current Assets / Current Liabilities
• Quick Ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities
• Acid test ratio = (Cash + Marketable Securities) / Current Liabilities
• Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
166
Fin Ratios: Cap Structure & Solvency Ratios
• Ratios :
• Total debt to total capital = (Current Liabilities + Long-term Liabilities) / (Equity +
Total Liabilities)
• Long-term Debt-Equity = Long-term Liabilities / Equity
167
Financial Ratios : Operating Performance
• Ratios :
• Gross Profit Margin = Gross Profit / Net Sales
• Operating Profit Margin = Operating Income / Net Sales
• Net Profit Margin = Net Income / Net Sales
168
Financial Ratios : Asset Utilization
• Look at effectiveness of a firm to utilize its assets, specially fixed assets.
• Ratios :
• Total Asset Turnover = Net Sales / Average Total Assets
• Fixed Asset Turnover = Net Sales / Average Net Fixed Assets
•A high turnover implies optimal use of assets.
169
Common Shareholders
• Owners of the firm.
• Appoint the management and Board of director for the management of
firm.
• The cash flows (return) are in the form of current and future dividends
distributed from the profits of the firm
170
Valuation of Common stock
• Two types:
• Intrinsic - Refers to value of a security
- Present value of all expected cash flows to the company
• Relative - Based on valuation of comparable firms in the industry
- Calculate share price
171
Valuation of Common stock
Valuation
Intrinsic
Discount
ed Cash
Flows
Constant
Dividend
Growth
Present
Value of
Growth
Opportu
nities
Relative
Discount
ed Free
Cash
Flow
Earning
Per
Share
Dividend
Per
Share
Price
Earning
ratio
Price
Book
Ratio
Return
on
Equity
Du Pont
Model
Dividend
Yield
Return
to
Investor
172
Intrinsic Valuation : Discounted Cash flows
• Values the share based on the expected dividends from the shares
• Price of a share :
• We can write the share price at the end of the year 1 as a function of
the 2nd year dividend and price of share at the end of the year 2.
173
Intrinsic Valuation : Discounted Cash flows
• We can also write as:
• When N tends to infinity,
174
Intrinsic Valuation : Constant dividend Growth
• Amount paid as dividends grows at a constant rate (say g) every year. In
this case, the cash flows in various years will be:
• Share Price : Po 
Div1
rg
• Condition : Expected rate of return(r) > Growth rate(g)
175
Example
Que: RNL has paid a dividend of Rs. 10 per share last year (D0) and it is
expected to grow at 5% every year. If an investor’s expected rate of return
from RNL share is 7%, calculate the market price of the share as per the
dividend discount model.
Answer: The following are given:
Dividend per share last year = Div0 = 10
Growth factor= g = 5% = 0.05
Expected rate of return= r = 7% = 0.07.
176
Example
Dividend per share this year = Div1 = Div0 * (1+ g) =10 * 1.05 = 10.50
Market price of share = P0 = Div1/(r-g) = 10.50/(0.07-0.05) = 525
Market price of RNL share as per the dividend discount model with
constant growth rate is Rs. 525.
177
Intrinsic Valuation : PVGO
• PVGO = Present Value Growth of Opportunities
• PVGO =Share Price – Present value of level stream of earnings
=Share price– EPS / r
• Firms do not distribute 100% of the earnings as dividends, but
plowbacks and invests certain portion of the current year profit on
projects whose yield will be greater than the market expected rate of
return. This causes growth in future dividend, g = Plowback ratio * ROE.
178
Intrinsic Valuation :Discounted Free Cash Flow
• First, find the value of enterprise.
• Next, find the value of the equity by deducting the debt value from the
firm value.
• Market value of equity (V0) = Value of the firm + Cash in hand – Debt
Value
179
Intrinsic Valuation :Discounted Free Cash Flow
• Price of share = Market Value of equity / No. of shares outstanding
• Value of firm = Present value of the future free cash flow of the firm
• Discounting rate = WACC of the firm
• WACC(Weighted average cost of capital) is the cost of capital that
reflects the risk of the overall business.
180
Intrinsic Valuation :Discounted Free Cash Flow
• WACC is calculated as:
181
Intrinsic Valuation :Discounted Free Cash Flow
•
• Free Cash flow: Cash that a company is able to generate after laying out
the money required to maintain or expand its asset base.
Assuming firm is 100 % equity owned, computed as:
Terminal VFCF = EBIT * (1 – T) + Depn – Capital Expenditure –
IncreaseinWorkingCapital, where T in the tax rate.
182
Intrinsic Valuation :Discounted Free Cash Flow
• Start with EBIT as cash outflow in the form of interest payments not
considered.
• Depreciation lowers the EBIT but is added back since it is a non-cash
expenditure.
• Since the firm has to incur any planned capital expenditure and has to
finance any working capital requirement before distributing the profits
to the shareholders the same is deducted while calculating the free cash
flows.
183
Relative Valuation : Earning Per Share
• Firms’ net income divided by the average number of shares outstanding
during the year.
Net Profit  Dividend On Preference shares
EPS 
Average number of shares outstandin g during the year
184
Relative Valuation : Dividend Per Share
• Dividend Per share : Amount that the firm pays as dividend to the
holder of one share.
Dividend Per share = total dividend / number of shares in issue
• Dividend Payout Ratio : Percentage of income that the company pays
out to the shareholders in the form of dividends.
DPR = Dividends / Net Income = DPS/EPS
185
Relative Valuation : Dividend Per Share
• Retention Ratio : Opposite of dividend payout ratio and measures the
percentage of net income not paid to the shareholders in the form of
dividends.
Retention Ratio = 1-DPR
186
Example
Que. The following is the figure for Asha International during the year
2008-09:
Net Income: Rs. 1,000,000
Number of equity shares (2008): 150,000
Number of equity shares (2009): 250,000
Dividend paid: Rs. 400,000
Calculate the earnings per share (EPS), dividend per share (DPS), dividend
payout ratio and retention ratio for Asha International.
187
Example
Ans.
188
Relative Valuation: Price Earning Ratio
• Price Earning Ratio = Market Price Per Share / annual Earning Per share
• Usually calculated for the last one year
• Sometimes, we also calculate the PE ratio using the expected future
one-year return. In such case, we call forward PE or estimated PE ratio.
189
Example
Que : Stock XYZ, whose earning per share is Rs 50 is trading in the
market at Rs 2000. What is the price to earnings ratio for XYZ?
Ans : Price earnings Ratio
= Market price per share / annual earning per share
= 2000/50 = 40
190
Relative Valuation: Price Book Ratio
• Used to judge whether the stock is undervalued or overvalued, as it’s
less susceptible to fluctuations than the PE ratio.
• Price-book ratio = Market price of the share / Book Value per share
191
Relative Valuation: Return on Equity
• Measures profitability from the equity shareholders point of view.
• It is return to equity shareholders.
Net Income After Tax  Preferred dividends
ROE 
Average shareholde r equity Excluding Preferred share Capital
192
Example
Que : XYZ Company net income after tax for the financial year ending
31st March, 2009 was Rs. 10 million and the equity share capital as on
31st March, 2008 and 31st March 2009 was Rs. 80 million and Rs. 120
million respectively. Calculate the return on equity of XYZ company for
the year 2008-09.
193
Relative Valuation: Du Pont Model
• DuPont Model breaks the Return on equity as under:
RoE = Return on Equity = Net Profits/Equity
= Net Profits/Sales * Sales/Assets * Assets/Equity
= Profit Margin * Asset Turnover * Financial Leverage
• It shows that the firm could improve its RoE by a combination of
profitability (higher profit margins), raising leverage (by raising debt), by
using its assets better (higher asset turn) or a combination of all three.
194
Relative Valuation: Dividend Yield
• Ratio between the dividend paid during the last 1-year period and the
current price of the share.
• Dividend Yield = Last year dividend / current Price of share
195
Relative Valuation: Dividend Yield
• Ratio between the dividend paid during the last 1-year period and the
current price of the share.
• Dividend Yield = Last year dividend / current Price of share
196
Example
Que : ABC Company paid a dividend of Rs. 5 per share in 2009 and the
market price of ABC share at the end of 2009 was Rs. 25. Calculate the
dividend yield for ABC stock.
Ans : Dividend Yield = Last year dividend / current Price of share
= 5/25 = 0.20 = 20%
197
Example
Expected Return(r) = Dividends+ ∆(market priceof the share)
OpeningMarket Price
Que : The share price of PQR Company on 1st April 2008 and 31st
March 2009 is Rs. 80 and Rs. 84 respectively. The company paid a
dividend of Rs. 6 for the year 2008-09. Calculate the return for a
shareholder of PQR Company in the year 2008-09.
198
Example
Answer:
Expected Return(r) = Dividends+ ∆(market priceof the share)
OpeningMarket Price
= 6 + (84 – 80)
80
= 10/80 = 12.5 %
199
Relative Valuation: Return to Investor
If we write the dividends during the year as Div1, the price of the share
at the beginning and at the end of the year as P0 and P1 respectively,
we can write the above formula as:
200
Example
Que. If a firm has $100 in inventories, a current ratio equal to 1.2, and a
quick ratio equal to 1.1, what is the firm's Net Working Capital?
Ans. : Current ratio = CA/CL = 1.2
Quick ratio = (CA-100)/CL = 1.1
Solve and find CL = 1,000 and CA = 1,200
Net working capital = CA-CL = 200
201
MCQs
Q1. A company's __________ provide the most accurate information to
its management and shareholders about its operations.
(a) advertisements
(b) financial statements
(c) products
(d) vision statement
202
MCQs
Q2. Gross Profit Margin = Gross Profit / Net Sales
(a) FALSE
(b) TRUE
Q3. Accounts payable appears in the Balance Sheet of companies.
(a) TRUE
(b) FALSE
203
MCQs
Q4. Net acquisitions / disposals appears in the Cash Flow Statement of
Companies.
(a) TRUE
(b) FALSE
204
MCQs
Q5. _______ measures the percentage of net income not paid to the
shareholders in the form of dividends.
(a) Withholding ratio
(b) Retention ratio
(c) Preservation ratio
(d) Maintenance ratio
205
MCQs
Q6. Which of the following accounting statements form the backbone
of financial analysis of a company?
(a) the income statement (profit & loss),
(b) the balance sheet
(c) statement of cash flows
(d) All of the above
206
MCQs
Q7. The balance sheet of a company is a snapshot of the ______ of the
firm at a point in time.
(a) the sources and applications of funds of the company.
(b) expenditure structure
(c) profit structure
(d) income structure
207
MCQs
Q8. A ________ provides an account of the total revenue generated by
a firm during a period (usually a financial year, or a quarter).
(a) Accounting analysis statement
(b) financial re-engineering statement
(c) promotional expenses statement
(d) Profit & loss statement
208
MCQs
Q9. Dividend Per Share = Total Dividend / Number of Shares in issue
(a) TRUE
(b) FALSE
209
MCQs
Q10. To measure a firm's solvency as completely as possible, we need to
consider
a. The firm's relative proportion of debt and equity in its capital structure
b. The firm's capital structure and the liquidity of its current assets
c. The firm's ability to use Net Working Capital to pay off its current liabilities
d. The firms leverage and its ability to make interest payments on its long-term
debt
e. The firm leverage and its ability to turn its assets over into sales
210
MCQs
Q11. Which of the following is considered a profitability measure?
a. Days sales in inventory
b. Fixed asset turnover
c. Price-earnings ratio
d. Cash coverage ratio
e. Return on Assets
211
Answer Key to MCQs
1)
2)
3)
4)
5)
6)
7)
8)
9)
10)
11)
b
b
a
a
b
d
a
d
a
d
e
212
Chapter – 6
Modern Portfolio Theory
213
Objectives of this Chapter
• Maximize portfolio expected return or equivalently minimizing risk.
• Understand the diversification and portfolio risks.
• Understand the Equilibrium Module (CAPM)
• APT Module
214
Introduction
• Two building blocks to analyze this behavior :
• Portfolio theory
• Equilibrium Mode
215
Portfolio Theory
• Theory about the risk - return characteristics of assets in a portfolio.
• Portfolio Risks and Returns.
• Portfolio Variance and covariance.
216
Portfolio Risks and Return
• Expected return - weighted average of the likely profits of the assets in
the portfolio.
• Risk - Standard deviation of returns.
• Depends on the stock price movement ( covariance ).
• It is not the weighted average of the individual stock risks.
• Let us now examine with the help of an example why and how
portfolio risk is different from the weighted risks of constituent assets.
217
Example
Que. What is the expected return for the following portfolio?
Stock
Expected returns
Investment
AAA
31.2%
$190,000
BBB
24.0%
$350,000
CCC
18.6%
$200,000
DDD
11.9%
$500,000
218
Example
Ans.
Stock
Expected returns
Investment
AAA
31.2%
$190,000/1,240,000 = 0.1532
BBB
24.0%
$350,000/1,240,000 = 0.2823
CCC
18.6%
$200,000/1,240,000 = 0.1613
DDD
11.9%
$500,000/1,240,000 = 0.4032
TOTAL $1,240,000
Exp return = (31.2%)(0.1532) + (24%)(0.2823) + (18.6%)(0.1613) + (11.9%)(0.4032)
Exp return = 19.35%
219
Example
Que. You are considering buying a stock with a beta of 2.05. If the risk
free rate of return is 6.9 percent, and the market risk premium is 10.8
percent, what should the expected rate of return be for this stock?
Ans. ki = kRF +(kM - kRF)bi
ki = 6.9% + (10.8%)(2.05)
ki = 29.04%
220
Portfolio Variance and Covariance
• Variance - determine the risk an investor might take when purchasing
a specific security.
• Depends on the variance of individual stocks.
• Covariance - inter relationship between the two stocks.
• Positive Covariance = Returns of assets move together.
• Negative Covariance = Returns move inversely.
• Covariance 0 = uncorrelated stocks.
221
Inference
 Risk of the portfolio would be lower than individual stocks considered
separately.
 Portfolio variance is the weighted sum of variance as well as the
covariance.
 Minimum portfolio standard deviation would always correspond to that
of the stock with the least standard deviation.
 Value of W should be chosen in a way so that the portfolio risk can be
brought down below that of the least risky stock in the portfolio.
222
Portfolio Variance : General Case
• Assuming n stocks,
where double summation indicates that covariance would not appear
for same ( ii or jj ) combination.
223
Portfolio Variance : General Case
Characteristics of including a large number of stocks in portfolio,
Assume, Wi = 1/N
= 1/N (Average variance) + [1-1/N] Average covariance
224
Inferences
1. For larger N, portfolio variance would be dominated by covariance
rather than variances.
2. Even for large number of assets, portfolio variance cannot be reduced
to 0.
3. Market Risk - Risk that cannot be eliminated by diversifying through
investments across assets.
4. Covariance risk - Relevant risk of an asset is what it contributes to a
widely held portfolio.
225
Equilibrium Model (CAMP)
 Mean variance investors
 Market Behaviour
 Beta
226
Mean-Variance Investors
 Investors are mean-variance optimizers.
 Portfolios with higher return for the same level of risk or minimum risk
for a particular return would be chosen by them.
 Investors have homogeneous information about different assets.
 Have the same investment horizon.
227
Portfolios chosen
 Efficient Portfolios : Portfolios offering the maximum return for any
given level of risk.
 Efficient portfolios with risk free asset.
 Combination of risky portfolio M and the risk free asset.
228
Efficient Portfolio
229
Explanation
 Market portfolio : Combination of all the risky assets.
 Nature of portfolio M:
 Same portfolio as M identified by 1) Investors having same portfolio
2) Investors having same information
230
Market Behavior
 To examine the aggregate behavior of the market - mean-variance
space used.
 All assets mapped on a return-standard deviation space.
 Combinations- characterized theoretically as correlation of stocks are
between 0 to 1.
231
Efficient frontier
232
Explanation
 All feasible combinations - space enclosed by the curve and straight line.
 Curved line - correlations of stocks are less than 1.
 Straight line - stocks with maximum correlation.
 No portfolios would lie to the right of the straight-line.
233
Explanation
 Portfolio A would be preffered to B, as it has lower risk for the same
level of return offered by B.
 Portfolio A would be preferred to portfolio C, as it offers higher
return for the same level of risk.
 D is the minimum variance portfolio among the entire feasible set.
 Portfolios that lie along D-E represent the best available combination
of portfolios as they are efficient portfolios.
234
CML Line
 Capital Market Line.
 Connects market portfolio to the risk free assets.
 Points on CML have superior risk-return profiles.
235
Asset Pricing Problem
 Understanding Risk Premium.
 Estimation of the discounting factor to be applied to the expected
cash flows of the asset.
236
Risk Premium
 Rate of risk required for unit variance of the market = RM-RF/ σ2M.
 In well diversified portfolio, only risk is covariance risk.
 Therefore, Risk Premium = RM-RF/ σ2M * COV(i,M)
 Here COV(i,M)/ σ2M is Beta.
 Total rate of return on any risky asset is,
Ri = Rf + (Rm - Rf) Bi
237
Estimation of beta
 Beta measures the sensitivity of the security compared to the market.
 If beta is k, then if market moves down/up by 1%, the security is
expected to move down/up by k%.
 Minimum expected return on stock = k(Rm -Rf)
 Estimated as a regression between the return on stock and that of the
market.
238
Estimation of beta
 Regression equation,
Ri = α i + β i RM + ei
Regression coefficient (βi) represents the slope of the linear
relationship between the stock return and the market return, and
αi denote the risk-free rate of return.
239
Estimation of beta
 Therefore, the beta of any stock can be conveniently estimated as a
regression between the return on stock and that of the market.
 If the firm holds more risky assets the beta shall also be higher.
 A firm’s beta is the weighted average of the beta of its assets.
240
Example
Que. If the risk-free rate is 4.3%, the expected return on the market is
15.7%, and the expected return on Security J is 21.5%, what is the beta
For Security J?
Ans. ki = kRF +(kM - kRF)bi
21.5% = 4.3% + (15.7% - 4.3%) bi
17.2% = (11.4%) bi
bi = 1.51
241
APT Model
 Investor portfolio is exposed to a number of systematic risk factors.
 Portfolios with equal sensitivity are priced equally.
 Risk factors can be expressed as linear combination of risk factors and
betas.
 Relaxes the assumption that all investors hold the same portfolio.
242
MCQs
Q1. The CAPM is founded on the following two assumptions (1) in the
equilibrium every mean variance investor holds the same market
portfolio and (2) the only risk the investor faces is the beta.
(a) TRUE
(b) FALSE
243
Answer Key to MCQs
1)
a
244
Chapter – 7
Valuation of Derivatives
245
Objectives of this Chapter
• Understand the major types of derivatives traded in the market and
their pricing
246
Introduction
 Derivatives are a wide group of financial securities defined on the
basis of other financial securities.
 The price of a derivative is dependent on the price of another
security, called the underlying (such as shares or bonds)
 Derivatives are among the most widely traded financial securities in
the world and the turnover in the futures and options market
(covered later) exceeds that in the cash (underlying) market.
247
Forwards and Futures
 Forwards contract and futures contract are derivate instruments in
the form of agreements to exchange an underlying security at an
agreed rate on a specified future date which is called expiry date.
 The rate prevailing as of today is called the spot rate.
 The agreed rate is called forward rate and the difference between
spot rate and forward rate is called the forward margin.
248
The long and short of forward & futures
 The party that agrees to buy the asset on a future date is referred to
as a long investor and is said to have a long position.
 Similarly, the party that agrees to sell the asset in a future date is
referred to as a short investor and is said to have a short position.
 Now, we explore the difference between the two contracts.
249
Comparison between the two contracts
250
Call and Put option
 An ‘option’ contract is a derivative instrument wherein a contract
written by a seller provides the buyer the right (not an obligation) to
either buy or sell an underlying asset at a specified price on a future
date.
 The option to buy is called ‘Call Option’ and the option to sell at
agreed price (strike rate or exercise price) is called ‘Put Option’.
 The seller collects a payment called premium from the other party for
having granted the option.
251
How does the option work?
 Since options do not enforce any obligation upon the buyer to buy or
sell, the buyers are protected from downside risks as well as enables
them to reap benefits from favorable movement in exchange rate.
 The maximum loss that a buyer can suffer is the premium paid to
enter into the contract.
 Option is exercised only when possibility of reaping profits otherwise
it is allowed to lapse.
252
Call and Put Option
 In case of American options, the right can be exercised on any day on
or before the expiry date, but in European options, the right can be
exercised only on the expiry date.
 Options can be used for hedging as well as for speculation purposes.
An option is used as a hedging tool if the investor already has (or is
expected to have) an open position in the spot market.
253
Forward and Futures Pricing
 Forwards and Futures contract prices are calculated using the cost of
carry model. It calculates the fair value of futures contracts based on
the current spot price of underlying asset. Formula for calculation:
254
Example
Security of ABB Ltd trades in the spot market at Rs. 850. Money can be
invested at 11% per annum. The fair value of a one-month futures
contract on ABB is calculated as follows:
 The presence of arbitrageurs and the increase in demand/ supply of
the futures (and spot) contracts will force the futures price to equal
the fair value of the asset.
255
Cost of Carry and Convenience Yield
 Cost of carry is the cost of holding a position usually represented as a
percentage of the spot price.
 Usually the risk free interest rate is the cost of carry but in case of
commodities contracts, cost of carry also includes storage costs of the
underlying asset until maturity.
 Convenience yield is the opposite of carrying charges and refers to the
benefit accruing to the holder of the asset. Has a negative relationship
with inventory storage levels (and storage cost).
256
Cost of carry and convenience yield
 High storage cost/high inventory levels lead to negative convenience
yield and vice versa.
 The cost of carry model expresses the forward (future) price as a
function of the spot price and the cost of carry and convenience yield.
c = convenience yield and t = time to delivery of the forward contract
(expressed as a fraction of 1 year)
257
Backwardation and Contango
 When the future price is lower than the current spot price, the market
is said to be backwarded and the opposite is called as a contango
market.
 Since future and spot prices have to converge on maturity, in the case
of a backwarded market, the future price will increase relative to the
expected spot price with passage of time, the process is referred to as
backwardation. In case of contango, the future price decreases relative
to the expected spot price.
258
Option Pricing
a) Payoffs from option contracts
 Payoffs from an option contract (excluding initial premium amount)
refer to the value of the option contract for the parties (buyer and
seller) on the date the option is exercised.
 In case of call options, the option buyer would exercise the option
only if the market price on the date of exercise is more than the
strike price of the option contract.
259
Option Pricing
 Otherwise, the option is worthless since it will expire without being
exercised.
 Similarly, a put option buyer would exercise her right if the market
price is lower than the exercise price.
 This would be clear in the diagrams in the next two slides.
260
Option Pricing (Payoff from Option Contract)
 The payoff of a call option buyer at expiration is:
Max [(Market price of the share – Exercise price), 0]
 Payoff diagrams for call options buyer and seller (Assumed exercise
price = 100)
261
Option Pricing (Payoff from Option Contract)
 The payoff for a buyer of a put option at expiration is:
Max [(Exercise Price – Market price of the share), 0]
 Payoff diagrams for call option buyer and seller (exercise price
assumed=100).
262
Put to Call Parity Relationship
Gives a fundamental relationship between European call and put options.
The payoff from the following two strategies is the same irrespective of
the stock price at maturity. The two strategies are:
a) Buy a call option & investing the PV of exercise price in risk-free asset.
263
Put to Call Parity Relationship
b) Buy a put option and buying a share.
Since payoff from two strategies is same, therefore: C + Ke–rt = P + S0
Value of call option (C); PV of exercise price (Ke–rt ); value of put option
(P);Current share price (S0 )
264
Black-Scholes Formula
The main question that is still unanswered is the price of a call option
for entering into the option contract, i.e. the option premium. The
premium amount is dependent on many variables.
a) Share Price (S0)
b) Exercise Price (K)
c) The time to expiration i.e. period for which the option is valid (T)
d) Prevailing risk-free interest rate (r)
e) The expected volatility of the underlying asset
265
Black-Scholes Formula
The Black-Scholes formula for valuing call options (c) and value of put
options (p) is as under:
N(.) is the cumulative distribution function of the normal distribution.
266
Example
Que. Find the prices for a call and a put, and the probabilities (both
risk-neutral and physical) of these options being in the money,
if S(0) = 100, K = 110, T = 0.5, r = 5%, µ = 8%, σ = 35%.
Ans. The call price is 6.97167, while the put price is 14.2558. The risk-
neutral probability is 0.4363, and the physical probability is 0.46027.
267
Example
268
Example
On March 6, 2001, Cisco Systems was trading at $13.62. We will
attempt to value a July 2001 call option with a strike price of $15,
trading on the CBOT on the same day for $2.00. The following are the
other parameters of the options:
• The annualized standard deviation in Cisco Systems stock price over
the previous year was 81.00%. This standard deviation is estimated
using weekly stock prices over the year and the resulting number was
annualized as follows:
269
Example (cont.)
Weekly standard deviation = 1.556%
Annualized standard deviation =1.556%*52 = 81%
• The option expiration date is Friday, July 20, 2001. There are 103 days
to expiration.
•The annualized treasury bill rate corresponding to this option life is
4.63%.
The inputs for the Black-Scholes model are as follows:
Current Stock Price (S) = $13.62
270
Example (cont.)
Strike Price on the option = $15.00
Option life = 103/365 = 0.2822
Standard Deviation in ln(stock prices) = 81%
Riskless rate = 4.63%
Inputting these numbers into the model, we get
271
Example (cont.)
Using the normal distribution, we can estimate the N(d1) and N(d2)
N(d1) = 0.5085, N(d2) = 0.3412
The value of the call can now be estimated:
Since the call is trading at $2.00, it is slightly overvalued, assuming that
the estimate of standard deviation used is correct.
272
MCQs
Q1. Mr. A buys a Call Option at a strike price of Rs. 700 for a premium
of Rs. 5. Mr. A expects the price of the underlying shares to rise above
Rs. ______ on expiry date in order to make a profit.
(a) 740
(b) 700
(c) 720
(d) 760
273
MCQs
Q2. The price of a derivative is dependent on the price of another
security, called the _____ .
(a) basis
(b) variable
(c) underlying
(d) options
274
MCQs
Q3. Call Options can be classified as :
(a) European
(b) American
(c) All of the above
275
MCQs
Q4. Mr. A buys a Put Option at a strike price of Rs. 100 for a premium of
Rs. 5. On expiry of the contract the underlying shares are trading at
Rs. 106. Will Mr. A exercise his option?
(a) No
(b) Yes
276
Answer Key to MCQs
1) b
2) c
3) a
4) a
277
Chapter – 8
Investment Management
278
Objectives of this Chapter
• Briefly understand professional asset management industry
• Understand various types of mutual funds
• Outline key metrics used to measure investment performance of funds
279
Introduction
• Two kinds of companies in asset management industry :
Engaged in investment advisory
Engaged in investment management
(wealth management activities)
Investment advisory firms recommend
Investment management companies
clients to take positions in various
combine their clients’ assets towards
securities; and wealth management
taking positions in a single portfolio,
firms have custody of their clients’
called a mutual fund
funds, to be invested according to their
discretion
280
Introduction
• What is a Mutual Fund ?
• also known as mutual funds, investment funds, managed funds or
simply funds
• represents positions in each of the securities owned in the portfolio
• clients track returns on the net asset value (NAV) of the fund, instead of
tracking return on their own portfolios
• Why invest into Mutual Funds?
• Because of the diversification they afford the investor
• E.g. instead of owning every large-cap stock in the market, an investor could
just buy units of a large-cap fund.
281
Investment Companies
• Pool funds from various investors and invest the accumulated funds in
various financial instruments or other assets
• Profits and losses from the investment (after repaying the management
expenses) distributed to investors in funds in proportion to the
investment amount
• Run by an asset management company who simultaneously operate
various funds within the investment company
• Each fund is managed by a fund manager who is responsible for
management of the portfolio
282
Benefits (Investment in Management Funds)
• Choice of schemes
• Professional Management (by team of experts)
• Diversification (since mutual fund assets are invested across a wide
range of securities)
• Liquidity (easy entry and exit of investment : investors can with ease
buy units from mutual funds or redeem their units at the net asset
value either directly with the mutual fund or through an advisor / stock
broker.
283
Benefits (Investment in Management Funds)
• Transparency (NAV of the assets and broad break-up of the instruments
where the investment is made published by asset management team)
• Tax Benefit (dividends received on investments held in certain schemes,
such as equity based mutual funds, are not subject to tax)
284
Active vs. Passive Portfolio Management
Passive Investment
• Assumes that gains in the market are those of the benchmark, and not
in the choice of individual securities, as opportunities in their selection,
or timing of entry/exit are too short to be taken advantage of
• Rests upon theory of market efficiency
• Passive fund managers try to replicate the performance of a benchmark
index, by replicating the weights of its constituent stocks
285
Active vs. Passive Portfolio Management
• Managers try to minimize the tracking error of the fund (calculated
as the deviation in its returns from that of the index), for daily price
movement in stock price
• choice of the index differentiates between funds
• E.g. an equity index fund would simply try to maintain the return profile of the
benchmark index, say, the NIFTY 50; but if investments are allowed across
asset classes, then the ‘benchmark’ could well consist of a combination of a
equity and a debt index
286
Active vs. Passive Portfolio Management
Active Investment
• Optimal selection of stocks, and the timing of entry/exit could lead to
‘marketbeating’ returns
• Investors view about the relative under pricing or over pricing of an
asset
• Over pricing presents an opportunity to engage in short selling, under
pricing an opportunity to take a long position, and combinations of the
two are also possible, across stocks, and portfolios
287
Active vs. Passive Portfolio Management
• Active portfolio manager try to make higher profits from investing, with
similar, or lower risks attached.
• A good portfolio manager :
• must have good forecasting ability
• must be better in the following than his competitors :
• market timing
• security selection
288
Active vs. Passive Portfolio Management
• Market timing : ability of the portfolio manager to gauge at the
beginning of each period the profitability of the market portfolio vis-avis the risk-free portfolio of Government bonds
• Security Selection : ability of a portfolio manager in identifying mispricing
in individual securities and then investing in securities with the maximum
mispricing, which maximizes the alpha.
• Alpha of a security = expected excess return of the security over the expected
rate of return
• E.g. estimated by an equilibrium asset pricing model like the CAPM
289
Active vs. Passive Portfolio Management
• Portfolio tilting uses both active and passive fund management
• A tilted portfolio shifts the weights of its constituents towards one or more of
certain pre-specified market factors, like earnings, valuations, dividend yields, or
towards one or more specific sectors
• In terms of their costs to the investors :
• Passive investment is characterized by low transaction costs (given their low
turnover), management expenses, and the risks attached
• Active fund management is understandably more expensive, but has seen costs
falling over the years on competitive pricing and increased liquidity of the
markets, which reduced transaction costs
290
Cost of Management : Entry/Exit Loads & Fees
• Running a mutual fund involves recurring or non-recurring costs (e.g.
remuneration to the management team, advertising expenses etc.)
• These costs recovered by :
• fund from the investors (e.g. from redemption fees), or
• charges on the assets (transaction fees, management fees and
commission etc.) of the funds
• Management team is paid a fixed percentage of the asset under
management as their fees.
291
Net Asset Value
• Metric of a fund’s performance
• Calculated as :
NAV (per share) = (Market Value of Assets – Market Value of Liabilities) /
Number of shares Outstanding
• NAV for a fund :
Fund NAV = (Market Value of the fund portfolio – Fund Expenses) /
Fund Shares Outstanding
(Net asset value (NAV) is a term used to describe the per unit value of the fund’s net
assets (assets less the value of its liabilities))
292
Classification of funds
 Open and Closed ended funds : Funds are also classified into the
following types based on their investments:
a)Equity Funds
b)Bond Funds
c)Money Market Funds
d)Index Funds
e)Fund of funds
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Open ended & closed-ended funds
Open-ended funds
The units are issued and
redeemed by the fund, at any time and
NAV is issued daily.
Closed-ended funds
Closed-ended funds sell units only at the
outset and do not redeem or sell units
once they are issued. Traded on stock
exchanges
Priced at the NAV prevalent at the time
Price of schemes are determined based
of issue / redemption
on demand & supply for the units at the
stock exchange. Can be more or less than
the NAV of the units
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Classification of funds (Contd.)
a) Equity Funds – primarily invest in common stock of companies. Equity
funds are of two types: growth funds and income funds.
Equity funds can also be sector-specific and investment in that case
would be restricted to those sectors only.
Growth Funds
Income Funds
Focus on companies with strong growth
Focus on companies with high dividend
potential i.e. growth stocks
yield
Capital appreciation is the major decision-
Focus on dividend income or coupon
driver in this case
payment from bonds
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Classification of funds (Contd.)
b) Bond Funds - Bond funds invest primarily in various bonds that were
described in the earlier segment. They have a stable income stream
and relatively lower risk. They could potentially invest in corporate
bonds, Government. bonds, or both.
c) Money Market Funds - Money market mutual funds invest in money
market instruments, which are short-term securities issued by banks,
non-bank corporations and Governments.
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Classification of funds (Contd.)
d) Index Funds - have a passive investment strategy and they try to
replicate a broad market index. A scheme from such a fund invests in
components of a particular index proportionate to their benchmark
representation. It is possible that a scheme tracks more than one index
(in some pre-specified ratio), in either equity, or across asset classes.
e) Fund of Funds – Investment strategy of holding a portfolio of other
mutual funds, with the fund managers’ mandate being the optimal
choice across mutual fund schemes given extant market conditions.
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Other Investment Companies
 There are other kind of funds depending on market opportunities &
investor appetite.
 Total Return funds look at combination of capital appreciation &
dividend income
 Hybrid funds invest in a combination of equity, bonds, convertibles,
and derivative instruments.
 We will now discuss UITs, REITS and Hedge funds.
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Other Investment Companies
a) Unit Investment Trusts (UIT) - Similar to mutual funds, UITs pool
money from investors and have a fixed portfolio of assets, which are
not changed during the life of the fund. Once established the portfolio
composition is not changed (hence called unmanaged funds).
b) REITS (Real Estate Investment Trusts) - invest primarily in real
estates or loans secured by real estate. REIT can be of 3 types: Equity
trusts invest in real estate assets, mortgage trusts invest in loans
backed by mortgage & hybrid trusts invest in either.
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Other Investment Companies
c) Hedge funds - Created by a limited number of wealthy investors who
agree to pool their funds and hire fund managers to manage their
portfolio.
Hedge funds are private agreements and generally have little or no
regulations governing them. This gives a lot of freedom to the fund
managers. Eg: Hedge funds can go short (borrow) funds and can invest in derivatives
instruments which mutual funds cannot do.
They usually have higher fees.
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Performance assessment of managed funds
In Modern Portfolio Theory (MPT), the goal of performance evaluation
is to study whether the portfolio has provided superior returns
compared to the risks involved in the portfolio or compared to an
equivalent passive benchmark such as Capital Market Line or Security
Market Line. The performance is attributed to the following factors:
a) Risk
b) Timing: Market or Volatility
c) Security Selection- of industry or individual stocks
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Performance assessment of managed funds
 Therefore, based on those parameters listed in the previous slide
a) Focus should be on excess returns.
b) Portfolio performance must account for difference in the risk.
c) Should be able to distinguish the timing skills from the security selection skills.
 Various measures are devised to evaluate portfolio performance, viz.
Sharpe Ratio, Treynor Ratio & Jensen Alpha.
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Sharpe Ratio (Excess return to variability)
 Measures the portfolio excess return over the sample period by the
standard deviation of returns over that period. Measures the
effectiveness of a manager in diversifying the total risk (σ). This
measure is appropriate if one is evaluating the total portfolio of an
investor or a fund, as SR of the portfolio can be compared with that of
the market.
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Sharpe Ratio (Excess return to variability)
 The formula for measuring the SR is:
 A higher ratio is preferable since it implies that the fund manager is able
to generate more return per unit of total risks.
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Example
Que. A portfolio has an average monthly return of 1.5% and a standard
deviation of 1.2%. If the risk-free rate is 0.25%, what is Sharpe ratio?
Ans.
RP  RF 1.5%  0.25%
Sharpe ratio 

 0.21
SD( RP )
1.2%
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Treynor Ratio
 Treynor’s measure evaluates the excess return per unit of systematic
risks (β) and not total risks.
 If a portfolio is fully diversified, then β becomes the relevant measure
of risk and the performance of a fund manager may be evaluated
against the expected return based on the SML (which uses β to
calculate the expected return). The formula is:
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Example
Que. From 1988-2007, the S&P 500 earned an average 13.9% per year
with a standard deviation of 15.1%. If the risk-free rate is 4%, calculate
and interpret the Sharpe Ratio and Treynor Index for the overall market.
Ans. The Sharpe Ratio shows the amount of risk premium earned relative
to total risk, where total risk is measured by standard deviation:
Sharpe Ratio = [E(RP) – RF]/SD(RP)
= (13.9% - 4%)/15.1%
= 0.66
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Example
The market as a whole provided 0.66% additional risk premium for
every 1% of portfolio risk (standard deviation). The Treynor Index shows
the amount of risk premium earned relative to systematic risk, where
risk is measured by beta (systematic risk):
Treynor Index = [E(RP) – RF]/ βM
= (13.9% - 4%)/1.0
= 9.90
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Example
Que. Assume the following information:
Your Portfolio
The Market
Expected return
15%
Expected return
14%
Standard deviation
20%
Standard deviation
12%
Beta
1.3
Beta
1.0
If the risk-free rate is 5%, calculate and compare the Sharpe Ratio and the
Treynor Index for both Your Portfolio and The Market. Did your portfolio
beat the market on a risk-adjusted basis?
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Example
Ans.
Your Portfolio
RP  RF 15%  5%
Sharpe 

 0.50
SD( RP )
20%
Treynor 
RP  RF
P
The Market
R P  R F 14%  5%
Sharpe 

 0.75
SD( R P )
12%
R P  R F 14%  5%
15%  5%

 9.00

 7.69 Treynor 
P
1.0
1.3
No. Because the Sharpe Ratio is lower than that for the overall market, your
portfolio is unattractive in that it offers a smaller risk premium per unit of risk
(standard deviation). Your portfolio is also unattractive in that it has a smaller
Treynor Index than the overall market, and thus offers a smaller risk premium
per unit of systematic risk (beta).
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Jensen measure
 The Jensen measure, also called Jensen Alpha, or portfolio alpha
measures the average return on the portfolio over and above that
predicted by the CAPM, given the portfolio’s beta and the average
market returns. It is measured using the following formula:
 This measure is widely used in evaluating mutual fund performance. If αp
is positive and significant, it implies that the fund managers are able to
identify stocks with high potential for excess returns.
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Example
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Example
Que. What is the portfolio beta if a portfolio has two stocks; GM with a
beta of 1.7 and WMT with a beta of 0.6? The portfolio is divided into GM
(35%) and WMT (65%).
Ans :
we have two stocks GM and WMT. Also, portfolio weight for GM is 35%
and for WMT is 65% therefore the
portfolio beta = 1.7×0.6 + 0.6×0.65 = 1.41
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MCQs
Q1. ______ fund managers try to replicate the performance of a
benchmark index, by replicating the weights of its constituent stocks.
(a) Active
(b) Passive
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MCQs
Q2. Over pricing in a stock presents an opportunity to engage in _____
the stock.
(a) short covering
(b) short selling
(c) active buying
(d) going long
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MCQs
Q3. Investment advisory firms manage ______.
(a) each client's account separately
(b) all clients accounts in a combined manner
(c) only their own money and not client's money
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MCQs
Q4. Average Return of an investor's portfolio is 10%. The risk free
return for the market is 8%. The Beta of the investor's portfolio is 1.2.
Calculate the Treynor Ratio.
(a) 4
(b) 8
(c) 2
(d) 6
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MCQs
Q5. Average Return of an investor's portfolio is 55%. The risk free
return for the market is 8%. The Beta of the investor's portfolio is 1.2.
Calculate the Treynor Ratio.
(a) 41
(b) 39
(c) 43
(d) 45
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Answer Key to MCQs
1) b
2) b
3) a
4) c
5) b
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End of Module.
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