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NPTEL Course

Course Title: Security Analysis and Portfolio Management


Course Coordinator: Dr. Jitendra Mahakud

Module-1
Session-2
Markets for Investment and Construction of Indexes

2.1. Financial System and Financial Market


Financial system or financial sector of an economy consists of several constituent aspects
such as: specialised and non-specialised financial institutions, organised and unorganised
financial markets, financial instruments and cervices which facilitate transfer of funds
and finally procedures and practices adopted in the market for the overall operation and
regulation. 1 Encompassing the major parts of the above mentioned definition, the
following diagram will give a broad representation of the financial system. A welldeveloped financial sector performs the following functions: 2 (i) it promotes overall
savings of the economy by providing alternative instruments; (2) it allocates resources
efficiently among the sectors; and it provides an effective channel for the transmission of
policy impulses provided the financial markets are competitive, efficient & integrated.

Source: Bhole, L.M., and Mahakud, J. (2009), Financial institutions and markets.5th Edition, Tata McGraw Hill (India)

Bhole, L.M., and Mahakud, J. (2009), Financial institutions and markets.5th Edition, Tata McGraw Hill (India).

In a more theoretical sense financial markets can be defined as the centers or


arrangements that provide facilities for demand and supply side of financial claims and
services. The primary role of financial markets, broadly interpreted, is to intermediate
resources from savers to investors, and allocates them in an efficient manner among
competing uses in the economy, thereby contributing to growth both through increased
investment and through enhanced efficiency in resource use.3
Classification of financial markets can be made on the basis of several aspects
such as: (i) Nature of Claims (e.g., debt market, equity market); (2) Maturity of Claims
(e.g., money market, capital market); (3) Seasoning of Claims (e.g., primary market,
secondary market); (4) Timing of Delivery (e.g., cash or spot market, forward or futures
market); (5) Organizational Structure (e.g., exchange traded market, over the counter
market). The important characteristics of a good market for goods and services are as
follows:4
1. Timely and accurate information: timely and accurate information is available on the
price and volume of past transactions and the prevailing bid and ask prices.
2. Liquidity: an asset can be bought or sold quickly at a price close to the prices for
previous transactions (has price continuity), assuming no new information has been
received. In turn, price continuity requires depth.
3. Price continuity: prices do not change much from one transaction to the next unless
substantial new information becomes available.
4. Depth: Presence of numerous potential buyers and sellers who are willing to trade at
prices above and below the current market price. These buyers and sellers enter the
market in response to changes in supply and
demand or both and thereby prevent drastic
price changes.
5. Low transaction cost: as transactions entail
low costs, including the cost of reaching the
market, the actual brokerage costs, and the
cost of transferring the asset.
6. Informational efficiency: prices rapidly

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Mohan Rakesh, (2007), Development of Financial Markets in India, RBI Monthly Bulletin
Reilly, Frank. and Brown, Keith, Investment Analysis & Portfolio Management, 7th Edition, Thomson Soth-Western.

adjust to new information; thus, the prevailing price is fair because it reflects all available
information regarding the asset.
Financial markets are said to be perfect when, (i) a large number of savers and
investors operate in markets, (ii) the savers and investors are rational, (iii) all operations
in the markets are well informed and information is freely available to all of them, (iv)
there are no transaction costs, (v) the financial assets are infinitely divisible, (vi) the
participants in markets have homogeneous expectations, and (vii) there are no taxes. The
equilibrium in financial markets is usually determined by assuming that there would be
perfect competition, and by using the well known tool of supply and demand. Following
the above mentioned ideal conditions, the financial market equilibrium position when the
expected demand for funds (credit) for short-term and long-term investments matches
with the planned supply of funds generated out of savings and credit creation. 5
Equilibrium is established when the expected demand for funds (credit) for short-term &
long-term investment matches with the planned supply of funds generated out of savings
and credit creation (Figure A,B &C ). Interest rate can also be fixed irrespective of the
equilibrium rate of interest i.e. Administered Interest rate (Figure D) in order to
match/adjust supply and demand for funds as per economic policy requirement.

Source: Bhole, L.M., and Mahakud, J. (2009), Financial institutions and markets.5th Edition, Tata McGraw Hill (India)

Bhole, L.M., and Mahakud, J. (2009), Financial institutions and markets.5th Edition, Tata McGraw Hill (India).

2.1.1 Investment Decision, Alternative Markets and Asset Allocation


An investment is the current commitment of dollars for a period of time in order
to derive future payments that will compensate the investor for (1) the time the funds are
committed, (2) the expected rate of inflation, and (3) the uncertainty of the future
payments.6 In all cases, the investor is trading a known dollar amount today for some
expected future stream of payments that will be greater than the current outlay. They
invest to earn a return from savings due to their deferred consumption. The major
investment characteristics of financial assets are, liquidity, marketability, reversibility,
transferability, transaction costs, default risk, maturity period, tax status, buy-back
options, price volatility and finally, the rate of return. Asset allocation is the process of
deciding how to distribute an investors wealth among different countries and asset
classes for investment purposes. An asset class is comprised of securities that have
similar characteristics, attributes, and risk/return relationships.

The alternative financial assets under consideration for investment can be


marketable and non-marketable assets. In case of marketable assets investor can manage
and control the investment and subsequent liquidation process by his/her own decision.
However these are less liquid in nature (e.g., all the market traded securities). In case of
non-marketable assets although investor looses the day to day management but these are
highly liquid (e.g., bank deposits, post office deposits etc.). The selected investment asset
class may also be direct or indirect in terms of the ownership of the portfolio by the
investor. In case of the direct financial assets investor owns the desired portfolio, whereas
in case of indirect investor owns a portion of investment companies fund.
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The broad range of financial markets that offer such financial assets can be
categorised under the following four categories:
In order to have a risk return trade-off Investors follow calculate the expected rate
of return and evaluate the uncertainty, or risk, of an investment by identifying the range
of possible returns from that investment and assigning each possible return a weight
based on the probability that it will occur. Most investors demand a higher rate of return
on investments if they perceive that there is any uncertainty about the expected rate of
return. The increase in the required rate of return over the zero risk return is called as the
risk premium. Investors want a rate of return investors required or expected rate of
return that compensates them for the time, the expected rate of inflation, and the
uncertainty of the return. In a more formal way this risk is the uncertainty that an
investment will earn its expected rate of return. Although the required risk premium for
investing in a asset class represents a composite of all uncertainty, it is possible to
consider several fundamental sources of uncertainty including: (a) business risk, (b)
liquidity risk, (c) financial risk or leverage risk, (d) exchange rate risk, and (e) country
(political) risk.

Source: Bhole, L.M., and Mahakud, J. (2009), Financial institutions and markets.5th Edition, Tata McGraw Hill (India)

The objective of maximising return can be pursued only at the cost of incurring
higher risk. The financial markets offer a wide range of assets from very safe to very
risky, with corresponding low to high returns. The above figure shows the risk return
trade-off in a capital market line example. It shows the expected return risk spectrum

such that the representative asset classes are arrayed over a range of risk on it. The figure
shows a positive linear relationship between expected return and risk for different set of
asset classes. The rational risk averse investor will chose the appropriate investment
opportunity by considering the desired level of risk.

2.2. Important Concepts Related to Capital Market


1. Margin Trading: This is the part of a transaction value that a customer has equity in the
transaction. Use of Margin: to buy more, to borrow money. Concepts associated with
margin: Initial margin: Amount Investor Puts up / value of transaction or It is the part of
transactions value the customer must pay to initiate the transaction with other part being
borrowed from the broker. Maintenance Margin: The percentage of a securitys value
that must be on hand as equity. Margin Call: Demand from the broker for additional cash
or securities as a result of the actual margin declining below the maintenance margin
2. Private Placement Vs. Preferential Allotment
Private placements refer to sale of equity or equity related instruments of an unlisted
company or sale of debentures of a listed or unlisted company. Preferential allotments
refer to sale of equity or equity related instruments of an listed company.
3. Open Outcry Trading System: Under this system traders shout and resort to signals on
the trading floor of the exchange which consists of several trading posts for different
securities. Buyers make their bids and sellers make their offers and bargains are closed at
mutually agreed-upon prices.
4. Screen-based Trading System: Started in November 4,1994 in India. The important
features are: buyers and sellers place their orders on the computer. They can be limit
order or best market price order. The computer constantly tries to match mutually
compatible orders on price and time priority. The limit order book or the list of
unmatched limit orders is displayed on the screen. Increases efficiency, confidence and
transparency in the market

5. Settling: Electronic Delivery system and it is facilitated by depositories which is an


institution which dematerializes physical certificates and effects transfer of ownership by
electronic book entries. Example: National Securities Depository Limited (NSDL),
Central Securities Depositories Limited (CSDL)
6. Settlement Procedure: Weekly Settlement, Carry forward system (badla and undha
badla), Rolling Settlement (T+1).

7. Badla and Undha badla: When a bull buys in the anticipation of an immediate rise in
price, but finds at the end of the accounting period that the price has not risen, he may
either pay for the shares and take delivery, or he may carry over his transaction to the
next accounting period by paying carry over charges or Seedha badla to the seller. When
a bear sells in anticipation of a fall in prices in the immediate future (so that he can pick
up shares later for delivery and make a profit), but the fall does not happen within the
accounting period, he has the option to borrow or buy the shares for delivery, or have his
sales carried over to the next accounting period on payment of Undha badla or
backwardation charges to the buyer.
8. Short Selling: In a normal transaction a security is bought and owned because the
investor believes the price is likely to rise. Eventually the security is sold and the position
is closed out. First you buy then you sell. A short-sell involves selling a security because
of belief that the price will decline and buying back the security later to close the position.
First you sell and then buy.
9. Actual selling and buying procedure: Procedure for Buying - Locating the broker----Placement of order (De-mat account in a depository) then - execution of order
(Contract note for tax and other legal purposes). Order may be Limit Order (upper limit
of the price has been given by the investor) or Market Order (to prevail the best market
price).Procedure for selling- Placement of order-- sale order----- execution of order
(same as buying)
10. Important abbreviations used in stock exchange quotations: Con-Convertible, Xd- ex
(excluding) dividend, Cd- cum (with) dividend, Xr- ex(excluding) right.

2.3. Importance of Stock Market Index


Three major advantage: to judge the performance of individual investor, to measure the
market rates of return, to predict the market movements. Factors affecting the
construction of stock market index: sample, it should be representative of total population,
base year, it should be a normal year, weighting criteria, equally weighted series, price
weighted series, market value weighted series.
Example:
Stock

Quantity

Beta

Price

60,000

30

45

20,000

25

80

90,000

65

85

Solution:
Equally weighted series--1/3 (45/30 + 80/ 25 + 85 / 65) = 2.0033
Price weighted series--(45 + 80 + 85)/ )(30 + 25 + 65) = 1.75
Market value weighted series = (60 000*45 + 20 000*80 + 90 000* 85) / (60 000*30 +
20 000*25 + 90 000* 65) = 1.46
Popular Stock Market Indexes in India

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Additional Readings:

Alexander, Gordon, J., Sharpe, William, F. and Bailey, Jeffery, V.,


Fundamentals of Investment, 3rd Edition, Pearson Education.
Bodie, Z., Kane, A, Marcus,A.J., and Mohanty, P. Investments, 6th Edition,
Tata McGraw-Hill.
Bhole, L.M., and Mahakud, J. (2009), Financial institutions and markets.5th Edition, Tata McGraw Hill
(India).

Fisher D.E. and Jordan R.J., Security Analysis and Portfolio Management, 4th
Edition., Prentice-Hall.
Jones, Charles, P., Investment Analysis and Management, 9th Edition, John
Wiley and Sons.
Prasanna, C., Investment Analysis and Portfolio Management, 3rd Edition, Tata
McGraw-Hill.
Reilly, Frank. and Brown, Keith, Investment Analysis & Portfolio Management,
7th Edition, Thomson Soth-Western.

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Additional Questions with Answers
Session 2: Markets for Investment and Construction of Indexes
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1. What are the different investment alternatives provided by different financial
markets?
Ans.
Marketable and Non-Marketable Assets:

Marketable: Investor can manage and control, Less Liquid in Nature: All the
Market Traded Securities
Non-Marketable: No management but has Right, Highly Liquid: Bank Deposits,
Post office Deposits, NSC etc.

Direct Vs. Indirect Investments:

Direct Investment: Investor(owns)---Portfolio--- (Dividend and Interest)--Income and Capital gain


Indirect Investments: Investor(owns)---Investment Companys Fund--(Dividend and Interest)---Income and Capital gain

Classification of Financial Markets:


Nature of Claims: Debt Market, Equity Market
Maturity of Claims: Money Market, Capital Market
Seasoning of Claims: Primary Market, Secondary Market
Timing of Delivery: Cash or Spot Market, Forward or Futures Market
Organizational Structure: Exchange Traded Market, Over the Counter Market

2. What is the difference between Primary market and secondary market?


Ans.
Primary market
The primary market is that part of the capital markets that deals with the issuance
of new securities. Primary market provides opportunity to issuers of securities,
Government as well as corporate, to raise resources to meet their requirements of
investment and/or discharge some obligation.
Equity Capital is raised in Primary Market. It can be raised through Public or
primary Issue, Right Issue, Private Placement, Preferential Allotment
The primary market is governed by the provisions of the Companies Act, 1956,
which deals with issues, listing and allotment of securities. Additionally the SEBI
- prescribes the eligibility and disclosure norms to be complied by the issuer,
promoter for accessing the market.
Secondary Market

Existing securities issued in the primary market are traded


This market enables participants who held securities to adjust their holdings in
response to changes in their assessment of risks and returns.
It operates through over-the-counter (OTC) market and the exchange traded
market.
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Operation of Secondary Market: Trading , Settlement


Trading: Can be Open Outcry System and/or Screen-Based System.
Under Open Outcry System traders shout and resort to signals on the trading floor
of the exchange which consists of several trading posts for different securities.
Buyers make their bids and sellers make their offers and bargains are closed at
mutually agreed-upon prices. Under Screen-Based System Buyers and sellers
place their orders on the computer. They can be limit order or best market price
order. The computer constantly tries to match mutually compatible orders on price
and time priority.
Modern settlement system is an electronic delivery mechanism: It is facilitated by
Depositories which is an institution which dematerializes physical certificates and
effects transfer of ownership by electronic book entries. Settlement Procedure can
be Weekly Settlement, Carry forward system (badla and undha badla), Rolling
Settlement (T+1)
3. What is the meaning of margin trading and what are the major concepts
associated with it?
Ans.
Margin Trading: This is the part of a transaction value that a customer has equity
in the transaction. Use of Margin: to buy more, to borrow money
Concepts associated with margin:

Initial margin: Amount Investor Puts up / value of transaction or It is the part of


transactions value the customer must pay to initiate the transaction with other
part being borrowed from the broker.
Maintenance Margin: The percentage of a securitys value that must be on hand
as equity.
Margin Call: Demand from the broker for additional cash or securities as a result
of the actual margin declining below the maintenance margin

4. Why stock market index is importance and what are the factors affecting
construction of stock market index?
Ans.
A good Stock Index captures the movement of the well diversified and highly liquid
stocks. It is the pulse rate of the economy. Index movements reflect the changing
expectations of the stock market about future dividends of the corporate sector.
Importance of Stock Market Index
To judge the performance of individual investor
To measure the market rates of return
To predict the market movements
Factors affecting the construction of stock market index
Sample: It should be representative of total population
Base year: It should be a normal year
Weighting criteria
Equally Weighted Series
Price Weighted Series
Market value Weighted Series

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