Security Analysis and Portfolio Management

Investment Investment is the employment of funds on

assets with the aim of earning income or capital appreciation.

Financial Investment is the allocation of money to assets that are expected to yield some gain over a period of time. It is an exchange of financial claims such as stocks and bonds for money.

SpeculationIt is about taking up the business risk in the

hope of achieving short-term gain.

It involves buying and selling activities with the expectation of making a profit from price fluctuations.

Difference between Investor and Speculator

Investmet SpeculationPlans for a longer time

horizon and holding period ranges from 1 to few years.

Assumes moderate risk.Likes to have moderate

return for the limited risk.Considers fundamental

factors.Uses his own funds and

avoids borrowed funds.

Plans for a very short period and holding period varies from few days to months.

Willing to undertake high risk.

Like to have high returns for assuming high risk.

Considers inside information here says and market behaviour.

Uses borrowed funds to supplement his personal resources.

Investment ObjectivesMaximizing the return Minimizing the riskMaintaining LiquidityHedging against inflationIncreasing safetySaving tax

Stages of Investment ProcessInvestment

Process

Investment Policy

Investible Fund

ObjectivesKnowledg

e

Security Analysis

Market IndustryCompan

y

Valuation

Intrinsic Value

Future Value

Portfolio Construction

Diversification

Selection and allocation

Portfolio Evaluation

Appraisal

Revision

RiskRisk is defined as variability in return or

volatility in return.

Risk is the chance of the actual return being less than the expected return. It means any deviation from the expected return.

Types of Risk

1. Systematic Risk: a. Market Risk b. Interest rate risk c. Purchasing power risk

2. Unsystematic Risk: a. Business Risk b. Financial Risk

Systematic RiskSystematic Risk affects the entire market.

The entire market is moving in a direction either downwards or upwards.

Systematic risk is unavoidable and beyond the control of the corporation or investor.

Example: Economic Conditions, Political Situations, Sociological Changes.

Market RiskMarket Risk: It is the portion of the

variability of return that is caused by the alternating forces of the bull and bear phases.

Bull Market- The index moves from a low level to its peak. It is due to the rising investor confidence and expectations of further capital gains.

Bear Market- Index declines haltingly from the peak to a market low point for a significant period.

Tangible Events – Real events such as earthquake, war, political uncertainty and fall in the value of currency.

Intangible Events – They are related to market psychology which are affected by real events. Reactions to real events become over reactions and push the market either upward or downward.

Interest Rate RiskIt is the variation in the return caused by fluctuations

in the market interest rate. It affects:1. Bond Return:- When interest rate rise, new issues will hit the

market with higher interest rate resulting in less demand for old bonds.

- When interest rate declines, new bonds will yield low returns making the old bonds worth more.

- Demand for bond goes up when the stock market is depressed and the demand for government bond goes up when the govt issues attractive bonds than the private sector.

2. Cost of Borrowing:

Purchasing Power RiskIt is the probable loss in the purchasing

power of the returns to be received. Inflation is the reason for purchasing power risk.

Inflation- Persistent increase in price.- Demand Pull Inflation- Cost Push Inflation - Real Rate of Return

Real Rate of Return = {(1 + r)/(1+IR) } – 1

Where IR = Inflation Rate r = return

Investor gets a return of 12% on his investment and the inflation rate is 6.8%

Real Rate of Return ={( 1+ 0.12)/(1+0.068)}-1 = {1.12/1.068}-1 RR = 1.0486-

1=0.0486=4.86%

Unsystematic RiskIt is unique and peculiar to a firm or an industry.

It stems from financial leverage, managerial inefficiency, technological change in the production process , availability of raw material, change in consumer preferences and labour problems.

1. Business risk refers to the difference between revenue and EBIT

2. Financial risk refers to the difference between EBIT and EBT. Financial risk is associated with capital structure of the company.

Business Risk

Internal Business Risk

Fluctuations in salesResearch and Development

Personnel ManagementFixed Cost

Single Product

External Business Risk

Social and Regulatory Factors

Political FactorsBusiness Cycles

Minimizing Risk ExposureProtection against market risk – studying

the past price behaviour of the stock.Protection against Interest rate risk-

Holding the investment to maturity, Buying TB and bonds of short maturity, investing in bonds with different maturity dates.

Protection against inflation- investment in short term securities and diversification in investment.

Protection against Business and Financial Risk-

Analyzing the strengths , weakness, profitability and capital structure of the company.

Risk MeasurementEx-post risk- Variance from mean value

measures the ex-post risk using historical data.

Ex-ante risk- Variance is calculated with the help of probable returns.

Characteristic Regression Line (CRL): It is a simple linear regression model estimated for a particular stock against the market index return to measure it’s diversifiable and undiversifiable risks.

CRL formula

Ri = αi + βi Rm + ei

where Ri = Return of the ith stock, αi = Intercept, βi =

Slope of the ith stock, Rm = Return of the market index, ei =The error term.

β = n ∑ XY – (∑X)(∑Y) --------------------- , α = Ỳ - βX n ∑ X2 - (∑X)2

Beta and its intrepretationBeta : It is the slope of the CRL. It describes

the relationship between stock return and the index return.

Beta = 1=> 1% change in the market index return causes exactly 1 % change in the stock return.

Beta = 0.5 => The stock is less volatile compared to the market.

Beta = 2 => The stock return is more volatile.

Negative Beta indicates that the stock moves in the opposite direction to the market return.

Characteristic Regression Line

Market Return

Sto

ck R

etu

rn A

lpha

Beta