Security Analysis Assign

7/26/2019 Security Analysis Assign

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Amity Campus

Uttar Pradesh

India 201303

ASSIGNMENTSPROGRAM: MFC

SEMESTER-IISubject Name : SECURITY ANALYSIS

Study COUNTRY :Zambia

Roll Number (Reg.No.) :MFC001412014-2016002

Student Name :DERICK MWANSA

INSTRUCTIONS

a) Students are required to submit all three assignment sets.

ASSIGNMENT DETAILS MARKS

Assignment A Five Subjective Questions 10

Assignment B Three Subjective Questions + Case Study 10

Assignment C Objective or one line Questions 10

b)Total weightage given to these assignments is 30%. OR 30 Marks

c) All assignments are to be completed as typed in word/pdf.

d)All questions are required to be attempted.

e) All the three assignments are to be completed by due dates and need to be

submitted for evaluation by Amity University.

f) The students have to attached a scan signature in the form.

Signature : _______________ ____________________

Date : ________________29/11/2015_________________

( ) Tick mark in front of the assignments submitted

Assignment

A Assignment B Assignment C


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SECURITY ANALYSIS

ASSIGNMENT A

Quest ion 1

What i s meant by Fundamenta l Analys i s? How does i t d i f fer from

technica l Analys i s?

Answer .

Fundamenta l Analys i s

Fundamental analysis is a method that attempts to understand, measure and predict the intrinsic

value of stocks based on an in-depth analysis of various economic, financial, qualitative, and

quantitative factors. Krantz (2009) suggests that fundamental analysis is the science which has its

fixed bases and steps to achieve its objectives in specifying the intrinsic value of the share in the

stock market, through a general framework which takes the form of studying the expected

economic forecasts reaching the sectors from which an increase in the sales and profits is

expected. According to its proponents, fundamental analysis offers a fuller picture of the possible

movements of both the stock market and individual stocks because as many elements as possible

are investigated where as Technical analysis, only looks at past data of stock prices.

According to Thomsett (2006), fundamental analysis is the study of a companys financial

strength based on historical data, sector and industry position, management, dividend policy,

capitalization, and potential for future growth. Fundamental analysis attempts to predict which

stocks are valuable and which are not. The strength of the firms is studied financially based on

the historical financial information and their current conditions and measuring the efficiency of

their management and their commercial opportunities and specifying the intrinsic value of

shares. This is followed by comparing them with the market values resulting from the

interactions between the demand and supply to determine the investments opportunities.

The combination of historical and fiscal status collectively represents all data not directly related

to the price of the stock and this body of information is used to define value in investing and to

compare one stock with another. Fundamental analysis observes numerous elements that affect


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stock prices such as sales, price to earnings (P/E) ratio, profits, earnings per share, and

macroeconomic and industry specific factors. The fundamental analysts observes trends, market

and price movements, company financial statements, interest rates, return on equity (ROE) and

numerous other indicators with one goal in mind: buying or selling stocks that will provide a

high return on investments (ROI).

The end goal of performing fundamental analysis is to produce a value that an investor can

compare with the security's current price with the aim of figuring out what sort of position to

take with that security, either to buy if the security is underpriced, or to sell if the security is

overpriced. Fundamental analysis is built on the idea that the stock market may price a company

wrong from time to time. Profits can be made by finding underpriced stocks and waiting for the

market to adjust the valuation of the company. By analyzing the financial reports fromcompanies fundamentalists get an understanding of the value of different companies and

understand the pricing in the stock market. Fundamental analysis gives a better understanding of

whether the price of the stock is undervalued or overvalued at the current market price.

Fundamental analysis can also be performed on a sectors basis and in the economy as a whole.

According to Thomsett (2006) a fundamental analyst believes that the market price of a stock

tends to move towards its intrinsic value, which is the true value of a company as calculated by

its fundamentals. If the market value does not match the true value of the company, there is an

investment opportunity. Example of this is that if the current market price of a stock is lower

than the intrinsic price, the investor should purchase the stock because he expects the stock price

to rise and move towards its true value. Alternatively, if the current market price is above the

intrinsic price, the stock is considered overbought and the investor sells the stock because he

knows that the stock price will fall and move closer to its intrinsic value. To determine the true

price of the company's stock, the following factors need to be considered.

Fundamental Analysis and Technical Analysis Compared

In order to a clear distinction between fundamental analysis and technical analysis there is need

to understand the latters meaning. Edwards, Magee and Bassetti (2013) defined technical

analysis as the science of recording, usually in graphic form, the history of trading (price changes


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and volume of transactions) in a certain stock or in the averages and then deducing from that

pictured history the probable future trend. Technical analysis may be suitable as one of the

effective means in extracting useful information from the market. The differences between the

technical and the fundamental analysis can be summarized as follows:

Although both use different types of historical information, the fundamental approach uses the

information related to stock dividend, sales, income and other rates, whereas the technical

analysis uses just simple information such as price and the volume factors. Edwards et al (2013)

States that while technical analysis is focused on the study of past performance of the market

action Fundamental analysis concentrates on the fundamental reasons that make an impact on the

market direction. Although the purpose of both methods is an attempt to forecast and determine

the future price movements the difference lies in how these two methods achieve that objective.Edwards et al (2013) postulates that fundamentalists study the cause of price movements

whereas the technicians study the results. Technicians do not find it necessary to know the

reasons why markets change but fundamentalists try to discover why. Technicians who are also

called chartists are interested in the price movement. They try to understand and study the

emotions in the market.

The Fundamental Analysis looks at the shares prices linked to the intrinsic value and comparing

it with the market value to reach whether it is estimated at less than its intrinsic value

(undervalued) or whether it is overvalued, but the technical analysis depends on the prices and

trends.

The other distinctive factor between fundamental analysis and technical analysis lies in their time

horizon. Fundamental Analysis is applied for long periods of time (i.e. years) to become more

credible in its results; whereas the technical analysis strategies is applied in short term periods

(i.e. hours, days, weeks, months) so that the results will have better credibility. Finally technical

analysis is generally used for trade whereas fundamental analysis is more appropriately used for

investment purposes.

Conclusion

Therefore, Technical Analysis is more sensitive to changes in prices, where they can produce

many signals (buying or selling during the daily trading). It is clear that both the technical

analysis and the fundamental analysis are methods which specialize in forecasting the future


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status of the market - specifying the trend of prices, which the market is expected to move

towards. The only difference is that each of these two methods attempts to get nearer to solve

this problem from a different point of view. Murphy (2001) believes that if the fundamental

analysis is reflected in the market price, then there is no necessity to study these fundamental

analyses. So that, reading the graph becomes as one of the technical analysis tools which is a

summarized model of fundamental analysis. However the contrast cannot be correct where the

fundamental analysis does not include a study of the movement of the price.

ASSIGNMENT A

Quest ion 2

Def ine r i sk & dis t inguish between Systemat ic & Unsystemat ic r i sk

Answer .

Risk

According to the business dictionary risk is a probability or threat of damage, injury, liability,

loss, or any other negative occurrence that is caused by external or internal vulnerabilities and

that may be avoided through preemptive action. It is the probability that an actual return on an

investment will be lower than the expected return. Risk consists of two components, the

systematic risk and unsystematic risk. The systematic risk is caused by factors external to the

particular company and uncontrollable by the company. The systematic risk affects the market as

a whole. In the case of unsystematic risk the factors are specific, unique and related to the

particular industry or company

Baker and Nofsinger (2010) said risk is based on the probability of actually earning less than

the expected return.Davis and Steil (2001) further defined risk as the danger that a certain

contingency will occur often applied to the future events that are susceptible to being reduced to

objective probabilities. Culp (2008) asserted that risk was any source of randomness that may

have an adverse impact on the market value of a corporations assets, net liability, on earnings

and/or on its raw cash flows. Risk therefore implies future uncertainty about deviation from

expected earnings or expected outcome. Risk measures the uncertainty that an investor is willing

to take to realize a gain from an investment. Risk includes the possibility of losing some or all of

the original investment.


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Requirements for Risk To Exist

From the above definitions we can agree with Holton (2004) who argues that there are two

ingredients that are needed for risk to exist. The first is uncertainty about the potential outcomes

from an experiment and the other is that the outcomes have to matter in terms of providing

utility. He notes, for instance that a person jumping out of an airplane without a parachute faces

no risk since he is certain to die (no uncertainty) and that drawing a balls out of a container does

not expose one to risk since ones wellbeing or wealth is not affectedby whether a red or black

ball is drawn. However attaching monetary value to a red or black ball would convert this

activity to a risk one.

Differences between Systematic and Unsystematic Risk

While investing in a stock market one needs to take into account two types of risks one is

systematic and other is unsystematic risk. Systematic risk refers to the risk which affects the

whole stock market and therefore it cannot be reduced or diversified away. For example any

global turmoil will affect the whole stock market and not any single stock, similarly any change

in the interest rates affect the whole market though some sectors are more affected then others.

This type of risk is called non diversifiable risk because no amount of diversification can reduce

this risk. Conversely Unsystematic risk is the extent of variability in the stock or securitys return

on account of factors which are unique to a company. For example it may be possible thatmanagement of a company may be poor, or there may be strike of workers which leads to losses.

Since these factors affect only one company, this type of risk can be diversified away by

investing in more than one company because each company is different and therefore this risk is

also called diversifiable risk.

Unsystematic Risk

Unsystematic risk is also known as micro level risk whereas systematic risk is also known as themacro level risk. Unsystematic risk is concerned with the company or industry. Strike, wrong

decisions by the management, change in management, increase in input costs (without increase

in sale price), change in government policy regarding particular type of companies or products,

emerging of substitutes of the company's product(s), cancellation of export order, key-person

leaving the company, fire, embezzlement by employees, unexpected tax demand and major


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problem in the plant. The incidence of such risks can be reduced through effective portfolio

selections. The serious unsystematic risks are:

Business risk:

Business risk is the possibility of adverse change in EBIT. Examples are: Reduction in demand

for companys products, increase in costs of inputs, change in import-export policy concerning

the company, Labour strike, some key-persons leaving the company, cancellation of large sized

export order etc.

Financial risk:

It is the possibility of bankruptcy. It arises because of

dependence on borrowed funds and that to it high interest rates.

Default risk:

The major customer of the company may go bankrupt.

Systematic Risk

It is known as macro level risk. It is concerned with the economy as a whole. The factors causing

this type of risk affect all the investments in a similar fashion (and

not in a similar degree). Examples are: failure of monsoon, change in government, change in

credit policy, recession, war, change in tax policy, etc. Every portfolio has to bear this risk. Themost serious systematic risks are:

Interest rate risk:

Increase in interest rates generally has adverse effects on the financial position and earnings of

the companies.

Inflation risk:

Inflation disturbs business plans of the most of the

organizations. Input costs may go up, all the increase in input costs may not been passed to the

customers.

Political risk:

This risk involves change in government policies and political instability.


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Conclusion

The difference between systematic risk and unsystematic risk is a key element of investment

strategies, and one that serious investors need to understand. Risk is one of the two most

significant factors that differentiate one investment product from another, with the other beingrate of return. Understanding the different kinds of risk helps an investor make investment

decisions, whether the investor is an active participant in the stock market or is a cautious first-

timer.

ASSIGNMENT A

Question 3

E x p l a i n t h e W h i t e b e c k K i s o r m o d e l ?

Answer.

Whitebeck Kisor Model

The Whitbeck - Kisor model was developed by V. S. Whitbeck and M. Kisor Jr. in order to test

the relationship between variables like growth rate, dividend payment rate and risk in growth rate

using multiple regression technique and indicate the impact of all three variables on the Price-

Earnings (P/E) ratio.

Analysis of Whitebeck Kisor Model

Whitbeck-Kisor model was one of earliest attempt to use a multiple regression analysis to

explain price earnings (P/E) ratio. According to Kevin (2015) Whitbeck and Kisor set out to

measure the P/E ratio of a stock to its dividend policy, growth and risk. The duo used dividend

payout rate, earnings growth rate and the variation (standard deviation) of growth rates to

measure the determining variables. They then used multiple regression analysis to define theaverage relationship between each of these variables and the P/E ratio. They took 135 stocks and

estimated the relations hip between P/E and the above mentioned variables. The results they

found are given below:

= 8.2 1.5 0.067

0.2


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Where g is the growth in dividend

D/E is the dividend payout rate and

is the standard deviation.

The numbers in the equation are the regression coefficients. 8.2 is the constant term and the other

numbers represent the weightage of the respective independent variables or factors influencing

the P/E ratio. The coefficients of the equation indicate the weights of the variables on the P/E

ratio. The signs show the direction of impact of the particular variable on the P/E ratio. One

percent increase in the standard deviation of growth rate would cause 0.2 unit decrease in the P/E

ratio. Further, the equation indicates that 1 percent increase in earnings' growth would cause

1.5unit increases, in the P /E ratio. One percent increase in payout ratio would result in

0.067units increase in the P/E ratio. Thus, the equation indicates higher growth, higher dividends

and lower risk would lead to high P/E ratio and vice versa.

With the help of the Whitbeck- Kisor model, the analyst can calculate the theoretical value of the

P/ E ratio and compare it with actual value. If,

Theoretical P/E > actual P/E Sell

Theoretical P/E < actual P/E Buy

The model is sample sensitive. The coefficients of the particular period and sample may not give

correct estimation of P/E for another period.

A S S I G N M E N T A

Q u e s t i o n 4

What i s Macaulays Durat ion?

A n s w e r .

Macau lay s D u r a t i o n

Macaulay Duration was developed in 1938 by Frederic Macaulay. This form of duration

measures the number of years required to recover the true cost of a bond, considering the present

value of all coupon and principal payments received in the future. It is the only type of duration

quoted in years. Interest rates are assumed to be continuously compounded.


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The original idea of duration of a bond was the brainchild of Frederick Macaulay, a Canadian-

born economist, published in the early 20th century. Macaulays idea was to compute the

weighted average time until a bondholder would receive the cash flows from a bond, where the

weight for each time period is the present value of the cash flow to be received at that time,

divided by the present value of all cash flows (market price of the bond). Since Macaulay

duration is a measure of time, the units of Macaulay duration are typically years. The Macaulay

duration of a bond is the weighted average maturity of cash flows, which acts as a measure

of a bond's sensitivity to interest rate changes.Bonds with a higher duration will carry more

risk, and hence have a greater volatility in prices, when compared to bonds with lower durations.

Importance of Duration

The concept of duration is important because it provides more meaningful measure of the length

of a bond, helpful in evolving immunization strategies for portfolio management and measures

the sensitivity of the bond price to changes in the interest rate.

Duration and price changes

The price of the bond changes according to the interest rate. Bonds price changes are commonly

called bond volatility. Duration analysis helps to find out the bond price changes as the yield to

maturity changes.

ASSIGNMENT A

QUESTION 5

Expla in Ef f ic ient market Hypothes i s?

Answer.

Efficient Market Hypothesis (EMH)

The Efficient Markets Hypothesis (EMH) is a theory developed by Professor Eugene Fama in the

1960s. The theory states that the prices of traded assets such as company shares and bonds take

into account all available information. In other words, the price of a traded asset is never

undervalued or overvalued but the price represents exactly what its worth at that point in time is.

The efficient markets hypothesis assumes that markets, such as the London Stock Exchange

(LSE), are efficient so that the prices of all assets are at a value that takes into account all the

information investors have access to. Therefore it states that no investor can beat the market by


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investing in undervalued or overvalued assets because the prices all represent their fair value at

that point in time.

Mortimer (2013) defines an efficient market as a market where there are large numbers of rational,

profit maximizers actively competing, with each trying to predict future market values of individual

securities and where important current information is almost freely available to all participants. In an

efficient market, competition among the many intelligent participants leads to a situation where, at any

point in time, actual prices of individual securities already reflect the effects of information based both

on events that have already occurred and on events which, as of now, the market expects to take place

in the future. In other words, in an efficient market at any point in time the actual price of a security will

be a good estimate of its intrinsic value. There are three common forms in which the efficient-market

hypothesis is commonly stated weak-form efficiency, semi-strong-form efficiency and strong-form

efficiency, each of which has different implications for how markets work.

Strongform Efficiency

In its strongest form, Mortimer (2013) says EMH is efficient if all information relevant to the value of a

share, whether or not generally available to existing or potential investors, is quickly and accurately

reflected in the market price. For example, if the current market price is lower than the value justified by

some piece of privately held information, the holders of that information will exploit the pricing anomaly

by buying the shares. They will continue doing so until this excess demand for the shares has driven the

price up to the level supported by their private information. At this point they will have no incentive to

continue buying, so they will withdraw from the market and the price will stabilize at this new

equilibrium level. This is called the strong form of the EMH. It is the most satisfying and compelling form

of EMH in a theoretical sense, but it suffers from one big drawback in practice. It is difficult to confirm

empirically, as the necessary research would be unlikely to win the cooperation of the relevant section

of the financial community such as the insider dealers.

Semi-strong form Efficiency

The semi-strong-form of EMH is a slightly less rigorous form. The EMH says a market is

efficient if all relevant publicly available information is quickly reflected in the market price. If

the strong form is theoretically the most compelling, then the semi-strong form perhaps appeals


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most to our common sense. It says that the market will quickly digest the publication of relevant

new information by moving the price to a new equilibrium level that reflects the change in

supply and demand caused by the emergence of that information. What it may lack in intellectual

rigor, the semi-strong form of EMH certainly gains in empirical strength, as it is less difficult to

test than the strong form.

One problem with the semi-strong form lies with the identification of relevant publicly available

information. Neat as the phrase might sound, the reality is less clear-cut, because information

does not arrive with a convenient label saying which shares it does and does not affect.

Weak-form Efficiency

The third and least rigorous form is known as the weak form. The EMH confines itself to just

one subset of public information, namely historical information about the share price itself. The

argument runs as follows. New information must by definition be unrelated to previous

information; otherwise it would not be new. It follows from this that every movement in the

share price in response to new information cannot be predicted from the last movement or price,

and the development of the price assumes the characteristics of the random walk. In other words,

the future price cannot be predicted from a study of historic prices.

Conclusion

Each of the three forms of EMH has different consequences in the context of the search for

excess returns, that is, for returns in excess of what is justified by the risks incurred in holding

particular investments.

If a market is weak-form efficient, there is no correlation between successive prices, so that

excess returns cannot consistently be achieved through the study of past price movements. This

kind of study is called technical or chart analysis, because it is based on the study of past price

patterns without regard to any further background information.

If a market is semi-strong efficient, the current market price is the best available unbiased

predictor of a fair price, having regard to all publicly available information about the risk and


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return of an investment. The study of any public information and not just past prices cannot yield

consistent excess returns. This is a somewhat more controversial conclusion than that of the

weak-form EMH, because it means that fundamental analysis the systematic study of

companies, sectors and the economy at large cannot produce consistently higher returns than

are justified by the risks involved. Such a finding calls into question the relevance and value of a

large sector of the financial services industry, namely investment research and analysis.

If a market is strong-form efficient, the current market price is the best available unbiased

predictor of a fair price, having regard to all relevant information, whether the information is in

the public domain or not. As we have seen, this implies that excess returns cannot consistently be

achieved even by trading on inside information. This does prompt the interesting observation that

somebody must be the first to trade on the inside information and hence make an excess return.

ASSIGNMENT B

Question 1

Expla in bond va lue theorems?

Answer.

Bond value theorem

Singh (2013) postulated that the relationship between bond value or price and the changes in the

market interest rates have been stated by Burton G. Malkiel in the form of the five general

principles. These five principles are known as the bond value or bond pricing theorems.

According to Malkiel (in Singh 2013) the value of the bond depend upon the factors namely, the

coupon rate, years to maturity and the expected yield to maturity or the required rate of return.

On the basis of this, bond value theorems have evolved.

Theorem 1

Theorem 1 states that bond prices and bond yields move in opposite directions. As a bonds price

increases, its yield decreases. Conversely, as a bonds pricedecreases, its yield increases. This


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means that as interest rates decline, the prices of bonds rise; and as interest rates rise; the prices

of bonds decline. So if an investor holds two bonds of same maturity and coupon rate, the

difference in the market price will lead to differences in the yield. The bond with low price will

have a high yield because with lesser amount of money more return is earned.

Theorem 2

Theorem 2 says, For a given change in a bonds Yield to Maturity (YTM), the longer the term

to maturity of the bond, the greater will be the magnitude of the change in the bonds price.Thismeans, the bond with a short term to maturity sells at a lower discount than the bond with a long

term to maturity. The bond value or price variability is therefore directly related to the term to

maturity; which means that for a given change in the level market interest rates, changes in bond

prices are greater for longer term maturities. This further means that if rates are expected to

increase, a prudent portfolio manager will avoid investing in long-term securities. The portfolio

could see a significant decline in value. If an investor expects interest rates to decline, he/she

may well want to invest in long-term zero coupon bonds. As interest rates decline, the price of

long-term zero coupon bonds will increase more than that of any other type of bond.

Theorem 3

According to theorem 3 for a given change in a bonds YTM, the size of the change in the bonds

price increases at a diminishing rate as the bonds term to maturity lengthensor if a bond's yield

remains constant over its life, the discount or premium amount will decrease at an increasing rate

as its life gets shorter. This means that a bonds sensitivity to the market interest rates increases at

a diminishing rate as the time remaining until its maturity increases.

Theorem 4

Theorem 4 states that for a given change in a bonds YTM, the absolute magnitude of the

resulting change in the bonds price is inversely related to the bonds coupon rate.This means

that bond volatility is related negatively to the coupon rate, which implies that the percentage


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change in the bond price due to change in the market interest rate will be smaller if its coupon

rate is higher or will be higher if its coupon rate is smaller. For a given change in interest rates,

the prices of lower-coupon bonds change more than the prices of higher-coupon bonds.

The lower a bonds coupon rate, the greater its price volatility and hence, lower coupon

bonds have greater interest rate risk.

The lower the bonds coupon rate, the greater the proportion of the bonds cash flow

investors will receive at maturity.

All other things being equal, a given change in the interest rates will have a greater

impact on the price of a low-coupon bond than a higher-coupon bond with the same

maturity.

Theorem 5

Theorem 5 says that for a given absolute change in a bonds YTM, the magnitude of the price

increase caused by a decrease in yield is greater than the price decrease caused by an increase in

yield. This implies that the price changes resulting from equal absolute increases in the market

interest rates are not symmetrical. Singh (2013) says, For any given maturity, a decrease in the

market interest rates causes a price rise that is larger than the price decline that results from an

equal increase in the market interest rates. For example a 2% decrease in the market interest

rates would cause a bond price increase which is higher than the price decline that would result

from a 2% increase in the market interest rates.

Conclusion

Therefore, a decline (rise) in interest rates will cause a rise (decline) in bond prices, with the

most volatility in bond prices occurring in longer maturity bonds and bonds with low coupons.

To receive maximum price impact of an expected drop in interest rates- bond buyer should

purchase low-coupon, long-maturity bonds. If rates are expected to increase, buy large coupons

and short maturities. Investors cannot control interest rates but can control the coupon and

maturity of the portfolio.

ASSIGNMENT B

Question 2


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Determine the pr ice o f Rs .1 ,000 zero coupon bond wi th y ie ld to

matur i ty o f 18% and 10 years to matur i ty & determine y ie ld to

matur i ty o f th i s bond i f i t s pr ice i s Rs 220?

Answer.

Pr ice o f the Bond

=

(+) =

= ( f =Rs .1000)

= ( r =18%)

= ( t =10yr s )

=

(+.)

=

(.)

= . 191.06

Yie ld to Matur i ty (YTM)

= (

)

1

= (

)

1

= 1.1635 1

= 16.35%


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ASSIGNMENT B

Question 3

Expla in in deta i l the Dow Theory and how i t i s used to determine the

direct ion o f s tock market?

Answer.

Background

Dow Theory was formulated from a series of Wall Street Journal editorials authored by Charles

H. Dow from 1900 until the time of his death in 1902. These editorials reflected Dows beliefs

on how the stock market behaved and how the market could be used to measure the health of the

business environment.

Dow first used his theory to create the Dow Jones Industrial Index and the Dow Jones Rail Index

(now Transportation Index), which were originally compiled by Dow for The Wall Street

Journal. Dow created these indexes because he felt they were an accurate reflection of the

business conditions within the economy because they covered two major economic segments:

industrial and rail (transportation). While these indexes have changed over the last 100 years, the

theory still applies to current market indexes.

The Dow Theory

The first basic premise of Dow Theory suggests that all information - past, current and even

future - is discounted into the markets and reflected in the prices of stocks and indexes. That

information includes everything from the emotions of investors to inflation and interest-rate data,

along with pending earnings announcements to be made by companies after the close. Based on

this tenet, the only information excluded is that which is unknowable, such as a massive

earthquake. But even then the risks of such an event are priced into the market. Like mainstreamtechnical analysis, Dow Theory is mainly focused on price. However, the two differ in that Dow

Theory is concerned with the movements of the broad markets, rather than specific securities. It's

important to note that while Dow Theory itself is focused on price movements and index trends,

implementation can also incorporate elements of fundamental analysis, including value- and


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fundamental-oriented strategies. However, Dow Theory is much more suited to technical

analysis.

Dow Theory Trend Analysis

The Dow Theory uses trend analysis. An important part of Dow Theory is distinguishing the

overall direction of the market. Before we can get into the specifics of Dow Theory trend

analysis, we need to understand trends. First, it's important to note that while the market tends to

move in a general direction, or trend, it does not do so in a straight line. The market will rally up

to a high (peak) and then sell off to a low (trough), but will generally move in one direction.

Dow Theory identifies three trends within the market: primary, secondary and minor. A primary

trend is the largest trend lasting for more than a year, while a secondary trend is an intermediate

trend that lasts three weeks to three months and is often associated with a movement against the

primary trend. Finally, the minor trend often lasts less than three weeks and is associated with the

movements in the intermediate trend. The primary trend is the major trend of the market, which

makes it the most important one to determine. The primary trend will also impact the secondary

and minor trends within the market. For example, if in an uptrend the price closes below the low

of a previously established trough, it could be a sign that the market is headed lower, and not

higher. Regardless of trend length, the primary trend remains in effect until there is a confirmed

reversal.

Primary, Secondary and Minor Trends

In Dow Theory, a primary trend is the main direction in which the market is moving.

Conversely, a secondary trend moves in the opposite direction of the primary trend, or as a

correction to the primary trend. For example, an upward primary trend will be composed of

secondary downward trends. In general, a secondary, or intermediate, trend typically lasts

between three weeks and three months, while the retracement of the secondary trend generally

lasts between one third to two thirds of the primary trend's movement. Another important

characteristic of a secondary trend is that its moves are often more volatile than those of the

primary move. The last of the three trend types in Dow Theory is the minor trend, which is

defined as a market movement lasting less than three weeks. The minor trend is generally the

corrective moves within a secondary move, or those moves that go against the direction of the


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secondary trend. Due to its short-term nature and the longer-term focus of Dow Theory, the

minor trend is not of major concern to Dow Theory followers. But this does not mean it is

completely irrelevant; the minor trend is watched with the large picture in mind, as these short-

term price movements are a part of both the primary and secondary trends.

Most proponents of Dow Theory focus their attention on the primary and secondary trends, as

minor trends tend to include a considerable amount of noise. If too much focus is placed on

minor trends, it can to lead to irrational trading, as traders get distracted by short-term volatility

and lose sight of the bigger. Stated simply, the greater the time period a trend comprises, the

more important the trend.

Phases of the Primary Trend

Since the most vital trend to understand is the primary trend, this leads into the third tenet of

Dow theory, which states that there are three phases to every primary trend the accumulation

phase (distribution phase), the public participation phase and a panic phase (excess phase). It is

important to look at each of the three phases as they apply to both bull and bear markets

Accumulation Phase.

The first stage of a bull market is referred to as the accumulation phase, which is the start of the

upward trend. This is also considered the point at which informed investors start to enter the

market. The accumulation phase typically comes at the end of a downtrend, when everything is

seemingly at its worst. But this is also the time when the price of the market is at its most

attractive level because by this point most of the bad news is priced into the market, thereby

limiting downside risk and offering attractive valuations. However, the accumulation phase can

be the most difficult one to spot because it comes at the end of a downward move, which could

be nothing more than a secondary move in a primary downward trend - instead of being the start

of a new uptrend. This phase will also be characterized by persistent market pessimism, with

many investors thinking things will only get worse.

Public Participation Phase


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When informed investors entered the market during the accumulation phase, they did so with the

assumption that the worst was over and a recovery lay ahead. As this starts to materialize, the

new primary trend moves into what is known as the public participation phase. During this

phase, negative sentiment starts to dissipate as business conditions - marked by earnings growth

and strong economic data - improve. As the good news starts to permeate the market, more and

more investors move back in, sending prices higher. This phase tends not only to be the longest

lasting, but also the one with the largest price movement. It's also the phase in which most

technical and trend traders start to take long positions, as the new upward primary trend has

confirmed itself - a sign these participants have waited for.

The Excess Phase

As the market has made a strong move higher on the improved business conditions and buying

by market participants to move starts to age, we begin to move into the excess phase. At this

point, the market is hot again for all investors. The last stage in the upward trend, the excess

phase, is the one in which the smart money starts to scale back its positions, selling them off to

those now entering the market. The perception is that everything is running great and that only

good things lie ahead.

This is also usually the time when the last of the buyers start to enter the market - after large

gains have been achieved. Unfortunately for them, they are buying near the top. During this

phase, a lot of attention should be placed on signs of weakness in the trend, such as strengthening

downward moves. Also, if the upward moves start to show weakness, it could be another sign

that the trend may be near the start of a primary downtrend.

Distribution Phase ( in Bear Market)

The first phase in a bear market is known as the distribution phase, the period in which informed

buyers sell (distribute) their positions. This is the opposite of the accumulation phase during a

bull market in that the informed buyers are now selling into an overbought market instead of

buying in an oversold market. In this phase, overall sentiment continues to be optimistic, with


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expectations of higher market levels. It is also the phase in which there is continued buying by

the last of the investors in the market, especially those who missed the big move but are hoping

for a similar one in the near future. This phase is similar to the public participation phase found

in a primary upward trend in that it lasts the longest and will represent the largest part of the

move - in this case downward. During this phase it is clear that the business conditions in the

market are getting worse and the sentiment is becoming more negative as time goes on. The

market continues to discount the worsening conditions as selling increases and buying dries up

Final Phase in Downward Market Trends

The last phase of the primary downward market tends to be filled with market panic and can lead

to very large sell-offs in a very short period of time. In the panic phase, the market is wrought up

with negative sentiment, including weak outlooks on companies, the economy and the overall

market. During this phase you will see many investors selling off their stakes in panic. Usually

these participants are the ones that just entered the market during the excess phase of the

previous run-up in share price. But just when things start to look their worst is when the

accumulation phase of a primary upward trend will begin and the cycle repeats itself.

Conclusion

Charles Dow relied solely on closing prices and was not concerned about the intraday

movements of the index.For a trend signal to be formed, the closing price has to signal the trend,

not an intraday price movement. Another feature in Dow Theory is the idea of line ranges, also

referred to as trading ranges in other areas of technical analysis. These periods of sideways (or

horizontal) price movements are seen as a period of consolidation, and traders should wait for the

price movement to break the trend line before coming to a conclusion on which way the market

is headed.

CASE STUDY

Answer.

The table be low shows the expected re turns from each of the three

bond inves tments over a per iod o f 3 years .


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Bond A Bond B Bond C

Coupon Rate 0 10% 10%

Maturity(Years) 5 7 5

Yield To Maturity 11% 12% 11%

Duration5 6.58 4.68

Price Rs. 593.45 Rs. 829.31 Rs.962.99%

Price After 3 Years Rs.811.62 Rs.939.25 rs.982.87

Holding Period Return 37% 49% 33%

Mr. Jose should pick Bond A and Bond B:

Below are some of the reasons for picking bond A and B

Bonds A and B offer higher capital appreciation than Bond C

The holding period return is higher for Bonds A and B than for C as shown in the table.

Although the longer maturity period of bond B makes it susceptible to price decline as

interest rates rise due to the expected rise in inflation, the situation will not be sustained

as the Reserve Bank of India is already planning a credit squeeze. Further the high

coupon rate for bond B makes its price to be less volatile.

ASSIGNMENT C

Multiple choice.

1 D 11 A 21 B 31 D

2 C 12 B 22 C 32 C

3 A 13 B 23 A 33 E

4 C 14 D 24 D 34 D

5 B 15 C 25 B 35 B

6 D 16 C 26 B 36 C

7 C 17 C 27 C 37 D

8 C 18 B 28 D 38 B9 C 19 A 29 D 39 A

10 A 20 B 30 A 40 C

Security Analysis Assign

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