Security Analysis Portfolio Management

5/27/2018 Security Analysis Portfolio Management

MBA(DISTANCE MODE)

DBA 1723 / 1750

SECURITY ANALYSIS AND PORTFOLIO

MANAGEMENT

III SEMESTER

COURSE 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 Engineering

Anna University Chennai

Chennai - 600 025

DrDrDrDrDr.H.P.H.P.H.P.H.P.H.Peeree reeree ree ru Mohamedu Mohamedu Mohamedu Mohamedu MohamedProfessor

Department of Management Studies


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 on ly)

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


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ACKNOWLEDGEMENT

The author has drawn inputs from several sources for the preparation of this course material, to meet the

requirements 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 and

not purposeful

Dr.J.Gopu

Author

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DBA 1723 / 1750 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

UNIT I INVESTMENT SETTING

Investment setting Securities Sources of investment information -Security market indications Security contract

regulation Act -investors protection.

UNIT II CAPITAL MARKETS

Overview of capital market, Institutional structure in capital market, Reforms and status of capital market, New

issue market and problems, Securities and Exchange Board of India (SEBI), Debt market.

UNIT III FUNDAMENTAL ANALYSIS

Economic analysis - Economic forecasting and stock investment DecisionsForecasting techniques. Industry

analysis-Industry classification. Economy and industry analysis. Industry life cycle Company analysis measuring

earnings-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 India

Private 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

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CONTENTS

UNIT - I

INVESTMENT SETTING

CHAPTER - I

INVESTMENT SETTING AND SECURITIES

1 OVERVIEW 1

2. DIFFERENCE BETWEEN SPECULATION AND INVESTMENT 1

3. OBJECTIVES OF INVESTMENT 2

4. SECURITIES 2

4.1 Debentures 3

4.2. Bonds 4

4.3. Advantages of Debentures and Bonds 5

4.4. Equity shares 6

4.5 Special features of equity shares 7

4.6 Non voting shares 84.7 Right shares 8

4.8 Bonus shares 8

4.9 Preference shares 8

4.10. Types of preference shares 8

5. INVESTMENT INFORMATION 9

5.1 Types of investment information 9

5.2. Importance of correct information 10

CHAPTER- II

SECURITY MARKET INDICATIONS - BOMBAY STOCK EXCHANGE

1. OVERVIEW 13

2. KINDS OF INDICES 13

3. SENSEX 14

3.1 Introduction 14

3.2 Sensex calculation methodologies 14

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4. FREE-FLOAT METHODOLOGY 15

4.1 Concept 15

4.2 Major advantages of free-float methodology 154.3 Definition of free-float 16

4.4 Determining free-float factors of companies 16

4.5 Index closure algorithm 17

5. MAINTENANCE OF SENSEX 17

5.1 On-line computation of the index 18

5.2 Adjustment for bonus, rights and newly issued capital 18

6. SENSEX - SCRIP SELECTION CRITERIA 19

7. INDEX REVIEW FREQUENCY 20

CHAPTER- III

SECURITY MARKET INDICATIONS - NATIONAL STOCK EXCHANGE

1. OVERVIEW 29

2. INDEX CONCEPTS 30

2.1 Impact cost 30

2.2 Definition 32

2.3 Beta 32

2.4 Unsystematic risks 33

2.5 Systematic risks 33

2.6 What is beta? 33

2.7 Methodology / formula 33

2.8 Standard deviation 34

3. TOTAL RETURN INDEX 34

4. METHODOLOGY FOR TOTAL RETURNS INDEX (TR) 34

5. ESSENTIAL OF A STOCK MARKET INDEX 35

6. THE MEANING OF UPS AND DOWNS OF AN INDEX 35

7. THE BASIC IDEA IN AN INDEX 35

8. AVERAGING 35

9. THE PORTFOLIO INTERPRETATION OF INDEX MOVEMENTS 35


CHAPTER- IV

SECURITIES TRADING REGULATIONS AND INVESTOR PROTECTION

1. OVERVIEW 38

2. OBJECTIVES OF THE SECURITIES CONTRACTS

(REGULATION) ACT, 1956 38

3. SCOPE OF THE SECURITIES CONTRACTS

(REGULATION) ACT, 1956 39

4. RECOGNITION OF STOCK EXCHANGES 39

5. OPTIONS IN CONTRACTS 39

6. REGULATION OF TRADING 40

7. RESTRICTION ON TRANSFERABILITY 42

8. SWEAT EQUITY AND EMPLOYEE STOCK OPTION PLAN (ESOP) 43

9. INVESTORS PROTECTION 44

10. PROTECTION AGAINST LOSS DUE TO

UNFAIR TRADE PRACTICE 45

11. INVESTOR PROTECTION FUND AND

CONSUMER PROTECTIONFUND (IPF / CPF) 45

12. HANDLING THE GRIEVANCES OF INVESTORS 45

13. PROTECTION AGAINST INSIDER TRADING 46

14. SECURITIES OMBUDSMAN 4615. INVESTORS EDUCATION 46

UNIT-II

CAPITAL MARKETS

CHAPTER - I

OVERVIEW AND INSTITUTIONAL STRUCTURE

OF CAPITAL MARKET

1. INTRODUCTION 49

2. OVERVIEW OF CAPITAL MARKET 49

2.1 The history of Indian capital market 50

2.2 The growth of indian stock exchanges 51

2.3 Post-independence scenario 51

2.4 Over the counter exchange of India (otcei) 52

2.5 Functions of stock exchange 53

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3. INSTITUTIONAL STRUCTURE OF STOCK MARKET 54

3.1 Organisational structure 54

3.2 Membership 54

3.3 Capital market reforms 55

3.4 State of capital market 56

CHAPTER - II

NEW ISSUE MARKET

1. OVERVIEW 58

2. NEW ISSUE MARKET PARTICIPANTS 58

3. FLOATATION OF THE ISSUE 59

4. PROBLEMS OF NEW ISSUE MARKET 61

5. MEASURES TO BE TAKEN FOR IMPROVING THE

CONDITION OF NEW ISSUE MARKET 61

CHAPTER III

NATIONAL STOCK EXCHANGE

1. OVERVIEW 63

2. OWNERSHIP AND MANAGEMENT 643. MARKET SEGMENTS AND PRODUCTS 64

4. MEMBERSHIP ADMINISTRATION 65

5. ELIGIBILITY CRITERIA 66

6. TRADING MEMBERSHIP 66

7. CLEARING MEMBERSHIP 67

8. GROWTH AND DISTRIBUTION OF MEMBERS 67

9. DISTRIBUTION OF TRADING MEMBERS

(AS ON MARCH 30, 2007) 67

10. TRANSACTION CHARGES 67

11. LISTING OF SECURITIES 67

12. BENEFITS OF LISTING ON NSE 68

13. LISTING CRITERIA 68

14. LISTING AGREEMENT 68

15. SHAREHOLDING PATTERN 69

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16. COMPLIANCE BY LISTED COMPANIES 69

17. DISCLOSURES BY LISTED COMPANIES 69

18. DELISTING 69

19. VOLUNTARY DE-LISTING OF COMPANIES 69

20. COMPULSORY DE-LISTING OF COMPANIES 70

CHAPTER IV

SEBI REGULATION OF SECURITIES MARKET

1. OVERVIEW 72

2. PRIMARY SECURITIES MARKET 72

3. REGISTRATION OF STOCK BROKERS 73

4 REGISTRATION OF SUB-BROKERS 75

5 RECOGNITION OF STOCK EXCHANGES 75

6. REGISTRATION OF FOREIGN INSTITUTIONAL INVESTORS 75

7. REGISTRATION OF CUSTODIANS OF SECURITIES 76

8. REGISTRATION OF MUTUAL FUNDS 76

9. REGISTRATION OF VENTURE CAPITAL FUNDS 76

10. SUPERVISION 76

11. INSPECTION OF MARKET INTERMEDIARIES 77

12. SURVEILLANCE 77

CHAPTER- V

INDIAN DEBT MARKET

1. OVERVIEW 79

2. THE INDIAN DEBT MARKET 79

3. THE STRUCTURE OF THE INDIAN DEBT MARKET 80

4. SECONDARY CORPORATE DEBT MARKET 81

5. THE PROBLEMS OF DEBT MARKET 83

6. DEBT MARKET AND NSE 86

7. MARKET PERFORMANCE 87

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UNIT-III

FUNDAMENTAL ANALYSIS

CHAPTER - I

ECONOMIC ANALYSIS

1. INTRODUCTION 91

2. ECONOMIC FORECASTING 91

3. STOCK INVESTMENT DECISIONS 92

4. TECHNIQUES OF ECONOMIC FORECASTING 93

CHAPTER - II

INDUSTRY ANALYSIS

1. INTRODUCTION 101

2. THE MEANING OF INDUSTRY 101

3 CLASSIFICATION OF INDUSTRY 101

4. INDUSTRY LIFE CYCLE 102

5. STAGES OF INDUSTRY LIFE CYCLE. 103

6 INDUSTRY ANALYSIS ISSUES TO BE ANALYSED 106

CHAPTER - III

COMPANY ANALYSIS

1. INTRODUCTION 113

2. FACTORS TO BE CONSIDERED 113

3. MEASURING EARNINGS 114

4. FORECASTING EARNINGS 115

CHAPTER - IV

APPLIED VALUATION TECHNIQUES

1. INTRODUCTION 119

2. GRAHAM AND DODDS INVESTOR RATIOS 119

3. THE DIVIDEND DISCOUNTING METHOD 120

4. P/E RATIO MODEL 120

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5. OTHER MODELS 120

6. BUYING STOCKS - BASED ON THE FUNDAMENTAL ANALYSIS 121

7. SELLING STOCKS - BASED ON THE FUNDAMENTAL ANALYSIS 122

8. HOW IS THE COMPANY EVALUATED BY THE MARKET? 122

UNIT-IV

TECHNICAL ANALYSIS

CHAPTER - I

TECHNICAL ANALYSIS AND CHARTING METHODS

1. INTRODUCTION 125

2. TECHNICAL ANALYSIS MEANING 126

3. ASSUMPTIONS OF TECHNICAL ANALYSIS 126

4. FUNDAMENTAL ANALYSIS Vs TECHNICAL ANALYSIS 126

6. CHARTING METHODS 128

6.1 Point and figure chart 128

6.2 Bar chart 129

6.3 Line chart 130

6.4 Candle stick chart 130

CHAPTER- II

MARKET INDICATORS, PATTERNS AND DOW THEORY

1 INTRODUCTION 133

2 PUT/CALL RATIO 133

3 FUND MANAGER SURVEYS 133

4. VOLATILITY INDEX 133

5. MUTUAL FUND DATA 134

6. MOVING AVERAGES 134

6.1 Uses of Moving Averages 134

6.2 Index Moving Average and Stock price 135

7. VOLUME 143

8. MARKET BREADTH 143

9 ODD-LOT THEORY 145

10 CONFIDENCE INDEX 145

11 RELATIVE STRENGTH INDEX (RSI) 145

12 RATE OF CHANGE (ROC) 146

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13 OSCILLATORS 147

14 TREND 147

15 TREND REVERSAL 147

16 PATTERNS 148

17 DOW THEORY 153

UNIT- V

PORTFOLIO MANAGEMENT

CHAPTER - I

PORTFOLIO THEORY AND PORTFOLIO CONSTRUCTION

1. INTRODUCTION 155

2. TRADITIONAL THEORY OF PORTFOLIO 155

3. STEPS IN TRADITIONAL THEORY OF

PORTFOLIO CONSTRUCTION 155

4. MODERN PORTFOLIO THEORY 157

5. CAPITAL ASSET PRICING MODEL 158

6. HEDGING AND DIVERSIFICATION 160

7. RETURN 1618. RISK 163

9. CAPITAL MARKET LINE 164

10. EFFICIENT FRONTIER 165

11. EFFICIENT FRONTIER EXHIBIT 1 166

12. MARKET RISK 167

CHAPTER II

PORTFOLIO EVALUATION, PORTFOLIO REVISION AND MUTUAL FUNDS

1. INTRODUCTION 170

2. SHARPES PERFORMANCE INDEX 170

3. TREYNORS PERFORMANCE INDEX 172

4. JENSENS PERFORMANCE INDEX 173

5. PORTFOLIO REVISION 174

5.1 Introduction 174

5.2 Passive management 174

5.3 Active management 174

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5.4 Formula plans 174

5.5 Assumption of formula plan 174

5.6 Types of formula plan 175

6. MUTUAL FUNDS 175

6.1 Introduction 175

6.2 Strategy for mutual fund investment 178

6.3 Exit timings 182


NOTES

1 ANNA UNIVERSITY CHENNAI

SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

UNIT - I

INVESTMENT SETTING

CHAPTER - I

INVESTMENT SETTING AND SECURITIES

Learning Objective

After going through this chaptert you would be able to understand the basic concept of

investment 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 getting

a 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 getting

short term capital gain. For example if a person buy a stock for Rs.100 and sell the same

stock 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 is

every chance of incurring capital loss also. Thus speculation involves high degree of risk

and return.

2. DIFFERENCE BETWEEN SPECULATION AND INVESTMENT


NOTES

DBA 1723 / 1750


3. OBJECTIVES OF INVESTMENT

a) Reasonable return :-

The investor expects a reasonable return on his investment. The return on investment

can be calculated by the following equation;

Value at the end of Dividend (or) Purchase price

holding period + Interest received __ of the investment

Return = X 100

Purchase price of the investment

In the above equation its very clear that the return includes regular dividend or interest

income and the capital appreciation.

b) Risk

The risk can be defined as the deviation of the actual return from the expected rate of

return. Every investor would like to reduce the degree of risk by constructing a sound

portfolio. The degree of risk will be less in government securities and fundamentally sound

company 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 much

of its value within very short period. In other words its the marketability of the investment.The investor prefers an investment outlet which has high liquidity. The equity share of

fundamentally 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 investor

while committing founds in an investment outlet. The safety of the capital is based on

various factors like; legal and regulatory frame work, the performance of the company and

the type of investment outlet.

4. SECURITIES

To mobilize long term funds the corporate are issuing various securities in the capital

market. Securities provide a claim to the holder on the assets and future cash flows that

will be generated by the assets of the company. Generally the term securities include

shares, Debentures and Bonds. According to the Securities Contracts (Regulation) Act

1956, Securities include shares, bonds, debentures or other marketable securities of any

company or government.


NOTES



4.1 DEBENTURES

According to companies Act 1956, Debenture includes debenture stock, bonds

and 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 certain

percentage of interest irrespective of its profitability. The interest is calculated on the face

value of the debenture. The interest may be paid quarterly, semi annually or annually as

per the terms and conditions in the offer document.

b)Redemption

The money mobilized by a company by issuing debenture is subject to repayment to

the investor on a specified maturity period. The redemption (repayment) of debenture is

made 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 who

represent the debenture holders. Financial Institutions, Banks, Insurance companies act

as 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 debenture

before maturity period. In order to change the capital structure or reduce cost of capital or

solve overcapitalization problems the company would like to redeem the debenture even

before maturity period.

Kinds of Debentures

a) Secure and Unsecured Debentures

When the debenture is secured by creating a charge on the assets of the company

then it is called a secured debenture. If the company fails to pay interest or repay the

debenture amount to the investor then the trustee can take hold of the secured assets on

behalf of the debenture investor.

When there is no such charge on the assets of the company, the debenture is called

unsecured debenture or naked debenture. The unsecured debentures are highly risky.


NOTES

DBA 1723 / 1750


b) Convertible Debentures

If the debenture holder is given the option of converting debenture in to equity share

of 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 fully

convertible debenture otherwise if only a part of debenture amount is converted in to

equity then it is called partly convertible debenture. The type and terms and conditions of

conversion will be clearly mentioned in the offer document.

c) Non Convertible Debenture

The non convertible debenture cannot be converted in to shares. The debentures

can 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 for

a specified period of time. Bond is an alternative form of debenture in India. Public sector

companies and financial institutions issues bonds. The bond has a face value. The offer

price 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 rate

of interest, period of interest payment, maturity period and redemption value will be

mentioned 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 company

then it is called Secured Bond. If there is no such charge on the assets of the issuing

company 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 reserve

then the company issues Sinking fund bond. The company makes a periodical payments

to the Sinking fund agent (the Trustee who is normally a Bank or Financial Institution or

Insurance 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 issuing

company. The investments held by the bond issuing company in other companies are

pledged for issuing the Collateral trust bond.


NOTES



d) Income Bonds

The interest is payable by the company on Income bonds out of current earnings. If

there 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. The

interest is payable on Adjustable Bond only if earnings are adequate.

f) Assumed Bonds

When one company takes over another company (Acquisition) it takes both assets

and liabilities. The bonds already issued by the acquired company become the bond of

acquiring company. Thus the acquiring company assumes the bonds already issued by the

acquired company.g) Joint Bonds

When two or more companies joins together and issues bonds then it is called Joint

bond. 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. The

debentures are issued by private sector corporate and Public sector organizations and

financial institutions issue the bonds. The advantages of issuing the debentures and bonds

are 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 secured

and there is a guarantee for payment of interest periodically and repayment of principal

amount at the time of maturity. Therefore the instrument can be issued at reasonable rate

of interest. Above all the interest paid by the issuing company is treated as revenue

expenditure and deducted for corporate tax calculations. The after tax cost of debt capital

is very low. So debentures and bonds are considered as the cheapest source of funds for

companies.

b) Financial leverage

The interest payable to debenture holders and bondholders are always less than the

return on investment and the cost of equity capital of the company. Thus the surplus

earnings after payment of interest and tax can be given to the equity shareholders. By

employing debenture and bond fund in the business the company can easily enhance return

available for equity holders. This strategy is called financial leverage. The practice of

financial leverage enhances Earning per share and in turn increases Dividend per share and

ultimately the market capitalization of the company increases.


NOTES

DBA 1723 / 1750


c) Savings over Corporate Tax

The interest on debentures and bonds are deducted as revenue expenditure for

corporate tax calculations. Thus the companys tax obligation gets reduced.

d) Widen the source of funds

Since there is a guarantee over the payment of interest and repayment of principal

amount 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 instrument

from rating agencies like ICRA, CARE (or) CRISIL etc,.

A company with sound rating symbol can easily mobilize large funds at reasonable

rate of interest. The rating symbols acts as a guiding lights for the investors to know the

risk level.

f) Flexibility in capital structure

The call option in the debenture or bond issue facilitates the issuing company to

redeem the instrument even before maturity period. This brings more flexibility in capital

structure. If the company faces financial troubles like over capitalization or increased

interest burden then it can exercise call option.

g) No dilution of control

The debenture holders and bondholders are simply the long-term creditors of the

company. They are not given any voting rights. Therefore there will be no interference

from the debenture holders or bondholders to the companys management and the control

is 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 the

total net assets of the company. The equity shareholder is entitled to all rights and obligations

as owner to the residual profits and assets of the company after the claims of creditors are

met. The dividend to equity shareholder is determined after meeting interest, preference

dividend and tax obligations and therefore the equity dividend is subject to uncertainty and

highly fluctuating. The dividend and increase in the market value of equity shares are the

forms of return available for equity shareholders.

The equity shareholders are the ultimate owners of a company. They have the following

rights 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 company

c. Right to get a share in the profits of the company in the form of dividend

d. Right to get on the residual value of the company after repayment of all theclaims 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 not

liable 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 is

paid only after payment of corporate tax and preference dividend if any.

The amount of dividend is determined based on the profitability, reserve requirements

and the expectation of shareholders.

The equity holders another form of return is the capital appreciation. When the

current market value of the equity is more than the offer price or purchase price of the

share 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 shareholders particulars and include new shareholders particular in the register of

members.

d) Liquidity

The company does not redeem the equity shares and it lists the shares in stock

exchanges 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 profit

making and growth-oriented companies shares are having high market value and liquidity

in stock market.


NOTES

DBA 1723 / 1750


e) Voting rights

The equity shareholders are given voting rights based on the number of shares held

by them. They can attend annual general meetings and extraordinary general meetings and

exercise their voting rights. The board of directors, charted accountant and legal advisors

of 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 get

additional (20%) dividends and they are eligible for bonus shares. If the company fails to

pay dividend for two consecutive years then the non-voting shareholders automatically

gets voting rights. A company can issue non voting shares to a maximum of 25% of the

voting shares.

4.7 RIGHT SHARES

When an existing company issues additional share capital the existing shareholders

should be given preemptive rights. The existing shareholders who apply for additional The

investment and disinvestment activities of Mutual funds, Institutional Investors and Foreign

Institutional Investors are greatly influencing the market direction. Therefore an investor

has 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 retains

the remaining profit as retained earnings. The accumulated retained earnings can be

converted in to equity shares by issuing bonus shares to the equity shareholders. Thus the

conversion of retained earnings in to equity capital enables the company to use the capital

for expansion, modernization and other business requirements. The bonus shares are

issued at free of cost to the existing equity shareholders.

4.9 PREFERENCE SHARES

Shares with two preferences are called preference shares. The preference shareholders

have the preference to get dividend before equity shareholders and the preference to get

back the capital before equity shareholders incase when the company is dissolved. The

preference shareholders dividend is pre-determined and they do not enjoy the voting

rights.

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 for

the current year but also for unpaid previous years also. Thus during loss making years the


NOTES



shareholder dont get dividend but the dividend will accumulate and the same will be paid

during 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 specified

period. This convertible option to the investor is very attractive.

The non-convertible preference share remains as preference shares and the same

cannot 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 its

preference shares. The company out of capital redemption reserve can redeem the fully

paid preference shares.

The Irredeemable preference shares cannot be redeemed unless the company comes

to an end. However this type of preference share is not permitted in India as per section

80A 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 constantly

gather various relevant information and analyse its impact on his market value of his

investment.

5.1 TYPES OF INVESTMENT INFORMATION

a) World Affairs

With increasing cross border trades and international trades the international economic

and political events influence the domestic capital markets. Each and every economy is

interdependent to certain extent. The economic recession felt in US during the last quarter

of 2007 has impacted on many Asian and Indian capital markets. The policies of IMF and

the 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 investors

from one country to another.


NOTES

DBA 1723 / 1750


b) Domestic Economic and Political factors

The Gross domestic product (GNP), agricultural output, monsoon, inflation money

supply, monetary policy of RBI, (Repo rate, Reverse Repo rate, cash adequacy ratio ofcommercial banks) Governments industrial policy, budget proposal, tax policies etc. are

the 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 market

share, outlook of the industry, exports prospects, government policy towards the industry

etc, influences the share price movements of the specific industry stocks.

d) Company Information

Financial results, change in management, orders received, joint venture, new product

and technology introduction, expansion programmes, dividend and bonus shares offered

are very important information which will influence the price movements of the companys

shares.

e) Security Market Information

The credit rating information and symbols announced by credit rating agencies like

ICRA, CRISIL, CARE etc; market movements, analyst reports etc. are the powerful

information 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 Investors

and Foreign Institutional Investors are greatly influencing the market direction. Therefore

an 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 market

information. The investors should identify the relevant information and its source. Those

who have better information use it to get extra mileage on such information. It is also

possible that insiders who have the information before it becomes public take advantage of

it called insider trading. At present the SEBI has acquired powers to control insider trading,

malpractices and rigging up of prices in the secondary market and penalize the offenders.


NOTES



Summary

Investment is the commitment of funds on assets with an ultimate objective of getting

a 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 capital

market. Securities provide a claim to the holder on the assets and future cash flows that

will be generated by the assets of the company. Generally the term Securities includes

shares, Debentures and Bonds.

Bonds are a long term debt instrument that promises to pay a fixed annual interest for

a specified period of time. Bond is an alternative form of debenture in India. Public sector

companies and financial institutions issue bonds. The bond has a face value. The offer

price 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 rate

of interest, period of interest payment maturity period and redemption value will be

mentioned on the bond certificate.

Equity shares constitute the ownership capital of a company and the equity holder

has the right of voting and sharing in profits and assets in proportion to his holding in the

total net assets of the company. The equity shareholder is entitled to all rights and obligations

as owner to the residual profits and assets of the company after the claims of creditors are

met. The dividend to equity shareholder is determined after meeting interest, preferencedividend and tax obligations and therefore the equity dividend is subject to uncertainty and

highly 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 constantly

gather various relevant information and analyse its impact on his market value of his

investment.

Key Terms

Speculation and Investment

Debentures

Bonds

Equity Shares

Right Shares

Bonus Shares

Preference Shares


NOTES

DBA 1723 / 1750


Questions

1. What do you mean by Investment and Speculation?

2. Differentiate Investment from Speculation

3. What are the objectives of investors in investing their funds in capital market?

4. Explain the various types of Debentures and its advantages

5. Discuss the merits and limitations of equity shares as an investment outlet

6. 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 of

indices, 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 index

we know how the market is faring. This information aspect also figures in myriad applications

of stock market indices in economic research. This is particularly valuable when an index

reflects highly up-to-date information and the portfolio of an investor contains illiquid

securities - in this case, the index is a lead indicator of how the overall portfolio will fare. In

recent years, indices have come to the fore owing to direct applications in finance, in the

form of index funds and index derivatives. Index funds are funds which passively invest in

the 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 management

in 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 for

measuring the performance of fund managers. An all-equity fund should obtain returns like

the overall stock market index. A 50:50 debt: equity fund should obtain returns close to

those 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 the

benchmark 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 the

large, liquid stocks of the country. In most countries, a single major index dominates

benchmarking, index funds, index derivatives and research applications. In addition, more

specialised indices often find interesting applications. In India, we have seen situations

where a dedicated industry fund uses an industry index as a benchmark. In India, where

clear categories of ownership groups exist, it becomes interesting to examine the

performance of classes of companies sorted by ownership group.


NOTES

DBA 1723 / 1750


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 1875

when 318 persons became members of what today is called The Stock Exchange, Mumbai

by paying a princely amount of Re1.

Since then, the countrys capital markets have passed through both good and bad

periods. The journey in the 20th century has not been an easy one. Till the decade of

eighties, there was no scale to measure the ups and downs in the Indian stock market. The

Stock Exchange, Mumbai (BSE) in 1986 came out with a stock index that subsequently

became the barometer of the Indian stock market.

Sensex is not only scientifically designed but also based on globally accepted

construction and review methodology. First compiled in 1986, Sensex is a basket of 30

constituent 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 widely

reported in both domestic and international markets through print as well as electronic

media.

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 regarded

as 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 be

the pulse of the Indian stock market. As the oldest index in the country, it provides the time

series data over a fairly long period of time (From 1979 onwards). Small wonder, the

Sensex has over the years become one of the most prominent brands in the country. The

growth of equity markets in India has been phenomenal in the decade gone by. Right from

early nineties the stock market witnessed heightened activity in terms of various bull and

bear runs. The Sensex captured all these events in the most judicial manner. One can

identify 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. As

per this methodology, the level of index at any point of time reflects the Free-float market

value of 30 component stocks relative to a base period. The market capitalization of a

company is determined by multiplying the price of its stock by the number of shares issued

by the company. This market capitalization is further multiplied by the free-float factor to

determine the free-float market capitalization.


NOTES



The base period of Sensex is 1978-79 and the base value is 100 index points. The

notation 1978-79=100 often indicates this. The calculation of Sensex involves dividing the

Free-float market capitalization of 30 companies in the Index by a number called the Index

Divisor. 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 adjustments

arising out of corporate actions, replacement of scrips etc. During market hours, prices of

the index scrips, at which latest trades are executed, are used by the trading system to

calculate 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 into

consideration only the free-float market capitalization of a company for the purpose of

index calculation and assigning weight to stocks in Index. Free-float market capitalization

is defined as that proportion of total shares issued by the company that are readily available

for 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 in

the 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 July

2001 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 becomes

the 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 into

consideration only those shares that are available for trading in the market.

Free-float Methodology makes the index more broad-based by reducing the

concentration of top few companies in Index. For example, the concentration of

top five companies in Sensex has fallen under the free-float scenario thereby making

the SENSEX more diversified and broad-based.

A Free-float index aids both active and passive investing styles. It aids active

managers by enabling them to benchmark their fund returns vis--vis an investable

index. This enables an apple-to-apple comparison thereby facilitating better

evaluation of performance of active managers. Being a perfectly replicable portfolio

of stocks, a Free-float adjusted index is best suited for the passive managers as it

enables them to track the index with the least tracking error.


NOTES

DBA 1723 / 1750


Free-float Methodology improves index flexibility in terms of including any stock

from the universe of listed stocks. This improves market coverage and sector

coverage 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 undue

influence on the index movement. However, under the Free-float Methodology,

since only the free-float market capitalization of each company is considered for

index calculation, it becomes possible to include such closely held companies in

the index while at the same time preventing their undue influence on the index

movement.

Globally, the Free-float Methodology of index construction is considered to be an

industry best practice and all major index providers like MSCI, FTSE, S&P and

STOXX have adopted the same. MSCI, a leading global index provider, shifted

all its indices to the Free-float Methodology in 2002. The MSCI India StandardIndex, which is followed by Foreign Institutional Investors (FIIs) to track Indian

equities, is also based on the Free-float Methodology. NASDAQ-100, the

underlying index to the famous Exchange Traded Fund (ETF) - QQQ is based on

the Free-float Methodology.

4.3 DEFINITION OF FREE-FLOAT

Share holdings held by investors that would not, in the normal course come into the

open market for trading are treated as Controlling/ Strategic Holdings and hence not

included in free-float. In specific, the following categories of holding are generally excluded

from 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 index

companies 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 companies

in the prescribed format. Free-float factor is a multiple with which the total market

capitalization 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-float

factor of say 0.55 means that only 55% of the market capitalization of the company will be

considered 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 all

the trades on Sensex constituents in the last 30 minutes of trading session. If a SENSEX

constituent has not traded in the last 30 minutes, the last traded price is taken for computation

of the Index closure. If a Sensex constituent has not traded at all in a day, then its last days

closing price is taken for computation of Index closure. The use of Index Closure Algorithm

prevents 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 the

base year average. The base year value adjustment ensures that replacement of stocks in

Index, 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 fact

that 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 within

the broad index policy framework set by the Index Committee. The Index Cell ensures

that Sensex and all the other BSE indices maintain their benchmark properties by striking

a delicate balance between frequent replacements in index and maintaining its historical

continuity. The Index Committee of the Exchange comprises of experts on capital markets

from all major market segments. They include Academicians, Fund-managers from leading

Mutual Funds, Finance-Journalists, Market Participants, Independent Governing Board

members, 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


NOTES

DBA 1723 / 1750


5.1 ON-LINE COMPUTATION OF THE INDEX

During market hours, prices of the index scrips, at which trades are executed, are

automatically used by the trading computer to calculate the Sensex every 15 seconds andcontinuously updated on all trading workstations connected to the BSE trading computer

in real time.

5.2 ADJUSTMENT FOR BONUS, RIGHTS AND NEWLY ISSUED CAPITAL

The arithmetic calculation involved in calculating Sensexis simple, but problem arises

when one of the component stocks pays a bonus or issues rights shares. If no adjustments

were made, a discontinuity would arise between the current value of the index and its

previous value despite the non-occurrence of any economic activity of substance. At the

Index Cell of the Exchange, the base value is adjusted, which is used to alter market

capitalization 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 affect

the 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, the

free-float market capitalisation of that company is increased by the number of additional

shares issued based on the theoretical (ex-right) price. An offsetting or proportionate

adjustment 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, the

market capitalisation of that company does not undergo any change. Therefore, there is no

change in the Base Market Capitalisation, only the number of shares in the formula is

updated.

Other Issues

Base Market Capitalisation Adjustment is required when new shares are issued by

way of conversion of debentures, mergers, spin-offs etc. or when equity is reduced by

way of buy-back of shares, corporate restructuring etc.

Base Market Capitalisation Adjustment

The formula for adjusting the Base Market Capitalisation is as follows:


NOTES

DBA 1723 / 1750


7. INDEX REVIEW FREQUENCY

The Index Committee meets every quarter to discuss index related issues. In case of

a 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 IDBIKirloskar 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


NOTES

DBA 1723 / 1750


INDEX AND RATIOS


NOTES



INDEX AND RATIOS


NOTES

DBA 1723 / 1750


INDEX AND RATIOS


NOTES



Summary

Traditionally, indices have been used as information sources. By looking at an index

we 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 index

reflects highly up-to-date information and the portfolio of an investor contains illiquid

securities - 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 the

large, liquid stocks of the country. In most countries, a single major index dominates

benchmarking, index funds, index derivatives and research applications. In addition, more

specialised indices often find interesting applications

The Stock Exchange, Mumbai (BSE) in 1986 came out with a stock index that

subsequently became the barometer of the Indian stock market.

Sensex is not only scientifically designed but also based on globally accepted

construction and review methodology. First compiled in 1986, Sensex is a basket of 30

constituent 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 widely

reported in both domestic and international markets through print as well as electronic

media.

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 regarded

as 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 of

a revision in the Index constituents, the announcement of the incoming and outgoing scrips

is made six weeks in advance of the actual implementation of the revision of the Index

Key Terms

Sensex

Free-float Methodology

Adjustments for Rights Issue

Adjustments for Bonus Issue

Market Capitalisation


NOTES

DBA 1723 / 1750


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 of

calculation of Free-float.

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


NOTES



CHAPTER- III

SECURITY MARKET INDICATIONS - NATIONAL STOCK EXCHANGE

Learning 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 market

index, the meaning of ups and downs of an index, the basic idea in an index, averaging, and

the portfolio interpretation of index movements.

1. OVERVIEW

India Index Services & Products Ltd. (IISL) is a joint venture between the National

Stock Exchange of India Ltd. (NSE) and CRISIL Ltd. (formerly the Credit Rating

Information Services of India Limited). IISL has been formed with the objective of providing

a variety of indices and index related services and products for the capital markets.

IISL has a consulting and licensing agreement with Standard and Poors (S&P), the

worlds leading provider of investible equity indices, for co-branding IISLs equity indices.

IISL Indices


NOTES

DBA 1723 / 1750


2. INDEX CONCEPTS

2.1 IMPACT COST

Liquidity in the context of stock markets means a market where large orders can be

executed without incurring a high transaction cost. The transaction cost referred here is not

the fixed costs typically incurred like brokerage, transaction charges, depository charges

etc. but is the cost attributable to lack of market liquidity as explained subsequently. Liquidity

comes from the buyers and sellers in the market, who are constantly on the look out for

buying and selling opportunities. Lack of liquidity translates into a high cost for buyers and

sellers.

The electronic limit order book (ELOB) as available on NSE is an ideal provider of

market liquidity. This style of market dispenses with market makers, and allows anyone in

the market to execute orders against the best available counter orders. The market may

thus be thought of as possessing liquidity in terms of outstanding orders lying on the buy

and 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 particular

stock, he can execute his buy order in the stock against such sell orders, which are already

lying 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 between

the best buy and the best sell orders (in this case, Rs.0.50) is the bid-ask spread. If a

person places an order to buy 100 shares, it would be matched against the best available

sell order at Rs. 4 i.e. he would buy 100 shares for Rs. 4. If he places a sell order for 100

shares, it would be matched against the best available buy order at Rs. 3.50 i.e. the shares

would be sold at Rs.3.5.

Hence if a person buys 100 shares and sells them immediately, he is poorer by the

bid-ask spread. This spread may be regarded as the transaction cost which the market

charges 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 management

capability, consumer preferences, labour, etc. contribute to unsystematic risks. Unsystematic

risks are controllable by nature and can be considerably reduced by sufficiently diversifying

ones 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 eliminated

merely by diversifying ones portfolio.

2.6 WHAT IS BETA?

The degree, to which different portfolios are affected by these systematic risks as

compared to the effect on the market as a whole, is different and is measured by Beta. To

put it differently, the systematic risks of various securities differ due to their relationships

with the market. The Beta factor describes the movement in a stocks or a portfolios

return in relation to that of the market returns. For all practical purposes, the market returns

are measured by the returns on the index (Nifty, Mid-cap etc.), since the index is a good

reflector of the market.

2.7 METHODOLOGY / FORMULA

Beta is calculated as:

)X(Var

)Y,X(Cov=

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 represent

the arithmetic averages of x and y.

In order to calculate the beta of a portfolio, multiply the weightage of each stock in

the portfolio with its beta value to arrive at the weighted average beta of the portfolio


NOTES

DBA 1723 / 1750


2.8 STANDARD DEVIATION

Standard Deviation is a statistical tool, which measures the variability of returns from

the expected value, or volatility. It is denoted by sigma(s) . It is calculated using the formulamentioned below:

Where, is the sample mean, xis are the observations (returns), and N is the total

number 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 is

made in the index portfolio. However, a price index does not consider the returns arising

from dividend receipts. Only capital gains arising due to price movements of constituent

stocks are indicated in a price index. Therefore, to get a true picture of returns, the dividends

received from the constituent stocks also need to be factored in the index values. Such an

index, which includes the dividends received, is called the Total Returns Index.

Total Returns Index reflects the returns on the index arising from (a) constituent stock

price 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 close

Price Index returns

Dividend payouts in Rupees

Index 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 Returns

index instead of the price index to determine the actual returns vis--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 of

Indias corporate sector. When the index goes up, it is because the stock market thinks

that the prospective dividends in the future will be better than previously thought. When

prospects of dividends in the future become pessimistic, the index drops. The ideal index

gives us instant-to-instant readings about how the stock market perceives the future of

Indias corporate sector.

7. THE BASIC IDEA IN AN INDEX

Every stock price moves for two possible reasons: news about the company (e.g. a

product launch, or the closure of a factory, etc.) or news about the country (e.g. nuclear

bombs, or a budget announcement, etc.). The job of an index is to purely capture the

second 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 - stock

news and index news. When we take an average of returns on many stocks, the individual

stock news tends to cancel out. On any one day, there would be good stock-specific news

for 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 that

is 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 a

weighted 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.1000

crore and B has a market capitalisation of Rs.3000 crore. Then we attach a weight of 1/4

to 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 made

of two stocks, one with a market cap of Rs.1000 crore and another with a market cap of

Rs.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 the

first and 75% on the second, then the portfolio returns will equal the index returns. So if

you want to buy Rs.1 lakh of this two-stock index, you would buy Rs.25,000 of the first

and Rs.75,000 of the second; this portfolio would exactly mimic the two-stock index. A


NOTES

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stock market index is hence just like other price indices in showing what is happening on

the overall indices the wholesale price index is a comparable example. In addition, the

stock market index is attainable as a portfolio.

SUMMARY

India Index Services & Products Ltd. (IISL) is a joint venture between the National

Stock Exchange of India Ltd. (NSE) and CRISIL Ltd. (formerly the Credit Rating

Information Services of India Limited). IISL has been formed with the objective of providing

a 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 be

executed without incurring a high transaction cost. The transaction cost referred here is not

the fixed costs typically incurred like brokerage, transaction charges, depository charges

etc. but is the cost attributable to lack of market liquidity as explained subsequently. Liquidity

comes from the buyers and sellers in the market, who are constantly on the look out for

buying and selling opportunities. Lack of liquidity translates into a high cost for buyers and

sellers.

Risk is an important consideration in holding any portfolio. The risk in holding securities

is generally associated with the possibility that realised returns will be less than the returns

expected.

Nifty is a price index and hence reflects the returns one would earn if investment is

made in the index portfolio. However, a price index does not consider the returns arising

from dividend receipts. Only capital gains arising due to price movements of constituent

stocks are indicated in a price index. Therefore, to get a true picture of returns, the dividends

received from the constituent stocks also need to be factored in the index values. Such an

index, 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 a

weighted 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.1000

crore and B has a market capitalisation of Rs.3000 crore. Then we attach a weight of 1/4

to 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 made

of two stocks, one with a market cap of Rs.1000 crore and another with a market cap of

Rs.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 Index

Averaging

Impact Cost

Unsystematic risks

Systematic risks

Standard Deviation

Questions

1. Briefly explain the Index Concepts

2. 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?


NOTES

DBA 1723 / 1750


CHAPTER- IV

SECURITIES TRADING REGULATIONS AND

INVESTOR PROTECTION

Learning objectives

After going through this chapter you would be able to understand the issues relating

to 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 in

1956 and came into force on February 20, 1957. It regulates the business of trading on

the stock exchanges and option trading and provides for recognition of stock exchanges

and related matters like listing of securities transfer of securities, etc. The regulation of

trading 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 in

securities are legal and what are void and illegal.

A reading of the Preamble itself indicates that the key word is securities which has

been defined in Section 2 (h) of the SCR Act. The definition is inclusive in nature and

includes shares, scrips, stocks, bonds, debentures, debenture-stock or other marketable

securities of a like nature in or of any incorporated company or other body corporate. It

also covers government securities and rights or interests in securities. But it does not

include securities of private companies as they are not capable of being dealt in on a stock

exchange 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 on

a stock exchange are also outside the purview of the said Act, as their transferability may

also 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 of

trade 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 Act

will not apply. In pursuance of this power, the Central Government has issued a Notification

dated 27thJune 1961 specifying contracts for pre-emption or similar rights contained in

the promotion or collaboration agreements or in the Articles of Association of limited

companies as contracts to which the SCR Act shall not apply. By another notification

dated 13thMay 1966, the Central Government has declared that contracts pertaining to

sale or purchase of shares of Government companies (as defined in Section 617 of the

Companies Act 1956), which are not listed on any recognized stock exchanges, shall not

be 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 to

regulate certain matters relating to the stock exchanges. Section 3 of the SCR Act lays

down 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 recognition

in Form A has to be accompanied by a copy of the byelaws of the stock exchange and also

a copy of the rules of the stock exchange.

On receiving such application, the Central Government, in terms of Section 4 of the

SCR Act read with Rule 5A of the SCR Rules, makes an inquiry as to whether it would be

in 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 the

prescribed conditions have been met, it grants recognition to the stock exchange. Such

recognition is granted in Form B as prescribed under Rule 6 of the SCR Rules, and it may

be for a temporary period or on a permanent basis. The Bombay Stock Exchange was

the only Exchange, which was recognized on a permanent basis from the beginning of the

operation of the Act.

Mention may be made here to the provisions under Rule 9 of the SCR Rules which

lays down that all contracts between the members of a recognized stock exchange have to

be confirmed in writing and are to be enforced in accordance with the rules and byelaws of

the stock exchange.

5. OPTIONS IN CONTRACTS

The word contract has been defined in Section 2 (a) of the SCR Act to mean a

contract for or relating to the purchase of securities, or sale of Securities.


NOTES

DBA 1723 / 1750


The expression option in securities means a contract for the purchase or sale of a

right to buy or sell securities in future and a contract for the purchase or sale of a right to

buy and sell securities in future.

The expression spot delivery contract means a contract, which provides for the

actual delivery of securities and the payment of a price thereof either on the same day as

the date of the contract or on the next day.

The difference between a spot delivery contract and an option in securities is that

the latter is a contract in future of an intangible right to buy or sell the securities, while the

former provides for the actual purchase and delivery of securities.

Section 13 of the SCR Act empowers the Central Government having regard to the

nature or volume of transactions in securities, to issue a Notification in the Official Gazette

declaring 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; or

ii). Through or with such member shall be illegal.

Under the SCR Act and the Rules, Byelaws of the Stock Exchange monopoly to

stock exchanges recognized by the Government is given thereby barring the unrecognized

stock exchanges to operate in such areas.

Section 20 of the SCR Act prohibits option in securities. By this section, options in

securities are not only made illegal but are also void. The more important effects of this

Act 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 through

or 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 general

nature but contracts in securities are governed by the special Act, namely, Securities

Contracts (Regulation) Act. This special Act supersedes the general Act but where there

is no provision in the Special Act as in the case of Principal and agent relationship or bailer

to bailee relationship, the Indian Contracts Act will apply. The SC(R) Act is supplemented

by the Rules framed there under and the Rules and Byelaws of the Stock Exchange which

are approved by the Government and adopted by the Stock Exchanges.


NOTES



Under the Rules and byelaws of the Exchange, all trading activities and post trading

issues are governed by a set of rules. The Byelaws provide for business days, hours of

trading, trading floor and authorized clerks and Remisiers who can put through the deals

etc.

The Exchange authorities supervise the trading floor; only brokers and their authorized

clerks can enter the floor and make deals. The Rules provide for quotations for bid/offer

rates for all listed securities and permitted securities for deals and trading lots etc. The

rules of the game involve the records of the purchase and sales transactions in the Sauda

block books, comparison of Saudas, taking delivery are all important aspects of regulation

of trading. In case of disputes in the trading floor or in their recording of deals etc., the

Rules and Byelaws have provided for arbitration and settlement of disputes and dispensation

of 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 Byelaws

of the Exchange supervised by the SEBI and the Government. As per the Rules, the

admission to trading, the method of recording of deals, the price quotations, types to

bargains to be struck, rules governing each category, margins to control trade, restriction

on prices and quantity of trade etc. are all regulated by the Exchange. Provisions for

inspecting the accounts of brokers, control on their cornering of shares, closing out and

Buying 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 scrip

to 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 members

and their clients.

Stopage of trade in any scrip temporarily through circuit breaker if it is raising or

falling in price beyond 5-10% spread on any trading day.

As part of the regulation of trading, arrangements are also made by each Stock

Exchange for settlement and clearance with the help of a bank. The giving and taking

delivery of shares, settlement through net payment or receipt by each member through a

clearing bank, arrangement of auction for effecting deliveries in case of failure to deliver by

any member are arranged by the Exchange. Where there are securities for clearing with

facility for carry forward from one settlement to another, the Exchange provides facility for

badla financing and carry

Security Analysis Portfolio Management

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