Security Analysis Portfolio Management (1)

MBA(DISTANCE MODE)

DBA 1723 / 1750

SECURITY ANALYSIS AND PORTFOLIOMANAGEMENT

III SEMESTERCOURSE MATERIAL

Centre for Distance EducationAnna University Chennai

Chennai – 600 025

ii

Reviewer

PrPrPrPrProfofofofof.S.S.S.S.S.R.R.R.R.Ramanaamanaamanaamanaamanathan,than,than,than,than,Visiting Professor,

Anna University Chennai,Chennai - 600 025

DrDrDrDrDr.T.T.T.T.T.V.V.V.V.V.Geetha.Geetha.Geetha.Geetha.GeethaProfessor

Department of Computer Science and EngineeringAnna University Chennai

Chennai - 600 025

DrDrDrDrDr.H.P.H.P.H.P.H.P.H.Peereereereereeru Mohamedu Mohamedu Mohamedu Mohamedu MohamedProfessor

Department of Management StudiesAnna University Chennai

Chennai - 600 025

DrDrDrDrDr.C.C.C.C.C. Chella. Chella. Chella. Chella. ChellappanppanppanppanppanProfessor


Chennai - 600 025

DrDrDrDrDr.A.K.A.K.A.K.A.K.A.KannanannanannanannanannanProfessor


Chennai - 600 025

Copyrights Reserved(For Private Circulation only)

Editorial Board

Author

DrDrDrDrDr.J.J.J.J.J.Gopu,.Gopu,.Gopu,.Gopu,.Gopu,Assistant Professor,

Department of Management Studies,BSA Crescent Engineering College,

Chennai - 600 048

ACKNOWLEDGEMENT

The author has drawn inputs from several sources for the preparation of this course material, to meet therequirements of the syllabus. The author gratefully acknowledges the following sources:

1. “Securities Analysis and Portfolio Management”, V.A.Avadhani , Himalaya Publishing House, 1997.

2. Investment Management”, V.K.Bhalla, , S.Chand & Company Ltd., Seventh Edition, 2000.

4. “Security Analysis & Portfolio Management”, Punithavathy Pandian,– Vikas

Publishing House Pvt., Ltd., 2001.

5. “Investment Management, Security Analysis and Portfolio

Management”, Preetisingh , Himalaya Publishing House, 2000.

6. www.nseindia.com

7. www.bseindia.com

8. www.sebi.com

9. www.yahoo.com (yahoo finance)

Inspite of at most care taken to prepare the list of references any omission in the list is only accidental andnot purposeful

Dr.J.GopuAuthor

v

DBA 1723 / 1750 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

UNIT I –INVESTMENT SETTING

Investment setting –Securities –Sources of investment information -Security market indications –Security contractregulation Act -investors protection.

UNIT II – CAPITAL MARKETS

Overview of capital market, Institutional structure in capital market, Reforms and status of capital market, Newissue market and problems, Securities and Exchange Board of India (SEBI), Debt market.

UNIT III – FUNDAMENTAL ANALYSIS

Economic analysis - Economic forecasting and stock investment Decisions–Forecasting techniques. Industryanalysis-Industry classification. Economy and industry analysis. Industry life cycle – Company analysis measuringearnings-Forecasting earnings – Applied valuation techniques – Graham and Dodds investor ratios.

UNIT IV –TECHNICAL ANALYSIS

Fundamental analysis Vs Technical analysis- Charting methods –Market indicators- Trend reversals –Patterns –moving average –exponential moving average-Oscillators-ROC Momentum –MACD –RSI- Stoastics.

UNIT V – PORTFOLIO MANAGEMENT

Portfolio Theory – Portfolio construction –Diagnostic management-Performance Evaluation – Portfolio revision–Mutual funds.

REFERENCES

1. Donald E.Fisher & Ronald J.Jordan,’Security Analysis &Portfolio Management’, Prentice hall of IndiaPrivate Ltd., Delhi 2000.

2. V.A.Avadhani –Securities Analysis and Portfolio Management’, Himalaya Publishing House, 1997.

3. V.K.Bhalla,’Investment Management’, S.Chand &Company Ltd., Seventh Edition, 2000.

4. Punithavathy Pandian,’Security Analysis & Portfolio Management’-Vikas Publishing House Pvt., Ltd.,2001

vii

CONTENTS

UNIT - I

INVESTMENT SETTING

CHAPTER - IINVESTMENT SETTING AND SECURITIES

1 OVERVIEW 12. DIFFERENCE BETWEEN SPECULATION AND INVESTMENT 13. OBJECTIVES OF INVESTMENT 24. SECURITIES 2

4.1 Debentures 34.2. Bonds 44.3. Advantages of Debentures and Bonds 54.4. Equity shares 64.5 Special features of equity shares 74.6 Non voting shares 84.7 Right shares 84.8 Bonus shares 84.9 Preference shares 84.10. Types of preference shares 8

5. INVESTMENT INFORMATION 95.1 Types of investment information 95.2. Importance of correct information 10

CHAPTER- IISECURITY MARKET INDICATIONS - BOMBAY STOCK EXCHANGE

1. OVERVIEW 132. KINDS OF INDICES 133. SENSEX 14

3.1 Introduction 143.2 Sensex calculation methodologies 14

ix

x

4. FREE-FLOAT METHODOLOGY 154.1 Concept 154.2 Major advantages of free-float methodology 154.3 Definition of free-float 164.4 Determining free-float factors of companies 164.5 Index closure algorithm 17

5. MAINTENANCE OF SENSEX 175.1 On-line computation of the index 185.2 Adjustment for bonus, rights and newly issued capital 18

6. SENSEX - SCRIP SELECTION CRITERIA 197. INDEX REVIEW FREQUENCY 20

CHAPTER- IIISECURITY MARKET INDICATIONS - NATIONAL STOCK EXCHANGE

1. OVERVIEW 292. INDEX CONCEPTS 30

2.1 Impact cost 302.2 Definition 322.3 Beta 322.4 Unsystematic risks 332.5 Systematic risks 332.6 What is beta? 332.7 Methodology / formula 332.8 Standard deviation 34

3. TOTAL RETURN INDEX 344. METHODOLOGY FOR TOTAL RETURNS INDEX (TR) 345. ESSENTIAL OF A STOCK MARKET INDEX 356. THE MEANING OF UPS AND DOWNS OF AN INDEX 357. THE BASIC IDEA IN AN INDEX 358. AVERAGING 359. THE PORTFOLIO INTERPRETATION OF INDEX MOVEMENTS 35

CHAPTER- IVSECURITIES TRADING REGULATIONS AND INVESTOR PROTECTION

1. OVERVIEW 382. OBJECTIVES OF THE SECURITIES CONTRACTS

(REGULATION) ACT, 1956 383. SCOPE OF THE SECURITIES CONTRACTS

(REGULATION) ACT, 1956 394. RECOGNITION OF STOCK EXCHANGES 395. OPTIONS IN CONTRACTS 396. REGULATION OF TRADING 407. RESTRICTION ON TRANSFERABILITY 428. SWEAT EQUITY AND EMPLOYEE STOCK OPTION PLAN (ESOP) 439. INVESTOR’S PROTECTION 4410. PROTECTION AGAINST LOSS DUE TO

UNFAIR TRADE PRACTICE 4511. INVESTOR PROTECTION FUND AND

CONSUMER PROTECTIONFUND (IPF / CPF) 4512. HANDLING THE GRIEVANCES OF INVESTORS 4513. PROTECTION AGAINST INSIDER TRADING 4614. SECURITIES OMBUDSMAN 4615. INVESTORS’ EDUCATION 46

UNIT-II

CAPITAL MARKETS

CHAPTER - IOVERVIEW AND INSTITUTIONAL STRUCTUREOF CAPITAL MARKET

1. INTRODUCTION 492. OVERVIEW OF CAPITAL MARKET 49

2.1 The history of Indian capital market 502.2 The growth of indian stock exchanges 512.3 Post-independence scenario 512.4 Over the counter exchange of India (otcei) 522.5 Functions of stock exchange 53

xi

3. INSTITUTIONAL STRUCTURE OF STOCK MARKET 543.1 Organisational structure 543.2 Membership 543.3 Capital market reforms 553.4 State of capital market 56

CHAPTER - IINEW ISSUE MARKET

1. OVERVIEW 582. NEW ISSUE MARKET PARTICIPANTS 583. FLOATATION OF THE ISSUE 594. PROBLEMS OF NEW ISSUE MARKET 615. MEASURES TO BE TAKEN FOR IMPROVING THE

CONDITION OF NEW ISSUE MARKET 61

CHAPTER – IIINATIONAL STOCK EXCHANGE

1. OVERVIEW 632. OWNERSHIP AND MANAGEMENT 643. MARKET SEGMENTS AND PRODUCTS 644. MEMBERSHIP ADMINISTRATION 655. ELIGIBILITY CRITERIA 666. TRADING MEMBERSHIP 667. CLEARING MEMBERSHIP 678. GROWTH AND DISTRIBUTION OF MEMBERS 679. DISTRIBUTION OF TRADING MEMBERS

(AS ON MARCH 30, 2007) 6710. TRANSACTION CHARGES 6711. LISTING OF SECURITIES 6712. BENEFITS OF LISTING ON NSE 6813. LISTING CRITERIA 6814. LISTING AGREEMENT 6815. SHAREHOLDING PATTERN 69

xii

16. COMPLIANCE BY LISTED COMPANIES 6917. DISCLOSURES BY LISTED COMPANIES 6918. DELISTING 6919. VOLUNTARY DE-LISTING OF COMPANIES 6920. COMPULSORY DE-LISTING OF COMPANIES 70

CHAPTER – IVSEBI REGULATION OF SECURITIES MARKET

1. OVERVIEW 722. PRIMARY SECURITIES MARKET 723. REGISTRATION OF STOCK BROKERS 734 REGISTRATION OF SUB-BROKERS 755 RECOGNITION OF STOCK EXCHANGES 756. REGISTRATION OF FOREIGN INSTITUTIONAL INVESTORS 757. REGISTRATION OF CUSTODIANS OF SECURITIES 768. REGISTRATION OF MUTUAL FUNDS 769. REGISTRATION OF VENTURE CAPITAL FUNDS 7610. SUPERVISION 7611. INSPECTION OF MARKET INTERMEDIARIES 7712. SURVEILLANCE 77

CHAPTER- VINDIAN DEBT MARKET

1. OVERVIEW 792. THE INDIAN DEBT MARKET 793. THE STRUCTURE OF THE INDIAN DEBT MARKET 804. SECONDARY CORPORATE DEBT MARKET 815. THE PROBLEMS OF DEBT MARKET 836. DEBT MARKET AND NSE 867. MARKET PERFORMANCE 87

xiii

UNIT-III

FUNDAMENTAL ANALYSIS

CHAPTER - IECONOMIC ANALYSIS

1. INTRODUCTION 912. ECONOMIC FORECASTING 913. STOCK INVESTMENT DECISIONS 924. TECHNIQUES OF ECONOMIC FORECASTING 93

CHAPTER - IIINDUSTRY ANALYSIS

1. INTRODUCTION 1012. THE MEANING OF INDUSTRY 1013 CLASSIFICATION OF INDUSTRY 1014. INDUSTRY LIFE CYCLE 1025. STAGES OF INDUSTRY LIFE CYCLE. 1036 INDUSTRY ANALYSIS – ISSUES TO BE ANALYSED 106

CHAPTER - IIICOMPANY ANALYSIS

1. INTRODUCTION 1132. FACTORS TO BE CONSIDERED 1133. MEASURING EARNINGS 1144. FORECASTING EARNINGS 115

CHAPTER - IVAPPLIED VALUATION TECHNIQUES

1. INTRODUCTION 1192. GRAHAM AND DODDS INVESTOR RATIOS 1193. THE DIVIDEND DISCOUNTING METHOD 1204. P/E RATIO MODEL 120

xiv

5. OTHER MODELS 1206. BUYING STOCKS - BASED ON THE FUNDAMENTAL ANALYSIS 1217. SELLING STOCKS - BASED ON THE FUNDAMENTAL ANALYSIS 1228. HOW IS THE COMPANY EVALUATED BY THE MARKET? 122

UNIT-IV

TECHNICAL ANALYSIS

CHAPTER - ITECHNICAL ANALYSIS AND CHARTING METHODS

1. INTRODUCTION 1252. TECHNICAL ANALYSIS – MEANING 1263. ASSUMPTIONS OF TECHNICAL ANALYSIS 1264. FUNDAMENTAL ANALYSIS Vs TECHNICAL ANALYSIS 1266. CHARTING METHODS 128

6.1 Point and figure chart 1286.2 Bar chart 1296.3 Line chart 1306.4 Candle stick chart 130

CHAPTER- IIMARKET INDICATORS, PATTERNS AND DOW THEORY

1 INTRODUCTION 1332 PUT/CALL RATIO 1333 FUND MANAGER SURVEYS 1334. VOLATILITY INDEX 1335. MUTUAL FUND DATA 1346. MOVING AVERAGES 134

6.1 Uses of Moving Averages 1346.2 Index Moving Average and Stock price 135

7. VOLUME 1438. MARKET BREADTH 1439 ODD-LOT THEORY 14510 CONFIDENCE INDEX 14511 RELATIVE STRENGTH INDEX (RSI) 14512 RATE OF CHANGE (ROC) 146

xv

13 OSCILLATORS 14714 TREND 14715 TREND REVERSAL 14716 PATTERNS 14817 DOW THEORY 153

UNIT- V

PORTFOLIO MANAGEMENT

CHAPTER - IPORTFOLIO THEORY AND PORTFOLIO CONSTRUCTION

1. INTRODUCTION 1552. TRADITIONAL THEORY OF PORTFOLIO 1553. STEPS IN TRADITIONAL THEORY OF

PORTFOLIO CONSTRUCTION 1554. MODERN PORTFOLIO THEORY 1575. CAPITAL ASSET PRICING MODEL 1586. HEDGING AND DIVERSIFICATION 1607. RETURN 1618. RISK 1639. CAPITAL MARKET LINE 16410. EFFICIENT FRONTIER 16511. EFFICIENT FRONTIER EXHIBIT 1 16612. MARKET RISK 167

CHAPTER – IIPORTFOLIO EVALUATION, PORTFOLIO REVISION AND MUTUAL FUNDS

1. INTRODUCTION 1702. SHARPE’S PERFORMANCE INDEX 1703. TREYNOR’S PERFORMANCE INDEX 1724. JENSEN’S PERFORMANCE INDEX 1735. PORTFOLIO REVISION 174

5.1 Introduction 1745.2 Passive management 1745.3 Active management 174

xvi

xvii

5.4 Formula plans 1745.5 Assumption of formula plan 1745.6 Types of formula plan 175

6. MUTUAL FUNDS 1756.1 Introduction 1756.2 Strategy for mutual fund investment 1786.3 Exit timings 182

NOTES

1 ANNA UNIVERSITY CHENNAI

SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

UNIT - I

INVESTMENT SETTINGCHAPTER - I

INVESTMENT SETTING AND SECURITIES

Learning Objective

After going through this chaptert you would be able to understand the basic concept ofinvestment and the various investment avenues available for the Indian investors

1. OVERVIEW

Investment is the commitment of funds on assets with an ultimate objective of gettinga return. The return on investment is in the form of regular income (interest or dividend)and capital gain or both.

Speculation means committing funds in business activities with an objective of gettingshort term capital gain. For example if a person buy a stock for Rs.100 and sell the samestock for Rs.120 within very short period (say 1 month) he can be termed as a speculatlor.In this transaction he made a profit of Rs.20 as short term capital gain. However there isevery chance of incurring capital loss also. Thus speculation involves high degree of riskand return.

2. DIFFERENCE BETWEEN SPECULATION AND INVESTMENT

NOTESDBA 1723 / 1750


3. OBJECTIVES OF INVESTMENT

a) Reasonable return :-

The investor expects a reasonable return on his investment. The return on investmentcan be calculated by the following equation;

Value at the end of Dividend (or) Purchase price holding period + Interest received __ of the investmentReturn = ————————————————————————— X 100

Purchase price of the investment

In the above equation it’s very clear that the return includes regular dividend or interestincome and the capital appreciation.

b) Risk

The risk can be defined as the deviation of the actual return from the expected rate ofreturn. Every investor would like to reduce the degree of risk by constructing a soundportfolio. The degree of risk will be less in government securities and fundamentally soundcompany stocks. At the same time the return from such investments would be reasonable.

c) Liquidity

The Liquidity means the possibility of encashing the investment without losing muchof it’s value within very short period. In other words it’s the marketability of the investment.The investor prefers an investment outlet which has high liquidity. The equity share offundamentally sound companies offers more liquidity, than the bonds and debentures.

d) Safety of the principal

The safety of the principal amount is another important objective of any investorwhile committing founds in an investment outlet. The safety of the capital is based onvarious factors like; legal and regulatory frame work, the performance of the company andthe type of investment outlet.

4. SECURITIES

To mobilize long term funds the corporate are issuing various securities in the capitalmarket. Securities provide a claim to the holder on the assets and future cash flows thatwill be generated by the assets of the company. Generally the term securities includeshares, Debentures and Bonds. According to the Securities Contracts (Regulation) Act1956, Securities include shares, bonds, debentures or other marketable securities of anycompany or government.

NOTES



4.1 DEBENTURES

According to companies Act 1956, “Debenture includes debenture stock, bondsand any other securities of company, whether constituting a charge on the assets of thecompany or not”.

Special features of Debentures

a) Return

The return on debentures is certain. The issuing company promises to pay a certainpercentage of interest irrespective of its profitability. The interest is calculated on the facevalue of the debenture. The interest may be paid quarterly, semi – annually or annually asper the terms and conditions in the offer document.

b)Redemption

The money mobilized by a company by issuing debenture is subject to repayment tothe investor on a specified maturity period. The redemption (repayment) of debenture ismade by creating a sinking fund. Creating of sinking fund ensures prompt repayment.

c) Indenture

Indenture is a trust deed between the issuing company and the debenture trustee whorepresent the debenture holders. Financial Institutions, Banks, Insurance companies actas Trustees to protect the interest of debenture holders and they ensure that the companyfulfils the contractual obligations.

d) Call option

The call option gives the right to the debenture issuing company to redeem the debenturebefore maturity period. In order to change the capital structure or reduce cost of capital orsolve overcapitalization problems the company would like to redeem the debenture evenbefore maturity period.

Kinds of Debentures

a) Secure and Unsecured Debentures

When the debenture is secured by creating a charge on the assets of the companythen it is called a secured debenture. If the company fails to pay interest or repay thedebenture amount to the investor then the trustee can take hold of the secured – assets onbehalf of the debenture investor.

When there is no such charge on the assets of the company, the debenture is calledunsecured debenture or naked debenture. The unsecured debentures are highly risky.



b) Convertible Debentures

If the debenture holder is given the option of converting debenture in to equity shareof the issuing company at the time of maturity then it is called convertible debentures. Tillthe conversion he is a debenture holder and after conversion he becomes a shareholder.

If the entire amount of debenture is converted in to equity shares then it is called fullyconvertible debenture otherwise if only a part of debenture amount is converted in toequity then it is called partly convertible debenture. The type and terms and conditions ofconversion will be clearly mentioned in the offer document.

c) Non – Convertible Debenture

The non – convertible debenture cannot be converted in to shares. The debenturescan be redeemed at the time of maturity.

4.2. BONDS

Bonds are a long term debt instrument that promises to pay a fixed annual interest fora specified period of time. Bond is an alternative form of debenture in India. Public sectorcompanies and financial institutions issues bonds. The bond has a face value. The offerprice may be more than the face value (issuing at premium) or less than the face value(issuing at discount). The interest is calculated only on the face value (par value). The rateof interest, period of interest payment, maturity period and redemption value will bementioned on the bond certificate.

Types of Bond

a) Secured and Unsecured Bond

When the Bond is secured by creating a charge on the assets of the issuing companythen it is called Secured Bond. If there is no such charge on the assets of the issuingcompany then the Bond is called Unsecured Bond (or) Naked Bond.

b) Sinking Fund Bond.

When the company wants to redeem the bond systematically by creating a reservethen the company issues Sinking fund bond. The company makes a periodical paymentsto the Sinking fund agent (the Trustee who is normally a Bank or Financial Institution orInsurance company) who will use the fund for redemption.

c) Collateral Trust Bonds

The Collateral trust bonds are issued by pledging the intangible assets of the issuingcompany. The investments held by the bond issuing company in other companies arepledged for issuing the Collateral trust bond.

NOTES



d) Income Bonds

The interest is payable by the company on Income bonds out of current earnings. Ifthere is no income during a particular year then the company need not pay the interest.

e) Adjustable Bonds

Companies issue the Adjustable Bonds when they go for financial restructuring. Theinterest is payable on Adjustable Bond only if earnings are adequate.

f) Assumed Bonds

When one company takes over another company (Acquisition) it takes both assetsand liabilities. The bonds already issued by the acquired company become the bond ofacquiring company. Thus the acquiring company assumes the bonds already issued by theacquired company.

g) Joint Bonds

When two or more companies joins together and issues bonds then it is called Jointbond. The investor has the additional security of two companies’ pledge.

4.3. ADVANTAGES OF DEBENTURES AND BONDS

Both Debentures and Bonds are basically secured long term debt instruments. Thedebentures are issued by private sector corporate and Public sector organizations andfinancial institutions issue the bonds. The advantages of issuing the debentures and bondsare almost similar. The advantages are explained in the following points;

a) Reduce cost of capital

Debentures and Bonds are the cheapest source of financing. Mostly they are securedand there is a guarantee for payment of interest periodically and repayment of principalamount at the time of maturity. Therefore the instrument can be issued at reasonable rateof interest. Above all the interest paid by the issuing company is treated as revenueexpenditure and deducted for corporate tax calculations. The after tax cost of debt capitalis very low. So debentures and bonds are considered as the cheapest source of funds forcompanies.

b) Financial leverage

The interest payable to debenture holders and bondholders are always less than thereturn on investment and the cost of equity capital of the company. Thus the surplusearnings after payment of interest and tax can be given to the equity shareholders. Byemploying debenture and bond fund in the business the company can easily enhance returnavailable for equity holders. This strategy is called financial leverage. The practice offinancial leverage enhances Earning per share and in turn increases Dividend per share andultimately the market capitalization of the company increases.



c) Savings over Corporate Tax

The interest on debentures and bonds are deducted as revenue expenditure forcorporate tax calculations. Thus the company’s tax obligation gets reduced.

d) Widen the source of funds

Since there is a guarantee over the payment of interest and repayment of principalamount the degree of risk taken by investors is less. It attracts more number of investors.Thus the company can easily mobilise large funds by issuing debentures and bonds.

e) Credit Rating

Before issuing the debenture or bond the company has to get ratings for the instrumentfrom rating agencies like ICRA, CARE (or) CRISIL etc,.

A company with sound rating symbol can easily mobilize large funds at reasonablerate of interest. The rating symbols acts as a guiding lights for the investors to know therisk level.

f) Flexibility in capital structure

The call option in the debenture or bond issue facilitates the issuing company toredeem the instrument even before maturity period. This brings more flexibility in capitalstructure. If the company faces financial troubles like over capitalization or increasedinterest burden then it can exercise call option.

g) No dilution of control

The debenture holders and bondholders are simply the long-term creditors of thecompany. They are not given any voting rights. Therefore there will be no interferencefrom the debenture holders or bondholders to the company’s management and the controlis not diluted.

4.4. EQUITY SHARES

Equity shares constitute the ownership capital of a company and the equity holderhas the right of voting and sharing in profits and assets in proportion to his holding in thetotal net assets of the company. The equity shareholder is entitled to all rights and obligationsas owner to the residual profits and assets of the company after the claims of creditors aremet. The dividend to equity shareholder is determined after meeting interest, preferencedividend and tax obligations and therefore the equity dividend is subject to uncertainty andhighly fluctuating. The dividend and increase in the market value of equity shares are theforms of return available for equity shareholders.

The equity shareholders are the ultimate owners of a company. They have the followingrights as per section 85 (2) of the Companies Act 1956.

NOTES



a. Right to exercise voting rights in the annual general meetings of the company.b. Right to control the management of the companyc. Right to get a share in the profits of the company in the form of dividendd. Right to get on the residual value of the company after repayment of all the

claims in the case of winding up of the company.e. To get preemptive rights when the company comes out with additional capital

issue.f. To get the copy of the audited financial report.g. Right to apply to the Central Government to call an annual general meeting of

the company when there are no such meetings convened by the company.h. Right to apply to the Company Law Board to call the company to convene an

extra ordinary general meeting.

4.5 SPECIAL FEATURES OF EQUITY SHARES

a) Limited liability

The equity shareholders liability is limited to their capital contribution. They are notliable for the liabilities of the company.

b) Return

The equity shareholders are getting returns in the form of dividend and capital gain.The dividend is calculated as a percentage on the face value of the share and the same ispaid only after payment of corporate tax and preference dividend if any.

The amount of dividend is determined based on the profitability, reserve requirementsand the expectation of shareholders.

The equity holders another form of return is the capital appreciation. When thecurrent market value of the equity is more than the offer price or purchase price of theshare then the difference is called capital gain.

c) Transferability

The equity shareholder can transfer his share to another person for a consideration.When the Registrar of the company is intimated about the name transfer he removes theold shareholder’s particulars and include new shareholders particular in the register ofmembers.

d) Liquidity

The company does not redeem the equity shares and it lists the shares in stockexchanges for enabling the shareholders to sell and encash their investment in equity shares.The investors buy and sell shares in stock market through stock brokers. The profitmaking and growth-oriented companies’ shares are having high market value and liquidityin stock market.



e) Voting rights

The equity shareholders are given voting rights based on the number of shares heldby them. They can attend annual general meetings and extraordinary general meetings andexercise their voting rights. The board of directors, charted accountant and legal advisorsof a company are selected by the majority of shareholders.

4.6 NON VOTING SHARES

The holders of non-voting shares do not have any voting rights. However they getadditional (20%) dividends and they are eligible for bonus shares. If the company fails topay dividend for two consecutive years then the non-voting shareholders automaticallygets voting rights. A company can issue non – voting shares to a maximum of 25% of thevoting shares.

4.7 RIGHT SHARES

When an existing company issues additional share capital the existing shareholdersshould be given preemptive rights. The existing shareholders who apply for additional Theinvestment and disinvestment activities of Mutual funds, Institutional Investors and ForeignInstitutional Investors are greatly influencing the market direction. Therefore an investorhas to gather and analyse such information to predict the market movement.

4.8 BONUS SHARES

Generally companies would not pay entire profit after tax and preference dividend tothe equity shareholders. A part of profit is declared as dividend and the company retainsthe remaining profit as retained earnings. The accumulated retained earnings can beconverted in to equity shares by issuing bonus shares to the equity shareholders. Thus theconversion of retained earnings in to equity capital enables the company to use the capitalfor expansion, modernization and other business requirements. The bonus shares areissued at free of cost to the existing equity shareholders.

4.9 PREFERENCE SHARES

Shares with two preferences are called preference shares. The preference shareholdershave the preference to get dividend before equity shareholders and the preference to getback the capital before equity shareholders incase when the company is dissolved. Thepreference shareholders’ dividend is pre-determined and they do not enjoy the votingrights.

4.10 TYPES OF PREFERENCE SHARES

a) Cumulative and Non-Cumulative Preference Shares

In case of cumulative preference shares the company will pay dividend not only forthe current year but also for unpaid previous years also. Thus during loss making years the

NOTES



shareholder don’t get dividend but the dividend will accumulate and the same will be paidduring profit making years.

In case of Non – Cumulative preference shares the dividend is not accumulating.Whenever there is adequate profit the dividend is paid otherwise there is no dividend.Thus in this type the dividend is paid only for the current year and not for the previous year.

b) Convertible and Non-Convertible Preference Shares

The convertible preference share can be converted in to equity shares at a specifiedperiod. This convertible option to the investor is very attractive.

The non-convertible preference share remains as preference shares and the samecannot be converted in to equity shares.

c) Redeemable and Irredeemable Preference Shares

As per the provisions in the Articles of Association of the Company it can redeem itspreference shares. The company out of capital redemption reserve can redeem the fullypaid preference shares.

The Irredeemable preference shares cannot be redeemed unless the company comesto an end. However this type of preference share is not permitted in India as per section80A of Companies Act 1956.

5. INVESTMENT INFORMATION

The share prices are influenced by various fundamental factors and technical factors.The demand and supply levels of stocks are frequently changing mainly due to information.To get reasonable return and to safeguard the investment the investor has to constantlygather various relevant information and analyse its impact on his market value of hisinvestment.

5.1 TYPES OF INVESTMENT INFORMATION

a) World Affairs

With increasing cross border trades and international trades the international economicand political events influence the domestic capital markets. Each and every economy isinterdependent to certain extent. The economic recession felt in US during the last quarterof 2007 has impacted on many Asian and Indian capital markets. The policies of IMF andthe World Bank affect the volume of loan for the development purpose of world economy.The change in the interest rates of countries shifts the investments of Institutional investorsfrom one country to another.



b) Domestic Economic and Political factors

The Gross domestic product (GNP), agricultural output, monsoon, inflation moneysupply, monetary policy of RBI, (Repo rate, Reverse Repo rate, cash adequacy ratio ofcommercial banks) Government’s industrial policy, budget proposal, tax policies etc. arethe vital information which influences the capital market to greater extent.

c) Information about industry

The life cycle of the industry, demand growth, capacity utilization, competition marketshare, outlook of the industry, exports prospects, government policy towards the industryetc, influences the share price movements of the specific industry stocks.

d) Company Information

Financial results, change in management, orders received, joint venture, new productand technology introduction, expansion programmes, dividend and bonus shares offeredare very important information which will influence the price movements of the company’sshares.

e) Security Market Information

The credit rating information and symbols announced by credit rating agencies likeICRA, CRISIL, CARE etc; market movements, analyst reports etc. are the powerfulinformation which influences the stock price movements.

f) Security Price Quotations

Stock market price quotations, index, volume, breadth, daily volatility, advance

declains ratios etc. reveals the pulse of the market.

g) Data on Mutual funds & Investment Companies

The investment and disinvestment activities of Mutual funds, Institutional Investorsand Foreign Institutional Investors are greatly influencing the market direction. Thereforean investor has to gather and analyse such information to predict the market movement.

5.2. IMPORTANCE OF CORRECT INFORMATION

The market participants and investors mostly depend on the timely and reliable marketinformation. The investors should identify the relevant information and its source. Thosewho have better information use it to get extra mileage on such information. It is alsopossible that insiders who have the information before it becomes public take advantage ofit called insider trading. At present the SEBI has acquired powers to control insider trading,malpractices and rigging up of prices in the secondary market and penalize the offenders.

NOTES



Summary

Investment is the commitment of funds on assets with an ultimate objective of gettinga return. The return on investment is in the form of regular income (interest or dividend)and capital gain or both.

To mobilize long term funds the corporate are issuing various securities in the capitalmarket. Securities provide a claim to the holder on the assets and future cash flows thatwill be generated by the assets of the company. Generally the term Securities includesshares, Debentures and Bonds.

Bonds are a long term debt instrument that promises to pay a fixed annual interest fora specified period of time. Bond is an alternative form of debenture in India. Public sectorcompanies and financial institutions issue bonds. The bond has a face value. The offerprice may be more than the face value (issuing at premium) or less than the face value(issuing at discount). The interest is calculated only on the face value (par value). The rateof interest, period of interest payment maturity period and redemption value will bementioned on the bond certificate.

Equity shares constitute the ownership capital of a company and the equity holderhas the right of voting and sharing in profits and assets in proportion to his holding in thetotal net assets of the company. The equity shareholder is entitled to all rights and obligationsas owner to the residual profits and assets of the company after the claims of creditors aremet. The dividend to equity shareholder is determined after meeting interest, preferencedividend and tax obligations and therefore the equity dividend is subject to uncertainty andhighly fluctuating

The share prices are influenced by various fundamental factors and technical factors.The demand and supply levels of stocks are frequently changing mainly due to information.To get reasonable return and to safeguard the investment the investor has to constantlygather various relevant information and analyse its impact on his market value of hisinvestment.

Key Terms

Speculation and InvestmentDebenturesBondsEquity SharesRight SharesBonus SharesPreference Shares



Questions

1. What do you mean by Investment and Speculation?2. Differentiate Investment from Speculation3. What are the objectives of investors in investing their funds in capital market?4. Explain the various types of Debentures and its advantages5. Discuss the merits and limitations of equity shares as an investment outlet6. What is the information to be analysed before investment?

NOTES



CHAPTER- II

SECURITY MARKET INDICATIONS - BOMBAY STOCK EXCHANGE

Learning Objectives

After reading this chapter you would be able to understand the various kinds ofindices, the Sensex, the methodology of Sensex calculations, the concept of Free-float,the maintenance of Sensex, Sensex - Scrip selection criteria and the Index Review Frequency.

1. OVERVIEW

Traditionally, indices have been used as information sources. By looking at an indexwe know how the market is faring. This information aspect also figures in myriad applicationsof stock market indices in economic research. This is particularly valuable when an indexreflects highly up-to-date information and the portfolio of an investor contains illiquidsecurities - in this case, the index is a lead indicator of how the overall portfolio will fare. Inrecent years, indices have come to the fore owing to direct applications in finance, in theform of index funds and index derivatives. Index funds are funds which passively ‘invest inthe index’. Index derivatives allow people to cheaply alter their risk exposure to an index(this is called hedging) and to implement forecasts about index movements (this is calledspeculation). Hedging using index derivatives has become a central part of risk managementin the modern economy. These applications are now a multi-trillion dollar industry worldwide,and they are critically linked up to market indices. Finally, indices serve as a benchmark formeasuring the performance of fund managers. An all-equity fund should obtain returns likethe overall stock market index. A 50:50 debt: equity fund should obtain returns close tothose obtained by an investment of 50% in the index and 50% in fixed income. A well-specified relationship between an investor and a fund manager should explicitly define thebenchmark against which the fund manager will be compared, and in what fashion.

2. KINDS OF INDICES

The most important type of market index is the broad-market index, consisting of thelarge, liquid stocks of the country. In most countries, a single major index dominatesbenchmarking, index funds, index derivatives and research applications. In addition, morespecialised indices often find interesting applications. In India, we have seen situationswhere a dedicated industry fund uses an industry index as a benchmark. In India, whereclear categories of ownership groups exist, it becomes interesting to examine theperformance of classes of companies sorted by ownership group.



3. SENSEX

3.1 INTRODUCTION

For the premier Stock Exchange that pioneered the stock broking activity in India,128 years of experience seems to be a proud milestone. A lot has changed since 1875when 318 persons became members of what today is called “The Stock Exchange, Mumbai”by paying a princely amount of Re1.

Since then, the country’s capital markets have passed through both good and badperiods. The journey in the 20th century has not been an easy one. Till the decade ofeighties, there was no scale to measure the ups and downs in the Indian stock market. TheStock Exchange, Mumbai (BSE) in 1986 came out with a stock index that subsequentlybecame the barometer of the Indian stock market.

Sensex is not only scientifically designed but also based on globally acceptedconstruction and review methodology. First compiled in 1986, Sensex is a basket of 30constituent stocks representing a sample of large, liquid and representative companies.The base year of Sensex is 1978-79 and the base value is 100. The index is widelyreported in both domestic and international markets through print as well as electronicmedia.

The Index was initially calculated based on the “Full Market Capitalization”methodology but was shifted to the free-float methodology with effect from September 1,2003. The “Free-float Market Capitalization” methodology of index construction is regardedas an industry best practice globally. All major index providers like MSCI, FTSE, STOXX,S&P and Dow Jones use the Free-float methodology.

Due to its wide acceptance amongst the Indian investors; Sensex is regarded to bethe pulse of the Indian stock market. As the oldest index in the country, it provides the timeseries data over a fairly long period of time (From 1979 onwards). Small wonder, theSensex has over the years become one of the most prominent brands in the country. Thegrowth of equity markets in India has been phenomenal in the decade gone by. Right fromearly nineties the stock market witnessed heightened activity in terms of various bull andbear runs. The Sensex captured all these events in the most judicial manner. One canidentify the booms and busts of the Indian stock market through Sensex.

3.2 SENSEX CALCULATION METHODOLOGIES

Sensex is calculated using the “Free-float Market Capitalization” methodology. Asper this methodology, the level of index at any point of time reflects the Free-float marketvalue of 30 component stocks relative to a base period. The market capitalization of acompany is determined by multiplying the price of its stock by the number of shares issuedby the company. This market capitalization is further multiplied by the free-float factor todetermine the free-float market capitalization.

NOTES



The base period of Sensex is 1978-79 and the base value is 100 index points. Thenotation 1978-79=100 often indicates this. The calculation of Sensex involves dividing theFree-float market capitalization of 30 companies in the Index by a number called the IndexDivisor. The Divisor is the only link to the original base period value of the Sensex. It keepsthe Index comparable over time and is the adjustment point for all Index adjustmentsarising out of corporate actions, replacement of scrips etc. During market hours, prices ofthe index scrips, at which latest trades are executed, are used by the trading system tocalculate Sensex every 15 seconds and disseminated in real time.

4. FREE-FLOAT METHODOLOGY

4.1 CONCEPT

Free-float Methodology refers to an index construction methodology that takes intoconsideration only the free-float market capitalization of a company for the purpose ofindex calculation and assigning weight to stocks in Index. Free-float market capitalizationis defined as that proportion of total shares issued by the company that are readily availablefor trading in the market. It generally excludes promoters’ holding, government holding,strategic holding and other locked-in shares that will not come to the market for trading inthe normal course. In other words, the market capitalization of each company in a Free-float index is reduced to the extent of its readily available shares in the market.

In India, BSE pioneered the concept of Free-float by launching BSE TECk in July2001 and BANKEX in June 2003. While BSE TECk Index is a TMT benchmark,BANKEX is positioned as a benchmark for the banking sector stocks. Sensex becomesthe third index in India to be based on the globally accepted Free-float Methodology.

4.2 MAJOR ADVANTAGES OF FREE-FLOAT METHODOLOGY

• A Free-float index reflects the market trends more rationally as it takes intoconsideration only those shares that are available for trading in the market.

• Free-float Methodology makes the index more broad-based by reducing theconcentration of top few companies in Index. For example, the concentration oftop five companies in Sensex has fallen under the free-float scenario thereby makingthe SENSEX more diversified and broad-based.

• A Free-float index aids both active and passive investing styles. It aids activemanagers by enabling them to benchmark their fund returns vis-à-vis an investableindex. This enables an apple-to-apple comparison thereby facilitating betterevaluation of performance of active managers. Being a perfectly replicable portfolioof stocks, a Free-float adjusted index is best suited for the passive managers as itenables them to track the index with the least tracking error.



• Free-float Methodology improves index flexibility in terms of including any stockfrom the universe of listed stocks. This improves market coverage and sectorcoverage of the index. For example, under a Full-market capitalization methodology,companies with large market capitalization and low free-float cannot generally beincluded in the Index because they tend to distort the index by having an undueinfluence on the index movement. However, under the Free-float Methodology,since only the free-float market capitalization of each company is considered forindex calculation, it becomes possible to include such closely held companies inthe index while at the same time preventing their undue influence on the indexmovement.

• Globally, the Free-float Methodology of index construction is considered to be anindustry best practice and all major index providers like MSCI, FTSE, S&P andSTOXX have adopted the same. MSCI, a leading global index provider, shiftedall its indices to the Free-float Methodology in 2002. The MSCI India StandardIndex, which is followed by Foreign Institutional Investors (FIIs) to track Indianequities, is also based on the Free-float Methodology. NASDAQ-100, theunderlying index to the famous Exchange Traded Fund (ETF) - QQQ is based onthe Free-float Methodology.

4.3 DEFINITION OF FREE-FLOAT

Share holdings held by investors that would not, in the normal course come into theopen market for trading are treated as ‘Controlling/ Strategic Holdings’ and hence notincluded in free-float. In specific, the following categories of holding are generally excludedfrom the definition of Free-float:

• Holdings by founders/directors/ acquirers which has control element• Holdings by persons/ bodies with “Controlling Interest”• Government holding as promoter/acquirer• Holdings through the FDI Route• Strategic stakes by private corporate bodies/ individuals• Equity held by associate/group companies (cross-holdings)• Equity held by Employee Welfare Trusts• Locked-in shares and shares which would not be sold in the open market in

normal course.• The remaining shareholders would fall under the Free-float category.

4.4 DETERMINING FREE-FLOAT FACTORS OF COMPANIES

BSE has designed a Free-float format, which is filled and submitted by all indexcompanies on a quarterly basis with the Exchange. The Exchange determines the Free-float factor for each company based on the detailed information submitted by the companiesin the prescribed format. Free-float factor is a multiple with which the total marketcapitalization of a company is adjusted to arrive at the Free-float market capitalization.Once the Free-float of a company is determined, it is rounded-off to the higher multiple of

NOTES



5 and each company is categorized into one of the 20 bands given below. A Free-floatfactor of say 0.55 means that only 55% of the market capitalization of the company will beconsidered for index calculation.

Free-float Bands:

4.5 INDEX CLOSURE ALGORITHM

The closing Sensex on any trading day is computed taking the weighted average of allthe trades on Sensex constituents in the last 30 minutes of trading session. If a SENSEXconstituent has not traded in the last 30 minutes, the last traded price is taken for computationof the Index closure. If a Sensex constituent has not traded at all in a day, then its last day’sclosing price is taken for computation of Index closure. The use of Index Closure Algorithmprevents any intentional manipulation of the closing index value.

5. MAINTENANCE OF SENSEX

One of the important aspects of maintaining continuity with the past is to update thebase year average. The base year value adjustment ensures that replacement of stocks inIndex, additional issue of capital and other corporate announcements like ‘rights issue’ etc.do not destroy the historical value of the index. The beauty of maintenance lies in the factthat adjustments for corporate actions in the Index should not per se affect the indexvalues.

The Index Cell of the exchange does the day-to-day maintenance of the index withinthe broad index policy framework set by the Index Committee. The Index Cell ensuresthat Sensex and all the other BSE indices maintain their benchmark properties by strikinga delicate balance between frequent replacements in index and maintaining its historicalcontinuity. The Index Committee of the Exchange comprises of experts on capital marketsfrom all major market segments. They include Academicians, Fund-managers from leadingMutual Funds, Finance-Journalists, Market Participants, Independent Governing Boardmembers, and Exchange administration.

% Free-Float Free-Float Factor % Free-Float Free-Float Factor >0 – 5% 0.05 >50 – 55% 0.55 >5 – 10% 0.10 >55 – 60% 0.60

>10 – 15% 0.15 >60 – 65% 0.65 >15 – 20% 0.20 >65 – 70% 0.70 >20 – 25% 0.25 >70 – 75% 0.75 >25 – 30% 0.30 >75 – 80% 0.80 >30 – 35% 0.35 >80 – 85% 0.85 >35 – 40% 0.40 >85 – 90% 0.90

>40 – 45% 0.45 >90 – 95% 0.95 >45 – 50% 0.50 >95 – 100% 1.00



5.1 ON-LINE COMPUTATION OF THE INDEX

During market hours, prices of the index scrips, at which trades are executed, areautomatically used by the trading computer to calculate the Sensex every 15 seconds andcontinuously updated on all trading workstations connected to the BSE trading computerin real time.

5.2 ADJUSTMENT FOR BONUS, RIGHTS AND NEWLY ISSUED CAPITAL

The arithmetic calculation involved in calculating Sensexis simple, but problem ariseswhen one of the component stocks pays a bonus or issues rights shares. If no adjustmentswere made, a discontinuity would arise between the current value of the index and itsprevious value despite the non-occurrence of any economic activity of substance. At theIndex Cell of the Exchange, the base value is adjusted, which is used to alter marketcapitalization of the component stocks to arrive at the Sensex value.

The Index Cell of the Exchange keeps a close watch on the events that might affectthe index on a regular basis and carries out daily maintenance of all the 14 Indices.

• Adjustments for Rights Issue

When a company, included in the compilation of the index, issues right shares, thefree-float market capitalisation of that company is increased by the number of additionalshares issued based on the theoretical (ex-right) price. An offsetting or proportionateadjustment is then made to the Base Market Capitalisation (see ‘Base Market CapitalisationAdjustment’ below).

• Adjustments for Bonus Issue

When a company, included in the compilation of the index, issues bonus shares, themarket capitalisation of that company does not undergo any change. Therefore, there is nochange in the Base Market Capitalisation, only the ‘number of shares’ in the formula isupdated.

• Other Issues

Base Market Capitalisation Adjustment is required when new shares are issued byway of conversion of debentures, mergers, spin-offs etc. or when equity is reduced byway of buy-back of shares, corporate restructuring etc.

• • • • • Base Market Capitalisation AdjustmentThe formula for adjusting the Base Market Capitalisation is as follows:



7. INDEX REVIEW FREQUENCY

The Index Committee meets every quarter to discuss index related issues. In case ofa revision in the Index constituents, the announcement of the incoming and outgoing scripsis made six weeks in advance of the actual implementation of the revision of the Index.

History of replacement of scrips in SENSEX

Date Outgoing Scrips Replaced by 01.01.1986 Bombay Burmah Voltas Asian Cables Peico Crompton Greaves Premier Auto. Scinda G.E.Shipping 03.08.1992 Zenith Ltd. Bharat Forge 19.08.1996 Ballarpur Inds. Arvind Mills Bharat Forge Bajaj Auto Bombay Dyeing BHEL Ceat Tyres BSES Century Text. Colgate GSFC Guj. Amb. Cement Hind. Motors HPCL Indian Organic ICICI Indian Rayon IDBI Kirloskar Cummins IPCL Mukand Iron MTNL Phlips Ranbaxy Lab. Premier Auto State Bank of India Siemens Steel Authority of India Voltas Tata Chem 16.11.1998 Arvind Mills Castrol G. E. Shipping Infosys Technologies IPCL NIIT Ltd. Steel Authority of India Novartis



INDEX AND RATIOS

NOTES



INDEX AND RATIOS



INDEX AND RATIOS

NOTES



Summary

Traditionally, indices have been used as information sources. By looking at an indexwe know how the market is faring. This information aspect also figures in myriad applicationsof stock market indices in economic research. This is particularly valuable when an indexreflects highly up-to-date information and the portfolio of an investor contains illiquidsecurities - in this case, the index is a lead indicator of how the overall portfolio will fare

The most important type of market index is the broad-market index, consisting of thelarge, liquid stocks of the country. In most countries, a single major index dominatesbenchmarking, index funds, index derivatives and research applications. In addition, morespecialised indices often find interesting applications

The Stock Exchange, Mumbai (BSE) in 1986 came out with a stock index thatsubsequently became the barometer of the Indian stock market.

Sensex is not only scientifically designed but also based on globally acceptedconstruction and review methodology. First compiled in 1986, Sensex is a basket of 30constituent stocks representing a sample of large, liquid and representative companies.The base year of Sensex is 1978-79 and the base value is 100. The index is widelyreported in both domestic and international markets through print as well as electronicmedia.

The Index was initially calculated based on the “Full Market Capitalization”methodology but was shifted to the free-float methodology with effect from September 1,2003. The “Free-float Market Capitalization” methodology of index construction is regardedas an industry best practice globally. All major index providers like MSCI, FTSE, STOXX,S&P and Dow Jones use the Free-float methodology.

The Index Committee meets every quarter to discuss index related issues. In case ofa revision in the Index constituents, the announcement of the incoming and outgoing scripsis made six weeks in advance of the actual implementation of the revision of the Index

Key Terms

SensexFree-float MethodologyAdjustments for Rights IssueAdjustments for Bonus IssueMarket Capitalisation



Questions

1. Write a brief note on Bobay Stock Exchange.

2. What are the different kinds of indices?

3. What do you mean by Sensex?

4. What is meant by Free-float? Explain the advantages and the methodology ofcalculation of Free-float.

5. Explain the Sensex - Scrip selection criteria and maintenance of Sensex.

NOTES



CHAPTER- III

SECURITY MARKET INDICATIONS - NATIONAL STOCK EXCHANGELearning Objectives

After going through this chapter you would be able to understand the Index Concepts,Total Return Index, Methodology for Total Returns Index, Essential of a stock marketindex, the meaning of ups and downs of an index, the basic idea in an index, averaging, andthe portfolio interpretation of index movements.

1. OVERVIEW

India Index Services & Products Ltd. (IISL) is a joint venture between the NationalStock Exchange of India Ltd. (NSE) and CRISIL Ltd. (formerly the Credit RatingInformation Services of India Limited). IISL has been formed with the objective of providinga variety of indices and index related services and products for the capital markets.

IISL has a consulting and licensing agreement with Standard and Poor’s (S&P), theworld’s leading provider of investible equity indices, for co-branding IISL’s equity indices.

IISL Indices



2. INDEX CONCEPTS

2.1 IMPACT COST

Liquidity in the context of stock markets means a market where large orders can beexecuted without incurring a high transaction cost. The transaction cost referred here is notthe fixed costs typically incurred like brokerage, transaction charges, depository chargesetc. but is the cost attributable to lack of market liquidity as explained subsequently. Liquiditycomes from the buyers and sellers in the market, who are constantly on the look out forbuying and selling opportunities. Lack of liquidity translates into a high cost for buyers andsellers.

The electronic limit order book (ELOB) as available on NSE is an ideal provider ofmarket liquidity. This style of market dispenses with market makers, and allows anyone inthe market to execute orders against the best available counter orders. The market maythus be thought of as possessing liquidity in terms of outstanding orders lying on the buyand sell side of the order book, which represent the intention to buy or sell.

When a buyer or seller approaches the market with an intention to buy a particularstock, he can execute his buy order in the stock against such sell orders, which are alreadylying in the order book, and vice versa.

An example of an order book for a stock at a point in time is detailed below:

There are four buy and four sell orders lying in the order book. The difference betweenthe best buy and the best sell orders (in this case, Rs.0.50) is the bid-ask spread. If aperson places an order to buy 100 shares, it would be matched against the best availablesell order at Rs. 4 i.e. he would buy 100 shares for Rs. 4. If he places a sell order for 100shares, it would be matched against the best available buy order at Rs. 3.50 i.e. the shareswould be sold at Rs.3.5.

Hence if a person buys 100 shares and sells them immediately, he is poorer by thebid-ask spread. This spread may be regarded as the transaction cost which the marketcharges for the privilege of trading (for a transaction size of 100 shares).

Buy Sell Sr.No. Quantity Price Quantity Price Sr. No.

1 1000 3.50 2000 4.00 5

2 1000 3.40 1000 4.05 6

3 2000 3.40 500 4.20 7

4 1000 3.30 100 4.25 8

NOTES



Risks can be classified as Systematic risks and Unsystematic risks.

2.4 UNSYSTEMATIC RISKS

These are risks that are unique to a firm or industry. Factors such as managementcapability, consumer preferences, labour, etc. contribute to unsystematic risks. Unsystematicrisks are controllable by nature and can be considerably reduced by sufficiently diversifyingone’s portfolio.

2.5 SYSTEMATIC RISKS

These are risks associated with the economic, political, sociological and other macro-level changes. They affect the entire market as a whole and cannot be controlled or eliminatedmerely by diversifying one’s portfolio.

2.6 WHAT IS BETA?

The degree, to which different portfolios are affected by these systematic risks ascompared to the effect on the market as a whole, is different and is measured by Beta. Toput it differently, the systematic risks of various securities differ due to their relationshipswith the market. The Beta factor describes the movement in a stock’s or a portfolio’sreturn in relation to that of the market returns. For all practical purposes, the market returnsare measured by the returns on the index (Nifty, Mid-cap etc.), since the index is a goodreflector of the market.

2.7 METHODOLOGY / FORMULA

Beta is calculated as:

)X(Var)Y,X(Cov

=β

where,

Y is the returns on your portfolio or stock - DEPENDENT VARIABLE

X is the market returns or index - INDEPENDENT VARIABLE

Variance is the square of standard deviation.

Covariance is a statistic that measures how two variables co-vary, and is given by:

Where, N denotes the total number of observations, and and respectively representthe arithmetic averages of x and y.

In order to calculate the beta of a portfolio, multiply the weightage of each stock inthe portfolio with its beta value to arrive at the weighted average beta of the portfolio



2.8 STANDARD DEVIATION

Standard Deviation is a statistical tool, which measures the variability of returns fromthe expected value, or volatility. It is denoted by sigma(s) . It is calculated using the formulamentioned below:

Where, is the sample mean, xi’s are the observations (returns), and N is the totalnumber of observations or the sample size.

3. TOTAL RETURN INDEX

Nifty is a price index and hence reflects the returns one would earn if investment ismade in the index portfolio. However, a price index does not consider the returns arisingfrom dividend receipts. Only capital gains arising due to price movements of constituentstocks are indicated in a price index. Therefore, to get a true picture of returns, the dividendsreceived from the constituent stocks also need to be factored in the index values. Such anindex, which includes the dividends received, is called the Total Returns Index.

Total Returns Index reflects the returns on the index arising from (a) constituent stockprice movements and (b) dividend receipts from constituent index stocks.

4. METHODOLOGY FOR TOTAL RETURNS INDEX (TR)

The following information is a prerequisite for calculation of TR Index:

Price Index closePrice Index returnsDividend payouts in RupeesIndex Base capitalisation on ex-dividend date

Dividend payouts as they occur are indexed on ex-date.

Indexed dividend = 1000x)Rs(apofindexsecBa)Rs(youtDividendpa

Indexed dividends are then reinvested in the index to give TR Index.Total Return Index = [Prev. TR Index + (Prev. TR Index * Index returns)] +

[Indexed dividends + (Indexed dividends * Index returns)]

Base for both the Price index close and TR index close will be the same.

An investor in index stocks should benchmark his investments against the Total Returnsindex instead of the price index to determine the actual returns vis-à-vis the index

NOTES



5. ESSENTIAL OF A STOCK MARKET INDEX

A stock market index should capture the behaviour of the overall equity market.Movements of the index should represent the returns obtained by “typical” portfolios in thecountry.

6. THE MEANING OF UPS AND DOWNS OF AN INDEX

They reflect the changing expectations of the stock market about future dividends ofIndia’s corporate sector. When the index goes up, it is because the stock market thinksthat the prospective dividends in the future will be better than previously thought. Whenprospects of dividends in the future become pessimistic, the index drops. The ideal indexgives us instant-to-instant readings about how the stock market perceives the future ofIndia’s corporate sector.

7. THE BASIC IDEA IN AN INDEX

Every stock price moves for two possible reasons: news about the company (e.g. aproduct launch, or the closure of a factory, etc.) or news about the country (e.g. nuclearbombs, or a budget announcement, etc.). The job of an index is to purely capture thesecond part, the movements of the stock market as a whole (i.e. news about the country).This is achieved by averaging. Each stock contains a mixture of these two elements - stocknews and index news. When we take an average of returns on many stocks, the individualstock news tends to cancel out. On any one day, there would be good stock-specific newsfor a few companies and bad stock-specific news for others. In a good index, these willcancel out, and the only thing left will be news that is common to all stocks. The news thatis common to all stocks is news about India. That is what the index will capture.

8. AVERAGING

For technical reasons, it turns out that the correct method of averaging is to take aweighted average, and give each stock a weight proportional to its market capitalisation.Suppose an index contains two stocks A and B. A has a market capitalisation of Rs.1000crore and B has a market capitalisation of Rs.3000 crore. Then we attach a weight of 1/4to movements in A and 3/4 to movements in B.

9. THE PORTFOLIO INTERPRETATION OF INDEX MOVEMENTS

It is easy to create a portfolio, which will reliably get the same returns as the index. i.e.if the index goes up by 4%, this portfolio will also go up by 4%. Suppose an index is madeof two stocks, one with a market cap of Rs.1000 crore and another with a market cap ofRs.3000 crore. Then the index portfolio will assign a weight of 25% to the first and 75%weight to the second. If we form a portfolio of the two stocks, with a weight of 25% on thefirst and 75% on the second, then the portfolio returns will equal the index returns. So ifyou want to buy Rs.1 lakh of this two-stock index, you would buy Rs.25,000 of the firstand Rs.75,000 of the second; this portfolio would exactly mimic the two-stock index. A



stock market index is hence just like other price indices in showing what is happening onthe overall indices — the wholesale price index is a comparable example. In addition, thestock market index is attainable as a portfolio.

SUMMARY

India Index Services & Products Ltd. (IISL) is a joint venture between the NationalStock Exchange of India Ltd. (NSE) and CRISIL Ltd. (formerly the Credit RatingInformation Services of India Limited). IISL has been formed with the objective of providinga variety of indices and index related services and products for the capital markets.

Liquidity in the context of stock markets means a market where large orders can beexecuted without incurring a high transaction cost. The transaction cost referred here is notthe fixed costs typically incurred like brokerage, transaction charges, depository chargesetc. but is the cost attributable to lack of market liquidity as explained subsequently. Liquiditycomes from the buyers and sellers in the market, who are constantly on the look out forbuying and selling opportunities. Lack of liquidity translates into a high cost for buyers andsellers.

Risk is an important consideration in holding any portfolio. The risk in holding securitiesis generally associated with the possibility that realised returns will be less than the returnsexpected.

Nifty is a price index and hence reflects the returns one would earn if investment ismade in the index portfolio. However, a price index does not consider the returns arisingfrom dividend receipts. Only capital gains arising due to price movements of constituentstocks are indicated in a price index. Therefore, to get a true picture of returns, the dividendsreceived from the constituent stocks also need to be factored in the index values. Such anindex, which includes the dividends received, is called the Total Returns Index.

For technical reasons, it turns out that the correct method of averaging is to take aweighted average, and give each stock a weight proportional to its market capitalisation.Suppose an index contains two stocks A and B. A has a market capitalisation of Rs.1000crore and B has a market capitalisation of Rs.3000 crore. Then we attach a weight of 1/4to movements in A and 3/4 to movements in B.

It is easy to create a portfolio, which will reliably get the same returns as the index. i.e.if the index goes up by 4%, this portfolio will also go up by 4%. Suppose an index is madeof two stocks, one with a market cap of Rs.1000 crore and another with a market cap ofRs.3000 crore. Then the index portfolio will assign a weight of 25% to the first and 75%weight to the second

NOTES



Key Terms

Total Return IndexAveragingImpact CostUnsystematic risksSystematic risksStandard Deviation

Questions

1. Briefly explain the Index Concepts2. What do you mean by Total Return Index and explain the methodology for Total

Returns Index (TR)3. What is meant by ups and downs of an index?4. What does averaging mean?5. What is the portfolio interpretation of index movements?



CHAPTER- IV

SECURITIES TRADING REGULATIONS AND

INVESTOR PROTECTION

Learning objectives

After going through this chapter you would be able to understand the issues relatingto regulations of securities market and investors protection

1. OVERVIEW

The Securities Contracts (Regulation) Act, 1956 (the SCR Act) is the basis forregulation of Securities Contracts and the Stock Exchanges in India. It was enacted in1956 and came into force on February 20, 1957. It regulates the business of trading onthe stock exchanges and option trading and provides for recognition of stock exchangesand related matters like listing of securities transfer of securities, etc. The regulation oftrading is also governed by the Rules and Byelaws of the Stock Exchange.

2. OBJECTIVES OF THE SECURITIES CONTRACTS (REGULATION) ACT, 1956

The Preamble to the Securities Contracts (Regulation) Act, 1956 says: “An Act toprevent undesirable transactions in securities by regulating the business of dealing therein,by prohibiting options and by providing for certain other matters connected therewith.”

The Act defines what a security is. The Act also lays down what transactions insecurities are legal and what are void and illegal.

A reading of the Preamble itself indicates that the key word is “securities” which hasbeen defined in Section 2 (h) of the SCR Act. The definition is inclusive in nature andincludes shares, scrips, stocks, bonds, debentures, debenture-stock or other marketablesecurities of a like nature in or of any incorporated company or other body corporate. Italso covers government securities and rights or interests in securities. But it does notinclude securities of private companies as they are not capable of being dealt in on a stockexchange and are not marketable securities due to the possible restrictions on transfer.The shares of public limited companies which are closely held and which are not dealt in ona stock exchange are also outside the purview of the said Act, as their transferability mayalso be limited.

NOTES



3. SCOPE OF THE SECURITIES CONTRACTS (REGULATION) ACT, 1956

Section 28 of the SCR Act also empowers the Central Government in the interest oftrade and commerce or the economic development of the country to issue a notification inthe Official Gazette and specify any class of contracts as contracts to which the SCR Actwill not apply. In pursuance of this power, the Central Government has issued a Notificationdated 27th June 1961 specifying contracts for –pre-emption or similar rights contained inthe promotion or collaboration agreements or in the Articles of Association of limitedcompanies as contracts to which the SCR Act shall not apply. By another notificationdated 13th May 1966, the Central Government has declared that contracts pertaining tosale or purchase of shares of Government companies (as defined in Section 617 of theCompanies Act 1956), which are not listed on any recognized stock exchanges, shall notbe subject to the constraints of the SCR Act.

4. RECOGNITION OF STOCK EXCHANGES

Besides the Act, the Securities Contracts (Regulation) Rules were made in 1957 toregulate certain matters relating to the stock exchanges. Section 3 of the SCR Act laysdown that a stock exchange is required to apply to the Central Government for recognition.In terms of Rule 3 of the Securities Contracts (Regulation) Rules, 1957 (the SCR Rules),this application has to be made in the prescribed Form A. That application for recognitionin Form A has to be accompanied by a copy of the byelaws of the stock exchange and alsoa copy of the rules of the stock exchange.

On receiving such application, the Central Government, in terms of Section 4 of theSCR Act read with Rule 5A of the SCR Rules, makes an inquiry as to whether it would bein the interest of the trade and public to grant recognition to the applicant stock exchange.

After making such an enquiry and if the Central Government is satisfied that theprescribed conditions have been met, it grants recognition to the stock exchange. Suchrecognition is granted in Form B as prescribed under Rule 6 of the SCR Rules, and it maybe for a temporary period or on a permanent basis. The Bombay Stock Exchange wasthe only Exchange, which was recognized on a permanent basis from the beginning of theoperation of the Act.

Mention may be made here to the provisions under Rule 9 of the SCR Rules whichlays down that all contracts between the members of a recognized stock exchange have tobe confirmed in writing and are to be enforced in accordance with the rules and byelaws ofthe stock exchange.

5. OPTIONS IN CONTRACTS

The word “contract” has been defined in Section 2 (a) of the SCR Act to mean acontract for or relating to the purchase of securities, or sale of Securities.



The expression “option in securities” means a contract for the purchase or sale of aright to buy or sell securities in future and a contract for the purchase or sale of a right tobuy and sell securities in future.

The expression “spot delivery contract” means a contract, which provides for theactual delivery of securities and the payment of a price thereof either on the same day asthe date of the contract or on the next day.

The difference between a “spot delivery contract” and an “option in securities” is thatthe latter is a contract in future of an intangible right to buy or sell the securities, while theformer provides for the actual purchase and delivery of securities.

Section 13 of the SCR Act empowers the Central Government having regard to thenature or volume of transactions in securities, to issue a Notification in the Official Gazettedeclaring that a “contract” entered into in a notified state or area otherwise than:

i). Between members of a recognized stock exchange in such state or area; orii). Through or with such member shall be illegal.

Under the SCR Act and the Rules, Byelaws of the Stock Exchange monopoly tostock exchanges recognized by the Government is given thereby barring the unrecognizedstock exchanges to operate in such areas.

Section 20 of the SCR Act prohibits “option in securities.” By this section, options insecurities are not only made illegal but are also void. The more important effects of thisAct are that:

i). Options in securities are illegal and void but made legal by an ordinance of Jan1995.ii). Only spot delivery contracts or contracts for cash or hand delivery can be entered

in to with those other than members of the stock exchanges.iii).Contracts other than sport delivery contracts (such as contracts for cash or hand

delivery) can be entered only between members of the Stock Exchange or throughor with such members, in places where a recognized stock exists.

6. REGULATION OF TRADING

Securities are claims on money and trading in them involves passing of contracts orentering into agreements. The Indian Contracts Act regulates the contracts of generalnature but contracts in securities are governed by the special Act, namely, SecuritiesContracts (Regulation) Act. This special Act supersedes the general Act but where thereis no provision in the Special Act as in the case of Principal and agent relationship or bailerto bailee relationship, the Indian Contracts Act will apply. The SC(R) Act is supplementedby the Rules framed there under and the Rules and Byelaws of the Stock Exchange whichare approved by the Government and adopted by the Stock Exchanges.

NOTES



Under the Rules and byelaws of the Exchange, all trading activities and post tradingissues are governed by a set of rules. The Byelaws provide for business days, hours oftrading, trading floor and authorized clerks and Remisiers who can put through the dealsetc.

The Exchange authorities supervise the trading floor; only brokers and their authorizedclerks can enter the floor and make deals. The Rules provide for quotations for bid/offerrates for all listed securities and permitted securities for deals and trading lots etc. Therules of the game involve the records of the purchase and sales transactions in the Saudablock books, comparison of Saudas, taking delivery are all important aspects of regulationof trading. In case of disputes in the trading floor or in their recording of deals etc., theRules and Byelaws have provided for arbitration and settlement of disputes and dispensationof justice in various tiers of judicature as in the case of courts of law.

Trading is regulated by the Stock Exchange authorities as per the Rules and Byelawsof the Exchange supervised by the SEBI and the Government. As per the Rules, theadmission to trading, the method of recording of deals, the price quotations, types tobargains to be struck, rules governing each category, margins to control trade, restrictionon prices and quantity of trade etc. are all regulated by the Exchange. Provisions forinspecting the accounts of brokers, control on their cornering of shares, closing out andBuying – in are provided for. The Exchange regulates trade through

Fixation of daily margins on purchases and sales.Fixation of adhoc margins on total turnover on excessive speculation.Carry forward margins on outstanding purchases and sales at the settlement.Fixation of ceiling and floor prices for any volatile scrip and forcing trading a scripto spot basis.Penalties on violation of rules.Fees and charges for any services rendered by the Exchange.Arbitration and Settlement of disputes between members and between membersand their clients.Stopage of trade in any scrip temporarily through circuit breaker if it is raising orfalling in price beyond 5-10% spread on any trading day.

As part of the regulation of trading, arrangements are also made by each StockExchange for settlement and clearance with the help of a bank. The giving and takingdelivery of shares, settlement through net payment or receipt by each member through aclearing bank, arrangement of auction for effecting deliveries in case of failure to deliver byany member are arranged by the Exchange. Where there are securities for clearing withfacility for carry forward from one settlement to another, the Exchange provides facility forbadla financing and carry forward of net outstanding position.



7. RESTRICTION ON TRANSFERABILITY

Section 22A was introduced in the SCR Act by an amendment and has come intoforce effective from 17th January 1986. The net effect of this section is that a public limitedcompany whose securities are listed on a recognized stock exchange cannot refuse totransfer shares lodged with it for transfer, unless the case for refusal falls under the specificprovisions laid down in Section 22A. This section has been introduced to ensure thatpublic companies whose shares are listed on a recognized stock exchange do not ct in anarbitrary or capricious manner in dealing with a transfer application lodged with it. Thus, apublic limited company whose shares are listed on a recognized stock exchange can refusean application for transfer only for the first of following grounds. For the rest of the grounds(ii) to (iv) the company has to make a reference to CLB that the instrument of transfer isnot proper or has not been duly stamped and executed or that the certificate relating to thesecurity has not been delivered to the company, or that any other requirements under thelaw relating to registration of such transfer has not been complied with;

i). That the transfer is in contravention of any law;ii). That the transfer is likely to result in such change in the composition of the board of

directors as would be prejudicial to the interest of the company or to the publicinterest; and

iii).That the transfer is prohibited by any order of any court, tribunal or other authorityunder law for the time being in force.

The above section 22A is a very welcome change made in the SCR Act and ensuresthat transferability of listed securities is not denied on frivolous grounds by the company. Ifa transfer is refused, it has to be done within the specified period of two months and thereasons for refusal have to be intimated to the transferor and transferee.

Section 22A applies only to listed companies. This right to refuse registration ofshares without adequate reason has been taken away only for listed companies.

The transfer of shares falls within the purview of the companies Act. Section 82describes the nature of shares and declares them as movable property. Since shares are amovable property, ordinarily a simple delivery should be enough to complete the transfer.Section 82, however, leaves it to the companies to lay down in the Articles of Associationthe manner in which the transfer should be effected. It is a general practice in India that theArticles of a Company invariably empower the Board of Directors to refuse the registrationto transfer of its securities.

It is Section 111, which recognises the right of companies to refuse registration oftransfer of shares, and has been substituted by a new one by the Companies (Amendment)Act, 1988. The recasting of Section 111 has been made in pursuance of therecommendations of the Sachar Committee considered that, while it might be necessary toretain and recognise the right of directors to refuse registration of transfer of shares if so

NOTES



authorized by the Articles of the company, this right should be hedged in with adequatesafeguards. Specially, under Section 111, as it stood prior to the amendment in 1988, thecompany was not required to give reasons for refusal to register transfers and it was theright of the adjudicating body only to require the company to disclose reasons at theappellate stage. It has now been made a compulsory requirement for companies to disclosethe reasons for refusal to register any transfer at the initial stage itself that is, at the time ofrefusal and convey the same to the transferor and the transferee.

Under Section 22A of SCR Act as presently under Section 111 of the CompaniesAct, corporate managements can easily stall the takeover bids. The assumed contraventionof some or the other law, viz., MRTP, Industrial licensing, FERA, Benami law to mentionsome, would come handy to counter the takeover bid.

In terms of this provision, the Board of Directors gets two months 9peridos reckonedfrom the day the instrument of transfer along with the share certificates is lodged with thecompany) within which to form an opinion and in case it proposes to refuse registration, tomake a reference to the CLB and forward the copies of such reference to that transferorand transferee. Thus Section 22A, as at present promotes the interest of the company asalso of the transferor and transferee.

8. SWEAT EQUITY AND EMPLOYEE STOCK OPTION PLAN (ESOP)

The phrase ‘sweat equity’ refers to equity shares given to the company’s employeeson favourable terms, in recognition of their work. Sweat equity usually takes the form ofgiving options to employees to buy shares of the company, so they become part ownersand participate in the profits, apart from earning salary.

The Companies Act defines ‘sweat equity shares’ as equity shares issued by thecompany to employees or directors at a discount or for consideration other than cash forproviding know-how or making available rights in the nature of intellectual property rightsor value additions, by whatever name called.

ESOP or employee stock option plan, or employee share ownership plan, is howsweat equity may often operate. ESOS is another abbreviation, to mean Employees StockOption Scheme, and there can be ESPS, or Employee Stock Purchase Plan. There is asimple description of ESOP as per Income Tax Act as “the generic term for a basket ofinstruments and incentive schemes that find favour with the new upward mobile salaryclass and which are used to motivate, reward, remunerate and hold on to achievers.”

ESOP can take place in many ways. The company may directly allot its shares toemployees at market price, or at a concession. Or, the company may give its employeesthe option to acquire the shares or debentures at an agreed price that may be attractive;but the option may be permitted to be exercised after a waiting period or ‘vesting period’,after which would comes the ‘exercise period’ during when the employee can exercise his



option, and that may be followed by a ‘lock-in period’ when the employee cannot sell theshares. A third type of ESOP is to give ‘stock appreciation rights’; shares are only notionallyallotted and at the end of an agreed period, an employee is paid difference in price. Yetanother type is offer ‘staggered options’ that the employee can exercise over a period.

The aim of ESOP or sweat equity is simple: retain your best employees by offering agood enough carrot. So, there is no limit to how discounted the share can be for employees.However, Section 79A of the Companies Act lays down conditions for the issue of sweatequity shares. Accordingly, a company may issue sweat equity shares of a class of sharesalready issued after passing a special resolution in the general meeting, specifying the numberof shares, current market price, consideration, if any, and the class or classes of directorsor employees to whom such equity shares are to be issued.

Also, it is necessary that not less than one year has, at the date of the issue, elapsedsince the date on which the company was entitled to commence business. For listedcompanies, there are regulations made by the Securities and Exchange Board of Indiasuch as prescribing the price of sweat equity shares not to be less than the higher of thefollowing: the average of the weekly high and low of the closing prices of the related equityshares during last six months preceding the relevant date; or the average of the weekly highand low of the closing prices of the related equity shares during the two weeks precedingthe relevant date.

SEBI also prescribes the accounting treatment for sweat equity. Thus, sweat equity isexpensed, unless it issued in consideration of a depreciable asset, in which case it is carriedto the balance sheet. The Institute of Chartered Accountants of India has recently finaliseda Guidance Note on “Accounting for Employee Share-Based Payments” intended to bemore elaborate than what the SEBI prescribes

ESOP is no unmixed blessing. If the company tanks, as did Enron, employees mayend up burdened with worthless paper in the form of sweat equity that’s no longer sweet.On the contrary, when the company performs too well, and so the options appreciate invalue, there can be criticism that the employees have been benefited the most

9. INVESTOR’S PROTECTION

Investors in capital market particularly small and marginal investors are alwaysbecomes the victims of wild market volatility. A perfect capital market digests the marketinformation in a perfect manner and move in to a particular direction in a logical manner.Unfortunately the Indian capital market is yet to attain a perfect market stage. The SecuritiesExchange Board of India (SEBI) is very keen in making the Indian Capital Market as anefficient market to protect the investors. SEBI is taking a lot of initiatives in educating thesmall investors and framing guidelines with an objective of protecting the interest of investors.

NOTES



10. PROTECTION AGAINST LOSS DUE TO UNFAIR TRADE PRACTICE

SEBI is taking efforts to protect investors not only against the frauds and cheating butalso against the losses arising out of unfair trade practices. The unfair trade practices. TheUnfair trade practices may be in the form of deliberate misleading statements in the offerdocument at the time of intial public offer or deliberate mis-statement of purchase or saleprice by a broker or by way of price rigging ie.. artificially changing the price of a share orin the form of insider trading. To protect investors against these unfair trade practices itbecomes pertinent to educate them about various key issues involves in prudent investment.SEBI has been framing guidelines to ensure correctness in the material informations disclosedin a) the offer document b) advertisements of initial public offer c) Price quotations oflisted Scrips d) news items and articles in financial dailies and magazines e) researchreports and f) investment advise from financial consultants and brokers.

11. INVESTOR PROTECTION FUND AND CONSUMER PROTECTION FUND (IPF / CPF)

In 1985, the Central Government had instructed the stock exchanges to establish theinvestor protection fund and consumer protection fund. In 2004, the SEBI had passedcomprehensive guidelines for establishing and managing such funds. The highlights of SEBIguidelines are ;

a) The protection funds shall be administered by a Trust. The trust should haverepresentatives from public, SEBI registered investor association and stockexchange.

b) The stock exchange should contribute for the protection funds.c) The investor can file claim against default member broker with in a month.d) No broker or associate broker shall be eligible to claim compensation.e) The stock exchange and the trust will determine the limits of claimf) The trust shall disburse the claim and shall not wait for the auction of the card of

the defaulting broker.

12. HANDLING THE GRIEVANCES OF INVESTORS

There are several kinds of grievances of investors that are to be handled by theregulatory authorities SEBI handle investors’ grievances like;

a) Delay in refund amount and the interest in case of public issueb) Interest due, in case of listed debentures andc) The investor’s grievances relating to the mutual funds. For the other kinds of

grievances the investors have to approach Department of company affairsapplication money, unclaimed deposits and interest should be credited to theInvestors Education and Protection Fund after Seven years from the date of thesebecoming due for payment. The fund shall be utilized for the protection of investor’sinterest and increasing their awareness level.



13. PROTECTION AGAINST INSIDER TRADING

Insider trading means using the unpublished information about the company for buyingand selling the shares of the company. For example a company is planning to issue bonusshares and the decision is not officially disclosed to outsiders. An inside trader could smellthis good news through his secret network with the company and buy the company’sshares at low rate. Later when the company officially announces the bonus plan thecompany’s share price will shoot up. Then the inside trader sell the shares at high price.

14. SECURITIES OMBUDSMAN

In order to make the investor protection mechanism as effective and transparent theSEBI (Ombudsman) Regulations was issued in 2003. The regulations facilitate the investorsto arrive at amicable settlement with respect to their grievances against the listed companiesor an intermediary.

The SEBI regulations describe the procedures to be followed for the appointment,qualifications, tenure, remuneration and disqualification of the Ombudsman.

15. INVESTORS’ EDUCATION

SEBI constituted a Working Group on Investors’ Education to suggest SEBI onissues relating to investors education. In 1998 SEBI Created the Investors Education andProtection Fund. The inside trading may benefit the vested interest at the cost of a largenumber of common investors. The SEBI has taken necessary steps to prevent insidertrading by checking and curbing unhealthy price manipulations. SEBI passed prohibitionof Insider Regulations in 1992.

SUMMARY

The Securities Contracts (Regulation) Act, 1956 (the SCR Act) is the basis forregulation of Securities Contracts and the Stock Exchanges in India. It was enacted in1956 and came into force on February 20, 1957. It regulates the business of trading onthe stock exchanges and option trading and provides for recognition of stock exchangesand related matters like listing of securities, transfer of securities, etc

The Preamble to the Securities Contracts (Regulation) Act, 1956 says: “An Act toprevent undesirable transactions in securities by regulating the business of dealing therein,by prohibiting options and by providing for certain other matters connected therewith.”

The Act defines what a security is. The Act also lays down what transactions insecurities are legal and what are void and illegal

NOTES



Securities are claims on money and trading in them involves passing of contracts orentering into agreements. The Indian Contracts Act regulates the contracts of generalnature but contracts in securities are governed by the special Act, namely, SecuritiesContracts (Regulation) Act. This special Act supersedes the general Act but where thereis no provision in the Special Act as in the case of Principal and agent relationship or bailerto bailee relationship, the Indian Contracts Act will apply.

SEBI also prescribes the accounting treatment for sweat equity. Thus, sweat equity isexpensed, unless it issued in consideration of a depreciable asset, in which case it is carriedto the balance sheet. The Institute of Chartered Accountants of India has recently finaliseda Guidance Note on “Accounting for Employee Share-Based Payments” intended to bemore elaborate than what the SEBI prescribes

Investors in capital market particularly small and marginal investors are always becomesthe victims of wild market volatility. A perfect capital market digests the market informationin a perfect manner and move in to a particular direction in a logical manner. Unfortunatelythe Indian capital market is yet to attain a perfect market stage. The Securities ExchangeBoard of India (SEBI) is very keen in making the Indian Capital Market as an efficientmarket to protect the investors. SEBI is taking a lot of initiatives in educating the smallinvestors and framing guidelines with an objective of protecting the interest of investors.

Key Terms

Securities Contracts (Regulation) Act, 1956Recognition of Stock ExchangesOptions in ContractsRestriction on TransferabilitySweat Equity and Employee Stock Option Plan (ESOP)Investor’s ProtectionUnfair trade practiceInvestor Protection FundConsumer Protection FundInsider TradingSecurities OmbudsmanInvestors’ Education

Questions

1. What are the objectives of the Securities Contracts (Regulation) Act, 1956?2. Explain the Scope of the Securities Contracts (Regulation) Act, 19563. What is meant by Options in Contracts?4. Explain the Sweat Equity and Employee Stock Option Plan (ESOP)5. Discuss the measures taken with respect to Investor’s Protection

NOTES



UNIT - II

CAPITAL MARKETS

CHAPTER - I

OVERVIEW AND INSTITUTIONAL STRUCTUREOF CAPITAL MARKET

Learning Objective

After going through this chapter you would be able to understand the; the history ofIndian capital market, the growth of Indian stock exchanges, Over the counter exchangeof India, functions of Stock Exchange, Institutional Structure of Stock Market, Membership,capital market reforms and state of capital market

1. INTRODUCTION

The significant developments in economic conditions have created the interest ofdomestic as well as foreign investors in the Indian Capital Market. Capital market is amarket where corporate mobilise long term capital. In capital market the investors buyand sell both equity debt and derivative instruments. The consistent economic reforms,de-licensing, rupee convertibility, privatization, encouragement given to foreign directinvestment and foreign indirect investment, increasing number of mutual funds, introductionof derivative instruments have resulted in making the Indian capital market as an emergingand promising capital market.

2. OVERVIEW OF CAPITAL MARKET

The capital market or stock market is an organized market place where securitiesare bought and sold. The Securities includes equity and debt instruments issued by theGovernment, Semi – Government bodies, public sector undertakings and private sectorcompanies. As per the Securities Contract Regulation Act 1956, Securities trading isregulated and the same is permitted only through stock exchanges. At present there are 23recognised Stock Exchanges in India. Of these major stock exchanges are Mumbai StockExchange, National Stock Exchange, Calcutta Stock Exchange, Delhi Stock Exchange,Chennai Stock Exchange, Hyderabad Stock Exchange. However, at present the MumbaiStock Exchange and National Stock Exchange are very active.



2.1 THE HISTORY OF INDIAN CAPITAL MARKET

Indian stock markets are one of the oldest in Asia. Its history dates back to nearly200 years ago. The earliest records of security dealings in India are meager and obscure.The East India Company was the dominant institution in those days and business in its loansecurities used to be transacted towards the close of the eighteenth century.

By 1830’s business on corporate stocks and shares in Bank and Cotton pressestook place in Bombay. Though the trading list was broader in 1839, there were only half adozen brokers recognized by banks and merchants during 1840 and 1850.

The 1850’s witnessed a rapid development of commercial enterprise and brokeragebusiness attracted many men into the field and by 1860 the number of brokers increasedinto 60.

In 1860-61 the American Civil War broke out and cotton supply from United Statesof Europe was stopped; thus, the ‘Share Mania’ in India begun. The number of brokersincreased to about 200 to 250. However, at the end of the American Civil War, in 1865,a disastrous slump began (for example, Bank of Bombay Share which had touched Rs2850 could only be sold at Rs. 87).

At the end of the American Civil War, the brokers who thrived out of Civil War in1874, found a place in a street (now appropriately called as Dalal Street) where theywould conveniently assemble and transact business. In 1887, they formally established inBombay, the “Native Share and Stock Brokers’ Association” (which is alternatively knownas “The Stock Exchange “). In 1895, the Stock Exchange acquired a premise in the samestreet and it was inaugurated in 1899. Thus, the Stock Exchange at Bombay wasconsolidated.

Ahmedabad gained importance next to Bombay with respect to cotton textile industry.After 1880, many mills originated from Ahmedabad and rapidly forged ahead. As newmills were floated, the need for a Stock Exchange at Ahmedabad was realised and in 1894the brokers formed “The Ahmedabad Share and Stock Brokers’ Association”.

What the cotton textile industry was to Bombay and Ahmedabad, the jute industrywas to Calcutta. Also tea and coal industries were the other major industrial groups inCalcutta. After the Share Mania in 1861-65, in the 1870’s there was a sharp boom in juteshares, which was followed by a boom in tea shares in the 1880’s and 1890’s; and a coalboom between 1904 and 1908. On June 1908, some leading brokers formed “The CalcuttaStock Exchange Association”.

In the beginning of the twentieth century, the industrial revolution was on the way inIndia with the Swadeshi Movement; and with the inauguration of the Tata Iron and SteelCompany Limited in 1907, an important stage in industrial advancement under Indianenterprise was reached.

NOTES



Indian cotton and jute textiles, steel, sugar, paper and flour mills and all companiesgenerally enjoyed phenomenal prosperity, due to the First World War.

In 1920, the then demure city of Madras had the maiden thrill of a stock exchangefunctioning in its midst, under the name and style of “The Madras Stock Exchange” with100 members. However, when boom faded, the number of members stood reduced from100 to 3, by 1923, and so it went out of existence.

In 1935, the stock market activity improved, especially in South India where therewas a rapid increase in the number of textile mills and many plantation companies werefloated. In 1937, a stock exchange was once again organized in Madras - Madras StockExchange Association (Pvt) Limited (In 1957 the name was changed to Madras StockExchange Limited).

Lahore Stock Exchange was formed in 1934 and it had a brief life. It was mergedwith the Punjab Stock Exchange Limited, which was incorporated in 1936.

2.2 THE GROWTH OF INDIAN STOCK EXCHANGES

The Second World War broke out in 1939. It gave a sharp boom which was followedby a slump. But, in 1943, the situation changed radically, when India was fully mobilized asa supply base.

On account of the restrictive controls on cotton, bullion, seeds and other commodities,those dealing in them found in the stock market as the only outlet for their activities. Theywere anxious to join the trade and their number was swelled by numerous others. Manynew associations were constituted for the purpose and Stock Exchanges in all parts of thecountry were floated.

The Uttar Pradesh Stock Exchange Limited (1940), Nagpur Stock Exchange Limited(1940) and Hyderabad Stock Exchange Limited (1944) were incorporated.

In Delhi two stock exchanges - Delhi Stock and Share Brokers’ Association Limitedand the Delhi Stocks and Shares Exchange Limited - were floated and later in June 1947,amalgamated into the Delhi Stock Exchange Association Limited.

2.3 POST-INDEPENDENCE SCENARIO

Most of the exchanges suffered almost a total eclipse during depression. LahoreExchange was closed during partition of the country and later migrated to Delhi and mergedwith Delhi Stock Exchange. Bangalore Stock Exchange Limited was registered in 1957and recognized in 1963.

Most of the other exchanges languished till 1957 when they applied to the CentralGovernment for recognition under the Securities Contracts (Regulation) Act, 1956. OnlyBombay, Calcutta, Madras, Ahmedabad, Delhi, Hyderabad and Indore, the well established



exchanges, were recognized under the Act. Some of the members of the other Associationswere required to be admitted by the recognized stock exchanges on a concessional basis,but acting on the principle of unitary control, all these pseudo stock exchanges were refusedrecognition by the Government of India and they thereupon ceased to function.

Thus, during early sixties there were eight recognized stock exchanges in India(mentioned above). The number virtually remained unchanged, for nearly two decades.During eighties, however, many stock exchanges were established: Cochin Stock Exchange(1980), Uttar Pradesh Stock Exchange Association Limited (at Kanpur, 1982), and PuneStock Exchange Limited (1982), Ludhiana Stock Exchange Association Limited (1983),Gauhati Stock Exchange Limited (1984), Kanara Stock Exchange Limited (at Mangalore,1985), Magadh Stock Exchange Association (at Patna, 1986), Jaipur Stock ExchangeLimited (1989), Bhubaneswar Stock Exchange Association Limited (1989), SaurashtraKutch Stock Exchange Limited (at Rajkot, 1989), Vadodara Stock Exchange Limited (atBaroda, 1990) and recently established exchanges - Coimbatore and Meerut. Thus, atpresent, there are totally twenty one recognized stock exchanges in India excluding theOver The Counter Exchange of India Limited (OTCEI) and the National Stock Exchangeof India Limited (NSEIL).

2.4 OVER THE COUNTER EXCHANGE OF INDIA (OTCEI)

The traditional trading mechanism prevailed in the Indian stock markets gave way tomany functional inefficiencies, such as, absence of liquidity, lack of transparency, undulylong settlement periods and benami transactions, which affected the small investors to agreat extent. To provide improved services to investors, the country’s first ringless, scripless,electronic stock exchange - OTCEI - was created in 1992 by country’s premier financialinstitutions - Unit Trust of India, Industrial Credit and Investment Corporation of India,Industrial Development Bank of India, SBI Capital Markets, Industrial Finance Corporationof India, General Insurance Corporation and its subsidiaries and CanBank FinancialServices.

Trading at OTCEI is done over the centres spread across the country. Securitiestraded on the OTCEI are classified into:

• Listed Securities - The shares and debentures of the companies listed on the OTCcan be bought or sold at any OTC counter all over the country and they should notbe listed anywhere else

• Permitted Securities - Certain shares and debentures listed on other exchangesand units of mutual funds are allowed to be traded

• Initiated debentures - Any equity holding at least one lakh debentures of particularscrip can offer them for trading on the OTC.

NOTES



OTC has a unique feature of trading compared to other traditional exchanges. Thatis, certificates of listed securities and initiated debentures are not traded at OTC. Theoriginal certificate will be safely with the custodian. But, a counter receipt is generated outat the counter which substitutes the share certificate and is used for all transactions.

In the case of permitted securities, the system is similar to a traditional stock exchange.The difference is that the delivery and payment procedure will be completed within 14days.

Compared to the traditional Exchanges, OTC Exchange network has the followingadvantages:

• OTCEI has widely dispersed trading mechanism across the country which providesgreater liquidity and lesser risk of intermediary charges.

• Greater transparency and accuracy of prices is obtained due to the screen-basedscripless trading.

• Since the exact price of the transaction is shown on the computer screen, theinvestor gets to know the exact price at which s/he is trading.

• Faster settlement and transfer process compared to other exchanges.

• In the case of an OTC issue (new issue), the allotment procedure is completed ina month and trading commences after a month of the issue closure, whereas ittakes a longer period for the same with respect to other exchanges.

Thus, with the superior trading mechanism coupled with information transparencyinvestors are gradually becoming aware of the manifold advantages of the OTCEI.

2.5 FUNCTIONS OF STOCK EXCHANGE

The Stock Exchange is an association of member brokers for the purpose of facilitatingand regulating the trading in Securities. The Stock Exchange through their members offersfacility for buying and selling securities which are listed. Following are the key functions ofStock Exchange;

a) By providing a market place and by providing quotation for securities the stockexchange facilitates buying and selling the securities of listed corporate.

b) The trading facility offered by stock exchange creates liquidity for the instruments.The liquidity (marketability) created for the securities benefits both the issuingcompany as well as the investors.

c) Through it’s rules, regulations and by-laws the stock exchange regulates the tradingactivities and it ensures investors protection. The investors are able to get a fairdeal.



d) The securities listed in Stock Exchange are bought and sold by investors. Thedemand and supply forces determine the price of the securities. Thus the StockExchange facilitates price fixation.

e) By issuing shares and securities and listing the same in Stock Exchanges thecorporate are able to mobilize long-term capital. The liquidity created and theregulated trading increases the investor’s confidence. Thus the Stock Exchangesfacilitate capital formation. The scattered savings of vast majority of investors aretransferred to the needy corporate.

f) The various publications and website of Stock Exchanges provides valuable, materialand updated information about listed corporate. The information enables theinvestors to take right investment decisions.

g) There is high demand for the shares of companies which are reporting good results,transparent and offering good returns to shareholders. Thus the increased demandfor the share increases the price and the market value of the firm. Therefore thestock market quotations are acting as the real performance inducer.

h) The stock exchange keenly monitors the integrity of brokers and listed companies.It takes constant efforts in educating and safeguarding the investors against unfairtrade practices.

3. INSTITUTIONAL STRUCTURE OF STOCK MARKET

3.1 ORGANISATIONAL STRUCTURE

There are 23 Stock Exchanges in India and most of the Stock Exchanges areincorporated as “Association of persons” Under Section 25 of companies Act 1956. Theseare organized as mutual and are considered beneficial in terms of tax benefits and mattersof compliances. The trading members, who provide broking service also own, controland manage stock exchanges. They elect their representatives to regulate the functioningof the exchange including their own activities.

3.2 MEMBERSHIP

The trading platform of a stock exchange is accessible only to brokers. The brokerenters into trades in exchanges either on his own account or on behalf of clients. Theclients may place their orders with them directly or through a sub-broker indirectly. Abroker is admitted to membership of an exchange in terms of the provisions of the SecurityContracts (Regulation ) Act, 1956 (SCRA), the Securities and Exchange Board of India(SEBI) Act 1992, the rules, circulars, notifications, guidelines,etc. prescribed there underand the byelaws, rules and regulations of the concerned exchange. No stock broker orsub broker is allowed to buy, sell or deal in securities, unless he or she holds a certificate ofregistration granted by SEBI. A broker/ sub- broker complies with the code of conductprescribed by SEBI. The stock exchanges are free to stipulate stricter requirements for itsmembers than / those stipulated by SEBI. The minimum standards stipulated by NSE formembership are in excess of the minimum norms laid down by SEBI. The standards for

NOTES



admission of members lay down by NSE stress on factors, such as corporate structure,capital adequacy, track record, education, experience, etc. and reflect a conscious endeavourto ensure quality broking services.

3.3 CAPITAL MARKET REFORMS

The Indian regulatory and supervisory framework of securities market has beenadequately strengthened through the legislative and administrative measures in the recentpast. The regulatory framework for securities market is consistent with the best internationalbenchmarks, such as, standards prescribed by International Organisation of SecuritiesCommissions (IOSCO).

• Extensive Capital Market Reforms were undertaken during the 1990sencompassing legislative regulatory and institutional reforms. Statutory marketregulator, which was created in 1992, was suitably empowered to regulate thecollective investment schemes through an amendment in 1999. Further, theorganization strengthening of SEBI and suitable empowerment through complianceand enforcement powers including search and seizure powers were given throughan amendment in SEBI Act in 2002. Although dematerialisation started in 1997after the legal foundations for electronic book keeping were provided anddepositories created the regulator mandated gradually that trading in most of thestocks take place only in dematerialised form.

• Till 2001 India was the only sophisticated market having account period settlementalongside the derivatives products. From middle of 2001 uniform rolling settlementand same settlement cycles were prescribed creating a true spot market.

• After the legal framework for derivatives trading was provided by the amendmentof SCRA in 1999 derivatives trading started in a gradual manner with stock indexfutures in June 2000. Later on options and single stock futures were introduced in2000-2001 and now India ’s derivatives market turnover is more than the cashmarket and India is one of the largest single stock futures markets in the world.

• India’s risk management systems have always been very modern and effective.The VaR based margin system was introduced in mid 2001 and the risk managementsystems have withstood huge volatility experienced in May 2003 and May 2004.This included real time exposure monitoring, disablement of broker terminals, VaRbased margining.

• India is one of the few countries to have started the screen based trading ofgovernment securities in January 2003.

• In June 2003 the interest rate futures contracts on the screen based trading platformwere introduced.



• India is one of the few countries to have started the Straight Through Processing(STP), which will completely automate the process of order flow and clearing andsettlement on the stock exchanges.

• RBI has introduced the Real Time Gross Settlement System (RTGS) in 2004 onexperimental basis. RTGS will allow real delivery v/s. payment which is theinternational norm recognized by BIS and IOSCO.

• To improve the governance mechanism of stock exchanges by mandatingdemutualisation and corporatisation of stock exchanges and to protect the interestof investors in securities market the Securities Laws (Amendment) Ordinancewas promulgated on 12th October 2004. The Ordinance has since been replacedby a Bill.

3.4 STATE OF CAPITAL MARKET

The Capital Market development is measured in terms of market capitalization andTurnover. There has been steady progress in market capitalization and turnover in Indiancapital market. The number of stock exchanges increased from 11 in 1990 to 23 in 2006.All the Stock Exchanges are fully computerized and offer 100% on line trading. Around9000 companies are listed in various Stock Exchanges and available for trading. Thereare around 10,000 registered stock brokers across the country. The turn over ratio,which reflects the volume of trading in relation to the size of the market, has been increasingby leaps and bounds after the advent of screen based trading system by National StockExchange (NSE)). The relative importance of various stock exchanges in the market hasundergone dramatic change during this decade. The increase in turnover took place mostlyat the large stock exchanges at the cost of small Stock Exchanges. NSE is the marketleader with over 60% of the total turnover. Top 6 Stock Exchanges accounted for 99% ofturnover, while the rest of 17 Stock Exchanges for less than 1% during 2000-01.

Summary

The significant developments in economic conditions have created the interest ofdomestic as well as foreign investors in the Indian Capital Market. Capital market is amarket where corporate mobilise long term capital. In capital market the investors buyand sell both equity debt and derivative instruments

The capital market or stock market is an organized market place where securities arebought and sold. The Securities includes equity and debt instruments issued by theGovernment, Semi – Government bodies, public sector undertakings and private sectorcompanies. As per the Securities Contract Regulation Act 1956, Securities trading isregulated and the same is permitted only through stock exchanges. At present there are 23recognised Stock Exchanges in India

NOTES



Indian stock markets are one of the oldest in Asia. Its history dates back to nearly200 years ago. The earliest records of security dealings in India are meager and obscure.The East India Company was the dominant institution in those days and business in its loansecurities used to be transacted towards the close of the eighteenth century.

To provide improved services to investors, the country’s first ringless, scripless,electronic stock exchange - OTCEI - was created in 1992 by country’s premier financialinstitutions

The Stock Exchange is an association of member brokers for the purpose of facilitatingand regulating the trading in Securities. The Stock Exchange through their members offersfacility for buying and selling securities which are listed

There are 23 Stock Exchanges in India and most of the Stock Exchanges areincorporated as “Association of persons” Under Section 25 of companies Act 1956. Theseare organized as mutual and are considered beneficial in terms of tax benefits and mattersof compliances. The trading members, who provide broking service also own, controland manage stock exchanges. They elect their representatives to regulate the functioningof the exchange including their own activities

The Capital Market development is measured in terms of market capitalization andTurnover. There has been steady progress in market capitalization and turnover in Indiancapital market. The number of stock exchanges increased from 11 in 1990 to 23 in 2006.All the Stock Exchanges are fully computerized and offer 100% on line trading. Around9000 companies are listed in various Stock Exchanges and available for trading. Thereare around 10,000 registered stock brokers across the country

Key Terms

Capital MarketOver The Counter Exchange of IndiaInstitutional Structure of Stock MarketMembershipCapital Market Reforms

Questions

1. Explain the history and growth of Indian Capital Market2. What do you mean by Over The Counter Exchange of India3. Discuss the functions of Stock Exchange4. Explain the Institutional Structure of Stock Market5. Discuss the current state of the Indian capital market and the reforms



CHAPTER - II

NEW ISSUE MARKET

Learning objectives

After going through this chapter you would be able to understand the new issue marketand participants, floatation of the issue and problems of new issue market measures to betaken.

1. OVERVIEW

When Shares and Securities are issued for the first time it is issued through new issuemarket. The issuing company may be new one or an existing one. Government and Semi-Government bodies, Mutual Funds and Financial Institutions and Private Sector corporatecan issue shares and securities in new issue market to mobilize funds. The new issue marketcannot function without the secondary market. The securities issued in the primary securityare provided liquidity by listing the issued security in the secondary market. The companywhich is issuing security should get the security listed in the stock exchange by fulfilling thelisting requirements of the stock exchange. The condition of the primary market dependson the secondary market and vice versa.

2. NEW ISSUE MARKET PARTICIPANTS

Earlier the public issue of shares and securities was managed by the issuing companyitself. However, at present issuing securities involves a lot of procedures, severe competitionand the market becomes highly complex. These require the involvement of merchantbankers so that the issue becomes a successful. Following intermediaries are involved inthe new issue market.

a) Managers to the issue

Lead Managers are to be appointed by the company which is issuing shares andsecurities in the primary market. The Lead managers helps the issuing company in; (i)Preparation of the issue prospectus (ii) Estimating the shares issue expenses (iii) Identifyingthe right timing for the public issue (iv) Marketing the public issue successfully (v) Advisingthe company in appointing other merchant bankers like Registrar to the issue, Underwriters,Brokers, Bankers, Advertisement Agencies etc., (vi) Directing the various merchant bankersin making the public issue as successful.

NOTES



b) Registrar

The Registrar to the issue is appointed by the issuing company. The role played bythe Registrar is very important. The Registrar receives the share application forms fromvarious collection centers and they help the issuing company in finalizing the shares allotmentafter consulting the concerned Stock Exchange. They make arrangement to deliver sharescertificate to the allotees and make necessary arrangements with Depositories to credit theshares in the allotees demat account.

c) Underwriters to the Issues

To ensure the minimum subscription of the public issue the issuing company has toappoint the Underwriters. The Underwriters give a guarantee to the issuing company tosubscribe to the issue if the public issue is not fully subscribed. The financial institution,banks, brokers, and Investment companies can act as Underwriters. The Underwritersgets commission for the underwriting agreement from the issuing company.

d) Bankers

The company which is coming out with public issue has to appoint the bankers to theissue to collect the filled up application from the investor with money. The number ofbankers to be appointed for a public issue depends on the size of issue.

e) Advertisement Agencies

The Advertisement agencies help the issuing company to make the public issue as asuccessful one. They design the advertisement as per the guidelines of SEBI and releasethe advertisements in the appropriate medias to create interest among the investors aboutthe public issue.

3. FLOATATION OF THE ISSUE

The company which is issuing the share securities can float the issue by following anyone of the methods which are described below;

a) Offer Through Prospectus

The issuing company should prepare the prospectus and the same should be issuedto all the investor’s, so that they get complete information about the issuing company andthe project, which will be useful for taking investment decisions. Before finalizing theprospectus and send it to the concerned stock exchange for approval. The prospectusshould contain complete information about the back ground of the company promotersand project, the risk factors of the project, track record of the company and issue details.The prospectus should enable the investors in taking right investment decisions. Theapplication form should contain the abstract of the prospectus. If any investors require thecomplete version of the prospectus it should be provided by the issuing company.



b) Offer for sale (or) Bought out deals

Bought out deals is another mode of issuing shares and securities. Under this methodthe issuing company off load the shares to an investment banker who is known as Boughtout dealers or sponsors. Later the investment banker sells the shares to the public. Theissuing company can allot either to a single investment company or a syndicate of InvestmentCompany. The investment company offloads the shares to the public after certain periodat a premium.

The Bought out deals advantageous to the issuing company since the issue expensesand the time taken for the issues are very less.

c) Private Placement

Under Private Placement method of issue of shares and securities the issuing companiesallot the shares to a small number of financial institutions, companies and big individualinvestor’s. They sell the shares to the public investors at a premium after sometime. ThePrivate Placements saves the cost of issue and the time taken for the issue. Above all theterms and conditions of the issue can be customized since the allotment is made to fewcompanies such as Financial Institution, Banks, Mutual Funds, and Big Individual Investorsetc.,

d) Rights Issue

Whenever company comes out with additional public issue the existing share holdershould be given preference at the time of allotment of shares and this is called Right Issue.It’s up to the share holders to subscribe the rights offer or renounce the rights offer to athird person for second price.

e) Book Building Process

The Book Building Process is a method by which the companies are issuing sharesand securities. Under this method the issue price is finalized through public bidding. Theissuing company invites the public and institutional investors to subscribe the new issuethrough a tendering process. The investors have to play their bids for any number ofshares at a price which is decided by them. The price decided by the investor’s should bein between the lower banned price and the upper banned price fixed by the issuing company.The allotment price will be finalized by the issuing company in consultation with the concernedstock exchange.

Book building is a process by which corporate determine the demand for a proposedissue of securities and build into it the offer document with the object of assessing the price.According to the SEBI guidelines, Book building can be by way of either the 75 percentbuilding or the 100 percent book-building.

NOTES



4. PROBLEMS OF NEW ISSUE MARKET

The New Issue Market has been facing ups and downs from March 1995 mainly dueto unearth of stock scam and subsequent secondary market crashes. For e.g. the numberof primary issues where 813 in 1996-97. But drastically came down to mere 62 issues innext year (1997-98). The initial public issues offered by EMMAR MGF and WackardHospitals during January 2008 were under subscribed and subsequently cancelled by thecompanies

The reasons for poor performance of new issue markets are many and some of themare explained below;

a) Very high premium

The issuing companies are given full freedom to fix premium, and they fix very highpremium particularly when market is in uptrend. By the time the share is listed and if themarket faces a down trend the listing price of a issue is less than the offer price. Thiserodes the investor’s value of investment and subsequently affects investors confident overnew issue market.

b) Low liquidity

When the issuing companies performance is below the expectation of the market theliquidity of the scrip is very low. This ill-liquidity is the main cause of the poor performanceof new issue market

c) Poor returns to the Investor

Delay in completing the project, under estimate of the cost of the project leads topoor cash flows of the issuing company. These results in poor returns to the share holders.

5. MEASURES TO BE TAKEN FOR IMPROVING THE CONDITION OF NEW ISSUE MARKET

a) Creating investors awareness

The stock exchanges and SEBI should take necessary steps to educate the awarenesslevel of investors in selecting the best initial public offer. They should be educated tounderstand the various vital information mentioned in the prospectus of the new issues.

b) Fixing fair price

The issuing companies should fix a reasonable premium for their public issues comingout with public issues at abnormal premium when market is at peak just to exploit theinvestor’s sentiment should be avoided. The issuing company should really justify thepremium



Summary

When Shares and Securities are issued for the first time it is issued through new issuemarket. The issuing company may be new one or an existing one. Government and Semi-Government bodies, Mutual Funds and Financial Institutions and Private Sector corporatecan issue shares and securities in new issue market to mobilize funds. The new issue marketcannot function without the secondary market.

Earlier the public issue of shares and securities was managed by the issuing companyitself. However, at present issuing securities involves a lot of procedures, severe competitionand the market becomes highly complex. These require the involvement of merchantbankers so that the issue becomes a successful. Following intermediaries are involved inthe new issue market.

The New Issue Market has been facing ups and downs from March 1995 mainly dueto unearth of stock scam and subsequent secondary market crashes. For e.g. the numberof primary issues where 813 in 1996-97. But drastically came down to mere 62 issues innext year (1997-98). The initial public issues offered by EMMAR MGF and WackardHospitals during January 2008 were under subscribed and subsequently cancelled by thecompanies

The stock exchanges and SEBI should take necessary steps to educate the awarenesslevel of investors in selecting the best initial public offer. They should be educated tounderstand the various vital information mentioned in the prospectus of the new issues.

The issuing companies should fix a reasonable premium for their public issues comingout with public issues at abnormal premium when market is at peak just to exploit theinvestor’s sentiment should be avoided. The issuing company should really justify thepremium.

Key Terms

New Issue Market ParticipantsFloatation of the IssueOffer Through ProspectusOffer for sale (or) Bought out dealsPrivate PlacementRights IssueBook Building Process

Questions

• Who are the new issue market participants? Explain their roles.• Explain the different methods of Floatation of the Issue• What are the problems of new issue market? Explain the measures to be taken.• What is meant by Offer Through Prospectus• Define Bought out deals• Explain the Book Building Process

NOTES



CHAPTER – III

NATIONAL STOCK EXCHANGE

Learning objectives

After going through this chapter you would be able to understand the Ownership andManagement, Market Segments and Products, Membership Administration andTransaction Charges National Stock Exchange

1. OVERVIEW

NSE was incorporated in 1992 and was given recognition as a stock exchange inApril 1993. It started operations in June 1994, with trading on the Wholesale Debt MarketSegment. Subsequently it launched the Capital Market Segment in November 1994 as atrading platform for equities and the Futures and Options Segment in June 2000 for variousderivative instruments.

NSE has been able to take the stock market to the doorsteps of the investors. Thetechnology has been harnessed to deliver the services to the investors across the countryat the cheapest possible cost. It provides nation-wide screen-based automated tradingsystem with a high degree of transparency and equal access to investors irrespective ofgeographical location. The high level of information dissemination through on-line systemhas helped in integrating retail investors on a nation-wide basis. The standards set by theexchange in terms of market practices, products, technology and service standards havebecome industry benchmarks and are being replicated by other market participants.

Within a very short span of time, NSE has been able to achieve all the objectives forwhich it was set up. It has been playing a leading role as a change agent in transforming theIndian Capital Markets to its present form.

For over a decade it has been playing the role of a catalytic agent in reforming themarkets in terms of market microstructure and in evolving the best market practices keepingin mind the stake holders. The Exchange is set up on a demutualised model wherein theownership, management and trading rights are in the hands of three different sets of people.This has completely eliminated any conflict of interest. This has helped NSE to aggressivelypursue policies and practices within a public interest framework. NSE’s nationwide,automated trading system has helped in shifting the trading platform from the trading hall inthe premises of the exchange to the computer terminals at the premises of the tradingmembers located at different geographical locations in the country and subsequently to thepersonal computers in the homes of investors and even to hand held portable devices for



the mobile investors It has been encouraging corporatisation of membership in securitiesmarket. It has also proved to be instrumental in ushering in scrip-less trading and providingsettlement guarantee for all trades executed on the Exchange. Settlement risks have alsobeen eliminated with NSE’s innovative endeavors in the area of clearing and settlementviz., establishment of the clearing corporation (NSCCL), setting up a settlement guaranteefund (SGF), reduction of settlement cycle, implementing on-line, real-time risk managementsystems, dematerialisation and electronic transfer of securities to name few of them. Inorder to take care of investor’s interest, it has also created an investor protection fundthat would help investors who have incurred financial damages due to default of brokers.

2. OWNERSHIP AND MANAGEMENT

The NSE is owned by a set of leading financial institutions, banks, insurance companiesand other financial intermediaries. It is managed by professionals, who do not directly orindirectly trade on the Exchange. The trading rights are with trading members who offertheir services to the investors. The Board of NSE comprises of senior executives frompromoter institutions and eminent professionals, without having any representation fromtrading members.

While the Board deals with the broad policy issues, the Executive Committees (ECs),which include trading members, formed under the Articles of Association and the Rules ofNSE for different market segments, set out rules and parameters to manage the day-to-day affairs of the Exchange. The ECs have constituted several committees, like Committeeon Trade Related Issues (COTI), Committee on Settlement Issues (COSI) etc., comprisingmostly of trading members, to receive inputs from the market participants and implementsuggestions which are in the best interest of the investors and the market. The day-to-daymanagement of the Exchange is delegated to the Managing Director and CEO who issupported by a team of professional staff. Therefore, though the role of trading membersat NSE is to the extent of providing only trading services to the investors, the Exchangeinvolves trading members in the process of consultation and participation in vital inputstowards decision making.

3. MARKET SEGMENTS AND PRODUCTS

NSE provides a trading platform for of all types of securities for investors under oneroof - Equity, Corporate Debt, Central and State Government Securities, T-Bills,Commercial Paper (CPs), Certificate of Deposits (CDs), Warrants, Mutual Funds (MFs)units, Exchange Traded Funds (ETFs), Derivatives like Index Futures, Index Options,Stock Futures, Stock Options. The Exchange provides trading in 3 different segments viz.,Wholesale Debt Market (WDM) segment, Capital Market (CM) segment and the Futures& Options (F&O) segment

NOTES



The Wholesale Debt Market segment provides the trading platform for trading of awide range of debt securities which includes State and Central Government securities, T-Bills, PSU Bonds, Corporate debentures, CPs, CDs etc. However, along with these financialinstruments, NSE has also launched various products e.g. FIMMDA-NSE MIBID/MIBOR owing to the market need. A reference rate is said to be an accurate measure ofthe market price. In the fixed income market, it is the interest rate that the market respectsand closely matches. In response to this, NSE started computing and disseminating theNSE Mumbai Inter-bank Bid Rate (MIBID) and NSE Mumbai Inter-Bank Offer Rate(MIBOR). Owing to the robust methodology of computation of these rates and its extensiveuse, this product has become very popular among the market participants. Keeping inmind the requirements of the banking industry, FIs, MFs, insurance companies, who havesubstantial investments in sovereign papers, NSE also started the dissemination of its yetanother product, the ‘Zero Coupon Yield Curve’. This helps in valuation of sovereignsecurities across all maturities irrespective of its liquidity in the market. The increasedactivity in the government securities market in India and simultaneous emergence of MFs(Gilt MFs) had given rise to the need for a well defined bond index to measure the returnsin the bond market. NSE constructed such an index, the ‘NSE Government SecuritiesIndex’. This index provides a benchmark for portfolio management by various investmentmanagers and gilt funds.

The Capital Market segment offers a fully automated screen based trading system,known as the National Exchange for Automated Trading (NEAT) system. This operateson a price/ time priority basis and enables members from across the country to trade withenormous ease and efficiency. Various types of securities e.g. equity shares, warrants,debentures etc. are traded on this system. The average daily turnover in the CM Segmentof the Exchange during 2006-07 was nearly Rs. 7,812 crs. (US $ 1,792 million).

Futures & Options segment of NSE provides trading in derivatives instruments likeIndex Futures, Index Options, Stock Options, Stock Futures and Futures on interest rates.Though only seven years into its operations, the futures and options segment of NSE hasmade a mark for itself globally. In the Futures and Options segment, trading in S&P CNXNifty Index, CNX IT index, Bank Nifty Index, CNX Nifty Junior, CNX 100 index and188 single stocks are available. The average daily turnover in the F&O Segment of theExchange during

4. MEMBERSHIP ADMINISTRATION

The trading in NSE has a three tier structure-the trading platform provided by theExchange, the broking and intermediary services and the investing community. The tradingmembers have been provided exclusive rights to trade subject to their continuously fulfillingthe obligation under the Rules, Regulations, Byelaws, Circulars, etc. of the Exchange. Thetrading members are subject to its regulatory discipline. Any person can become a trading



member by complying with the prescribed eligibility criteria and exit by surrendering tradingmembership without any hidden/overt cost. There are no entry/exit barriers to tradingmembership.

5. ELIGIBILITY CRITERIA

The Exchange stresses on factors such as corporate structure, capital adequacy,track record, education, experience, etc. while granting trading rights to its members. Thisreflects a conscious effort by the Exchange to ensure quality broking services which enablesto build and sustain confidence in the Exchange’s operations. The standards stipulated bythe Exchange for trading membership are substantially in excess of the minimum statutoryrequirements as also in comparison to those stipulated by other exchanges in India. Theexposure and volume of transactions that can be undertaken by a trading member arelinked to liquid assets in the form of cash, bank guarantees, etc. deposited by the memberwith the Exchange as part of the membership requirements.

The trading members are admitted to the different segments of the Exchange subjectto the provisions of the Securities Contracts (Regulation) Act, 1956, the Securities andExchange Board of India Act, 1992, the rules, circulars, notifications, guidelines, etc.,issued there under and the byelaws, Rules and Regulations of the Exchange. All tradingmembers are registered with SEBI.6. TRADING MEMBERSHIP

A prospective trading member is admitted to any of the following combinations ofmarket segments:

• Wholesale Debt Market (WDM) segment,• Capital Market (CM) and the Futures and Options (F&O) segments,• CM Segment and the WDM segment, or• CM Segment, the WDM and the F&O segment.

In order to be admitted as a trading member, the individual trading member/at leasttwo partners of the applicant firm/at least two directors of the applicant corporate must begraduates and must possess at least two years’ experience in securities markets. Theapplicant for trading membership/any of its partners/shareholders/directors must not havebeen declared defaulters on any stock exchange, must not be debarred by SEBI for beingassociated with capital market as intermediaries and must not be engaged in any fund-based activity. For the F&O segment, at least two dealers should also have passed SEBI-approved certification test for derivatives. In case of corporate applicant, the minimumpaid up capital should be Rs. 30 lakh and the dominant promoter/shareholder group shouldhold at least 51% (40% in case of listed companies) of paid-up equity capital of suchcorporate entity. The net worth required for trading members on CM & F&O Segment is100 lakh, however, a net worth of Rs. 300 lakh is required for members clearing for self aswell as for other trading members.

NOTES



7. CLEARING MEMBERSHIP

The trades executed on the Exchange may be cleared and settled by a clearingmember. The trading members in the CM segment are also clearing members. In the F&Osegment, some members, who are registered with SEBI as self-clearing members, clearand settle their own trades. Certain others, registered as trading member-cum-clearingmember, clear and settle their own trades as well as trades of other trading members.Besides this, there is a special category of members, called professional clearing members(PCMs), who do not trade but only clear trades executed by others. This means that somemembers clear and settle their trades through a trading member-cum-clearing member ora PCM, not themselves. The members clearing their own trades or trades of others, andthe PCMs are required to bring in additional security deposits in respect of every tradingmember whose trades they undertake to clear and settle.

8. GROWTH AND DISTRIBUTION OF MEMBERS

As at end March 2007, the Exchange had 1,009 members. A large majority (91.48%) of them were corporate members, and the remaining, individuals and firms. There were1,002, 63 and 845 members in the CM, WDM and F&O segments respectively.

9. DISTRIBUTION OF TRADING MEMBERS (AS ON MARCH 30, 2007)

A total of 12,743 (1,186 corporates, 862 partnership firms and 10,695 individuals)sub-brokers were affiliated to 502 trading members of the Exchange on March 30, 2007.

10. TRANSACTION CHARGES

In addition to annual fees, members are required to pay transaction charges on tradesundertaken by them. They pay transaction charge at the rate of Rs. 3.5 for every Rs. 1lakh of turnover in the CM segment. The transaction charges payable to the exchange bythe trading member for the trades executed by him on the F&O segment are fixed at therate of Rs. 2 per lakh of turnover (0.002%) subject to a minimum of Rs. 1, 00,000 peryear. However, for the transactions in the options sub-segment, the transaction chargeswill be levied on the premium value at the rate of 0.05% (each side) instead of on the strikeprice as levied earlier. The Exchange has waived the transaction charges for WholesaleDebt Market Segment for the period April 1, 2007 to March 31, 2008.

11. LISTING OF SECURITIES

The stocks, bonds and other securities issued by issuers require listing for providingliquidity to investors. Listing means formal admission of a security to the trading platform ofthe Exchange. It provides liquidity to investors without compromising the need of the issuerfor capital and ensures effective monitoring of conduct of the issuer and trading of thesecurities in the interest of investors. The issuer wishing to have trading privileges for itssecurities satisfies listing requirements prescribed in the relevant statutes and in the listing



regulations of the Exchange. It also agrees to pay the listing fees and comply with listingrequirements on a continuous basis. All the issuers who list their securities have to satisfythe corporate governance requirement framed by regulators.

12. BENEFITS OF LISTING ON NSE

The benefits of listing on NSE are as enumerated below:

NSE provides a trading platform that extends across the length and breadth of thecountry. Listing on NSE thus, enables issuers to reach and service investors across thecountry.

NSE being the largest stock exchange in terms of trading volumes, the securitiestrade at low impact cost and are highly liquid. This in turn reduces the cost of trading to theinvestor.

The trading system of NSE provides unparallel level of trade and post -tradeinformation. The best 5 buy and sell orders are displayed on the trading system and thetotal number of securities available for buying and selling is also displayed. This helps theinvestor to know the depth of the market. Further, corporate announcements, results,corporate actions etc are also available on the trading system, thus reducing scope forprice manipulation or misuse.

The facility of making initial public offers (IPOs), using NSE’s network and software,results in significant reduction in cost and time of issues.

NSE’s web-site www.nseindia.com provides a link to the web-sites of the companiesthat are listed on NSE, so that visitors interested in any company can visit that company’sweb-site from the NSE site. Listed companies are provided with monthly trade statisticsfor the securities of the company listed on the Exchange.

13. LISTING CRITERIA

The Exchange has laid down criteria for listing of new issues by companies, IPOs byknowledge-based issuers, companies listed on other exchanges, and companies formedby amalgamation/ restructuring, etc. in conformity with the Securities Contracts (Regulation)Rules, 1957 and directions of the Central Government and the Securities and ExchangeBoard of India (SEBI). The criteria include minimum paid-up capital and marketcapitalisation, project appraisal, company/ promoter’s track record, etc.

14. LISTING AGREEMENT

All companies seeking listing of their securities on the Exchange are required to enterinto a formal listing agreement with the Exchange. The agreement specifies all the quantitativeand qualitative requirements to be continuously complied with by the issuer for continuedlisting. The Exchange monitors such compliance. Failure to comply with the requirements

NOTES



invites suspension of trading, or withdrawal/delisting, in addition to penalty under theSecurities Contracts (Regulation) Act, 1956. The agreement is being increasingly used asa means to improve corporate governance.

15. SHAREHOLDING PATTERN

In the interest of transparency, the issuers are required to disclose shareholding patternon a quarterly basis. On an average, the promoters hold more than 54.23% of the totalshares. Though non-promoter holding is nearly 43.56 %, Individuals held only 14.41%and the institutional holdings ( FIIs,MFs, VCF’s- Indian and Foreign) accounted for20.77%.

16. COMPLIANCE BY LISTED COMPANIES

NSE has institutionalised a process of verifying compliance of various conditions ofthe listing agreement. It conducts a periodic review for compliance on account ofannouncement of book closure/record date, announcement of quarterly results, submissionof distribution schedule and annual reports, appointment of compliance officer, investorgrievances, various disclosures, etc.

17. DISCLOSURES BY LISTED COMPANIES

It is essential that all critical price sensitive/material information relating to securities ismade available to the market participants and the investors immediately to enable them totake informed decisions in respect of their investments in securities. The Exchange thereforeensures certain important timely disclosures by listed companies and disseminates them tomarket through the NEAT terminals and through its website. The disclosures includecorporate actions, quarterly/half yearly results, decisions at board meeting, compliancewith corporate governance norms, non-promoters’ holding, verification of media reportsetc.

Keeping in mind the investor community and the importance of the information aboutcompanies, NSE has also put a system in place where in all corporate announcementsincluding that of Board meetings that a company discloses to the market is handled in astraight through and hands free manner. As and when the company submits information thesame will be seamlessly broadcast to the market.

18. DE-LISTING

The securities listed on NSE can be de-listed from the Exchange as per the SEBI(Delisting of Securities) Guidelines, 2003 in the following manner:

19. VOLUNTARY DE-LISTING OF COMPANIES

Any promoter or acquirer desirous of delisting securities of the company under theprovisions of these guidelines shall obtain the prior approval of shareholders of the



company by a special resolution passed at its general meeting, make a public announcementin the manner provided in these guidelines, make an application to the delisting exchange inthe form specified by the exchange and comply with such other additional conditions asmay be specified by the concerned stock exchanges from where securities are to be de-listed. Any promoter of a company which desires to de-list from the stock exchange shallalso determine an exit price for delisting of securities in accordance with the book buildingprocess as stated in the guidelines. The stock exchanges shall provide the infrastructurefacility for display of the price at the terminal of the trading members to enable the investorsto access the price on the screen to bring transparency to the delisting process.

20. COMPULSORY DE-LISTING OF COMPANIES

The stock exchanges may de-list companies which have been suspended for a minimumperiod of six months for non-compliance with the listing agreement. The stock exchangeshave to give adequate and wide public notice through newspapers and also give a showcause notice to a company. The exchange shall provide a time period of 15 days withinwhich representation may be made to the exchange by any person who may be aggrievedby the proposed delisting. Where the securities of the company are de-listed by anexchange, the promoter of the company shall be liable to compensate the security holdersof the company by paying them the fair value of the securities held by them and acquiringtheir securities, subject to their option to remain security-holders with the company.

SUMMARY

NSE was incorporated in 1992 and was given recognition as a stock exchange inApril 1993. It started operations in June 1994, with trading on the Wholesale Debt MarketSegment. Subsequently it launched the Capital Market Segment in November 1994 as atrading platform for equities and the Futures and Options Segment in June 2000 for variousderivative instruments

The NSE is owned by a set of leading financial institutions, banks, insurance companiesand other financial intermediaries. It is managed by professionals, who do not directly orindirectly trade on the Exchange. The trading rights are with trading members who offertheir services to the investors. The Board of NSE comprises of senior executives frompromoter institutions and eminent professionals, without having any representation fromtrading members.

The trading in NSE has a three tier structure-the trading platform provided by theExchange, the broking and intermediary services and the investing community. The tradingmembers have been provided exclusive rights to trade subject to their continuously fulfillingthe obligation under the Rules, Regulations, Byelaws, Circulars, etc. of the Exchange. Thetrading members are subject to its regulatory discipline. Any person can become a tradingmember by complying with the prescribed eligibility criteria and exit by surrendering trading

NOTES



membership without any hidden/overt cost. There are no entry/exit barriers to tradingmembership

The stocks, bonds and other securities issued by issuers require listing for providingliquidity to investors. Listing means formal admission of a security to the trading platform ofthe Exchange. It provides liquidity to investors without compromising the need of the issuerfor capital and ensures effective monitoring of conduct of the issuer and trading of thesecurities in the interest of investors. The issuer wishing to have trading privileges for itssecurities satisfies listing requirements prescribed in the relevant statutes and in the listingregulations of the Exchange. It also agrees to pay the listing fees and comply with listingrequirements on a continuous basis. All the issuers who list their securities have to satisfythe corporate governance requirement framed by regulators.

Key Terms

Ownership and ManagementMarket Segments and ProductsMembership AdministrationTransaction ChargesListing of Securities

Questions

• Explain the ownership and management NSE• What are the market segments and products of NSE?• Explain the membership administration of NSE• What are the Transaction Charges in NSE?• Explain the advantages of Listing of Securities in NSE



CHAPTER – IV

SEBI REGULATION OF SECURITIES MARKET

Learning Objectives

After going through this chapter you would be able to understand the current status ofRegistration of Stock Brokers, Registration of Sub-brokers, Recognition of StockExchanges, Registration of Foreign Institutional Investors, Registration of Custodians ofSecurities, Registration of Mutual Funds, Registration of Venture Capital Funds and thesupervision and inspection of market intermediaries by SEBI.

1. OVERVIEW

The SEBI Act, 1992 was enacted to empower SEBI with statutory powers for (a)protecting the interests of investors in securities (b) promoting the development of thesecurities market, and (c) regulating the securities market. Its regulatory jurisdiction extendsover corporate in the issuance of capital and transfer of securities, in addition to allintermediaries and persons associated with securities market. It can conduct enquiries,audits and inspection of all concerned and adjudicate offences under the Act. It has powersto register and regulates all market intermediaries and to penalize them in case of violationsof the provisions of the Act, Rules and Regulations made thereunder. SEBI has full autonomyand authority to regulate and develop an orderly securities market.

2. PRIMARY SECURITIES MARKET

Market intermediaries play a very important role in development of the market byproviding a variety of services. Market intermediaries can be classified on the basis of theservices provided by them. Typically, they are classified as: merchant bankers, stockbrokers, bankers to issues, debenture trustees, portfolio managers, DPs, registrars to issues,share transfer agents, etc. These entities are regulated by SEBI.

During 2006-07, the number of intermediaries belonging to the group of merchantbankers, portfolio managers, and DPs increased over the previous year. As on March 31,2007, the number of portfolio managers was 158 as against 132 in the previous yearindicating an increase of 19.7 per cent. The number of merchant bankers increased to 152as on March 31, 2007 as against 130 in the previous year, showing an increase of 16.9 percent. The number of DPs also increased from 526 to 593, amounting to an increase of12.7 per cent.

The number of registrar to an issue and share transfer agents, debenture trustees,bankers to an issue and underwriters, declined in 2006-07 over the previous year. Thedecline was noticeable in the case of bankers to an issue and underwriters.

NOTES



3. REGISTRATION OF STOCK BROKERS

During 2006-07, 263 new stock brokers were registered with SEBI. There were155 cases of reconciliation/ cancellation/surrender of membership during 2006-07 whichwas lower than that, in the previous year. As on March 31, 2007, the total number of stockbrokers registered with SEBI was 9,443 as against 9,335 in the previous year, showing anet increase of 108.

Registered Intermediaries

The share of corporate brokers was 43.52 per cent of the total stock brokers as onMarch 31, 2007 as against 42.43 per cent in the previous year As on March 31, 2007,among the exchanges, NSE had the highest number of stock brokers (trading members) at1,077 followed by the Calcutta Stock Exchange at 960, Inter-connected Stock Exchange(ISE) at 925 and BSE at 901. At NSE, corporate brokers constituted 91.7 per cent of thetotal stock brokers. The proportion of corporate brokers at BSE and OTCEI was 80.1per cent and 76.3 per cent, respectively.

Registered Stock Brokers

Note: Data in parentheses pertains to year 2005-06.



Exchange-wise Stock Brokers Registered with SEBI

Brokers can also be categorised as: proprietary, partnership, corporate, institution,composite corporate, etc. Since, the number of broking entities registered under categoriesof institution and composite corporate was negligible during the recent years; therefore,these categories are clubbed together under corporate brokers.

In 17 out of 22 recognised stock exchanges (barring Ahmedabad, BSE, Delhi, NSE,and OTCEI), as a proportion of total number of members, the number of stock brokersunder ‘proprietorship’ was 50 percent or above. The percentage of stock brokers in‘proprietorship’ category was the highest in Gauhati Stock Exchange Ltd. at 96.2 percent, followed by 95.1 per cent in Jaipur Stock Exchange.

As on March 31, 2007, the percentage of stock brokers in ‘partnership’ categorywas at the highest in Delhi Stock Exchange Ltd. (8.56 per cent), followed by (8.29 percent) in Madras Stock Exchange Ltd. There were no stock brokers in ‘partnership’ categoryin Bhubaneswar Stock Exchange Ltd. and Coimbatore Stock Exchange Ltd.

NOTES



4. REGISTRATION OF SUB-BROKERS

The number of sub-brokers registered during 2006-07 witnessed a rise as comparedto the previous year. The total number of sub-brokers registered at the end of 2006-07,rose to 27,541, as against 23,479 in the previous year. In effect, there was a net additionof 4,062 sub-brokers during 2006-07, reflecting an increase of 17.3 per cent. The twomajor stock exchanges, that is, BSE and NSE accounted for 95.2 per cent of the totalsub-brokers operating in the country as compared to 93.9 per cent a year ago

Registered Sub-brokers

5. RECOGNITION OF STOCK EXCHANGES

SEBI grants recognition to stock exchanges under Section 4 of the SecuritiesContracts (Regulation) Act, 1956. There were 22 stock exchanges recognised under SC(R)Act. Out of the 22 stock exchanges, eight stock exchanges have been granted permanentrecognition. During 2006-07, SEBI granted yearly renewal to 10 stock exchanges.

6. REGISTRATION OF FOREIGN INSTITUTIONAL INVESTORS

The total number of FIIs registered with SEBI increased to 997 as on March 31,2007, compared to 882 a year ago, showing a net increase of 217 over the year. Duringthe year, a distinctive feature of the profile of the newly registered FIIs was increase inregistration from places like Slovenia, Brussels, Guernsey, Cyprus, Oman, Sweden, andJapan.



7. REGISTRATION OF CUSTODIANS OF SECURITIES

As on March 31, 2007, there were 14 custodians registered with SEBI, under SEBI(Custodian of Securities) Regulations, 1996. Three new Custodians, including one forcustodial services of gold and gold related instruments, were registered with SEBI , during2006-07. The registration fee and period of registration for custodians were also revised.

8. REGISTRATION OF MUTUAL FUNDS

As on March 31, 2007, 40 mutual funds were registered with SEBI, of which 33were in the private sector and seven (including UTI) were in the public sector. The Certificateof Registration granted to Bank of India MF was cancelled. Lotus India MF, AIG GlobalInvestment Group MF, and JP Morgan MF were registered with SEBI during 2006-07

Mutual Funds Registered with SEBI

9. REGISTRATION OF VENTURE CAPITAL FUNDS

It is generally agreed that venture capital funds play an important role in developmentof entrepreneurship and help in the technological progress of an economy. These fundsprovide the capital required for various industries being set up by new generationentrepreneurs who have limited access to conventional sources of finance. Venture CapitalIndustry has made considerable progress during the last five years. The number of domesticventure capital funds increased to 90 during 2006-07, from 80 in 2005-06. However, thenumber of foreign venture capital funds doubled to 78 in 2006-07 from 39 in 2005-06

Registration of Venture Capital Funds

10. SUPERVISION

Implementation of the Regulations entails a multi-stage process of supervision throughon-site and off-site inspections, enforcement through initiation of adjudication, enquiryagainst violations of rules and regulations, and prosecutions. Inspections of intermediaries

March 31, 2006 March 31. 2007

1 2 3

VCF 80 90

FVCI 39 78

NOTES



were carried out directly by SEBI or by stock exchanges, depositories, etc. SEBI conductedinspections on a periodic basis to verify the compliance levels of intermediaries. It alsoconducted specific/ limited purpose inspections on the basis of complaints, references,surveillance reports, specific concerns etc. SEBI also directed stock exchanges anddepositories to carry out periodic /specific purpose inspections of their members/participants.

11. INSPECTION OF MARKET INTERMEDIARIES

According to the revised inspection policy, approved by the SEBI Board, SEBIconducts risk-based inspection. It does not normally conduct routine inspections of stockbrokers /sub –brokers and DPs. Such inspections are left to the stock exchanges anddepositories concerned, which is in line with international practices. SEBI oversees thequality of such inspections by calling for periodic reports on inspections conducted, violationsobserved, and actions taken to check whether the quality, content, and coverage ofinspections are adequate.

12. SURVEILLANCE

SEBI monitored market movements, analysed trading pattern in stocks and indices,and initiated appropriate action, as necessary, in conjunction with the stock exchanges andthe depositories. Towards this end, SEBI also took into account any unusual or suspiciousmarket movements, formal or informal information from the stock exchanges and thedepositories, specific complaints from any entities / persons, etc.

The stock exchanges played prime role in detection of market manipulation, pricerigging , and other regulatory breaches regarding stock market functioning. SEBI alsokept constant vigil on the activities of the stock exchanges to facilitate effective surveillancesystems.

SUMMARY

The SEBI Act, 1992 was enacted to empower SEBI with statutory powers for (a)protecting the interests of investors in securities (b) promoting the development of thesecurities market, and (c) regulating the securities market. Its regulatory jurisdiction extendsover corporate in the issuance of capital and transfer of securities, in addition to allintermediaries and persons associated with securities market. It can conduct enquiries,audits and inspection of all concerned and adjudicate offences under the Act.

Market intermediaries play a very important role in development of the market byproviding a variety of services. Market intermediaries can be classified on the basis of theservices provided by them. Typically, they are classified as: merchant bankers, stockbrokers, bankers to issues, debenture trustees, portfolio managers, DPs, registrars to issues,share transfer agents, etc. These entities are regulated by SEBI.



During 2006-07, 263 new stock brokers were registered with SEBI. There were155 cases of reconciliation/ cancellation/surrender of membership during 2006-07 whichwas lower than that, in the previous year. As on March 31, 2007, the total number of stockbrokers registered with SEBI was 9,443 as against 9,335 in the previous year, showing anet increase of 108.

Implementation of the Regulations entails a multi-stage process of supervision throughon-site and off-site inspections, enforcement through initiation of adjudication, enquiryagainst violations of rules and regulations, and prosecutions. Inspections of intermediarieswere carried out directly by SEBI or by stock exchanges, depositories, etc. SEBI conductedinspections on a periodic basis to verify the compliance levels of intermediaries. It alsoconducted specific/ limited purpose inspections on the basis of complaints, references,surveillance reports, specific concerns etc. SEBI also directed stock exchanges anddepositories to carry out periodic /specific purpose inspections of their members/participants

Key Terms

Primary Securities MarketStock BrokersSub-brokersStock ExchangesForeign Institutional InvestorsCustodians of SecuritiesMutual FundsVenture Capital FundsSupervisionInspection of Market Intermediaries

Questions

What is meant by Primary Securities Market?Explain the current status of stock brokersWho is known as Custodians of securities?What is meant by Venture Capital Funds?Explain the role of SEBI in Inspection of Market Intermediaries

NOTES



CHAPTER- V

INDIAN DEBT MARKET

Learning Objectives

After going through this chapter you would be able to understand the overview of theIndian Debt Market, the structure and the problems of debt market and Debt Market andNSE

1. OVERVIEW

The role of a healthy corporate debt market as a channel that links society’s savingsinto investment opportunities is of vital importance for several reasons. For the issuer itprovides low cost funds by bypassing the intermediary role of a bank. Although corporationshave to go through intermediaries like brokers, underwriters in the debt market too, theintense competition amongst them pushes down intermediation cost .For the investor, thereexists a yield premium opportunity in comparison to traditional deposits at banking institutions.It also increases the investment opportunities in different type of instruments and tailorsrisk reward profile according to his/her preferences. The basic philosophy of developing adiversified financial system with banks and non-banks operating in equity market and debtmarket is that it enhances risk pooling and risk sharing opportunities for investors andborrowers.

2. THE INDIAN DEBT MARKET

The debt market is much more popular than the equity markets in most parts of theworld. In India the reverse has been true. This has been due to the dominance of thegovernment securities in the debt market and that too, a market where government wasborrowing at pre-announced coupon rates from basically a captive group of investors,such as banks. Thus there existed a passive internal debt management policy. This, coupledwith automatic monetization of fiscal deficit prevented a deep and vibrant governmentsecurities market.

The debt market in India comprises broadly two segments, viz., Government SecuritiesMarket and Corporate Debt Market. The latter is further classified as Market for PSUBonds and Private Sector Bonds.

The market for government securities is the oldest and has the most outstandingsecurities, trading volume and number of participants. Over the years, there have beennew products introduced by the RBI like zero coupon bonds, floating rate bonds, inflationindexed bonds, etc. The trading platforms for government securities are the “Negotiated



Dealing System” and the Wholesale Debt Market (WDM) segment of National StockExchange (NSE) and Bombay Stock Exchange (BSE).

The PSU bonds were generally treated as surrogates of sovereign paper, sometimesdue to explicit guarantee of government, and often due to the comfort of governmentownership. The perception and reality are two different aspects. The listed PSU bondsare traded on the Wholesale Debt Market of NSE.

3. THE STRUCTURE OF THE INDIAN DEBT MARKET

It is necessary to understand microstructure of any market to identify processes,products and issues governing its structure and development. Market structure consists ofissuers, instruments, processes, investors, rating agencies and regulatory environment.

i) Issuers

Indian Debt Market has almost all possible variety of issuers as is the case in manydeveloped markets. It has large private sector corporate, public sector undertakings (unionas well as state), financial institutions, banks and medium and small companies: Thus thespectrum appears to be complete.

ii) Instruments

Till recently Indian debt market was predominantly dominated by plain vanilla bonds.Over a period of time, many other instruments have been issued. They include partlyconvertible debentures (PCDs), fully convertible debentures (FCDs), deep discount bonds(DDBs), zero coupon bonds (ZCBs), bonds with warrants, floating rate notes (FRNs) /bonds and secured premium notes (SPNs). The coupon rates mostly depend on tenureand credit rating. However, these may not be strictly correlated in all cases. The maturitiesof bonds generally vary between one year to ten years. However, the median could bearound four to five years. The maturity period by and large depends on outlook oninterest rates.

iii) Processes

In a mature and developed market where large number of institutional investor /sophisticated investors is available and a highly developed mutual fund industry is in operation,the private placement route may be acceptable to issuers, investors and regulators. In aless developed market / small market private placement is not suitable because this marketdo not have adequate number of informed investors and the public issue route may createregulatory arbitrage, higher compliance costs resulting sometimes in migration of markets.In India private placement route is highly popular owing to various reasons

NOTES



iv) Intermediaries

Two classes of intermediaries required for the proper development of debt marketare broker and investment banker/ merchant banker. Most of the brokers as well asmerchant bankers in India are inadequately capitalized and their professional knowledgealso needs further improvement.

v) Investors

For the development of Corporate Debt Market / Fixed Income Securities Market,it is necessary and sufficient to have a large as well as diverse number ofsophisticated / institutional investors. The most important structural weakness in India islack of large and diverse institutional investors.

vi) Rating agencies

India has a well developed Credit Rating Agency system and rating agencies are wellexperienced and regarded. By and large, their ratings do carry confidence in the market.

4. SECONDARY CORPORATE DEBT MARKET

Appropriate ‘micro-structure’ of secondary market is vital for trading, clearing andsettlement. The present infrastructure has its own merits and demerits. Some of the microstructure features are discussed below:

i) Trading Platform

Corporate debt instruments are traded either as bilateral agreements between twocounterparties or on a stock exchange through brokers. Worldwide, the majority oftransactions in corporate bonds is conducted in the over -the-counter (OTC) market bybilateral agreements. In India corporate bonds are traded, mostly, on WDM segment ofNSE.

The National Stock Exchange (NSE) introduced a transparent screen- based tradingsystem in the whole sale debt market, including government securities in June 1994. Thewholesale debt market (WDM) segment of NSE has been providing a platform fortrading / reporting of a wide range of debt securities.

The WDM trading system, known as NEAT (National Exchange for AutomatedTrading), is a fully automated screen based trading system, which enables members acrossthe country to trade simultaneously with enormous ease and efficiency. The trading systemis an order driven system, which matches best buy and sell orders on a price/time priority.

Trading system provides two market sub -types:

Continuous Automated Market: In continuous market, the buyer and seller do notknow each other and they put their best buy/ sell orders, which are stored in order book



with price/time priority. If orders match, it results into a trade. The trades in WDM segmentare settled directly between the participants, who take an exposure to the settlement riskattached to any unknown counter-party. In the NEAT -WDM system, all participants canset up their counter-party exposure limits against all probable counter-parties. Thisenables the trading member/participant to reduce/minimize the counter-party risk associatedwith the counter-party to trade. A trade does not take place if both the buy/sell participantsdo not invoke the counter-party exposure limit in the trading system.

Negotiated Market: In the negotiated market, the trades are normally decided by theseller and the buyer, and reported to the exchange through the broker. Thus, deals negotiatedor structured outside the exchange are disclosed to the market through NEAT-WDMsystem. In negotiated market, as buyers and sellers know each other and have agreed totrade, no counter-party exposure limit needs to be invoked.

ii) Clearing and Settlement Mechanism

Primary responsibility of settling trades concluded in the WDM segment rests directlywith the participants and the exchange monitors the settlement. Mostly these trades aresettled in Mumbai. Trades are settled gross, i.e. on trade for trade basis directly betweenthe constituents / participants to the trade and not through any clearing house mechanism.Thus, each transaction is settled individually and netting of transactions is not allowed.

Settlement is on a rolling basis, i.e. there is no account period settlement. Each orderhas a unique settlement date specified upfront at the time of order entry and used as amatching parameter. It is mandatory for trades to be settled on the predefined settlementdate. The Exchange currently allows settlement periods ranging from same day (T+0)settlement to a maximum of two business days from the date of trade (T+2).

iii) Instruments traded on WDM

The WDM provides trading facilities for a variety of debt instruments includinggovernment securities, Treasury Bills and bonds issued by Public SectorUndertakings(PSU)/ corporate/ banks like Floating Rate Bonds, Zero Coupon Bonds,Commercial Paper, Certificate of Deposit, corporate debentures, State Government loans,SLR and Non -SLR bonds issued by financial institutions, units of mutual Funds andsecuritized debt by banks, financial institutions, corporate bodies, trusts and others.

iv) Investors in WDM

Large investors and a high average trade value characterize this segment. Till recently,the market was purely an informal market with most of the trades directly negotiated andstruck between various participants. The commencement of this segment by NSE has

NOTES



brought about transparency and efficiency to the debt market, along with effective monitoringand surveillance to the market.

v) Regulatory Environment

The listed corporate debt is under the regulations of SEBI. SEBI is involved wheneverthere is any entity raising money from Indian individual investors through public issues/private placement. It regulates the manner in which such moneys are raised and tries toensure a fair play for the retail investor. It forces the issuer to make the retail investoraware of the risks inherent in the investment. SEBI has in fact laid down guidelinesknown as Disclosure and Investor Protection (DIP) Guidelines, 2000 guidelines to maintaintransparency in the market and make it efficient.

5. THE PROBLEMS OF DEBT MARKET

After reviewing functioning of debt market in some other markets and in India, thefollowing issues have been identified as some of the major aspects affecting the market.

a) Poor Quality Paper

Quality of paper refers to regular payment of coupon and repayment of principal atthe right time. Companies that do not default on these two counts are said to be issuinghigh quality paper. High quality paper issued in the market does not create problems /issues for investors, regulators and issuers. The question of private placement vs. publicissue and institutional investors vs. retail investor are of less significance and almost noconsequence in the market, if the quality of the paper is good.

It is the poor quality paper with a possibility of non-payment of coupon and principalthat poses threat to the development of the market and hence stringent regulatory normsare warranted.

Imposition of additional regulatory provisions, though has its opportunity cost,therefore, it is essential to strike a balance between regulatory protection and disclosurebased regulation.

Further, in an emerging market / developing market the incidence of industrial sicknessis relatively high. This high industrial sickness generally translates into default of companiesand their obligations. The bond paper issued by companies turns worthless and createsproblems in the minds of investors. Since most retail investors, who invest in bonds, holdfor maturity and also hold their investment in a fewer number of companies, any default willwipe out their savings and security for the post retirement / old age requirements. Therefore,defaults in fixed income securities market attract more attention of the public and theregulators.



b) Inadequate liquidity

Secondary Market for Corporate Debt lacks liquidity in India. Hardly few tradestake place, that too, in a limited number of issues. There is a chicken and egg problem.Poor liquidity is attributable to inadequate number of good papers and lack of sufficientinvestor base in terms of quantity as well as diversity. We can address the liquidity issuein the following ways:

o By developing ‘bond manager’;o By enlarging number of investors;o By introducing good quality paper.

The third factor is exogenous and the second will take long time. Therefore, what isfeasible and achievable in the near term is the development of ‘bond manager’ so thatliquidity issue can be addressed and to some extent the quality of paper also.

c) Investor base

In many markets the number of investors in fixed income securities market runs intothousands and their variety include mutual funds, insurance companies, pension funds,endowments, private banking institutions, banks and retail investors. In India, we haveprimarily mutual funds investing in bond funds and their investment requirements are onesided, if money starts coming in all mutual funds will get in large quantities and if it startsgoing out it will go in huge quantities thus creating storms in the market. Insurance fundsand pension funds are the long term investors. Any short term shocks can be absorbed bythese long term players. Insurance companies in India till recently were limited in numberand they were investing to hold till maturity. Individual investors generally hold for maturity.Now that we have more private sector and joint sector players, their presence in theprimary as well as in the secondary market can be felt in the time to come. Pension fundsare not there today. Banks do invest in the primary market and their activity in the secondarymarket is almost nil.

d) Regulatory arbitrage (additional costs on listed companies)

Companies operating in India can be broadly divided into two categories on the basisof regulatory jurisdiction: Listed and Unlisted. All companies are, by and large,administered by the Companies Act, 1956 and the regulatory administration is carried outby DCA, Ministry of Finance.

Listed companies are overseen by SEBI through Listing Agreement of exchanges.Listed companies are required to follow elaborate corporate governance principles,accounting and disclosure standards, continuous disclosure standards and hence incuradditional costs. Unlisted companies, thus, enjoy regulatory arbitrage over listed companies.There is a perception that listed companies seek delisting owing to perceived regulatoryarbitrage.

NOTES



e) Debt Versus Equity: Cost and risks

By design and necessity debt has finite life sometimes, very short whereas equity issaid to have perpetual life. Therefore, debt paper is offered and reoffered quite frequentlyby companies. In falling interest rate scenario, as has been the case in India for the pastfew years, corporate tend to borrow for shortest possible period thus restoring to repeatedissue costs and interest rate risks. High regulatory and compliance costs add to cost ofresources. Therefore, corporate might innovate new methods of raising capital. Eitherway, the corporate debt market will be affected adversely.

f) Incomplete access to information

One of the most important issues is lack of sufficient, timely and reliable informationon bonds and on bond markets to the investors. Information on bond issue, size, coupon,latest credit rating, trade statistics are sparsely available. If the investors have access tothe relevant information more frequently then it may be possible for them to assess thequality of the paper and take decisions.

In addition, there is no one place in India where one can have all the data pertainingto corporate debt issues. No one knows exactly how much debt is outstanding on anygiven date and different agencies have incoherent estimates for the same. Annual publicissue amount averages around Rs. 40,000 crore for the past 3 years. If the entire 5 yearperiod is considered roughly Rs. 170,000 crore was raised through public issue. However,the amount of debt outstanding for trading at NSE excluding government securitiesand treasury bills comes to roughly Rs. 100,000 crore. There is a wide gap betweenpublicly issued amount and that which is admitted for trading even if one considers averagematurity period of five years. Generally bonds have longer maturity. Hence, any regulatoryaction either becomes ineffective or misdirected leading to unintended results target.Therefore, there is an urgent need to launch a survey and prepare a comprehensive databaseand bring in transparency. Transparency ensures confidence which in turn ensures liquidity.Sudden shocks can be mitigated.

g) Interest rate structure

Very skewed interest rate structure exists in India. Corporate with “AAA” ratingoffer lower coupon than sovereign rate offered on certain instruments such as public providentfund, National Saving Certificates. Individual investors, therefore, have almost nil or nointerest in coupon debt market, both primary as well as in secondary, unless they areaccompanied by some fiscal concessions resulting in net higher return compared to abovecited instruments.



6. DEBT MARKET AND NSE

The Exchange started its trading operations in June 1994 by enabling the WholesaleDebt Market (WDM) segment of the Exchange. This segment provides a trading platformfor a wide range of fixed income securities that includes Central Government Securities,Treasury Bills (T-bills), State Development Loans (SDLs), Bonds issued by Public SectorUndertakings (PSUs), Floating Rate Bonds (FRBs), Zero Coupon Bonds (ZCBs), IndexBonds, Commercial Papers (CPs), Certificates of Deposit (CDs), Corporate Debentures,SLR and non-SLR bonds issued by financial institutions (FIs), bonds issued by foreigninstitutions and units of mutual funds (MFs).

To further encourage wider participation of all classes of investors, including the retailinvestors, the Retail Debt Market segment (RDM) was launched on January 16, 2003.This segment provides for a nation wide, anonymous, order driven, screen based tradingsystem in government securities. In the first phase, all outstanding and newly issued CentralGovernment Securities were traded in the retail debt market segment. Subsequently othersecurities like State Government Securities, T-bills were added for trading. The settlementcycle is same as in the case of equity market i.e., T+2 rolling settlement cycle.

The WDM trading system, known as NEAT (National Exchange for AutomatedTrading), is a fully automated screen based trading system that enables members acrossthe country to trade simultaneously with enormous ease and efficiency. It supports ananonymous order driven market which operates on a price/time priority and providestremendous flexibility to users in terms of orders with various time/price/quantity relatedconditions that can be placed on the system. It also provides on-line market informationlike total order depth, best buys and sells available, quantity traded, the high, low and lasttraded price for securities are available at all points of time.

The WDM Trading system provides two market sub-types: continuous market andnegotiated market. In the continuous market, the buyer and seller do not know each otherand they put their best buy/sell orders, which are stored in order book with price/timepriority. If orders match, it results into a trade. The trades in WDM segment are settleddirectly between the participants, who take an exposure to the settlement risk attached toany unknown counter-party. In the NEAT-WDM system, all participants can set up theircounter-party exposure limits against all probable counter-parties. This enables the tradingmember/participant to reduce/ minimize the counter-party risk associated with the counter-party to trade. A trade does not take place if both the buy/sell participants do not invokethe counter-party exposure limit in the trading system.

In the negotiated market, the trades are normally decided by the seller and the buyeroutside the exchange, and reported to the Exchange through a trading member for approval.Thus, deals negotiated or structured outside the exchange are disclosed to the marketthrough NEAT-WDM system. In negotiated market, as buyers and sellers know eachother and have agreed to trade, no counter-party exposure limit needs to be invoked.

NOTES



The trades on the WDM segment could be either outright trades or repo transactionswith settlement cycle of T+2 and repo periods (1 to 14 days). For every trade, it is necessaryto specify the number of settlement days and the trade type (repo or non-repo), and in theevent of a repo trade, the repo term and repo rate.

7. MARKET PERFORMANCE

Turnover

The trading volume on the WDM Segment of the Exchange witnessed a year on yeardecline of 54 % from Rs. 475,523 crore during 2005-06 to Rs. 219,106 crore during2006-07. The average daily trading volume also decelerated from Rs.1,755 crore during2005-06 to Rs. 898 crore in fiscal 2006-07. The highest recorded WDM trading volumeof Rs. 13,912 crore was registered on August 25, 2003.

The transactions in dated government securities accounted for a substantial share of73.02 % on the WDM segment. There were no repo transactions recorded during 2005-06 and 2006-07. The WDM’s SGL Outright Transactions as a percentage to the totalSGL Outright transactions was 51.7 % in 2006-07.

It is observed that the market is dominated by dated government securities (includingstate development loan), which accounted for 70 % of WDM trades during 2006-07.Among the market participants, the trading members accounted for 30.88 % of the totalWDM trades followed by domestic banks which held a share of 26.03 %. Share of foreignbanks in WDM trades had spiked up to 20.57 % during 2006-07 as compared with itsshare of 14.11 % in the last fiscal.

The share of top ‘N’ securities/trading members/participants in turnover in WDMsegment is presented in Table 5-4. The share of top ‘10’ securities decreased from 59.78% in 200506 to 51.29% in 2006-07. The share of top ‘50’ and top ‘100’ securitiesaccounted for 77.15% and 86.91% respectively in 2006 - 07

Market Capitalisation

Market capitalisation of the WDM segment has witnessed a constant increase indicatingan increase in the number of securities available for trading on this segment. Total marketcapitalisation of the securities available for trading on WDM segment stood at Rs.1,784,801 crore as on March 30, 2007. Central Government securities accounted for thelargest share of the market capitalisation with 66.24%.



Summary

The role of a healthy corporate debt market as a channel that links society’s savingsinto investment opportunities is of vital importance for several reasons. For the issuer itprovides low cost funds by bypassing the intermediary role of a bank. Although corporationshave to go through intermediaries like brokers, underwriters in the debt market too, theintense competition amongst them pushes down intermediation cost

The debt market is much more popular than the equity markets in most parts of theworld. In India the reverse has been true. This has been due to the dominance of thegovernment securities in the debt market and that too, a market where government wasborrowing at pre-announced coupon rates from basically a captive group of investors,such as banks. Thus there existed a passive internal debt management policy. This, coupledwith automatic monetization of fiscal deficit prevented a deep and vibrant governmentsecurities market.

Quality of paper refers to regular payment of coupon and repayment of principal atthe right time. Companies that do not default on these two counts are said to be issuinghigh quality paper. High quality paper issued in the market does not create problems /issues for investors, regulators and issuers. The question of private placement vs. publicissue and institutional investors vs. retail investor are of less significance and almost noconsequence in the market, if the quality of the paper is good.

It is the poor quality paper with a possibility of non-payment of coupon and principalthat poses threat to the development of the market and hence stringent regulatory normsare warranted.

In many markets the number of investors in fixed income securities market runs intothousands and their variety include mutual funds, insurance companies, pension funds,endowments, private banking institutions, banks and retail investors. In India, we haveprimarily mutual funds investing in bond funds and their investment requirements are onesided, if money starts coming in all mutual funds will get in large quantities and if it startsgoing out it will go in huge quantities thus creating storms in the market. Insurance fundsand pension funds are the long term investors.

The Exchange started its trading operations in June 1994 by enabling the WholesaleDebt Market (WDM) segment of the Exchange. This segment provides a trading platformfor a wide range of fixed income securities that includes Central Government Securities,Treasury Bills (T-bills), State Development Loans (SDLs), Bonds issued by Public SectorUndertakings (PSUs), Floating Rate Bonds (FRBs), Zero Coupon Bonds (ZCBs), IndexBonds, Commercial Papers (CPs), Certificates of Deposit (CDs), Corporate Debentures,SLR and non-SLR bonds issued by financial institutions (FIs), bonds issued by foreigninstitutions and units of mutual funds (MFs).

NOTES



Key Terms

Rating agenciesContinuous Automated MarketNegotiated MarketMarket Capitalisation

Questions

• Explain the status of Indian Debt Market• Discuss the Structure of the Indian Debt Market• What are the the problems of Indian Debt Market?• Explain the role of NSE in Debt Market

NOTES



UNIT - III

FUNDAMENTAL ANALYSISCHAPTER - I

ECONOMIC ANALYSIS

Learning Objective

After going through this chapter you would be able to understand the concept ofeconomic analysis, the economic factors to be analysed for stock investment decisionsand the technique of economic forecasting.

1. INTRODUCTION

The investors’ ultimate aim is to get a reasonable return on his investment. The investorwho wants to get a reasonable return should analyse various fundamental factors beforecommitting his hard earned funds and should hold his investment for a reasonable period.Fundamental Analysis helps the investor to identify the right investment outlet and the rightentry and exit timings and thus it helps in enhancing the return and reduces the risk ofinvesting. The fundamental analysis mainly focuses on the analysis of economy, industryand the company performance. The general economic conditions affect the performanceof companies and resultantly influence the returns available for the equity investors. Thereforeanalysing economy becomes pertinent before investing in shares and securities. A study onthe economic conditions would certainly give an idea about the future earning prospectusof companies and the dividends, capital gain and interest available for investors.

2. ECONOMIC FORECASTING

The growth of economy is influenced by a large number of factors. The growth ratemay be fluctuating from period to period and in turn influences the stock price movements.The investor has to analyse and predict the growth of economy so that he can take rightinvestment decisions. The economic forecasting should be done both for short term andlong term for taking stock investment decisions. Forecasting for a period above threeyears can be treated as long term and below three years can be treated as short term.



3. STOCK INVESTMENT DECISIONS

a) Population of the country

Analysing the population of the country gives a complete picture about the kind oflabour force. Increase in population results in increase in demand for many goods andservices and at the same time the availability of manpower also increases. If the populationexplosion is strategically used by the country certainly it is an asset.

b) Research and Development facilities

The economic growth mainly depends on the emphasis given on research anddevelopment and the infrastructure development. The investor should select the industrybased on the above issue. For example the Government is focusing on the development ofinfrastructure, telecommunication and power sector. These sectors future growth rate invery high.

c) Capital Formation

The capital formation in the country influences the growth of various industries.Mobilisation of scattered savings and passing the same to the needy industries requireefficient financial system.

d) Resources

Natural resources are very much important for the economic growth of the country.Water, oil, mines resources are the backbone of any economy. Technological discoveriesin recycling of materials, nuclear and solar energy and new synthetics offers lot of potentialfor growth of economy.

e) Gross Domestic Product (GDP)

The GDP indicates the growth rate of the economy and it represents the total valueeconomy and it represents the total value of goods and services produced in the country.The growth of GDP reflects the growth of various sectors, companies and per capitaincome. If the GDP growth rate increases certainly the return available for investors alsowill increase.

f) Savings and Investments.

The savings made by the large number of people and various sectors determine thegrowth of economy. If the people save a part of their earnings and make investments invarious shares and securities then corporate can easily make investments in expansion andmodernization programmes and this will fuel their earning capacity.

NOTES



g) Rate of Inflation

The rate of inflation prevailing in the country determines the real economic growth. Ifmoney supply increases without increase in production of goods and services then inflationrises. During inflationary conditions more money chasing few goods. When inflation ishigh the cost of living and cost of business operations are increasing. The returns availablefrom stock market investments will be declining.

h)Budget Proposals

The annual budget proposals submitted by the State and Central Governments affectsthe economic growth. When budget deficit increases the economic growth will slowdownand inflation starts rising.

i) The taxation policy

The various taxes imposed by the Central and State Government on individuals andcorporate affects their purchasing ability. High corporate tax leaves the companies withfewer surpluses which will be inadequate to pay dividend to shareholders and to meetbusiness development expenditures.

j) Balance of Payment of Currency value

The balance of payment position determines the currency value against overseascurrencies and in turn the currency value determine the profitability of exports and importers.When the currency value appreciates against overseas currencies then it benefit the importersbut affect the exporters.

k) Monsoon and Agriculture

In India around 79% of the people lives in rural areas and engaged in agriculture andallied activities. The agriculture mainly depends on monsoon. Moreover many sectors getraw materials from agriculture. Therefore the monsoon and agricultural output influencesthe stock market.

4. TECHNIQUES OF ECONOMIC FORECASTING

a) Surveys

The Survey method of economic forecasting involves getting the concerned peoplesopinion about the current development and outlook of the economy and specific sector. Itis very difficult to meet all the concerned people and a sample can be taken and aquestionnaire or interview schedule can be administered with the selected sample. Thussurvey involves the collection of first hand information from the concerned respondentsand this method is more reliable. However the survey method is a time consuming andcostly method.



b)Indicators

The economic forecasting can be done with the help of analyzing the economicindicators. The factors like GDP, capital investments, corporate profits, liquidity, rate ofinterest, forex level, currency value, unemployment rate, percapita income etc, gives lot ofinsight and indicate the direction of the economic growth.

The economic indicators may be classified as Leading Indicator, Coincidental Indicatorand Lagging Indicator. The Leading Indicators give a hint about what would happen toeconomy. This indicates the future direction of the economy. The examples of LeadingIndicator are fiscal policy, Monitory Policy, Productivity, Monsoon and Stock marketindices.

The coincidental indicator indicates the current condition of the economy. For exampleGNP, GDP, Industrial production and interest rate etc. shows the current developments ofeconomy. The charges that are taking place in leading and coincidental indicators arereflected in the lagging indicators. For example unemployment rate, inflation, and forexlevel are the outcome of leading and coincidental indicators.

c)Diffusion Index

The Diffusion Index is considered as a composite index and consensus index. Thediffusion index includes the futures of leading indicators, coincidental indicator, and laggingindicator. Under diffusion index both micro as well as macro factors are analysed. Howeverthis complex statistical method is very difficult to understand and apply.

d)Economic Model Building

Under Economic Model Building technique of economic forecasting relationshipbetween two variables are found to draw some conclusions so as to predict the futuredirection of the economy. One independent variable and dependent variable are taken andtheir relationship is measured. Like this many variables are compared to draw somemeaningful inferences and to know to the future direction of the economy. However, toapply this model one has to have the computer, necessary software and accurate data.

e) Opportunistic Model Building

The Opportunistic Model Building is also known as Sectoral analysis of Gross NationalProduct Model Building and this is widely used economic forecasting technique. Thismethod is based on the national accounting data and helps to find out the total income andtotal demand for various goods and services. The forecast is made for the CentralGovernment Sectors, State Government Sectors, Private Sectors, and the ConsumptionSector. The expenses and income of all the above sectors are carefully analysed. Thismethod is very reliable and highly flexible in forecasting the economic conditions and futuredirections.

NOTES



CASE STUDY

Analysis of Monetary Policy announced by RBI (October 30, 2007)

The CRR hike is a policy decision to manage capital flows rather than arising frominflationary concerns

Surging capital flows remain RBI’s key concerned

The Reserve Bank of India (RBI) decided to hike the cash reserve ratio (CRR) by50 basis points to 7.5%, while keeping other policy rates unchanged. The decision to hikethe CRR is more of a policy decision to manage the liquidity condition in the bankingsystem rather than that arising from inflationary concerns. RBI has mentioned that theinflationary expectations have been contained and the decision to hike CRR is mainly tomoderate the surging money supply growth resulting from excessive net capital inflows.Liquidity management seems to be the key focus area of RBI, hence further CRR hikescannot be ruled out if capital flow doesn’t moderate resulting in a more acceptable money-supply growth

Key policy highlights

• Bank rate, repo rate, and reverse repo rate kept unchanged• CRR increased by 50 basis points to 7.5% effective November 10, 2007• Gross domestic product (GDP) growth forecast retained at 8.5 % during 2007-

08, assuming no further escalation in international crude prices and barring domesticor external shocks

• Inflation to be contained close to 5% during 2007-0with a medium-term objectiveof around 3.0 % inflation

Impact of CRR hike across different markets

There was a 33% chance of a 50-basis points hike in the CRR, hence we believemarkets were more or less discounting the action to some extent. The equity market(Sensex) didn’t correct significantly, however it closed almost 200 points below its previousday’s closing at 19,783. Bond yields at the longer (10-year) and shorter (1-yearend remainedstable, while the rupee showed an appreciation of seven basis points to close at Rs39.36per US dollar.

Domestic inflation concerns still remain

RBI has stated that while the recent headline inflation is indicative of reasonably well-anchored inflation expectations, some of the recent developments have shown that thereare major risks to this assessment that are still evolving. Consumer price index (CPI) levelis at 7.3% indicating that the softening of wholesale food prices has not set in at the retaillevel. The global environment with crude at above $90 per barrel and elevated food andmetal prices pose a significant pass-through risk to inflation going forward. Finally, thedomestic monetary and liquidity conditions prevalent currently could carry the seeds offuture inflation.



At a global level inflation expectations have resur-d face

The expansion of global liquidity conditions in the wake of the recent financial marketturmoil has occurred in a period when global central banks were concerned about inflationexpectations. The massive injection of liquidity by mature central banks reflects a deviationfrom their stance on inflation in order to ensure financial stability, which could potentiallyweaken their ability to fight inflationary pressures.

RBI’s view on the economic prospects of key sectors

Agriculture: Rainfall in the current season has been above normal and reasonablywell-distributed. Thus Kharif sowing has been higher than that in last year’s season reflectingexpectations of higher production than that in the preceding year. These developmentshave improved the outlook for agriculture. The positive prospects for agriculture augurwell for the economy as a whole in terms of both aggregate supply conditions and foodprices, which, until early 2007, were the main drivers of inflation.

Manufacturing: the manufacturing sector continued to record a double-digit growthdespite some modest deceleration in the industrial activity. There are indications that theindustrial activity will continue to sustain its momentum on the back of strong fundamentals.Contraction in the output has occurred mainly in the consumer goods segment, transportequipment, metal products, paper and textiles, which could be reflecting transitory factors.A marginal moderation in the overall industrial activity over the rest of 2007-08 may not beruled out within the generally positive prospects for the industrial sector.

RBI survey gives mixed responses

RBI’S survey for manufacturing companies indicates stable business conditions. Whileother surveys including services sector present a somewhat mixed picture with businessconfidence reporting a fall of 8.9% in July-December 2007 relative to its previous survey,thereby reflecting some increase in the cost of finance and rising prices of raw materials.

Concerns expressed by RBI

Domestic: Foreign direct investment (FDI) to India has been running higher in thecurrent financial year. It is necessary to note that a significant portion of these flows isattributable to private equity and venture capital, which are essentially in the nature ofportfolio flows. There has been a rapid escalation in asset prices, particularly equity andreal estate, which are significantly driven by capital flows. These pools of private, opaque,highly leveraged and largely unregulated capital flows continue to worry RBI and we couldexpect some policy action in these sectors going forward if capital flows doesn’t moderatein these sectors.

Global: RBI seems to be bothered by the unknown possible impact of the US subprimesaga and the possible spill-over effect of enhanced global liquidity post the accommodativestance adopted by global central banks on India.

NOTES



Impact of the above global concerns on Indiad

RBI perceives that the most important issue for India at the current juncture is thepossible affect of these global developments on the domestic financial markets. The impactof the same could be felt in our financial sector, balance sheet, trade, and inflation channels.In regard to the financial sector channel, the primary channel in India is through the equitymarkets. The currency markets are affected through equity market players. Thus RBI feelsthat the immediate task for public policy in India is to manage the possible financial contagion,which is in an initial stage with highly uncertain prospects of being resolved soon.

Capital flows remain the key challenge in conduct of domestic monetary policyd

RBI has stated that though the monetary policy has operated reasonably well on thedomestic demand-supply and credit-deposit balances even as the liquidity emanating fromthe capital flows has been absorbed in the short run, the key future challenge is the liquiditymanagement taking into account the current levels of the capital flows. The persistence ofthese flows has implications for domestic financial stability and future inflation with potentiallagged effects on the aggregate demand. “Consequently, monetary policy will have toaddress not only the liquidity overhang but also incremental flows in the future if theycontinue at present levels.” In view of the above statement made in the policy review wefeel that the monetary policy stance has not moderated and would continue to be guidedby the capital flows and the global factors more than the domestic factors at the currentjuncture.

Further policy actions cannot be ruled out

The RBI has also said that it will continue with its policy of active management ofliquidity through appropriate use of CRR and other policy instruments at its disposal asand when the situation warrants.

Policy highlights related to the banking sector

Impact of CRR hike: The guidelines on the issue of preference shares announcedyesterday was a sweetener for the banking sector, however the 50-basis points CRR hikeis likely to reduce FY2008 profit after tax (PAT) by 1 -2.5% on an annual basis, as banksdon’t get to earn any interest income on such reserve balances.

Expected reaction from the banking sector: We don’t expect banks to pass on theincreased cost to its borrowers when credit demand is low, but rather expect banks tostart cutting deposit rates to protect the margins.

Banks need to be careful on recovery tactics as RBId sounds toughd

The RBI has decided to consider imposing a temporary ban (or even a permanentban in case of persistent abusive practices) on those banks and their directors or officers



where strictures have been passed or penalties have been imposed by a high court or thesupreme court with regard to the abusive practices followed by their recovery agents. Anoperational circular in this regard is expected to be issued by the reserve bank in November15, 2007.

Discussion paper on holding companies in banking groups— The guidelines in thisregard is expected to be issued by end-November 2007. These guidelines assumessignificance for ICICI Bank and the State Bank of India as these two banks are in advancestages of forming such holding companies.

Policy highlights related to the foreign exchanged marketd

• Reinstatement of the eligible limits under the past performance route for hedgingfacility to be permitted.

• Oil companies to be permitted to hedge foreign exchange exposures by usingoverseas over-the-counter/ exchange traded derivatives up to a maximum of oneyear forward.

• Importers and exporters having foreign currency exposures to be allowed to writecovered call and put options in both foreign currency/ rupee and cross currency,and receive premia.

• Authorised dealers to be permitted to run cross currency options books subject tothe reserve bank’s approval.

Banking stock performance and impact of CRR hike on FY2008E PATd

Source: Sharekhan.com

NOTES



Conclusion

The major challenge for RBI currently is not growth and inflation, but managing thedollar deluge in the system. Thus the hike in CRR is to moderate the surging money-supplygrowth rather than the inflation worries, which the central bank feels to have been contained.Markets to some extent expected a 50-basis points CRR hike, hence across the marketswe haven’t witnessed any major correction. Liquidity management seems to be the keyfocus area of RBI, hence further CRR hikes cannot be ruled out if capital flow doesn’tmoderate resulting in a more acceptable money-supply growth. Banks are likely to getaffected from the CRR hike but we don’t expect lending rate hike is possible, rather banksshould start cutting deposit rates aggressively if credit growth doesn’t pickup to maintainthe margins. RBI has also expressed concerns on surging asset prices and capital flows viaprivate equity route to real estate. Some policy action could also be expected in this sector.Economic growth outlook remains stable at 8.5% for FY2008, however some moderationin industrial activity is not ruled out.

Summary

The investors’ ultimate aim is to get a reasonable return on his investment. The investorwho wants to get a reasonable return should analyse various fundamental factors beforecommitting his hard earned funds and should hold his investment for a reasonable period.Fundamental Analysis helps the investor to identify the right investment outlet and the rightentry and exit timings and thus it helps in enhancing the return and reduces the risk ofinvesting. The fundamental analysis mainly focuses on the analysis of economy, industryand the company performance. The general economic conditions affect the performanceof companies and resultantly influence the returns available for the equity investors.

The growth of economy is influenced by a large number of factors. The growth ratemay be fluctuating from period to period and in turn influences the stock price movements.The investor has to analyse and predict the growth of economy so that he can take rightinvestment decisions.

Key Terms

Economic ForecastingCapital FormationIndicatorsDiffusion IndexEconomic Model BuildingOpportunistic Model Building



Questions

i) What do you understand by Economic Analysis?ii) What do you understand by Economic Forecasting?iii) What are the economic issues to be analysed for Stock Investment Decisions?

Explainiv) Discuss the various Techniques of Economic Forecasting

NOTES



CHAPTER - II

INDUSTRY ANALYSIS

Learning Objectives

After going through this chapter you would be able to understand the meaning ofindustry, classification of industry, industry life cycle, stages of industry life cycle and theissues to be analysed for industry analysis

1. INTRODUCTION

Under fundamental analysis the next focus area is Industry Analysis. When the investoris ensured about the growth of economy he has to evaluate various industries and selectthe most promising industry for identifying investment opportunities. Because in a soundeconomy it is not necessary that all industries will be sound. Therefore it becomes pertinentto carefully select the growth oriented industries for investment.

2. THE MEANING OF INDUSTRY

An industry means a group of frms doing similar business. The companies in aparticular industry are almost using similar materials, technology manpower skill anddistribution system. They target the same customer segment. Following are the examplesof Industries;

i) Banking Industryii) Software Industryiii) Automobile Industryiv) Cement Industryv) Steel Industryvi) Paper Industryvii) Aluminum Industryviii) Textiles Industryix) Rubber Industryx) Leather Industryxi) Chemical Industryxii) Pharmaceutical Industry.

3. CLASSIFICATION OF INDUSTRY

a) Growth Industry

The industry which is growing at faster rate is termed as growth industry. This industryis growing at high rate when compared to other industry and to certain extent independentof the economy life cycle. In other words the growth industry growth rate is high whencompared to the growth rate of economy and other sectors. For instance the Indian



Software and Information technology enabled services industry and Infrastructure industryis considered as growth industry.

b) Cyclical Industry

The Cyclical Industries’ growth depends on the growth of economy. For examplethe consumer goods industry such as consumer white goods industry ( colour television,washing machine, fridge etc.,) growth rate depends on the growth of general economicconditions.

c) Defensive Industry

The Defensive industry to certain extend is independent from the ups and downs ofthe other sectors. For example the growth of industry which is producing consumer essentialgoods such as food, cloth and basic requirements of the consumer are steady always.

d) Cyclical Growth Industry

The industry is basically cyclical and at the same time it is growing. For example thedemand for passengers cars increases when the economy is in sound shape and facingdown trend when they economy started facing trouble. The technological innovation andeffective marketing strategy results in growth of the demand at high rate. However, whenthere is a slow down in economical conditions, the growth rate of cyclical growth industrycomes down.

4. INDUSTRY LIFE CYCLE

Every industry has to undergo various stages due to changes in technology, consumerbehaviour and innovations. The length of each and every stage may be different fromindustry to industry. The cost, profitability and demand are influenced mainly by the stagesof the industry life cycle.

Life cycle models are not just a phenomenon of the life sciences. Industries experiencea similar cycle of life. Just as a person is born, grows, matures, and eventually experiencesdecline and ultimately death, so too do industries. The stages are the same for all industries,yet industries cycle through the stages in various lengths of time. Even within the sameindustry, various firms may be at different life cycle stages. Strategies of a firm as well as ofcompetitors vary depending on the stage of the life cycle. Some industries even find newuses for declining products, thus extending the life cycle. Others send products abroad inhopes of extending their life.

The growth of an industry’s sales over period is used to chart the life cycle. Thedistinct stages of an industry life cycle are: introduction, growth, maturity, and decline.Sales typically begin slowly at the introduction phase, and then take off rapidly during thegrowth phase. After leveling out at maturity, sales then begin a gradual decline. In contrast,

NOTES



profits generally continue to increase throughout the life cycle, as companies in an industrytake advantage of expertise and economies of scale and scope to reduce unit costs overtime.5. STAGES OF INDUSTRY LIFE CYCLE.

a) Pioneering Stage

This is the first stage of the industry life cycle and at this stage a new product isintroduced and the demand is created by educating the consumers about the product. Thenumber of players at the stage is less and the sales are also less. No company can operateat its full capacity. The cost of production, marketing and distribution are very high.

In the introduction stage of the life cycle, an industry is in its infancy. Perhaps a new,unique product offering has been developed and patented, thus beginning a new industry.At the introduction stage, the firm may be alone in the industry. It may be a smallentrepreneurial company or a proven company which used research and developmentfunds and expertise to develop something new. Marketing refers to new product offeringsin a new industry as “question marks” because the success of the product and the life of theindustry are unproven and unknown.

A firm will use a focus strategy at this stage to stress the uniqueness of the newproduct or service to a small group of customers. These customers are typically referredto in the marketing literature as the “innovators” and “early adopters.” Marketing tacticsduring this stage are intended to explain the product and its uses to consumers and thuscreate awareness for the product and the industry. According to research by Hitt, Ireland,and Hoskisson, firms establish a niche for dominance within an industry during this phase.For example, they often attempt to establish early perceptions of product quality,technological superiority, or advantageous relationships with vendors within the supplychain to develop a competitive advantage.

Because it costs money to create a new product offering, develop and test prototypes,and market the product from its embryonic stage to introduction, the firm’s and the industry’sprofits are usually negative at this stage. Any profits are typically reinvested into the companyto further prepare it for the next life cycle stage. Introduction requires a significant cashoutlay to continue to promote and differentiate the offering and expand the productionflow from a job shop to possibly a batch flow. Market demand will grow from theintroduction, and as the life cycle curve experiences growth at an increasing rate, the industryis said to be entering the growth stage. Firms may also cluster together in close proximityduring the early stages of the industry life cycle to have access to key materials ortechnological expertise, as in the case of the U.S. Silicon Valley computer chip manufacturers.



b) Growth Stage

Under growth stage the companies in the industry are seeing growth rate of sales andprofits. The demand for the product is consistently increasing since the consumer hasaccepted the product. To meet increased demand the companies expand their capacity.Thus the companies enjoy the economics of large scale activities. In other words theincreased capacity utilization helps the company to reduce over head cost. .

Like the introduction stage, the growth stage also requires a significant amount ofcapital for the firm. The goal of marketing efforts at this stage is to differentiate a firm’sofferings from other competitors within the industry. Thus the growth stage requires fundsto launch a newly focused marketing campaign as well as funds for continued investment inproperty, plant, and equipment to facilitate the growth required by the market demands.However, the industry is experiencing more product standardization at this stage, whichmay encourage economies of scale and facilitate development of a line-flow layout forproduction efficiency.

Research and development funds will be needed to make changes to the product orservices to better reflect customer’s needs and suggestions. In this stage, if the firm issuccessful in the market, growing demand will create sales growth. Earnings andaccompanying assets will also grow and profits will be positive for the firms. Marketingoften refers to products at the growth stage as “stars.” These products have high growthand market share. The key issue in this stage is market rivalry. Because there is industry-wide acceptance of the product, more new entrants join the industry and more intensecompetition results.

The duration of the growth stage, as all the other stages, depends on the particularindustry under study. Some items—like food, clothing, for example may experience a veryshort growth stage and move almost immediately into the next stages of maturity anddecline. A hot toy this holiday season may be nonexistent or relegated to the back shelvesof a deep-discounter the following year. Because many new product introductions fail, thegrowth stage may be short for some products. However, for other products the growthstage may be longer due to frequent product upgrades and enhancements that forestallmovement into maturity. The computer industry today is an example of an industry with along growth stage due to upgrades in hardware, services, and add-on products and features.

During the growth stage, the life cycle curve is very steep, indicating fast growth.Firms tend to spread out geographically during this stage of the life cycle and continue todisperse during the maturity and decline stages. As an example, the automobile industry inthe United States was initially concentrated in the Detroit area and surrounding cities.Today, as the industry has matured, automobile manufacturers are spread throughout thecountry and internationally

NOTES



c) Boom Stage

In the Boom Stage of the industry the companies are achieving robust growth in salesand profit. By seeing the profitability many companies jump in to the industry and make itmore competitive. The demand for the products will increase at very very high rate. Theprofitability of all companies is very high. Introduction of new technologies, research anddevelopment and various collaborations enhances quality of the product and customersatisfactions.

d) Maturity Stage

The next stage is called Maturity stage. At this stage the market is stabilizing and thegrowth rate is very less. At the fag end of the stage the symptoms of obsolesces of thetechnology and product will appear. To continue the business the companies have to takea lot of efforts to increase quality and customer satisfaction.

As the industry approaches maturity, the industry life cycle curve becomes noticeablyflatter, indicating slowing growth. Some experts have labeled an additional stage, calledexpansion, between growth and maturity. While sales are expanding and earnings aregrowing from these “cash cow” products, the rate has slowed from the growth stage. Infact, the rate of sales expansion is typically equal to the growth rate of the economy.

Some competition from late entrants will be apparent, and these new entrants will tryto steal market share from existing products. Thus, the marketing effort must remain strongand must stress the unique features of the product or the firm to continue to differentiate afirm’s offerings from industry competitors. Firms may compete on quality to separate theirproduct from other lower-cost offerings, or conversely the firm may try a low-cost/low-price strategy to increase the volume of sales and make profits from inventory turnover. Afirm at this stage may have excess cash to pay dividends to shareholders. But in matureindustries, there are usually fewer firms, and those that survive will be larger and moredominant. While innovations continue they are not as radical as before and may be only achange in color or formulation to stress “new” or “improved” to consumers. Laundrydetergents are examples of mature products.

e) Declining Stage

This is last life cycle of the industry and at this stage the demand for the product startsdeclining. Thus causes of declining stage may be changes in raw material, technology,consumer behavior or Government policy. Under declining stage the companies’ productionis declining whereas the cost is high and above all the profitability is severely affected andultimately it results in loss. Declines are almost inevitable in an industry. If product innovationhas not kept pace with other competitors, or if new innovations or technological changeshave caused the industry to become obsolete, sales suffer and the life cycle experiences adecline. In this phase, sales are decreasing at an accelerating rate, causing the plotted



curve to trend downward. Profits may continue to rise, however. There is usually another,larger shake-out in the industry as competitors who did not leave during the maturity stagenow exit the industry. Yet some firms will remain to compete in the smaller market. Mergersand consolidations will also be the norm as firms try other strategies to continue to becompetitive or grow through acquisition and/or diversification.

6 INDUSTRY ANALYSIS – ISSUES TO BE ANALYSED

To analyse an industry for taking investment decisions the various factors which affectthe prospects should be studied. Following are the key issues to be analysed.

Growth of the Industry

The rate of growth in terms of sales and profitability is very important factor to beanalysed. The growth rate of industry has a significant impact on the profitability andgrowth rate of the companies in the industry.

Profitability of the Industry

The profit margin of the industry determines the return available for investors. Theasset structures (fixed and current assets) and the operating expenses influence theprofitability.

Nature of the Industry

The nature of the industry that is whether consumer goods, industrial goods, or servicesector influences the profitability. If the particular industry directly depends on other industrythen that industry also should be anlysed. For example the demand for tyre industrydepends on the growth of automobile industry.

Degree of competition

The level of competition is an important factor to be analysed for sound investmentdecision. If the competition level is very high the profit margin of this company will be verylow. The growth prospects also will be very less.

Government policy

The Government policy over a particular industry determines the profitability. Thetaxation policy, price control, environmental norms etc., affects directly the performanceof the companies.

Manpower

The availability of skilled manpower and it’s cost structure are very important issuesto be analysed. When the required skilled manpower is available at reasonable cost thenthe cost of recruitment, training and development will be low. Otherwise the employeecost will be very high and in turn it will affect the profitability of the industry.

NOTES



Research and development

The investment on Research and Development and the facilities available will help theindustry to achieve high growth rate.

CASE STUDY

Pharmaceutical Industry Analysis (September 19, 2007)

Key points

One can remain positive on the Indian pharmaceutical sector on account of the steadydomestic growth, growing revenues from generics in the regulated markets, geographicalexpansion into growing emerging markets and synergies arising out of integration ofacquisitions. Further, the unlocking of value and the increase in the focus on drug discoveryarising out of the demerger of discovery research divisions enhance the attractiveness ofthe business models of companies like Nicholas Piramal (Nicholas) and Sun Pharmaceuticals(Sun Pharma).

The growth of the domestic market has moderated to around 10-12% in Q2FY2008,off a high base in Q2FY2007 (when the industry had shown a record growth of around17% due to the spread of infectious diseases like malaria, dengue and chinkungunya).Even though this might affect the growth of companies like Cipla, Sun Pharma and CadilaHealthcare (Cadila), which have a large exposure to the domestic market, we believe thecompanies will still manage to grow at above average industry rates due to the continuousstream of new launches and an increased geographical penetration.

Even though volume-led export growth is likely to be good during the quarter formost companies, especially Orchid Chemicals (Orchids; due to big launches like cefepimeand cefdinir), Ranbaxy Laboratories (Ranbaxy; due to revenues from Pravastatin 80mgunder exclusivity) and Lupin (due to launch of cefdinir tablets and suspension), the realisationon exports will continue to remain under pressure due to the 9.5%year-on-year (y-o-y)appreciation in the rupee against the US Dollar.

Large one-time gains that were recorded in the previous quarter (Q1FY2008) ontranslation of foreign currency liabilities (due to the appreciation of the rupee) by companieslike Ranbaxy and Orchid Chemicals (Orchid) will not be there in Q2FY2008, as the rupeehas remained more or less at the same level as it was at the beginning of the quarter.

It is expected that the trend of global consolidation to continue, with Indian companiescontinually eyeing acquisitions in the domestic as well as overseas markets. According tomedia sources, large companies like Ranbaxy and Dr Reddy’s Laboratories (DRL) aswell as the mid-cap companies like Wockhardt, Sun Pharma and Lupin are bidding forlarge-ticket acquisitions in the world’s biggest pharmaceutical market, the USA. Further,companies such as Wockhardt and Cadila are expected to receive a significant boost totheir top line due to the consolidation of a series of acquisitions made in the recent past.



After having created a substantial presence in the US generic market, mid-sized Indiancompanies have become aggressive participants in challenging the patents of global pharmagiants. Apart from companies like Ranbaxy and DRL, who had already been active inchallenging patents on blockbuster drugs like Lipitor, mid-sized companies like Lupin andSun Pharma too have emerged as formidable opponents to global innovator companies.While Lupin has successfully defeated King Pharmaceuticals and Sanofi Aventis in theRamipril case, Sun Fharma has been awarded a 180-day exclusivity for generic Protonixwhose patent is valid until July 2010.

The past few quarters have seen research and development (R&D) emerging as adistinct business segment with an increased focus. With a growing number of moleculesentering the clinics and mounting R&D budgets, pharmaceutical companies have begunlooking at innovative ways to fund their future discovery research activities. While Nicholashas already announced the demerger and listing of its discovery research arm, companieslike Ranbaxy are exploring various means of funding for their innovative research divisions.The discovery R&D pipelines of several players like Cadila, Lupin and Nicholas too haveexpanded substantially. One can expect further positive news flow on the innovative R&Dfront from Lupin, Cadila, Ranbaxy and Glenmark Pharmaceuticals (Glenmark)in the comingquarters, which would act as a strong growth trigger in the medium to long term.

Companies under this coverage are expected to report a 19.7% growth in profits onthe back of an 18.7% increase in the revenues. The operating profit margin (OPM) ofcompanies under our coverage is expected to decline by 50 basis points, largely due tolower realisation on exports. Companies such as DRL and Cipla will witness a substantialdecline in revenues and profits due to a high base in Q2FY2007, when these companieshad gained from one-time opportunities (DRL was the authorised generic supplier forZocor and Proscar whereas Cipla had supplied sertraline and finasteride activepharmaceutical ingredients (APIs) to its marketing partner, Teva, in Q2FY2007).

Ranbaxy

Ranbaxy is expected to report a 21% increase in its net sales to $434 million, largelydriven by the contribution from Pravastatin 80mg under the 180-day exclusivity and thestrong performance in the emerging markets. However, the almost 10% appreciation inthe rupee over the last one year will result in a subdued 7.8% growth in rupee terms. TheOPM is expected to decline by 220 basis points to 15.5% during the quarter partially dueto the impact of the currency appreciation and partly due to the one-time high marginrecorded in Q3CY2006 (on account of Simvastatin 80mg sales under exclusivity). However,on a sequential basis, one can expect the margin to bounce back due to the high-marginPravastatin 80mg sales during the quarter. One can expect Ranbaxy to deliver a 2 5% jump in its net profi t to Rs174.1 crore.

NOTES



Sun Pharma

Sun Pharma is likely to report a 17.9% growth in its revenues on the back of a 19.4%improvement in its domestic business and a 13.2% jump in its exports. Despite pricingconcerns, Caraco (the US outfit of the company) is expected to maintain its momentum,primarily supported by new product launches (like Allopurinol, Octrotide injection, Atenololand Carbidopa/Levodopa) and progressive improvement in its share of the US market.Despite the impact of the rupee’s appreciation, Sun Pharma will be able to show a robustmargin expansion of 260 basis points to 34.5% during the quarter, on account of strongcost management efforts. This would lead to a growth of 14.3% in the net profit to Rs213.0crore in Q2FY2008.

Nicholas

Nicholas is expected to deliver a subdued top line growth of just 3.4%, off a highbase in Q2FY2007 (when the consolidation of Morpeth had boosted the top line), toRs658.8 crore in Q2FY2008. Though one can expect a partial revival in the sales of itslargest brand phensedyl (phensedyl sales had plunged sharply in Q1FY2008 on accountof shortage of codeine, a key raw material for phensedyl), the contract manufacturingrevenues are expected to remain more or less stagnant (as the revenues from the newcontracts would start flowing in only in Q3FY2008). The OPM is expected to remain flatat 15.1% on a y-o-y basis but show an improvement on a sequential basis due to anincreased contribution from the high-margin phensedyl. However, a substantially lower taxincidence in Q2FY2008 would result in an appreciable growth of 23.9% in the net profitprior to extraordinary items to Rs57.1 crore. On including the extraordinary income ofRs17.8crore received from Boots in Q2FY2007, the adjusted profit growth would berestricted to only 6% year on year (yoy).

Wockhardt

Wockhardt is expected to show a strong growth of 63.5% in its sales to Rs715.5crore, driven by the consolidation of the Pinewood and Negma businesses, a ramp-up inits US business on account of new launches such as Furosemide, Ketorolac, Cefprozil,Fosphenytoin and Terbinafine, and the steady growth in its domestic and UK businesses.One can expect Wockhardt’s OPM to decline by 100 basis points to 21.2% due to theacquisition of the relatively lower-margin businesses of Pinewood and Negma. However,the increase in depreciation (due to the commissioning of the new biotech facility atAurangabad and the consolidation of the acquired businesses) along with the higher interestexpenses (due to the acquisitions) will restrict Wockhardt’s net profit growth to 15% toRs85 crore.



Lupin

The investor can expect Lupin’s sales to grow by 25.8% yoy to Rs623.9 crore inQ2FY2008, driven by a 6% growth in the domestic business and an impressive 38.9%rise in the exports. The export growth will primarily be driven by a strong growth in the USbusiness, which will be boosted by the full quarter impact of cefdinir sales (estimated tocontribute approximately $15 million). Lupin’s OPM is expected to jump by 70 basispoints to 17.6% due to the contribution from the sales of the high-margin cefdinir in theUSA. The expanding margin will cause the net profit of the company to jump by an impressive35.2% to Rs78.8 crore.

Cadila

An improvement in the branded domestic formulation business post-restructuring, astrong growth of 71% in the consumer product business (aided by the acquisition of anadditional 50% stake in the animal health business) and a 61.2% rise in the exports arelikely to drive up Cadila’s revenues by 30.6% to Rs620.0 crore in Q2FY2008. On theexport front, we expect the growth to be driven largely by the growing revenues from theFrench and US businesses as well as the consolidation of the recently acquired Nikkho inBrazil. One can expect the OPM to decline by 250 basis points to 20.5%, largely due tothe lower realisation on exports on account of the appreciation in the rupee. The shrinkingmargins, along with a substantial increase in the depreciation charge (due to the acquisitionof additional assets), would restrict the net profit growth to 8.5%, off a high base inQ2FY2007, to Rs76.5 crore in Q2FY2008.

Orchid

The investor can expect Orchid’s revenues to grow by an appreciable 15.0% yoy{off a high base in Q2FY2007) to Rs282.3 crore in Q2FY2008, driven by a full quarterimpact of cefepime injections and two months of revenues from cefdinir capsules andsuspension in the USA. One can expect these two products to contribute an incrementalRs43 crore approximately to Orchid’s revenues during the quarter. An improving productmix, with a higher share of formulations, is expected to improve the OPM by 90 basispoints yoy to 32.6%. The expanding margin, along with the savings in interest expense(due to the repayment of debt from the foreign currency convertible bond funds), willcause the net profit to grow by a strong 35.8% to Rs40.0 crore in Q2FY2008.

Elder Pharmaceuticals

Elder Pharmaceuticals is expected to show a growth of 17% yoy in its revenues, ledby the continued momentum in its key brands, such as Shelcal, Chymoral and Eldervit, andrising revenues from its in-licenced portfolio. It is expected that the company’s OPM toremain flat at 18.1% on account of higher selling and marketing expenses incurred duringthe quarter due to the sponsorship of the Filmf are awards in the south and the increased

NOTES



marketing spend to promote the new in-licenced products such as Bonviva. Higher interestand depreciation costs (as the company has just commissioned its Paonta Sahib plant) willcause Elder Pharmaceuticals’ net profit to grow by 9.4% yoy to Rs15.5 crore.

Quarterly estimates: July - September 2007

Source: sharekhan.com

Valuation table: Pharma universe

Source: sharekhan.com

Summary

Under fundamental analysis the next focus area is Industry Analysis. When the investoris ensured about the growth of economy he has to evaluate various industries and selectthe most promising industry for identifying investment opportunities. Because in a soundeconomy it is not necessary that all industries will be sound. Therefore it becomes pertinentto carefully select the growth oriented industries for investment.



Every industry has to undergo various stages due to changes in technology, consumerbehaviour and innovations. The length of each and every stage may be different fromindustry to industry. The cost, profitability and demand are influenced mainly by the stagesof the industry life cycle.

Life cycle models are not just a phenomenon of the life sciences. Industries experiencea similar cycle of life. Just as a person is born, grows, matures, and eventually experiencesdecline and ultimately death, so too do industries. The stages are the same for all industries,yet industries cycle through the stages in various lengths of time. Even within the sameindustry, various firms may be at different life cycle stages. Strategies of a firm as well as ofcompetitors vary depending on the stage of the life cycle. Some industries even find newuses for declining products, thus extending the life cycle. Others send products abroad inhopes of extending their life.

Key Terms

Growth IndustryCyclical IndustryDefensive IndustryCyclical Growth IndustryPioneering StageGrowth StageBoom StageMaturity StageDeclining Stage

Questions

i) What do you mean by industry?ii) Explain the classification of industryiii) What do you mean by industry life cycle? Discuss the stages of industry life

cycle.iv) How the various stages of life cycle of industry is important to stock investment

decision? Explainv) What are the issues to be kept in mind while analyzing industry for investment

decision?

NOTES



CHAPTER - III

COMPANY ANALYSIS

Learning Objectives

After going through this chapter you would be able to understand the concept ofcompany analysis, the factors to be considered for company analysis, measuring earnings,analysis of financial statement and forecasting earnings

1. INTRODUCTION

This type of looking at the problem consists of selecting the stocks based on informationregarding the financial situations of the company, its area of activity, and also on comparingthe price with other similar ones from the market. The fundamental analysis is useful wheninvesting in stocks for a long period of time (at least a year). Those who use this type ofanalysis have themselves different objectives of evalution and profit, using mostly certaincriteria.

The company analysis is the major part in fundamental analysis. For taking prudentinvestment decision, the investor has to analyse economic conditions and select the mostpromising industry. However it doesn’t mean that all the companies in the selected industrywill be really growth oriented. Therefore it becomes necessary to identify the best companyfrom the selected industry for investment. For this purpose the investor has to carefullyanalyse various important fundamental factor which influences the valuation and growthprospects of the company.

2. FACTORS TO BE CONSIDERED

a) The Core strength of the Company

Each and every company has it’s own competitive edge when compare to others.For example Unilever, Colgate Palmolive Ltd., and P&G are having lot of powerful brandsin their product portfolio. This competitive edge helps the companies to retain and increasetheir customer base and market share. This competitive edge ensures stable earnings forthe company.

b) Market Share

The market share enjoyed by a company facilitate strong earnings growth. For exampleTatamotor’s significant market share in automobile industry enables the company to haveconsistent profitability. When a company has high market share in it’s product it acts asprice dictation. It dominates in various marketing activities. This dominant certainly guaranteehigh profit margin.



c) Growth of Sales

The Growth of the sales of the company should be steadily increasing, so that it’sfinancial results really improves. The growth of sale indicates the increasing market share,increasing number of loyal customers. Such growth results in optimum utilization of theresources of the company.

d) Profitability

The profitability is the result of the efficiency of various functional areas of the company.The increase in cash profit and operating margin really improves the liquidity conditions ofthe company. Besides paying a reasonable dividend to share holder the company can usethe surplus for expansion programme and reduce it’s debts burden, so as to reduce thecost of capital. All these will certainly increase the financial position of the company.

3. MEASURING EARNINGS

The investor has to go through the financial statements and analyse the profitabilityand financial position of the company. The various accounting policies and accountingstandards adopted by the company for preparation of the financial statement should beunderstood so that the real financial health of the company is known. In this regards thefollowing areas should be carefully analysed

Analysis of Financial Statement

The Trading, Profit and Loss account and Balance sheet are the basic financial statementof a company. The Trading, Profit and Loss account shows the results of one year businessoperation that is loss profit or loss. The Balance sheet shows the financial position of thecompany. Following are the techniques of financial statement analysis

a) Comparative Financial Statement

The figures of financial statement for more than one period are presented in a table foranalysis. The increase or decrease of various items such as expenses, income, liabilitiesand assets over two years period are calculated and shown in terms of actual amounts andpercentage. Such analysis helps the investor which items is increasing or decreasing andthe percentage of increase or decrease.

b) Common Size Statement

The common items in the financial statements are taken as hundreds and the rest ofthe items are converted as a percentage of the common item. For example in common sizeincome statement the sale figure is taken as hundred and all the expenses are converted asa percentage of sales. Similarly in common size balance sheet the total liabilities are takenas hundred and all the liabilities are shown as a percentage of the total liabilities. Whencome to assets side of the balance sheet the total asset is taken as hundred and all the

NOTES



assets are converted as percentage of total assets. This exercise simplifies lengthy accountingfigures and facilitates easy and quick understanding of the importance of each and everyaccounting figure.

c)Trend Analysis

The Trend analysis considers more than two years figures. For example a company’sfive years balance sheet can be shown in the form of table by taking the first year figure asbase data. The base data is taken as hundred and the subsequent years figures areconverted as a percentage of the based data. This Trend Analysis helps to understand themovement of the trend of the profitability and the financial position of the company.

d) Funds Flow and Cash Flow Analysis

The funds flow and cash flow analysis shows the various sources of funds andapplications of funds of a company. It shows changes in the financial condition of thecompany over two years period. This statement also shows funds earned from corebusiness or funds lost in the core business. The Cash flow statement shows the routecauses of changes in cash position over two years period.

e) Ratio Analysis

Ratio is a relationship between two accounting figures expressed mathematically.Calculating ratio and analysing the same will give a better picture about the turn overefficiency, profitability and financial position of a company. There are many ratios but theratios under the following classifications will be immense useful to the investor (i) Profitabilityratios, (ii) Turn over ratio, (iii) Leverage ratios (iv) Valuation ratios.

4. FORECASTING EARNINGS

It’s all about earnings. When you come to the bottom line, that’s what investors wantto know. How much money is the company making and how much is it going to make inthe future.

Earnings are profits. It may be complicated to calculate, but that’s what buying acompany is about. Increasing earnings generally leads to a higher stock price and, in somecases, a regular dividend. When earnings fall short, the market may hammer the stock.Every quarter, companies report earnings. Analysts follow major companies closely and ifthey fall short of projected earnings, sound the alarm. While earnings are important, bythemselves they don’t tell you anything about how the market values the stock. To beginbuilding a picture of how the stock is valued you need to use some fundamental analysistools.

The investor has to predict the future earnings of the company, so as to know thereturns on his investment. The cost structure changes in sale and provisions etc., will



influence the profitability. To predict earnings in the following factors should be carefullyanalysed

a) The cost and sales

The cost structure that is the proposition of variable cost and fixed cost and thepattern of sales affects the profitability of the company. When the fixed cost proportion isvery high the company can earn more profit by increasing volume. Therefore growth insale under the circumstances will yield maximum benefit to the company.

b) Depreciation

The provision for depreciation and other reserve determine the profitability of thecompany. If the company follows a conservative approach then the amount of depreciationand other reserve will be very high and leaves share holders with very less cash dividend.From such companies the shareholders can get only less immediate return. However thebook value of the share may increase and in turn the market value of the equity shares getsincreased. If the company changes the method depreciation it will have an impact on theprofitability.

c) Depletion of resources

If the company is in oil, mining, gas and forest based business the depletion of suchnatural resources will pull down the profitability of the company. Therefore the resourcesavailable and the rate of depletion will give a hint about the future profitability of the company.

d) Employee cost

If the company is in manpower intensive industry and if the manpower cost is increasingthen the future profitability of the business is doubtful. For example there is a consistentincreasing employees cost in Indian IT Sectors and the profit margin is affected.

e) Currency Value

If the company is in export or import business the currency value against overseascurrencies determine the profitability. For instance for the last one year the Indian currencyappreciate against U.S $ benefiting the importers and affecting the exporters. Thereforethe trends of currency value can give better idea about the future profit margin of thecompanies.

f) Capital Structure

The capital structure that is the source of long term capital employed by a companyinfluences the ultimate profit available for the equity share holders. By employing debtcapital the company can reduce the cost of capital since the payment of interest is madebefore payment of corporate tax and results in tax savings. Above all the company promisesto pay interest to the debenture holders irrespective of the profitability of the company

NOTES



Thus the debenture holders are on safer side and they expects only a reasonable interest.Thus the after tax cost of debt capital is always less . So the capital structure indicates infuture returns available for the equity share holders.

g) Efficiency of management

If the board of directors consists of highly experienced, efficient and dedicated peoplethen the company can be really successful. The efficiency of the management will bereflected in terms of ; introduction of new products, financial discipline, good corporategovernance and taking strategic decision.

SUMMARY

This type of looking at the problem consists of selecting the stocks based on informationregarding the financial situations of the company, its area of activity, and also on comparingthe price with other similar ones from the market. The fundamental analysis is useful wheninvesting in stocks for a long period of time (at least a year). Those who use this type ofanalysis have themselves different objectives of evaluation and profit, using mostly certaincriteria.

The investor has to go through the financial statements and analyse the profitabilityand financial position of the company. The various accounting policies and accountingstandards adopted by the company for preparation of the financial statement should beunderstood so that the real financial health of the company is known.

Earnings are profits. It may be complicated to calculate, but that’s what buying acompany is about. Increasing earnings generally leads to a higher stock price and, in somecases, a regular dividend. When earnings fall short, the market may hammer the stock.Every quarter, companies report earnings. Analysts follow major companies closely and ifthey fall short of projected earnings, sound the alarm. While earnings are important, bythemselves they don’t tell you anything about how the market values the stock. To beginbuilding a picture of how the stock is valued you need to use some fundamental analysistools.

The investor has to predict the future earnings of the company, so as to know thereturns on his investment. The cost structure changes in sale and provisions etc., willinfluence the profitability. To predict earnings in the following factors should be carefullyanalysed

Key Terms

• Market Share• Comparative Financial Statement• Common Size Statement• Trend Analysis



• Funds Flow and Cash Flow Analysis• Ratio Analysis

Questions

i) What do you mean by market share of a company?ii) What is meant by Comparative Financial Statement, Common Size Statement?iii) What is the use of Trend Analysis for taking investment decision?iv) Explain the uses of Funds Flow and Cash Flow Analysis and Ratio Analysis for

stock analysisv) How would you forecast earnings of a company? Explain

NOTES



CHAPTER - IV

APPLIED VALUATION TECHNIQUES

Learning Objectives

After going through this chapter you would be able to understand the concept ofapplied valuation techniques, Graham and Dodds Investor ratios, The Dividend DiscountingMethod, P/E Ratio Model and other Models

1. INTRODUCTION

Fundamentalists, make a careful analysis of shares. According to them, there shouldbe a preliminary screening of investment, the economic and industrial analysis and analysisof the company to find out its profitability and efficiency and a study of the different kindsof company’s management. Future projections of investments also form a major role inthe study of investments.

The fundamental school of thought has developed certain valuation models to showthe effect of business decisions based on the market value of a firm. The fundamentalvaluation models were first laid by Timbergen and William. They were further developedby Graham Dodd Bodenhorn, Ezra Solomon and Modgiliani Miller.

2. GRAHAM AND DODDS INVESTOR RATIOS

In their book on Security Analysis (1934) Benjamin Graham, and David Dodd, arguedthat future earnings power was the most important determinant of the value of stock. Theoriginal approach of identifying the undervalued stock is to find out the present value offorecasted dividends, and if the current market price is lower, it is undervalued. Alternatively,the analyst could determine the discount rate that makes the present value of the forecasteddividends equal to the current market price of the stock. If that rate (I.R.R. or discountrate) is more than the required rate for stocks of similar risks, then the stock is underpriced.

Graham and Dodd had argued that each dollar of dividends is worth four times asmuch as one dollar of retained earnings (in their original Book); but subsequent studies ofdata showed no justification for this. Graham and Rea have given some questions onRewards and risks for financial data analysts to answer yes or no and on the basis of thesestudy to answer questions, they decided to locate undervalued stocks to buy and overvaluedstocks to sell.



Such readymade formulas or questions are now out of favour due to various empiricalstudies which showed that earnings models are as good as or better than dividend modelsand that a number of factors are ably studied for common stock valuation and no uniqueformula or answer is justifiable.

3. THE DIVIDEND DISCOUNTING METHOD

The expected future dividend payments by the company are discount to the presentday by the use of an appropriate discount rate, which is supposed to reflect the magnitudeof risk-free return. The risk premium of stocks may have some risk element and manyadditional uncertainties. In this model, each of the future year’s dividend up to, say, for ‘n’years (10 years) is discounted with the appropriate discount rate to the present and summedup to arrive at the worth of the stock today. Dividends are expected to remain constantand the discount rate is assumed to remain unchanged. In this simplified model, no provisionis made for changes in dividend or for a variable growth of dividend/ earnings. The formulais D/K –g, where D is the dividend, k is the discount rate and g is the constant growth rateof dividends. In this model, the discount rate is a mater of individual perception and issubjective. It is based on the expected depreciation of the rupee and one’s own timepremium of the present over the future. Thus, today one rupee may be worth Rs. 1.10 inthe next year (a premium of 10 per cent inclusive of inflation).

4. P/E RATIO MODEL

The present value of the stock is also arrived through the assumed relationship betweenthe P/E ratio of a company and that of the average of the whole industry in which thecompany is. If the company’s P/E ratio and the industry P/E ratio have some relationship,these can be related to derive the industry relative, which can be applied to the company’searnings per share to arrive at its price. Thus, if P/E for electronics has a P/E relative at 15,then for the company in electronics industry says Tata Unisys data on earnings persharecan be multiplied by 15 to arrive at its price. If this price is higher than the market price, thesecurity is undervalued and vice versa.

5. OTHER MODELS

Some writers speak of two supplementary to valuation which came into fairly wideuse, namely, price –to-asset ratio According to the first, the stocks of a company areevaluated by references to the true net asset values using various capital goods and inventoryprice indices to adjust reported book values. A number of analysts define this as thereplacement cost of book value of the company. Some take it as the net working capitalper share measured by current assets minus current liabilities, fixed assets minus long-termdebt and preferred stock minus intangible assets dividend by the number of shares. This issomething like the breakdown value of the company’s assets.

NOTES



According to the second, the average price –to-sales ratio of the industry group isapplied to the company price to sales or P/S ratio to judge whether it is overpriced orunder priced. A low P/S ratio indicates a low probability of bankruptcy and hence a goodbuy, if other conditions are satisfied for choosing the company.

6. BUYING STOCKS - BASED ON THE FUNDAMENTAL ANALYSIS

Certain criteria are to be taken into consideration. There are three important categoriesthat can be used alone or in combinations.

a) Value investing

Some of the long term investors are preoccupied with determining the value of thebusiness they are placing their money in, searching to buy the stock at the greatest discountpossible compared to the calculated value. In other words, the question here is how muchdo the companies’ goods would be worth if they were to be sold? An estimative answercan be given evaluating active elements they posses (such as lands, fixed transportationmeans, floating actives) at a correct market price, adding to that the funds the companyhas. Investors who use this criterion think that the respective business has a future in efficiencyif the stock holders are to be chanced, if the economic environment is changed and improvedor any other major alteration, at which moment the company would value at least threetimes as much as in the beginning.

b) Growth Stocks

They are used by the investors preoccupied with identifying companies belonging toareas that tend to increase and to expand. They are focusing on the rhythm of evolution ofthe business figure and profit, determining the growth rate in real terms. This can beforecasted upon the future, but it is necessary to also identity the economic and legislativerisk factors that could appear and alter the graph. Also investors reflect upon the quality ofthat company and their advantage or disadvantage compared to concurrent companies.Usually, growing companies don’t give dividends, the profit remaining just the differencebetween the buying price and the selling price of a stock. These companies are the mostrisky ones, especially because of the lack of dividends, which could’ve added some stability.

c) Income Stocks

Income stocks are dividend stocks. Investors prefer these stocks because theygive them some stability and a clear benefit. These stocks are recommended if the stockprice is lower than the estimated dividend price, and if they belong to mature companies.Usually, when investing in such stocks investors are making a long-term investment.



7. SELLING STOCKS - BASED ON THE FUNDAMENTAL ANALYSIS

A stock has to be sold if analyzing the situation fundamentally when the answer to thequestion “Why am I buying this stock?” is not true anymore. The following situations canalso be reasons to sell: - a newsflash about a company or about the entire economic areamodifies initial expectations - the price for the stock has been over evaluated

- over evaluation can be determined by comparing it with the ones from othercompanies

Before investing in a company the investor has to inform himselves about the businessarea it belongs to, taking into consideration the factors that stick to that area and to themacro-economical environment. Let’s briefly review some selecting methods and norms.

a) Business Area

Competition: It always helps to know how much of the market our company hasand if it has or not an advantage that can make it superior to others.

The customer power: How much does the company depend on customers? Coulda customer buy a concurrent company to integrate production?

If the products being offered by the companies are threatened by the state, society orsome kind of substitute goods that might exist on the market.

If hurdles exist on the market area the company has placed its business in.

b) The structure of share holders: Companies that have most of their shares on thestock market should be preferred. This is because there will be more liquidity in suchstocks and in times of crisis one will not be “stuck” with these shares.

c) Financial performance: The investor should watch the growth and efficiency indicatorsover a relevant interval of 3 to 5 years of that company and of its peers. Also it’s importantto know the debt if any, the health of the transactions, and the cash balance variable factor.

8. HOW IS THE COMPANY EVALUATED BY THE MARKET? - To correctlyanswer the investors have to look through three further factors:

- The P/E multiple of a stock, notion that has as theoretical interpretation the numberof years in which the starting costs are paid back with the profits.

- The price/book value which generally depends on the efficiency of the company.- The dividend yield that only occurs when we are talking about companies that give

their shareholders dividends for every share.

NOTES



Summary

Fundamentalists, make a careful analysis of shares. According to them, there shouldbe a preliminary screening of investment, the economic and industrial analysis and analysisof the company to find out its profitability and efficiency and a study of the different kindsof company’s management. Future projections of investments also form a major role inthe study of investments.

In their book on Security Analysis (1934) Benjamin Graham, and David Dodd, arguedthat future earnings power was the most important determinant of the value of stock. Theoriginal approach of identifying the undervalued stock is to find out the present value offorecasted dividends, and if the current market price is lower, it is undervalued.

The expected future dividend payments by the company are discount to the presentday by the use of an appropriate discount rate, which is supposed to reflect the magnitudeof risk-free return. The risk premium of stocks may have some risk element and manyadditional uncertainties. In this model, each of the future year’s dividend up to, say, for ‘n’years (10 years) is discounted with the appropriate discount rate to the present and summedup to arrive at the worth of the stock today.

The present value of the stock is also arrived through the assumed relationship betweenthe P/E ratio of a company and that of the average of the whole industry in which thecompany is. If the company’s P/E ratio and the industry P/E ratio have some relationship,these can be related to derive the industry relative, which can be applied to the company’searnings per share to arrive at its price.

Some writers speak of two supplementary to valuation which came into fairly wideuse, namely, price –to-asset ratio According to the first, the stocks of a company areevaluated by references to the true net asset values using various capital goods and inventoryprice indices to adjust reported book values. A number of analysts define this as thereplacement cost of book value of the company.

Key Terms

Graham and Dodds Investor ratiosThe Dividend Discounting MethodP/E Ratio ModelValue investingGrowth StocksIncome Stocks



Questions

i) What do you mean by applied valuation technique?ii) Explain Graham and Dodds Investor ratiosiii) Discuss about the Dividend Discounting Methodiv) What is meant by P/E Ratio Modelv) What do you understand by Value investingvi) Breifly explain Growth Stocks and Income Stocks

NOTES



UNIT - IV

TECHNICAL ANALYSISCHAPTER - I

TECHNICAL ANALYSIS AND CHARTING METHODS

Learning Objective

After going through this chapter you would be able to understand the concept ofTechnical Analysis, the differences between Technical Analysis and Fundamental Analysisand various charting methods.

1. INTRODUCTION

The fundamental analysis focus on the analysis of the economy, industry and companyfor investment decisions. The decisions are based on fundamental facts but the fundamentalanalysis ignores the importance of market timings ie…entry and exit timings. The technicalanalysis focus on the price movements and volume so as to give signals to the investor toidentify the right entry and exit timings.

The shares and securities price movements are analyzed broadly by two keyapproaches, namely Fundamental approach and Technical approach. The Fundamentalapproach emphasis much on the growth prospects of economy, stability of government,the prospects of the specific industry and the specific company where as the technicalapproach emphasis much on the price and volume movement of the stock. Based on theprice and volume movements of stock the buying and selling decisions are taken.

The technical approach is the oldest approach to equity investment, dating back tothe late 19th century. The Technical analysis continues to flourish in modern times as well.It is widely used by institutional investors, operators and a large number of retail investors.In fact the investor analyses both fundamentals and technical so that he can buy the rightstock at right time. The Technical approach to investing is essentially a reflection of the ideathat prices move in trends, which are determined by the changing attitudes of investorstowards a verity of economic, monetary, political and psychological forces. The Technical



analysis helps the investor to identify the trend reversals at an earlier stage to formulate thebuying and selling strategy.

2. TECHNICAL ANALYSIS – MEANING

Technical an analysis is applied to find out the future direction of the market by analyzingthe past and current price as well as volume movements. With the help of charts andgraphs the patterns are analysed to predict the market trend. Technical analysis can beapplied to the market as well as to the individual scrip. The technical analyst believes thatthe market is in a trend and they try to predict the trend well in advance so that the investorcan take buying and selling decisions at appropriate timings.

3. ASSUMPTIONS OF TECHNICAL ANALYSIS

a) The market price of a stock is basically determined by the demand and supplyforces.

b) Various rational and irrational factors influence the demand and supply of stocks.

c) The market discounts everything. The good news and bad news will cause theshift in demand supply forces.

d) The market moves in trend. The trend is formed subject to minor corrections.

e) The trend may be up or down or flat. The shift in demand and supply results inchange in the trend.

f) The technical analyst analyse the past price behaviour of the market / stock topredict the future trend.

g) The price pattern can be predicted with the help of technical charts.

4. FUNDAMENTAL ANALYSIS VS TECHNICAL ANALYSIS

There are two primary schools of thought regarding security analysis - fundamentaland technical analysis. Fundamental analysis utilizes a much wider range of informationthan does technical analysis and relies on traditional financial statement analysis. Technicalanalysis, on the other hand, concerns itself with attempting to identify patterns in past pricemovements. Both consider macro economic trends to differing degrees, but emphasize theuse of firm specific microeconomic data.

Fundamental Analysis

Fundamental analysis generally refers to the study of the economic factors underlyingthe price movement of securities or commodities, not the price movements themselves.For the most part, this form of analysis usually results in longer-term investments and isconsidered to be a more conservative approach. At a high level, fundamentalists attempt

NOTES



to quantify the current value of a stock by gathering data relating to general industry outlook,overall market conditions, corporate financial strength, historical patterns of sales, earnings,market share, dividends, etc. Using this data they then try to assign a future value to thestock by interpretation and projection. The difference between the current and future valuesreflects the fundamentalist’s assessment of the stock’s potential as an investment opportunity.Investment decisions are made based on this fundamental information relative to otheropportunities.

Much of the work of the fundamentalist involves accurately projecting earnings goingforward and the factors affecting earnings. In theory, the fundamentalist who can makeaccurate projections and who chooses quality securities when they are under-valued andsells them when they are over-valued can reap substantial profits. Of course, when theseassessments are faulty the result is a tendency to maintain a losing position longer thannecessary.

Technical analysis is based on the following three principles:

Everything relevant to the value of a company’s stock is discounted and reflectedin share price.Trends sometimes appear in share price moves and when once started, thesetrends tend to persist.Activity in the market repeats.

The purpose of technical analysis is to detect the trend or momentum of a stock earlyso that a good entry or exit point can be selected. Traditionally, charting is the main approachfor technical analysis. However, interpreting a chart or an indicator is, at least in part, asubjective issue. Even if you have the knowledge and experience to understand what achart is telling you, the accuracy is still limited since many trading patterns and somecorrelative information are not visible or not perceptible directly. The technical analysisgenerally concentrates on the study of historical price and volume data to detect futuretrends.

Within the ranks of technical analysis there are two factions - chartists and technicians.While the chartist embraces a more visual approach to the analysis, the technician uses amore quantitative approach and often employs sophisticated statistical methods. Chartistsrefer to line studies such as trendlines, triangles, speed resistance lines, Gann angles, andthe like. Technicians employ technical indicators which usually are variations of commonstatistical methods such as ordinary least-square regression, exponential moving averages,etc. Whereas fundamental analysis allows you to make an informed determination of acompany’s current share valuation, technical analysis aims to improve the timing of yourinvestment.



6. CHARTING METHODS

Technical analysis uses charts as important tool to predict the future trend of shareprice movement. The price movements of a stock presented in the form of charts enableinvestor to easily understand and predict the price movements. The graphical presentationhelps the investor to understand the past and present price movements. The charts indicatethe main support and resistance levels of the stock.

6.1 POINT AND FIGURE CHART

The Point and figure chart is useful to predict the change of price direction. The pointand figure chart is drawn on the ruled paper. The price interval of the stock is entered onthe left side of the chart. For high priced scrip the price intervals are high and for lesspriced scrip the price intervals are less. When the price of the scrip moves up to the nextprice interval then it is marked up with “X” symbol and as long as the share price increasesthe “ X “ symbols are plotted in the vertical column. When the share price declines by theprice intervals then the chart is plotted with “O” symbols in the next column. The pricemovements are analysed and interpreted by reading the ‘X” and “ O” symbols on thechart.

The point and figure chart have the price interval of Rs.3 when ever the price rises byRs.3 then the chart is plotted “X” symbols vertically and when price declines by Rs.3 thenthe chart is plotted with “O” symbol in the next column. The point and figure chart showsthe support and resistance levels and also indicates the buy and sells signals. However the

NOTES



point and figure chart fails to show the intra – day price movements and minor fluctuationsbelow the selected price intervals. The chart does not show the volume which is veryimportant aspect of technical analysis.

6.2 BAR CHART

The bar chart is based on the statistical technique. The bar chart shows the completeprice movements of a stock. It reveals the days opening price, low price, high price,closing price and the volume of a stock. The closing price and opening price are markedin between the high price and low price by marking a tick on the vertical bar. The volumeof transactions is shown as separate vertical bars in the bottom portion of the bar chart.

Bar Chart

Source:finance.yahoo.com



6.3 LINE CHART

The line chart is the simple presentation of price movement of a stock over a specifiedperiod. The period is represented by “ X” axis and the price movement is represented by“ Y” axis. The closing price of the stock for various period are plotted in the chart withdots and then all the dots are joined by a line and the line is called variable line. Line chartscan be prepared by considering daily closing price, weekly closing price or monthly closingprice. To predict short term movements daily closing price can be used to prepare linecharts. To predict medium term and long term movements the weekly and monthly closingprice can be considered. Traders in the stock market prepare intra – day line charts byconsidering every ten minutes / 1/2 hr price movements.

The line chart can be prepared for volume of a stock, index numbers or total volumeof the stock exchange.

Line Chart

Source: finance.yahoo.com

6.4 CANDLE STICK CHART

The candle stick chart shows the price movements of the stock in vertical form. Thetop and bottom points of the stock passes through the candle. A clear candle without anyshading indicates increase in price and a shaded candle indicate decrease in price. Whenthe day’s closing price is higher than the opening price then it is considered as increase inprice and the candle is kept clear.

NOTES



When the day’s closing price is less than the opening price it is considered as decrease inprice and the candle is shaded. The candle stick chart shows the day’s opening price, lowprice, high price and closing price and the price movements. The candle stick charts canbe prepared for weekly or monthly.

Candle stick Chart


Summary

The fundamental analysis focus on the analysis of the economy, industry and companyfor investment decisions. The decisions are based on fundamental facts but the fundamentalanalysis ignores the importance of market timings ie…entry and exit timings. The technicalanalysis focus on the price movements and volume so as to give signals to the investor toidentify the right entry and exit timings.

Technical analysis uses charts as important tool to predict the future trend of shareprice movement. The price movements of a stock presented in the form of charts enableinvestor to easily understand and predict the price movements. The graphical presentationhelps the investor to understand the past and present price movements. The charts indicatethe main support and resistance levels of the stock

The Point and figure chart is useful to predict the change of price direction. The pointand figure chart is drawn on the ruled paper. The price interval of the stock is entered onthe left side of the chart. For high priced scrip the price intervals are high and for lesspriced scrip the price intervals are less



The bar chart is based on the statistical technique. The bar chart shows the completeprice movements of a stock. It reveals the days opening price, low price, high price,closing price and the volume of a stock. The closing price and opening price are markedin between the high price and low price by marking a tick on the vertical bar. The volumeof transactions is shown as separate vertical bars in the bottom portion of the bar chart.

The line chart is the simple presentation of price movement of a stock over a specifiedperiod. The period is represented by “ X” axis and the price movement is represented by“ Y” axis. The closing price of the stock for various period are plotted in the chart withdots and then all the dots are joined by a line and the line is called variable line. Line chartscan be prepared by considering daily closing price, weekly closing price or monthly closingprice

The candle stick chart shows the price movements of the stock in vertical form. Thetop and bottom points of the stock passes through the candle. A clear candle without anyshading indicates increase in price and a shaded candle indicate decrease in price. Whenthe day’s closing price is higher than the opening price then it is considered as increase inprice and the candle is kept clear.

Key Terms

Technical AnalysisPoint and Figure chartBar ChartLine ChartCandle stick Chart

Questions

1. What do you understand by Technical Analysis?2. Explain the assumptions of Technical Analysis3. Discuss the differences between Fundamental Analysis and Technical Analysis4. Draw a Point and Figure Chart with imaginary figures and explain5. What do you understand by Bar Chart and Line Chart?6. Draw a Candle stick Chart

NOTES



CHAPTER- II

MARKET INDICATORS, PATTERNS AND DOW THEORY

Learning Objective

After going through this chapter you would be able to understand the various TechnicalIndicators, Trend, Patterns and Dow Theory

1. INTRODUCTION

The indicator analysis gives a hint about the future direction of the scrip and marketwith the help of series of calculations and analysis of price movements and volumemovements. The technical analysts are trying to get the indications of the future direction.

2. PUT/CALL RATIO

A put option gives the purchaser the right, but not the obligation, to sell a security fora certain price by a specific time. Conversely, a call option gives the buyer the right, but notthe obligation, to buy a security for a certain price by a specific time. An extremely highput/call ratio indicates fear in the market, since more investors are betting on a downturnrather than an upturn. On the other hand, an extremely low put/call ratio indicates anabundance of optimism, as investors are aggressively betting on future stock market gains.

3. FUND MANAGER SURVEYS

Many print and electronic media organisations conduct such surveys during thebeginning of every calendar year. Usually, it is observed that, in case a vast majority of theresponses are on any particular side (either bullish or bearish), it is very likely that exactlythe opposite will happen during the course of the next year.

In fact investment professionals (as a group, rather than as individuals) often eclipsethe weather department in terms of inaccurate predictions. In the US, the Yale School ofManagement Stock Market Confidence Index is based on investor surveys.

4. VOLATILITY INDEX

A high VIX reading indicates high volatility and tends to occur when fear is prevalentin the market. A low VIX reading indicates complacency, which is typically associatedwith stock market tops. Though this VIX is associated with the Chicago Board of Options



Exchange, the Securities Exchange Board of India has indicated that such a VIX for theIndian stock market should be launched soon.

5. MUTUAL FUND DATA

There are other indicators as well, like mutual fund data that can be used to evaluatesentiment and gauge the excesses. When mutual funds are holding lower than average cashbalances, there is usually less liquidity available for investing in stocks and is negative forthe stock market outlook. This often coincides with an extremely positive economicenvironment, which in turn, makes a stock market correction look extremely improbable.The drawback involved in blindly following such sentiment indicators is that they are oftentoo early in predicting trend reversals. Hence, even if a trend looks overextended, thereare no set rules as to when it will end. As the famous saying by John Maynard Keynesgoes, “Markets may remain irrational for far more time than you can remain solvent”.Hence, remember that while such indicators give you a clue, do not over react to them.

6. MOVING AVERAGES

Technical Analysts are using indicators like; Volume of trade, Breadth of the market,Moving averages, Short sales position, Odd lot trading, Relative strength and Cash reserveratio of Mutual funds. Theses indicators are used to predict the direction of the pricemovements of scrip and the direction of the market and of theses indicators the Movingaverages is considered as most reliable and better indicator of the future direction. Most ofthe Technical analysts use the Moving average since it is very simple and gives reliablesignal about the forth coming bull / bear trend.

The word moving means that the body of data moves ahead to include the recentobservation. If it is 10 days Moving averages, on the 11th day the body of data moves toinclude the 11th day observation eliminating the first day’s observation likewise it continues.For the Moving average calculation the closing price of the stock is considered, becausethe day’s closing price gives better indication about the next day’s movements than theintra day’s high low price. The Moving average can be calculated for the individual scripand for the Index and it indicates the underlying trend in the scrip (or) the market as thecase may be. To predict short-term trend 10 – 30 days, to predict medium term, 50 – 125days and to predict the long – term 200 days Moving averages can be applied.

6.1 USES OF MOVING AVERAGES

There are many advantages of Moving averages. It is possible to identify the trendand confirm the trend. There are three ways to identify the direction of the trend withMoving averages; i) direction, ii) location and iii) crossovers.

NOTES



The first trend identification techniques use the direction of the moving average todetermine the trend. If the Moving averages are rising, the trend is considered up. If theMoving average is declining, the trend is considered down.

The location of the price relative to the Moving average can be used to determine thebasic trend; if the price is above the Moving average the trend is considered up if the priceis below the Moving average the trend is considered down.

The third technique for trend identification is based on the location of the Short-termMoving average relative to the Long term Moving average and if it is above the Long-termMoving average the trend is considered up. If the Short term Moving average is below theLong-term Moving average then the Long term Moving average trend is considered down.

Another important use of Moving average is the identification of support and resistancelevels. It helps the investor to find out the Support and Resistance Level for the market aswell as for individual stock. Support and resistance level identification through Movingaverages works best in trending market.

6.2 INDEX MOVING AVERAGE AND STOCK PRICE

The individual stock price can be compared with the moving average of the StockMarket Index say Nifty 50. The Moving average of the Index and the stock price areplotted in the same sheet and trends are compared. If the closing price of the stock isabove the Moving average of the Index then the stock is said to be in bullish mode. Whenthe closing price of the stock crosses and falls below the Moving average of the Index thestock is said to be bearish.

Moving Averages are calculated for S&P CNX NIFTY-50 and ACC Share price.

The closing price and closing index values are considered for the analysis for a periodof three years from 27.08.03 to 27.08.06. The data were gathered from www.nseindia.com.For easy and meaning full comparison the ACC Stock price and the Index values areconverted to 100 during the study period.

Charts –1, 2 and 3 shows the Moving average of the S&P CNX NIFTY – 50 andthe daily closing price of ACC Stock for the last three years. The Moving averages arecalculated for a period of 10 days, 50 days and 200 days. It is very obvious that when thestock price crosses the Moving averages of the Index the stock goes to a bull mode.



CHART - 1

CHART - 2

NOTES



CHART - 3

Points to be considered while applying the Moving averages

The Moving averages follow the trend and works well when the stock is trending butthe same Moving average fails as an indicator when the stock is in trading range. Thereforethe investor who tries to apply the Moving averages should see whether the particularstock is trending. This process does not have to be a scientific examination. Usually, asimple visual assessment of the price chart can determine if a stock exhibits characteristicsof trend. In its simplest form a stocks price can be of three forms; trending up, trendingdown or trading in a range

An up trend is established when a stock reaches higher highs and higher lows. Adown trend is established when a stock a touches lower lows and lower highs. A tradingrange is established if a stock cannot establish neither up trend nor down tend.

Once a stock has been with enough features of trend then the next important task isto select the number of moving average periods. The factors such as stock’s volatility,trendiness and personal preference should be considered for the selection moving averagesperiod. If the stock’s volatility is high it is better to select long period so as to smoothen themoving average. The speculators would prefer short term moving average and the investorwould prefer long-term moving averages. However the trial and error method would givebest results. Price movements should be carefully watched. If there are too many breaks,lengthen the moving average to decrease its sensitivity. If the moving average is slow toreact short – term the moving average to increase it sensitivity.



Moving average can be effective tool to identify and confirm trend and to identify thesupport and resistance levels. However the investors should ensure that the selectedstock is in trending before applying the Moving average. The Moving average will help toensure that a stock is in line with the current trend. As with most tools of Technical analysisMoving averages should not be used on their own but in combination with other tools thatcomplement them. Using Moving averages to confirm other indicators and analyzing cangreatly enhance Technical analysis.

However the Moving average is not a perfect tool of Technical analysis and it has itsown limitations. The Moving averages are lagging indicators and will always be “behind”the price. When the price movement results in bull trend or bears trend then the Movingaverage works well as an indicator. However when the price movements are not forminga trend, the Moving averages will give misleading signals.

Moving Average – 5 Days


NOTES






Exponential Moving Average (EMA)

A type of moving average that is similar to a simple moving average, except that moreweight is given to the latest data. Also known as “exponentially weighted moving average



This type of moving average reacts faster to recent price changes than a simplemoving average. The 12- and 26-day EMAs are the most popular short-term averages,and they are used to create indicators like the moving average convergence divergence(MACD) and the percentage price oscillator (PPO). In general, the 50- and 200-dayEMAs are used as signals of long-term trends

Exponential Moving Average Calculation

Parameters: n - number of days

Notes:

Exponential moving average is related to simple moving average. In other words it isa weighted simple moving average putting more weight on the today’s closing price. It maybe measured in percentage, which is the percentage that is applied to today’s closing priceweighting yesterdays simple moving average. The formula to convert exponential percentageinto simple moving average number of span days is as following:

Simple Vs. Exponential Moving Averages

A question about moving averages that seems to weigh heavily on many swing traders’minds is whether to use the “simple” or “exponential” moving average. Perhaps because ofits name, an exponential moving average sounds more sophisticated or more elegant thanthe simple moving average. The simple moving average may sound, perhaps, too simple.

The exponential moving average is considerably more complicated. The basic conceptis that it weights the most recent price data most heavily. The formula for the weighting ofthe current trading day’s value is 2 / (n+1), where “n” is the number of days in the movingaverage. The result of this weighting is then added to the previous exponential movingaverage calculation.

For example, let’s say you were calculating a 10-day exponential moving average.To the previous exponential moving average figure you would add the weighting of 2 / (10+ 1), or 2/11, or .1818 times the current closing price. If you were working with a 20-daymoving average, then the calculation would be 2/21 or .095 times the current close addedto the previous exponential moving average. The longer the period for which you calculatethe moving average, the less of an impact the exponential weighting has on the most recentdata.

NOTES



Moving averages are lagging indicators, and therefore, by definition, will give latesignals. By weighting recent price data more heavily, exponential moving averages attemptto speed up the signal given. The disadvantage of doing this, of course, is that this more-rapid signal can sometimes be premature and therefore give the swing trader a false indicationto trade.

Exponential Moving Average – 200 Days







Moving Average Convergence and Divergence (MACD)

MACD is another indicator used for disinvestment and investment process. It measuresthe convergence and divergence between two exponential or simple moving averages.Two series of closing price data – one for short term moving average of say 12 day and theother for 26 days of long-term moving average. The MACD should reflect the absolutedifferences between these two moving averages. With differences shown the Y-axis anddays represented on the X-axis the chart can be drawn with a MACD line oscillatingacross the zero line.

As long as the MACD line moves above the zero line but likely to cross it, we haveto select a point for disinvestment. Care has to be taken to see that some false signals arenot pursued, but disinvestment may be based on some confirmation of likely trend to crossthe zero line from above. This means that the short-term moving average is above thelonger one, and the MACD is positive and in the opposite case, it is negative and fallsbelow the zero line. This is seen from the above chart of MACD.

One can see many sell signals in the above chart, namely, A,B,C and D but after Dthe line started falling continuously and crossed the zero line and thus the point of ‘D’ is thelast chance for disinvestment with advantage. If the market is in the overbought zone onecan sell but not in the coversold zone. A daily chart prices will first give preliminary indications,which are to be confirmed by the oscillators or the MACD lines. Even with confirmation,one cannot be certain that the disinvestment has taken place at the right time. Experimentationand research through stimulation is the only guide to expertise and experience in the field oftechnical analysis to act as an aid for disinvestment management.

NOTES



Moving Average and Moving Average Convergence and Divergence – 5 Days


7. VOLUME

The popular technical analyst Charles H Dow emphasized on the volume of sharestraded in understanding the price movements of a stock. The volume of shares tradedincreases consistently during bull market and the volume will decline during bear market.High price increase with high volume indicates the bull trend and significant price decreasewith low volume indicates the bear trend.

8. MARKET BREADTH

The market breadth is an important technical indicator and widely used by technicalanalyst to predict the future trend. The market breadth is the difference between numberof stocks advanced and number of stocks declined. If the day’s closing price of a stock ismore than the previous day’s closing price then it is said to be advanced. If the daysclosing price of a stock is less than the previous day’s closing price then it is said to bedeclined. The cumulative index of net differences of number .of stocks advanced andnumber of stocks declined measures the market breadth.



When the market breadth is positive and consistently increasing it indicates the bullmarket. Instead if the market breadth is reducing then it is the signal of bear market. Themarket breadth can be shown in the form of chart also. The market breadth can becompared with the bench mark like Sensex or Nifty to get indication about future direction.The consistent decline of market breadth in a bull market indicates the end of bull marketand forthcoming bear market. Whereas the consistent increase in market breadth in abear market indicates the end of the bear trend and beginning of bull trend. While calculatingthe market breadth the shares which are neither advancing nor declining are simply ignored.

Market Breadth

Short Sales

The bear operator expects a down trend in the market and he thinks that the currentmarket price is over priced. Therefore he will sell the shares at current level and later whenmarket faces down trend he will buy the same stocks at lower level. The bear operatorsare known as short sellers and their initial sales are known as short sales. When the shortsales positions are increasing day by day then the next direction will be bull trend becausewhat are sold by bear operators should be covered (bought). Therefore when bear operatorstart covering the short sales (by place buying orders) the market will start rise.

The short sales positions indicate whether the market is oversold or over bought.

Theories of Contrary Opinion

According to the theory of contrary opinion the common man cannot make wisepredictions of future price movements. The professional investors are making wisepredictions and thus the professional investors are taking opposite direction to the commoninvestors. When the market is flooded with buying orders from large number of commoninvestors then the professional investors keep away from market, expecting a down fall inthe market. When market started facing down the common investors (retail investor) willcontinuously sell which results in panic selling across the market. Then the professionalinstitutional buyer will start buying. Therefore the type of investor who is buying and sellingindicates the future direction of the market.

NOTES



9 ODD-LOT THEORY

Odd-lot is a method of trading shares in groups which are less than 100 shares. Suchinvestments are usually not made by professional investors but mostly by retail investors.When the odd-lot trading is very high then the market is said to be dominated by retailinvestors. The presence dominance of retail investors or professional investors gives a hintabout the next direction of market.

10 CONFIDENCE INDEX

The confidence index basically analyse the shift in investments between high gradebonds and low grade bonds. The high grade bonds are with high credit rating and lowreturns. Thus the returns are low but safety is very high. The low grade bonds are withlow credit rating but with high returns. Thus here the risk is high but returns also high. Theinvestment shifts between high grade bond and low grade bond shows the confidence ofinvestors and the future directions of the market. If investors are shifting their investmentsfrom low grade securities to high grade securities so as to reduce their risk level then thenext direction of the market would be down trend. But if the investors shift their investmentfrom high grade securities to low grade securities such movements shows the investorsconfidence in the market and the next direction would be bull trend.

11 RELATIVE STRENGTH INDEX (RSI)

The Relative Strength Index was developed by ells wilder. The RSI is used to findout the relative strength of a stock. RSI is calculated with the help of the following formula; 100 RSI = 100 – ——— 1 + Rs

Average Gain per dayRs = ————————————————

Average loss per day

The RSI can be calculated for one week or two weeks. If it is calculated for twoweeks period the probability of getting wrong indications is minimum.



Average gain per day 6 Rs = ——————————————— = —— = 1.20 Average loss per day 5

100 RSI = 100 - ———— 1 + 1.20

= 100 - 45.45

= 54.55

The RSI can be calculated and shown in a graph. When RSI crosses seventy then itindicates a down trend and it is time to sell. When the RSI goes below thirty it is indicatingthe next direction of uptrend.

12 RATE OF CHANGE (ROC)

The Rate of Change (ROC) indicates the rate of change in price of a stock betweentwo periods. The ROC shows the change between the current price and the price “n”number of days in the past. The ROC indicates the overbought and oversold positions ofa stock. The ROC also shows the trend reversals. ROC can be calculated by consideringthe closing price and it can be prepared weeks or months. ROC can be calculated byusing the following formula

NOTES



Today’s price ROC = —————————————— X 100 Price ‘n’ days back

The ROC can be calculated and shown in a chart form.

13 OSCILLATORS

Oscillators are widely used by technical analyst to know the overbought and oversoldpositions of a particular scrip or market. The oscillators show the trend reversal and therise or decline in the momentum. The Oscillators shows the share price movements acrossa reference point from one extreme to another extreme.

The Oscillators are indicators that we use when viewing charts that are non-trending. Moving averages and trends are paramount when studying the direction of anissue. A technician will use oscillators when the charts are not showing a definite trend ineither direction. Oscillators are thus most beneficial when a company’s stock either is in ahorizontal or sideways trading pattern, or has not been able to establish a definite trend ina choppy market.

When the stock is in either an overbought or oversold situation, the true value of theoscillator is exposed. With oscillators a chartist can see when the stock is running out ofsteam on the upside, the point at which the stock moves into an overbought situation. Thissimply means that the buying volume has been diminishing for a number of trading days;traders will then start to think about selling their shares. Conversely, when an issue hasbeen sold by a greater number of investors for a period of time (from one to two weeks tothree to six months or longer), the stock will enter an oversold situation

14 TREND

The trend is the direction of movement. The stock price can have three trends. Theprice trend may either rising or falling or flat. The share price cannot steadily increase. Theuptrend is subject to minor corrections. Similarly during flat trend the stock price cannotsteadily face down but it is subject to minor corrections.

15 TREND REVERSAL

The increase or decrease in share price cannot go on forever. The trend may takeits reverse directions at any time due to shift in demand and supply forces. If a share pricecuts the rising trend line from above, it is a violation of trend line and signals the possibilityof decline in price. Similarly if the share price pierces the trend line from below, it indicates1the rise in price.



16 PATTERNS

The price volume charts can be used to analyse the patterns of price behaviour. Thepattern analysis emphasizes the tendency of the price movements in a particular directionor to repeat the same formation over and over again. The technical analyst strongly believesthat stock prices move in patterns which can be identified and standardized. Based on aparticular formation of price movements or price patterns the likely behaviour of prices infuture can be predicted.

Various PatternsV – Shaped Reversal

NOTES



Double Top

Double Bottom



Head and Shoulders

Inverted Head and Shoulders

NOTES



Symmetrical Triangle

Ascending Triangle

Descending Triangle



Up Flag

Down Flag

Up Pennant

NOTES



Down Pennant

17 DOW THEORY

Charles H DOW contributed a lot of research work towards technical analysis. Hewrote a series of articles in Wall street Journal in 1984. Charles H.DOW developed thetheory to explain the movement of the indices of Dow Jones Averages. He formulatedthree hypotheses to develop the theory. They are;

(i) No individual investor can influence the market trend. However he can influencethe price movement of particular scrip by buying or selling significant volumeof the particular scrip.

(ii) Market digest and discount every good news as well as bad news(iii) Dow theory is not a tool to beat the market but the theory can be used to

understand the market in a better way.

Dow has classified the trend as three;

(i) Primary trend (ii) Secondary trend and (iii) Minor trend. The Primary trend is thebroad long term trend and it may the primary up trend or primary down trend. Theprimary trend may continue for more than one year. The secondary trend is the correctionof the primary trend. The correction of primary trend may last for few weeks. The minortrend refers to the day to day price movements. The above mentioned three trends arenamed as Tide, Waves and Ripples.



DOW Chart–

DOW Chart

NOTES



UNIT - V

PORTFOLIO MANAGEMENTCHAPTER - I

PORTFOLIO THEORY AND PORTFOLIO CONSTRUCTION

Learning Objective

After going through this chapter you would be able to understand Traditional Theoryof Portfolio, Steps in Traditional Theory of Portfolio Construction, Modern Portfolio Theory,Capital Asset Pricing Model, Hedging and Diversification, Return, Risk, Capital MarketLine, Efficient Frontier and Market Risk

1. INTRODUCTION

The Portfolio Theory is the basis of portfolio management. The portfolio theory is theframe work of efficient investment management. The portfolio is a combination of securitiessuch as stocks, bonds and money market instruments. The portfolio is developed by theinvestor based on his preferences over risks and return.

2. TRADITIONAL THEORY OF PORTFOLIO

According to the traditional theory of portfolio construction the selection of securitiesfor the portfolio is made based on the investors’ preference over income needs and capitalgain needs. The traditional theory of portfolio management focuses on the various importantsteps in developing and managing a portfolio. The investor’s investment objectives to beevaluated and based on the objectives the securities are to be selected and then thediversification is to be practiced.

3. STEPS IN TRADITIONAL THEORY OF PORTFOLIO CONSTRUCTION

a) Analysis of Investment Constraints

First the investment constraints such as the investor’s expectation over income, liquidityholding period, safety and tax benefits are to be carefully analysed.



(i) Income Needs

The income needs of the investor are determined by the inflation and the level of hisdisposable income. If the investor needs current income to maintain his living standardsand face inflation then the portfolio should be developed in such a way that it offers aperiodical return consistently. If the inflation is raising then the portfolio should be developedin such a way that it offset the pressure of inflation by selecting securities with high growthreturn potential.

(ii) Liquidity Needs

While developing the portfolio the investor should carefully analyse his expectationover liquidity. When the investor requires high liquidity (i.e. the desire to encash his investmentwith in very short period) he has to select securities with very short period of maturity andwider marketability. For example the money market instruments and shares of leadingcompanies can be easily bought and sold.

(iii) Preference over safety of the principal

The investor’s risk attitude is the major parameter in deciding the securities for theportfolio. If the investor is risk taker he can develop a portfolio with growth orientedequity shares. If the investor is risk averter, then he has to select securities, bonds anddebentures. On the other hand if the investor is having balanced attitude over risk, he canconstruct a portfolio with combination of growth oriented equity stocks and debt instruments.

(iv) Preference over investment holding period

Another important constraint to be analysed is decision over investment holding period.How long the investor would like to hold his investment is the holding period. The investmentholding period is influenced by many factors such as the desired risk level, life cycle of theinvestor.

(v) Tax benefits

The tax burden of the investor is another important constraint to be analysed forconstructing the portfolio. If the investor’s tax obligation is very high then he would likeselect securities which gives tax benefits. Otherwise if the tax obligation is very less thenthe investor would select securities by emphasising other investment aspects.

b) Determination of Investment Objectives

The objectives of investment are to be clearly defined and ranked. In fact manyinvestors would have multiple objectives of investment. The objectives may be income,capital gain, future provision etc..



We call CAPM a “capital asset pricing model” because, given a beta and an expectedreturn for an asset, investors will bid its current price up or down, adjusting that expectedreturn so that it satisfies formula [1]. Accordingly, the CAPM predicts the equilibrium priceof an asset. This works because the model assumes that all investors agree on the beta andexpected return of any asset. In practice, this assumption is unreasonable, so the CAPM islargely of theoretical value. It is the most famous example of an equilibrium pricing model.

6. HEDGING AND DIVERSIFICATION

A portfolio that is invested in multiple instruments whose returns are uncorrelated willhave an expected simple return which is the weighted average of the individual instruments’returns. Its volatility will be less than the weighted average of the individual instruments’volatilities. This is diversification. Diversification is the “free lunch” of finance. It means thatan investor can reduce market risk simply by investing in many unrelated instruments. Therisk reduction is “free” because expected returns are not affected. The concept is oftenexplained with the age-old saying “don’t put all your eggs in one basket.”

Diversification should not be confused with hedging, which is the taking of offsettingrisks. With diversification, risks are uncorrelated. With hedging, they have negativecorrelations

A common misperception is the notion that the more uncorrelated risks a portfolio isexposed to, the lower that portfolio’s overall market risk will be. This is not true. If aportfolio is leveraged in order to take new risks, the net result is likely to be an increase inrisk. Let’s consider a common example:

A salesman for a foreign exchange trading firm approaches the trustees of a pensionplan and proposes that they add a currency overlay strategy to their existing portfolio ofdomestic stocks and bonds. The strategy will consist of an actively traded portfolio ofcurrency forwards. Because forwards represent long/short positions, they require little orno up-front investment. Accordingly, the strategy could be implemented without changingany of the plan’s existing investments. That is why it is called an “overlay” strategy.

In addition to possibly generating positive returns, the salesman argues that the addedexposure to currencies will have a diversifying effect on their portfolio—decreasing theportfolio’s total market risk.

Is the salesman right? Will the overlay strategy reduce the portfolio’s market risk? Atfirst blush, it is difficult to say. Fluctuations in the value of the overlay portfolio should havelittle or no correlation with returns on the existing portfolio. On the other hand, the overlaystrategy introduces a new risk in addition to the portfolio’s existing risks.

NOTES



The investment objective plays a major role in the selection of securities of the portfolio.The objective to get current income, growth of income, capital appreciation safety ofprincipal influence the asset mix. Each and every of these objectives are different andrequires unique set of securities.

c) Risk and return analysis

The next important step in traditional approach to portfolio construction is the analysisof risk and return. To get more return the investor has to take higher degree of risk. Riskis the deviation of actual return from the expected return. There are various risks such asinterest rate risk, purchasing power risk, financial risk and market risk. The investor has toanalyse the various risk factors before constructing the portfolio

d) Diversification of the portfolio

The last and important step in traditional portfolio is the diversification of the portfolio.The securities are selected based on the investment constraints and investment objectives.The investor has to ensure the diversification so as to minimize the risk and enhance return.He has to select various types of securities from various sectors.

4. MODERN PORTFOLIO THEORY

Modern portfolio theory (MPT)—or portfolio theory—was introduced by HarryMarkowitz with his paper “Portfolio Selection,” which appeared in the 1952 Journal ofFinance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller and WilliamSharpe for what has become a broad theory for portfolio selection.

Prior to Markowitz’s work, investors focused on assessing the risks and rewards ofindividual securities in constructing their portfolios. Standard investment advice was toidentify those securities that offered the best opportunities for gain with the least risk andthen construct a portfolio from these. Following this advice, an investor might concludethat railroad stocks all offered good risk-reward characteristics and compile a portfolioentirely from these. Intuitively, this would be foolish. Markowitz formalized this intuition.Detailing mathematics of diversification, he proposed that investors focus on selectingportfolios based on their overall risk-reward characteristics instead of merely compilingportfolios from securities that each individually has attractive risk-reward characteristics.In a nutshell, inventors should select portfolios not individual securities.

If we treat single-period returns for various securities as random variables, we canassign them expected values, standard deviations and correlations. Based on these, wecan calculate the expected return and volatility of any portfolio constructed with thosesecurities. We may treat volatility and expected return as proxies for risk and reward. Outof the entire universe of possible portfolios, certain ones will optimally balance risk and



reward. These comprise what Markowitz called an efficient frontier of portfolios. Aninvestor should select a portfolio that lies on the efficient frontier.

James Tobin (1958) expanded on Markowitz’s work by adding a risk-free asset tothe analysis. This made it possible to leverage or deleverage portfolios on the efficientfrontier. This lead to the notions of a super efficient portfolio and the capital market line.Through leverage, portfolios on the capital market line are able to outperform portfolio onthe efficient frontier

Sharpe (1964) formalized the capital asset pricing model (CAPM). This makes strongassumptions that lead to interesting conclusions. Not only does the market portfolio sit onthe efficient frontier, but it is actually Tobin’s super-efficient portfolio. According to CAPM,all investors should hold the market portfolio, leveraged or de-leveraged with positions inthe risk-free asset. CAPM also introduced beta and relates an asset’s expected return toits beta.

Portfolio theory provides a broad context for understanding the interactions ofsystematic risk and reward. It has profoundly shaped how institutional portfolios aremanaged, and motivated the use of passive investment management techniques. Themathematics of portfolio theory is used extensively in financial risk management and was atheoretical precursor for today’s value-at-risk measures.

5. CAPITAL ASSET PRICING MODEL

William Sharpe (1964) published the capital asset pricing model (CAPM). Parallelwork was also performed by Treynor (1961) and Lintner (1965). CAPM extended HarryMarkowitz portfolio theory to introduce the notions of systematic and specific risk. For hiswork on CAPM, Sharpe shared the 1990 Nobel Prize in Economics with Harry Markowitzand Merton Miller.

CAPM considers a simplified world where:

• There are no taxes or transaction costs.

• All investors have identical investment horizons.

• All investors have identical opinions about expected returns, volatilities andcorrelations of available investments.

In such a simple world, Tobin’s (1958) super-efficient portfolio must be the marketportfolio. All investors will hold the market portfolio, leveraging or de-leveraging it withpositions in the risk-free asset in order to achieve a desired level of risk.

CAPM decomposes a portfolio’s risk into systematic and specific risk. Systematicrisk is the risk of holding the market portfolio. As the market moves, each individual asset



We call CAPM a “capital asset pricing model” because, given a beta and an expectedreturn for an asset, investors will bid its current price up or down, adjusting that expectedreturn so that it satisfies formula [1]. Accordingly, the CAPM predicts the equilibrium priceof an asset. This works because the model assumes that all investors agree on the beta andexpected return of any asset. In practice, this assumption is unreasonable, so the CAPM islargely of theoretical value. It is the most famous example of an equilibrium pricing model.

6. HEDGING AND DIVERSIFICATION

A portfolio that is invested in multiple instruments whose returns are uncorrelated willhave an expected simple return which is the weighted average of the individual instruments’returns. Its volatility will be less than the weighted average of the individual instruments’volatilities. This is diversification. Diversification is the “free lunch” of finance. It means thatan investor can reduce market risk simply by investing in many unrelated instruments. Therisk reduction is “free” because expected returns are not affected. The concept is oftenexplained with the age-old saying “don’t put all your eggs in one basket.”

Diversification should not be confused with hedging, which is the taking of offsettingrisks. With diversification, risks are uncorrelated. With hedging, they have negativecorrelations

A common misperception is the notion that the more uncorrelated risks a portfolio isexposed to, the lower that portfolio’s overall market risk will be. This is not true. If aportfolio is leveraged in order to take new risks, the net result is likely to be an increase inrisk. Let’s consider a common example:

A salesman for a foreign exchange trading firm approaches the trustees of a pensionplan and proposes that they add a currency overlay strategy to their existing portfolio ofdomestic stocks and bonds. The strategy will consist of an actively traded portfolio ofcurrency forwards. Because forwards represent long/short positions, they require little orno up-front investment. Accordingly, the strategy could be implemented without changingany of the plan’s existing investments. That is why it is called an “overlay” strategy.

In addition to possibly generating positive returns, the salesman argues that the addedexposure to currencies will have a diversifying effect on their portfolio—decreasing theportfolio’s total market risk.

Is the salesman right? Will the overlay strategy reduce the portfolio’s market risk? Atfirst blush, it is difficult to say. Fluctuations in the value of the overlay portfolio should havelittle or no correlation with returns on the existing portfolio. On the other hand, the overlaystrategy introduces a new risk in addition to the portfolio’s existing risks.

NOTES



In fact, the salesman is wrong. Far from reducing market risk, the overlay strategywill increase total market risk. The overlay strategy does diversify the portfolio’s risks, butit also leverages them. The diversification effect will reduce market risk, but this will bemore than offset by the leveraging effect.

Let’s look at the situation in terms of eggs and baskets. Suppose you are carrying abasket of 12 eggs. To diversify your risk, you might obtain a second basket and place sixof the eggs in it. Now, carrying one basket in each hand, you will have reduced risk.Suppose instead, you act under a misperception that risk is reduced by simply carryingmore baskets of eggs. Instead of dividing your 12 eggs between two baskets, you insteadoffer to carry your friend’s basket of 12 eggs as well as your own. Now you are carryingtwo baskets of 12 eggs each. In financial terminology, you have leveraged your position.The net result is an increase in risk. In effect, this is what the salesman’s overlay strategywill do to the pension portfolio.

For diversification to work, it is not sufficient to add risks to a portfolio. Instead,where there are concentrations of risk, these need to be reduced while other, unrelatedrisks are taken on.

he issue of how investors can use diversification to optimize their portfolios is a centralconcern of portfolio theory.

7. RETURN

There is an old saying: Be more concerned about return of your investment thanreturn on your investment.

The term return on investment, or simply return, is used to refer to any of a number ofmetrics of the change in an asset’s or portfolio’s accumulated value over some period oftime. Of course, accumulated value can be measured in different ways. In investmentmanagement, a distinction is drawn between total returns and net returns. The former arecalculated from accumulate values reflecting only price appreciation and income fromdividends or interest. The latter are calculated from accumulated values that also reflectitems such as management fees, custody fees, transaction costs, taxes, and perhaps eveninflation.

Measure time in appropriate units—days, weeks, months, years, etc. Let denote aportfolio or asset’s accumulated value at time t (see the notation conventions documentation).There are three standard metrics of return, any of which can be calculated on a total or netbasis. They are



Where log denotes a natural logarithm.

Suppose an asset has accumulated value of USD 100 at time t–1 and accumulated valueUSD 110 at time t. Then it had a

• gross return of 1.100,

• simple return of 0.100, and

• log return of 0.095

Over the period t–1 to t.

Gross return is increasingly falling out of use. Note that simple return is gross returnminus 1. Simple returns are sometimes called net returns to distinguish them from grossreturns. This can be confusing, given the alternative meaning of net return indicated earlier.As gross returns fall out of use, so is this alternative use of the term net return. For smallreturns, simple and log returns closely approximate one another. This is evident in outexample above. Simple and log returns are sometimes called arithmetic and geometricreturns, respectively.

Returns are most often calculated over a one-year period, but shorter periods areincreasingly being used. If a period of less than a year is used, a return may be reported onan annualized basis. The result is called an annualized return. This may also be called anannual rate of return or simply a rate of return. For example, if a portfolio experiences a.01 log return over a one month period, it might be said to have experienced a .12 log rateof return over that month.

Let z be a (simple or log) return calculated over a period of one of a year (i.e. thereare n such periods in a year). Then the formulas for annualizing the return are

[1]

[2]

[3]

NOTES



for simple returns, and

for log returns.

A shortcoming of returns is the fact that their calculation entails division. If an instrumentor portfolio’s accumulated value can take on the value 0 or negative values, returns may bepoorly behaved or undefined. This is especially a problem with derivatives such as swaps.An equity investor might use returns to describe the performance of his portfolio. Aderivatives trader would not.

Increasingly, in quantitative finance, the notion of return is being used in an entirelymathematical sense. For example, if an implied volatility rises one day from .050 to .055,it is reasonable to say that the implied volatility had a 1-day 10% simple return. In thiscontext, return is no longer a metric of change in accumulated value, but a metric of changein any time series. Suppose the temperature at the summit of Mt. Washington rises over aday from 50? F to 55? F. Isn’t it reasonable to say that the temperature had a 1-day 10%return? Accordingly, we may treat returns as a purely mathematical notion. Simple or logreturns may be used in this manner. Such usage tends to be limited to very technicaldiscourse.

8. RISK

Risk has two components:

1. uncertainty, and

2. exposure.

If either is not present, there is no risk. Suppose a man jumps out of an airplane witha parachute on his back. He may be uncertain as to whether or not the chute will open. Heis taking risk because he is exposed to that uncertainty. If the chute fails to open, he willsuffer personally.

Now suppose the man jumps out of the plane without a parachute on his back. If heis certain to die, he faces no risk. Risk requires exposure and uncertainty.

A synonym for uncertainty is ignorance. We face risk because we are ignorant aboutthe future. After all, if we were omniscient, there would be no risk. Because ignorance is apersonal experience, risk is necessarily subjective. Consider another example

[4]

[5]



A man is heading to the airport to catch a flight. The weather is threatening, and it ispossible the flight has been canceled. He is uncertain as to the status of the flight and facesexposure to that uncertainty. His travel plans will be disrupted if the flight is canceled.Accordingly, he faces risk.

Suppose a woman is also heading to the airport to catch the same flight. She hascalled ahead and confirmed that the flight is not canceled. She has less uncertainty andfaces lower risk.

In this example, there are two individuals exposed to the same event. Because theyhave different levels of uncertainty, they face different levels of risk. Risk is subjective.

Risk is a personal experience, not only because it is subjective, but because it isindividuals who suffer the consequences of risk. Although we may speak of companiestaking risk, in actuality, companies are merely conduits for risk. Ultimately, all risks whichflow through an organization accrue to individuals—stockholders, creditors, employees,customers, board members, etc.

9. CAPITAL MARKET LINE

James Tobin (1958) added the notion of leverage to portfolio theory by incorporatinginto the analysis an asset which pays a risk-free rate. By combining a risk-free asset with aportfolio on the efficient frontier, it is possible to construct portfolios whose risk-returnprofiles are superior to those of portfolios on the efficient frontier. Consider Exhibit 1:

Capital Market Line Exhibit 1

Source: Risk Glossary

The capital market line is the tangent line to the efficient frontier that passes throughthe risk-free rate on the expected return axis.

NOTES



In Exhibit 1, the risk-free rate is assumed to be 5%, and a tangent line—called thecapital market line—has been drawn to the efficient frontier passing through the risk-freerate. The point of tangency corresponds to a portfolio on the efficient frontier. That portfoliois called the super-efficient portfolio.

Using the risk-free asset, investors who hold the super-efficient portfolio may:

a) leverage their position by shorting the risk-free asset and investing the proceeds inadditional holdings in the super-efficient portfolio, or

b) de-leverage their position by selling some of their holdings in the super-efficientportfolio and investing the proceeds in the risk-free asset.

The resulting portfolios have risk-reward profiles which all fall on the capital marketline. Accordingly, portfolios which combine the risk free asset with the super-efficient portfolioare superior from a risk-reward standpoint to the portfolios on the efficient frontier.

Tobin concluded that portfolio construction should be a two-step process. First,investors should determine the super-efficient portfolio. This should comprise the riskyportion of their portfolio. Next, they should leverage or de-leverage the super-efficientportfolio to achieve whatever level of risk they desire. Significantly, the composition of thesuper-efficient portfolio is independent of the investor’s appetite for risk. The two decisions:

a) the composition of the risky portion of the investor’s portfolio, and

b) the amount of leverage to use,

are entirely independent of one another. One decision has no effect on the other. This iscalled Tobin’s separation theorem.

William Sharpe’s (1964) capital asset pricing model (CAPM) demonstrates that,given strong simplifying assumptions, the super-efficient portfolio must be the marketportfolio. From this standpoint, all investors should hold the market portfolio leveraged orde-leveraged to achieve whatever level of risk they desire.

10. EFFICIENT FRONTIER

The efficient frontier was first defined by Harry Markowitz in his groundbreaking(1952) paper that launched portfolio theory. That theory considers a universe of riskyinvestments and explores what might be an optimal portfolio based upon those possibleinvestments.

Consider an interval of time. It starts today. It can be any length, but a one-yearinterval is typically assumed. Today’s values for all the risky investments in the universe areknown. Their accumulated values (reflecting price changes, coupon payments, dividends,stock splits, etc.) at the end of the horizon are random. As random quantities, we may



assign them expected return and volatilities. We may also assign a correlation to each pairof returns. We can use these inputs to calculate the expected return and volatility of anyportfolio that can be constructed using the instruments that comprise the universe.

The notion of “optimal” portfolio can be defined in one of two ways:

a) For any level of volatility, consider all the portfolios which have that volatility.From among them all, select the one which has the highest expected return.

b) For any expected return, consider all the portfolios which have that expectedreturn. From among them all, select the one which has the lowest volatility. Eachdefinition produces a set of optimal portfolios. Definition (1) produces an optimalportfolio for each possible level of risk. Definition (2) produces an optimal portfoliofor each expected return. Actually, the two definitions are equivalent. The set ofoptimal portfolios obtained using one definition is exactly the same set which isobtained from the other. That set of optimal portfolios is called the efficient frontier.This is illustrated in Exhibit 1:

11. EFFICIENT FRONTIER EXHIBIT 1

Source: Risk Glossary

The dark region corresponds to the achievable risk-return space. For every point inthat region, there will be at least one portfolio that can be constructed and has the risk andreturn corresponding to that point. The efficient frontier is the gold curve that runs along thetop of the achievable region. Portfolios on the efficient frontier are optimal in both thesense that they offer maximal expected return for some given level of risk and minimal riskfor some given level of expected return.

In Exhibit 1, the green region corresponds to the achievable risk-return space. Forevery point in that region, there will be at least one portfolio constructible from the investmentsin the universe that has the risk and return corresponding to that point. The yellow region isthe unachievable risk-return space. No portfolios can be constructed corresponding to thepoints in this region.

NOTES



The gold curve running along the top of the achievable region is the efficient frontier.The portfolios that correspond to points on that curve are optimal according to both definitions(1) and (2) above.

Typically, the portfolios which comprise the efficient frontier are the ones which aremost highly diversified. Less diversified portfolios tend to be closer to the middle of theachievable region.

12. MARKET RISK

Business activities entail a variety of risks. For convenience, we distinguish betweendifferent categories of risk: market risk, credit risk, liquidity risk, etc. Although suchcategorization is convenient, it is only informal. Usage and definitions vary. Boundariesbetween categories are blurred. A loss due to widening credit spreads may reasonably becalled a market loss or a credit loss, so market risk and credit risk overlap. Liquidity riskcompounds other risks, such as market risk and credit risk. It cannot be divorced from therisks it compounds.

An important but somewhat ambiguous distinguish is that between market risk andbusiness risk. Market risk is exposure to the uncertain market value of a portfolio. A traderholds a portfolio of commodity forwards. She knows what its market value is today, butshe is uncertain as to its market value a week from today. She faces market risk. Businessrisk is exposure to uncertainty in economic value that cannot be marked-to-market. Thedistinction between market risk and business risk parallels the distinction between mark-to-market accounting and book-value accounting. Suppose a New England electricitywholesaler is long a forward contract for on-peak electricity delivered over the next 3months. There is an active forward market for such electricity, so the contract can bemarked to market daily. Daily profits and losses on the contract reflect market risk. Supposethe firm also owns a power plant with an expected useful life of 30 years. Power plantschange hands infrequently, and electricity forward curves don’t exist out to 30 years. Theplant cannot be marked to market on a regular basis. In the absence of market values,market risk is not a meaningful notion. Uncertainty in the economic value of the powerplant represents business risk.

The distinction between market risk and business risk is ambiguous because there isa vast “gray zone” between the two. There are many instruments for which markets exist,but the markets are illiquid. Mark-to-market values are not usually available, but mark-to-model values provide a more-or-less accurate reflection of fair value. Do these instrumentspose business risk or market risk? The decision is important because firms employfundamentally different techniques for managing the two risks.

Business risk is managed with a long-term focus. Techniques include the carefuldevelopment of business plans and appropriate management oversight. Book-value



accounting is generally used, so the issue of day-to-day performance is not material. Thefocus is on achieving a good return on investment over an extended horizon.

Market risk is managed with a short-term focus. Long-term losses are avoided byavoiding losses from one day to the next. On a tactical level, traders and portfolio managersemploy a variety of risk metrics —duration and convexity, the Greeks, beta, etc.—toassess their exposures. These allow them to identify and reduce any exposures they mightconsider excessive. On a more strategic level, organizations manage market risk by applyingrisk limits to traders’ or portfolio managers’ activities. Increasingly, value-at-risk is beingused to define and monitor these limits. Some organizations also apply stress testing totheir portfolios.

Summary

The Portfolio Theory is the basis of portfolio management. The portfolio theory is theframe work of efficient investment management. The portfolio is a combination of securitiessuch as stocks, bonds and money market instruments. The portfolio is developed by theinvestor based on his preferences over risks

According to the traditional theory of portfolio construction the selection of securitiesfor the portfolio is made based on the investors’ preference over income needs and capitalgain needs. The traditional theory of portfolio management focuses on the various importantsteps in developing and managing a portfolio. The investor’s investment objectives to beevaluated and based on the objectives the securities are to be selected and then thediversification is to be practiced

Modern portfolio theory (MPT)—or portfolio theory—was introduced by HarryMarkowitz with his paper “Portfolio Selection,” which appeared in the 1952 Journal ofFinance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller and WilliamSharpe for what has become a broad theory for portfolio selection.

Prior to Markowitz’s work, investors focused on assessing the risks and rewards ofindividual securities in constructing their portfolios. Standard investment advice was toidentify those securities that offered the best opportunities for gain with the least risk andthen construct a portfolio from these. Following this advice, an investor might concludethat railroad stocks all offered good risk-reward characteristics and compile a portfolioentirely from these. Intuitively, this would be foolish. Markowitz formalized this intuition.Detailing mathematics of diversification, he proposed that investors focus on selectingportfolios based on their overall risk-reward characteristics instead of merely compilingportfolios from securities that each individually has attractive risk-reward characteristics.In a nutshell, inventors should select portfolios not individual securities

NOTES



Key Terms• Traditional Theory of Portfolio• Modern Portfolio Theory• Capital Asset Pricing Model• Hedging and Diversification• Return• Risk• Capital Market Line• Efficient Frontier• Market Risk

Questions• What do you mean by Traditional Theory of Portfolio?• Explain the steps in Traditional Theory of Portfolio Construction• Discuss about the Modern Portfolio Theory• What is meant by Capital Asset Pricing Model?• Briefly explain the concept of Hedging and Diversification• What do you mean by Risk and Return?• What is meant by Capital Market Line?• What do you mean by Efficient Frontier?



CHAPTER – II

PORTFOLIO EVALUATION, PORTFOLIO REVISION AND MUTUALFUNDS

Learning objectives

fter going through this chapter you would be able to understand Sharpe’s PerformanceIndex, Treynor’s Performance Index, Jensen’s Performance Index, Portfolio Revision,Passive Management, Active Management, Formula plans, Strategy for Mutual FundInvestment and Exit Timings

1. INTRODUCTION

The investment analysts and portfolio managers are regularly monitoring and evaluatingthe performance of their portfolio. The revision of portfolio i.e.. the change of securities inthe portfolio is done based on the performance of the securities in the portfolio. The fundmanager tries to show higher returns from their portfolio than the return from bench mark.The right market timings, proper diversifications so as to reduce the systematic risk, properbeta estimates (so as to reduce systematic risk) are the strategies adopted by portfoliomanagers in making their portfolio to offer superior returns. There was no compositeindex, which measures both return and risk under the Traditional Theory. But the modernportfolio theory focus on maximizing return and minimizing risk and therefore it becomesessential to develop composite measures of return and risk of the portfolio. Researcherslike Sharpe, Treynor and Jensen conducted research to develop a composite index tomeasure risk based returns by considering various types of risks such as systematic risk,unsystematic risk and residual risk.

2. SHARPE’S PERFORMANCE INDEX

The Sharpe’s performance index is basically measures the total risk by standarddeviation Sharpe Index measures the risk premium of the portfolio relative to the totalamount of risk in the portfolio. Sharpe Index is measured by adopting the following formula;

Rp _ Rf St = _____________

6p

NOTES



Where,

St = Sharpe Measure

Rp = Return of the portfolio

Rf = Risk free rate of return

6p = Standard deviation of the portfolio return.

The risk premium is the difference between the average return from the portfolio andthe risk free rate of return. The Standard deviation of the portfolio is the risk of the portfolio.The sharpe Index assign the maximum value to securities that have the highest risk – adjustedaverage rate of return.

Illustration

By applying the Sharpe’s Index formula we can rank the securities.

Security “ X “

—————Rp _ Rf

St = ________________ 6p

0.25 _ .10 = ________________ = 3 .05Security “ Y “————— Rp _ Rf St = _______________ 6p

0.30 __ .10 = ___________________ = 2.5 .08



As the security ‘X’ is ranked higher at 3 % than security ‘Y’ ie. 2.5 %, security “X “is a better performer.

3. TREYNOR’S PERFORMANCE INDEX

In Treynor,s measure, the risk measure of standard deviation, namely total risk of theportfolio is replaced by market risk, measured by Beta, which is not diversifiable. Themutual fund’s performance is measured in relation to the market performance. The efficientportfolio’s return is increasing at a faster rate than the market return. During down trendthe portfolio’s return declines slowly than the market return.

Treynor’s performance Index can be calculated with the following formula;

Portfolio average returns - Risk free returnTn = ___________________________________________

Beta co – efficient of portfolio

Rp __ Rf Tn = _____________________ Bp

Illustration

Rank the securities by following Trynor’s Performance Index model.

Rp __ RfTn = _____________

Bp.30 _ .10

Security “X “ = ___________ = 0.4 0.5

25 __ .10Security “ Y “ = _____________ = 0.15

1.0

Security “ X “ performance is better than Security “ Y “.

NOTES



4. JENSEN’S PERFORMANCE INDEX

The Jensen’s performance measure the relative performance of various portfolios ona risk adjusted basis. According to Jensen’s performance index the successful predictionof security price would enable the manager to earn higher return than the ordinary investorexpects to earn in a given level of risk.

Jensen performance Index can be calculated with the help of the following formula.

Rp = ALPHA+BETA (Rm _ Rf)

Rp = Average return of the portfolio

Rf = Risk free rate of return

Alpha = the intercept

Beta = Systematic risk

Illustration

From the following information rank the portfolio by following Jensen’s performanceIndex.

Rp = Rf + B ( Rm _ Rf )

Portfolio “ X “ = 6 + 1.3 ( 12 _ 6 ) = 13.8

Portfolio “ Y “ = 6 + 0.8 ( 12 _ 6 ) = 10.8

Portfolio “ Z “ = 6 + 1.0 ( 12 _ 6 ) = 12.0

The difference between the actual and expected return is compared.

X = 20 – 13.8 = 6.2

Y = 15 - 10.8 = 4.2

Z = 15 - 12.0 = 3.0

Among the risk adjusted performance of the three portfolio “ X “ is the best “ Y “ thesecond and the last portfolio is “ Z “



5. PORTFOLIO REVISION

5.1 INTRODUCTION

The developed portfolio’s performance should be continuously evaluated and revisedas and when require so as to get maximum return. The securities in the portfolio should besold when the expected rate of return is realized or when the particular security’s return isvery less than the expected return. New securities that can offer higher return should beadded and less performing securities should be sold.

5.2 PASSIVE MANAGEMENT

Passive management is the strategy of holding a well diversified portfolio for a longterm with the buy and hold approach. The passive management aims to get a return similarto market return. The portfolio is constructed in line with the index like Sensex or Nifty.For example if ONGC has 5 % weightage in the Sensex the Fund invest 5 % of its amountin ONGC stock. The limitation of the strategy is the high transaction cost. For example ifthe portfolio manager wants to develop a portfolio in line with Nifty 50, he has to buy 50stocks for his portfolio and this will results in high transaction cost.

5.3 ACTIVE MANAGEMENT

The Active Portfolio Management strategy involves selection of the stocks based onpredicted future performance. If a particular stock is expected to outperform then it isgiven more weightage. Therefore the fund manager gives his own weightage and notfollowing the weightage of the Index. The fund manager rotates the securities in the portfolioso as to beat the market returns.

5.4 FORMULA PLANS

The formula plans provide important basic rules and regulations to be followed inbuying and selling securities for the portfolio. The proportion of each security to the totalportfolio value is determined based on the investor’s attitude over risk and return. Therules and regulations in the formula plan are rigid and help the investor to overcome humanemotion. He can earn higher return by adopting the formula plans.

5.5 ASSUMPTION OF FORMULA PLAN

a) The portfolio is allocated to fixed income securities and common stocks.

b) The portfolio will be aggressive in the low market and defensive during bull market.

c) Securities are bought and sold during the period of significant change in the price.

d) Once the investor choose a formula plan he has to continue with it

e) The selected securities should move along with the market.

NOTES



5.6 TYPES OF FORMULA PLAN

(a) Rupee Cost Averaging

Under the Rupee cost averaging the fundamentally growth oriented stocks are identifiedfirst. Then the investor has to buy the selected stock at various price intervals instead ofbuying a large number of shares at single point. This is called time diversification. Therupee cost averaging reduces the average cost of purchase.

(b) Constant Rupee Plan

The constant Rupee plan suggests that the investor should sell when the prices riseand start buy when the prices starts decline. The investor has to select the action points.The action points are the times at which the investor has to readjust the values of the stocksin the portfolio. The main advantage of this method is that the buying and selling of securitiesare determined automatically. This facilitates the investor to earn capital gain by selling thestocks when the price increases and buying it at a relatively lower price.

c) Constant Ratio Plan

Constant plan attempts to maintain a constant ratio between the aggressive andconservative portfolios. The ratio is fixed by the investor. The investor’s attitude towardsrisk and return plays a major role in fixing the ratio. The conservative investor may like tohave more of bond and the aggressive investor, more of stocks. Once the ratio is fixed, itis maintained as the market moves up and down. As usual, action points may be fixed bythe investor. It may vary from investor to investor.

d) Variable Ratio Plan

According to this plan, at varying levels of market price, the proportions of the stocksand bonds change. Whenever the price of the stock increases, the stocks are sold andnew ratio is adopted by increasing the proportion of defensive or conservative portfolio.To adopt this plan, the investor is required to estimate a long term trend in the price of thestocks.

6. MUTUAL FUNDS

6.1 INTRODUCTION

Different investment avenues are open to Indian investors. Mutual funds also offerattractive and sound investment opportunities. Unit Trust of India was the first MutualFunds set- up in India in the year 1963. In early 1990s Indian Government allowed PublicSector Banks and Financial Institutions to set - up Mutual funds.

Mutual fund is mechanism for mobilizing the scattered savings by issuing units to theinvestors and investing the funds in shares and securities in accordance with objectives as



disclosed in offer document. Investment in securities is spread across wide cross- sectionof industries and sectors and thus the risk is reduced. Mutual fund issues units to theinvestors in accordance with quantum of money invested by them. Investors of Mutualfunds are known as unit holders. The profits or loses are shared by the investors in proportionto their investments. A Mutual fund is required to be registered with Securities and ExchangeBoard of India (SEBI) that regulates Securities Market.

In spite of the core strength and regulation the Mutual fund is not free from risk,because it invest the corpus in various instrumental of Capital Market and Money Marketwhich are subject to lot of risk and uncertainty. Mutual fund investing requires some cautionand careful attention of the investor. Very often investors commit mistakes by being ignorantor adventurous enough to take risks more than what they can absorb. The following pointsshould be analysed for prudent mutual fund investing: Understanding the basics of MutualFunds, Offer Document, Net Asset value (NAV), Portfolio and network, Investmentobjective and the ultimate expectation from Mutual fund investment. The investor has todecide to whether to react to change in the structure of the scheme, change in asset allocation,to change of fund manager is very important. Analyzing the services offered, avoidingspeculation, practicing diversification, analyzing Tax benefits, ready to switch over, knowingwhen to say good bye will certainly bring down risk and increase the return from MutualFund Investing.

Markets for equity shares, preference shares, debentures and other fixed incomebearing securities have become highly complex and information driven. A wide range ofunpredictable fundamental and technical factors mostly influences these markets. The smalland marginal investors hardly able to attribute reasons for price changes rather predictingthe price changes. A typical individual investor is unlikely to have the knowledge, skills,inclination and time to keep track of events, understand their implications and act speedily.An individual also finds it difficult to keep track of ownership of his assets, investmentsbrokerage dues and bank transactions etc. A mutual fund is the answer to all these complexsituations.

Mutual fund is a Trust that pools the savings of number of investors who share acommon financial goal. The money thus collected is invested by the Fund manager indifferent types of securities depending upon the objective of the scheme. The revenuegenerated from these investment outlets and capital gain realized by the scheme is distributedto unit holders (Mutual fund investors) in proportion to the number of units held by them.Any body with an invisible surplus of as little as a few thousand rupees can invest.

NOTES



Chart-1

Chart-2

Growth of Assets of Mutual Funds (Rs in Crores)

Source: www.amfi.com



Chart-3

Growth of Mutual Funds Schemes

Source: www.amfi.com

6.2 STRATEGY FOR MUTUAL FUND INVESTMENT

Understanding the basics of Mutual Funds

It is very much important to understand the basic concept, kinds and operationalmechanism of Mutual funds. The degree of risk, return, invetment objective and the termsand conditions of the Mutual funds are vary from scheme to scheme. The investor shouldgo through the relevant literature for the theoretical concept and website and the factsheets of the schemes.

Almost all the Mutual funds have their own websites. Investors can also access to theNAV, half–yearly results and portfolios all Mutual funds at the website of Association ofMutual Funds in India (www.amfindia.com). Many newspapers and websites like http://www.mutualfundsindia.com also publish useful information on Mutual funds on daily andweekly basis. Investors can approach their agents and distributors in the regard

Furnishing the necessary details is vital.

While applying for Mutual funds the investor has to give the necessary details so thatthe returns offered by mutual funds is not misused by anybody. The aaplicant of Mutualfund has mention clearly his name, address, number of units applied for and other suchrelated information as per the requirements at the time of applying for Mutual funds.Furnishing the correct bank account number is essential to avoid any fraudulent encashmentof any cheque, draft issued by the Mutual fund at a later date for the purpose of dividend

NOTES



or repurchases. Any changes in the address, bank account number etc at a later dateshould be informed to the Mutual fund immediately.

To ensure communications from Mutual fund

Mutual fund investors should get adequate and proper communication from the Mutualfund. Mutual funds are required to dispatch certificates or statements of accounts with insix weeks from the date of closure of the initial subscription and required to dispatch thedividend warrants with in 30 days of the declaration of dividend and the repurchase proceedswith in 10 working days from the date of repurchase or otherwise the Asset ManagementCompany has to pay interest at 15% as per the norms of SEBI

The Mutual funds are required to inform any material changes to unit holders.Apart from it, many Funds send quarterly newsletters to their unit holders. The offerdocuments are to be revised and updated at least once in two years.

Proper understanding of Offer Document

An abridged Offer Document of Mutual funds contains very useful and material facts,which are very much required for rational investment decisions. The Application form ofthe Fund is an integral part of the Offer document. The investor should carefully go throughand analyse the following features of the scheme: a) Risk Factors, b) Initial issue cost andrecurring cost to be charged to the scheme, c) Entry and exit load charges, d) Sponsor’strack record, e) Performance of the other schemes lunched by the Sponsor and f)Qualification and experiences of Fund Manager.

Analyzing the benefits and services

Doing some homework is necessary before committing funds in Mutual funds. Carefulanalysis of the investment objective, portfolio management, returns and NAV of the schemeand updating such analysis are very important.

Tax benefits of Mutual fund investing are also to be emphasized, as the individual incometax is high in India. Investors should keep in mind that all dividends are currently tax – freein India and so their tax liabilities can be reduced if the dividend pay out option is used.

Other facilities offered by the scheme also to be analysed. For eg. DSP Merill Lynchoffers the following services under it’s Opportunities Fund; Direct deposit application facility,Loan against units, Switching, Telephonic transaction and Redemption cheques in threedays etc.

Define your expectation

The investor has to assess his expectation and risk bearing capacity. Ambiguity overrisk analysis and irrational expectations will only bring pain to invertors. The life stage of an



investor influences his investment objective and the desirable risk level. An young investormay prefer higher return at the cost of higher risk level, say Equity Fund. But the sameinvestor when he is nearer to retirement prefer to switch over to Debt Funds to minimiserisk and to ensure steady return

Understanding the investment objective

The investor has to ensure that his investment objective match with the schemesinvestment objective. Analysis of the schemes portfolio will be useful in this regard. Mutualfunds, invest with a certain ideology such as the value principle (or) growth philosophy.The investment objective of the Scheme is mentioned in its’ Fact Sheet and the investorhas to carefully analyse and ensure that the selected Scheme’s investment objective ismatched with his investment objective.

Understanding the portfolio.

The portfolio of a Mutual fund shows it’s asset structure, such as equity, debentures,money market instruments, government securities and their quantity, market values andpercentage to NAV. The investor has to see whether the portfolio contains any illiquid andunrated securities and non- performing assets because such securities will pull down theNAV and return of the Mutual fund.

Understanding the ABC of Net Asset value (NAV)

The Net Asset Value of a Fund is the cumulative market value of the assets net of itsliabilities. In other words, if the Fund is dissolved or liquidated, by selling off all the assetsin the Fund, this is the amount that the unit holders would collectively own. The NAV iscalculated per unit.

Sum of market value of investment + liquid assets + dividend and interest accrued –outstanding expensesNAV is calculated per unit.

Sum of market value of investment + liquid assets + dividend and interestaccrued – outstanding expenses

NAV = ________________________________________________________

No of outstanding units

Expenses include management fees, custody charges etc calculated on a daily basis

Reacting to change in the structure of the scheme and asset allocation.

The business of portfolio management, by its very nature, is individualistic in nature asit involves making judgment calls. Every Fund manager brings a unique package of investing

NOTES



styles, skills and values to the table. His selection of sectors & stocks, his ability to predictmarket trends and spot emerging stocks, his contacts in the corporate world who give himaccess to information etc. goes a long way in determining the success of the Mutual fund.Of course, the Fund manager manages the portfolio within the framework of the Fund (asper the investment objective). However, the styles of managing portfolio, stock pickingand risk taken by the Fund manager are greatly influencing the success of the Fund manager,the investor has to observe the functioning of new Fund manager. If satisfied one will haveno reason to complain later but the process needs time and so an investor has to observethe Fund manager for some time before taking a decision

Avoid Speculation and practice diversification

To enhance return and minimize risk the investor should prefer long term investmentrather than speculation for short term gain. Speculation by switching from one scheme toanother scheme very frequently for short tem gain is highly risky. Investing for a reasonabletime horizon based on fundamentals will never let down the investor.

The investor should not put all the eggs in one basket. Irrespective of the risk bearingcapacity, the investor should always, practice diversification by selecting different schemesfrom different sponsors. The diversification certainly would reduce the risk level.

Be regular and be ready to switch over

To be successful in Mutual fund investing one has to have regular habit of investment.Some times the first attempt may be a failure but one should not loose the hope and

confidence. It is extremely difficult to predict market movement and to identify the righttime to enter or exit the market. It is highly important to beat the market by being systematic.The basic philosophy of rupee cost averaging would suggest that if one invests regularlythrough the ups and downs of the market, he would stand a better change of generatingmore returns than the market for the entire duration.

The Fund manager will invest the corpus in the debt market (or) equity market (or)both according to the investment objective of the scheme. The investor should have an eyeover the market developments. If the equity market is moving towards a bearish phase, theinvestors in equity fund will benefit by switching to debt fund. One can always switch backto equity if the equity market starts to show bull trend.

Know when to say good bye

Targeting a reasonable return is good but being greedy is highly risky. One should exitwhen enough has been earned that is the initial expectation from the Fund has been metwith.



Chart-4

6.3 EXIT TIMINGS

a) When relative performance is poor

The investor should compare the performance of his fund with its’ peers. It is essentialto analyse the relative performance and not absolute performance. Comparisons shouldbe drawn between parallels and so equity funds cannot and should not be compared withdebt funds when choosing a benchmark, one must select funds in the same category. Ifone’s fund was down by 2% and the average performance of other funds of that category,then there is no sound reason to sell it. The investor should make such analysis for areasonable time horizons, such as I Year, II Year, 3 Year and above. If the fund has underperformed a sizable period then there is enough reason to exit from the fund.

NOTES



c) A Change in life stage

The life stage of an investor influences his investment objective and the desirable risklevel. A young investor may enter higher return at the cost of higher risk level, say equityfund. But the same investor when he is in nearer to retirement prefer to switch over to debtfunds to minimize risk and to ensure steady return. So a change in life stages would be onesuch reason to consider switching in to a fund that matches with ones needs.

d) Material change in the basics of fund

Changes in AMC (or) investment pattern or change from open end to close end etcare the material change in the basics of fund. Such changes will influence the risk return andliquidity of the fund. Then it is for the investor to consider exit from the fund

e) Deviated from the Investment Objective

The investor selects a fund with an investment objective, which matches with his owninvestment objective. The investment objective of the fund says a lot about how the fundplans to invest. If the objective is not being complied with, it is one of the exit points worthconsidering. For example if a fund claims to be diversified equity fund and yet they havehuge exposure to select scrips of particular sector then the risk is very high and it is notdiversified equity fund as it claims.

f) Higher Expense Ratio

The expenses of mutual fund include management fees and all the fees associatedwith the funds’ daily operations. Expenses Ratio refers to the annual percentage of fund’sassets that is paid out in expenses. A small rise in an expense ratio is not going to affect thefund but a significant rise in the ratio would bring down the return to greater extent and it isadvisable to exit from the fund

g) Target Return has been earned

Before investing the investor has to specify the target return. Such target should berealistic. It is very important to exit when target as expected has been achieved irrespectiveof the fact that it might be generating better returns in a short – term. Waiting longer mightnot prove beneficial, as one need not be lucky al the time. Equity market is volatile and itdoes not take long for the moods in the markets to swing either way. So, it would only forwise to move out when the going is still good

Change of Fund Manager

The business of portfolio management, by its very nature is individualistic as it involvesmaking judgment calls. Ever fund manager brings a unique package of investing style, skills



and values to the table. His selection of sectors, his ability to predict market trends andspot emerging stocks, his contacts in the corporate world who give him access to informationetc. goes a long way in determining the success of the fund

However, the fund managers are not cent percent on their own. Most of the IndianAMCs have outlined some broad investment rules and limits for their fund managers.Typically, these deal with fund management issues like which kinds of stocks to invest inand which stock to avoid, which sectors to focus on, how much can scheme invest in aparticular sector or stock, how to zero in on a stock and so on. Sundaram Mutual Fund,for instance, lists just 200 stocks for its fund managers to invest in, not the entire universeof 6000 – odd listed stocks, the objective being to prevent its fund managers from going into unknown territory. Sundaram is also strict about portfolio diversification and prohibits ascheme from holding more than five percent in a single stock. Of course, the fund managersmanage the portfolio with in the framework of the fund (as per the investment objective).However the styles of managing portfolio, stock picking and risk taken by the fund managerare greatly influencing the success of the fund. If there is a change of fund manager, theinvestor has to observe the functioning of new fund manager. If satisfied one will have noreason to complain later but the process needs time and so an investor has to observe thefund manager for some time before taking a decision

Summary

The investment analysts and portfolio managers are regularly monitoring and evaluatingthe performance of their portfolio. The revision of portfolio i.e.. the change of securities inthe portfolio is done based on the performance of the securities in the portfolio. The fundmanager tries to show higher returns from their portfolio than the return from bench mark.The right market timings, proper diversifications so as to reduce the systematic risk, properbeta estimates (so as to reduce systematic risk) are the strategies adopted by portfoliomanagers in making their portfolio to offer superior returns. There was no compositeindex, which measures both return and risk under the Traditional Theory. But the modernportfolio theory focus on maximizing return and minimizing risk and therefore it becomesessential to develop composite measures of return and risk of the portfolio. Researcherslike Sharpe, Treynor and Jensen conducted research to develop a composite index tomeasure risk based returns by considering various types of risks such as systematic risk,unsystematic risk and residual risk.

Mutual fund industry today, with about 34 players and more than 500 schemes, isone of the most preferred investment avenues in India. However with a plethora of schemesto choose from, the retail investor faces problems in selecting funds. Factors such asinvestment strategy and management style are qualitative, but the Fund’s record is animportant indicator too. Though past performance alone cannot be indicative of future

NOTES



performance, it is frankly; the only quantitative way to judge how good a Fund is at present.Therefore, there is need to correctly asses the past performance of different Mutual funds.

Like direct investment in stock Mutual fund investing is also subject to risk, which iscaused by market flueations, but investors believe that mutual funds can mange risks betterthan they could. The ups and downs in Mutual find returns may give several investmentexperiences but will not drive investors away from mutual funds because they still areamong the best investment avenues available to them. The financial news papers on weeklybasis are publishing various studies on Mutual funds including yields of different schemes.Apart form these; many research agencies also publish research reports on performanceof mutual funds including the ranking of various schemes in terms of their performance.Investors should study these reports and keep themselves informed about the performanceof various schemes. Investors can compare the performance of their schemes with otherschemes in the same category. The returns can be compared with the Bench marks likeBSE sensex, S & P CNX , Nifty etc

Key Terms

• Sharpe’s Performance Index

• Treynor’s Performance Index

• Jensen’s Performance Index

• Portfolio Revision

• Passive Management

• Active Management

• Formula plans

Questions

1. Explain Sharpe’s Performance Index

2. Discuss about Treynor’s Performance Index

3. Explain Jensen’s Performance Index

4. What do you mean by Portfolio Revision?

5. What is meant by Passive Management?

6. Explain ‘Active Management’

7. What do you understand by Formula plans?

8. Discuss the strategy for Mutual Fund Investment

9. Explain the Exit Timings from Mutual Fund investments



NOTES

Security Analysis Portfolio Management (1)

Documents

Transcript of Security Analysis Portfolio Management (1)