Sapm Text

INVESTMENT
MANAGEMENT
Security Analysis and Portfolio Management
Preeti Singh
Professor,
Jagannath International Management School,
New Delhi.
NINETEENTH REVISED EDITION : 2015
MUMBAI z NEW DELHI z NAGPUR z BENGALURU z HYDERABAD z CHENNAI z PUNE z LUCKNOW

z AHMEDABAD z ERNAKULAM z BHUBANESWAR z INDORE z KOLKATA z GUWAHATI
© Author
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by
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First Edition : 1988 Tenth Revised Edition : 2002

Second Revised Edition : 1990 Eleventh Revised Edition : 2003
Third Revised Edition : 1992 Twelfth Revised Edition : 2004
Fourth Revised Edition : 1994 Thirteenth Revised Edition : 2005
Fifth Revised Edition : 1996 Fourteenth Revised Edition : 2006
Sixth Revised Edition : 1997 Fifteenth Revised Edition : 2007
Seventh Revised Edition : 1998 Sixteenth Revised Edition : 2008
Eighth Revised Edition : 1999 Seventeenth Revised Edition : 2009
Ninth Revised Edition : 2000 Eighteenth Revised Edition : 2013
Nineteenth Revised Edition : 2015
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PREFACE
Investment Management is a science of combining different kinds of investments available in an individual’s
portfolio. It requires both long term and short term planning. It comprises of high risk and low risk investments.
Normally an investor is averse to risk and therefore he has to plan his portfolio and constantly review it to get
an additional income in addition to his regular income. There are systematic and unsystematic kinds of risks
present in the investment market and they affect the investor in different ways. Unsystematic risk can be
reduced completely because it is unique and it affects a particular organization or industry. However, systematic
risk is broad spectrum and cannot be reduced but it can be somewhat diversified which may help in reducing
some risks but it cannot be completely elimated. The book explains the different kinds of risks that surround
the investors and the techniques through which they can be minimized.
This book provides some techniques through which different securities can be combined to get a high
return. It explains different theories of portfolio management and guides an investor to take correct decisions
in combining their securities. Investor should take their own decisions and through fundamental analysis. They
should not follow a herd or group.
This book analyzes the profile of the investor and his expectations to make investments. It discusses the
network of financial markets and institutions and the manner in which they function in India. It has explained
the online and the broker method of purchasing and selling securities and how the market regulator disciplines
and regulates the intermediaries and transactions in the financial markets.
The theories of Harry Markowitz and William Sharpe have been discussed for analyzing and diversifying
the portfolio of an individual. Fundamental Analysis, Technical Analysis and Efficient Market Theory, Capital
Asset Pricing Model and Arbitrage Theory are useful in investing funds.
This is the 19th edition of the book and it gives an insight to the investor of the investment climate in
India. It is useful for students of management, commerce, accounting and finance. It is comprehensive and
completely revised to suit the latest developments in the Indian financial system. Certain chapters have been
added, changed or deleted to make the book useful.
I would like to acknowledge the co-operation of my publishers M/s Himalaya Publishing House Pvt. Ltd.
and continuing support in publishing this book.
Brajendra Kumar has provided prompt and efficient secretarial assistance in preparing the manuscript of
this book.
I would like to thank my colleagues from various colleges for giving me a feedback of my book and for
making suggestions during the revision process.
Finally I would like to thank all my students for continuously supporting me and giving me suggestions
while revising the book.
Dr. PREETI SINGH

CONTENTS
1. INVESTMENT MANAGEMENT - AN INTRODUCTION 1–13
1.1 Introduction
1.2 What is Investment?
1.3 Financial and Economic Meaning of Investment
1.4 Investment and Speculation
1.5 Investment and Gambling
1.6 Investment and Arbitrage
1.7 Real and Financial Assets
1.8 Why is Investment Important?
1.9 Factors Favourable for Investment
1.10 Investment Media
1.11 Features of an Investment Program
1.12 The Investment Process
2. FINANCIAL INSTITUTIONS AND MARKETS IN INDIA 14–53

2.1 Background of the Financial System
2.2 Financial System: An Introduction
2.3 Legislative Measures
2.4 Structure of the Financial Markets
2.5 Important Stock Markets in India
2.6 Financial Institutions
– Commercial Banks
– Development Banks
2.7 A Critique of the Indian Financial System
3. INDIAN SECURITIES MARKET 54–91

3.1 Indian Securities Market
3.2 Participants in the Securities Market
3.3 Financial Instruments
3.4 Financial Engineering Instruments
3.5 Security Market Indices
3.6 Sources of Financial Information
3.7 The Relationship of the New Issue Market and Stock Exchange
3.8 Structure of the Indian Capital Market with Participants
3.9 Intermediaries/Participants in the New Issue Market
3.10 Issue of Capital in New Issue Market
3.11 Functions of the New Issue / Primary Market
3.12 Secondary / Stock Markets
3.13 Listing of Securities
3.14 Depository System or Paperless Trading
3.15 Broker System of Trading of Securities
3.16 Control of Indian Capital Market : SEBI
3.17 Developments in the Stock Market
– Insider Trading
– Circuit breakers
– Free Pricing of Issue/Stock Splits
– Screen Based Trading
– Regulation of Foreign Institutional Investors (FIIs)
– Regulation of Mutual Funds
– Options and Derivatives
– Regulation of Stock Brokers
– Surveillance on Price Manipulation
– Buyback of shares
– Stock lending.
4. SECURITIES EXCHANGE BOARD OF INDIA 92–99

4.1 Establishment of Securities and Exchange Board of India (SEBI)
4.2 Objectives of SEBI
4.3 Investor Protection
4.4 Listed Companies and Model Code of Conduct
4.5 Investor Grievances
4.6 Departments of SEBI
4.7 OMBUDSMAN 2003
4.8 National Stock Exchange and Arbitration Facilities
4.9 Investor Education
4.10 Prohibition of Insider Trading
4.11 MAPIN
4.12 Investors’ Protection Fund
5. RISK 100–126
5.1 Background of Risk and Return
5.2 Risk
5.3 Systematic Risk
5.4 Unsystematic Risk
5.5 Quantitative Analysis of Risk
5.6 Investor’s attitude towards Risk and Return
6. RETURNS 127–140
6.1 Measurement of Returns
6.2 Traditional Technique
6.3 Modern Technique
6.4 Holding Period Yield: Influence on Bonds and Stocks
6.5 Returns and Probability Distributions
6.6 Taxes and Investment
6.7 Inflation and Investment
6.8 Return: Statistical Techniques
7. THE INVESTMENT ALTERNATIVES 141–163
(Bonds, Preference Shares and Equity Shares)
7.1 Investor Classification
7.2 Corporate Bonds
7.3 Convertible Bonds
7.4 Preference Shares
7.5 Equity Shares
8. DERIVATIVES 164–182
8.1 Derivatives
8.2 Financial Derivatives
8.3 Options
8.4 Black Scholes Model
8.5 Forwards
8.6 Futures
8.7 Swaps
8.8 Derivatives Market in India
9. SECURITY VALUATION 183–228

9.1 Background
9.2 Approaches to Investment
9.3 Historical Developments of Investment Management
9.4 Basic Valuation Models – Fundamental Approach
9.5 Valuation of Bonds or Debentures
9.6 Valuation of Preference Shares
9.7 Valuation of Equity Shares
9.8 Valuation of Equity Shares – Dividend Concept
9.9 Valuation of Equity Shares – Earnings Concept
9.10 Capital Asset Pricing Model (CAPM Model): Share Valuation
10. ALTERNATIVE FORMS OF INVESTMENT 229–253

10.1 Introduction
10.2 Government Securities
10.3 Life Insurance
10.4 Private Insurance Companies
10.5 Unit Trust of India
10.6 Commercial Banks
10.7 Provident Fund
10.8 Post Office Schemes
10.9 Fixed Deposit Schemes in Companies
10.10 New Instruments
10.11 Financial Engineering Securities
10.12 ADRs, GDRs & IDRs
10.13 Non-Bank Finance Companies
10.14 Mutual Funds
10.15 Land and House Property
10.16 Gold
10.17 Silver
10.18 Coins and Stamps Collection
10.19 Diamonds
10.20 Antiques
11. DIVIDEND POLICIES AND THE INVESTOR 254–283

11.1 Types of Dividend
11.2 Stock Splits
11.3 Procedure for Payment of Dividends
11.4 Dividend Policy
11.5 Dividend Decisions
11.6 Factors Affecting Dividend Decisions of Firms
11.7 Limitation on Dividend Payments
11.8 Walter’s Model
11.9 Gordon’s Model
11.10 M.M. Hypothesis
12. INVESTOR AND INTEREST RATES 284–292

12.1 What is Interest?
12.2 Different Kinds of Interest Rates
12.3 Approaches to Interest Rates
— Static Form, Dynamic Form and Eclectic Approach
12.4 Yield Curve
12.5 Liquidity Premium Hypothesis
12.6 Market Segmentation Hypothesis
12.7 Unbiased Expectations Theory
12.8 Expected Interest Rates and Term Structure of Interest Rates
12.9 Eclectic Theory and Investors
12.10 Financial Intermediaries and Term Structure
12.11 Interest Rates in India
13. FUNDAMENTAL ANALYSIS 293–320

13.1 What is Fundamental Analysis?
13.2 Economic Analysis
13.3 Industry Analysis
13.4 Company Analysis
13.5 Ratios Relevant for Equity Shareholders
13.6 Economic Value Added (EVA)
14. TECHNICAL ANALYSIS 321–332

14.1 Introduction
14.2 Dow’s Technical School of Thought
14.3 Assumptions of the Theory
14.4 Market Movements
14.5 Charts
14.6 Construction of Charts
14.7 Analysis of Charts
14.8 Short Sales
14.9 Confidence Index
14.10 Breadth of the Market
14.11 Relative Strength
14.12 Trading Volume
14.13 Moving Average Analysis
15. EFFICIENT MARKET THEORY 333–343

15.1 Background
15.2 Concept of Efficient Market Theory
15.3 Efficient Market Hypothesis
15.4 Empirical Analysis
15.5 The Random Walk Model Comparison with other Theories
15.6 Random Walk – Conclusions
16. PORTFOLIO ANALYSIS 344–379

16.1 Traditional Versus Modern Portfolio Analysis
16.2 Modern Portfolio Theories
16.3 Investor Attitude towards Risk and Return
16.4 The Rationale of Diversification of Investments
16.5 Markowitz Theory
16.6 Capital Market Line (CML)
16.7 Limitations of Markowitz Model
16.8 Sharpe’s Single Index Model
16.9 Sharpe’s Optimal Portfolio
17. PORTFOLIO SELECTION AND INTERNATIONAL DIVERSIFICATION 380–401

17.1 Introduction
17.2 Importance of Beta
17.3 Capital Market Theory — Capital Asset Pricing Model
17.4 Security Market Line
17.5 Limitations of CAPM Model
17.6 Distinction between Capital Market Line and Security Market Line
17.7 Validity of CAPM Model
17.8 Arbitrage Pricing Theory
18. TECHNIQUES OF PORTFOLIO REVISION 402–411

18.1 Formula Plans
18.2 Rules for Formula Plans
18.3 Constant Rupee Value Plan
18.4 Constant Ratio Plan
18.5 Variable Ratio Plan
18.6 Modifications of Formula Plans
18.7 Rupee Cost Average
19. PERFORMANCE MEASUREMENTS OF MANAGED PORTFOLIOS 412–428

19.1 Introduction
19.2 Structure of Mutual Fund
19.3 Features of Mutual Funds
19.4 Classification of Mutual Funds
19.5 Net Asset Value
19.6 Costs in Mutual Fund Investments
19.7 Return from Mutual Fund
19.8 SEBI and Mutual Fund Regulations
19.9 Management Performance Evaluation
– Sharpe’s Performance Measure
– Treyner’s Performance Measure
– Jensen’s Model
19.10 Mutual Funds as Investments
GLOSSARY 429–436
APPENDICES 437–448
Table A1
Table A2
Table A3
Table A4
INDEX 449–451
Chapter
INVESTMENT MANAGEMENT —
AN INTRODUCTION
Chapter Plan
1.1 Introduction
1.2 What is Investment?
1.3 Financial and Economic Meaning of Investment
1.4 Investment and Speculation
1.5 Investment and Gambling
1.6 Investment and Arbitrage
1.7 Real and Financial Assets
1.8 Why is Investment Important?
1.9 Factors Favourable for Investment
1.10 Investment Media
1.11 Features of an Investment Program
1.12 The Investment Process
1.1 INTRODUCTION
This chapter is an introduction to the investment environment. It discusses the basic concepts of investment.
It distinguishes between financial and economic meaning of investment and investment and speculation. It
outlines the direct and indirect investments available to individuals.
It also discusses the major types of investment media available to individuals and institutions.
1
2 INVESTMENT MANAGEMENT
1.2 WHAT IS INVESTMENT?

Investment is the employment of funds with the aim of achieving additional income or growth
in value. The essential quality of an investment is that it involves ‘waiting’ for a reward. It involves the
commitment of resources which have been saved or put away from current consumption in the hope that some
benefits will accrue in future. The term ‘Investment’ does not appear to be as simple as it has been defined.
Investment has been categorized by financial experts and economists. It has also often been confused with the
term speculation. The following discussion will give an explanation of the various ways in which investment is
related or differentiated from the financial and economic sense and how speculation differs from investment.
It must be clearly established that investment involves long-term commitment.
1.3 FINANCIAL AND ECONOMIC MEANING OF INVESTMENT

Investment is the allocation of monetary resources to assets that are expected to yield some gain or
positive return over a given period of time. These assets range from safe investments to risky investments.
Investments in this form are also called ‘Financial Investments’.
From the point of view of people who invest their funds, they are the suppliers of ‘capital’ and in their
view, investment is a commitment of a person’s funds to derive future income in the form of interest, dividends,
rent, premiums, pension benefits or the appreciation of the value of their principal capital. To the financial
investor, it is not important whether money is invested for a productive use or for the purchase of secondhand
instruments such as existing shares and stocks listed on the stock exchanges. Most investments are considered
to be transfers of financial assets from one person to another.
The nature of investment in the financial sense differs from its use in the economic sense. To the economist,
‘Investment’ means the net additions to the economy’s capital stock which consists of goods and
services that are used in the production of other goods and services. In this context, the term investment implies
the formation of new and productive capital in the form of new construction, new producers’ durable equipment
such as plant and equipment. Inventories and human capital are included in the economist’s definition of
investment.
The financial and economic meaning of investment are related to each other because investment is a part
of the savings of individuals which flow into the capital market either directly or through institutions, divided
into ‘new’ and secondhand capital financing. Investors as ‘suppliers’ and investors as ‘users’ of long-term
funds find a meeting place in the market. In this book, however, investment will be used in its ‘financial
sense’ and investment will include those instruments and institutional media into which savings are placed.
1.4 INVESTMENT AND SPECULATION

Traditionally, investment is distinguished from speculation in three ways which are based on the factors
of:
¾ Risk
¾ Capital gains, and
¾ Time period
The distinction between investment and speculation is given in Table 1.1.
Table 1.1 DISTINCTION BETWEEN INVESTMENT AND SPECULATION
Investment Speculation
1. Time Horizon Long term time framework beyond 12 months. Short term planning holding assets even for
one day with the objective.
2. Risk It has limited risk. There are high profits & gains.
3. Return It is consistent and moderate over a long period. High Returns though risk of loss is high.
INVESTMENT MANAGEMENT — AN INTRODUCTION 3
4. Use of funds Own funds through savings. Own and borrowed funds.
5. Decisions Safety, liquidity, profitability & stability Market behavior information, judgments on
considerations & performance of companies. movement in the stock market. Haunches &
beliefs.
1. Risk
The word ‘risk’ has a definite financial meaning. It refers to the possibility of incurring a loss in a financial
transaction. In a broad sense, investment is considered to involve limited risk and is confined to those avenues
where the principal is safe. ‘Speculation’ is considered as an involvement of funds of high risk. An example may
be cited of the stock brokers’ lists of securities which labels and recommends securities separately for investment
and speculation purposes. Risk, however, is a matter of degree and no clear-cut lines of demarcation can be
drawn between high risk and low risk and sometimes these distinctions are purely arbitrary. No investments are
completely risk-free. Even if safety of principal and interest are considered, there are certain non-manageable
risks which are beyond the scope of personal power. These are (a) the purchasing power risk – in other words,
it is the fall in the real value of the interest and principal and (b) the money rate risk or the fall in market value
when interest rate rises in the economy.
These risks affect both the speculator and the investor. High risk and low risk are, therefore, general
indicators to help an understanding between the terms investment and speculation.
2. Capital Gain
Another distinction between investment and speculation emphasizes that if the motive is primarily to
achieve profits through price changes, it is speculation. If purchase of securities is preceded by proper
investigation and analysis and review to receive a stable return over a period of times it is termed as investment.
Thus, buying low and selling high, making a large capital gain is associated with speculation.
3. Time Period
The third difference is the consideration of the time period. A longer-term fund allocation is termed as
investment. A short-term holding is associated with trading for the ‘quick turn’ and is called speculation.
The distinctions between investment and speculation help to identify the role of the investor and speculator.
The investor constantly evaluates the worth of a security through fundamental analysis, whereas the speculator
is interested in market action and price movement. These distinctions also draw out the fact that there is a very
fine line of division between investment and speculation. There are no established rules and laws which identify
securities which are permanently for investment. There has to be a constant review of securities to find out
whether it is a suitable investment. To conclude, it will be appropriate to state that some financial experts have
called investment ‘a well grounded and carefully planned speculation’, or good investment is a successful
speculation. Therefore, investment and speculation are a planning of existing risks. If artificial and unnecessary
risks are created for increased expected returns, it becomes gambling.
1.5 INVESTMENT AND GAMBLING

The difference between investment and gambling is very clear. From the above discussion, it is established
that investment is an attempt to carefully plan, evaluate and allocate funds in various investment outlets
which offers safety of principal, moderate and continuous returns and long-term commitment. Gambling is
quite the opposite of investment. It connotes high risk and the expectation of high returns. It consists of
uncertainty and high stakes for thrill and excitement. Typical examples of gambling are horse racing, game of
cards, lottery etc. Gambling is based on tips, rumors and hunches. It is unplanned, non-scientific and without
knowledge of the exact nature of risk. These distinctions between investment, speculation and gambling give
us a basic idea of their nature, purpose and role.
1.6 INVESTMENT AND ARBITRAGE

Investment is usually a planned method of safely putting ones savings into different outlets to get a good
return. Arbitrage is the mechanism of keeping ones risk to the minimum through hedging and taking advantage
of price differences in different markets. The simultaneous purchase of the same or similar security in two
different markets would be an arbitrage transaction. Short-term gains can be expected through such transactions.
An investor can also be an arbitraguer if he buys and sells securities in more than one stock exchange to take
advantage of the price differentials in such exchanges. Derivatives introduced in the Indian market have a great
potential for arbitrage transactions. Arbitrage transactions help in enhancing efficiency and liquidity in the stock
market and in increasing the volume of trade. Hedgers, speculators and arbitrageurs can make riskless profits
through the arbitrage process.
1.7 REAL AND FINANCIAL ASSETS

It is important to distinguish between real and financial assets. While real assets have some goods in
possession of a person, financial securities represent papers which are dependant on real assets to create
wealth.
1. Real Assets
Real assets refer to tangible assets, which are in the form of land and buildings, furniture, gold, silver,
diamonds or artifacts. These assets have a physical appearance. They may be marketable or non-marketable.
They may also have the feature of being moveable or non-moveable. These assets are used to produce goods
or services.
2. Financial Assets
A financial asset is a claim represented by securities. These assets are popularly called paper securities.
Shares, bonds, debenture, bills, loans, lease, derivatives and fixed deposits are some of the financial assets.
Therefore financial assets represent a claim on the income generated by real assets of some other parties.
Financial assets can be easily traded, as they are marketable and transferable. Financial assets are usually
between two parties. For example, if a person buys a bond of A 10,000 of ICICI Bank. The bonds are liabilities
of ICICI but an asset of the person buying a bond because he has a claim over the bank to receive the principal
sum with interest.
Table 1.2 DISTINCTION BETWEEN REAL AND FINANCIAL ASSETS
Real Assets Financial Assets
Land and building, Furniture, Machinery Shares, Debentures, Bonds, Derivatives, Fixed Deposits,
Bills, Loans
Tangible Assets Moveable and Immoveable These are called paper securities as they deal with claims
generated on the issuer.
Theses assets are used for production of goods These assets are financial claims represented by securities
and services
3. Commodity Assets
Commodity assets consist of wheat, sugar, potatoes, rubber, coffee and other grains. Commodities are also
in the form of metal like gold, silver, aluminum and copper. It also consists of items like cotton, crude oil and
foreign currency. Importers and exporters invest in commodities to diversify their portfolios. Traders hedge or
transact in commodities to make gains. A National Commodity and Derivatives Exchange Ltd. (NCDEX) has
been setup in India in 2003 as a public limited company to transact in commodities.
The promoters of NCDEX were ICICI Bank Ltd., National Bank for Agriculture and Rural Development
(NABARD), Life Insurance Corporation of India, Punjab National Bank, Canara Bank, CRISIL Ltd., Indian
Farmers Fertilizer, Co-operative Ltd. (IFFCO) and National Stock Exchange of India Ltd. (NSE). All these
institutions subscribed to the equity shares of NCDEX.
Following the background of investments, this chapter now presents the importance of investments, opportunities
conducive to investment, media available for investment, investment features and the process of investment.
1.8 WHY IS INVESTMENT IMPORTANT?

Investments are both important and useful in the context of present-day conditions. Some factors that
have made investment decisions increasingly important are:
Longer life expectancy or planning for retirement, increasing rates of taxation, high interest rates, high rate
of inflation, larger incomes and availability of a complex number of investment outlets.
1. Longer Life Expectancy
Investment decisions have become significant as people retire between the age of 60 and 65. Also, the
trend shows longer life expectancy. The earnings from employment should be calculated in such a manner that
a portion is put away as savings. Savings by themselves do not increase wealth; these must be invested in such
a way that the principal and income will be adequate for a longer number of retirement years.
The importance of investment decisions is enhanced by the fact that there are an increasing number of
women working in organizations. Men and women will be responsible for planning their own investments during
their working life so that after retirement they are able to have a stable income.
Increase in the working population, proper planning for life span and longevity have ensured the need for
balanced investments.
2. Taxation
Taxation is one of the crucial factors in any country which introduces an element of compulsion in a
person’s savings. There are various forms of savings outlets in our country in the form of investments which
help in bringing down the tax level. These are discussed under availability of investment media.
3. Interest Rates
The level of interest rates is another aspect which is necessary for a sound investment plan. Interest rates
vary between one investment and another. These may vary between risky and safe investments; they may also
differ due to different benefit schemes offered by the investments. These aspects must be considered before
allocating any amount in investments. A high rate of interest may not be the only factor favouring the outlet
for investment. The investor has to include in his portfolio several kinds of investments. He/she must maintain
a portfolio with high risk and high return as well as low risk and low return. Stability of interest is as important
as receiving a high rate of interest. This book is concerned with determining that the investor is getting an
acceptable return commensurate with the risks that are taken.
4. Inflation
Every developing economy is phased with the problem of rising prices and inflationary trends. In India,
inflation has become a continuous problem since the last decade. In these years of rising prices, several
problems are associated coupled with a falling standard of living. Before funds are invested, erosion of the
resources will have to be carefully considered in order to make the right choice of investments. The investor
will try and search an outlet which will give him a high rate of return in the form of interest to cover any
decrease due to inflation. He will also have to judge whether the interest or return will be continuous or there
is a likelihood of irregularity. Coupled with high rates of interest, he/she will have to find an outlet which will
ensure safety of principal. Besides high rate of interest and safety of principal, an investor has to always bear
in mind the taxation angle. The interest earned through investment should not unduly increase his taxation
burden. Otherwise, the benefit derived from interest will be reduced by an increase in taxation.
5. Income
Investment decisions have assumed importance due the general increase in employment opportunities in
India. The stages of development in the country have accelerated demand and a number of new organizations
and services have increased. Jobs are available in new sectors like software technology, business processing
offices, call centers, exports, media, tourism, hospitality, manufacturing sector, banks, insurance and financial
services. The employment opportunities gave rise to increasing incomes. More incomes have increased a
demand for investments in order to bring in more income above their regular income. The different avenues
of investments can be selected to support the regular income. Awareness of financial assets and real assets has
led to the ability and willingness of working people to save and invest their funds for return in their lean period
leading to the importance of investments.
Thus the objectives of investment are to achieve a good rate of return in the future, reducing risk
to get a good return, liquidity in time of emergencies, safety of funds by selecting the right
avenues of investments and a hedge against inflation.
1.9 FACTORS FAVOURABLE FOR INVESTMENT

The investment market should have a favourable environment to be able to function effectively. Business
activities are marked by social, economic and political considerations. It is important that the economic and
political factors are favourable. Generally, there are four basic considerations which foster growth and bring
opportunities for investment. These are legal safeguards, stable currency and existence of financial institutions
to aid savings and forms of business organization.
1. Legal Safeguards
A stable government which frames adequate legal safeguards encourages accumulation of savings and
investments. Investors will be willing to invest their funds if they have the assurance of protection of their
contractual and property rights.
In India, the investors have the dual advantage of free enterprise and control. Freedom, efficiency and
growth are ensured from the competitive forces of private enterprises. Statutory control exerts discipline and
curtails some element of freedom. In India, the political climate is conducive to investment since the new
economic reforms in 1991 leading to liberalization and globalization.
2. A Stable Currency
A well organized monetary system with definite planning and proper policies is a necessary prerequisite
to an investment market. Most of the investments such as bank deposits, life insurance and shares are payable
in the currency of the country. A proper monetary policy will give direction to the investment outlets. As far
as possible, the monetary policy should neither promote acute inflationary pressures nor prepare for a deflation
model. Neither condition is satisfactory.
Price inflation destroys the purchasing power of investments. Thrift is also penalized when the net interest
after taxes received by the investor is less than the rise in the price level, leaving the investor with less total
purchasing power than he had at the time of saving. Inflation occurs generally in unstable conditions like war
or floods but in the last decade, it also discernible in peace conditions especially in developing countries
because of huge government deficit in creating infrastructure. Deflation is equally disastrous because the
nominal values of inventories, plant and machinery and land and building tend to shrink. An example of the
evil effects of deflation can be cited for the period 1929–1933 in the United States when the shrinkage in
nominal values came to a point of producing wholesale bankruptcy.
A reasonable stable price level which is produced by wise monetary and fiscal management contributes
towards proper control, good government, economic well-being and a well disciplined growth oriented investment
market and protection to the investor.
3. Existence of Financial Institutions and Services

The presence of financial institutions and financial services encourage savings, direct them to productive
uses and helps the investment market to grow. The financial institutions in existence in India are mutual funds,
development banks, commercial banks, life insurance companies, investment companies, investment bankers,
mortgage bankers. The financial services include venture capital, factoring and forfeiting, leasing, hire purchase
and consumer finance, housing finance, merchant bankers and portfolio management. Investment bankers are
merchants of securities. They buy bonds and stocks of companies for re-sale to investors. The investment
bankers are distinguished from security brokers who act as agents in buying and selling already issued securities
for commission. Mortgage bankers sometimes act as merchants and sometimes as agents on mortgage loans
generally on residential properties. They serve as middlemen between investors/borrowers and perform collateral
service in connection with loans. Commercial banks and financial institutions also act as mortgage bankers in
giving mortgage loans and servicing the loans.
In India, there are a number of institutions under Central Government and State Government and rural
bodies that have encouraged the growth of savings and investment. The Life Insurance Corporation and Unit
Trust of India offer a wide variety of schemes for savings and give tax benefits also.
Since 1991 there has been a development of the private corporate sector. Many new financial institutions
have emerged in the private sector. Insurance companies, mutual funds, venture capitalists and leasing companies
have been opened up to private financing agencies. Foreign banks have been allowed to do business.
Thus, there is the presence of a large number of institutions and services which channallise the funds in
productive directions.
4. Form of Business Organization
The form of business organization which is permanent in existence encourages savings and investment.
The public limited companies have been said to be the best form of organization. The three characteristics of
the corporation which have been very useful for investors are limited liability of shareholders, perpetual life and
transferability and divisibility of stocks and shares. The public limited company with the ability to continue its
business irrespective of members comprising it, gives longevity and soundness to its business activity. In contrast
to a public limited company whose shareholders have limited liability, the sole proprietor or a partner in a
partnership firm is liable for all the debts of the firm to the full extent of his personal wealth. In these
conditions, investors are hesitant to risk their savings in these forms of organizations. Besides unlimited liability,
the partnership and proprietor also suffer from short life of the organization. With the death or retirement of
any of the partners, a partnership firm is dissolved. Similarly, a sole proprietor carries on business only during
his life-time. In these unstable and unsure conditions, investors would not like to make their investments.
Finally, the public limited company lends an element of liquidity to its shares. In contrast, partnership restricts
stability and transferability freely from person to person. The public limited company, therefore, is a popular
form for investment as the investors benefit from liquidity, convenience and longevity.
In India since 1991 there is the existence of large corporate organizations. There have been many mergers
and amalgamations and consolidation has taken place. Business has become more permanent in nature. Family
businesses have expanded appears to be stable and well organized. Indian business is taking new forms and
being recognized in the world. With increased awareness and stability the investor has many favorable outlets
for making investments.
5. Choice of Investment
The growth and development of the country leading to greater economic activity has led to the introduction
of a vast array of investment outlets. Apart from putting aside savings in savings banks where interest is low,
investors have the choice of a variety of instruments. The question to reason out is which is the most suitable
channel? Which media will give a balanced growth and stability of return? The investor in his choice of
investment will have to try and achieve a proper mix between high rate of return and stability of return to reap
the benefits of both. Some of the instruments available are equity shares and bonds, provident fund, life
insurance, fixed deposits and mutual funds schemes.
6. Risk-less Vs Risky Investments

Most investors are risk averse but they expect maximum return from their investment. Every investment
must be analyzed because there is definitely some risk in it.
The Indian investment scene has many schemes to offer to an individual. On an analysis of these schemes,
it appears that the investor has a wide choice. A vast range of investments is in the government sector. These
are mostly risk free but low return yielding. Several incentives are attached to it. The private sector investments
consist of equity and preference shares, debentures and public deposits with companies. These have the
features of high risk. Ultimately, the investor must make his investment decisions.
The dilemma faced by the Indian investor is the reconciliation of profitability, liquidity and risk of investments.
Government securities are risk free and the investor is secured. However, to him the return or yield is very
important as he has limited resources and would like to plan an appreciation of the investments for his future
requirements. Government securities give low returns and do not fulfill his objective of money appreciation.
Private sector securities are attractive though, risky. The success stories of Reliance, Infosys, Wipro give
to the investor the dream of future appreciation of investment by several times. The multinational and blue chip
companies offer very high rates of return and also give bonus shares to their shareholders. Food Specialties
Limited, Cadburys, Colgate Palmolive, Hero-Honda have been known to raise the hopes of investors by giving
high rates of return.
Real Estate & Gold have the advantage of eliminating the impact of inflation, since the price rises
experienced by them have been very high. The Indian investor in this context cannot choose his investments
very easily.
An investor can maximize returns with minimum risk involved if he carefully analyses the information
published in the prospectuses of companies. Contents such as the past performance, name of promoters and
board of directors, the main activities, its business prospects and selling arrangements should be assessed
before the investor decides to invest in the company.
From the point of view of an investor, convertible bonds may under proper conditions, prove an ideal
combination of high yield, low risk and potential of capital appreciation.
If private companies would offer a wider range of investments to the public, they would be able to
mobilize a larger part of pubic savings and at the same time, the investor would be in a position to make a
better choice. This would solve his dilemma of being at the crossroads.
1.10 INVESTMENT MEDIA

In India many types of investment media or channels are available for making investments. A sound
investment program can be constructed, if the investor familiarizes himself with the various alternative investments
available. Investment media are of several kinds. Some are simple and direct, others present complex problems
of analysis and investigations. Some are familiar; others are relatively new and unidentified. Some investments
are appropriate for one type of investor and another may be suitable to another person.
The ultimate objective of the investor is to derive a variety of investments that meet this preference for
risk and expected return. The investor will select the portfolio which will maximize his utility. Securities present
a wide range of risk-free instruments to highly speculative shares and debentures. From this broad spectrum,
the investor will have to select those securities that maximize his utility. The investor, in other words, has an
optimization problem. He has to choose the security which will maximize his expected returns subject to certain
considerations. The investment decision is of optimizing returns but risk taking capacity varies from investor to
investor. It is not only the construction of a portfolio that will promise the highest expected return but it is the
satisfaction of the need of the investor. For instance, one investor may face a situation when he requires
extreme liquidity. He may also require safety of securities. Therefore, he will have to choose a security with low
returns. Another investor would not mind high risk because he does not have financial problems but he would
like a high return. Such an investor can put his savings in growth shares as he is willing to accept risk. Another
important consideration is the temperament and psychology of the investor. Some investors are temperamentally
suited to take risks; there are others who are not willing to invest in risky securities even if the return is high.
One investor may prefer safe government bonds, whereas another may be willing to invest in blue chip equity
shares of at company.
Many alternative investments exist. These can be put into different categories. The investment alternatives
are given below in Table 1.3.
1. Direct and Indirect Investments
These media alternatives have basically been categorized as direct and indirect investment alternatives.
Direct investments are those where the individual makes his own choice and investment decision. Indirect
investments are those in which the individual has no direct hold on the amount he invests. He contributes his
savings to certain organizations like Life Insurance Corporation (LIC) or Unit Trust of India (UTI) and depends
upon them to make investments on his and other people’s behalf. So there is no direct responsibility or hold
on the securities.
Table 1.3 INVESTMENT MEDIA
INVESTMENT MEDIA
Direct Investment Alternatives Indirect Investment Alternatives

Fixed Principal Investments Pension Fund
Cash Provident Fund
Savings Account Insurance
Savings Certificate Investment Companies and
Government Bonds Unit Trust of India and other trust funds
Corporate Bonds and Debentures
Non-Security Investments
Variable Principle Securities Real Estate
Equity Shares Mortgages
Convertible Debentures or Preference Commodities
Securities Art, Antiques and Other Valuables
An individual also makes indirect investment for retirement benefits, in the form of provident funds and
pension, life insurance policy, investment company securities and securities of mutual funds. Individuals have
no control over these investments. They are entrusted to the care of the particular organization. The organizations
like Life Insurance Corporation, Unit Trust of India, and Provident Funds are managed according to their
investment policy by a group of trustees on behalf of the investor. The examples of indirect investment alternatives
are an important and rapidly growing segment of our economy. In choosing specific investments, investor will
need definite ideas regarding a number of features that their portfolio should have.
2. Fixed and Variable Principal Securities
Fixed principal investments are those in which principal amount and the terminal value are known with
certainty. Cash has a definite and constant rupee value, whether it is deposited in a bank or kept in a cash
box. It does not earn any return. Savings accounts have a fixed return; they differ only in terms of time period.
The principal amount is fixed plus interest earned. Savings certificates are quite recent — some examples being
national savings certificates, bank savings certificates and postal savings certificates. Government bonds, corporate
bonds and debentures are sold having a fixed maturity value and a fixed rate of income over time.
The variable principal securities differ from the fixed principal securities because their terminal values are
not known with certainty. The price of preference shares is determined by demand and supply forces even
though preference shareholders have a fixed return. Equity shares also have no fixed return or maturity date.
Convertible securities such as convertible debentures or preference shares can convert themselves into equity
shares according to certain prescribed conditions and thus have features of fixed principal securities supplemented
by the possibility of a variable terminal value. Debentures, preference shares and equity shares are examples
of securities sold by corporations to investors to raise necessary funds.
3. Non-Security Investments
‘Non-Security Investments’ differ from securities in other categories. Real estate may be the ownership of
a single home or include residential and commercial properties. The terminal value of real estate is uncertain
but generally there is a price appreciation, whereas depreciation can be claimed in tax. Real estate is less liquid
than corporate securities. Mortgages represent the financing of real estate. It has a periodic fixed income and
the principal is recovered at a stated maturity date. Commodities are bought and sold in spot markets; contracts
to buy and sell commodities at a future date are traded in future markets. Business ventures refer to direct
ownership investments in new or growing business before firms sell securities on a public basis. Art, antiques
and other valuables such as silver, fine china and jewels are also another type of specialized investments which
offer aesthetic qualities also.
These features should be consistent with the investors’ objectives and in addition should have additional
conveniences and advantages. The following features are suggested for a successful selection of investments.
1.11 FEATURES OF AN INVESTMENT PROGRAM

The features of an investment program consists of safety of principal, liquidity, income stability, adequate
income, purchasing power stability, appreciation, freedom from management of investments, legality and transferability.
1. Safety of Principal
The investor, to be certain of the safety of principal, should carefully review the economic and industry
trends before choosing the types of investment. To ensure safety of principal, the investor should consider
diversification of assets. Adequate diversification involves a variety of investment commitments, by industry,
geographically, by management, by financial type and by maturities. A proper combination of these factors
would reduce losses. Diversification to a great extent helps in proper investment programmes but it must be
reasonably accomplished and should not be carried out to extremes.
2. Liquidity
An investor requires a minimum liquidity in his investments to meet emergencies. Liquidity will be ensured
if the investor buys a proportion of readily saleable securities out of his total portfolio. He may therefore keep
a small proportion of cash, fixed deposits, units and shares which can be immediately converted into liquid
investments. Real estate is a long term commitment and the investor cannot be sure of its immediate liquidity.
3. Income Stability
Regularity of income at a consistent rate is necessary in any investment pattern. Not only stability, it is
also important to see that income is adequate after taxes. It is possible to find out some good securities which
pay practically all their earnings in dividends.
4. Appreciation and Purchasing Power Stability
Investors should balance their portfolios to fight against any purchasing power instability. Investors should
judge price level inflation, explore the possibility of gain and loss in the investments available to them, limitations
of personal and family considerations. The investors should also try and forecast which securities will appreciate.
A purchase of property at the right time will lead to appreciation over a period of time. Growth stock will also
appreciate over time. These, however, should be done thoughtfully and not in a manner of speculation or
gamble.
5. Legality and Freedom from Care

All investments should be approved by law. The law relating to minors, estates, trusts, shares and insurance
should be carefully examined before making investments. Illegal securities will bring out many problems for the
investor. One way of being free from care is to invest in securities like Unit Trust of India, Life Insurance
Corporation or Savings Certificates. The management of securities is then left to the care of the Trust who
diversifies the investments according to safety, stability and liquidity with the consideration of their investment
policy. The identity of legal securities and investments in such securities also provides a control mechanism and
the investor is free from the care of legality of the investments.
6. Tangibility
Intangible securities have many times lost their value due to price level inflation, confiscatory laws or
social collapse. Some investors prefer to keep a part of their wealth invested in tangible properties like building,
machinery and land. It may, however, be considered that tangible property does not yield an income apart from
the direct satisfaction of possession or property.
Table 1.4 FEATURES OF INVESTMENT AVENUES
Particulars Risk Return Capital Liquidity/ Tax benefit

Current Yield appr. marketability
Equity Shares High Low High High High

Debentures Low High Very low Very low Nil
Bank Deposit Low Low Nil High Nil
Public Provident Fund Nil Nil Low Low Moderate
Life Insurance Policies Nil Nil Low Low Moderate
Real Estate Medium Low High in Moderate Changes
Long-term according to rules
Gold and Silver Low Nil High in Moderate Nil
long-term
1.12 THE INVESTMENT PROCESS – STAGES IN INVESTMENT

The investment process is generally described in four stages. These stages are investment policy, investment
analysis, valuation of securities and portfolio construction.
Investment Policy
The first stage determines and involves personal financial affairs and objectives before making investments.
It may also be called preparation of the investment policy stage. The investor has to see that he should be able
to create an emergency fund, an element of liquidity and quick convertibility of securities into cash. This stage
may, therefore, be considered appropriate for identifying investment assets and considering the various features
of investments.
1. Investment Analysis
When an individual has arranged a logical order of the types of investments that he requires on his
portfolio, the next step is to analyse the securities available for investment. He must make a comparative
analysis of the type of industry, kind of security and fixed vs variable securities. The primary concerns at this
stage would be to form beliefs regarding future behaviour or prices and stocks, the expected returns and
associated risk.
2. Valuation of Securities
The third step is perhaps the most important consideration of the valuation of investments. Investment
value, in general, is taken to be the present worth to the owners of future benefits from investments. The
investor has to bear in mind the value of these investments. An appropriate set of weights have to be applied
with the use of forecasted benefits to estimate the value of the investment assets. Comparison of the value with
the current market price of the asset allows a determination of the relative attractiveness of the asset. Each asset
must be valued on its individual merit. Finally, the portfolio should be constructed.
3. Portfolio Construction
As discussed earlier under features of an investment programme, portfolio construction requires knowledge
of the different aspects of securities. These are briefly recapitulated here, consisting of safety and growth of
principal, liquidity of assets after taking into account the stage involving investment timing, selection of investment,
allocation of savings to different investments and feedback of portfolio as given in Table 1.5. 1
While evaluating securities, the investor should realize that investments are made under conditions of
uncertainty. There cannot be a magic formula which will always work. The investor should be concerned with
concepts and applications that will satisfy his investment objectives and constantly evaluate the performance
of his investments. If need be, the investor may consider switching over to alternate proposals.
Table 1.5 THE INVESTMENT PROCESS
Investment Policy Determination of investible wealth. Determination of portfolio objectives.

Identification of potential investment assets. Consideration of attributes
of investment assets. Allocation of wealth to asset categories
Investment Valuation Valuation of debentures/bonds, equity shares, preference shares,
other assets
Investment Analysis Equity stock, debentures and bond analysis, other asset analysis
Analysis of the Economy Screening Analysis of yield structure, qualitative analysis
of Industries
Analysis of Industries Consideration of debentures, equity shares, quantitative analysis

Quantitative Analysis Quantitative analysis of debentures, equity
Portfolio Construction Determination of diversification level Consideration of investment
timing Selection of investment assets. Allocation of investible wealth
to investment assets. Evaluation of portfolio for feedback
The next chapters, chapter 2 discusses the structure of the financial institutions and markets and chapter
3 is an understanding of the new issue and the second hand securities market. This will help the investor to
understand the working of the securities markets and how to participate in them.
SUMMARY
r The success of every investment decision has become increasingly important in recent times. Making sound
investment decisions require both knowledge and skill. Skill is needed to evaluate risk and returns associated
with an investment decision. Knowledge is required regarding the complex investment alternatives available
in the economic environment.
r This chapter explains the meaning of investment and how it differs from speculation and gambling and
arbitrage. Investment is a long term commitment whereas speculation is short term based on quick profits.
Both have risk and return but speculation and gambling have very high risk.
r Distinctions between direct and indirect investments, real and financial assets and commodity assets have
been explained. Individuals make their own choice in direct investments, but in indirect investments there is
no direct hold on the investment. For example investment in mutual funds.
1. Refer Page 12, Keith V. Smith & David I. Eiterman (for a more elaborate discussion), Modern Strategy for Successful Investment,
Dow Jones Irvin Inc., Illinois 1978, pp. 11-20.
r Risk and return and various investment alternatives like equity, preference, debentures/bonds are explained.
Type of risk and return are given for other investments like bank deposit, Public Provident Fund, Life Insurance
policies, real estate, gold and silver.
r Finally it gives an explanation of the process of investment. The process of investment is a four-stage
process: investment policy, investment analysis, investment valuation and portfolio construction and feedback.
OBJECTIVE TYPE QUESTIONS

State whether the following statements are TRUE (T) or FALSE (F):
(i) Investments are concerned with risk and return.
(ii) Investments involve long term commitments.
(iii) Speculation brings about stable return for long term period of time.
(iv) Speculation is considered with review and analysis and investments with capital gain.
(v) Investments are based on portfolio construction, valuation, identification and analysis.
(vi) The variable investments consist of cash, bonds and savings certificates.
(vii) The investment objective is high risk and high return.
(viii) Arbitrage is a long term investment.
(ix) The commodity investment is through saving bank.
(x) Indirect securities consist of mutual fund and life insurance securities.
Answers: (i) T (ii) T (iii) F (iv) F (v) T (vi) F (vii) F (viii) F (ix) F (x) T.
QUESTIONS
1. Why do people invest? What are the factors which are favourable for making investments in an economy?
2. What is the meaning of investment? Discuss the different channels or alternatives available to an investor for
making investments?
3. Describe the features of an investment programme? What steps should an investor follow to make an investment?
4. Distinguish between investment, speculation and gambling. What is the usefulness of a sound investment plan?
5. Writes notes on (i) commodity assets (ii) process of investment (iii) investment alternatives.
6. Distinguish between (i) direct and indirect assets (ii) real and financial assets (iii) Investment and arbitrage.
SUGGESTED READINGS
l Amling, Frederick: Investments, 3rd ed., Prentice Hall, Englewood Cliffs, N.J., 1978, I.
l Dougall, Herbert, E.: Investments, 9th ed., Prentice Hall, Englewood Cliffs, N.J., 1978.
l Smith, Eiteman: Modern Strategy for Successful Investing, Dow Jones Irvin Inc., Illinois 1978.
l Stevenson, Jennings: Fundamentals of Investments, West Publishing House, New York, 1977.
nnnnnnnnnn
Chapter
FINANCIAL INSTITUTIONS AND

MARKETS IN INDIA
Chapter Plan
2.1 Background of the Financial System
2.2 Financial System: An Introduction
2.3 Legislative Measures
2.4 Structure of the Financial Markets
2.5 Important Stock Markets in India
2.6 Financial Institutions
– Commercial Banks
– Development Banks
2.7 A Critique of the Indian Financial System
2.1 BACKGROUND OF THE FINANCIAL SYSTEM

The financial system in India is based on the policy framework of India. From 1947 to 1990 it has been
the phase of growth, experimentation, development and public sector dominated policies. Since 1991 there has
been liberalization and deregulation and the path towards competition and opening up of private sector and
internationalization of the economy.
1. Growth of Financial System (1947-90)
The financial system in India at the time of Independence in 1947 was semi-organized and presenting a
restricted narrow structure. It was marked by the absence of issuing institutions and non-participation of
intermediary financial institutions. The industrial sector showed a lack of growth as it had no access to savings
of the community and no supportive or responsive financial intermediaries to depend upon.
14
FINANCIAL INSTITUTIONS AND MARKETS IN INDIA 15
The development of the financial system in India began with the inception of planning in the country.
Wedded to the theory of mixed economy, the government evolved the financial system in such a way that there
was social and economic justice with a consideration of Indian political requirements.
Banks and Financial Institutions
The evolution of the financial system in India was in the fulfillment of the socio-economic and political
objectives. Since, there was no strong financial institutional mechanism in the country, chaotic conditions
prevailed. The Government found the need of progressively transferring important financial institutions from
private ownership to public control. It also planned to create new financial institutions in the public sector and
nationalize some of the existing institutions. The year 1948 was significant for beginning the process of transfer
by nationalizing the Reserve Bank of India (RBI) and bringing it under government control. The Imperial Bank
was the next to be transferred. Its name was changed and it was re-named State Bank of India (SBI). This
process took place in the year 1956. In the same year, 245 Life Insurance Companies were consolidated and
merged into a monolithic institution under government control and re-named Life Insurance Corporation of
India. A further development took place in 1969 when fourteen commercial banks were nationalized. Ten banks
were nationalized in 1980. After the commercial banks, the general insurance companies were reorganized
under the name of General Insurance Corporation. This was amalgamated because a large number of these
companies defrauded their customers and closed their units after making adequate profits for themselves.
Besides the process of transfer, government also started new financial institutions under its own control.
The Unit Trust of India was started in 1964 under the public sector to form an important intermediary by
collecting the savings of the people and inter-linking it with the users of funds. It is an important link between
sources and uses of funds. The other significant form of savings is the provident funds and pension funds. These
are directly under the control of the Government of India. The public sector was thus in full command of all
the resources of the country.
Development Banks
Another significant development which marks the strengthening of the Indian Financial System is the
inception of development banks. The development banks were conceived as gap fillers in institutional credit.
Their role was not to be quantitative alone but also to lend support to the financial mechanism qualitatively.
Their objective included the development of backward regions, small and new entrepreneurs. They differed
from financial institutions in their functions. While the financial institutions linked the sources and uses of funds,
the development banks were considered to be the backbone of the financial system, lending support to the
financial institutions with the facilities of credit as well as advisory functions.
The development banking era began in India with the setting up of the Industrial Financial Corporation
of India (IFCI) in 1948. While IFCI was set-up at the all-India level, State Financial Corporations (SFCs) were
conceived as regional institutions. The first SFC was formed in 1951. The IFCI and SFCs were organized to
assist small and medium enterprises and to work in the form of industrial mortgage banks. IFCI’s working was
on orthodox lines. A more dynamic and modern approach was brought about with the introduction of Industrial
Credit and Investment Corporation of India (ICICI) in 1955. It was considered to be a pioneer in its participation
in the private corporate sector. It channeled foreign currency loans from the World Bank and also entered the
Industrial Securities Market as an underwriter of capital issues. Subsequently, the Government of India set-up
the Refinance Corporation of India (RCI) in 1958 to provide refinance to banks against term loans granted by
them to medium and small enterprises. Subsequently, the RCI merged with the Industrial Development Bank
of India (IDBI) in 1964. In the same year, IDBI was established as a subsidiary of the RBI. Later the IDBI was
elevated to the position of an apex institution to provide finance and to co-ordinate the activities of all the
financial institutions. At the State Level, the State Industrial Development Corporation (SIDC)/State Industrial
Investment Corporation were created to meet the financial requirements of the states and to promote balanced
regional development. In 1971 the IDBI and LIC jointly set-up the Industrial Reconstruction Corporation (IRCI)
to rehabilitate sick mills.
The expansion in size and the number of institutions has led to a considerable degree of diversification
and increase in the types of financial instruments. The impetus given by planning led to rapid industrialization,
relative decline in the private proprietorship type of business organization, growth of corporate sector and the
growth of the government sector. The financial instruments grew in addition to those already in existence, new
instruments were introduced in the form of innovative deposit scheme of banks, time deposits, recurring
deposits and cumulative time deposits with post offices, public provident fund accounts, participation certificates,
new schemes of LIC, UTI, National Development Bonds and Rural Debentures. However, most of the development
banks are now no longer operative.
2. Process of Change (1991)
Since 1991 many private as well as foreign banks have been permitted to do business. Life insurance
companies have been allowed to enter in the private sector. The monolithic Unit Trust of India has been
restructured. There are a large number of mutual funds operating now in the private sector. Commercial banks
have started mutual fund business. The development banks have started banking business. ICICI and IDBI have
entered into commercial banking.
The retail sector has been developed and many banks have become financial super-markets. Consumer
housing and finance have been given focus. A variety of financial services have been added in the economy.
There are many changes in the capital market. Reforms have taken place in the new issue market and stock
market. SEBI has been formed as the market regulator and it has introduced investor awareness and protection
guidelines. Thus the financial system has completely changed.
The Indian Financial System is both developed and integrated today when compared to the initial period
in 1950. Integration has been through a participatory approach between saving and investment agencies.
2.2 FINANCIAL SYSTEM: AN INTRODUCTION

The financial system of a country consists of a network of financial markets, institutions, investors, services
and regulators. A well fortified structure is able to encourage public and institutional support leading to an
organized network of supporting financial markets. A vibrant and diversified system plays an important role in
mobilizing the savings of different classes of people, whose investment objectives differ widely in terms of their
expected returns, depending upon their ability to take risk.
The financial system deals with the finances of the people of the country. Its main product is money and
credit and through these two variables it is able to bring about activity and in turn economic development of
a country.
A financial system comprises of the following agencies:
1. Financial Markets: These are capital market comprising of New Issue Market and Stock Exchange,
Government Securities Market, Foreign Exchange Market and Government Securities Market.
2. Financial Institutions: Such as development banks, life insurance companies, general insurance
companies, mutual funds, leasing companies, chit funds, post offices. These are also called financial
intermediaries.
3. Banks: The central bank of a country is the apex bank. In India it is the Reserve Bank of India. It
regulates the monetary policy of a country and the supporting commercial banks engaged in money
and creation of credit.
4. Financial Instruments: Which is long-term and short-term in nature? These are shares, debentures,
treasury bills, mutual fund schemes, commercial papers, treasury bills, units, post-office schemes.
These are in the nature of assets and claims.
5. Market Regulators: These are necessary to bring in discipline in the market by making certain laws,
rules and regulations and procedures. In India some regulatory authorities are the Securities Exchange
Board of India (SEBI), Reserve Bank of India (RBI), Insurance Regulatory Authority of India.
6. Market Participants: The market participants are individuals, corporate organizations, government,
intermediaries and regulators.
2.3 LEGISLATIVE MEASURES

In 1956, the Companies Act was passed to give protection to the investors through improvement in
allotment of shares, floatation of new companies and terms and conditions in the capital structure of companies.
The object of the Act was to regulate the working of a corporate organization with a view to channel funds in
accordance with the country’s planning policy objectives and avoidance of wasteful investment and non-
essential investment activities. Through this Act the government planned to screen all new issues of capital
before allowing them to offer for public subscription and to discourage undesirable practices. Another objective
of the Act was to regulate foreign capital in the country.
In the same year in 1956, reforms were also made in stock exchange trading methods through the
Securities Contract (Regulation) Act, 1956. This Act permitted only recognized stock exchanges to function. The
Government was empowered to regulate the stock exchanges from time to time. A Directorate of Stock Exchanges
was set-up to enforce the Securities Act.
In the eighties, the financial markets witnessed changes and new developments. The Government became
liberal and allowed public sector undertakings to enter the Indian capital market.
A legislative development to protect the investors is the setting up of the Securities Exchange Board of
India (SEBI) in 1987. SEBI was established to promote measures for fair and efficient trading in securities and
for transparency of companies in which trading of securities is to take place. Every company is required to
register with Board and agree to work under the limiting principles and rules. The Board has the powers to take
action against the erring management in certain cases.
SEBI was formed with the view that the mechanics of buying and selling shares, nominations and transfers
required simplification. Further, a large number of new companies required disciplining. They used questionable
methods of making their issues successful through the creation of artificial demands, unofficial premiums and
fraudulent sales. After making their issues, a large number of companies disappeared from the market. One
more responsibility of the SEBI was to standardize accounting procedures of brokers and companies. It also had
to create awareness programs and educate investors for protecting their interests.
The development in the financial system shows vast changes in the Indian financial system since 1991.
The introduction of new innovative financial instruments, development of commercial banks into universal
banking and legislative enactments have vastly reorganized the system and have brought confidence in the
minds of the investing public and some order in the Indian capital market. There has been a closer link between
the different institutions, fostering growth and progress and at the same time protecting the interests of the
investing public. The structure of the markets in the country is briefly given below.
2.4 STRUCTURE OF THE FINANCIAL MARKETS

The financial system of any country comprises within its fold the financial markets and its supporting
financial institutions. A well fortified structure is able to encourage public and institutional support leading to
an organized network of supporting financial markets. In India, as already presented, there exist a large number
of financial institutions which have grown or restructured. A closer look is now taken at the existing markets.
The financial markets which exist in India are:
¾ Organized and Unorganized Market
¾ Treasury Bill Market
¾ Call Money Market
¾ Commercial Bills Market
¾ Market for Financial Guarantees
¾ Market for Mortgages
¾ Foreign Exchange Market
¾ Government (Gilt-Edged) Securities Market and
¾ Industrial Securities Market

¾ Commodity Markets
The objectives and functions of these markets are briefly described for the purpose of familiarity.
The distinctive features of these markets are discussed below:
(a) Organized and Unorganized Market
An organized market is a formal financial market that operates under rules, regulations and guidelines
set by regulatory authorities such as Securities Exchange Board of India, Reserve Bank of India, Insurance
Regulatory Authority, Mutual Fund Regulations, and Central Government Policies.
Unorganized market is an informal market that operates without any standardization and control of any
regulatory authority. In India it is operated by moneylenders and traders. There are high rates of interest and
it operates mainly in rural areas. Such informal markets also exist in urban areas and they are outside the
purview of government control. Table 2.1 shows the distinction between organized and unorganized market.
Table 2.1 ORGANIZED AND UNORGANIZED MARKET
Organized Market Unorganized Market
A market operating with rules and regulations. Non-standardized procedures. Variable rates of interest
and transactions.
Control of a recognized controller ex; SEC. No control on transactions as no rules operate.
It is a formal recognized market like It is operated by money lenders and traders. It is also
New Issue Market and Stock Exchange. called an informal market.
Institutions play an important role in collection There is no large institution but there are some chit
of savings of people in the intermediation process. funds and lotteries in operation in an informal manner.
Rates of interest are exorbitant.
1. Treasury Bills Market

A Treasury bill is promissory note or a finance bill arising without any genuine transaction in goods. It is
a claim against the government and does not require any ‘grading’, ‘endorsement’ or ‘acceptance’. It is highly
liquid because it is guaranteed for repayment by the government. The Treasury bill rate is fixed from time to
time by the Reserve Bank of India (RBI). The rate of discount of the treasury bills sold by the RBI is the lowest
in the country. It is deliberately kept at a low rate, and even when determined by market forces, its level is
very low. The reason for this is ‘high safety’ ‘low risk’ and ‘short-term maturity’.
In India, treasury bills are of two types – ‘ordinary’ and ‘ad-hoc’. The ordinary treasury bills are issued
to the public and the RBI to enable the government to meet its requirement for short-term finance. Ad hoc
treasury bills, popularly known as ‘ad hocs’ are created in favour of the Reserve Bank of India. Both types of
treasury bills have a maturity of 91 days. The ad hoc bills serve the government in two ways. They replenish
government cash balances. The finance raised through these bills is used by the Central Government as an
advance by the RBI to State Governments. Secondly, this helps the government by providing a medium for
investing temporary surpluses of state governments, semi-government departments and foreign central banks.
To some extent, this is able to eliminate undesirable fluctuation in this document rate which might occur if state
governments competed with regular investors in treasury bills issued to the public.
The Treasury bill market is limited in India. Although its participants are the Reserve Bank of India,
Commercial Banks, State Governments and the financial institutions like Life Insurance Corporation and Unit
Trust of India, the market is not as active as in the UK. In the UK, banks actively engage in treasury market
and sell bills to discount houses for settling inter-bank indebtedness and government payments and receipts.
Discount houses hold treasury bills because they can offer security for obtaining call loans from banks. They
also conduct business dealings in treasury bills with foreign banks overseas and with clients who hold treasury
bills. In London, the treasury bills are treated as liquid. The banks have the facility to buy treasury bills from
discount houses when a part of the maturity has elapsed, i.e., after the discount houses have held the bills for
four to five weeks. In India, the bills do not have as much liquidity or facility. The banks have to buy treasury
bills on their account and once they buy them, they have to hold it up to the maturity period. Also, the low
rate of return on investment in treasury bills dissuades banks to operate in them. The effect of non-liquidity
and low interest rate is seen in the undeveloped state of the Treasury bill market. In India, an additional facility
has been made available. The banks have been offered rediscounting facilities with the Central Bank but the
market has not picked up because the banks do not enjoy dealing with a formal government agency and would
prefer a non-official financial agency like a discount house in London to look after their requirements. This
market continues to be small and underdeveloped in India.
Chakravarty and Vaghul committee recommendations have brought about changes in the market. Yields
have become more attractive and now the ad hoc Treasury bills have been discontinued and the RBI continues
to play an important role in the Treasury bill market. There are at present 14 days, 91 days, 182 days and 364
days Treasury bills. The new Treasury bills introduced in 1997 were of 14 days duration. With the introduction
of the auction system the interest rates of Treasury bills are determined by the market. With all its limitations
the Treasury bill market is attractive because of the absence of the risk of default and high liquidity.
2. Call Money Market
The Call Money Market deals in loans which have very short maturity and are highly liquid. The loans
are payable on demand, at the option of either the tender or the borrower and the maturity period varies from
one day to fourteen days. Call money markets are located in India in major industrial towns where important
stock exchanges are located. They are located in Mumbai, Kolkata, Chennai, Delhi and Ahmedabad. The
markets in Mumbai and Kolkata are most significant. While in UK and USA there are separate call money
markets, in India they are associated with the pressure of the stock exchange. The call loans in India are given:
¾ to the bill market;
¾ for inter-bank uses;
¾ for dealing in stock exchanges and bullion markets; and
¾ individuals for trade purposes to save interest on cash credits and overdrafts.
Out of the four uses mentioned here, the inter-bank uses have been most significant for call money
market. Call loans in India are unsecured and extremely useful because of inter-bank uses, banks borrow from
other banks in order to meet a sudden demand for funds, large payments, large remittances and to maintain
cash or liquidity with the Reserve Bank of India.
In India, commercial banks, both scheduled and unscheduled, foreign banks, state, district, urban and co-
operative banks use the facility offered by the call market. The financial institutions such as LIC, GIC, and UTI
also participate in the call market by giving loans to banks. The Development Banks such as IDBI, ICICI, IFC
also indirectly participate in the call market. Since 1970 brokerage has been prohibited by the RBI on operations
in the call market. The call market has a special feature regarding interest on short-term loan. This loan varies
from day-to-day and sometimes from hour to hour and centre to centre. It is very sensitive to changes in
demand and supply of call loans. It has been lowest in Mumbai and highest in Kolkata in the past years.
The entry of term lending institutions in the call market has also changes the complexion of the system.
It has to some extent regulated the working of the short-term market. It has also made available a huge
reservoir of funds hitherto invested in long-term funds only. This has helped the call money market to grow.
The Call Money Market in India is, to a great extent, controlled through the Reserve Bank operations.
When the RBI follows a restrictive monetary policy the call market becomes very active and there is a scramble
for funds. If the RBI follows a liberal policy, the banks stop borrowing from the call market. In this way, the
call money market functions in India and reflects variations in its requirements through ‘dull’ and ‘active’
borrowing scenario.
The call money market where money was borrowed for a very short period had a ceiling rate of 10% rate
of interest. From May 1, 1989, the Reserve Bank of India has withdrawn ceiling rates on inter bank money,
participation certificates and on rediscounting of commercial bills. The commercial banks were also given the
option of getting short-term funds through the new instruments called Certificate of Deposits (CD). Another
instrument called the inter participation was introduced for improving short-term liquidity with the banking
system.
The Reserve Bank further decided to set-up an apex body for improvement in the monetary system. This
organization was to be called the Discount and Finance House of India. The RBI would set this up jointly with
public sector bankers and financial institutions.
Another important dimension in this direction was the liberalization of the credit policy of banks. Banks
were to rename credit authorization scheme and to call it ‘credit monitoring arrangements’. All proposals
exceeding 5 crores could be sanctioned by the banks and the RBI’s sanction to such working capital requirements
should be only a post sanction security. From November, 1988 RBI has permitted the transfer of customer’s
account from one bank to another without any questions. Transfer of accounts was made possible without any
objections from the existing bank. The transferee bank had to take over both the liabilities as well as responsibilities
existing in the present bank.
The call and short money market was liberalized to the extent of allowing the private sector companies
to issue commercial paper with competitive interest rates for a period of three to six months. Companies would
be allowed to issue commercial paper if it got a rating from Credit Rating and Information Services of India
Limited. The bank finance could not exceed 250 million rupees.
There have been many developments in the money market since 1991. Existing money market instruments
have been changed. New instruments have been adopted and the money market has increased liquidity. In
1997 the Narsimham committee recommended the reforms in the call money market for its development. The
call money market became an inter bank market with primary dealers and the repo market was developed.
Primary and satellite dealers have been appointed within prudential norms to improve the lending and borrowing
situation in the market. The banks and primary dealers were permitted to lend and borrow whereas other
participants could only be lenders in the market. From 2002 primary dealers can lend in the call money market
up to 25% of their net owned assets. This reform was made in a phased manner between 1999 and 2005.
3. Commercial Bills Market
In India, there are many kinds of bills in the Commercial Bills Market. A bill of exchange, according to
the Indian Negotiable Instruments Act, 1881, is a ‘self-liquidating’ paper and negotiable. It can change hands
during its currency and has legal safeguards. The bills of exchange are generally for short-term accommodation
and vary in maturity from three to six months. Bills may be classified as:
¾ Demand and Usance bills: A bill in which no time of payments is specified in the demand bill, it
is payable immediately at sight. Usance or time bill refers to the time period recognized by custom or
usage for payments of bills.
¾ D/A and D/P bills: A D/A bill becomes a clean bill after delivery of the documents. In a D/P
(documents against payments) bill, documents of title will be held by the banker, once the bill has
been accepted by the drawee, till the maturity of the bill of exchange.
¾ Inland and foreign bills: Inland bills are drawn and payable in India upon a person resident in
India. Foreign bills are drawn outside India; they may be payable in India or outside India or drawn
upon a person resident in India.
¾ ‘Hundis’ are the purely Indian method of trade bills used to raise or remit money or finance inland
trade by indigenous bankers in the country. The ‘hundis’ are known by various names such as
‘Shahjog’, ‘Namjog’, ‘Dekharnarjog’, ‘Fermainjog’, ‘Jokhani’, ‘Dhanijog’, and ‘Darshani’.
¾ Accommodation Bills: In India there are other bills of exchange in evidence which are not genuine
bills. These are called accommodation and supply bills. Such a bill is also called ‘kite’ or ‘wind-
mill’. In this bill there is no genuine transaction but a person accepts the bill to help the other person
to meet his financial obligations. Such a bill is prepared because government payments are low and
the supplier needs funds. Government does not accept a bill which is not accompanied by the documents
of title to goods but bank advances can be easily received through accommodation bills.
The concept of bill of exchange has been the availability of funds as soon as a sale has been executed.
The buyer accepts a bill and promises to pay at a later date, but the seller can ensure payment immediately
by discounting the bill or, in other words, getting the release of the payment by paying a small amount of
money to the bank called the ‘Discount Rate’. On the maturity date the banker claims the amount on the bill
from the person accepting the bill.
In India, the bill market is under-developed. It is neither established nor widespread. The banks usually
accept bills for the conversion of cash credits of overdrafts of their customers. These are, therefore, bills which
are not genuine. Sometimes banks give loans on the security of bills. Unfortunately, there is no practice of re-
discounting of bills between banks who need funds and those who have excess funds. In 1974, the Reserve
Bank of India took the step of involving financial institutions like LIC, UTI, GIC and ICICI for re-discounting
genuine bills of commercial banks. Yet, bill financing has not been a significant source of short-term finance
in India.
The Bill Market rates in India are the same as those prevailing in the short-term market. However, there
are two types of rate – ‘prevailing in the organized and unorganized sector’. The RBI publishes the discount
rate prevailing with the State Bank of India. The ‘Bazar’ Bill rate differs from location to location depending
on the requirement of finance.
In India, apart from the short-term bills market, there is a long-term bills market also. This was introduced
in 1965 by the IDBI under the bills Re-discounting Scheme. These bills have their creation through the sale
of machinery on deferred payment basis. This bill enables the manufactures of machinery to get the value of
machinery sold immediately. Banks and other eligible financial institutions discount these bills or re-discount
them from banks and other institutions. The maturity of these bills is up to 5 years. Sometimes they are
extended to 7 years.
The IDBI fixes rates of discounting according to period of maturity. IDBI has been able to organize the
long-term bill finance better than the prevailing short-term bill finance in India. Also, the long-term bill finance
made available by IDBI is cheaper than short-term bill finance.
Government has tried to enlarge the bill market since 1991. There have been additions in the form of
foreign bills but not Indian bills. Hence, the market continues to be small.
4. Market for Financial Guarantees
Guarantee is a contract to discharge the liability of a third party in case of default. Creditors secure their
advance against various types of tangible securities. In addition, they also ask guarantees from borrowers. It
can be called a security demanded by the creditor. Usually the borrower finds a person himself to guarantee
his acts. The purpose of seeking guarantee is to minimize the risk of default. The guarantor should undoubtedly
be known to both parties to be a person of repute and a person who has the means to discharge his liability.
Guarantee can both written or oral and single or joint.
Guarantees may be – (a) ‘specific’ or ‘continuing’. Specific guarantee covers only one particular transaction.
Continuing guarantee covers a series of transactions. (b) Guarantees may also be ‘unsecured’ or ‘secured’ with
tangible asset. (c) Explicit or Implicit. An implicit guarantee arises out of the special nature of the guarantee
and explicit guarantees are properly spelled out. (d) Another category of guarantees are ‘performance’ and
‘financial’ guarantees. Performance guarantees cover payment of earnest money, retention money, penalty
charges, advance payments and non-completion of contracts. Financial guarantees consist of financial contracts
only. In India, guarantee contracts consists of: (i) deferred payments for imported and indigenous capital goods,
(ii) medium and long-term loans raised abroad, (iii) credit advanced by banks and other institutions. In India,
there are generally financial guarantees of varying maturity periods.
The market for financial guarantees is well organized in India. There are various suppliers of guarantee.
Personal Guarantee is the oldest form of guarantee service but the institutional market for financial guarantees
is also well developed in India. There are specialized guarantee institutions who guarantee payments but the
maximum period for guarantee is 15 years. Central and State Government also provide guarantees. Commercial
Banks guarantee funds and they are accepted in contracts. Insurance Companies and other statutory companies
also undertake to make guarantees but there is no specialized private institution providing guarantee service
in the credit market in India. A large number of guarantees issued by insurance companies is given to banks
or financial institutions like IDBI, ICICI, IFC who give guarantees to creditors, suppliers or contractors. The IDBI
guarantees deferred payments due from industrial public market or from scheduled banks. The ICICI guarantees
loans from other private investment sources. The SFC’s guarantee loans raised by industrial concerns and are
repayable up to 20 years. They issue secured guarantees. State Industrial Corporation extends guarantees for
loans and deferred payments for industrial concerns. National Small Industries Corporation guarantees loans
from banks to Small Industrial Units.
Government has also set-up certain specialized agencies with the central objectives of providing guarantees.
These are: (a) Credit Guarantee Organization (CGO) which is a part of RBI and guarantees loans from
lending institutions to the small-scale industrial units. (b) The Export Credit Guarantee Corporation
(ECGC) was set-up in 1964 to offer financial protection to the exporters, especially in their relationship with
bankers. ECGC provides packing credit, post-shipment export credit guarantee, export production and export
finance guarantee. (c) Deposit Insurance and Credit Guarantee Corporation (DICGC). This was started
in 1971 as a public limited company. It operated three schemes: (i) Small Loans Guarantee Scheme,
(ii) Financial Corporation Guarantee Scheme, and (iii) Service Co-operative Societies Guarantee Scheme. In
1981 government integrated Credit Guarantee Organization and Deposit Insurance and Credit Guarantee Corporation
under one organization, namely the Deposit Insurance and Credit Guarantee Corporation for greater flexibility.
Thus, the guarantee market is well organized in India. The DICGC provides loans to traders in the retail sector,
professionals, farmers, Joint Hindu families and association of persons. The loans are guaranteed for a maturity
period of 15 years. It charges a guarantee fee of 1.5% per annum. Thus, the guarantee market is well organized
in India.
5. Mortgages Market
A mortgage loan is a loan against the security of immovable property like land and buildings. Mortgages
are well secured and have low credit risk but the degree of security depends on whether it is the first charge
or second charge on mortgage. In the first charge, the mortgage transfers his interest in a given piece of
property to the mortgage concerned and no one else. When the property has already been mortgaged once
to another creditor it is known as second mortgage. When the mortgagee transfers his interest by way of
mortgage it is called sub-mortgage. Mortgage loans maturity period varies from 15 years to 25 years.
The market for mortgages can be arbitrarily divided into: (a) Primary Market, (b) Secondary Market.
Primary market consists of original extension of credit and secondary markets have sales and re-sales of existing
mortgages at prevailing prices.
In India, market for residential mortgages is significant. The two major institutions providing mortgage
loans for purchase of houses are Housing and Urban Development Corporation (HUDCO), and Life Insurance
Corporation (LIC). HUDCO finances residential projects located near commercial or industrial sties. It provided
loans for co-operative housing societies also. The market for residential mortgages is quite inadequate although
supported by institution in its present position in India.
The second form of mortgages is land mortgages both in rural and urban areas. The land development
banks provide cheap mortgage loans for development of land including purchasing of equipment like tractors,
machinery and pump-sets. Land development banks obtain resources at concession rates from RBI and other
institutions and also get subsidies from government but land development banks also face inadequate resources
and cannot always help in conditions of shortages.
As a part of the mortgage market it may be mentioned that the land development banks issue debentures
which are secured by mortgages of land by borrowers and are often guaranteed by State Governments in
respect of payment of interest and principal. These debentures are treated as trustee securities and are on par
with government securities for making advances. They are transferable and can be used as security against
borrowings. The agriculture debenture market is fully dependent on institutional investors like LIC and commercial
banks to purchase these debentures so that individual savings can be channeled through this market. Funds in
this market are also derived through direct and indirect budgeting support. Rural debentures are being floated
since 1957. Special Development Debentures have become the major source of development loans during
1970. This discussion now brings forth some aspects of the Foreign Exchange Market.
6. Foreign Exchange Market

The Foreign Exchange Market is for transacting business between different countries. The different kinds
of activities are interbank dealings between ADs, exchange brokers and Central Bank. Business with banks
abroad is part of Foreign Exchange Market. ADs open branches in the overseas market to carry out business
abroad. Apart from ADs, the Central Bank also licenses hotels and other individuals as AMCs or Authorised
Money Changers. The money changers are categorised as: (i) full-fledged money changers, and (ii) restricted
money changers. The restricted money changers can purchase only foreign currency notes, coins and travellers’
cheques whereas the former category has a right to both purchase and sale to the public.
Foreign institutional investment has an important role to play in a country. These are pension funds,
Investment trusts, asset management companies and portfolio managers. They usually invest in developing
countries because they are able to get higher rates of interest than in their own developed infrastructure.
Companies also raise funds through the floatation of their bonds and equities in the euro capital markets. The
two instruments which are popularly floated by them are Global Depository Receipts and Foreign Currency
Convertible Bonds.
Foreign capital has also come into India through trust companies which raise funds for investments in
Indian securities. The first offshore fund was floated by the UTI in collaboration with Merrill Lynch International
better known as India Fund; Morgan Stanley floated Indian Magnum Fund and India Investment Fund. Can
Bank floated the Himalayan fund in collaboration with Indo-Suez Investment Management Asia. SBI Mutual
Fund floated Asian convertibles. Jardinal Flemming floated the India Pacific Fund. Many more funds were also
floated. These are Bombay Fund, India Opportunities Fund, India Liberalization Fund, and Lloyd George India
Fund.
In India, the foreign exchange business is controlled and regulated by the Reserve Bank of India. It has
a three-tier structure consisting of foreign business: (a) trading between banks and their commercial customers,
(b) between banks through brokers, and (c) business with banks abroad. Banks, individuals and institutions
wanting to deal in foreign exchange have to receive formal authority from the RBI. Those engaged in foreign
exchange business are also bound by Foreign Exchange Regulations Act (FERA). Under this Act those banks
dealing in these securities get their formal authorization through licenses. Only banks in the Second Schedule
of Reserve Bank of India Act, 1934, were eligible to apply for these licenses. Banks receiving these licenses are
called Authorized Dealers or (Ads). They are allowed to run foreign exchange business under FERA and are
supposed to help in the smooth flow of foreign currency and try to stop any misuse of foreign currency.
(a) Inter-bank dealings go on between Ads, exchange brokers and central bank. Inter-bank dealings in
India take place in Kolkata, Mumbai and Chennai. (b) Brokers play a significant role in the foreign exchange
market of India. They are licensed brokers under the (FEBAI) or Foreign Exchange Brokers Association of India.
Brokers serve as a link between the banks. All Ads dealings except those with RBI take place through the
brokers. The brokers get a small percentage of brokerage fees. (c) Business with banks abroad is also a part
of Foreign Exchange Market. Ads open branches in the overseas market to carry out business abroad.
Apart from ADs, the RBI also licenses hotels and other individuals as AMCs or Authorized Money Changers.
The money changers are categorized as: (i) full-fledged money changers, and (ii) restricted money changers.
The restricted money changers can purchase only foreign currency notes, coins and travellers’ cheques whereas
the former category has a right to both purchase and sale to the public.
Foreign capital in India has acquired an enlarged role since 1991. The new areas of foreign capital flow
are direct foreign investment, non-resident Indian investments, Foreign Institutional investments, Euro Issues
and Offshore Mutual funds. A foreign investment promotion board has been set-up for automatic approvals to
proposals. RBI has relaxed its rules for approval. It gives automatic approvals to trading houses for foreign
investment if the company is registered as an export house. Major incentives are given to foreign collaborations
in the area of power generation and promotion of agriculture. Non-Resident Indians (NRIs) have been given
many relaxation facilities for promotion of business in India.
Foreign Institutional investment has an important role to play in India. In 1994 there were 165 foreign
investment institutions in India. These are pension funds, investment trusts, asset management companies and
portfolio managers. Indian companies also raised funds through further relaxations by government. They
floated bonds and equities in the Euro Capital Markets. The new instruments floated in the stock market to raise
equity are the American depository receipts, Global depository receipts and European depository
receipts.
The Sadhani committee report was made on foreign exchange market reforms in India in 1995. In 1997
the Tarapore committee report was made on ‘capital account convertibility’ and the Rangarajan committee
report was prepared on ‘balance or payments’ to make reforms and changes in the foreign exchange market
for a liberal foreign exchange market. These reforms were expected to make trading simple and to increase the
volume of transactions.
In 2005 the RBI constituted an internal technical group for further flexibility in foreign exchange transactions
and freedom for carrying on business transactions. Reforms were instituted for commercial banks for increasing
trading volumes. The reforms towards commercial banks were to provide them with more freedom in foreign
exchange dealings. Banks were permitted to extend their closing time in the foreign exchange market from 4
PM to 5 PM. They are permitted to provide capital on actual overnight open exchange positions which was
maintained by them rather than on their open position limits. The technical group also recommended that
besides the popular US Dollars, Pound Sterling, Euro and Japanese Yen foreign exchange non resident deposits
should also be accepted in Canadian Dollars, Australian Dollars and New Zealand Dollars. The non-resident
entities were allowed re-booking and cancellations of forward contracts booked by residents. They were permitted
to hedge in international exchanges. Another reform was to raise the ceiling on investments made by Indians
abroad. The Authorized Dealers were permitted to have foreign currency account of offices set-up by foreign
companies in India with any approval from the RBI.
Foreign capital has also come into India through trust companies which raise funds for investments in
Indian securities. The first offshore fund was floated by the UTI in collaboration with Merrill Lynch International
better known as India Fund; Morgan Stanley floated Indian Magnum Fund and India Investment Fund. Can-
Bank floated the Himalayan fund in collaboration with Indo-Suez Investment Management Asia. SBI Mutual
Fund floated Asian convertibles. Jardinal Flemming floated the India Pacific Fund. Many more funds were also
floated. These are Bombay Fund, India Opportunities Fund, India Liberalization Fund, Lloyd George India
Fund. Let us now view the government gilt edged securities market.
7. Government (Gilt-Edged) Securities Market
The Government Securities Market in India is an integral part of the Stock Exchange. Apart from the
government securities, the stock exchange also deals in industrial securities for which it is better known.
In India there are many kinds of government securities. These are issued by the Central Government, State
Government and Semi-Government authorities including City Corporation Municipalities, Port Trusts, Improvement
Trusts, State Electricity Boards, Metropolitan Authorities and Public Sector Corporations. The development
banks and agencies are also engaged in the issue of these securities. Included in this category are the IDBI,
IFCI, SFCs, SIDCs, ARC, LDBs and Housing Boards.
The Government Securities Market consists of various kinds of participating institutions. Apart from the
major contributions of the government agencies who are issuing securities, there are other participants also.
They support the issuing institutions. These are: (a) the banking sector. They include RBI, SBI, commercial
banks and co-operative banks, (b) LIC, (c) Provident Funds, (d) other special financial institutions, (e) joint
stock companies, (f) local authorities, (g) trusts, (h) individuals, resident and non-resident.
The most active participation in the government securities market is of the banking and corporate sector.
They purchase and sell large quantities of government securities. Apart from these two sectors, government
selling is extremely limited. LIC, UTI and other special financial institutions are rarely active in this market. The
reason for this is the special kind of policy formation of these organizations. They prefer to hold securities till
maturity rather than sell them at an earlier date to make profit. For these reasons, the government securities
secondary market is quite dull. Whatever limited dealings are held is confined to Mumbai Stock Exchange.
The role of brokers in marketing government securities is also limited. In fact, there is no individual dealer
especially for the purpose of government securities. Broker’s firms dealing in other securities also include
government selling as a part of their function in the stock market. The brokers receive ‘over the counter’ orders
from their customers locally. They have to negotiate each purchase and sale separately. Anyone who purchases
government securities from brokers holds it till maturity. The broker thus acts like a mere jobber. He, however,
keeps in contact with RBI, LIC and other institutional investors.
Government securities are issued in denominations of ` 100. Interest is payable half-yearly and it is
exempted from income tax up to ` 3,000 and wealth tax up to ` 1,50,000. Financial institutions and commercial
banks maintain their secondary reserve requirements in the form of these securities. Against collateral of these
securities, commercial banks obtain accommodation from the Reserve Bank of India. Since, it is the most
secure financial instrument guaranteed by government, it is called a ‘gilt-edged security’ or ‘near gold’, or
‘ultimate liquidity’.
The government securities are in many forms. These are: (a) Stock Certificates (SC) or inscribed stock,
(b) Promissory notes, (c) Bearer Bonds which are now discounted. Promissory Notes of any loan can be
converted into stock certificates of any other loan or vice versa. These are, therefore, most popular. Government
issues are sold through the RBI’s Public Debt Office (PDO) while Treasury Bills are sold through auctions. The
method of selling government securities is through notification before the date of subscription. Subscription is
kept open for two or three days. RBI makes an announcement after which it suspends the sale of existing loans
till the closure of subscriptions to new loans. Government can retain up to 10% in excess of notified amounts.
Applications are received by the RBI and in the different States in the country by the State Bank. Over-
subscription to loans of one state is transferable to another state government whose loan is still open subscription
at the option of the subscriber.
Government securities obtained through subscription help the exchequer to obtain inexpensive finance.
The RBI being the Central Bank of the country is able to fix interest rates on government borrowing and selling
and able to influence the behaviour of prices and yields in the gilt-edged market. Thus, RBI can execute its
interest rate policy through changes in the bank rate and control the advances policy and liquidity of commercial
banks. The government gilt-edged securities market is, therefore, considered important from the point of view
of monetary management. There are many reforms in the government securities market.
The Fiscal responsibility and budget management Act 2003 was passed. This Act proposed to separate
debt management and monetary operations within the RBI. The open market operation of the RBI would
become its focus and it would withdraw its participation from the primary issues of the government securities.
In 2005 a technical group on securities market made several recommendations. These were – (a) Primary
dealers would be allowed to underwrite hundred percent of each government auction both in the whole sale
and retail segment. (b) RBI would be permitted to participate in the secondary market for improving liquidity
in government securities. (c) There would be an effective transparency through monitoring and surveillance
through the negotiated dealing system.
As a part of the reform process the government securities would be on a negotiated dealing system which
is an electronic order matching trading module for government securities. All orders would be matched on price
and time priority and trade would be settled through the Clearing Corporation of India.
The Securities Trading Corporation of India was set-up with all India financial institutions and RBI for
developing and supporting the secondary market for government securities. Two way quotes were introduced
through Primary Dealers.
Retail trading of government securities was started in select stock markets. Private sector mutual funds,
finance companies and individuals were permitted to participate in the government securities market.
8. Industrial Securities Market
The Industrial Securities Market consists of two complementary parts, i.e., the New Issue Market (NIM)
and the Stock Exchange. The New Issue Market deals with those securities which are issued to the public for
the first time. The stock exchange is a place for secondary sale of securities. These are securities which have
already passed through the NIM and are quoted in the stock exchange, thus, providing continuous and regular
market for buying and selling of securities in India. This is discussed in chapter 3 in detail.
9. Industrial Securities
The most important component of the Industrial Securities Market comprising the New Issue and Stock
Exchange Market are the ‘Industrial Securities’ themselves. This is the physical or tangible asset through which
the market functions. The three types of securities through which the corporate sector raises their capital are:
(a) Equity Shares or Ordinary Shares or Common Stock. (b) Preference Shares, and (c) Debenture or Bonds.
(a) Equity Shares or Ordinary Shares: These are also called variable securities. From the point of
view of the company it is advantageous to issue these securities as payment of dividend is not mandatory. The
investors’ view is that this is the best type of investment as the shareholdings can be converted into cash.
Further the investor also participates in the earnings and wealth of the company.
(b) Preference Shares: These are called fixed interest bearing securities of several types. The preference
shareholders are entitled to claims before ordinary shareholders but after fulfilment of creditors’ shares. The
operating preference shares are: (a) Cumulative and non-cumulative. Most Indian preference shares have a
fixed dividend with cumulative rights. (b) Redeemable and irredeemable. Redeemable preference shares with
varying maturity periods are the usual form of shares issued in India. (c) Participating and non-participating.
Participating shares are not issued in India. In India preference shares are not very popular.
(c) Debentures or Bonds: In India, debentures derived importance only since 1970. There are various
kinds of debentures in the market. These are: (a) registered, (b) bearer, (c) redeemable, (d) perpetual,
(e) convertible, and (f) right. In India, the pattern of debentures quoted in the stock exchange show that the
prevalent ones are redeemable and convertible debentures. Normally, the face value of a debenture is ` 100.
In India, the convertible debentures have become significant. These debentures can be converted into ordinary
shares at the option of the shareholders after a certain number of years. Right debentures are also being issued
but generally financial institutions and trusts purchase these debentures.
The bond market in India is not well developed but the bonds issued by public sector financial institutions
were quite popular with the public. Since 1985 public sector institutions have been encouraged to borrow
directly from the public. This had led to the issue of bonds by mutual funds and financial institutions. In recent
years the Bonds issued by IDBI have received overwhelming support of the public and have been oversubscribed.
Banks issue infrastructure bonds for giving tax relief to people. These have a great response in the month of
March every year.
(i) New Issue Market: The New Issue Market according to Henderson has three important functions.
These are: Origination, Underwriting and Distribution. 1 The NIM facilitates the capital market to raise long-term
funds for industry. New issues are further classified as ‘initial’ issues and ‘further’ issues. Initial issues are
capital issues offered for the first time by a new company. Initial capital can be raised only through equity or
preference shares. When existing companies raise issues, it is called ‘further’ capital. Such organizations can
raise debentures.
There are various methods of issuing fresh capital. They are issued through prospectus, offer for sale,
private placement, stock market placing, and rights issues. In recent times book building and bidding for new
issues has become the method for subscription of shares.
SEBI has introduced many reforms for regulating pre issue and post issue activities in the New Issue
Market. It has also tried to bring in reforms to protect the interest of the investors. It has tried to regulate the
dealings on the stock exchange. Some of the reforms consist of free pricing and book building method of
floating shares, code of conduct and regulations for merchant bankers, underwriting made non
compulsory, and allotment of shares within 30 days of subscription.
(ii) The Stock Market: In India, there are 24 recognized Stock Exchanges but the National Stock Exchange
and Bombay Stock Exchange are the two active stock markets. The regional stock markets found it difficult to
survive with the entry of NSE in 1994. Most of them have become the institutional members of the NSE and BSE
by setting up subsidiaries of their own. Members of such stock markets can do business both in NSE and BSE
as well as their regional stock market. Some of the large stock markets in India are discussed below:
1. Henderson, R.J., New Issue Market and Finance for Industry, 1951. Read for a detailed account, p. 24.
The main objectives of the stock market are to provide ready marketability, liquidity, negotiability,
control of dealings and protection of interest to investors. In the Stock Exchanges only listed securities
are allowed to be traded. Listed securities are ‘cleared’ and ‘non-cleared’. To get listing, arrangements have to
be made by observing certain rules. These are: (a) memorandum of association should be filed with SEBI,
(b) public subscription should be offered through prospectus, (c) prospectus should conform to the rules,
(d) allotment of shares must be fair and unconditional, (e) listing agreement must be executed. Securities after
listing can be branded as cleared securities only if they comply with certain requirements. They will be put on
the clearing list if they are fully paid-up equity shares, of non-banking companies, being traded in the stock
exchange for at least three years and should not be on the cleared list of any other stock exchange. The shares
have to be registered with SEBI and listing has to be approved by it.
The Securities Exchange Board of India (SEBI) has been established as a statutory autonomous body
protects the interest of the investors and develops and regulates the securities market.
Trading in the stock market can be by ready delivery or through a future date. Derivatives have been
introduced. This implies buying or selling of certain goods at some future date on which date the transaction
is to be settled. Derivatives in India are through shares, commodities and foreign exchange.
The Money Market and Capital Market have been discussed above. The distinctions between them are the
following:
Table 2.2 MONEY MARKET AND CAPITAL MARKET
Money Market Capital Market
It is a market for financial assets of less than It is a market for long-term financial investments.
one year maturity.
It is a market for those assets, which can be converted It is a market for shares, debentures and mutual fund
into cash immediately at a small transaction cost. investments. There are 23 stock exchanges in India.
Examples inter-corporate deposits, treasury bonds, NSE and BSE are the most popular. SENSEX is the
commercial papers and bills and CD’s. most popular indicator.
It is a market whose participants are large institutional Capital market is categorized as Primary Market
investors who deal in short-term instruments. There or New Issue Market for first time issue of securities and
is no separate category for call money market like Stock Exchange or Secondary Market for sale of second
primary market and secondary market. All short hand securities. Individual investors and institutions
term transactions are executed. both operate in the market.
The volume of transaction is very high. Volume of transactions is high but less than money
market.
(iii) Commodity Markets

In India there are three national level commodity exchange markets. These are National Commodity and
Derivatives Exchange of India Ltd. (NCDEX), Multi Commodity Exchange of India (MCX), and National Multi
Commodity Exchange of India Ltd. (NMCEIL). These exchanges deal with commodity derivative trading like
gold, silver, mettles, wheat and rice. In India only futures trading is performed.
Commodity futures are used by agricultural producers and industrial raw material users to hedge price
risks. The participants who purchase commodity futures try to lock a future fixed price to hedge against future
price rise. The sellers of commodity futures try to lock a price which can be realized against delivery and the
future date.
India was known for its commodity derivatives in agricultural products, raw materials and precious metals
up-to 1960. However, government banned commodity futures trading in mid sixties and it only got established
in India after liberalization. In 2003, national level commodity exchanges were instituted to offer trade in
commodity futures. 78 commodities were allowed to trade in futures.
The potential of the commodity market in India is approximately three times higher than the equity
markets. It is expected that commodity trade would help in contributing to India’s gross development product
(GDP).
Future settlements can be either through cash settlement or a physical delivery. They are used for hedging
to reduce a particular risk. The classic hedging example is of the price of wheat by a farmer when his produce
is ready for harvesting. When he sells his crop for a future date he locks his price at a predetermined price.
A short hedge requires a short position in a futures market. This is possible when a hedger owns an asset or
is likely to own it and expects to sell it at some time in the near future. A cotton grower is a good example
when he sells his cotton crop even before it is ready for sale, on the expectation that it will be ready in the
next two months. Another example is of people who receive foreign currency in payments after four months.
If he makes a futures deal and the value of the foreign currency increases, he will gain. If the value of the
currency declines, he will make a loss. A long position taken in a future markets is called a long hedge. Maney
companies take a long hedge when they expect to purchase certain assets in future and are interested in locking
the price at present.
A commodity futures market is often considered to be speculative. Commodities are bulky products and
the costs and procedures of handling them are expensive. Therefore, it is difficult to stock them but they can
speculate on the price of underlying commodities. In a competitive market, it is possible to indulge in the
arbitrage activity by simultaneously buying and selling the same commodity in two different markets for advantage
of different prices and thus hedging favourably.
In India there has been a high rate of inflation since January 2008. The Abhijit Sen committee was
appointed to study the commodities market to find out if it had any relationship with inflation. Although the
committee did not find a correlation, futures in soya have been suspended. The RBI has tried to control traders
who have taken speculative positions in overseas markets. Trade has also been suspended in chana (Gram),
potato and rubber. Investors and trader have to square of their positions in May 2008 in India. In 2012,
inflation of commodities has again risen and the position of the market is weak.
2.5 IMPORTANT STOCK MARKETS IN INDIA

In India some of the well known stock markets are the National Stock Exchange, Bombay Stock Exchange,
Inter Connected Stock Exchange of India and Over the Counter Exchange of India.
1. National Stock Exchange (NSE)
The National Stock Exchange was incorporated in 1992 and was given recognition as a stock exchange
in April 1993 and started its operations in June 1994. The objectives of the NSE was:
¾ To establish a nation wide trading facility for all types of securities.
¾ To have an equal access of information for all the investor in the country through an appropriate
communication network.
¾ To provide an efficient and transparent securities market which is fair and equal all the investors.
¾ To use the electronic trading system and meet international standards and benchmarks.
¾ To have book entry settlements as well as enable shorter settlement cycles.
The NSE operates in 3 markets segments. These are:
¾ Wholesale debt market segment which was begun in June 1994.
¾ The capital market segment which started in November 1994 and,
¾ Futures and options segment which started in June 2003.
Ownership and Management: NSE is owned by leading financial institutions, banks, insurance companies,
and financial intermediaries. It is managed by professionals who do not trade in the stock exchange. Its Board
consists of professional senior executives. The board prepares the policy of the stock market. It has executive
committees which were formed under the Articles of Association and rules of NSE for different market segment
to manage the working and administration of the exchange. The executive committees have members some of
which may also be traders in the market. There are several committees. For example, committee on trade
related issues, settlement issues, and regulatory issues. The managing director and CEO is the head of the
professional staff.
NSE was set-up to bring about a nation wide facility of equity debentures and hybrid securities. It is a
fully automated screen based trading system having a wholesale debt market and capital market segment and
future option segment. The equity and derivative segment account for the maximum trading volume. The
system provides full transparency of trading operations.
Wholesale Debt Market Segment: The wholesale debt market segment in NSE offers financial services
of high value transactions. It facilitated transactions for institutions and banks in instruments of public sector
bonds, treasury bills, government securities, units of Unit Trust of India, certificate of deposits, and floating
yield bonds. The trading members of Wholesale Debt Market (WDM) consist of institutional members, subsidiaries
of banks and body co-operates. These members should have a minimum net worth of ` 2 crores and an annual
fees of ` 30 lakhs with a minimum period of membership for 5 years. The securities traded in this segment are
listed at the NSE. In the wholesale debt market sector, NSE introduced trading in Rupees in Government
securities and Treasury Bills, Repo is restricted from 2 to 14 days. A Repo is essentially the sale of a security
but with the agreement that it will be repurchased at a later date.
Capital Market Segment: The trading members of the capital market may be either individuals, registered
firms or institutional members having a minimum net worth of ` 75 lakhs but corporate bodies should have
a minimum of ` 100 lakhs. The members in whole sale debt segment and capital market segment should be
actively engaged in purchase and sale of securities. They should also have a background and experience of
securities. Only securities listed and NSE can be traded. Trading on equity segment takes place on all days of
the week accept Saturday, Sunday and holidays declared by NSE. The market timing of NSE is 9:55 AM to
15:30 hours.
Futures and Options Trading: The NSE deals in many products. It is active in the derivatives market.
It trades in NIFTY Futures, NIFTY Options, individual stock options and individual stock futures. The NSE has
a settlement guarantee system which is like the Chicago Futures Exchange.
Criteria for Listing of Shares: The NSE is very particular that trade is carried out in securities only
after the companies are listed with it. There are strict rules for listing of shares. A new company can list its
shares if it has an equity capital of more than 10 crores and its market capitalization is not less than 25 crores.
The application for listing should be from a company which has at least a 3 years good past record. For existing
companies entry to NSE can be gained if such a company was listed on any other recognized stock exchange
for a minimum of 3 years or it should have a net worth of 50 crores. It should have paid a dividend in 2 out
of last 3 financial years. The NSE started equity trading functions since November 1994. It provides listing to
only those companies which have a minimum paid up capital of ` 10 crores.
Settlement of Securities: The NSE clears and settles its securities according to a periodic settlement
cycle. The trading period begins on Wednesday and ends on Tuesday; in the following week settlement is made.
For all outstations the NSE is the only stock exchange for inter bank securities. It also enters into Government
securities, treasury bills, public sector bonds and units. The settlement on the Retail Debt Market is on T+2
rolling basis. That is on a second working day for arriving at the settlement day all holidays are excluded. If
trade takes place on Monday, it is settled by Wednesday. Clearing and settlement is based on netting of the
trades in a day. In NSE trade in rolling settlement are settled on a T+2 bases. The National Securities Clearing
Corporation Ltd. (NSCCL) is the clearing and settlement agency for all deals made at the NSE.
Nation Wide Trading: The National Stock Exchange provides the service of trading securities at the
same price at any stock exchange in the country. The NSE brokers can link themselves to the automated
quotation system and allow brokers to buy and sell electronically. NSE operates on National Exchange for
Automated Trading (NEAT) system. Equipped with the data of the National Stock Exchange the price data will
be broadcasted by Press Trust of India. The National clearing house will be able to give information about the
owner of the scrip and the number of scrip owned by a specific person.
NSE provides many services and index related services and products. Its main index is the 50 shares S
& P CNX NIFTY. The index consists of 50 companies representing 25 sectors of the economy. It represents 47%
of the traded value of all stocks on the National Stock Exchange in India. It is calculated as a weighted average,
so the changes in the share prices of large companies have an effect. The base is defined as one thousand at
the price level of November 3rd 1995 when the market capitalization total was 20,60,000 million.
Developments in NSE: NSE has launched internet trading services since 2000. In the same year it
started index futures derivatives trading. In 2001 it began trading in Index Options, and Options and Futures
on individual securities. In 2002 it launched the exchange traded funds and NSE government securities index.
It also won the Wharton-Infosys Business Transformation Award in organization wide transformation category.
In 2003 it started trading in Retail Debt Market. It also started trading in Interest Rate Futures and in 2004 it
began the electronic interface for listed companies. In 2005 it instituted the Futures and Options Bank NIFTY
Index. In this way the NSE has continuously tried to develop new activities and it ranks amongst the largest
stock markets in the world.
2. Bombay Stock Exchange (BSE) Mumbai
The Bombay Stock Exchange was established in 1875. It is situated in Dalal Street Mumbai. It is the oldest
stock exchange in Asia.
Origin: It was started with stock brokers trading under the banyan tree opposite the town hall of Bombay.
This group of stock brokers formed an association called The Native Share and Stock Brokers Association and
1875, it became of a formal stock market. In 1928 BSE was shifted to Dalal Street. It is the first stock market
in India which got permanent recognition from Government of India under the Securities Contract Regulation
Act 1956. In 1955 BSE became screen based trading system.
Index: The BSE Sensex is the most popular value weighted index. It is composed of 30 companies with
April 1979 = 100 as its base. The companies in the sensex are about one fifth of the market capitalization of
BSE. BSE uses other stock indices besides the popular sensex. These indices are BSE-100 and BSE-500.
Sensex was introduced in 1986 which has become the barometer of the movements of the share prices in the
stock market. It is a market capitalization weighted index. It reflects the total market value of all 30 stocks from
different industries. The total market value is determined by multiplying the price of the stock with the number
of shares outstanding. The daily calculation of sensex is done by dividing the aggregate market value of the
30 companies in the index by a number called the index divisor. The divisor is dealing with the original base
period of sensex.
Importance: BSE has been a pioneer in many areas. It was the first stock market to introduce Equity
Derivatives. It introduced Free Float Index. It enabled the internet trading platform. It was the first to obtain
the ISO certification for Surveillance, Clearing and Settlement. It had the facility for financial training and it
was the first stock market to become electronic. It also launched the nation wide investor awareness campaign
and dissemination of information through print and electronic media.
BOLT: The BSE Online Trading System (BOLT) started in March 1995 to bring about transparency and
liquidity and to increase market depth. It was started to eliminate mismatches and settlement risks. It brings
about dissemination of information and volumes in trade.
Investor Protection Fund: BSE has set-up an investor protection fund since 1987 to help the investors
against defaulting members. The fund is managed by the trustees appointed by the stock exchange. The
members contribute to it. The stock market contributes 2.5% of the listing fees collected by it. The stock market
also credits the interest on securities deposit kept by it with companies making a public issue. The exchange
also released 5% of its surplus to this fund. The maximum amount payable to an investor from this fund in
the case of default by a member is ` 10 lakhs. There is a defaulter committee which finds out the genuineness
of the claim. It is then released by the trustees of the fund.
Investor Education and Training: BSE has been giving a lot of attention to investor education and
training. It provides safety and security in the capital market mechanism to ensure investor protection. It
provides financial assistance up to ` 1 crore to recognized investor associations for their development expenditure
towards investor protection measures. It has set-up an Investor Assistance centre in many cities. These centres
provide redressal of investor grievances and information and other facilities to investors. BSE has trend more
than 20,000 investors on the capital market mechanisms in the BSE Training Institute. It brings out many
publications providing information to the investor. It has arranged seminars and lecturers for creating awareness
among investors. It is associated with professional bodies. It has initiated many research projects in collaboration
with the management institutes. Its websites bseindia.com provides information on capital markets. It uses
audio-visual media and internet for education and training of investors.
BSE has collaborated with ZEE Interactive Learning Systems to provide knowledge, information and
awareness through structured training on various aspects of the capital market to investors. The collaboration
would have a pilot series of 26 episodes and it will be aired 3 times in a week. The television series would
be called the BSE investor awareness program.
Corporatization and Demutualization: The Securities and Exchange Board of India (SEBI) has approved
the scheme for corporatization and demutualization of the stock exchange. The stock market would become a
company limited by shares. The ownership and management of BSE Ltd. would be separate from the trading
rights of the members. The initial membership will be from cardholders of BSE who will become its share holder
and can also become their trading members. A trading member of BSE will also become a trading member of
BSE Ltd. After the organization they will be only one class of trading members with similarity in rights. There
will be uniforms standards in capital adequacy, deposits and fees. The governing board would be constituted
in a manner that the trading members do not exceed one fourth of the total strength of the government board.
The existing assets and reserves would be transferred from BSE to BSE Ltd. There would be at least 51% of
equity shares held by public other than the share holders which have trading rights.
3. Over the Counter Exchange of India (OTCEI)
Formation: OTCEI is a unique experience in India. It was established in October 1990 under section 25
of the companies Act 1956. The objective of setting up the OTCEI was to have a recognized stock exchange
under the securities contract regulation Act of 1956. It was to be the first screen based and automated exchange
and to replace the ring system with the ring-less trading system. Its focus was to have transparency in transactions
and to help new projects or existing companies to expand their activities by raising capital in a cost effective
manner. It was formed through a consortium of financial institutions like UTI, ICICI Bank, IDBI, IFCI, LIC, GIC,
SBI and Can Bank Financial Service Ltd.
Listing: OTCEI was set-up for small and medium size companies. Companies applying to OTCEI for
listing should be ‘public limited’ having a minimum equity capital of 30 lakhs and maximum of 25 crores.
Companies with an issued capital of more than 3 crores must be listed with OTCEI. The minimum offer made
to public should be 25% of the issued capital or equity shares of the face value of ` 20 lakhs whichever being
highest. The OTCEI has trading of listed securities, permitted securities and initiated securities. Instead of
brokers it has ‘members’ and ‘dealers’. Only members can be ‘sponsors’ and can help in getting the shares of
a company appraised by him. He performs pre issue and post issue functions and does voluntary market
making. OTCEI network is nationwide. Sometimes listing can be done through ‘bought out deals’. In this case
a member/sponsor/merchant banker agrees to buy the entire equity from the company. He then sells the shares
of the company later through offer for sale method. Through this method, listing can be done immediately
without any past records of profitability. The sponsor can sell the shares at par or at a premium. He can hold
the shares for a long time as there are no restrictions. He can sell them whenever he finds the market and price
appropriate for the sale.
Participants: Members and dealers can both engage in voluntary market making (VMM) and additional
market making but dealers cannot act as sponsors. A member of the OTCEI should have a good organizational
set-up. The members may be merchant banks approved by SEBI, mutual funds, banking and financial institutions.
A dealer should be an individual, a firm or a corporate body with a net worth of 5 lakhs and sound capital
packing. Members have to pay non-refundable fees of ` 20 lakhs and annual subscription of ` 1 lakh. Dealers
have to pay ` 6 lakhs on admission and ` 5000 yearly.
Market maker: A market maker provides liquidity by buying and selling securities. He analyses companies
and provides information to investors. There are 3 kinds of market makers. These are compulsory market
maker, additional market maker and voluntary market maker. The market makers generate investor’s interest
by quoting the buying and selling rates and creating a competitive environment.
Trading mechanism: The trading mechanism on OTCEI is quite different to other stock exchanges. It is
based on a created tradable document called counter receipt (CR). Share certificates have to be converted to
CR to begin trading. A Sale Confirmation Slip (SCS) is given to an investor when he sells the CR and the
transaction is completed.
A listed company may either make a direct sale to the public or offer for sale and bought out offer. In
a direct public issue a sponsor does not have to take any shares. If the sponsor takes up shares he can offer
these later to the public and the price can be in accordance with the OTCEI.
If an investor purchases a security at a public offer he is issued a counter receipt which gives information
about the investor as well as the company, share price, date of transaction, brokerage and total value of
transactions. When an investor wishes to sell the security he has to produce the counter receipt (CR).
Transfer process: The transfer procedure is little different to other stock exchanges. The transfer and the
transferee signs separate transfer deeds. The registrars of the company match the two transfer documents and
execute the deal. The OTCEI has a 5 day trading cycle. As the exchange does not allow short selling or forward
buying the deals are concluded at the time of confirmation.
The advantage of OTCEI is that the small and medium companies are encouraged. It is cost effective and
it has nationwide trading by listing only one stock exchange. The transactions are fast and investor friendly with
single window request. It is computerized and it is traded through permanent counter receipt. It has an OTC
Index based at 100 since 23rd July 1993. Only listed equities are included in the OTCEI compose it index.
One of the ‘over the counter exchanges’ operating in U.S.A. is called National Association for Securities
Dealers Automated Quotation (NASDAQ). The majority of the shares traded in it are those of software companies.
4. Inter-connected Stock Exchange (ISE)
The Inter-connected Stock Exchange of India Ltd., is a National level Stock Exchange and is promoted
by 15 Stock Exchanges in India. It was set-up as a trading facility at regional stock market inter connected with
the national market. ISE provides protection and support required for trading, clearance, settlement and risk
management.
Inter-connectivity: Inter-connectivity of Stock Exchanges is a mechanism to enable a trader member
broker of any participating exchange or a dealer trading member who is directly enrolled by ISE to deal with
another trader or dealer through his own Local Trader Work Station. All trading members have to satisfy the
capital adequacy requirements of ICSE separate from the requirements of their regional stock exchange.
Clearing: ISE has appointed ABN-Amro Bank and Vysya Bank as the Central Clearing Bank to ensure
that all collection and movement of funds is centralized. The margin in the inter-connected market would be
collected by directly debiting the accounts of the Traders or Dealers in the Central Clearing bank. This account
at the Central Clearing Bank acts as a control account for monitoring margin collection and risk management.
The funds collected during the settlement are adjusted during pay-in and pay-out of that settlement.
Listing: Only listed security can be traded on the stock exchange. The listing agreement between a
company and SEBI has to be filled by providing disclosure of information and payment of listing fees. The
security can be traded at all the stock markets which are inter-connected ones it is listed on a regional stock
market.
5. National Commodity and Derivatives Exchange Limited (NCDEX)
In 2003 the NCDEX was formed as an online multi-commodity exchange. It is recognized by government
of India as a national level exchange in commodities. It has eight shareholders. These are Canara Bank,
CRISIL, ICICI Bank Ltd., Indian Farmers Fertilizers Co-operative Ltd., and Life Insurance Corporation of India,
NABARD, National Stock Exchange and Punjab National Bank. NCDEX trades in 45 different commodities it
covers agricultural commodities, bullion, energy and metals. The forward market commission is the regulator
for commodities exchanges in India. It provides sport prices of commodities traded on the exchange. It has
participated in many pilot projects for encouraging farmers to hedge their price risk. It works in an electronic
mode. It has dematerialized system for settlement of trades through National Securities Depository Ltd. and
Central Depository Services Ltd.
2.6 FINANCIAL INSTITUTIONS

The various financial markets in the country which have been briefly described have several supporting
financial institutions and development banks. The date of origin and growth of these special institutions during
the post planning period have already been studied. Let us now look at these institutions in their individual
capacity, their functions and growth and relevance in the economy briefly. The first of the institutions that we
take up is the apex institution that is Reserve Bank of India.
1. Reserve Bank of India
The Reserve Bank of India is the nerve centre of the monetary system of the country. It is the Central Bank
of the country and it started operating since April 1, 1935 subsequent to the RBI Act in 1934 under private
shareholders’ institutions. The Central Government is now empowered to appoint Directors, Deputy Governors
and Governors of the bank. The position of the bank is that it is a State-owned institution. This transfer to
public ownership from private shareholders’ institution came with the RBI Act in 1948.
The Reserve Bank of India is empowered to control, regulate, guide and supervise the financial system
of the country through its monetary and credit policies. This authority was derived from the various acts. These
are RBI in 1934, Banking Regulations Act 1949, Companies Act 1956, Banking Laws Act 1965 (applicable to
co-operative societies), and Banking Laws Act 1963.
The Reserve Bank of India has several functions to perform. Traditionally, it is the bankers’ bank, and
banker to State and Central Governments. It is also a banker to the commercial banks, State co-operative banks
and financial institutions of the country. It is the only bank engaged in the issue of legal tender currency.
RBI also performs development functions and controls the monetary policy of the country. Amongst the
development or promotional roles it has improved the banking business by integrating the organized and
unorganized sector of the money market. It has acted as a leader in implementing the ‘Lead Bank’ scheme.
It also tried to bring appropriate geographical diversification of bank branches. To give adequate security to
banks and their customers it created the Deposit Insurance Corporation in 1962.
The RBI has also played a role in the country’s agricultural sector. It conducted an All-India Rural Credit
Survey in 1954 and Rural Credit Review in 1968 to study the problems of rural credit. It provides agricultural
credit through State Co-operative Banks to Co-operative Banks for short-term purposes for marketing of crops.
It provides long-term credit (a) by subscribing to debentures of Land Development Banks, (b) by operating the
National Agricultural Credit Fund, (c) National Agricultural Credit (Stabilization) Funds (long-term operation
fund), (d) it has also established the Agricultural Refinance Corporation through which it gives long-term and
medium-term funds.
In the institutional financial structure the RBI played an important development role. The IDBI was started
as a wholly-owned subsidiary of the Reserve Bank of India in 1964. The Unit Trust of India was also originally
an associate institution of the RBI. All the other financial institutions and development banks have been
provided technical consultancy, financial help and guarantees at the times of formation and growth.
The RBI has under its command the entire economic situation in the country. To fulfill this role, it regulates
the monetary policy of the country, it uses three kinds of techniques: the bank rate technique, modified as the
‘quota-cum-slab’ system and ‘net liquidity ratio’ system. By using these systems the RBI charges differential
interest rates from different banks to raise the cost of refinance on the basis of the level of liquid assets
maintained by different banks without changing the level of bank rate to maintain stability in the government
securities market. RBI also operates a Credit Authorization Scheme since 1965 to regulate the volume and
distribution of bank credit. The RBI also uses selective credit controls on sensitive commodities like food-grains,
cotton and oilseeds and since 1970 it has resorted to a reserve ratio technique for controlling the monetary
policy which is the cash ratio maintained by banks. Finally, the RBI resorts to the ‘moral suasion’ technique
most actively and effectively for regulating the economy. Let us now give a brief description of the commercial
banks in India.
Since 1992 the RBI has carried out many reforms and promotional measures to strengthen the banking
and financing system in India. It has focused on efficiency and profitability of banks and has streamlined
measures to bring about the discipline in protection of depositors. The RBI has issued guidelines on asset
classification, income recognition and capital adequacy of commercial banks.
The RBI has announced the entry of new private sector banks since January 1993 to provide efficiency
profitable and protection to investors it has issued guidelines for the scope of banking of private sector banks.
It has also allowed the entry of foreign banks and joint sector banks.
The RBI has also in pursuance of Narsimhan committee report gradually reduced the cash reserve ratio
and statutory liquidity ratio of banks. It has tried to reduce control and allowed financial institutions and banks
to mobilize their resources according to capital market related arrangements. It has deregulated the interest
rates as a measure of liberalization since 1991.
2. Commercial Banks
The commercial Banks are the oldest institutions in the financial market in India. The structure of banks
is shown in Table 2.3.
Table 2.3 STRUCTURE OF BANKS IN INDIA
STRUCTURE OF BANKS IN INDIA
Scheduled Banks Non-Scheduled Banks
State Commercial Central Co-operative Commercial

Co-operative Banks Bank and Primary Banks
Banks Credit Societies
Public Sector Private Sector

Banks Scheduled Banks
There are many kinds of banks. These are categorized under scheduled and non-scheduled. Commercial
banks can be both scheduled and non-scheduled and in the public and private sector. Further, they can be
Indian or foreign banks. Scheduled Banks are those which are included in the Second Schedule of Banking
Regulation Act 1965 Scheduled banks are required to maintain a certain amount of reserves with the RBI in
return for which they have the facility of financial accommodation and remittance facilities at concession rates
from the RBI.
Banks in India have been traditional in providing credit to industry. They have given short-term credit for
financing working capital requirements. They have provided finance through loans, cash credits, and overdrafts,
demand loans, purchasing and discounting commercial bills, installment and hire purchase credit. Bank credit
in India has often been used for holding excessive inventories for earning speculative profits which have been
responsible for inflationary pressures in the country. Banks in India have also given credit for long-term
purposes since 1951. They provide demand loans for short-term and term loans for long-term. In 1974, the
Tandon Committee decided to separate the demand loans into demand credits and variable credits. The
demand credit is to have a minimum level of borrowing which the borrower is expected to use throughout the
year. This is called the ‘core’ portion of credit. The borrower is supposed to pay interest on the entire amount
of demand loan and on the utilized part alone only on the variable cash credit. The Tandon Committee
suggested that the rate of interest on demand loan should be lower by one per cent than the rate on variable
cash credit.
Term loans for long-term are advanced for purchasing fixed assets. Commercial banks have the facility of
refinancing themselves from the IDBI but very few banks used this facility till 1970. Term lending by banks has
increased quantitatively since 1974-75. Banks have been lending to (a) public and private sectors, (b) rural and
urban sectors, industrial agricultural and commercial sectors, large-scale and small-scale sectors.
Apart from term lending and demand lending the commercial banks are engaged in other functions and
it helps new issues in more than one way.
Traveller’s cheques and cash credits: Banks provide funds to people in the course of travel through
traveller cheques for purposes of security and ease. Credit cards can be used instead of giving cash at a
particular place. These credit cards system is a form of giving credit to the customers and the ability to move
with confidence without having to carry cash.
Merchant banking: This activity provides technical consultancy, financial help, and promotion of new
issues and revival of sick units. The first Merchant Banking division in India was opened by Grindlays Bank
in 1969. Many other Indian Banks have started separate Merchant Banking Divisions. Since 1980 banks have
become active participants both in the capital market as providers of finance as well as promoter of industries
on turn key basis. They have also leased out equipments and have been refinanced by IDBI. They are promoting
industry by advising sick units on the methodology of revival as well as by giving development loans at a
rebate.
Mutual funds: Another important development is that commercial banks in India have also started
mutual funds. State Bank was the first to go into the capital market and showed direction to the other
commercial banks. Canara Bank and later on Indian Bank also started mutual funds. Factoring: Commercial
banks have entered into the financial service of factoring. This is a service whereby banks undertake to collect
the debts of their clients by financing them on their credit sales or accounts receivables. Banks take a service
charge by taking a discount from the bills.
Retail banking: Banks have begun to offer credit to consumers for their purchases. Cars and personal
loans as well as loans for purchasing household goods are being offered by banks. In fact the retail banking
has gone to the extent that banks make frequent calls to people to offer loans. A notification was issued by
government that customers could opt for do not disturb registry after which banks would not be permitted
to call customers. In fact they would have to pay a penalty.
Automated Teller Machines (ATMs): Plastic money or the use of credit and debit cards has become
an important feature of banks. Customers can purchase goods through these cards. Money can be withdrawn
through ATMs with the use of the cards. In a debit card money will be debited directly to the customers account
but in a credit card a customer is sent a statement and he pays for the credit taken by him after a gap of 30
days.
The Narsimhan Committee was set-up in 1991 to improve and strengthen bank services in a deregulated
environment in India. It analyzed the banking system and recommended certain reforms to make it internationally
competitive. In 1992 RBI issued guidelines for capital adequacy norms, income recognition and classification
of assets. These changes were expected to bring about international acceptance and professionally managed
structure of the banking system. Certain changes were also brought about in order to simplify the lending rates
of banks. Multiple interest rates were reduced and simplified and market determined rate was to be preferred.
Taking into consideration the new economic policy the cash reserve ratio and statutory liquidity ratio were
reduced to bring about macro economic stability. Repayment of loans and interest payments attached to them
were also streamlined. Through the introduction of a special recovery tribunal the loan recovery process was
activated and expedited.
As a step toward improvement, new banks have been open in the private sector and no further nationalization
of banks would take place. Banks could open new branches without the approval of the RBI and make
improvements to their existing working operations. The entry of foreign banks is permitted in India subject to
RBI guidelines and controls. Joint ventures between Indian and foreign banks are also allowed and such banks
take interest in the financial services like merchant banking and leasing operations. With the implementation
of these changes the focus of banks has changes from target oriented credit distribution to improving their
profitability.
To bring about quality of service to customers, computerization has been introduced and services have
been upgraded. A board of financial supervision has been set-up under Reserve Bank of India to supervise
the functioning of banks and financial institutions. To improve profitability banks have been permitted to
increase their share in private placements of debentures and shares of blue chip companies from 1.5% to 5%
of their incremental annual deposits.
To sum up, the diversification of banking function can be said to be a natural corollary to the changing
concepts of lending and the need to industrialization through advance lending concepts. Basel I is already been
implemented and Basel II norms have to be implemented by the banks in 2008-09 for bringing about capital
adequacy and income asset recognition.
However, with the losses in sub prime loans in the USA the effects spread in different countries. Some
banks in India experienced the problems or side effects of sub prime losses. With globalization there are
interactions and transactions between different banks in the world. Therefore, problems are interconnected and
they affect transactions of banks in different countries.
3. Universal Banks
The term 'universal banks' refers to those banks that offer a wide variety of financial services, especially
insurance. In universal banking, large banks operate extensive networks of branches, provide many different
services. Universal Banks are the one-stop shops. These institutions sell a wide portfolio of financial products
integrating commercial banking term lending, retail operations, investment banking, mutual funds, and pension
funds, insurance and underwriting of issues. Universal bank has the potential to leverage on its large capital
base, comprehensive portfolio of products and services, and technology-enabled distribution. They hold several
claims on firms (including equity and debt), and participate directly in the corporate governance of firms that
rely on the banks for funding or as insurance underwriters.
Universal banks in transition economies can potentially impose a better corporate control structure on the
firms, they can be the source of long-term finance, and they can contribute to real sector restructuring. Among
other countries like Germany, Switzerland, France, Luxembourg, Netherlands and USA, Universal Banking has
been mainly practiced in Germany wherein banks own shares of companies to which they grant loans and thus
are in the position to influence the management of these companies. For example, Deutsche Bank owns 25 per
cent stake in Daimler Benz, one of the largest automotive company in the world. This, on one hand, gives them
better access to the company related information while on the other it reduces the chances of adverse selection
and moral hazards.
Types of Universal Banks: There are four different types of Universal banks in the world as shown in
table 2.2 they are type: (A) Fully Integrated Universal Banks are one institutional entity offering complete range
of financial services that is banking securities and insurance. This system can take the best advantage of the
universal banking system such as the economies of scope optimal location of resources and stability in profits.
This system has certain demerits such as conflict of interest bureaucratic inefficiencies and difficulty in auditing.
In practice full integration is rare. (B) Partly integrated financial conglomerate are those which offers range of
services but some of the range, e.g., mortgage banking, leasing, asset management, factoring, management
consulting and insurance are provided through wholly owned or partially owned subsidiaries. Duteshe Bank is
a good example of this type of universal structure. This type of structure is called the German Type of financial
system. It has been adopted in Germany, France, Italy, Netherlands and Switzerland. (C) In Type C Universal
bank the commercial banks focus on regular functions and have established separate subsidiaries for carrying
out other functions such as Investment banking and Insurance the U.K. type universal banks concentrate only
on commercial banking operations and their subsidiaries deal with securities and insurance related services.
Japanese banks as well as U.K. banks have adopted this system and (D) Is called the U.S. type of universal
bank or holding company structure – where one financial holding company owns both banking and non-
banking subsidiaries that are legally separate and individually capitalized insofar as financial services other than
banking are permitted by law. Under this financial system bank subsidiaries and non-bank-subsidiaries are not
closely related and so advantage cannot be taken of economies of scope. The U.S. type of bank has a strong
point as the losses in one subsidiary do not spread to other subsidiaries.
Generally, the concept of universal bank is based on two financial models. One is German type in which
banks carry comprehensive banking activities including commercial banking as well as other services such as
securities related services and insurance. The other model is British-American type in which “Financial Conglomerates”
offering full range of financial services in accordance with change of financial environment pursue diversification
in securities and investment. In India, we find that “Financial Conglomerates” are emerging. One important
difference among others between the financial conglomerates and universal banking is that while in respect of
financial conglomerates the various activities are undertaken through different- subsidiaries, and in the case of
universal banking, the bank is free to choose the activities it wanted to carry out subject to certain regulations.
Table 2.4 TYPES OF UNIVERSAL BANKING SYSTEMS
(A) FULL INTEGRATION

Universal Bank
Banking Activities Securities Activities Insurance Activities Other Activities
(B) GERMAN VARIANT

Universal Bank (banking activities + securities activities)
Mortgage Banking Insurance Activities Other Activities
(subsidiary) (subsidiary) (subsidiary)
(C) U.K. VARIANT

Universal Bank (banking activities)
Securities Activities Insurance Activities Other Activities
(D) U.S. VARIANT

Holding Company
Banking Activities Securities Activities Insurance Activities

Universal Banking in India: World over Universal Banking refers to an integration of the Commercial
Banking and Investment Banking activities with both equity and debt being provided by the same institution
under one roof. Banks and financial institutions are the most important financial intermediaries, both in developing
and developed countries in the world. In India, post liberalization reforms phase after 1991 has opened up a
plethora of avenues for financial intermediation. The mounting NPA level, falling interest rate spreads and new
capital adequacy norms necessitated the need for long-term strategic planning for survival and sustenance of
banks and financial institutions, in the Indian Financial System. Banks in India were playing the role of short-
and medium-term financing while the financial institutions were involved in long-term project financing. Under
the 1991 reforms, there was a need to devise an innovative financial mechanism to provide adequate financial
support to the industries universal banking has emerged as one of the alternatives that may lend some support
to the ailing banking and financial institutions. By underwriting, investing and trading in securities ICICI bank
made the first step in India to becoming a universal bank.
Universal Banking in India was discussed in two committee reports which were appointed by the Government
namely. The Report of the committee on Banking Sector Reforms (1998) – Narasimhan Committee-II and the
Report of Shri S.H. Khan Committee on “Working Group for Harmonizing the Role and operations of DFI’s
(Development Financial Institutions) and Banks. While Narasimhan Committee-II suggested creation of Multi-
tier banking and one stop financial supermarkets, S.H. Khan Committee suggested harmonization of the role
of DFI’s with the bank to integrate the debt related services whether short-term or long-term under one roof.
Both the committees have drawn upon the factors like transfer of resources from savers to investors across the
globe, exchange of financial assets at minimum transaction cost and risk control.
There are many issues that need to be investigated like improving the corporate governance of banks, the
strengthening of banking supervision, transparency in dealings and customer oriented services. The current
interest to the Government is the issue of harmonizing the role of banks and development financial institutions.
In India, the bank portfolio consists of short-term assets and liabilities whereas the financial institutions have
longer-term assets and liabilities. This is a challenge in the reform process in the management of interest rate
risk, foreign exchange risk, liquidity risk and credit risk.
A brief study of specialized financial institutions is given below. We first take a look at the activities of the
LIC, GIC and UTI better known as investment financial institutions and then study the development banks and
State Financial Institutions.
4. Life Insurance Corporation (LIC)
The LIC was set-up in 1956 after amalgamating 245 companies and was governed by the Insurance Act
of 1938 under Section – 27 A. In 1980, this monolithic institution was again sought to be broken up into four
units because of its unwieldy structure and vast increase in business during the last 24 years. It was also felt
that there was a lack of spirit of competition and more effort was required to tap the savings surpluses from
households both in rural and in urban areas. Under these circumstances, it was finally decided to divide its
operations into four units in 1983 during the parliamentary session.
The LIC’s main aim has been to mobilize the savings of the household and to offer protection against
death and sickness. It has also become a medium for saving tax. The LIC, collects huge resources of funds from
the people. These resources are built into a ‘life fund’ and invested in various types of classes of investment,
to benefit the policyholders in their time of need. LIC continuously plans its investments in such a way that
it has liquid funds for immediate satisfaction of shareholders as well as secured for long-term investments for
the purpose of earning a higher rate of interest. For this purpose LIC has an investment policy in which the
various investment outlets are specified. Within the framework, the investments are made. LIC has its investments
in government securities, public sector, co-operative sector, private sector and joint sector.
LIC has been the largest underwriter of capital issues in the Indian Capital Market till the year 1978 after
which it has reduced its activities in favour of socially-oriented projects. It used to underwrite firm and give
confidence to the investing public to purchase the shares of a company. Its main objective in investing in the
capital market in India was to lend stability to it especially during the down swings in the market.
Socially oriented sector: Since 1970 LIC has been disbursing ‘loans’ for infrastructure and socially
oriented sector. One of the major avenues of investment in 1983 constituted financing through loans for
generation and transmission of electricity for agricultural and industrial use, housing schemes, piped water
supply schemes and development of road and transport. Its activities in the capital market reduced. The
rationale behind this change has been to go in for developmental work. Own Your House (OYH) schemes have
been given priority. Apart from these schemes, loans for sewerage, road and transport and electricity generation
have also been given priority in the recent years.
Influence in private corporate sector: Another direction which the LIC has taken has been to influence
the private corporate sector, by virtue of its shareholding it has been recognized amongst the top ten shareholders
in one out of every three companies listed in the stock exchange in which it has a shareholding. While LIC has
invested in large blocks of equities and in later years in debenture holdings, it had kept away and did not
interfere in the decisions of the management of the past. In recent years, it has influenced the management
to take proper decisions and to tone up the quality of working in the organizations. This is intended to promote
confidence in the minds of the public and to exercise control in the corporate sector as they have a very small
shareholding but are playing a controlling role in their organization. In 1984 LIC has dominated the Indian
industrial scene. One notable instance which may be cited in which it interfered in the policies of the management
has been in the Nanda Group of Companies, i.e., ‘Escorts Ltd.’ These changes in the direction of the policies
of a large institution like the LIC is bound to exert some pressure on the industry and change the complexion
of Indian Industrial scenario.
Withdrawal from capital market: Since 1984 several changes are noticeable in LIC’s capital market
activity. It continued its policy of withdrawing from investment in corporate securities and enlarging its activities
in welfare schemes of the state electricity boards. Consequently their investment in corporate securities declined
from 16% in 1956-57 to 5% in 1986-87 and to 3% in 1992-93 and it has lost the rating of Captive Investor.
Reforms: In 1993 the Malhotra Committee suggested reforms for restructuring regulation and liberalization
of the insurance sector. The committee suggested that LIC’s policies should be made attractive for the small
saver, the insurance services should be improved and LIC should be converted from a monolithic institution
to a public limited company. The private sector should be allowed to enter insurance business with a view to
encourage competition. According to the committee the insurance sector should also have technology up-
gradation and high standards of accounting. It is necessary to institute an Insurance Regulatory Authority (IRA)
as a statutory autonomous board in order to improve the standards of insurance business and provide consumer
protection.
In 1995 government announced an interim IRA to begin functioning and streamlining procedures and
bringing discipline and professionalism in the insurance sector. The interim IRA would have three full time
members and a chairman appointed by government. The chairman would take over the powers of the present
controller of insurance. This team would be assisted by four other members nominated by government. The IRA
was proposed to work under the Ministry of Finance.
Thus, the interest of the policyholders has been given great importance and emphasis by Malhotra committee.
The LIC would fail in its purpose if it is not satisfying the policyholders. Private insurance and foreign companies
would be allowed to enter into insurance business. Joint venture was considered as a responsibility for the entry
of new insurance companies to bring about innovative schemes for attracting policy holders and for linking the
ultimate pool of savers and investors in the capital market in India.
New business offices: As a follow up of the Malhotra committee reforms, LIC has set-up a network of
branches, divisions and zonal offices in India. It transacts business in India and abroad and has opened its
offices in Fiji, Mauritius and United Kingdom. LIC also has joint ventures abroad. It has collaborated with
insurance companies like Ken-India Assurance Company Limited, Nairobi, United Oriental Assurance Company
Limited, Kuala Lumpur and Life Insurance Corporation (International) E.C. Bahrain. LIC has registered a joint
venture company in 26th December, 2000 in Kathmandu, In Nepal in collaboration with Vishal Group Limited,
An off-shore company L.I.C. (Mauritius) Off-shore Limited has also been set-up in 2001. It is keen to extend
its services in the African insurance market.
5. Private Life Insurance Companies
Life Insurance has now been extended to the private sector as well. A large number of new companies
have been floated for providing life insurance cover. The companies whose life business is notable are Industrial
Credit and Investment Corporation of India (ICICI), Tata’s Insurance and Housing Development Finance Corporation
of India (HDFC).
The private insurance companies have introduced innovative offers, customer-centric products, increasing
awareness levels of consumers through a need-based, structured approach of selling, sound risk-management
practices, good service standards, reaching out to the customer through a number of distribution and communication
channels. Private companies have tried to give distinct products. The endowment plans offered by them have
different benefits, but the overall structure is quite similar. There are new concepts of whole life policies as they
cover risk and offer opportunities for savings schemes and tax benefits.
Private companies have entered into the corporate pension management business, where a corporate
house can outsource its pension management system to the insurance company. Companies are also introducing
investment-linked company schemes and credit-card insurance, where the bill is insured against death of the
cardholder. These product innovations have provided new customer oriented services in India.
6. General Insurance Corporation (GIC)
While the LIC is regulated by the Insurance Act of 1938 under Section 27A, the GIC is governed by the
same Act under Section 27B. GIC was formed as a government company under Section 9 of the General
Insurance Business (Nationalization) Act 1972 and registered as a private company under the Companies Act,
1956 and its four subsidiaries, viz., (a) National Insurance Company Ltd., Kolkata, (b) New India Assurance
Co. Ltd., Mumbai, (c) Oriental Fire and General Insurance Co. Ltd., New Delhi and (d) United India Fire and
General Insurance Co. Ltd., Chennai.
The GIC’s have a prudent conservative and rational investment policy with the purpose of fulfilling
national priorities. GIC’s pattern of investments is diversified for purposes of liquidity and high return on
investments. It has a well balanced portfolio. It has investments in Central and State Government Securities and
debentures and equity shares of companies. It also gives loans to banks under participating and bills re-
discounting schemes.
GIC’s investments are influential in the India Capital Market. Unlike the LIC, the GIC is an active underwriter
of capital issues and purchaser of industrial securities. It continues its policy of taking on its portfolio those
securities which combine liquidity with maximum return on its portfolio. Reforms were made in 1992 in the
insurance sector to make it more efficient and functional. The Malhotra Committee proposed certain changes
in its structure and investment pattern. Restructuring the GIC was important in the light of the experience of
running the general insurance business. When GIC was nationalized it had been formed with a holding company
and four subsidiaries. The subsidiaries had gained experience in functioning and administration. The Malhotra
Committee suggested that four subsidiaries should be made. Shares should be held by government and 50%
by the public and employees of the General Insurance Companies.
In its investments GIC would be allowed to invest 55% of the annual accretion of funds or additional
premium income in the private corporate securities through the financial market. 20% of the share would be
in the Central Government Securities, 10% in the State Government Securities and 15% in the housing loans
to HUDCO. Thus, the share of the private sector was increased from 30% to 55% whereas other securities were
reduced from 70% to 45%.
General Insurance Business: There are various kinds of general insurance policies. Yearly premiums
are taken by the companies for providing protection against unforeseen events such as accidents, illness, fire,
burglary contingencies. Products that have a financial value in life and have a probability of getting lost, stolen
or damaged can be covered through General Insurance policy. Some of them are fire insurance, marine
insurance Property (both movable and immovable), vehicle, cash, household goods, health.
The health insurance is useful because it allows cashless hospitalization through the issue of cards. Motor
Insurance and Public Liability Insurance become compulsory through Acts of parliament. Home, health, motor
and travel insurance are the most popular general insurance policies.
The Insurance Regulatory Development Authority (IRDA) act was passed in 1999 to regulate, promote and
ensure growth of insurance and reinsurance business. It has notified 27 Regulations on insurance companies.
These are Registration of Insurers, Regulation on insurance agents, Solvency Margin, Reinsurance, Obligation
of Insurers to Rural and Social sector, Investment and Accounting Procedure and protection of policy holders’
interest.
7. Unit Trust of India
Unit Trust of India is a significant financial institution in India. The objective of setting up UTI was to
encourage savings and to make available the benefits of equity investments to small investors to enable them
to get a fair return on their investments with the benefit of having trustees to manage their investments.
UTI started with an initial capital of ` 5 crores contributed by RBI, LIC, State Bank of India and other
financial institutions. The general supervision, direction and management of the units business is vested in a
Board of Trustees consisting of Chairman, Executive Trustee and other Trustee Members.
Units Scheme: UTI sells units under various plans. There are the unit Scheme 1964, Reinvestment Plan
1966, Children’s Gift Plan, Unit Linked Insurance Plan 1971, Capital Unit Scheme 1976 (now terminated since
1981) and Units Income Scheme 1985.
Scheme for charitable and registered trusts and registered societies 1981, Income unit scheme 1982,
Monthly income unit scheme 1983, Growing income unit scheme 1986, Growth and income unit scheme 1983,
Mutual Fund (Subsidiary) unit scheme 1986 (Master Share), Children’s gift fund unit scheme 1986, Rajalakshmi
unit scheme 1992, Children’s college and career fund unit plan 1993, Grahalakshmi unit plan 1994, Senior
Citizen’s Unit Plan (SCUP) 1993, Institutional Investors Special Fund Unit Scheme (IISFUS) 1993, Bhopal gas
victims monthly income plan 1992, Growing monthly income unit scheme 1991, Deferred income unit scheme
1991, Unit Growth Scheme (UGS) 2000, Master Equity Plan (MEP) 1991, Capital growth unit scheme 1991,
Master share plus unit scheme (Master gain) 1992, Unit growth scheme 5000 (UGS – 5000), Master growth
(1993), Grand-master 1993, Master equity plan (1993), Master equity plan 1995. Many schemes of Unit Trust
of India have now been deleted but the unit scheme of 1964 is till popular.
Unit Trust of India collects the surplus resources of the household through the various unit schemes and
invests the amount in those channels in which it is sure of capital growth. Its investments are generally in ‘blue
chip’ companies. Its investments have been mainly in the private sector. It preferred to purchase debentures
originally but switched to equities in the seventies.
Investments UTI invests in industrial securities through direct subscriptions, underwriting and private
placing. Among these methods, it prefers private placing. LIC has withdrawn from the capital market and UTI
took its place as the single most dominating institution in the New Issue Market. UTI invest generally as a long-
term investor but it also invests in short-term market in the form of bridge finance, deposits with companies
and call deposits with banks. It has also participated in LIC and GIC in participation certificates. UTI has also
made inter-corporate deposits.
In recent years, UTI has provided assistance to priority sector projects and in backward areas. It has also
diversified its investments towards a better and well-balanced portfolio. These measures have helped the small
investor to participate indirectly in the Industrial Securities Market. The UTI has thus ‘bridged’ the gap between
the corporate sector and small saving community.
The objective of the UTI continues to be mobilization of savings through the various schemes. It operates
as a manual fund. Its main interest is to control a large reservoir of funds and to invest these funds in corporate
and non-corporate investments to get the maximum rate of return for its unit holders. It functioned as a
monolithic institution in the public sector it had a dominating role to play in the Indian Financial System. In
India it has been the sole mutual fund till 1987 and has emerged as a financial conglomerate. It
introduced a large number of schemes ranging from the unit scheme of 1964 to cover every kind of need and
requirement in the economy covering children, retired people, women, education, insurance, stock exchange,
speculative investments, monthly income plans, charitable trusts and institutions. It has both open ended and
close ended schemes.
Capital market strategy: As an investment institution, UTI’s investment pattern has been changing
according to the economy’s economic policies, changes in financial market and its own requirements of capital
appreciation. Since, its inception in 1964 and until 1980 nine-tenth of its total investment was in corporate
securities. In order to maximize its income UTI changed its policy and around two-thirds of its investments were
in corporate securities. After 1987 the flow of funds in close ended scheme had been so large the UTI invested
a large amount of funds as a deposit with banks. Since, UTI’s strategy for investment of funds has been mainly
with the intention of growth capital appreciation and maximum returns its main interest has been to develop
its portfolio with corporate securities. Since, 1987 it has continued to invest four-fifth of the total amount in
corporate securities, one-fifth of its investment being in the form of deposits both at call and fixed and other
investments in government securities and in financial institutions like IDBI, IFCI, ICICI, HDFC and IRFC.
UTI’s role in corporate securities had also changed during the years. In 1964 when it was conceived its
aim was to provide security to its unit holders. It gave a secure but low rate of return to its unit holders. Its
main plan was the unit scheme of 1964. It modified its investment strategy to give higher returns to unit
holders. UTI thus showed that its prime interest was maximization of return to its unit holders. Its investment
pattern reflects these changes. From 1964 to 1970 it invested mainly in fixed income bearing securities like
preference shares and debentures. From 1970 to 1977 it had an equity-oriented portfolio.
Since 1977 it again changed its strategy and purchased debentures partly because of lack of good equity
issues in the new issue market and partly because of more attractive rates of return on debentures. Since 1990
UTI has again resorted to change in its strategy and its portfolio is heavily dominated with equities. The
changing conditions in the capital market since the new economic policy in 1992 has brought about changes
in UTI’s investment pattern. 40% of its funds are now in equity shares and 21% in debentures. UTI’s activity
in the new issue market as an underwriter of capital issues has also undergone a change. Since, LIC withdrew
into socially oriented sector, UTI had emerged as a dominating underwriter of capital issues but since 1972-
73 due to its changes in its investment strategy, it has mainly been interested in private placements of debentures
and direct purchase of attractive corporate securities. UTI has however replaced the LIC as a large purchaser
of corporate securities. It has investments in more than 1500 companies in India.
Promotional role: UTI has co-promoted financial institutions like Credit Rating Information Services of
India (CRISIL), Infrastructural leasing and financing services (ILFS), Stock Holding Corporation of India (SHCIL),
Housing Promotion and Finance Co. Ltd. (HPFC), Canfin Homes Ltd., Technology Development and Information
Company of India Ltd. (TDICI), Tourism Finance Corporation of India (TFCI), Over the Counter Exchange of
India (OTCEI), UTI institute of capital market. These institutions have been promoted to meet the changing
requirements of finance in the economy. These are for the new areas like tourism providing listing facilities,
providing housing finance research and trading facilities, clearing and transfer facilities and leasing facilities and
techno managerial guidance.
UTI has also diversified by opening new divisions. It started UTI Bank in 1994 that is now merged into
Axis Bank. It has also started a brokerage firm called UTI Securities Exchange Ltd. in 1994 for placement of
issues in India and abroad. It has also set-up a subsidiary called UTI investor service by issuing certificates
immediately against cash and deal with complaints at a single window. It is also setting up divisions for loans
syndication under UTI investment banking division. It is also setting up an asset management company to enter
into collaborations. In this way UTI has emerged as an important financial institution in the Indian economy.
Crash of UTI: UTI had built a public image and gathered the confidence of the middle income group
of people. The small saver invested in its flagship scheme called UTI-1964. UTI invested a large part of this
money into equities of different companies. Since, these companies did not do well in business UTI began to
face a cash crunch. In July 2001 it announced that the 1964 scheme had crashed out UTI could not fulfil its
promise of giving a good return to the small investors. The falling of UTI shook the confidence of the small
savers. In December 2001 a new scheme has been brought about by Government to bail out the investments
of the small investor through restructuring from January 1, 2002. The units repurchase price would be based
on Net Asset Value. UTI would repurchase units under the US-64 scheme.
8. Mutual Funds
Mutual Funds first came into existence with the issue of Master Shares by the UTI in 1986. The Reserve
Bank of India provided guidelines on July 7, 1989 to govern the funds to provide measures of confidence to
the investors. In 1990 and 1991 new guidelines were issued by the Ministry of Finance for regulation of mutual
funds. The Dave Committee in 1991 recommended the entry of mutual funds and suggested certain guidelines
for regulating them. SEBI and the Ministry of Finance issued regulation in 1992 and 1993 on the basis of such
reports. Five mutual banks were first set-up. They were subsidiaries of public sector banks. These were SBI
Mutual Fund, Can-bank Mutual Fund, PNB Mutual Fund, BOI Mutual Fund, and the Indbank Mutual Fund.
Mutual Funds were also set-up by financial institutions. In the economic liberalization phase after 1992 LIC
Mutual Fund and GIC Mutual Fund were floated. Mutual Funds were also set-up in the private corporate sector.
Some of these were Sri Ram Mutual Fund, Birla Global Finance, Tata Mutual Fund, JM Mutual Fund, 20th
Century Finance, Apple Industries and Morgan Stanley Mutual Fund.
Schemes: Mutual Funds may have both open end and closed end schemes. The mutual funds provide
to their investors pure income schemes which provide regular income, balance schemes providing regular
income and capital appreciation and tax savings schemes offering growth with rebate on income earned from
the mutual fund.
New schemes such as sector funds have also been started. CANEXPO is one such scheme under this
section. It concentrates on the Export Sector. Funds in this scheme called sector funds are specialized and
invested in a single industry. Since, funds are invested in different companies but within the same industry there
is diversification and more sophisticated and specialized investment.
The Mutual Funds (MF) have certain schemes for specific purposes. Dhanavidya has been floated especially
for children’s higher education. This scheme may be availed by parents or grandparents as there is a waiting
period for the scheme to become operative. Another scheme called Dhanvriddhi, is an insurance linked investment
plan. The minimum amount of investment required in this scheme is ` 1,000. Bank of India has a Bonanza
exclusive Growth Scheme.
The mutual funds also allow “roll over” facility to the investments: Investors are allowed to shift from one
scheme to another of the same Mutual Fund, through this facility without any sales charge. A good example
of the roll over facility was in the case of CanBank Mutual Fund, where the investors were given the roll over
facility. A large number of investors shifted from Canstock, Canshare, Candouble to Canganga automatically
on the amount equivalent to the amount due on redemption. Canganga collected an amount of ` 40 crores
out of ` 100 crores through the roll over facility.
MFs also provide the ‘Safety Net Facility’ to give confidence to the investors. The IDBI has given this
facility in their scheme called NIT-95. Through this facility, it buys back from the original investor up to 5000
units at the original price at the option of the investor. The schemes provide the facility of encashment from
specified branches of the bank.
In 1987 public sector banks and Life Insurance Corporation of India (LIC) and General Insurance Corporation
of India (GIC) were permitted to do mutual fund business.
In 1993 private sector banks were permitted to enter into mutual fund industry. The first mutual fund
regulations came into being, under which all mutual funds, except UTI were to be registered and governed. In
July 1993 the Kothari Pioneer which is presently merged with Franklin Templeton was the first private sector
mutual fund to be registered. The 1993 a more comprehensive and revised Mutual Fund Regulations came into
force. In 1996 the industry was brought under the SEBI (Mutual Fund) Regulations.
The SEBI regulation act of 1996 has defined a mutual fund as one, which is constituted in the form of
a Trust under the Indian Trust Act 1882. The structure of a mutual fund consists of an Asset Management
Company, sponsor and board of trustees.
The number of mutual funds increased with many foreign mutual funds setting up funds in India and also
the industry went through mergers and acquisitions. As at the end of January 2003, there were 33 mutual
funds.
In February 2003, the Unit Trust of India Act 1963 was repealed UTI was bifurcated into two separate
entities. One is the Specified Undertaking of the Unit Trust of India with assets under management of ` 29,835
crores as at the end of January 2003, representing broadly, the assets of US 64 scheme, assured return and
certain other schemes. The Specified Undertaking of Unit Trust of India, functioning under an administrator and
under the rules framed by Government of India and does not come under the purview of the Mutual Fund
Regulations. 2
The second is the UTI Mutual Fund Ltd, sponsored by State Bank of India (SBI), Punjab National Bank
(PNB), Bank of Baroda (BOB) and LIC. It is registered with SEBI and functions under the Mutual Fund
Regulations. With the bifurcation of the UTI which had in March 2000 more than ` 76,000 crores of assets
under management and with the setting up of a UTI Mutual Fund, conforming to the SEBI Mutual Fund
Regulations, and with recent mergers taking place among different private sector funds, the mutual fund
industry is in the phase of consolidation and growth. As at the end of September 2004, there were 29 funds
and in 2012 they were 33 funds.
9. Investment Companies
Investment Companies in India find their origin in business houses. They provide finance mainly to
companies belonging to their associated industrial group. Most of these companies are not independent and
owe their existence to another controlling company. Of recent origin it is a variation of such companies in the
form of investment and leasing companies. Other forms of investment companies are chit fund companies
engaged in simple chits, prize chits, business chits or joint stock companies. Other finance companies are hire-
purchase companies and housing finance companies. These investment companies also have the objective of
providing finance and in their own small way contribute in the financial markets of the country. Apart from
these institutions the Indian Financial System is marked by the presence of development banks. Let us briefly
discuss the role of these banks in the economy.
2. Source Association of Mutual Funds in India Handbook.

10. The Development Banks

The Development Banks are special financial institutions, which discussed in the earlier part of the chapter
are different from investment type financial institutions. These have been essentially viewed as gap fillers. They
are like artificial limbs specially instituted to compensate for the slow growth of the normal sources of finance.
The accent of these banks is on providing development finance. As development agencies they are concerned
with the development of total financing and its impact on the economy. These banks are IDBI, IFCI, ICICI and
State Financial Corporations.
11. Industrial Development Bank of India
The IDBI was set-up in 1964 as a subsidiary of the RBI. Subsequently, it was de-linked and made an
independent institution in 1975 under the Public Financial Institutions Act. It is now the apex special financial
institution in the economy. Its objective is to strengthen the resources of financial institutions including banks.
It is engaged in re-financing industrial loans granted by eligible financial institutions like banks, IFC, SFCs, LIC,
etc. It also re-discounts machinery bills and subscribe to the shares and bonds of IFC, ICICI and SFCs.
The IDBI follows a flexible approach in its financing pattern. Being a development agency it is not
interested in receiving high profits on amounts it loans to industrial units. Also, it prefers to assist industrial
organization indirectly through other institutions. It has set-up a special ‘Development Assistance Fund’ for
assisting deserving projects which other financial institutions are not likely to finance. It also acts as a ‘lead’
institution by coordinating the work of other financial institutions through regular appraisals, supervision of
projects and follow-up meetings.
The IDBI plays a promotional role in backward and underdeveloped countries. It has set-up Technical
Consultancy Organizations (TCOs) in backward areas to fortify institutional structure in consonance with growth
of these areas. It also offers concession finance in backward areas. It provides facilities for joint industrial
surveys to identify growth potential in backward areas.
IDBI’s role in industry takes various forms. It helps industry directly through underwriting operations and
provisions of loans. It also undertakes guarantees for repayment of loan. Indirectly it refinances the loans given
to industry. It also subscribes to bonds and debentures of other financial institutions. IDBI also renders technical
and advisory help to industry. Another innovative role in has played has been to revive sick industrial units.
IDBI has been of great help to the industrial small-scale sector. IT has provided them with financial
concessions, refinancing and rediscounting bills and channeling of foreign currency loans under the IDA credit
from the World Bank.
IDBI also provides export finance through the scheme of direct participation, refinance and medium-term
export credit and overseas buyers’ credit. It functioned as the Export Import Bank of India.
Its major effort has been in the direction of technical up-gradation scheme. It has given liberal assistance
to those established industries which have desired to import machinery. It also established a venture capital
fund scheme for promoting new and risky ventures. Since, environmental conditions have been the primary
concern of India, IDBI has been identifying and implementing cost effective programs for controlling pollution.
It has assisted industries in effluent treatment and promoting new techniques for reducing pollution. It conducts
a training program on environmental issues. Since 1985 it has been refinancing SFCs and SIDCs on their
equipment financing schemes. It provided refinancing assistance to a single project up to ` 5 crores. IDBI’s role
in energy conservation is especially noteworthy. It finances plant and machinery instruments acquired for
energy audit including erection, installation changes, technical know-how and fees paid for designs and drawing
to the technical consultant.
IDBI has also made changes in its borrowing pattern. Initially IDBI’s borrowing was from government and
Reserve Bank of India but since 1971 it has strengthened its resources through market borrowings. IDBI has
issued bonds and debentures in India as well as abroad. The borrowing is approximately ` 20,000 crores as
on June 30th 1996.
In the post reforms period after 1991 Government of India decided to transform IDBI into a commercial
bank. Its objective of low-cost current, savings bank deposits would help overcome most of the limitations of
the current business model of development finance while simultaneously enabling it to diversify its client/ asset
base. The IDBI (Transfer of Undertaking and Repeal) Act 2003 was passed by Parliament in December 2003.
The Act provides for repeal of IDBI Act, for making the IDBI into a corporate organization with majority
Government holding of 58.47% and transformation into a commercial bank.
On July 29, 2004, the Board of Directors of IDBI and IDBI Bank approved the merger of IDBI Bank with
the Industrial Development Bank of India Ltd., to be formed incorporated under the Companies Act, 1956
pursuant to the IDB (Transfer of Undertaking and Repeal) Act, 2003 (53 of 2003), subject to the approval of
shareholders and other regulatory and statutory approvals. The merger was expected to be completed by March
31st, 2005.
In its new role the IDBI has the objective of becoming a one stop super-shop and most preferred brand
for providing total financial and banking solutions to corporate organizations and individuals.
12. Industrial Finance Corporation (IFC)
IFC was set-up in 1948. It is a pioneer development bank in India. Its main objective is to provide long-
and medium-term requirements of capital to industry. It does not give assistance for short-term purposes, i.e.,
for working capital or for repayment of existing liabilities but the IFC encourages loans for setting up new
industrial projects and also loans for expansions of existing units’ diversification, modernization and renovation.
It is the only known agency for providing import of capital goods such as machinery, but it does not import
capital goods for the purpose of trading. The various activities of the IFC are centered on public limited
companies, or the corporate sector. Private companies, partnership and proprietary concerns are beyond their
purview.
IFC assists industrial enterprises in all States in the country. Maharashtra, Tamil Nadu, Uttar Pradesh, West
Bengal and Andhra Pradesh have from its inception in 1949 till the year 1982 received substantial financial
help which accounts for three-fourths of IFC’s net approval. The IFC has generally provided industries in these
States concession finance up to ` 1 crore. IFC always encouraged new enterprises. It assisted the new technician
entrepreneurs. It extended necessary guidance to them in formulating their projects to become technically
feasible and economically viable to qualify for assistance from development banks. IFC assisted these organizations
since 1975 through ‘Risk Capital Foundation’.
Assistance to industry: The IFC assist schemes in industrial areas in more than one way: (a) It grants
loans both in rupees and in foreign currencies. (b) It underwrites issues both ‘initial’ and ‘further’ in the NIM.
(c) It makes direct subscriptions to shares and debentures of public limited companies. (d) It guarantees
deferred payments for imported machinery. (e) It raises foreign currency loans from institutions.
IFC’s assistance has been especially noteworthy to sugar and jute industries. It has been a ‘Lead Institution’
for providing funds on a priority basis for revival of their sick units. Assistance under this scheme was based
on the need of each individual organization and there was no ceiling for individual loans.
The IFC has broadened the scope of its activities. Well established in merchant banking activities in India,
it has extended these outside India as well. It also provides credit syndication assistance by providing documentation
and registration services.
Tourism: Since 1989, IFC has actively promoted tourism related projects, sponsoring Tourism Finance
Corporation of India (TFCI) and Tourism Advisory and Financial Corporation of India Ltd. (TAFSIL) for promotion
of financial and advisory services to tourism.
Merchant banking: In 1994-95 the IFC set-up subsidiaries for merchant banking and stock exchange
services. Industrial Finance Corporation Investor Services Ltd., was set-up for transfer agents and registrars
services. The Industrial Finance Corporation Custodial Services Ltd., was primarily set-up to be a custodian of
shares and securities and Industrial Finance Corporation Financial Services Ltd., was directed towards merchant
banking activities.
Promotional Role: IFC played an influential role in co-promoting agencies such as the OTCEI, National
Stock Exchange of India and Investment Information and Credit Rating Agency of India Ltd. (ICRA). This role
it performed in association with other financial institutions to bring about better trading and assessment facilities
to investors and creditors in the capital market.
IFC has always taken great interest in encouraging professionalism in management. It sponsored the
Management Development Institute (MDI) in 1973 and a development banking centre in 1977. Their main
activities are research and training programs.
The IFC took the initiative in supporting entrepreneurs. It supported the Entrepreneurship Development
Programs (EDPs) conducted by National Science and Technology Entrepreneurship Development Board (NSTEDB)
and Entrepreneurship Development Institute of India (EDI).
Loans to new sectors: IFC has extended financial services in new areas of industrial activity. It provides
loans to leasing and hire purchase companies which lease equipment and machinery to industries. It also has an
equipment credit scheme through which it finances the full cost of equipment purchased by an industrial concern.
Since 1988, it has an equipment procurement scheme for new areas such as computer pollution control and those
equipments under national priority. It pays the cost of the equipment directly to the supplier and later recovers
it from the user. In November 1991 it introduced the installment credit scheme whereby IFCI would pay the
supplier the total cost of the equipment purchased. It would then recover the amount in 36/48 monthly installments
from the beneficiary. It has also provided assistance to users of equipment through leasing facilities.
IFCI however went into losses in 1999. It had high NPAs and its cost of borrowing exceeded its income
from operations. Government of India based on the recommendations of Basu Committee made a plan for
restructuring IFCI. Its suggested a ` 100 crores package for reviving IFCI. This was to be in two parts. ` 400
crores were to be given by government in the form of subscription to long-term convertible debentures and
` 600 crores by government control institutional shareholders. This plan was prepared in 2001. The government
appointed Mc Kinsey consulting company to revive IFCI. This company suggested that IFCI should be divided
into two companies. One company was to have good assets, the other one with bad assets. The good assets
company was to provide finance to mid sized companies and to take fee based services. It also suggested a
merger with a potential universal bank and change in the top management position of the company.
13. Industrial Credit and Investment Corporation of India (ICICI)
The ICICI was conceived as a ‘private sector development bank’ for providing ‘foreign currency loans’ and
for developing ‘underwriting facilities in the NIM’. It was set-up in 1955. The special feature of the ICICI was
that it was to be privately owned and its assistance was to be given to private sector industries only.
The objectives of the ICICI were: (a) to create, expand and modernize enterprises, (b) to encourage private
capital both external and internal to grow, (c) to provide finance for long- and medium-term needs, (d) to
underwrite new issues, (e) to guarantee loans, (f) to provide guidance in managerial, technical and administrative
matters.
Resources: The ICICI’s resources came from several sources. Its rupee resources are (a) share capital,
(b) reserves, (c) loans from government, (d) advance from IDBI, (e) debentures issued to public. Its foreign
resources consist of: (i) credit from World Bank, (ii) loans from KFW, (iii) sterling loans from U.K. Government,
(iv) fund from USAID and public issues of bonds in Swiss Francs.
Foreign credit: The ICICI has provided a major share of assistance in foreign currency. The industries
to which it has given credit have generally been those which require foreign credit. Non-traditional and growth-
oriented industries like chemicals, metal products, machinery manufacturers have received a major share of
finance. Its assistance to these industries has been concentrated in Maharashtra, Gujarat, Tamil Nadu and West
Bengal. The ICICI has also given assistance to backward and less developed regions in the country. It has
provided concession finance for their promotion.
Modernization credit: The ICICI has also participated in the consortium of IDBI, IFC and other financial
institutions to provide assistance on ‘soft’ terms for modernization of industries like cotton textiles, jute, sugar,
cement and engineering industry. The ICICI is the first financial institution to have a Merchant Banking Division
in 1974. It assists new entrepreneurs through this division by giving them sound advice on the nature of the
project. It also promotes their venture through the NIM. It also supervises and follows up the progress of these
concerns. Another new and promotional role has been to appoint its nominee directors on firms which have
received its assistance for constant evaluation of these projects. The ICICI has also directed its financial sources
towards leasing of equipment for industrial use.
Research and development: ICICI has participated actively in financing industrial firms for initiating
research and development through its sponsored scheme called SPREAD or Sponsored Research and Development
Program. It has focused its attention to agriculture through ACE or Agricultural Commercialization and Enterprise
Project. This project aims at increasing agricultural business sector through private investment. It provides funds
for new technology and equipment. ICICI is entrusted with the responsibility for providing funds for commercial
energy research. The scheme is called Program for Acceleration of Commercial Energy Research (PACER). The
ICICI has another Program for Advancement of Commercial Technology (PACT) which is based on market-
oriented research and development.
Merchant banking: ICICI’s Merchant Banking activities have undergone major changes based according
to the needs of the economy. In 1993, ICICI floated a new company called ICICI Securities and Finance Co.
Ltd. (I-SFC) which is a joint venture with the subsidiary of J.P. Morgan. 60% of the shares are owned by ICICI.
This company is engaged in New Issue Management, security trading, underwriting and company advisory
services. It is registered as a member of the OTCEI and the NSE and is registered as a merchant banker with
the SEBI.
The ICICI also sponsored a mutual fund in 1993. It was called ICICI Trust Ltd. This mutual fund launched
its first 100 crore issue on November 30, 1993. To provide even more services to the investor, it promoted
another wholly owned subsidiary called ISERV with the objective of offering services as registrars and transfer
agents. In 1994, ICICI also set-up a bank called the ICICI Banking Corporation Ltd. This bank has a 75%
ownership of ICICI.
The ICICI also formed a joint venture in 1993 for the Exports of Auto Components. This is formed to act
as a single window trading house. It has also set-up the Credit Rating Information Services of India Ltd.
(CRISIL) with the UTI – with the objective of rating the different financial instruments offered to the investors.
Promotional role: It promoted the Technology Development and Information Company of India Ltd.
(TDICI) to undertake venture capital and technology up-gradation financing. It has also associated itself with
UTI and IFCI for promoting OTCEI and Stock Holding Corporation of India for streamlining trading of shares.
IFCI has promoted academic learning in Financial Management by setting up three institutes. These are
– Institute for Financial Management and Research, the ICICI Foundation for Research and Development and
Indian Institute for Foreman Training. Using the Indian academic it set-up a Foundation for Globalization of
Indian Industry in 1993. This foundation aims at restructuring value engineering and competition analysis.
The ICICI’s resources pattern and functioning has undergone a change since, it was set-up. Its foreign
currency resources have declined. It now relies on Domestic Rupee Resources. Thus, ICICI has continued to
change its financing activities in accordance with the economic scenario in India.
ICICI Bank: The ICICI bank became the first universal bank in India. It has emerged as one stop retail
banking organization. Its commercial banking operations have done well. It offered a reverse merger whereby
the ICICI merged with the commercial bank. It entered into insurance through ICICI prudential. Its single
premium scheme is rated very high and is extremely popular with individuals who have taken retirement under
the voluntary retirement scheme. It has launched 8 schemes. One of the new schemes called Pru Lifetime
combines protection with market linked returns. ICICI also facilitate other lending services. Commercial banks
have been lending to private individuals for purchasing cars. ICICI has also stepped into financing of cars. This
has brought about good returns to the bank. It offers debit cards and credit cards to its customers. It has
modernized its offices and has customer oriented services.
New developments: The ICICI Banking Corporation was renamed ICICI Bank Limited. In 1999 it
became the first Indian company to list itself on New York Stock Exchange. In 2000 it acquired the Bank of
Madura. In 2002 the Board of Directors of ICICI and ICICI decided jointly to merge both the institutions with
ICICI Bank integrating their financing and banking operations into a single entity. ICICI extended its services
beyond the national boundaries. In 2002 it established its representative offices in New York and London. In
2003 it opened subsidiaries in Canada and the United Kingdom (UK). It also started an Offshore Banking Unit
(OBU) in Singapore and representative offices in Dubai and Shanghai. In 2004 it extended its services to
Bangladesh by opening and establishing its representative office in that area. In 2005, it acquired a Russian
Bank Investitsionno Kreditny Bank (IKB) with its head office in Balabanovo in the Kaluga region and with a
branch in Moscow. ICICI renamed the bank ICICI Bank Eurasia. In the same year it established a branch in
Hong Kong and in Dubai International Financial Centre. In 2006, ICICI Bank UK opened a branch in Antwerp
in Belgium. It also started its representative offices in Bangkok, Jakarta, and Kuala Lumpur. In 2007, ICICI
amalgamated Sangli Bank, in Maharashtra State. ICICI was also permitted by the government of Qatar to open
a branch in Doha and from the US Federal Reserve to open a branch in New York. ICICI Bank Eurasia opened
its second branch in St. Petersburg. In 2008 ICICI Bank introduced iMobile which is a comprehensive Mobile
banking solution. iMobile is a breakthrough innovation in Indian Banking. It allows its customers to make their
banking transactions through a GPRS-enabled mobile phone.
Thus, ICICI is the most modern institution in the present situation in India.
14. State Financial Corporations (SFCs)
Many State level institutions have been set-up to provide assistance to State level industrial units but the
SFCs were established as far back as 1951 under the State Financial Corporation Act with the specific purpose
of being development banks for promotion and balanced development of each state. The first SFC was formed
in 1953 in Punjab. SFCs are confined to one State and also cover those neighboring states or territories which
do not have their own SFC. The scope of this discussion is limited and, therefore, we will take its activity as
a total group.
Objectives: The objectives of the SFCs are to confine themselves to small and medium enterprises. It was
setup initially to grant loans to any industry whose paid up capital and free reserves together not exceeding
` 1 crore. Further, the maximum loan it sanctioned was ` 90 lakhs to companies and co-operative societies
and ` 15 lakhs to other borrowers. Moreover, SFCs holding of a company and 10% of its own paid up capital
and reserves, whichever is less. SFCs are prohibited from entering into a business in which any of its directors
is a proprietor, partner, director, manager, agent, employee, or guarantor.
Loans: The SFCs provide assistance through loans or advances not exceeding 20 years. They also
subscribe to debentures repayable within 20 years. They guarantee loans for industrial purposes. They provide
assistance by underwriting issues of shares, bonds or debentures and they subscribe to shares and bonds of
special financial institutions.
SFCs have emerged as primary lending institutions. They have liberal terms of lending. Their areas of
operation are wider than All India Development banks. They have been significant developers of backward
regions. They have assisted industrial units of divergent fields ranging from artisan enterprises to units engaged
in sophisticated lines of manufacture. It has been of great help to technician entrepreneurs. The assistance to
them has been on liberal terms regarding interest, margin requirements and repayments. The assistance ranges
between ` 2 and 3 lakhs. Its efforts have been noteworthy in providing ‘seed capital’ to small entrepreneurs.
It has also provided assistance for meeting the foreign exchange requirements of medium and small projects
through the International Development Association (IDA).
New directions: The SFCs have since the New Economic Policy of 1992 made several changes in their
assistance pattern. They have provided loans for modernization and technology up-gradation especially in the
areas of energy saving, conservation of raw materials, anti-pollution measures and export oriented and import
substitution products. They have enlarged their areas of operation into industries like hotels, transport, research
and development. They extend loans up to ` 5 lakhs to medical graduates for setting up clinics. They now
provide loans to women entrepreneurs to the extent of ` 10 lakhs, under the Mahila Udyam Nidhi Scheme.
SFCs are extending their functions of term lending. They are also entering into new areas like merchant
banking and equipment leasing keeping in view the financial reforms in the economy.
The SFCs have a change in their methodology of resource mobilization. They drew strength in receiving
inexpensive funds directly and through refinancing from the IDBI. SFCs have started investing in stocks, shares,
bonds and debentures of industrial concerns. To meet the growing demand of financing SFCs has started the
process of finding new areas such as financial services sector to improve profitability.
The role of foreign institutional investors is given in the following discussion.
15. Foreign Institutional Investors

Foreign Institutional Investors (FII’s) came into India in 1993 bringing with them a large volume of funds
termed as ‘hot money’. Although capital inflows into India and other developing countries from capital surplus
countries encourage growth and provide finance in their investment programs they also bring certain inherent
risks and problems. The countries receiving large inflows have felt several market related effects. Significant
changes have been witnessed in their stock markets as well. According to Steil (1993) internationalization of
securities markets is like acid rain which may be produced at one place but its effects are spread in many
countries. There are various issues relating to the FII’s in India, these are:
¾ The magnitude of inflows of capital of FII’s since 1993 after the financial and economic reforms in
India.
¾ Effect of FII’s participation and volatility in the stock market.
¾ Relation of FII’s and capital market size, liquidity, risk and volatility.
¾ Whether the regulations adequately protect the stock market from financial shocks in the case of
volatile outflows.
¾ Market impact of price rigging whether it amounts to price manipulation or is it of lasting nature.
¾ Effect of FII’s inflows and control of corporate organizations.
¾ Money laundering and impact on equity returns in the capital market.
¾ Effect on shareholders protection.
¾ Relationship of FII’s and capital market development.
Significance of FII’s in India: India moved from a controlled economy into current account convertibility
and a market determined exchange rate. There have been excessive capital inflows during 1993-94 followed
by volatility of inflows in 1995-96, 1997, 2000 and 2001. Since, the world is globalized institutional investors
enter markets in different countries where they are able to find gains and participate actively and also influence
other markets because of the large volume of funds which they can invest. The active participation of foreign
financial institutions in countries in which their influence has been observed in recent years are Mexico, Korea,
Latin America, Thailand and India. Its significance relates to: (a) the consequences of the large inflows of capital
from the developed to the developing countries, (b) to consider the macroeconomic effects on the financial
markets which they provide funds, (c) the interest rate differential between the developed and the developing
countries as funds flow to out of the developed countries due to low rate of interest in their own country and
the time of gaining high rates of interest in developing countries. The importance of the study is thus derived from
the global integration of financial markets, financial institutions in the international investment process.
It will be useful to review the participation of the FII’s in India and its implications for the future. It would
provide a base for making policies and controls to protect the capital market from negative effects. It would
also draw attention to the positive effects of linking of financial institutions and financial markets in different
countries.
Before we sum up, let us take a brief look at the Indian Financial System.
2.7 A CRITIQUE OF THE INDIAN FINANCIAL SYSTEM

The organization of the capital market in India presents a striking contrast to the institutional structure in
the industrially advanced countries of the west. The rise of institutional finance for industry abroad has been
the result mainly of institutionalization of personal savings through savings media like life insurance, pension
and provident funds and unit trusts and so on. The growth of institutional finance for industry in India has come
largely through industrial financing institutions created by the government both at the national and regional
levels, collectively referred to as development banks. In other words, a pronounced feature of the system of
industrial financing in India is the heavy domination of its structure by the development banks and the relatively
minor role of the normal channels of financing. As a result, industry has come to rely very heavily on the
development banks as far as its financing requirements are concerned. In terms of their massive role development
banks have out-grown their supplementary character of suppliers of finance in terms of their conception as
‘gap-fillers’. They have been able to channel sufficient funds into the productive system despite un-favourable
conditions in the investment market. The rigorous, exacting and detailed appraisal that development banks
conduct is an integral part of term-lending, tones up the quality of projects and ensures efficient use of
available resources. Moreover, the evaluation of projects by them is objective and impersonal. This has led to
the availability of funds to varied types of enterprises, in particular new or relatively new firms of industries.
The provision of financial facilities to such enterprises is of special significance at the present stage of India’s
industrialization.
The relevance of the development banks in the industrial financing system is not merely quantitative; it
has overwhelmingly qualitative dimensions in terms of their promotional and innovational function. With the
evolution of a meaningful industrial strategy, the accent in financing by the development banks is geared so
that industrial development would sub-serve the basic economic objectives of balanced regional development,
growth of new entrepreneurial talents and small enterprises and development of indigenous industrial technology,
and thus, contribute to the emergence of a widely-diffused yet viable process of industrialization consistent with
the socio-economic objective of State policy. The development banks, in fact, constitute the backbone of the
Indian capital market. 3
This overwhelming relevance of development banks in India notwithstanding their phenomenal growth
and the massive reliance of industry on them in consequence have far-reaching implications in so far as the
ability of the market to cope with the future requirements of the accelerated programs of industrial development
is concerned. The present experience of the supply of industrial capital gives a distorted view of this ability.
This ‘distortion’ has, inter alia, two serious dimensions. The first aspect of this ‘distortion’ relates to the real
ability of the financing system to cope with the growing requirements of an expanding corporate sector of
private industry resulting from accelerated program of industrial development under the five-year plans. The
relevance of capital markets to economic development is based on mobilization of savings and their distribution
to productive enterprises. These two interrelated functions are a sine-qua-non of an efficient capital market. 4
Judged in these terms development banks play rather partial and limited role and a system of industrial
financing so heavily dominated by them as the one in India has certainly failed to grow pari-pasu with the
planned growth of industry. This is because the development banks, as financial intermediaries, are essentially
distributive agencies as they derive most of their funds from their sponsors and, to that extent, a divorce
between collection of savings and their allocation has come into being. This is a serious obstacle to the growth
of an autonomous financing system in the sense of equilibrium between the demand for and supply of capital
funds. Attention to this weakness of the Indian capital market was drawn in the following words:
“A weakness of the present institutional structure with its heavy dependence on special institutions is that
the system is not organically linked to the ultimate source of savings and depends a little too much on
ad hoc allocation from the treasury. It will be desirable to forge links between the distributory mechanism,
on the one hand, and the normal channels of savings on the other, so that the distributing mechanism
becomes increasingly capable of growing autonomously with the needs of the economy on the basis of
available savings.” 5
The domination of the institutional structure of the capital market by development banks in India has
created yet another serious ‘distortion’ in the form of financial practices of questionable prudence. Since, the
development banks provided most of the funds in the form of term loans, there is a preponderance of debt in
the financial structure of corporate enterprises.
There is, of course, no doubt that term loans, as a form of financing, reduce the dependence of investment
on the erratic stock exchanges and the detailed scrutiny of the loan agreement have the effect of promoting
greater financial discipline among the borrowers, on the one hand, and more effective public control over the
private enterprise, on the other, but the predominant position of debt capital has made the capital structure of
3. For a penetrating account of development banks in India, please refer to Khan, M.Y., Indian Financial System, 1979, Vikas Publishing
House, New Delhi, Chapter VIII.
4. For detailed account of the relevance of capital market attention is drawn to Van Horne, Function and Analysis of Capital Market
Rates, Englewood Cliffs, 1970, Chapter 1.
5. Gupta, L.C., Changing Structure of Industrial Finance in India, Oxford University Press, London, 1969, (please refer p.70).
the borrowing concerns lopsided and unbalanced and, on considerations of orthodox canons of corporate
financing, highly imprudent. The sympathetic and flexible attitude of development banks as public financial
institutions in case of defaults arising out of temporary difficulties can, of course, permit a greater use of debt
than is warranted by the traditional concept of a sound capital structure but it does not justify the unlimited
use of debt capital as it is likely to jeopardize the future of the company itself.
The solution to the problem implicit in these distortions obviously lies in securing an organic link between
the distributive mechanism and the ultimate pool of the savings of community. 6
New Developments in the Financial System Since 1991
The changes in the financial system have occurred as a result of the recommendations of the Chakravarti
Committee which was working on the changes of the monetary system, the Vaghul Committee on money
markets and the Abid Hussain Committee on capital market.
The call money market where money was borrowed for a very short period had a ceiling rate of 10% rate
of interest. From May 1, 1989, the Reserve Bank of India has withdrawn ceiling rates on inter bank money,
participation certificates and on rediscounting of commercial bills. The commercial banks were also given the
option of getting short-term funds through the new instruments called Certificate of Deposits (CD). Another
instrument called the inter bank participation was introduced for improving short-term liquidity with the banking
system.
Another important dimension in this direction was the liberalization of the credit policy of banks. Banks
were to rename credit authorization scheme and to call it ‘Credit Monitoring Arrangements.’ All proposals
exceeding ` 5 crores could be sanctioned by the banks and the RBI’s sanction to such working capital requirements
should be only a post sanction security. From November, 1988 RBI has permitted the transfer of customer’s
account from one bank to another without any questions. Transfer of account was made possible without any
objections from the existing bank. The transferee bank had to take over both the liabilities as well as responsibilities
existing in the present bank.
The call and short money market was liberalized to the extent of allowing the private sector companies
to issue commercial paper with competitive interest rates for a period of three to six months. Companies would
be allowed to issue commercial paper if it got a rating from Credit Rating and Information Services of India
Limited. The bank finance could not exceed 250 million rupees.
The financial markets had many reforms to tone up the quality of borrowing and lending. SEBI instituted
many reforms for the benefit of the investors. Commercial banks have provided new services for customers. RBI
monitors the capital adequacy and transparency of banks. Basel I and II norms have to be adopted by all the
banks. New insurance companies and mutual funds have been permitted in India. There have been new
legislations. The Indian Financial System has changed to a great extent. There are many financial services.
These are merchant banking, underwriting, portfolio managers, investment bankers, credit rating agencies,
mutual funds, and leasing, factoring and housing finance. The financial system has modernized. Communication
and quick access between different countries has led to the strengthening of the capital market. The development
banks like ICICI and IDBI entered into commercial banking and resorted to reverse mergers as the banks
became very successful. Thus, the weakness of the financial system brought about by heavy lending and
dependence of the development banks has diminished. The financial system is now more developed with
liberalization and globalization.
SUMMARY
r This chapter has provided a synoptic view of the scenario of the Indian Financial System.
r The financial system of a country consists of a network of financial markets, institutions, investors, services
and regulators.
6. A critique of the India Financial System forms part of the concluding chapter of the author’s unpublished thesis, “Life Insurance
Corporation and The Capital Market in India,” Delhi University, Feb. 1979, for a detailed account read Chapter IX of this thesis.
r A financial system helps in effective collection of savings of the individuals and institutions and helps in
transforming the funds into investment.
r The object of the chapter was to present the structure of the financial markets and the institutions, the
financial markets and the institutions in the broader perspective of the system as a whole.
r Many changes have come about since 1991. Markets and institutions have instituted reforms. The economy
has opened up from control to liberal working in the financial sector se-tup.
r There are 24 stock markets in India. The important stock markets are National Stock Exchange, Bombay
Stock Exchange, OTCEI and ISC.
r Private life insurance companies have been permitted to operate in India.
r Mutual funds have been set-up in the private sector.
r The monolithic institutions of LIC and UTI have more competition with the entry of new companies in insurance
and units.
r The commercial banks have been modernized and many new services which are custom oriented have been
started.
r ICICI was the country’s first universal bank. The financial markets have geared up their operations with the
introduction of innovative financial instruments through financial engineering.

(i) A financial system is a network of financial markets, institutions, instruments and intermediaries.
(ii) Money market is for long-term investments.
(iii) The Reserve Bank of India is the Central Bank of India.
(iv) Mutual Funds are market intermediaries.
(v) The ownership securities consist of Deep Discount Bonds.
(vi) Financial engineering is the creation of new securities by combining different options.
(vii) Security Exchange Board of India acts as a controlling agency in a securities market.
(viii) A mutual fund has income, growth and sectoral schemes.
(ix) Debt securities are mostly ownership based.
(x) The role of a financial system is to establish a link between savers and investors.
Answers: (i) T (ii) F (iii) T (iv) T (v) F (vi) T (vii) T (viii) T (ix) F (x) T.
QUESTIONS
1. Describe the financial structure of India. What Legislative measures have strengthened its financial system?
2. Distinguish between New Issue Market and Stock Market. Is their role complementary or competitive?
3. What is the weakness of the financial system of India? What new developments have taken place since 1991 for
improving conditions for borrowers and lenders in the market?
4. Do you think development banks are important in the Indian Scenario? How do they differ from investment
financial institutions?
5. Discuss the developments that have taken place in the business of commercial banking in India.
6. What changes have taken place since the new economic policy in 1991 to improve financial investment climate
in India? Discuss.
7. What is universal banking? Discuss the different types of universal banks. How do they operate in India?
8. What is the importance of National Stock Exchange of India? Describe briefly its methodology of operations.
9. Which are the important stock exchanges in India? Discuss the working of the Bombay Stock Exchange at Mumbai.
10. Write notes on: (i) OTCEI. (ii) Inter Connected Stock Exchange of India. (iii) Development in Life Insurance
Business (iv) Mutual Fund.
11. Discuss the developments in the mutual fund industry in India since 1991.
SUGGESTED READINGS
l Bhole, L.H., Financial Markets and Institutions, Tata McGraw-Hill Publishing Co. Ltd., New Delhi, 1982, p. 360.
l Davis, Yeomans, Company Finance and the Capital Market – Effects of Firm Size, Cambridge University
Press, p. 135.
l Dougall & Gaumitz, Capital Market and Institution, Prentice Hall Inc.
l Gupta, L.C., The Changing Structure of Industrial Finance in India, Oxford University Press, London, 1969.
l Henning Pigott, Financial Markets and the Economy, Prentice Hall Inc., Englewood Scott Cliffs, New Jersey,
1978, p. 543.
l Khan, M.Y., Indian Financial System – Theory and Practice, Vikas Publishing House, New Delhi, 1989, p. 36.
nnnnnnnnnn
Chapter
INDIAN SECURITIES MARKET
Chapter Plan
3.1 Indian Securities Market
3.2 Participants in the Securities Market
3.3 Financial Instruments
3.4 Financial Engineering Instruments
3.5 Security Market Indices
3.7 The Relationship of the New Issue Market and Stock Exchange
3.8 Structure of the Indian Capital Market with Participants
3.9 Intermediaries/Participants in the New Issue Market
3.10 Issue of Capital in New Issue Market
3.11 Functions of the New Issue/Primary Market
3.12 Secondary/Stock Markets
3.13 Listing of Securities
3.14 Depository System or Paperless Trading
3.15 Broker System of Trading of Securities
3.16 Control of Indian Capital Market: SEBI
3.17 Developments in the Stock Market
– Insider Trading
– Circuit Breakers
54
INDIAN SECURITIES MARKET 55
– Free Pricing of Issue/Stock Splits

– Screen Based Trading
– Regulation of Foreign Institutional Investors (FIIs)
– Regulation of Mutual Funds
– Options and Derivatives
– Regulation of Stock Brokers
– Surveillance on Price Manipulation
– Buyback of Shares
– Stock Lending
3.1 INDIAN SECURITIES MARKET

The Indian securities market consists of the new issue market and the stock market which trades in the
securities after they have been placed through the new issue market.
Primary Market and Secondary Market
The Primary Market is also called New Issue Market. In this market securities are sold for the first
time. In India many developments have taken place in this market. The New Issue Market in the past issued
fixed price shares. Currently most of the shares are being issued through the book building method based on
demand and supply of the security. Bids are made by people interested in the purchase of shares and then
according to the price that is fixed shares are allotted within 30 days of the closing of the issue. The New Issue
Market mobilizes the savings of the investors.
The Stock Market provides the sale and purchase of securities only after their allotment and listing with
SEBI and Stock Market in which trading is desired. In India there are 23 stock markets. The most important
are National Stock Exchange (NSE) and Mumbai Stock Exchange (BSE). Two other well known stock markets
are the Over The Counter Exchange of India (OTCEI) and Inter Connected Stock Exchange (ICSE). The stock
market has an index. The most important index is the SENSEX. This is made up of 30 stocks traded most
actively in the market. It gives the information as to whether the market is moving in an upward trend or is
falling downwards. In India there is screen based trading through the depository system. The distinction between
Primary Market and Secondary Market is given in Table 3.1.
Table 3.1 PRIMARY MARKET AND SECONDARY MARKET
Primary Market Secondary Market
Primary Market helps in mobilization of savings of It is market for purchase and sale of securities and is
individuals. Bankers, stock brokers, and merchant represented by share brokers. After the issue of
bankers operate for the success of the issue. securities in the primary market they are listed on the
stock exchange.
This market is called the New Issue Market. All When the security has been registered in the New Issue
securities are first issued through this market. Market all subsequent trades take place in the secondary
It is the market for IPOs or Initial Public Offering. market popularly called the Stock Exchange after
listing of shares.
This market helps in raising funds for industry or The stock market helps in lending liquidity and
corporate organizations. marketability to such securities.
3.2 PARTICIPANTS IN THE SECURITIES MARKET

The role of the participants in the financial markets is to create a flow of funds from savers
to investors. They are the main link between the savings efficient to savings deficient organizations.
The link consists of financial institutions and intermediaries, individuals, firms and corporate
organizations, government and market regulators.
The following are identified as participants in the market:
1. Individual. Individual purchasers and sellers of securities. The trend in many countries has shown the
increased participation of households and the popularity of stocks in the life of a general household.
2. Corporate organization. Corporate organizations help in the flow of funds in the market. Organizations
raise their funds for expansion of their business or because they require funds for business activity.
Surplus organizations lend funds to the deficit organizations.
3. Government. Government plays multiple roles in the market. It borrows funds or lends funds through
its gilt edged securities. From the point of view of security it is excellent as it is 6 ‘near gold’ as the name
gilt-edged suggests. Interest is however low and so investors do not look for it as a good investment.
Government also plays the role of a regulator and controller by making a monetory policy and by
appointing a regulator for making rules and regulations for protection of the investors. Many countries
call it a Securities exchange commission. In India it is called the Securities Exchange Board of India.
4. Regulators. Regulators may be appointed by Government in some countries but is usually an independent
board which frames rules and regulations especially because trading has now become a household
word and people are able to make money on stocks or lose money because of the high risk. Also
market scams and frauds take place so regulators become important in capital markets.
5. Intermediaries. The market intermediaries help in the process of transfer of funds from savers to
investors. These intermediaries are brokers, underwriters, clearing houses, depositories, mutual funds,
investment companies, lead managers, portfolio managers, credit rating agencies, Reserve Bank of
India.
These intermediaries/participants are discussed in greater detail in chapter 3.
3.3 FINANCIAL INSTRUMENTS

Financial Investments consist of ownership securities debt securities and Mutual Fund units. They are:
Ownership securities consist of
1. Equity shares
2. Preference Shares
Debt Securities are listed in the following way.
1. Nonconvertible Debentures
2. Convertible debentures
3. Deep discount Bonds
Mutual Fund Securities are called units. They have:
1. Income schemes
2. Growth schemes
3. Equity schemes
4. Money Market Schemes
Financial instruments help in the process of intermediation. A choice of financial instruments to cater to
the needs of the different types of investors will provide dynamism in trade of the securities in the financial
markets. An array of securities creates development in the financial system. As discussed in chapter 1 an
economy devoid of financial instruments is financially backward.
The following instruments are traded in the Indian capital market. Financial instrument consists of ownership
securities, debt securities, mutual funds units and financial engineering securities.
Equity Shares
The shares are ownership securities. Investors find equity shares the best type of investment as the shares
can be traded. The investor participates in the earnings of the company and receives dividends. The equity
share value increases and during inflation it acts as a hedge, increasing the importance of such shares. The
equity shares also have capital appreciation. They are however very risky shares as the prices can also fall and
there can be losses.
Preference Shares
Preference shares are fixed dividend bearing instruments. They are called hybrid instruments because they
have the features of both the equity shares and bonds. They have certain important features like cumulative
dividends and are redeemable after some years.
Debentures/Bonds
There are many kinds of debentures/bonds in the Indian capital market. These are redeemable, perpetual,
convertible, registered and bearer issues. They have a fixed interest called ‘coupon’ rate. These are debt
securities and the holders do not have any right to attend the annual general meeting of the company. They
are also not allowed to vote in any issues.
3.4 FINANCIAL ENGINEERING INSTRUMENTS

These are new type of securities which combine different features in one security. They are called innovative
instruments. It is called a hybrid security as it creates different types of cash flows from one security. In India
for example, financial institutions like ICICI, IFCI, and IDBI had issued Deep Discount Bonds with different
maturity periods. These are redeemable at full value and issued at a discount in the face value. Interest is not
paid. The total redeemable value is paid at the end of the period. Corporate organizations have also created
securities through financial engineering. Reliance Petroleum gave investors different options for interest, redemption,
right shares in their optionally convertible debentures. Unit Trust of India through its mutual fund operations
issued an open ended equity linked funds with a set of 6 equity linked funds to provide maximum returns and
flexibility in switching between these funds.
Many companies have tried to innovate to give a choice to the investors. The financial institutions and
development banks in India have also issued such securities. The following are some financial engineering
securities issued in India.
Participating Debentures have been issued by companies. The investors are given a part of the excess
profits that it has earned after giving a dividend to equity share holders.
Convertible Debentures Redeemable at Premium: These securities are issued by a company at the
par value but the holders have a ‘put option’. This enables the holders to sell the security at of premium. Zero
Interest Fully Convertible Debentures (FCD’s): These debentures do not carry any interest but on the
specified date they are converted into shares.
Floating Rate Bonds (FRB’s): These bonds are issued by financial institutions by linking the interest
on the bond to a benchmark interest rate. The benchmark may be the interest rate on treasury bills, prime
lending rate or interest rate of term deposits. The floating rate may be either above or below the benchmark
rate.
Zero Interest Coupon Bonds: Such bonds do not pay interest but are offered at a low price. The
investors get returns from the difference he receives between the acquisition and redemption amount.
Deep Discount Bonds: Such bonds have a long-term maturity period between 20 to 25 years. They
carry the feature of ‘call’ which means that the company can call back the bond after 5 or 10 years. It is sold
at a discount but has no interest for example, a 25 year bond is issued at rupees 10,000 but is redeemed at
rupees 1,00,000. The discount makes up for not receiving any interest during the waiting period.
Regular Income Bonds: These bonds have ‘call’ and ‘put’ options. They are for a fix period of kind
and they pay interest after every 6 months. The period can also be monthly and the bond can be called
monthly income bonds. It also carries a front end discount.
Retirement Bonds: These bonds are useful for investors who are in the retirement stage. They are issued
at a discount with the option of monthly income and for a specified fix term period. On the exit time of the
bond the investor gets a lump sum amount.
The most important component of the Industrial Securities Market comprising the New Issue and Stock
Exchange market are the ‘Industrial Securities’ themselves. This is the physical or tangible asset through which
the market functions.
The three types of securities through which the corporate sector raises their capital are (a) Equity Shares
or Ordinary Shares or Common Stock. (b) Preference Shares, and (c) Debenture or Bonds.
Financial innovation has brought many new financial instruments of which the pay-offs or values depend
on the prices of stocks. Examples are exchange traded funds (ETFs), stock index and stock options, equity
swaps, single-stock futures, stock index futures, etc. These may be traded on futures exchanges. Through the
help of financial innovation and financial engineering (mixing of security options) help in bringing about a
balanced result.
Derivatives
Derivatives are also relatively new securities. They were introduced in India in 2001. These are financial
instruments whose performance is derived, at least in part, from the performance of an underlying asset,
security, or index. Even small market movements can dramatically affect their value, sometimes in unpredictable
ways. In India derivatives have become popular in recent years. The different derivatives are forwards,
options, futures and swaps. Derivatives can be classified into commodity or financial instruments, they are
basic and complex and exchange traded and OTC derivatives.
3.5 SECURITY MARKET INDICES

Stock Market Indices help in showing the stock market behaviour. In fact they represent the market by
showing upward and downward trends in the stock market. Since, it is not possible to see all the stocks
everyday a price index and wealth index are Stock Market Indices help in showing the stock market behaviour.
A price index is the authentic average of share prices with a base date and reflects general price movement
of stock. A wealth index is prepared by giving weights through market capitalization the base period values are
adjusted for subsequent bonus and right issues. This index presents real wealth created for shareholders over
a period of time.
Let us take an example of an index constructed with three scrip’s ABZ
Equity of Co. A 100 (Par Value ` 1)
Market Price of scrip A = ` 2
Market Price of scrip B = ` 3
Market Price of scrip Z = ` 4
Market Capitalization (MC) = No. of Shares x Prices of Shares
A = 100 × 2 = 200
B = 200 × 3 = 600
Z = 250 × 4 = 1000
Market Capitalization 1800
Index at period N = 100
Market price at N + 1
= A share price ` 2.2

= B share price ` 4.0
= Z share price ` 5.0
Market Capitalization
A = 100 × 2.5 = 250
B = 200 × 4.0 = 800
Z = 250 × 5.0 = 1250
Market Capitalization 2300
Index at period N + 1 = 2300 × 100/1800
N + 1 = 127.78
Indices depend on (a) the number of stocks in an index (b) the composition of the stock (c) the weights
and (d) the base year. In India SENSEX and BSE National index are very popular. However, BSE National
index has 100 stocks and is stated to be more representative compared to SENSEX. NIFTY also provides a
good index in the Indian Stock Market.
The SENSEX is like a barometer, which indicates the health, sentiment and mood of the market. It was
named by Deepak Mohani The BSE Sensex or Bombay Stock Exchange Sensitive Index is a value-weighted
index composed of 30 stocks with the base April 1979 = 100. It consists of the 30 largest and most actively
traded stocks, representative of various sectors, on the Bombay Stock Exchange. These companies account for
around one-fifth of the market capitalization of the BSE. The base value of the Sensex is 100 on April 1, 1979
and the base year of BSE-SENSEX is 1978-79. It is constantly reviewed and modifications are made to make
it reflect the current market condition. The stock market has grown by over ten times from June 1990 to 2006.
S&P CNX Nifty is a well-diversified 50 stock index accounting for 25 sectors of the economy. It is used
for benchmarking fund portfolios, index based derivatives and index funds.
S&P CNX Nifty is owned and managed by India Index Services and Products Ltd. (IISL), which is a joint
venture between NSE and CRISIL. IISL is India’s first specialized company focused upon the index as a core
product. IISL have a consulting and licensing agreement with Standard & Poor’s (S&P), who are world leaders
in index services.
Major Stock Market Indices
Indian Stock Market Indices Weighting Base No. of Stock Base Year
Economic Times Index of Unweighted 72 1984-85
Ordinary Share Prices
BSE Sensex Market Value 30 1978-79
BSE National Index Market Value 100 1983-84
BSE-200 Market Value 200 1989-90
Dollex Market Value 200 1989-90
S&P Nifty (NSE-50) Market Value 50 Nov 1995
S&P CNX Nifty Junior Market Value 50 ----
(NSE madcap)
S&P CNX -500 Market Value 500 1994
S&P Midcap-200 Market Value 200 1994
CMIE Market Value 72 June 1994
International Stock Indices
Dow Jones Industrial Average Price Weighted 30 1928
Nikkei Dow Jones Average Price Weighted 225 1949
S&P Composite Market Value 500 1941-42
3.6 SOURCES OF FINANCIAL INFORMATION

Fundamental analyst insists that the investor should also be aware of the sources of information that are
available to him while evaluating a firm’s performance. This gives a fairly good idea of both the company’s
internal management as well as the analyst’s opinion who makes projection of these firms without actually
managing their funds. In India, the following sources of information are available to an investor for analysing
the records of the firm and ascertaining its past performances and an insight to its future projections:
(a) Annual Report: Annual report indicates: (a) the company’s name, (b) location of company’s factories,
(c) number of shareholders, (d) company’s expansion programmes, (e) analysis of company’s operations
in the current year, (f) analysis of previous year’s performance through consolidated balance sheets,
(g) company’s prospects for the next year, (h) the economic and business involvement of the firm,
(i) dividend policies, (j) proposal for issue of right shares, bonus shares, debentures.
(b) Financial Dailies: In India, the daily newspapers also give information about the financial news
about the leading firms. These firms are generally quoted on the stock exchanges of the major centres
in the country. Most important financial dailies in the country are ‘Economic Times’ and the ‘Financial
Express’. These papers give an in depth study of the share prices, quoted in the stock exchanges, and
economic, business, commercial and industrial information about different firms from time to time.
There are some investment magazines also and other corporate magazines, which give details about
the economic, industrial performance of companies. These may be listed as: (a) Business World,
(b) Business India, (c) Directors’ Digest, (d) Industrial Times, (e) India Today, (f) Economic and
Political Weekly, (g) Investments Today, and (h) Investments India.
(c) Directories Besides, these sources of information there are important directories available to give
information and also indications of growth shares and income shares. They also give case studies and
analyse the performance of different firms with projection of future. Valuable guides which are sources
of information also are listed below:
(d) Stock Exchange Directory: This is bound in eighteen volumes and gives information about all
listed public limited companies and major public sector corporations.
(e) Kothari’s Economic and Industrial Guide of India: This gives relevant financial information and
analysis of more than 3,000 companies. It is designed in a manner to make the investor aware of the
problems of investment and depicts the nature of investments available for current investment.
(f) Times of India Directory: Time of India has also a directory which gives full information about
many industrial companies and groups. It makes an analysis of the different companies on stock
exchange.
The buyer of share should be careful in making an analysis of company and he should generally buy
shares which are listed on the stock exchange. Listed shares have some kind of predictions from the stock
exchange brokers of the solvency, profitability investment value and price of the shares. Moreover, listed shares’
information is available, whereas the unlisted shares suffer from grave risk as no information is available on
them. As a rule, the investor should also buy those investments which are actively traded on the stock exchange.
An active share is one which is transacted in the stock exchange at least three times a week. While activity of
a share price will depend on the depressed or prosperous conditions of the market, yet the trend can be gauged
by the investor by following the rule of number of times it is transacted on the stock exchange. Inactive shares
are priced at a very low rate and it gives the investor a chance of investing his money at a cheap rate but these
shares have no value and the investor will find that his capital becomes eroded if he purchases these shares.
A share is inactive because there are no buyers and this is why the prices are quoted at very low rates. It also
indicates that since there are no buyers in the market it is not a worthwhile investment. Active shares offer
attractive investments for the future. They are priced at higher rates. Investor is sure of either capital appreciation
or good dividend income. In India, the price of a share rises in relation to dividend that is declared on it. Active
shares can be discerned from two categories of listed shares, cleared securities and non-cleared securities.
These securitie are usually known in the stock exchange as Group A shares and Group B shares. Group A
shares are considered to be the most active shares. Group B shares are generally negative in nature. Group
A shares are periodically analysed by the stock exchange officials.
Fundamentalists, therefore, make a careful analysis of shares. According to them, there should be a
preliminary screening of investment, the economic and industrial analysis and analysis of the company to find
out its profitability and efficiency and a study of the different kinds of company’s management.
3.7 THE RELATIONSHIP OF THE NEW ISSUE MARKET AND STOCK EXCHANGE
This chapter discusses the manner in which the New Issues Market and Stock Exchanges operate. What
are the mechanisms of floatation of new issues? How are orders placed for the “purchase and sale of securities”?
What are the factors that the investor should keep in mind in connection with the transfer of securities?
The last chapter presented the broad features of the structure of the securities market in India. The New
Issue Market and Stock Exchanges which are the constituents of the industrial securities market in India. They
are also called the capital market and their main function is to issue new shares through the new issue market
and after following the statutory regulations to have active trading in the stock market in India.
The New Issue Market (NIM) deals with those securities which have been made available to the public for
the first time; the Stock Exchanges in India provide a forum for free transferability of shares held by the public.
The Stock Exchanges not only affect purchases and sales of securities but also make a continuous valuation
of securities traded in the market.
The New Issue Market and Stock Exchange are inter-linked and work in conjunction with each other. They
cannot be described as two separate markets because of the kind of functions they perform the NIM and stock
exchange are connected to each other even at the time of the New Issue. The usual practice by the firms issuing
securities is to register themselves on a stock exchange by applying for listing of shares. Listing of shares
provides the firm with an added prestige and the investing public is encouraged with this service. The advantage
of listing on a recognised stock exchange is that it widens the market for the investor. It provides the investor
with the facility of sale of his shares thus offering him a ‘market’ for immediate liquidity of funds. Secondly,
the working of the stock exchange and NIM provides a greater protection for the investing public as the
companies applying for stock exchange registration are bound by the statutory rules and regulations of the
market.
Further, the securities markets are closely connected to each other because of the sensitive nature of the
movements of stock prices. Stock prices are to a great extent affected by environmental conditions such as
political stability, economic and social conditions, industrial pattern, monetary and fiscal policies of the government.
The long-term and short-term changes in these factors have an effect on the day-to-day changes in prices of
stocks. The NIM depends on the stock exchange to find out these price movements and the general economic
outlook to forecast the climate for investing and the success of new issues floated in the NIM. Thus, the prices
of shares in the NIM are sensitive to changes in the stock market and act and react accordingly and in the same
direction and the general outlook in the market will show a “downswing” in trading activity of securities.
3.8 STRUCTURE OF THE INDIAN CAPITAL MARKET WITH PARTICIPANTS

The Indian capital market comprising of the new issue market and stock exchange has the following
important participants:
¾ Regulators
¾ Depositories
¾ Underwriters
¾ Portfolio Managers
¾ Merchant Bankers
¾ Stock Exchanges
¾ Brokers
¾ Mutual Funds
¾ Clearing House
¾ Institutional Investors
Figure 3.1 depicts the structure and participants of the Indian capital market. The role of each of these
participants is discussed in this chapter. The new issue market deals with securities issued for the first time and
after they are listed the securities can be sold in the stock market. The two markets are assisted by a large
number of financial institutions and services for trading to take place. The various steps in trading mechanism
are also given in detailed.
Controlling Authority - Securities and Exchange Board of India
Primary Market/New Issue Market Secondary Market/Stock Market
• Companies: Public & Private Sector • Credit Rating • Companies: Public & Private Sector
• Mutual Funds • Merchant Bankers • Mutual Funds
• Underwriters
• New Issues • Retail Investors

• Shares
• Right Issues • Institutional Investors
• Debentures • FII’s • Debentures
• Mutual Fund Units • Mutual Funds • Mutual Fund Units
• Depositories • Clearing House

• Custodians • Stock Brokers
• Stock Exchanges
Fig. 3.1: Structure of the Indian Capital Market with Participants
3.9 INTERMEDIARIES/PARTICIPANTS IN THE NEW ISSUE MARKET

Intermediaries are very important participants in the Indian securities market. They help in the process of
issue of securities and their trading thereof in the stock market.
1. Merchant Bankers
One of the developments in the NIM was the role of intermediaries in selling ‘new issues’. The role of the
Merchant bankers was considered complementary to the NIM as they carry out all the activities relating to issue
of shares.
¾ They draft prospectus of the company
¾ Appoint registrars for share application and transfers
¾ Provide arrangements for underwriting
¾ Select brokers, bankers to the issue and handle past issue problems
SEBI has made it mandatory for all firms issuing shares to appoint merchant bankers. Merchant bankers
must be regulated with the SEBI and is granted recognition on the basis of its capital adequacy norms in terms
of its net worth. A merchant banker has to pay a registration fee annually.
Categories of Merchant Bankers

There are 4 categories of merchant bankers
Category I to carry out activities relating to issue management has to pay fees of ` 2.5 lakhs for the first
two years and 1.50 for the third year.
Category II merchant bankers were to pay ` 1,50,000 for the first two years and 50,000 for the 3rd year.
Merchant bankers in this category were to act as advisor, consultant, portfolio manager, underwriter or manager.
Those in Category III were to act as advisor, underwriter and consultant.
Category IV acts only as advisors or consultants to the issue. Therefore, merchant bankers in category I
are the lead managers to an issue.
Code of Conduct of Merchant Bankers
A merchant banker has to abide by the code of conduct laid down by SEBI. They have to submit
documents and records and other legal papers under the guidelines of the SEBI. A lead manager has to prepare
prospectus and submit it to the SEBI at least two weeks before the issue. The number of lead managers is
related to the size of the issue. Two lead managers are appointed for an issue of less than ` 50 crores. ` 50-
100 crores issue requires 3 lead managers and for ` 100-200 crores 4 lead managers may be appointed.
2. Lead Manager
The commercial or investment bank which has primary responsibility for organizing a given IPO (Initial
Public Offering) or bond issues is called a lead manager. This bank will find other lending organizations or
underwriters to create the syndicate, negotiate terms with the issuer, and assess market conditions. He is also
called syndicate manager, managing underwriter or lead underwriter. SEBI merchant banking regulation 1992
states that all issues of a company should be managed by at least one merchant banker functioning as a lead
merchant banker known as a lead manager. In a rights issues up to ` 50 lakhs it is not necessary to have a
lead manager. A lead manager is supposed to make an underwriting commitment which is 5% of total underwriting
commitment or ` 25 lakhs whichever is lower. If there are two lead managers they should have separate
responsibility areas. Their main interest is to protect the investors. They have to send particulars of an issue
to SEBI. The number of lead managers depends on the issue size. The following are the number of lead
managers according to the sizes of issues.
Number of lead manages Issue size
2 Less than 50 Crores
3 50 to 100 Crores
4 100 to 200 Crores
5 200 to 400 Crores
More than 5 Above 400 Crores
The functions of the lead manager are the following:

¾ A lead manager has to make draft prospectus and letter of an offer.
¾ He has to prepare monitoring reports after the date of closer of the subscription list of the company.
¾ He has to dispatch share certificates and refund orders within two days of finalizing the allotment.
¾ He has to participate in solving investor grievances regarding allotment, refund and dispatch of share
certificates.
3. Portfolio Manager
The portfolio manager tracks and monitors investments, cash flow and assets, through price updates.
Investments like equity, mutual funds, assets, cash flows, and borrowing funds is the work of the portfolio
manager it is the most up-to-date and precise indicator of net worth and investments at each stage. It can be
used as a record of holdings to base any future investments decisions.
The Portfolio Manager has useful tools to gain an insight of volatile markets this help to track the trends
of current investments and stocks. Under the SEBI portfolio manager regulation of 1993 any person can work
as a portfolio manager but he should be registered with SEBI. He should have adequate infrastructure, professional
qualifications and capital adequacy of ` 50 lakhs. A portfolio manager advices, directs, and under takes on
behalf of the client. He is under a contract with a client and he is entitled to a fees.
The role of the portfolio manager is the following:
¾ To invest the funds of his clients in a fiduciary capacity by proper and timely action regarding their
profitability.
¾ To engage in legal activities and not make any speculative trades with the clients funds.
¾ To build the investments of his clients and manage the portfolio in accordance with proper instructions.
¾ He should prepare a report and give the accounts to the client subject to the regulations of SEBI
(1993).
Code of Conduct of Portfolio Managers
¾ A portfolio manager should have a high sense of integrity while dealing with his client and with other
portfolio managers and business associates.
¾ He should exercise due diligence, care and professional judgement to the clients’ investments.
¾ He should comply with the code of conduct prohibiting Insider Trading Regulations of 1992.
¾ He should take adequate steps for registration and transfer of his client’s securities and for claiming
dividends and interest payments for him.
¾ A portfolio management should practice fair competition which is not harmful to the interest of his
client or his client’s business associates.
4. Underwriters
Since 1995, another change in the NIM is with respect to intermediaries in the role of underwriters.
Underwriting is no longer mandatory. Underwriters should have a certificate of registration with the SEBI and
are governed by the rules and regulations of the SEBI. He has to abide by a code of conduct. The third
intermediary is the banker to the issue. He has also to be registered with the SEBI and has to pay fees of 2.5
lakhs for the first 2 years and ` 1 lakh for the third year. He has also to abide by the code of conduct laid
down by the SEBI. Another intermediary, i.e., Brokers to the issue is extremely important in the stock market
but it is not compulsory in the NIM.
5. Registrars and Transfer Agents
An important activity in NIM which has been carried on after 1985 is to appoint Registrars and share
transfer agents to an issue. The role of the registrars is extremely useful. They keep a record of the investor
and assist companies for allotment of securities. They despatch allotment letters, refund orders, certificates and
other documents relating to the issue of capital. The transfer agents maintain records of holders of security and
deal with transfers and redemptions of securities. In Category I are placed those who are both Registrars and
transfer agents and in Category II are those who are either transfer agents or registrars. They must be compulsory
registered with the SEBI and the capital adequacy requirement in ` 6 lakhs for Category I and 3 lakhs for
Category II. They also have to maintain a code of conduct and act within the legal jurisdiction of the SEBI.
A debenture trustee is also a necessary intermediary in the NIM. The debenture trustee has to be registered with
SEBI. Only scheduled commercial banks, public financial institutions, insurance companies and companies are
entitled to act as debenture trustees. The registration fees for a debenture trustee are ` 2 lakhs for the first two
years and 1 lakh for the third year. The role of debenture trustee is to look after the trust property and carry
out all the activities for the protection of the debenture holders. Since, the work requires integrity and fairness
in discharging their duties. SEBI has a code of conduct for debenture trustees within which they have to carry
out their duties.
6. Promoters
The contribution of the promoters in the public issue has to compulsorily be made before the opening of
the public issue. However, where companies are issuing shares of above ` 100 crores, 50% are to be made
before the opening of the issue and the balance is to be collected before the calls are made. After receiving
the contribution of the promoters the company has to file a copy of the amount received from the promoters
with the SEBI. The promoters’ contribution has a lock in period during which they are not transferable. These
shares can be used as security with banks on loans granted by them.
The intermediaries have thus to follow a code of conduct, should fulfill capital adequacy norms and be
disciplined in their dealing in the NIM. In case they do not follow the SEBI guidelines their registration can be
cancelled and they may be penalised by a penalty also.
3.10 ISSUE OF CAPITAL IN NEW ISSUE MARKET

The SEBI has also made certain procedural changes in the mode of issue of capital for removing deficiencies
in the issue procedure. Those companies which intend to issue capital have been classified into existing listed
companies, existing unlisted companies and new companies. These are divided into 8 categories. These are:
1. Categories of Companies Issuing Shares
Category A: This category consists of new companies with less than 12 months in operation. At least 25%
and 20% of total issued capital of ` 100 crores and above ` 100 crores respectively should be
through promoters like friends, relatives and associates. The first public issue must be made at
par.
Category B: In this category are those companies which have a good record of making profits for the last
five years and are making their first public issue. They are free to price their issue at par or
premium.
Category C: Consists of private, closely held and unlisted companies which are making their first public
issue. Such companies have a good past record of profits in at least three out of five years. It
can issue shares at premium but it must provide a justification to the SEBI.
Category D: Is of private, closely held and unlisted companies without a consistent record of past profitability.
Category E: Consists of the same group of companies without a consistent past record of profitability but
supported by existing companies with a consistent record of profitability in the last five years.
Category F: Is of existing listed companies that are making a public issue.
Category G: Existing companies - private, closely held and unlisted companies of past profitability by offering
to public without issuing fresh capital and seeking disinvestment. The promoters’ share should
be at least 25% and they can offer their shares at premium.
Category H: Existed companies- private, closely held and unlisted without a record of profitability by offering
securities to the public without issue of fresh capital. They can make their issue only at par.
The minimum offer made to public should be 25% of each type of securities. The limit may be relaxed
in the case of development financial institutions and government companies. The balance of 75% may be
allotted to different categories of people and includes the promoters’ contribution and reservations with it.
Investors under firm allotment category cannot apply in the general category. Firm allotment may be given
specifically under SEBI guidelines.
2. Eligibility for Public Issue
One of the most important issues in the primary securities market was to protect the investors from
fraudulent dealings. Hence, SEBI made certain important reforms. SEBI made eligibility criteria for New Issues.
A company could issue shares in the New Issue Market only if it had paid a dividend for at least three years
prior to the public issue. If a company did not have a record of payment of dividends in the previous three
years it should get its project appraised by banks or financial institutions which have a 10% stake in equity
participation of the issuing company. A third criterion is that the securities of the company should be listed with
OTCEI (Over the Counter Exchange of India). SEBI also asked such companies to make draft prospectus of
company available to public and to give financial projections in their offer documents.
3. Share Application Procedure
The application for shares is also made in accordance with SEBI guidelines. The minimum application
money paid is 25% of the issue price. If the face value is ` 10, a minimum of ` 2.50 should be paid at the
time of application of shares. There should be a minimum of 30 collection centres at which money can be
collected. The collection agents are authorised to collect application money by cheques or drafts but not in
cash. The application money so collected should be deposited in the share application account with the
authorised banker. If the minimum subscription amount of 90% of the issue is not received it will not be a valid
issue and within 45 days of the closing of the issue a report signed by the chartered accountant must be sent
to the SEBI. If the issue is oversubscribed, proportionate allotment is to be made to all the investors. Before
the public issue is made it is mandatory that a prospectus is filled by the lead managers to the SEBI.
¾ Guidelines for advertisement: SEBI has issued guidelines regarding code of ‘advertisement’ for
issue of shares. The statements in these advertisements should be clear and fair and not misleading
and false.
¾ Bought out deals: SEBI has also issued guidelines for Bonus issues and right issues and debentures.
A new development in the NIM relates to ‘Bought Out deals’ in sale of securities. Bought Out deals
involve the promoters, sponsors and investors. It is an outright sale of a larger amount of equity to
one single sponsor by an unlisted company. The price settled for purchase of those shares depends
on negotiations and project evaluation and the price is competitive. The shares can be treated at the
OTCEI or any recognized stock exchange to help the company to get listed. This is a specific activity
of a merchant banker. The main difference between bought out deals and private placements is that
bought out deals are usually in unlisted companies and private placements are dealings of listed
companies.
4. Allotment of Shares
Reforms relating to allotment of shares to investors were also made by SEBI. In case preferential allotment
was to be applied by a company 50% of the public offer was to be reserved for individual investors applying
for less than 100% securities and 50% to be allotted to these who apply for more than 1000 shares or
maximum of ` 1 lakh. Also shareholders allotted shares were to receive their allotment within 30 days of closure
of the issue after which the company would have to pay 15% rate of interest. Merchant Bankers of SEBI
imposed Mandatory restrictions on costs of public issue on underwriting commission, brokerage, fee of managers
of issue, fee to registrars to the issue, listing fees and advertisement cost and compulsory registration of
Merchant Bankers and Bankers to the Issue. Only corporate bodies would be allowed to function as Merchant
Bankers, Restriction was imposed upon them for carrying out funds based activities exclusively in the capital
markets. They were prohibited from accepting deposits and leasing and Bill discounting.
The NIM continued to make changes for improvements and toning up the quality of work in the market.
SEBI appointed the Malegam Committee in 1995 to offer guidance in respect of disclosures made by companies
to the SEBI in respect of documents such as prospectus, financial information through the annual balance sheet
and accounts and information to be given to SEBI on different issues from time to time. The Malegam Committee
has suggested requirements on disclosures in documents of a company. This has come into effect since October
1, 1995. They cover all aspects such as prospectus, advertisements, new issues and right issues, pricing of
shares, issue of shares at a premium, pure rigging and mergers.
We now turn to the mechanics of purchasing and selling shares on the stock exchange.
3.11 FUNCTIONS OF THE NEW ISSUE/PRIMARY MARKET

The NIM has three functions to perform. These may be put together to be called ‘performing’ role of the
NIM. These functions as described as: (a) Origination, (b) Underwriting, and (c) Distribution. The interplay of
these functions helps to transfer resources from the sources of surplus funds to those who require these funds,
i.e., the ultimate users of these funds.
1. Origination
Origination is the work which begins before an issue is actually floated in the market. It is the stage where
initial ‘spade work’ is conducted to find out the investment climate and to be sure that if the issue is floated
it will be subscribed to by the public. The factors which have to be carefully analysed are regarding the
soundness of the project. Soundness of the project refers to its technical feasibility backed by its economic and
financial viability. It is also concerned with background factors which facilitate the success of an issue. The
underlying conditions are:
(a) The Time of Floating of an Issue: This determines the mood of the investment market. Timing is
crucial because it has a reflection on the subscription of an issue. Periods of buoyancy will clearly show over-
subscription to even ordinary quality issues and are marked by the general lack of public support during
depression. From September 2008 till August 2009 the number of new issues has been very few due to financial
crisis affecting world over and also India.
(b) Type of Issues: This refers to the kind of securities to be issued whether equity, preference, debentures
or convertible securities. These have significance with the trends in the investment market. Sometimes there is
a sudden spurt of new issue of shares marked with government support and tax incentives. Investors are keen
buyers of such an issue. The success of one encourages issues of these kinds to be floated. In these times the
market will have little support from even sound and good issues of other types of securities. The kind of
marketability of the issue is an important analysis at the time of origination.
(c) Price: The encouragement of public to a particular issue will largely depend on the price of an issue.
Well established firms of some group connections may be able to sell their shares at a very high premium at
the times of a new issue but relatively unknown firms will have to be cautious of the price. In India most of
the shares are priced according to the demand and supply through the method of book building and bidding
for shares.
The functions of the NIM at the same time of origination are, therefore, based on preliminary investigation
and are mainly advisory in nature. Since 1981, the function of origination has been taken over in India by
certain specialised divisions of commercial banks. Commercial banks have created a special cell called the
‘merchant banking’ division through which they advise the companies about the viability of the project. Merchant
banking was first started in 1969 in India by Grindlays Bank. They took the entire function of working out the
necessary inputs and details for floating an issue and undertook to the function of origination of only those
firms in whom they believed that success could be achieved. The Merchant Banking Divisions of commercial
banks in India do not undertake to achieve the success of floatation of an issue. This division has begun its
operations with the view of promoting new issues and those units which are useful for the economic development
of the country.
2. Underwriting
Underwriting is not compulsory in India but since it lends stability to companies they prefer institutions
that underwrite their new issues because according to the Companies Act 1946 allotment of shares cannot take
place unless 90% of the shares have been subscribed. Underwriting is a kind of guarantee undertaken by a
financial institution, bank or firm of brokers ensuring the marketability of an issue. It is a method whereby the
guarantor makes a promise to see the stock issuing company that he would purchase a certain specified number
of shares in the event of their not being invested by the public. Subscription is thus guaranteed even if the
public does not purchase the shares for a commission from the issuing company.
The brokers do not underwrite ‘firm’. They guarantee shares only with the view of earning commission
from the company floating its shares. They are known to off-load their shares later again to make a profit. The
broker’s policy can thus be identified with ‘profit motive’ in underwriting industrial securities. Financial Institutions
underwrite firm and keep the shares on their own portfolio.
3. Distribution
The New Issue Market has a third function besides the function of origination and underwriting. The third
function is that of distribution of shares. Distribution means the function of sale of shares and debentures to
the investors. The primary market is supported by financial intermediaries to bring about sale of shares. This
is performed by lead managers, merchant bankers, portfolio managers, underwriters and bankers to the issues.
4. Mechanics of Floating New Issues
The objective of the New Issue Market is to centre its activities towards floatation of New Issues. The
methods by which the new issues are placed in the market are: (a) Public Issues, (b) Offer for Sale, (c) Book
building, (d) red herring prospectus, (e) green shoe option and (f) Private Placement. SEBI through its Act of
1992 has classified issues in the new issue market as new issues, right issues and employees’ stock options and
sweat equity.
(a) Public Issue: The most popular methods for floating shares in the new issue market is through a legal
document called the ‘Prospectus’. The issuing company makes an offer to the public directly of a fixed number
of shares at a specific price. Two features are noticeable in floatation through prospectus method: it is usually
underwritten by strong public financial institutions in India. The public issue through prospectus is made when
a company sells shares through a fixed price.
Prospectus
Offer to the public is made through prospectus. The contents of the prospectus are the following:
(i) Name of the company.
(ii) Address of the Registered Office of the company.
(iii) Activities of the company. Existing business functions and its proposal for the future.
(iv) Location of the industry.
(v) Names of the Directors of the firm.
(vi) Minimum subscription.
(vii) Dates when subscription is opened and date of closing offer.
(viii) Institutions underwriting the issue, their names, address and amounts underwritten.
(ix) A statement made by the company that it will apply to the stock exchange for quotation of its shares.
Sale through prospectus is a direct method of floatation of shares. Intermediaries are participants for sale
of shares. The company has to incur expenses on administration, advertisement, printing, prospectus, paper
announcements, bank’s commission, underwriting commission, agents’ fees, legal charges, stamp duty, document
fees, listing fees and registration charges.
(b) Offer for Sale: Offer for sale is a method of floatation of shares through an ‘intermediary’ and
‘indirectly’ through an ‘issuing house’. It involves sale of securities through two distinct steps. The first step is
a direct sale by the issuing company to issuing houses and brokers. The second step is also a second sale of
these securities involving the issue house and the public. The price of the shares is at a higher rate to the public
for which the ‘issuing house’ (or intermediary) purchases from the ‘issuing company’. The profit charged by
the issuing house is called a ‘turn’. Offer for sale method is not used in India. It is widely used for floatation
as described in the public offer method. In India, offer for sale method is sometimes used when a foreign
company floats its shares.
(c) Book Building: A price band is given and the public is asked to bid for the price within that band.
The preferred price settles the pricing of the issue. This method of decision through bids is called book building.
The bidding process is to be open for 5 days. The retail bidder has the option to bid at cut off price, they are
allowed to revise their bids and the bidding demand is displayed at the closing time each day. The syndicate
members can bid at any price. Allotment of shares is done within 15 days of closing the issue. If a certain
category is under subscribed, the unsubscribed portion can be allotted to bidders in other categories. The book
building portion has to be underwritten by book runners or syndicate members. Book building facility was
developed in the initial public offer to bring about the flexibility of price and quantity, which would be decided
on the basis of demand. In India book building was first developed for issues above 100 crores and consisted
of that portion which is reserved for institutional and corporate investors. It is a flexible pricing method based
on feedback from investors and in the US it is called soft underwriting.
In November 2001, the book building guidelines brought about 100% book building for companies which
wanted to bring out a public issue. The issuer company was allowed to issue securities to public through a
prospectus either through 100% of the net offer to the public through book building process or 75% of the net
offer to the public through book building process and 25% of the price determined through book building. The
Red Herring Prospectus would disclose the floor price of the securities and not the maximum price. The lead
manager would make the bids on a real time basis. The bidding centres for 100% book building of the net offer
to the public would be made through all recognized stock exchanges. When the offer is made in accordance
with 75% of the net offer to the public then the process would be according to the collection from the number
of mandatory collection centres.
If a company issues 100% of the net offer to the public through book building, the following conditions
are applicable.
¾ Retail bidders would be allotted not less than 25% of the net offer to public. The investors eligible
under this category were those who applied up to 1000 shares.
¾ 15% of the net offer to public would be allotted to investors which apply for more than 1000 securities.
¾ 60% of the net offer would be offer to qualified institutional buyers.
If a company issues 75% of the net offer to public and 25% is determined through book building:
¾ 15% of the net offer to public would be allotted to non-institutional investors.
¾ 60% of the offer would be allotted to qualified institutional buyers.
¾ 25% of the balance through book building would be provided for individual investors who have not
participated or received any allocation of the book built portion.
(d) Red Herring Prospectus: It is issued when the price of the shares is not given in the prospectus.
There are no details of the number of shares offered to the public. This is a prospectus which is introduced
with the concept of book building.
(e) Green Shoe Option (GSO): It is a stabilizing mechanism in the form of an option available to a
company to allocate shares at a price, which is higher, then that of the public issue. It operates a post-listing
price through stabilizing agent. This provision has been allowed by SEBI from August 2003 to those companies,
which issue shares through book building mechanism for stabilizing the post-listing price of the shares. ICICI
bank was the first Indian company to offer GSO services in 2004. The green shoe option operates in the
following manner.
1. The company appoints a lead book runner as stabilizing agent for stabilizing the price of the securities.
2. The stabilizing agent enters into a agreement with the promoters to the company to lend shares upto
15% of the total issue size.
3. The shares are kept in GSO demat account that is separate from the issue account and borrowed
shares are in a dematerialized form.
4. If shares are over subscribed allocation is done on a pro-rata basis for the applicants.
5. When the money is received from allotting shares it is placed in the separate GSO account.
6. To stabilize the post listing price the stabilizing agent determines the timing and quality of shares that
are to be purchased.
7. The shares have to be returned to the promoters within two days of closing stabilizing process.
8. On the expiry of the stabilization period the stabilizing agent has to remit the amount from GSO
account the amount multiplied by the issue price to the investor protection fund.
(f) Private Placement: This is another method of floatation not used normally in the Indian capital
market. In the London Stock Exchange this is operative and is used for an issuing house to sell shares to its
own clients. ‘The Issuing House’ or ‘Intermediaries’ purchase shares from companies issuing their shares.
Subsequently, the issuing house sells these shares for a profit. The issuing houses maintain their own list of
clients and through customer contacts sell shares.
The main disadvantage of this method is that the issues remain relatively unknown. A small number of
investors buy a large number of shares and are in this way able to corner shares of firms.
This method is useful when small companies are issuing their shares. They can avoid the expenses of issue
and also have their shares placed. Timing is crucial from the point of view of floatation of shares. In a
depressed market condition when these issues are not likely to get proper public response through prospectus
placement method, this is an excellent process for floatation of shares.
Special Types of Issues
The different types of issues in the new issue market are equity shares, bonds, financial engineering
securities and some special securities like right issues, employee’s stock option and sweat equity.
1. Right Issues: Shares floated through ‘right issues’ are a measure for distribution of shares normally
used for established companies which are already listed in the stock exchange. This is an offer made
to existing shareholders through a formal letter of information. In India, according to Section 81 of
the Companies Act, 1956 (a) one year after the company’s first issue, (b) or two years after its
existence, right shares must be issued first to existing shareholders. The shares can also be offered to
the public after the rights of the existing shareholders have been satisfied. These shares are issued in
proportion to the shares held by the existing shareholders. This right can be taken away by the
company by passing a special resolution to this effect.
2. Employees Stock Option: This is a right given to the employees, officers as well as directors of a
company to purchase shares at a future date but at a pre-determined price. This option is only for the
employee and is not transferable to other people.
3. Sweat Equity: The company Act of 1956 and the rules as per SEBI Sweat Equity Regulation 2003
allows a company to issue its shares to its employees or directors at a discount or free for consideration
other than cash for providing services or knowledge based activities to the company. Sweat Equity can
be sold even below the par value. It is a method of recognizing the employees’ contribution to
intellectual property rights to the company, which may be in a form of contribution towards research,
strategy, or additions to the companies profitability. SEBI allows such an issue to a company if:
(i) such shares have already been issued, (ii) commercial activity has taken placed for at least one
year, (iii) the issue has been authorized by special resolution.
The changes in the NIM especially those relating to market intermediaries, issue procedures and disclosures
have helped in removing inadequacies and deficiencies in the New Issue Market and in bringing about significant
improvement in compliance with the New Economic Policy of the economy which came into force in 1991.
The four methods of floatation discussed above are: (a) Offer to public, (b) Offer for sale, (c) Book
building and (d) Private Placement. In India, offer to public through prospectus and some special types of issues
like right issues, employee’s stock option and sweat equity have also been discussed.
3.12 SECONDARY/STOCK MARKETS

The secondary market has the main function of providing liquidity to companies through sale and purchase
of already issues securities. The marketing of securities of the stock markets can be done only through members
of the Stock Exchange. These members are either individuals or partnership firms. Trading among the members
of a recognised stock exchange is to be done under the statutory regulations of the stock exchange. The
members carrying on business are known as ‘brokers’ and can trade only on listed securities. These members
execute customer’s orders to buy and sell on the exchange and their firms receive negotiated commissions on
those transactions. About one-fourth of all members of the exchange are ‘specialists’, so called because they
specialise in ‘making a market’ for one or more particular kind of stock. In the process of trading in stock
exchanges there is the basic need for a ‘transaction’ between an individual and broker. A transaction to buy
and sell securities is also called ‘trades’. This is to be done through selection of a broker.
3.13 LISTING OF SECURITIES

When listing is granted to a company, it means that the securities are included in the official list of the
stock exchange for the purpose of trading. Security listing ensures that, a company is solvent and its existence
is legal. Listing provides the following advantages:
1. Advantages of Listing on Stock Exchange
(a) Detailed information about the company is available.
(b) Information increases the activity of purchase and sale of the security of that organization.
(c) Continuous dealing raises the value of security.
(d) Convenience of sale of security lending liquidity to the shares.
(e) There is safety in dealing.
(f) It ensures creditworthiness.
(g) Creates a favourable impression on the investor.
(h) Listing gives collateral value in making loans and advances from banks who prefers quoted securities.
(i) Widens the market of the security.
Thus, listing benefits both the investor as well as the company. Listing on stock exchange is done only
when the company follows the statutory rules laid down under the Securities Exchange Board of India (SEBI).
2. Rules for Listing of Securities
The following statutory rules have been laid down for the listing of securities under the SEBI. A company
requiring a quotation for its shares (i.e., desiring its securities to be listed) must apply in the prescribed form
supported by the documentary evidence given below:
Documents to be Attached
(i) Copies of Memorandum and Articles of Association, Prospectus or Statement in lieu of Prospectus,
Directors’ Reports, Balance Sheets, and Agreement with Underwriters etc.
(ii) Specimen copies of Share and Debenture Certificates, Letter of Allotment, Acceptance, Renunciation
etc.
(iii) Particulars regarding its capital structure.
(iv) A statement showing the distribution of shares.
(v) Particulars of dividends and cash bonuses during the last ten years.
(vi) Particulars of shares or debentures for which permission to deal is applied for.
(vii) A brief history of the company’s activities since its incorporation.
3. Criteria for Listing
The Stock Exchange has to direct special attention to the following particulars while scrutinizing the
application:
Articles of Associations:
(a) Whether the Articles contain the following provisions:
(i) A common form of transfer shall be used.
(ii) Fully paid shares will be free from lien.
(iii) Calls paid in advance may carry interest, but shall not confer a right to dividend.
(iv) Unclaimed dividends shall not be forfeited before the claim becomes time barred.
(v) Option to call on shares shall be given only after sanction by the general meeting.
(b) Whether at least 49% of each class of securities issued was offered to the public for subscription
through newspapers for not less than three days.
(c) Whether the company is of a fair size, has a broad based capital structure and there is sufficient public
interest in its securities.
4. Listing of Agreement
After scrutiny of the application, the stock exchange authorities may, if they are satisfied, call upon the
company to executive a listing agreement which contains the obligations and restrictions which listing will
entail.
This agreement contains 39 clauses with a number of sub-clauses. These cover various aspects of the issue
of letters of allotment, share certificates, transfer of shares, information to be given to the stock exchanges
regarding closure of register of members for the purpose of payment of dividend, issue of bonus and right
shares and convertible debentures, holding of meetings of the board of directors for recommendation or
declaration of dividend or issue of rights or bonus shares or convertible debentures, submission of copies of
directors’ report, annual accounts and other notices, resolutions and so no to the shareholders.
The basic purpose behind making these provisions in the listing agreement is to keep the shareholders and
investors informed about the various activities which are likely to affect the share prices of such companies so
that equal opportunity is provided to all concerned for buying or selling of the securities. On the basis of these
details, investors are able to make investment decisions based on correct information.
The stock exchange enlisting the securities of a company for the purpose of trading insists that all applicants
for shares will be treated with equal fairness in the matter of allotment. In fact, in the event of over-subscription,
the stock exchange will advise the company regarding the basis for allotment of shares. It will try to ensure that
applicants for large blocks of shares are not given under the preference over other.
A company whose securities are listed with a stock exchange must keep the stock exchange fully informed
about matters affecting the company, e.g.,
(i) to notify the stock exchange promptly of the date of the Board Meeting at which dividend will be
declared;
(ii) to forward immediately to the stock exchange copies of its annual audited accounts after they are
issued;
(iii) to notify the stock exchange of any material change in the general nature or character of the company’s
business.
(iv) to notify the stock exchange of any change in the company’s capital; and
(v) to notify the stock exchange (even before shareholders) of the issue of any new shares (right shares
or otherwise) as the issue of any privileges or bonus to members.
The company must also undertake:
(a) not to commit a breach of any condition on the basis of which listing has been obtained;
(b) to notify the exchange of any occasion which will result in the redemption, cancellation or retirement
of any listed securities;
(c) avoid as far as possible the establishment of a false market for the company’s shares;
(d) to intimate the stock exchange of any other information necessary to enable the shareholders to
appraise the company’s position.
According to Section 73 of the Companies Act, 1976, if a company indicate in its prospectus that an
application has been made or will be made to a recognized stock exchange for admitting the company’s shares
or debentures to dealings therein, such permission must be applied for within a stipulated period to time.
The Securities contracts (Regulation) Act, 1956, gives the Central Government power to compel an
incorporated company to get its securities with a recognized stock exchange in accordance with the rules and
regulations prescribed for the purpose. If a recognized exchange refuses to list the securities of a company, the
company can file an appeal against such a decision with the government. The Act empowers the government
to set aside or change the decision after giving proper opportunity to both the parties to explain their position
in this regard.
The following are the types of securities that can be traded in a stock market.
5. Specified and Non-specified Securities
Three kinds of securities can be traded upon in the Mumbai Stock Exchange – specified, non-specified and
odd lot.
(a) Specified securities: In the specified category of equity shares the criteria are that the share should
be listed on the stock exchange for at least 3 years and the issued capital should not be less than `
75 crores. It should have a market capitalisation of two or three times. At least 20,000 shareholders
should be on the dividend receiving list. It should be a growth company with shares of ` 4.5 crores
face value and its shares should be actively traded on the Mumbai Stock Exchange.
(b) Non-specified securities: The companies which do not have specified securities are in the non-
specified securities list.
In order to trade in the stock market the broker must be selected. A person can engage in online trading
but in India a large number of people depend on brokers to help them to buy and sell securities. The broker
is useful because he gives the following kinds of services.
3.14 DEPOSITORY SYSTEM OR PAPERLESS TRADING

The Depository Act was passed in 1996 allowing dematerializing of securities and transfer of security
through electronic book entry to help in reducing settlement risks and infrastructure bottlenecks. The dematerialized
securities will not have any identification numbers or distinctive numbers. The National Securities Depository
Ltd., was set-up in Nov 1996. Trading of new Initial (NSDC) public offers were to be in dematerialized form
upon listing. An exclusive feature of the Indian Capital Market is that multiple depository system has been
encouraged. Hence, there are two Depository Services. The other depository system is also registered. It is
called Central Depository service Ltd. (CDSL). Debt instruments however, are not transferable by endorsement
delivery.
Dematerialization of securities is one of the major steps for improving and modernizing market and
enhancing the level of investor protection through elimination of bad deliveries and forgery of shares and
expediting the transfer of shares. Long-term benefits were expected to accrue to the market through the removal
of physical securities.
1. Usefulness of a Depository System
A depository system was required in India to eliminate physical certificates. A depository system has the
following advantages:
¾ It eliminates risks, as this system does not have physical certificates. There are no problems regarding
bad deliveries or fake certificates.
¾ It is an electronic form and provides transfer of securities immediately without any delay;
¾ A depository provides a demat account with a client identification number and a depository identification
number. Therefore, there is a special identity of a member. He also has a trading account, which
enables him with identity and immediate transfer.
¾ There is no stamp duty on transfer of securities because there is no physical transfer. It is transfer
through a pass book similar to a bank;
¾ The DP charges a yearly charge for maintaining the member account, hence, there is a reduction of
paper work and transaction cost of a frequent transfers of securities.
¾ Investors had the problem of selling shares in Odd Lots but with the depository system even one share
can be sold.
¾ Since a depository allows a nomination facility, hence shares can be easily transferred at the time of
death of a participant.
¾ Change in address recorded with DP gets registered with all companies in which investor holds
securities electronically eliminating the need to correspond with each of them separately;
¾ Transmission of securities is done by DP eliminating correspondence with companies; There is an
automatic credit into demat account of shares, arising out-of bonus, split, consolidation, merger etc.
2. The Working of a Depository System
A depository consists of the following constituent members:
(a) Depository: This is an institution which is similar to a bank. An investor has the facilities of depositing
securities or withdrawing them. He can buy and sell securities through the depository.
(b) Depository Participants (DP): A DP is an agent of a depository. He is the link between the
investor and the depository. To avail the services of a depository you require to open an account with
any of the depository Participant of any depository. Share brokers, banks, financing institutions and
custodians can become a DP after they are registered with the SEBI.
(c) Opening of an Account: An investor has to approach a DP and fill up an account opening form
and follow the Account opening procedure. He has to fill a form and give Proof of Identity: Signature
and photograph of investor must be authenticated by an existing demat account holder or by his
banker. He has to submit some proper identification papers. He may submit a copy of a valid Passport,
Voters Id Card, Driving License or PAN card with photograph. As Proof of Address he may submit
passport, voter ID, PAN card, driving license or bank passbook. Investor should carry original documents
for verification by an authorized official of the depository participant, under his signature. Further
investor has to sign an agreement with DP in a depository prescribed standard format, which details
investor's and DPs rights and duties. DP should provide investor with a copy of the agreement and
schedule of charges for his future reference.
(d) Identification Number: The DP will open investors’ account in the system and give an account
number, which is also called BO ID (Beneficiary owner Identification number). An investor can have
multiple accounts in the same name with the same DP and also with different DPs. It is not necessary
to have any minimum balance.
(e) Broker: A. Depository/DP can be chosen by an investor to be his broker for sale and purchase of
securities as well as his DP. He also has the option of having a trading account with another broker
which may not be his DP.
(f) Conversion of Shares into Dematerialized Form: In order to dematerialize physical securities an
investor has to fill in a DRF (Demat Request Form) which is available with the DP and submit the
same along with physical certificates DRF has to be filled for each ISIN no. The investor has to surrender
certificates for dematerialisation to the DP (depository participant). Depository participant intimates
Depository of the request through the system. He then submits the certificates to the registrar. The
Registrar confirms the dematerialisation request from depository. After dematerialising certificates,
Registrar updates accounts and informs depository of the completion of dematerialisations. Depository
updates its accounts and informs the depository participant. Depository participant updates the account
and informs the investor
(g) Rematerialization: If an investor is interested in getting back his securities in the physical form he
has to fill in the RRF (Remat Request Form) and request his DP for rematerialisation of the balances
in his securities account. He has to make a request for rematerialisation. Then the DP intimates the
depository of the request through the system. The Depository confirms rematerialisation request to the
registrar. Registrar updates accounts and prints certificates. Depository updates accounts and downloads
details to depository participant. Registrar dispatches certificates to investor.
(h) Distinctive Numbers: Dematerialized shares do not have any distinctive numbers. These shares are
fungible, which means that all the holdings of a particular security will be identical and interchangeable.
(i) Purchase and Sale of Dematerialized Shares: The procedure for buying and selling dematerialized
shares is similar to the procedure for buying and selling physical shares. The difference lies in the
process of delivery (in case of sell) and receipt (in case of Purchase) of securities. If an account holder
wants to purchase he will instruct the broker. The broker will receive the securities in his account on
the pay-out day. The broker will give instruction to its DP to debit his account and credit the account
of the account holder.
An account holder can give standing instruction for credit into his account so that he will not need to give
Receipt Instruction every time. If an account holder once to sell his shares he will give delivery instruction to
DP to debit his account and credit the broker’s account. Such instruction should reach the DP’s office at least
24 hours before the pay-in
3. Transaction Statement
The DP gives a Transaction Statement periodically, which details current balances and various transactions
made through the depository account. Transaction Statement is received through the DP once in a quarter. If
a transaction has been carried out during the quarter, the statement is received within fifteen days of the
transaction. In case of any discrepancy in the transaction statement, the account holder must immediately
contact the DP.
It can be concluded that the depositories transfer securities like a bank. There is no physical handling of
shares and the procedure consists of the following steps:
¾ Depository
¾ Depository Participants (DP)
¾ Opening of an Account
¾ Identification Number
¾ Broker
¾ Conversion of Shares into Dematerialized Form
¾ Rematerialization
¾ Distinctive Numbers
¾ Purchase and Sale of Dematerilized Shares
¾ Transaction Statement
3.15 BROKER SYSTEM OF TRADING OF SECURITIES

Trading in stock requires a procedure. First the shares have to be issued through the New Issue Market.
Then they should be listed on the stock market. In India, the stocks have to be registered with a depository.
Only dematerialized stocks can be traded through the depository system. The sale and purchase of securities
may be done either online or through a broker. However, all shares have to follow the demat system/depository
system or paperless trading in India.
1. Membership Rules in a Stock Exchange
In a Stock Exchange the contract can be made only by brokers or other registered members of the stock
exchange. To be a member a person has to conform to certain rules and regulations specified under the
Securities Exchange Board of India. These rules provide the following:
(a) No person shall be eligible to be elected as a member if he is less than 21 years of age;
(b) Not an Indian citizen;
(c) Adjudged bankrupt or proved to be insolvent or has compounded with his creditors;
(d) Convicted of an offence involving fraud or dishonesty;
(e) Engaged as principal or employee in any business other than that of securities;
(f) Member of any other association in India where dealings in securities are carried on;
(g) Director or employee of company whose principal business is that of dealing in securities;
(h) Lastly, firms and companies are not eligible for membership of a recognised stock exchange and
individuals are ordinarily not deemed to be qualified unless they had at least two years’ market
experience as an apprentice or as a partner or authorised assistant or authorised clerk or remisier of
a member.
(i) Members of the Exchange are entitled to work either as individual entities, or in partnership, or as
representative members transacting business on the floor of the market not in their own name but in
the name of the appointing members who assume the market responsibility for the business so transacted.
The formation of partnerships and appointment of representative members is subject to the approval
of the Governing Body.
(j) Members are entitled to appoint attorneys to supervise their stock exchange business. Such persons
must satisfy in all respects the conditions of eligibility prescribed for membership of the Exchange and
their appointment must be approved by the Governing Body.
(k) Active members are also entitled to appoint authorised assistants or clerks to enter into bargains in
the market on their behalf and to introduce clientele business. Remisiers to bring in customers’ business
may also be appointed.
(l) Registered members are given entry to the floor of the exchange and remunerated with a share of
brokerage but they are not permitted to transact any business except through the appointed members
or their authorised assistants or clerks. But their appointments as well as of authorised assistants and
clerks are subject to the approval of the Governing Body.
(m) The Governing Body of a recognised Stock Exchange has wide government and administrative powers.
It has the power, subject to government approval, to make, amend and suspend the operation of the
rule, by-laws and regulations of the Exchange. It also has complete jurisdiction over all members and
in practice, its power of management and control are almost absolute.
A member of the stock exchange must have the necessary infrastructure, manpower and experience to
conduct the business of purchasing and selling securities. He has to work under the rules, regulations and bye-
laws of the different stock exchanges. Every broker has to be registered by paying a fees and forwarding an
application to the SEBI through the stock exchange where he wants to become a member. He has to maintain
a high standard of integrity and protect the interest of the investor by making prompt deliveries and payments.
He has to maintain a record of his dealings through books of accounts such as Journal, ledger, cash book, bank
pass book, contract notes to clients and details of contracts. These books should be maintained and a record
of 5 years should be preserved. If a member fails to comply with the conditions of registration his membership
can be cancelled or he may be penalised by the SEBI. SEBI is also empowered to inspect the books of members
and in the interest of investors attend to any complaints made by them about a stock broker through investigations
and audit of documents and organizational activities.
SEBI has also brought about control over members by investing on capital adequacy norms. A member
is required to have a lease capital and an additional capital which is related to the value of business. The base
or minimum capital required by Bombay Stock Exchange and Kolkata Stock Exchanges is ` 5 lakhs. Ahmedabad
and Delhi stock exchanges require a minimum of ` 3.5 lakhs from members. Other stock exchanges require
` 2 lakhs as a minimum deposit. One-fourth of the minimum requirements is to be maintained by the brokers
in cash with the stock exchange. 25% is to be maintained as a long-term fixed deposit with a bank with a lien
of the stock exchange. The rest of the 50% is to be maintained in the form of securities with a margin of at
least 30%. The gross outstanding business should not be more than 12.5 times of the combined base and
additional capital. For any additional business there should be additional capital. As a rule this should not be
less than 8% of the gross outstanding business of the broker. The member’s capital is calculated by taking into
account all his assets minus non-allowable assets. A member or broker must maintain separate accounts for
himself and his client but the broker can claim his charges from his client.
SEBI also insists that stock brokers (members) of a stock exchange should also maintain a code of conduct
in their dealings with other brokers of the same stock exchange. In the interest of the investors he should be
disciplined and should not make false statements to fellow brokers as it is likely to jeopardize the interest of
the investors.
2. Functions of a Broker
The selection of broker depends largely on the kind of service rendered by a particular broker as well as
upon the kind of transaction that a person wishes to undertake. An individual usually prefers to select a broker
who can render the following services:
(a) Provide Information: A broker to be selected should be able to give information about the available
investments. These may be in the form of capital structure of companies’ earnings, dividend policies,
and prospects. These could also take the form of advice about taxes, portfolio planning and investment
management.
(b) Availability of Investment Literature: Secondly, a broker should be able to supply financial
periodicals, prospectuses and reports. He should also prepare and analyse valuable advisory literature
to educate the investor.
(c) Appoint Competent Representatives: Brokers should have registered competent representatives
who can assist customers with most of their problems. In other words, to personalise brokerage
business so that the customers need not have to look after for their broker, the broker should be able
to give the services at the residence or office of the investor.
The investor who is satisfied with the qualities of the broker will have to look next for a specialised broker.
The second process is to find a good, reputed and established broker in the kind of deal that the investor is
interested. In India, the stock exchange rules, by-laws and regulations do not prescribe any functional distinction
between the members. Brokers establish themselves and are known for their specialisation.
After a broker has been selected the investor has to place an ‘order’ on the broker. The broker will open
an account in the name of the investor in his books. In case, the investor wishes to sell his securities he will
have to give his dematerialized (DEMAT) account number and trading account number.
3. Broker Receiving, Buying and Selling Orders
Brokers receive a number of different types of buying and selling orders from their customers. Brokerage
orders vary as to the price at which the order may be filled, the time for which the order is valid, and
contingencies which affect the order. The customer’s specifications are strictly followed. The broker is responsible
for getting the best price for his customer at the time the order is placed. The price is established independently
by brokers on an auction basis and not by officials of the exchange. The following transactions take place on
orders in the stock exchange.
4. Exercising Choice of Orders
(a) Spot Delivery: Spot delivery means delivery and payment on the same day as the date of the
contract or on the next day.
(b) Forward Delivery: Forward delivery is the transaction involving delivery and payment within the
time of the contract or on the date stipulated when entering into the bargain which time or date is
usually not more than 14 days following the date of the contract.
(c) Market Orders: Market orders are instructions to a broker to buy or sell at the best price immediately
available. Market orders are commonly used when trading in active stocks or when a desire to buy
or sell is urgent. With this order a broker is to obtain the best price he can for his customer – that
is the lowest price if it is an order to buy and highest price if it is one to sell at the time when the
order is executed.
(d) Limit Orders: Limit orders instruct a broker to buy or sell as a stated price ‘or better’. When a buyer
or seller of stock feels that he can purchase or sell a stock at a slight advantage to himself within the
next two or three days, he may place a limited order to sell at a specified price. A limit order protects
the customer against paying more or selling for less than intended. A limit, therefore, specifies the
maximum or minimum price the investor is willing to accept for his trade. The only risk attached to
a limit order is that the investor might lose the desired purchase or sale altogether for a small margin.
For example, if an investor instructs his broker to buy 10 shares of company, at limit price of ` 20/- the
market price at the time of this limit order is placed at 21. The order will ‘go on’ the broker’s records
at 20 and ‘stay in’ for however long the investor specifies. It cannot be executed except at 20. Indeed
it may never be executed at all. On the other hand, if he wishes to sell stock which is selling at 21
in the market and he enters a limit order of 23, he runs the risk that the stock may never go up to
23 and he may not be able to sell, on the contrary the price may come down.
(e) Stop Order: Another type of order that may be used to limit the amount of losses or to protect the
amount of capital gains is called the stop order. This order is sometimes also called the “stop loss
order”. Stop orders are useful to both speculators and investors. Stop orders to sell can be used to
sell out holdings automatically in case a major decline in the market occurs. Stop orders to buy can
be used to limit possible losses on a short position. It may also be used to buy if a market price seems
to indicate a major upswing in the market. Stop orders are most frequently used as a basis for selling
a stock once its price reaches a certain point. Suppose that an investor owns securities in a company
X whose current market price is ` 44. After an analysis he finds that the market conditions is uncertain
and the price can move either way. To minimise the potential loss he stops order at ` 42. If the market
price goes down his shares will sell at 42. If the market price rises, he has nothing to lose. On the
contrary, if the market price rises to 50, to ensure some gain on this price rise the investor might raise
the stop loss order at 48. The investor may gain if all his securities are sold at 48. Most likely he will
not be able to off-load all at the price but he will ensure that no loss arises out of this transaction.
He might even be expecting some profit.
The market order, limit order and the stop order are three main kinds of orders. There are various other
discretionary orders also in the securities market. These orders are executed through various trading techniques.
To stabilize the market, limits have been imposed. When the stock market is on the rise being bullish or
when it is bearish, limits on brokers and jobbers help in keeping the market firm and stabilized. In normal
periods of time, the total outstanding purchases and sales which can be made at one point of time is ` 5 crores.
If these have to be carried forward the limit is ` 3 crores. A broker’s carry forward business should not exceed
one-fourth of this daily transaction. 75% of his daily transaction should be in cash. This system is called the
“thin track” system whereby SEBI keeps a strict vigil on broker’s dealings in the stock market. A capital
adequacy norm has also been suggested for individual brokers. These reforms have been brought about after
recommendations were made by G.S. Patel Committee in 1995. SEBI was set-up to regulate the organization
and working of the stock exchanges and members operating within it. SEBI has brought about uniformity in
the different stock exchanges. Nine stock exchanges were given permanent recognition. Every stock exchange
is to be managed by a committee called a governing board consisting of brokers, directors, government, SEBI
and public representatives.
5. Kinds of Trading Activity
(a) Options: An ‘Option’ is a contract which involves the right to buy or sell securities (usually 100
shares) at specified prices within a stated time. There are various types of such contract, of which ‘puts’ and
‘calls’ are most important. A ‘put’ is a negotiable contract which gives the holder the right to sell a certain
number of shares at a specified price within a limited time. A ‘call’ is the right to buy under a negotiable
contract.
Example: Mr. X is an investor holding 100 shares of a certain stock selling at ` 60 per share. He wishes
to hold the stock but fears a decline in the price. He may purchase a ‘put’ which gives him the right to sell
stock at ` 45 a share to the seller of the option. Similarly, another investor may purchase a ‘call’ if he wishes
to buy 100 shares at the market price of ` 60. He may buy if he gets the right to buy the stock of ` 55 a share
from the seller of the option. That investor may purchase this call who knows that the time is not opportune/
appropriate but fears that the price may rise suddenly when he is waiting. The purchase of an option runs the
risk of losing his entire investment in a short period of time. If the market price of the security fails to rise above
the required price, the option will become worthless on its expiry. Sometimes these option transactions are
combined. These are called options and are exercised through the following strategies:
(b) Establishing a Spread: A spread involves the simultaneous purchase and sale of different options
of the same security. A vertical spread is the purchase of two options with the same expiry date but different
striking prices. In a horizontal spread, the striking price is the same but the expiry date differs.
(c) Buying a Call: Buyers of Call look for option profits from some probable advance in the price of
specified stock with a relatively small investment compared with buying the stock outright. The maximum that
can be lost is the cost of the option itself.
(d) Writing Options: A written option may be ‘covered’ or ‘uncovered’. A covered option is written
against an owned stock position. An uncovered or ‘naked’ option is written without owning the security. A
covered option is very conservative. The income derived from the sale of a covered option offsets the decline
in the value of the specified security.
(e) Wash Sales: A wash sale is a fictitious transaction in which the speculators sells the security and then
buys it a higher price through another broker. This gives a misleading and incorrect position about the value
of the security in the market. The price of the security in the market rises in such a misleading situation and
the broker makes a profit by ‘selling’ or ‘unloading’ his security to the public. This kind of trading is considered
undesirable by the stock exchange regulations and a penalty is charged for such sales.
(f) Rigging the Market: This is a technique through which the market value of securities is artificially
forced up in the stock exchange. The demands of the buyers force up the price. The brokers holding large
chunks of securities buy and sell to be able to widen and improve the market and gradually unload their
securities. This activity interferes with the normal interplay of demand and supply functions in the stock market.
(g) Cornering: Sometimes brokers create a condition where the entire supply of particular securities is
purchased by a small group of individuals. In this situation those who have dealt with ‘short sales’ will be
‘squeezed’ and will not be able to make their deliveries in time. The buyers, therefore, assume superior position
and dictate terms to short sellers. This is also an unhealthy technique of trading in stock exchange.
(h) Arbitrage: Arbitrage is a technique of making profit on stock exchange trading through difference in
prices of two different markets. If advantages of price is taken between two markets in the same country it is
called ‘domestic arbitrage’. Sometimes arbitrage my also be between one country and another. It is called
‘foreign arbitrage’. Such an advantage in prices between two countries can be taken when the currencies of
both the countries can be easily converted.
Arbitrage usually equalises the price of security in different places. When the security is sold at a high price
in a market, more of the supply of the security will tend to bring a fall in the price, thus, neutralising the price
and making it equal to the price in the cheaper market.
On placing an order, the brokers get busy through different kinds of trading activities, which may also
include options and other speculations such as wash sales, rigging, cornering, blank transfers or arbitrage. The
speculators in the stock market are generally represented by ‘bull’, ‘bear’, ‘stag’, and ‘lame duck’.
6. Types of Speculators – Bull, Bear, Stag, Lame Duck
(a) Bull
A bull is a person on the stock exchange who expects a rise in the price of a certain security. A bull is
also called a ‘tejiwala’ because of his expectation of price rise. The usual technique followed by a bull is to
buy security without taking actual delivery to sell it in further when the price rises. The bull raises the price
in the stock market of those securities in which he deals. He is said to be on the ‘long side of the market’.
If the price falls (since there is no actual delivery) the bull pays the difference at a loss. The ‘bull’ may
thus close his deals if the price continues to fall or carry forward the deal to the next settlement day by paying
an amount called ‘contango’ charge. The bull may carry forward his deal if he expects a price rise in the future
which will cover the contango charge and also bring him profit.
Thus, active bulls in a stock exchange put pressure in a stock market and raise the price of the security.
The increase in prices is generated through bulk purchasing of securities.
Example of Bull Transaction: A person asks his broker to buy for him 500 shares at ` 10 each for
which there is no immediate payment. Before he pays for the shares on the date of settlement, the price of
shares rises by ` 5 per share. He would instruct his broker to sell the shares on his behalf. The transaction may
not be real. Only the difference may be paid for on the date of settlement. The Bull’s profit is calculated below:
`
500 shares sold @ ` 15 each 7,500
500 shares bought @ ` 10 each 5,000
Profit 2,500
(b) Bear
A bear is the opposite of a bull. He expects a fall in prices always. He is popularly known as ‘Mandiwalla’.
He agrees to sell for delivery, securities on a fixed date. He may or may not be in actual possession of these
securities. On the due date he purchases securities at a lower price and fulfils his promise at a higher price.
In this way he makes a profit on a transaction which may be ‘real’ or ‘notional’ with settlement of difference
only.
The bear makes a loss if the price rises on the date of delivery. In such a situation he will have to buy
at a higher price and sell at a lower rate in fulfillment of his agreement.
The share market usually shows a decline in price when ‘bears’ operate and sell securities not in their
possession. On the date of settlement the bear has an option either to close the deal or carry it forward by
an amount called the ‘backwardation’ charges. If the bear is able to make a profit on the settlement date it is
called ‘cover’ because the bear buys the requisite number of shares and sells them at a specified price on the
delivery date.
Example: A person expects a fall in the price of shares of a company. He may agree to sell 500 shares
at ` 15 each on a specified date. If before the fixed date the price of the shares has failed to ` 12 he makes
a profit of ` 3 per share, as calculated below is total profit on 500 shares:
`
500 shares sold @ ` 15 each 7,500
500 shares bought @ ` 12 each 6,000
Profit 1,500
(c) Bullish and Bearish
When the price is rising and the ‘bulls’ are active in the market, there is buoyancy and optimism in the
share market. The market in this situation is reigning ‘bullish’. Where there is decline in prices, the market is
said to go ‘bearish’. This is followed by pessimism and decline in share market activity.
(d) Bull Campaign and Bear Raid
The bulls begin to spread rumours in the market about rise in prices where there is an over-bought
condition in the market, i.e., the purchases made by the speculators exceed sales made by them. This is called
a ‘bull campaign’. Similarly, a ‘bear raid’ is a condition when speculative made by bear speculators exceed the
purchases made by them and they spread rumours to bring the price down.
(e) Lame Duck
A bear cannot always keep his commitments because the price does not move the way he wants the shares
to move. He is, therefore, said to be struggling like a ‘lame duck’.
Example: A bear may agree to sell 500 shares for ` 15 each on a specified date. On the due date, he
may not be able to settle his agreement for scarcity or non-availability of security in the market. When the other
party insists on delivery on that date itself, the bear is said to be a ‘lame duck’.
(f) Stag
A stag is a cautious speculator. He does not buy or sell securities but applies for shares in the new issue
market just like a genuine investor on the expectation that the price of the share will soon rise and be sold for
a premium. The stag shares the same approach as a bull, always expecting a rise in price. As soon as the stag
receives an allotment of his shares, he sells them. He is, therefore, taking advantage in the rise in price of shares
and is called ‘premium hunter’.
The stag does not always make a profit. Sometimes public response is not extraordinarily good and he
may have to acquire all the shares allotted to him and he may have to sell at a lower price than he purchased
it for when the stag sells at a discount he makes a loss. The market also suffers a decline. The stag is not looked
upon with favour.
(g) Hedging
Hedging is a device through which a person protects himself against loss. A ‘bull’ agreeing to purchase
a security for someone may ‘hedge’ or protect himself by buying a ‘put option’ so that any loss that he may
suffer in his transaction may be offset. Similarly, a seller can hedge against loss through ‘call’.
7. Giving Margin Money to Broker
Margin: Margin is the amount of money provided by customers to the brokers who have agreed to trade
their securities. It may also be called a provision to absorb any probable loss. When a customer buys on margin
the customer pays only part of the margin, the broker lends the remainder. For example, if a customer
purchases ` 10,000 market value of stocks and bonds, the customer might provide 60% margin or ` 6,000 and
the broker would lend the margin, the securities bought become collateral for the loan and have to be left with
the broker. The collateral in banks is carried in the broker’s name but is the purchaser’s property. He is entitled
to receive dividends and to vote in the shareholders’ meeting. Therefore, margin may be expressed in the
following manner:
Value of Collateral – Debit Balance

Margin =
Value of Collateral
OR
Equity
Margin =
Value of Collateral
Example: If X purchases 100 shares @ ` 100 per share or a total of ` 10,000 worth of stock at a margin
of 70% (` 7,000) and he borrows ` 3,000 from the broker. Assuming no commission is paid.
(a) X’s margin = 7,000 (70%)
Debit balance = 3,000
Equity = Current market value (` 10,000)
= Current debit balance (` 3,000)
= ` 7,000
7,000
Margin = ×100 = 70%
7,500
(b) If value of stock falls to 75
Calculate X’s margin
Debit balance = 3,000
Equity (7,500 – 3,000) = 4,500
5,500
Margin = ×100 = 60%
7,500
(c) If value of stock fall to 50
Calculate X’s margin
Equity (5,000 – 3,000) = 2,000
2,000
Margin = × 100 = 60%
5,000
Margin System: ‘Margin trading’ must be distinguished from ‘margin system’. Margin system is the
deposit which the members have to maintain with the clearing house of the stock exchange. The deposit is a
certain percentage of the value of the security which is being traded by members. In India, the margin system
is applied in Mumbai, Kolkata, Ahmedabad and Delhi Stock Exchanges. In these exchanges if a member buys
of sells securities marked for margin above the free limit, a specified amount per share has to be deposited with
the clearing house.
8. Preparing Contract Note in the Stock Exchange
Contract Note: The broker makes the transactions during the day depending on the instructions of the
buyer and the seller and prepares a contract note. He gets this signed by the buyer and the seller on a
prescribed form. The contract note gives the details of the contract for the purchase or sale of securities. It
records the number of shares, rate and date of purchase or sale. It also gives the ‘brokerage’ entitlement to
the broker.
Settlement of Contracts
Rolling Settlement: The last step is the settlement of the contract by the broker for his client.
A ready delivery contract is to be settled within 3 days in Kolkata Stock Exchange and 7 days at the
Mumbai and Chennai Stock Exchange. A ready delivery contract is also called a ‘spot’ contract. The settlement
under this contract can be made on the same day or during the maximum period of 7 days and there can be
no extension, or postponement of the time of settlement. Price is paid or received in full.
Rolling Settlements are based on the total net of the issue traded during the day. The NSE (National Stock
Exchange) System of settlement on T+2 basis. T stands for the trading day. E.g., if a trade has been executed
on Wednesday then it should settled after two working days, i.e., Friday. An investor has to give the securities
immediately when he gets the contract note. If he is buying securities then he has to pay within two days. The
trading member has to pay within 48 hours.
The depository participant ‘DP’ has to take instruction from the investor to give delivery by transferring
the shares from his beneficiary account to the pool account of the trading member to whom the shares has to
transferred. If share are sold it is called Delivery Out and when the shares are purchased it is called Delivery
In. Instruction has to be given regarding the number of shares, which are to be transferred with details of scrip
and quantity to be delivered. If an investor is buying shares then the trading member has to directly credit the
beneficiary account as soon as he receives a receipt from the clearing house.
To sum up the trading procedure in the stock market is carried out through the following steps.
¾ Step 1: Listing of securities.
¾ Step 2: Finding the right broker.
¾ Step 3: Opening an account with a broker.
¾ Step 4: Placing an order with a broker.
¾ Step 5: Exercising the right or choice of type of method.
¾ Step 6: Giving margin money to broker.
¾ Step 7: Execution of order through screen based trading and depository system.
¾ Step 8: Preparing the contract note.
¾ Step 9: Settlement of contracts.
3.16 CONTROL OF INDIAN CAPITAL MARKET: SEBI

In 1987 as a measure of legislative reform as well as to bring in confidence among the investors, a
Securities Exchange Board was set-up. Every company issuing capital was to register itself with the board and
abide by its rules and regulations. The securities exchange board would help in streamlining procedures regarding
issue and transfer of shares. It would bring discipline among existing companies and provide information to the
investors about the working of these companies.
The SEBI has taken over the functions of the capital issues control. It has brought out guidelines for the
issue of securities. These are given as follows:
1. Underwriting of Capital Issues is mandatory to ensure success of an issue.
2. The debt equity ratio of companies should be 2:1 but it is relaxed in capital intensive projects.
3. The equity preference ratio should be 3:1.
4. The cost of a public issue has been fixed. It cannot exceed the prescribed limit. Equity and convertible
debentures up to 5 crores will consist of mandatory cost + 5%. Issues above 5 crores will be mandatory
cost + 2% and non-convertible debenture up to 5 crores is mandatory cost + 2% above 5 crores =
mandatory cost + 1%.
5. The quota of promoters is fixed between 20 to 25% depending on the paid up capital of the company.
6. There is quota for employees and collaborators.
7. The issue price is determined on the company’s 3 year track record. The average of the Book value
and earnings capitalisation model is taken.
8. The offer of the issue and prospectus have to be submitted to SEBI with documents, agreements,
technical collaborations, full information about the company’s capital structure, business activity and
the interest of promoters and directors.
9. The capital required by a company should be in accordance with the amount that it issues. It should
maintain a proper balance and avoid evils of over and under capitalisation.
The issuing company must file the requirement of capital, the reason for the need of the company,
projects for the next 5 years, interest charges and working capital charges during early period of
formation and construction. The issuing company should also indicated foreign exchange requirements
of the company and file its profitability projections of the project also.
The issuing company is also supposed to be issuing capital because it should not rely wholly on loans
and uncertain sources of capital or on projected future profits. a company issuing capital should be
confident that it is raising sufficient capital and does not have to make another public issue before the
completion of the project.
The issue made public should be issued in a manner that the securities are eligible for listing on stock
exchange. The issue should be so attractive that listing is made immediately on the stock exchange
and public confidence is given a boost and are encouraged to purchase shares on public offer.
10. When a company wishes to make an issue at premium after the initial issue, the profit on this premium
should be limited. The price of right issues should be such that the profit becomes available to the
company for using it productively in its projects.
The issue price should, therefore, be dependent on the economic, social and political factors of the
economy and the state of the capital market. The profit earning capacity of the firm should also be
considered. Company analysis should also be made regarding its dividend record and reserves position.
In the case of right issues the existing shareholders should also be allowed to take the offer of purchase
of additional shares beyond the right of purchase in proportion to their holding offered by the firm.
Those shareholders who renounce their rights on right issues will not be given the facility to apply for
additional issues. When right shares are not fully subscribed they can be distributed equally to the
applicants, small shareholders should be given preference. If balance is still left unissued the company
can sell the shares at the market price.
11. The allotment of shares had been very irregular by the issuing companies. Some shareholders allottees
received their allotment and refund letters even after six months. Now, according to the regulations
placed on companies, allotment of shares or refund of non-allotment of shares should be made within
90 days of receiving applications. If the amount or information is not received by the applicant within
the prescribed period the issuing company is liable to pay interest with refunds or allotment letters.
3.17 DEVELOPMENTS IN THE STOCK MARKET

The stock markets in India have gone through several reforms with the inception of SEBI. There have been
guidelines issued for the protection of the investors. Reforms have been attempted in re-organization and
administrative aspects of the stock exchange. Regulations have been made on broker dealings with investors.
One major development is the prohibition on insider trading. Other changes are in share transfer procedure,
establishment of depositories, Bombay On Line Trading system (BOLT). Over the Counter Exchange of India
(OTCEI) and the setting up of National Stock Exchange. These issues are discussed briefly.
Insider trading had become an extremely sensitive and controversial subject in the stock market in India.
Any person in power whether an officer or director who had access to information of private matters of the
company relating to expansion programmes of the company, changes in policies, amalgamations, joint contracts,
collaboration or any information about its financial results was making full use of his position to give an
advantage to relatives, friends or known persons by leaking out information leading to frauds and rigging of
price relating to securities. SEBI has laid down guidelines by prescribing norms handling information which may
be considered sensitive. Price forecasts, changes in investment plans, knowledge of mergers and acquisitions,
information about contracts are not to be disclosed. The staff and officers who have such sensitive information
are to be identified in each company. Controls are to be made on the handling of sensitive information.
The SEBI is empowered to prosecute any company which does not comply with the act and the persons
are liable to penalty and fine or imprisonment if they violate the laws. Form time to time SEBI can give
directions to the officers of the company, scrutinise records and documents and conduct an investigation of
books and accounts on the complaint of an investor.
1. Free Pricing of Issue/Stock Splits
Keeping in view the changes in the capital market emanating from free pricing of shares and free access
to market for funds by the issuers, the SEBI with the objective of broadening the investors’ base, dispensed with
the requirement of standard denomination of ` 10 and ` 100, gave freedom to companies with dematerialized
shares, to issue shares at any denomination. The existing companies, with shares at ` 10 and ` 100, also can
avail of this facility by consolidating or splitting their existing shares. In order to enable the investors to take
informed investment decisions, the stock exchanges were directed to indicate the denomination value of shares
as fixed by the company alongwith the market quotation. However, the companies availing of this facility are
required to strictly adhere to disclosures and accounting norms. SEBI also decided that there would be only
one set of disclosures and entry norms for all the issues irrespective of the issue price. Thus, the different
requirements for making issues at par and premium were merged to create a common set of requirements.
2. Surveillance on Price Manipulation
SEBI introduced surveillance and enforcement measures against intermediaries violation of laws especially
in price manipulations. All exchanges have surveillance departments which co-ordinate with SEBI. SEBI has
enforced information to be submitted by exchanges on daily settlement and monitoring reports. SEBI has also
created a database for trading on National and Bombay Stock Exchanges. If price manipulation is detected
auction proceeds may be impounded or frozen so that the manipulation cannot use it.
SEBI has introduced ‘Stock Watch’ an advances software for surveillance of market activities programmed
to show movements from historical patterns through follow ups by analyst and trained investigators to act as
a deterrent to trading and price rigging.
3. Insider Trading
Insider Trading Regulations in 1992 notified by SEBI prohibited Insider trading, as it is unfair upon
investors. Persons who posses price sensitive information because they have connections with a company take
advantage of the situation to ‘peg up’ or ‘down’ prices of securities to their advantage. The TISCOs case is an
example, whereby there was intense activity in trading volume of shares between October 22, 1992, and
October 29, 1992, as there was insider information on poor performance of the companies working. Profits of
the company had declined. After having brought trading under their control the prices of shares brought about
a sharp fall in the prices from October 29 to Nov 6, 1992. Insiders had manipulated the market. When a probe
took place the presence of insider information was considered to be the main problem area. As a result of this
case, Insider Regulation took place in November 1992, to avoid creation of problems for small investors.
4. Regulation of Stock Brokers
Stock Broker and sub-brokers Regulation Act, was passed in 1992. Brokers had to have a dual registration
both with SEBI and with Stock Exchange. Penal action would be taken against any broker for violation of laws.
Capital adequacy norms were introduced and they were 3% for individual brokers and 6% for corporate
brokers. For investor protection measures brokers have been disciplined by introducing the system of maintaining
accounts for clients and brokers own account and disclosure of transaction price and brokerage separately in
contract note. Audit has been made compulsory of the brokers’ books and filing of auditor’s report with the
SEBI has been made mandatory. SEBI has also extended regulations to sub-brokers. Sub-brokers have to be
registered by entering into an agreement with the stock brokers from whom he seeks affiliation. Sub-brokers
can transact business only through stock broker with whom he is registered. If he wants to do business through
more than one stock broker he has to be registered separately with each one of them.
5. Forward Trading and Badla
Forward trading had been in practice in India as it was the main speculative activity in stock exchange.
Futures and Options were absent in the Indian Market and Forward Trading was called Contracts for Clearing.
This system enables a trader to play with price expectations, transfer outstanding buy or sell positions and
delivery of securities. In 1969, Contract trading was banned in India. However, a new system called Badla was
developed which was used in carry forward of trades to the settlement period. This system was regulated in
1983 by permitting trade through specified securities and carry forward facility up to 90 days.
Controls were also set on margins and limits were placed on positions. In December 1993, badla was
banned. In 1995, it was reviewed by Patel committee and SEBI reintroduced carry forward system with
restrictions. 90-day limit was fixed for carry forward, trade settlements could be made in 75 days with delivery.
For investor protection exchanges had to adopt a twin track trading system where transactions for delivery were
separated from those that were carried forwards. Limits were also imposed on carry forwards positions and on
scrip wise limits on brokers. Badla was again reviewed in 1997 by Varma Committee. SEBI increased carry
forward limits of brokers to 20 crores and reduced margins from 15% to 10% and after the Ketan Parekh scam
Badla was again banned from July 1, 2001. Trading in 246 scrips including all stocks that make of group A
of Bombay Stock Exchange became cash down and day trade.
6. Options and Derivatives
Options can be classified as call options or put options. The National Stock Exchange (NSE) and the
Bombay Stock Exchange (BSE) have launched derivatives. They will offer derivatives for three tenures one in
the first instance each for subsequent three months. So in July Nifty call and put options can be purchased for
July end, August end and September end. The last day of the contract would be the expiration date. In an
options contract a premium has to be paid to enter a contract. Buyer’s losses are limited to the extent of
premium paid but his gains are unlimited. Seller’s profits are limited to premiums received but losses are
unlimited. These derivatives have been started by SEBI to bring about investor confidence to establish the
market and to reduce risk. Initially options trading will be allowed only in 14 stocks. Option will not allow a
person to defer settlement of sale/purchase but they will enable placing of bets on Stock Markets.
7. Regulation of Mutual Funds

SEBI regulates the Mutual Funds to provide portfolio disclosure and standardization of accounting procedures.
It is a requirement of SEBI that mutual funds should have a trustee company which is separate from the asset
management company and the securities of the various schemes should be kept with a custodian independent
of the mutual fund. All Mutual Funds should be regulated with the SEBI. All schemes of UTI after 1994 have
also been brought under the control of SEBI. SEBI created certain procedures of valuation norms and asset
value and pricing for the Mutual Funds. The primary interest of SEBI to control Mutual Fund schemes was to
protect investors from fraudulent deals.
To bring transparency in operations, SEBI directed mutual fund investors to mention their permanent
account number (PAN) for investments over ` 50,000. In case where neither the PAN no the GIR number has
been allotted, the fact of non-allotment is to be mentioned in the application form. Mutual Fund was prohibited
from accepting any application without these details.
All mutual funds were also told to obtain a unique client code from the Bombay Stock Exchange or the
National Stock Exchange for each of their existing schemes and plans.
Following the collapse of Global Trust Bank (GTB) SEBI asked all mutual funds to provide details of their
investments in fixed deposits (FDs) of banks. In particular, SEBI called for specifying FD investments exceeding
25% of the total portfolio of a scheme.
To prevent MF schemes from turning into portfolio management schemes (PM), each has directed mutual
funds scheme and individual plan under the schemes should have a minimum of 20 investors and no single
investor should account for more than 25% of the corpus of such scheme/plan. In case of non-complience, the
schemes/plans will be wound up and investors money redeemed at applicable NAV.
SEBI issued a new format for MFs to file information details of investment objective of the scheme, asset
allocation pattern of the scheme, risk profile of the scheme, plans and options, name of the fund manager,
name of the trustee company, performance of the scheme, expenses of the scheme, i.e., (i) load structure and
(ii) recurring expenses, tax treatment for the investors (unitholders) and daily net asset value (NAV).
SEBI issued detailed guidelines regarding uniform cut-off time for calculating NAV for the purpose of
subscriptions and redemption. In respect of valid applications received up to 3 p.m., the closing NAV of the
next business day is be applicable for both purchases and redemption.
In case of liquid schemes, the cut-off timing for applying NAV, in case of purchase, will be closing NAV
of the day immediately previous to the day on which funds are available for utilization. In case of redemption,
for valid applications received up to 10:00 a.m., the previous day’s closing NAV is applicable.
8. Regulation of Foreign Institutional Investors (FIIs)
FII’s had a large volume of funds. By the nature of their trading volumes FII’s can retain Control over the
stock market. SEBI had to keep these FIIs under its control for protecting the investors. Hence, all FIIs had to
be registered with SEBI. FIIS having a capital of 100 crorescould resgister themselves as depositories and their
procedures were to be evaluated by an independent agency. FIIs are also allowed to invest in debt securities
but investment in equity and debt securities should be in the ratio of 70:30.The FIIs under SEBI include Pension
Funds, Mutual Funds, Asset Management Companies, Investment Trust and Charitable Institutions.
9. Screen Based Trading
In 1993, SEBI made the policy of bringing about screen based trading. In March 1995, BSE online trading
(BOLT) was started. It brought about the facility of trading with order book functioning as an ancillary jobber.
The order book allows retention and matching of orders and improves the price competitive character. It
provides investors to place orders at prices better than the quotes presently available. Jobbers quote would be
given priority as incoming orders would first be matched against jobber quote. On the remaining quantity if the
best price in the market is through order book then incoming order would be matched against the order book.
This is called Price Jobber Time Priority Matching. BOLT brought about improvement in trading of volumes of
transactions.
10. Circuit Breakers

Circuit breakers are a check on excessive fluctuation in stock market prices. It is a control system introduced
by SEBI to be effected when there is a great volatility in trading of a particular scrip. If the NIFTY or SENSEX
shows too much volatility on a particular day and there is a fluctuation of 10% in the index either on NIFTY
or SENSEX automatically circuit breakers will apply. Trade would reopen after one hour but if after reopening
the prices again fluctuate more than 5% after reopening, the trade will again stop to allow cooling off time.
This helps in applying brakes to fluctuations and brings about order in the stock market. In the BSE (Bombay
Stock Exchange) circuit breaker was applied on 22nd May 2006 as trade was volatile and the stocks fell below
10%. Trading was stopped for one hour and then trading was restarted. When it was expected that condition
would improve.
11. Settlements and Clearing
Settlements in Indian Stock Exchanges have an account period of settlement. It involves netting of trades
and drawing up of statements by members, amount of securities due, scripwise and memberwise. In a physical
trade environment trades were stuck on the floor statements had to be generated and confirmed by the
members but in the computerized environment information the exchange can download the information to the
member at the end of the day. There is a risk involved in the absence of a clearinghouse. In 1996 after the
M.S Shoes scam (1995) involving 18 crores of Rupees, a National Securities Clearing Corporation was started
to guarantee all trades in NSE. Regional clearing facilities have also been provided.
12. Bombay on Line Trading (BOLT) Systems
Bombay Stock Exchange (BSE) was the first to introduce on line computerised trading of scrips to replace
manual trading practices. In BSE most of the equity shares have transformed from trading in the ring to the
BOLT system. From July 1, 1995 the BOLT system has become very active and now allows other stock
exchanges for instant on line trading. The BOLT system provides systematic trading in a growing volume of
business. In 1995 the average daily turnover was exceeding 30 crores as there were more than 750 scrips to
cope with. This led to delays in transactions as physical movement of share transfers took a long time and in
the absence of custodial services the settlement periods kept on increasing.
The BOLT system provides information on the best buy and sell rates for each scrip, pending and executed
orders, negotiated and crossed deals, market position of all the scrips of a broker, domestic share indices and
market and economy related news.
The on line system provides a quota trading facility. The highest buy price and the lowest sale price are
the best offers. These quotas are given priority according to time. Price being the same between two offers
priority is given to the offer that is made first. Each transfer who has an access to the on line system has the
information about all the daily transactions which involve orders, deals and quotas.
BSE has in addition to Equity Scrips has also initiated debt trading since July 1995. The BOLT system
has an integrated debt trading system and is different from NSE which has separate segments for wholesale and
retail items. BSE has 60 actively traded debentures on the BOLT system.
13. Buyback of Shares
Buyback of shares is another development of Indian corporate practice. It was permitted by SEBI in 1998
following the companies (amendment) ordinance by the Central Government. Buyback of shares is a method
whereby a company is allowed to purchase its own shares out of its free reserves, securities premium account,
or the proceeds of other specified securities like preference shares. However it cannot be made out of earlier
issue of equity shares. Buyback of shares may be done from existing shareholders on a proportionate basis,
through open market purchases and through company employees where securities are issued under stock option
or sweat equity. It is a strategy used for restructuring a company’s share capital and increasing the value of its
shares. It can also have the effect of a greater control of the company by the management and promoters
through the use of excess funds available with the company. A company would announce a buyback of its
shares when it has the confidence that a buyback program will be beneficial to the company and will provide
a greater return to the shareholders.
A company can buyback its shares as per SEBI’s regulations only when the following conditions are
fulfilled:
¾ The Articles of Association of a company authorize buyback of shares.
¾ A special resolution is passed by the general body to authorize the repurchase of shares. The resolution
should have an attached document giving details of all material facts like: need for buyback, amount
to be invested, type of securities intended for repurchase and time limit for completion of buyback.
¾ The debt equity ratio after buyback should not be more than 2:1 of secured and unsecured debt except
with prior permission of Central Government.
¾ The other specified securities of the company are fully paid up and (both listed and unlisted securities)
are in accordance with SEBI regulations.
¾ The buyback of shares is less than 25% of paid up capital and free reserves of the company as shown
in the latest balance sheet of the company.
¾ The buyback should be completed within twelve months from the date of passing the special resolution.
¾ The shares/other specified securities would be extinguished within seven days of completion of buyback
procedure of the company.
¾ The company will not be permitted to issue the same type of shares/securities which have been bought
back for a period of twenty-four months. The exception to such an issue would be the issue of bonus
shares of stock-option schemes, conversion of preference shares/debentures into equity issues.
¾ In addition a company has to file a declaration of solvency verified by an affidavit in a prescribed form
with the registrar of companies within 30 days after completion of buyback. This has been amended
in October 2001 to bring in relaxation to companies to buyback shares. The amendments are:
– There can be only one buyback in 365 days.
– Companies can buyback less than 10% of equity with the approval of the Board of directors
meeting.
– If a company issues less than 10% equity it does not require shareholders approval.
Corporate organizations had a long standing demand for buybacks, it faced many controversies and was
finally allowed in 1998.
In Hong Kong, Japan and Germany shares buybacks have been allowed in 1998. In other parts of Europe
as well share buyback are gaining popularity. The experience in USA and Canada will help to deepen our
understanding of the problem in India.
There are a number of hypothesis for underlying the motives of corporate stock reacquisition. These are
Signaling hypothesis, free cash flow hypothesis, leverage hypothesis, signaling tax benefit hypothesis, managerial
incentive hypothesis, takeover deterrence hypothesis, shareholder servicing cost hypothesis.
Buyback can be made through open market, stock exchange and through tender offers.
Buybacks are a very normal occurrence in the USA and it is considered as a short-term strategy to bring
the company’s shares in value with the market Share buyback require more legal legislation in India. Good
shares are being de-listed. In India buybacks take place because companies have no long-term plans to diversify
or expand. It appears from the buybacks that management is slowly increasing their powers through buyback
of shares. This may not have an immediate effect but there are long-term implications. Buyback should be
treated as a short-term measure for improving the value of the shares of a company but long-term measures
such as expansion and additions to the business should help in adding value to the Indian business scenario.
14. Stock Lending
Stock lending has been introduced in India by SEBI on February 6, 1997. It means borrowing of securities
through an approved intermediary from a lending institution. The lending and borrowing is arranged by an
approved intermediary through an agreement for specified period of time. The modus operandi is that the
borrower has to return equivalent securities of the same class after the specified period ends. This also includes
dividends bonus shares, right shares and redemption benefits which accrue on these securities. The approved
intermediary should be a person which has at least 50 crores worth of assets and has been registered with SEBI.
The following are the salient points of stock lending.
1. The approved intermediary interacts with the lender and the borrowers through an agreement. The
borrower and the lender do not have any direct link with each other.
2. The approved intermediary has to guarantee to the lender that the borrower will return equivalent
securities that he has borrowed.
3. The approved intermediary is liable to return the securities if the borrower fails do so.
4. The agreement of stock lending provides that all the benefits and rights of such securities will be
passed to the borrower.
5. The title of the securities will be with the borrower and he can sell or dispose of the securities but he
has the obligation to return equivalent securities within a specified period.
6. The borrower does not have to return the securities either by paying cash or in kind only equivalent
securities are allowed for discharging the liability.
7. The borrower has the obligation of depositing with the approved intermediary collateral security and
fees for borrowing securities. The collateral security can be in cash or through bank guarantee or
government securities.
8. If the borrower fails to pay the approved intermediary can liquidate the collateral securities and
purchase equivalent securities from the open market and return the same to the lender.
9. Code of conduct has to be maintained by the approved intermediary. (a) He has to draw an agreement
between the borrower and the lender. (b) He has to give some guarantee that the borrowing will not
be misused. (c) He has to give a true and correct picture of the lending transactions and (d) he also
has to keep confidential the information of the lender and the borrower.
10. This agreement of stock lending has the objective of being a hedging strategy and to cover the gap
in timing of the settlement of the issues. This scheme has been prepared to have minimum delivery
defaults.
SUMMARY
r This chapter deals with the new issue market and stock market and all the processes and developments in
the market.
r The New Issue Market deals with those securities, which are issued to the public for the first time. The stock
exchange is a place for secondary sale of securities.
r A commercial bank acts as a banker to an issue. It supplies application forms and earns a brokerage. It also
makes underwriting commitments with those companies, which are backed by strong ownership and management
groups. It also participates in the stock market.
r Financial engineering is a new financial instrument, which is a hybrid of different securities. It has been
created to suit the needs of an investor.
r Market intermediaries consist of lead managers, underwriters, clearing houses, mutual funds, investment
companies, share brokers, credit rating agencies, depositories, and investment companies.
r The Most popular stock market indices in India are SENSEX, BSE National Index and NIFTY.
r The New Issue Market is called the Primary Market and the stock exchange is called the Secondary Market.
r The New Issue Market has three functions origination, underwriting and distribution.
r New Issues consists of floating shares through offer for sale either through public offer or book building
process.
r Prospectus is issued for new offer of shares but if book building process is used then there should be a red
herring prospectus.
r Merchant bankers lead manager and portfolio manager’s help in the process of issue of shares.
r There can be a Green Shoe Option for post issue stabilization of shares.
r A company may also offer Sweat Equity for services, rendered by employees.
r Stock market consists of a broker and different types of orders for buying and selling securities.
r Listing of securities is very important because they cannot be purchase or sale of securities without listing.
r There have been many developments in the stock market. Some examples are depository and electronic
trading of shares, prohibition of insider trading practices, circuit breakers, rolling settlements, introduction of
derivatives.
r There are 23 stocks exchanges in India. The most important stock exchanges are BSE (Bombay Stock
Exchange) and NSE (National Stock Exchange).

(i) A financial system is a network of financial markets, institutions, instruments and intermediaries.
(ii) Money market is for long-term investments.
(iii) The central bank of India is the Reserve Bank of India.
(iv) Mutual Funds are market intermediaries.
(v) The ownership securities consist of Deep Discount Bonds.
(vi) Financial engineering is the creation of new securities by combining different options.
(vii) Security exchange commission acts as a controlling agency in a securities market.
(viii) A mutual fund has income, growth and sectoral schemes.
(ix) Debt securities are mostly ownership based.
(x) The role of a financial system is to establish a link between savers and investors.
Answers: (i) T (ii) F (iii) T (iv) T (v) F (vi) T (vii) T (viii) T (ix) F (x) T.
QUESTIONS
1. Distinguish between New Issue Market and Stock Market. Is their role complementary or competitive?
2. Give a list of the players and participants in new issue market and stock market.
3. Discuss the sources of financial information.
4. What are financial engineering instruments? Discuss their importance in the Indian securities market.
5. What is a stock market index? Discuss the difference between BSE stock index and NIFTY index.
6. Explain the role of market intermediaries.
7. Discuss the developments in the NIM and Stock Exchange after the new economic policy in India.
8. What is listing of shares? Describe the advantages provided for listing. What documents should be filed for listing
of shares?
9. Write notes on:
(a) bull,
(b) bear,
(c) stag,
(d) margin,
(e) wash sales.
10. Describe the different kinds of trading activities that take place in a Stock Exchange.
11. What is the methodology adopted in security trading on a stock exchange?
12. Discuss the mechanics of floating shares in the New Issue Market in India.
13. What is the role of the New Issue Market? How is it related to the Stock Exchange?
14. What are the different kinds of brokers operating in the stock exchange? How do they trade securities in the Stock
Exchange?
15. Discuss the rules relating to the appointment of stock brokers in India.
16. Write notes on:
(a) OTCEI
(b) NSE
(c) BOLT
(d) Badla or Forward Trading
(e) Sub-broker
17. How has SEBI regulated (a) stock brokers, (b) insider trading in the stock exchange?
18. What is a depository? What is the procedure for dematerialization of shares?
19. Explain the terms: (a) Red Herring Prospectus, (b) Employees Stock Option, (c) Sweat Equity, (d) Green Shoe
Option, (e) book building.
SUGGESTED READINGS
l Bhalla, V.K., Investment Management, S. Chand & Co. Ltd., New Delhi, 1982.
l Bolten Steven, E., Security Analysis and Portfolio Management, Holt, Rinehart and Winston Inc., New York,
1976.
l Fredrick, Amling, Investments: An Introduction to Analysis and Investment, Englewood Cliffs, N.J., Prentice
Hall Inc., 1978.
l Haynes, D.A. & Bauman, S.W., Investments: Analysis and Management, (Third Edn.), MacMillan Co. Inc., New
York, 1976.
l Khan, M.Y., Indian Financial System, Theory & Practice, Vikas Publishing House, New Delhi, 1980.
l Kuchhlal, S.C., Corporation Finance: Principles and Problems, Chaitanaya Publishing House, Allahabad, 1976.
l Simha, Hemalatha Balakrishnan, Investment Management, Institute for Financial Management and Research,
Chennai, 1979.
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Chapter
SECURITIES EXCHANGE BOARD OF INDIA
Chapter Plan
4.1 Establishment of Securities and Exchange Board of India (SEBI)
4.2 Objectives of SEBI
4.3 Investor Protection
4.4 Listed Companies and Model Code of Conduct
4.5 Investor Grievances
4.6 Departments of SEBI
4.7 OMBUDSMAN 2003
4.8 National Stock Exchange and Arbitration Facilities
4.9 Investor Education
4.10 Prohibition of Insider Trading
4.11 MAPIN
4.12 Investors’ Protection Fund
4.1 ESTABLISHMENT OF SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI)

Securities and Exchange Board of India (SEBI) is a regulatory authority, for the investment market in
India. It has been established under Section 3 of SEBI Act 1992. The purpose of this board is to maintain stable
and efficient markets by creating and enforcing regulations in the market place. The Securities and Exchange
Board of India is similar to the U.S. Securities Exchange Commission (SEC). Its main objective is to protect
the interests of the investors in the new issue market and stock exchange and to regulate, develop and
improve the quality, of the securities market in India.
92
SECURITIES EXCHANGE BOARD OF INDIA 93
4.2 OBJECTIVES OF SEBI

SEBI has the main objective of protecting the investor in its dealings in the new issue market and stock
market. With the view to achieve this objective it has issued various guidelines. It also has the objective of
removing grievances of investors, educating investors about their rights and prohibiting unfair practices in the
stock market. These are briefly discussed below:
(i) Guidelines for Investor Protection: SEBI has issued guidelines for investor protections in four
areas. These are:
l Guidelines to companies issuing public offers.
l Guidelines to intermediaries functioning between the investor and companies in the new issue
market.
l Issue of directions to intermediaries in the stock market and
l Guidelines for investor’s rights and liabilities.
(ii) Grievance: SEBI has a grievance cell for protection of investors who face problems while making
investments. Some of these problems are delays in refunds, delays in transfer of securities and misleading
statements in advertisements.
(iii) Investor Education: The third area refers is investor education. SEBI is engaged in investor information
and workshops for them to know their rights as shareholders and investors.
(iv) Prohibition of Unfair Practices: SEBI has issued a prohibition of fraudulent and unfair trade
practices regulation in 2003. These regulations relate to securities markets for protection of investors.
(v) Model Code of Conduct: SEBI has issued a model code of conduct for listed companies for
protection of investors trading in the stock market.
(vi) Insider Trading Regulation: SEBI has issued regulation of 1992 for investigation of insider trading
and also prohibition of insider trade practices so that no one can take undue advantage in trading of
securities.
(vii) Grievances Redressal: To have a transparent system of redressal of grievances. The trading procedure
may have certain problems that create grievances for investors against certain intermediaries. SEBI
has passed a regulation called Ombudsman Regulations of 2003 for protection of investors.
(viii) Arbitration: SEBI has also provided a facility at National Stock Exchange for arbitration of investor
grievances to fulfil its objective of providing protection to investors from dealings that are unfavourable
and non democratic in nature.
The role of SEBI in Investor protection is discussed below in detail.
4.3 INVESTOR PROTECTION

The first area, which is important for the protection of the investors, is to keep a discipline of the
companies, which issue securities. SEBI has issued guidelines, rules and regulations (2000) to protect the
investor by making it compulsory for companies to provide information through documents so that the investors
can take decisions in purchasing securities in a fair manner. Some of the important aspects are:
(i) Offer Document: A company has to prepare its offer document giving information of general and
financial nature according to SEBI’s guidelines.
(ii) Prospectus: A company has to file a draft prospectus with SEBI before making a public offer.
(iii) Listing: A Company cannot issue securities until it applies for listing of its shares at a stock exchange.
(iv) Capital: A company can make a rights issue or public issue only when the existing shares of a
company are fully paid-up.
(v) Credit Rating: SEBI restricts companies to make a debt issue without obtaining a credit rating and
an investment grade.
(vi) Restrictions: SEBI restricts unlisted companies from issuing their shares. It makes an exception in
some cases. An unlisted company can issue shares if its promoters contribute at least 20% of post issue
capital. The company should have a track record of distributing profits, having a net worth of A 1
crore and tangible assets of A 3 crores in previous 3 out of 5 years.
(vii) Inspection: SEBI also monitors companies. It may carryout inspection of the books of accounts and
other records of a listed company in respect of matters covered by its guidelines.
(viii) Advertisement: A company usually advertises a public issue. Such advertisements should contain
statements, which are fair, clear and truthful giving the risk factor to enable an investor to make his
judgment and not be influenced by any wrong statements.
SEBI has issued a model code of conduct for listed companies this is discussed below:
4.4 LISTED COMPANIES AND MODEL CODE OF CONDUCT

The SEBI regulations of 1992 also provided a model code of conduct for listed companies. Companies
listed on the stock exchange have to frame a code of internal procedures and conduct of corporate disclosure
practices. Some of the provisions are given below:
(i) Code of Conduct: The code of conduct has to be strictly observed and those employees, officers
or directors of the company who violate the code of conduct will be subject to disciplinary action by
SEBI or by the company.
(ii) Duty of Officer: Every listed company is required to employ a compliance officer who has to report
to the Managing director or to the Chief Executive Officer (CEO)of the company.
(iii) Security: Confidential files should be protected and kept secure. These pertain to all files but especially
computer files and passwords, which are likely to have sensitive price information.
(iv) Closed Trading Window: Every company should have a closed trading window period when no
trade takes place. It should be a closed period when the annual profit and loss and balance sheet have
to be declared, when dividends have to be declared and when amalgamations and mergers take place.
(v) Open Trading Window: SEBI has also provided that trading windows would open only after 24
hours of making sensitive prices available to the public.
(vi) Information: To avoid insider trading practices each listed company has to provide price sensitive
information on a continuous basis to the stock exchange.
(vii) Problems: SEBI also deals with problems faced by investors. These are dealt with in the investor
grievance cell. The process of grievances and their settlement are now discussed.
4.5 INVESTOR GRIEVANCES

Investor grievances are dealt with three different types of departments. Certain grievances are taken-up by
SEBI, others are dealt with by the department of company affairs and registrar of companies. Some grievances
are taken-up by Reserve Bank of India (RBI). These departments take-up grievances of different kinds and
depending on the nature of the complaint the department has clearly separated its area of operations.
Investor grievances are usually due to delays in dispatch of allotment letters, refund orders, misleading
statements in advertisements or in the prospectus, delay in transfer of securities, non-payment of interest or
dividend. Theses grievances are dealt with either SEBI or department of company affairs. Stock exchanges have
information centres where investors can put in their complaints about problems relating to shares and complaints
of traders.
(i) SEBI deals with complaints, which are regarding:
l Securities traded or listed with the exchanges.
l The trades effected by listed company or by the members of the stock exchange.
(ii) The Department of Company Affairs and Registrar of Companies (ROC) deal with the following
complaints:
l Complaints against unlisted companies.

l Complaints regarding non-receipt of annual report, notice of Annual General Meeting.
l Complaints regarding Fixed deposit in manufacturing companies.
l Complaints regarding Forfeiture of Shares.
(iii) The Reserve Bank of India looks into problems of investors relating to:
l Fixed deposits in banks and Non-Banking Financial Institutions.
4.6 DEPARTMENTS OF SEBI

In the secondary market operations SEBI has divided different segments of activities according to different
departments. It has Market Intermediaries Registration and Supervision Department (MIRSD), Market Regulation
Department (MRD) and Derivatives and New Products Departments (DNPD). These departments register, supervise
and formulate new policies that are useful for both investors and traders. The following departments of SEBI
as listed in Table 4.1 take care of various activities in the secondary market.
Table 4.1 DEPARTMENTS AND AREA OF OPERATIONS OF SEBI
Department Activities
Market Intermediaries Registration and Registration, supervision, compliance monitoring and inspections
Supervision Department (MIRSD) of all market intermediaries in respect of all segments of
the markets viz. equity, equity derivatives, debt and debt
related derivatives.
Market Regulation Department (MRD) Formulating new policies and supervising the functioning
and operations excluding derivatives of securities exchanges,
their subsidiaries and market institutions such as clearing
and settlement organizations and Depositories (These are
collectively called ‘Market SROs’.)
Derivatives and New Products Departments (DNPD) Supervising trading at derivatives segments of stock exchanges,
introducing new products to be traded, and consequent
policy changes.
4.7 OMBUDSMAN 2003

SEBI issued OMBUDSMAN regulations in 2003 to provide fair and transparent systems of redressal of
grievances. These regulations empower an investor to get redressal against both listed companies and intermediaries.
According to the Act, an investor can make a complaint for any of the following problems that it faces. This
act will help in solving disputes between parties.
The complaints dealt with by the OMBUDSMAN Act are in respect of:
l Delays in receiving refund orders, allotment letters, dividend or interest.
l Non-receipt of dividends, certificates, bonus shares, annual reports, refunds in allotments or redemption
of mutual fund unit.
l Non-receipt of letters of offer in respect of Buyback of Shares or in the case of delisting.
l Complaints regarding grievances against intermediaries or listed companies.
The OMBUDSMAN is empowered to receive complaints of listed companies and intermediaries and to
deal with them in a way to make a settlement between the investor and the companies as early as possible.
4.8 NATIONAL STOCK EXCHANGE AND ARBITRATION FACILITIES

The complaints of investors are also dealt with at the National Stock Exchange. This stock exchange
provides for arbitration facilities for investors problems. This is a mechanism, which resolves disputes between
trading members and clients in those trades, which takes place on this exchange. Arbitration is much faster in
this stock exchange. The arbitrators selected by the National Stock Exchange are list of persons approved by
SEBI and have an expertise in banking, finance and capital market activities. The stock exchange accepts
application for arbitration in a prescribed format within six months from the date of the dispute. The members
can apply to any of the four regional centres, which have been opened in metropolitan cities. The stock
exchange enters into arbitration facilities for the following members:
l Investors dealing on the exchange having a valid contract note issued to them by the trading member
of the exchange.
l Investors who deal through registered brokers and registered sub-brokers of the trading members of
National Stock Exchange.
l Any trading member who has a dispute, difference of opinion or claim against another member of the
exchange.
4.9 INVESTOR EDUCATION

To bring about transparency in the primary and secondary markets and to protect the investor, education
of investors, has become necessary in matters relating to companies, the securities markets and intermediaries.
SEBI has education programmes, workshops and published material to inform the investor on issues relating
to the market. The investors have the responsibilities of exercising their rights by being informed, vigilant and
participating in annual general meetings. SEBI has also established an education and protection fund for
protection of the investors, providing awareness, education and information for trading.
SEBI makes investors aware of the procedure relating to trading and transfer of securities and also the risk
that they are surrounded within the market. The investor is also given information about his rights and
responsibilities and the kind of problems that may be encountered. The investors have the following rights:
¾ To participate and vote in annual general meetings and the right to receive a notice for them or their
proxy to attend the meeting.
¾ To receive dividends, rights shares, bonus offers from the company after approval of the board.
¾ To receive and inspect minutes of the general meeting.
¾ To receive balance sheet, profit and loss account, auditors report and directors reports.
¾ To receive allotment letters and share certificates.
¾ To requisition an extraordinary general meeting.
¾ To apply for winding-up of the company.
¾ To proceed in civil or criminal proceedings against the company.
Another Act to protect the investor was made in 2003 and it was called the Prohibition of Fraudulent
and Unfair Trade Practices Relating to Securities Market Regulation. This regulation was made to
prohibit any false or misleading advertisements as well as activities intended to defraud an investor. This
regulation was also intended to debar any intermediary from entering into transactions to increase his commission
or brokerage. The regulation was also in favour of investors and it was meant to protect them from any false
or misleading statements, which would induce them to sell or purchase their securities. This Act had its main
focus on the following issues:
¾ Prohibition of misleading statements.
¾ Prohibition of manipulation of price of securities by traders and intermediaries
¾ Prohibition of entering into a transaction without the intention of ownership of a security.
¾ Prohibition of intermediaries promising clients falsely not wanting to actually completing the contract.
SEBI has also passed a regulation on prohibition of insider trading practices. This is being discussed in
the following part of the chapter:
4.10 PROHIBITION OF INSIDER TRADING

Insider trading is not allowed by SEBI. The reason for this prohibition is that it gives an individual, a group
of people or a company an edge over others, trading in the market. Such people have the advantage of
knowing important information about the company, which may benefit those who have extra information.
However, it is not fair to those who do not have this information. SEBI issued regulations in 1992 for prohibition
of insider trading. SEBI has defined an insider in the following way.
An insider is a person who is internally connected to a company. He may be an employee, a director,
promoter, a relative or a friend or an exemployee who in someway has an access to price sensitive information.
In a formal way an insider may be defined as the following:
¾ Any company in the same management or group of companies.
¾ Any intermediary, asset management company, clearing corporation, an official of a stock exchange,
a director or an employee who has access to information.
¾ A merchant banker, registrars to an issue, underwriters, portfolio managers, bankers to an issue,
members of board of directors or their relatives.
According to these regulations, insiders having an access to unpublished price sensitive information will
not use it or communicate to other persons to use it for trading purposes. The price sensitive information has
been defined as information, which is unpublished and available to a few people. Such information is usually
concerned with changes in policy matters of a company, dividend declaration, merger or amalgamation plans
of a company to issue buy-back of shares, delisting of companies and to prepare financial reports of a company.
SEBI can investigate into complaints from investors or intermediaries and also take action against an
individual or companies, which use price sensitive information for making gains.
To regulate the market participants SEBI introduced a system of their identification through MAPIN.
4.11 MAPIN
SEBI introduced MAPIN which is the Market Participants and Investors Integrated Database in 2003.
According to this regulation all the participants, registered intermediaries, listed companies and investors should
get registered and obtain a unique identification number (UIN). The major objective is to create a comprehensive
database of market participants to establish identity of those people who are doing trading in large volume to
enable SEBI to take preventive or remedial measures to identify defaulters and manipulators. SEBI has suspended
fresh registrations for applications of UIN from 1st July 2005.
4.12 INVESTORS’ PROTECTION FUND

An investor’s protection fund has been set-up. The trustees appointed by the stock exchange manage it.
An investor who has been defrauded can be compensated to the extent of A 10 lakhs or the amount under
default whichever is lower. The arbitration awards obtained by investors against defaulters are scrutinized by
the defaulters committee which is a standing committee constituted by the stock exchange, to ascertain their
genuineness, of the claim. It makes a recommendation if it is satisfied about the claim to the trustees of the
fund for release of the award amount. The investor’s protection fund consists of contributions from some of the
following sources:
¾ Members of stock exchange provide A 0.15 per A 1 lakh of their gross turnover. This is debited to their
general charges account.
¾ On a quarterly basis stock exchange contributes 2.5% out of the listing fees collected by it.
¾ Interest earned by stock exchange on security deposits of companies making public issues.
¾ SEBI added another directive. According to this directive auction proceeds of cases where price
manipulations and rigging had taken place were also to be transferred to this fund.
SEBI as a regulatory department brought about several developments in the stock market. A transparent
system for protection of investors was developed through the developments like depository or paperless trading,
dematerialization through depositories, surveillance on price manipulation, regulation of stock brokers, regulation
of merchant bankers, prohibition of insider trading, regulation of mutual funds, regulation of foreign institutional
investors, screen based trading, circuit breakers, settlement and clearing, credit rating of debt securities, introduction
of financial derivatives.
All these changes have been discussed in chapter 3, of the book. SEBI is still developing rules and
regulations to bring about discipline in the capital market in India. These changes usually take place to rectify
problems after they have occurred. SEBI has many guidelines for protection of investors. Although there is an
improvement over the previous years, SEBI has to make many more changes for developing the market and
protecting the interest of the investors.
SUMMARY
r This chapter provides some of the measures of investor protection by SEBI.
r SEBI is a market regulator and it was formed in 1992 for the introduction of reforms in the capital market to
ensure fair dealings for investors and for development of the market.
r Investor protection measures consist of regulations and guidelines.
r SEBI has prepared a model code of conduct for listed companies.
r It has also brought about a regulation to prohibit unfair trade practices.
r It has prohibited insider trading, as some people would have unfair advantage over others in trading securities.
r It has played an active part with the stock exchanges, in the creation of an investor protection fund. This fund
is to compensate those investors who have been fraudulently manipulated in buying and selling of securities
through unfair practices.
r SEBI has issued guidelines (2000) for redressal of investor grievances.
r OMBUDSMAN (2003) has been passed for a transparent system of receiving complaints and amiable settlement
of disputes.
r Investor awareness through education of investor’s rights and liabilities has become a very important part of
SEBI’s activities.

State whether the following statements are TRUE (T) or FALSE (F).
(i) SEBI regulates the primary market by controlling the investors.
(ii) Investor information centres have been set-up by SEBI for protecting the investor.
(iii) Investor protection helps to bring about growth in the capital market.
(iv) SEBI protects the investors against unfair trade practices and frauds.
(v) The Government of India has appointed securities OMBUDSMAN.
(vi) Insider trading refers to information provided by the company’s accountant to the investors.
(vii) SEBI regulates unfair trade practices through a formal regulation.
(viii) The OMBUDSMAN does not take any individual complaints.
(ix) SEBI provides redressal for investor grievances.
(x) The SEBI has a model code of conduct for listed companies since 1992.
Answers: (i) F (ii) T (iii) T (iv) T (v) F (vi) F (vii) T (viii) F (ix) T (x) T.
QUESTIONS
1. What are some of the common grievances of an investor? Give the process of redressal system to the investors.
2. What is insider trading? Who is an insider? How does SEBI deal with such practices?
3. What is a trading window? In what circumstances it is closed?
4. Discuss the provisions of model code of conduct for companies.

5. Write notes on:
(i) OMBUDSMAN
(ii) Investor protection fund
(iii) Investor education
(iv) Insider trading
SUGGESTED READINGS
l H.R. Machiraju, Indian Financial System, Vikas Publishing House, New Delhi, 2nd edition 2005.
l M.Y. Khan, Indian Financial System, Tata McGraw-Hill, New Delhi, 4th edition 2005.
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Chapter
RISK
Chapter Plan
5.1 Background of Risk and Return
5.2 Risk
5.3 Systematic Risk
5.4 Unsystematic Risk
5.5 Quantitative Analysis of Risk
5.6 Investor’s Attitude towards Risk and Return
5.1 BACKGROUND OF RISK AND RETURN

The returns are dependant on the varying degrees of risk. A functional definition as defined by Amling is
“Investment maybe defined as the purchase by an individual or institutional investor of a financial or real asset
that produces a return proportional to the risk assumed over some future investment period”. 1 Fischer and
Jordan describe it in a similar manner – “An Investment is a commitment of funds made in the expectation of
some positive rate of return. If the investment is properly undertaken, the return will be commensurate with
the risk the investor assumes”. 2
These definitions of investments bring forth three elements of investment and can be categorized as the
following:
l Return,
l Relationship of return and risk and
l Time factor.
1. Return
Investors may buy and sell financial assets in order to earn returns on them. Return or a reward from
investments includes both current income and capital gains or losses which arise by the increase or decrease
1. Amling, F., Investments – An Introduction to Analysis and Management (Fifth Edition), Prentice Hall Inc., Englewood Cliffs, New
Jersey, 1984, p. 3.
2. Fischer, D. E. & Jordan, R.J., Security Analysis and Portfolio Management (Third Edition), Prentice Hall Inc., Englewood Cliffs, New
Jersey, 1983, p. 4.
100
RISK 101
of the security prices. The capital gains or the income earned are then treated as a percentage of the beginning
investment. Return, therefore, maybe expressed as the total annual income and capital gain as a percentage
of investment.
Satisfactory returns are different for different people. Two rational investors may be satisfied by different
levels of anticipated return and estimated risk. Rational investors like return but are risk averse. They try to
maximize their utility by buying, holding or adjusting their portfolio to achieve ‘maximum utility’.
Return, in other words, is the ‘yield’ on a security. Yield of the stock will be the price of the stock divided
into the current dividend. This is known as current yield. There is no compounding of returns. The annual
capital gains are included on a stock price to find out their returns. For example, if an investor receives A 2
per share in dividends and earns A 3 per share per year in capital gains and has an average investment of
A 20, the return on the stock would be 25%.
While return in stocks is not related to a maturity date, in bond investments, the maturity date is very
important. Yield is the compound rate of return on the purchase price of the bond over its life. This is referred
to as ‘yield to maturity’. Return, therefore, includes interest and capital gains or losses. Stock yields and bond
yields should be carefully compared since the method to measure them is different. Methods of measurement
of return are presented in this chapter as well as in the next.
2. Relationship of Risk and Return
Risk and return are inseparable. To ignore risk and only expect returns is an outdated approach to
investments. The investment process must be considered in terms of both aspects — risk and return. Return
is a precise statistical term; it is not a simple expectation of investor’s return but is measurable also. Risk is not
a precise statistical term but we use statistical terms to quantify it. The investor should keep the risk associated
with the return proportional as risk is directly correlated with return. It is generally believed that higher the risk,
the greater the reward but seeking excessive risk does not ensure excessive return. At a given level of return
each security has a different degree of risk. The entire process of estimating return and risk for individual
securities is called ‘Security Analysis’.
The ultimate objective of the investor is to derive a portfolio of securities that meets his preferences for
risk and expected return. Securities represent a spectrum of risks ranging from virtually risk-free debt instruments
to highly speculative bonds, common stocks and warrants. From this spectrum, the investor will select those
securities that maximize his utility, managing securities may be viewed as comprising two functional areas. First,
the risk and return co-incident with individual securities must be determined. These estimates must be used to
form portfolios that best meet the needs of the investor. This decision involves the ‘trade-off ’ between risk and
expected return. To arrive at this trade-off the investor has to constantly review and ask certain questions and
find solutions to the problems. Some of the posers are: Should the portfolio contain only bonds or only
common stock? In case, it is decided to have a mix what should be the combination of the two kinds of
securities? What part of it should contain stocks and what part bonds? Additionally, the decisions are attempt
to predict market behaviour in order to improve the return of the investor. The investor may also consider the
value of time in his investments. If investment timing is considered, several different policies may have to be
considered.
3. Time
Time is an important factor in investments. Time offers several different courses of action. It may involve
and range from trading to buying and selling at major turning points in the market. It may also consider the
time period of investment such as long-term, intermediate or short-term. Time period depends on the attitude
of the investor. As investments are examined over the time period, expected risk and return are measured. The
investor usually selects a time period and return that meet expectations of return and risk. Since, equity should
be considered the investor can follow a ‘buy and hold’ policy and analyze to make successful decisions during
the longer-term framework. Some professional analysts think that three year periods are best to analyze stocks
and bonds as it is long enough to eliminate the effects of business and market cycle on security prices. Such
a period is also just right to achieve economics results from new products, new developments and new ideas.
As time moves on, analysts believe that conditions change and investors re-evaluate expected return and risk
for each investment.
5.2 RISK
What is risk? This chapter discusses systematic and unsystematic risk compares risk with return, and its
purpose is two-fold:
l To specifically discuss the different kinds of risks in holding securities and
l To make an attempt to measure risk.
Risk and uncertainty are an integral part of an investment decision. Technically, ‘risk’ can be defined as
a situation where the possible consequences of the decision that is to be taken are known. ‘Uncertainty’ is
generally defined to apply to situations where the probabilities cannot be estimated. However, risk and uncertainty
are used interchangeably.
Risk is composed of the demands that bring in variations in return of income. The main forces contributing
to risk are price and interest. Risk is also influenced by external and internal considerations. External risks are
uncontrollable and broadly affect the investments. These external risks are called systematic risk. Risk due to
internal environment of a firm or those affecting particular industry are referred to as unsystematic risk.
1. Systematic Risk
Systematic risk is non-diversifiable risk and is associated with the securities market as well as the economic,
sociological, political, and legal considerations of the prices of all securities in the economy. The effect of these
factors is to put pressure on all securities in such a way that the price of all stocks will move in the same
direction. For example, during a boom period prices of all securities will rise and indicate that the economy
is moving towards prosperity. This is based on the forces of demand and supply. It is uncontrollable; it can be
reduced but not eliminated because it is an external risk.
2. Unsystematic Risk
It is unique to a firm or industry. It does not affect an average investor. Unsystematic risk is caused by
factors like labour strike, irregular disorganized management policies and consumer preferences. These factors
are independent of the price mechanism operating in the securities market. The problems of both systematic
and unsystematic risk are inherent in industries dealing with basic raw materials as well as in consumer goods
industries.
3. Identification of Risk
Those industries producing industrial products and dealing with basic raw materials follow the level of
economic activity and the price levels of the securities markets. High degree of systematic risk can be discerned
in such industries and low degree of unsystematic risk. Some of the industries cited as an example are steel,
glass, rubber and automobile industry.
Industries producing consumer goods are not dependent in their prices on the stock market. Their sales,
profits and stock prices depend on the consumers and the kind of products that they manufacture. Consequently,
they present a high degree of unsystematic risk. Examples of such industries are foodstuffs, toys, telephones.
Other industries supplying basic necessities to consumers also have the problems of unsystematic risk inherent
in the industry. The electricity and power industries may be pointed out as suitable examples portraying
unsystematic risk.
Systematic and unsystematic risks can be further classified. Systematic risk covers market risk, interest rate
and unsystematic risk contains business and financial risk. Every industry and its shareholders face both
systematic and unsystematic risk. The systematic portion results from overall market influences and the unsystematic
portion results from company and industry influences. Systematic and unsystematic risk can be sub-divided and
analyzed separately.
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Risks
Systematic Unsystematic
Economic Industry Risks
Sociological
Political
Legal Risks
Risk of Unique Risks

Securities Market Labour Strikes
Economy Weak Managerial Policies
Consumer Preferences
External Environmental Risks Internal Risks

Market Risk Business Risk
Interest Rate Risk Financial Risk
Purchasing Power Risk
Fig. 5.1: Classification of Risks
5.3 SYSTEMATIC RISK

Market risk, interest rate risk and purchasing power risk are grouped under systematic risk.
1. Market Risk
Market risk is referred to as stock variability due to changes in investor’s attitudes and expectations. The
investor’s reaction towards tangible and intangible events is the chief cause affecting ‘market risk’. The first set,
that is the tangible events, has a ‘real’ basis but the intangible events are based on a ‘psychological’ basis or
reaction to expectations or realities.
Market risk triggers off through real events comprising political, social, economic reasons. The initial
decline or ‘rise’ in market price will create an emotional instability of investors and cause a fear of loss or create
an undue confidence, relating possibility of profit. The reaction to loss will culminate in excessive selling and
pushing prices down and the reaction to gain will bring in the activity of active buying of securities. However,
investors are more reactive towards decline in prices rather than increase in prices.
Market risks cannot be eliminated while financial risks can be reduced. Through diversification also,
market risk can be reduced but not eliminated because prices of all stocks move together and any equity stock
investor will be faced by the risk of a downwards market and decline in security prices.
Investors can try and eliminate market risk by being conservative in framing their portfolios. They can time
their stock purchases and also choose growth stocks only. These methods will reduce their risk to some degree
but as explained earlier market risk will not be completely eliminated because falling markets would bring down
the prices of all stocks. Obviously the decline in some stock will be more than in others. With a wise combination
of stocks on the portfolio, to some extent, the risk will be reduced. While the impact on an individual security
varies, experts in investment market feel that all securities are exposed to market risk. Market risk includes such
factors as business recessions, depressions and long-run changes in consumption in the economy.
2. Interest Rate Risk
There are four types of movements in prices of stocks in the market. These may be termed as: (a) long-
term, (b) cyclical (bull and bear markets), (c) intermediate or within the cycle and (d) short-term. The prices
of securities will rise or fall, depending on the change in interest rates. The longer the maturity period of a
security the higher the yield on an investment and lower the fluctuations in prices. Shorter-term interest rates
fluctuate at a great speed and are now more volatile than long-term securities but their changes have a similar
effect on price. Traditionally, investors could attempt to forecast cyclical swings in interest rates and prices
merely by forecasting ups and downs in general business activity. However, in India a combination of factors
have produced a situation where it is difficult to accurately find out the changes in interest rates. Some of the
factors that are responsible for complicated analysis are the differences between actual and expected inflation,
monetary policies and industrial recessions in the economy. If interest rates could be calculated and predicted
accurately, investors would buy and sell securities with confidence.
Interest rates continuously change for bonds, preferred stock and equity stock. Interest rate risk can be
reduced by diversifying in various kinds of securities and also buying securities of different maturity dates.
Interest rate risk can also be reduced by analyzing the different kinds of securities available for investment.
A government bond or a bond issued by the financial institution like IDBI is a risk-less bond. Even if government
bonds give a slightly lower rate of interest, in the long-run they are better for a conservative investor because
he is assured of his return. Moreover, government bonds are made more attractive by additional advantages
of tax benefits. Therefore, one way to avert interest rate risk would be to purchase government securities. Then
the price of securities in the private corporate sector will fall and interest rates will increase. This process will
create a chain reaction in the securities. This is rarely possible in the real world situation.
The direct effect of increase in the level of interest rates will raise the price of securities. High interest rates
usually lead to stock prices because of a diminished demand by speculators who purchase and sell by using
borrowed funds and maintaining a margin.
The effect of interest can be different for lending institutions and borrowing institutions. Term lending
banks and financial institutions may find it attractive to lend during the prevailing high rates of interest.
Consequently, the borrowing institutions and corporate organizations will be paying a high interest amount
during the high rates of interest. Therefore, investors should during times of high rate of interest purchase
indirect securities of financial institutions and avoid purchasing securities of the corporate sector in order to
reduce the rate of risk on securities. This switching over of securities is not practical in the actual practice of
making investments. The brokers and speculators can, however, use this as a hedge against possible occurrences
of loss.
3. Purchasing Power Risk
Purchasing power risk is also known as inflation risk. This risk arises out of change in the prices of goods
and services and technically it covers both inflation and deflation periods. During the last two decades it has
been seen that inflationary factors have been continuously affecting the Indian economy. In India, purchasing
power risk is associated with inflation and rising prices in the economy.
Inflation in India has been either ‘cost push’ or ‘demand pull’. This type of inflation has been seen
when costs of production rise or when there is a demand for products but there is no smooth supply and
consequently prices rise. In India, the cost push inflation has led to enormous problems as the rise in prices
of raw materials has greatly increased costs of production. The increase in costs of production has shown a
rising trend in ‘wholesale price index’ and ‘consumer price index’. A rising trend in price index reflects
a price spiral in the economy.
The consumers who wanted to forego their present consumption level to purchase commodities in future
found that they could not adjust their budgets because they were faced with rising prices and shortage of funds
for allocation according to their preferences.
All investors should have an approximate estimate in their minds before investing their funds of the
expected return after making an allowance for purchasing power risk. The allowance for rise in prices can be
made through a check list of the ‘cost of living index’. If a cost of living index has a base 100 and the next
year shows 105, the rate of increase in inflation is (105-100) 100 or 5%. If the index rises further in the second
year to 108, the rate is (108-105) 105 or 2.8%.
The importance of purchasing power risk can be equated to a simple example. If Z, lends A 100 today,
for a promise to be repaid A 110 at the end of the year, the rate of return is 10%. This effect becomes nullified
if the prices in the country increase. Assuming that the prices rise from 100 base index to 112 A 110 received
RISK 105
at the end of the year has purchasing power value of only 88% of A 110 or 96.80. A rate of 2% should be
charged in the beginning (10% + 12% expected inflation) to allow for this.
The behaviour of purchasing power risk can in some ways be compared to interest rate risk. They have a
systematic influence on the prices of both stocks and bonds. If the consumer price index in a country shows
a constant increase of 4% and suddenly jumps to 5% in the next year the required rates of return will also have
to be adjusted with an upward revision. Such a change in process will affect government securities, corporate
bonds and equity shares.
The explanation of systematic risk shows that market, interest rate risk and purchasing power risk are the
principal sources of systematic risk in securities. The unsystematic risk which affects the internal environment
of a firm or industry although peculiar to a particular industry also causes variability of returns for a company’s
stock. The two kinds of unsystematic risks in a business organization are ‘business risk and financial risk’. The
characteristics of these forms of risks are explained below.
5.4 UNSYSTEMATIC RISK

The importance of unsystematic risk arises out of the uncertainty surrounding a particular firm or industry
due to factors like labour strike, consumer preferences and management policies. These uncertainties directly
affect the financing and operating environment of the firm. Unsystematic risks can owing to these considerations
be said to complement the systematic risk forces.
1. Business Risk
Every corporate organization has its own objectives and goals and aims at a particular gross profit and
operating income and also expects to provide a certain level of dividend income to its shareholders. It also
hopes to plough back some profits. Once, it identifies its operating level of earnings, the degree of variation from
this operating level would measure business risk. For example, if operating income is expected to be 15% in
a year, business risk will be low if the operating income varies between 14% and 16%. If the operating income
is as low, as 10% or as high as 18% it would be said that the business risk is high.
Business risk is also associated with risks directly affecting the internal environment of the firm and those
of circumstances beyond its control. The former is classified as internal business risk and the latter as external
business risk. Within these two broad categories of risk the firm operates.
Internal business risk may be represented by a firm’s limiting environment within which it conducts its
business. It is the framework within which the firm conducts its business drawing its efficiency largely from the
constraints within which it functions. Internal business risk will be of differing degrees in each firm and the
degree to which each firm achieves its goals and attainment level is reflected in its operating efficiency.
Each firm also has to deal with specific external factors. Many a time, these factors are beyond the control
of a firm as they are responsive to specific operating environmental conditions. External risks of the business
are due to many factors. Some of the factor’s that can be summarized are:
l Business cycle: Some industries move automatically with the business cycle, others move counter-
cyclically;
l Demographic factors: Such as geographical distribution of population by age, group and race;
l Political policies: Change in decisions, toppling of State Governments to some extent affect the
working of an industry;
l Monetary policy: Reserve Bank of India’s policies with regard to monetary and fiscal policies may
also affect revenues through an effect on cost as well as availability of funds. When the RBI controls
its monetary policies in a way that money asset becomes expensive, people postpone their purchases
and the impact of such factors can be seen in retailers’ showrooms. As buying activity is restricted,
sales slide down;
l Environment: The economic environment of the economy also influences the firm and costs and
revenues;
Internal Business Risk can be identified through rise and decline of total revenues as indicated in the firm’s
earnings before interest and taxes. A firm which has high fixed costs has large internal risk because the firm
would find it difficult to curtail its expenses during a sluggish market. Even when market conditions improve,
a firm with a high fixed cost would be unable to respond to changes in the economy because it would already
be burdened with a certain fixed cost factor.
A firm can reduce its internal business risk both by keeping its fixed expenses low and through other means.
One of the methods of reducing internal business risk is to diversify its business cycle others will be quite
profitable. Internal risk can be reduced to this extent because a decline in revenue from one product line can
be offset by an increase in another, leaving total revenue unchanged. Other methods to reduce risk are to cut
costs of production through other techniques and skills of management.
2. Financial Risk
Financial risk in a company is associated with the method through which it plans its financial structure.
If the capital structure of a company tends to make earnings unstable, the company may fail financially. How
a company raises funds to finance its needs and growth will have an impact on its future earnings and
consequently on the stability of earnings. Debt financing provides a low cost source of funds to a company,
at the same time providing financial leverage for the equity share holders. As long as the earnings of the
company are higher than the cost of borrowed funds, the earnings per share of equity share are increased.
Unfortunately, large amounts of debt financing also increases the variability of the returns of the equity share
holders and thus increases their risk. It is found that variation in returns for shareholders in levered firms
(borrowed funds company) is higher than in un-levered firms. The variance in returns is the financial risk.
Financial risk and business risk are somewhat related. While business risk is concerned with an analysis
of the income statement between revenues and earnings before interest and taxes (EBIT), financial risk can be
stated as being between earnings before interest and taxes (EBIT) and earnings before taxes (EBT). If the
revenue, cost and EBIT of a firm is variable, it implies that there is business risk and in this situation borrowed
funds can magnify risk especially in unprofitable years. Debt in modest amounts is desirable. Excessive debt
is to be avoided as the long range profitability of the company can be depressed. The company should
constantly test its debt to fixed assets, debts to net worth, debts to working capital, and give coverage of interest
charges and preferred dividends by net income after taxes. These methods will check imbalance in the firm’s
financing method and help to reduce risk.
The various force of risk both systematic and unsystematic cause variations in returns for individual
securities or classes of securities. These risk forces may move individually or collectively or at cross currents
to bring variations in return. Risk can be measured scientifically through probability distributions and through
statistical measures of standard deviation and beta. Risk and return have a relationship. Investors are aware
that there is uncertainty in returns because there is risk associated with it. General awareness of investors is
not enough. Risk must be quantified. The next chapter explains the method of quantifying return. This chapter
explains the kinds of risk a company is surrounded with. Now, we turn to the different ways in which risk can
be quantified and its relationship with return. To quantify systematic and unsystematic risk separately is rather
a difficult task because their effects are involved. An attempt is made to try and measure risk in such a way
that all the qualitative factors are taken together as a single measure.
5.5 QUANTITATIVE ANALYSIS OF RISK

To measure risk, an investor should first understand the fact that risk cannot be measured accurately
because it is surrounded with complex environment factors such as social, economic and political forces. The
uncertainties make the measurement of risk an approximation or a fairly accurate estimation. The analyst must
be very cautious while making predictions because much depends on his accuracy in predicting risks. The
quantification of risk ensures comparison as well as uniformity in measurement, analysis and interpretation. To
eliminate guesses and haunches in measurement is possible by finding out the difference between actual return
and estimated return that is the dispersion around the expected return. Discussion as to how probability
distributions are framed will be made, in the next chapter while discussing returns. These distributions are
RISK 107
calculated through ‘standard deviations’ and ‘variances’. They are used for quantifying risk. Fischer and Jordan 3
describe risk in the following manner.
“The variability of return around the expected average is thus a quantitative description of
risk”.
1. Standard Deviation and Variance
The most useful method for calculating the variability is the standard deviation and variance. Risk arises
out of variability. If we compare the stocks of Company-A and Company-B in the following example (Table 5.1),
we find that the expected returns for both the companies are same but the spread is not the same. Company-
A is riskier than Company-B because returns at any particular time are uncertain with respect to its stock.
The average stock for Company-A and B is 12 but appears riskier than B as future outcomes are to be
considered.
Another example may be cited here (Table 5.2) of probability distributions to specify expected return as
well as risk. The expected return is the weighted average of returns. When each return is multiplied by the
associated probability and added together the result is termed as the weighted average return or in other words
expected average returns, for example:
Table 5.1 COMPARING RISK OF STOCKS OF COMPANY A & B
Company-A(Stock) Company-B(Stock)
12 11
16 12
4 13
20 10
8 14
Σx = 60 Σx = 60
60
Arithmetic mean = = 12
5
Stocks of Company-A and Company-B have identical expected average returns. But the spread is different.
The range in Company-A is from 8 to 12 and for Company-B it ranges between 9 and 11 only. The range does
not imply greater risk. The spread or dispersion can be measured by standard deviation.
The following example (Table 5.2) calculates return and risk through probability distribution and standard
deviation and variance method of two companies.
Table 5.2 (COMPANY A & B)

Company-A
Possible Return Probability Weighted Deviation Deviation Weighted Deviation

Outcome Rk K (2 × 3) Rk – E 1 Squared Squared
k kR k (R k – E 1 ) 2 k(R k – E 1 ) 2
1. 0.04 (4%) 0.25 0.010 –0.075 0.005625 0.001406

2. 0.12 (12%) 0.50 0.060 0.005 0.000025 0.000013
3. 0.18 (18%) 0.25 0.045 0.065 0.004225 0.001056
0.002475
Expected Return = 0.115
E1 = (11.5%)
Standard Deviation = θ = k (R k − E 2 )2
3. Op. cit., p. 121, Fischer and Jordan.

Where,
K = Outcome = 0.002475
R k = Return = 0.049 or (4.9%)
πk = Probability = θ2 or Variance 0.002475
Weighted probability and Return πkR k
Company-B
Possible Return Probability Weighted Deviation Deviation Weighted Deviation

Outcome Rk K (2 × 3) Rk – E 2 Squared Squared
k kR k (R k – E 2 ) 2 k(R k – E 2 ) 2
1 0.05 (5%) 0.25 0.0125 –0.040 0.001600 0.000400

2 0.09 (9%) 0.50 0.0450 0.0000 0.000000 0.000000
3 0.18 (13%) 0.25 0.0325 0.040 0.001600 0.000400
0.0900 0.000800
Expected Return = 0.0900
θ = k (R k − E 2 )2 = 0.000800 = 0.028 (2.8%)

or Variance = θ 2 = 0.000800
Comparison of return and risk for stocks of Company-A and Company-B with standard deviation 4.9% of
Company-A and 2.8% of Company-B.
The standard deviations and probability distributions show that stock of Company-A has a higher expected
return and a higher level of risk as measured by standard deviation. In Figure 5.2 are plotted probability
distributions, expected returns and standard deviations of returns. Company-B's stocks are symmetrical about
its expected return, Company A's not. This diagram also highlights important properties of standard deviation
and variance. The deviations are squared and added on both sides of expected return. Many investors are
contented when deviations in return are higher than expected. Standard deviation and variance is the best
method for calculations in upward returns but when deviations are below the expected return, then instead of
standard deviation, the investors or the security analysts should use semi-variance as a measurement of risk
as it reflects only downside variations in return.
Rk Rk
.60
.60
.50
.50
.40
.40
.30 .30
.20 .20 T T
T T
.10 .10
0 0
Rk
RETURN, Rk (%) RETURN, Rk (%)
COMPANY-A COMPANY-B
Fig. 5.2: Risk
Standard deviation measures risk for both individual assets and for portfolios. It measures the total
variation return about expected return. Another example of risk through standard deviation measurement is given
through mean. An example is shown in the return chapter also. Given below in Table 5.3 (a) are the stocks of
two companies ABC and XYZ. Show the relationship between risk and return. Which of the two stocks show
higher risk?
RISK 109
The relationship of risk and return is clearly established in this example. Company-ABC has a higher return
and a higher standard deviation than Company-XYZ and the return related to risk (standard deviation) is higher
than the XYZ which shows that the stock in ABC has performed better than XYZ but is somewhat riskier.
Risk associated with individual stocks is as discussed earlier of two types, systematic or non-diversifiable
and unsystematic or diversifiable. Systematic risk is often referred to as market risk and unsystematic part
as financial risk. Return of all stocks consists of an element of both types of risks. While systematic risk is
correlated with the variability of overall stock market, the unsystematic risk is the remaining portion of the total
variability of stock prices.
Table 5.3(a) FINDING OUT RISK BETWEEN STOCKS OF TWO COMPANIES

COMPANY-ABC
Annual Return Mean Average Stock Difference (1) – (2) Difference Squared
(1) (2) (3) (4)
0.10 0.06 0.04 0.0016

0.12 0.06 0.06 0.0036
0.24 0.06 0.18 0.0324
0.36 0.06 0.3 0.09
0.28 0.06 0.22 0.0484
0.08 0.06 0.02 0.0004
0.14 0.06 0.08 0.0064
0.2 0.06 0.14 0.0196
0.24 0.06 0.18 0.0324
0.24 0.06 0.18 0.0324
2/10 0.2672
0.2672
Mean = 20% ΣN 2 =
10
Table 5.3(b) FINDING OUT RISK BETWEEN STOCKS OF TWO COMPANIES
Annual Return Mean Average Stock Difference (1) – (2) Difference Squared
(1) (2) (3) (4)
0.06 0.1 –0.04 0.0016

0.08 0.1 –0.02 0.0004
0.1 0.1 0 0
0.12 0.1 0.02 0.0004
0.15 0.1 0.05 0.0025
0 0.1 –0.1 0.01
0.04 0.1 –0.06 0.0036
–0.08 0.1 –0.18 0.0324
0.12 0.1 0.02 0.0004
–0.15 0.1 –0.25 0.0625
0.44/10 0.1138
0.1138
Mean = 4.4% Σn 2 =
10
θ = 3.37%
The risk of stocks in terms of systematic and unsystematic compounds is tested through the ‘market
model’. According to the market model the return on any stock is related to the return on the market index
in a linear manner. 4
This widely accepted market model is based on ‘Empirical Testing’. This measure of quantifying risk is also
referred to as Beta analysis or ‘volatility’. The application of the Beta concept or market model is done
through the use of statistical measurement through a regression equation. According to Amling, Investment
Management through this model is the following:
“Returns of stocks are regressed against the return of the market index”. The basic equation
for calculating risk can then be formulated as:
Regression Equation
Y = α + βX + E…. Equation 7.1
Y = Return from the security in a given period.
α = Alpha or the intercept (where the line crossed vertical axis.)
β = Beta or slope of the regression formula.
E = Epsilon or Error involved in estimating the value of the stock.
2. Beta
The most important part of the equation is β or beta. It is used to describe the relationship between the
stock’s return and market index's returns. If the regression line is at an exact 45º angle, Beta will be equal to
+1.0. A 1% change in the market index (horizontal axis) shows that it is on an average accompanied by a 1%
change in the stock on the vertical axis. The percentage changes in the price of the stock are regressed against
the percentage changes in the price of a market index. S&P 500 Price Index 5 Beta may be positive or
negative. Usually Betas are found to be positive. We rarely find a negative Beta which reflects a movement
contrary to the market. A 0.5 Beta indicates that the market index change of 1% was reflected by a 0.5% price
change in stocks. Similarly, a 1.5 Beta would reflect that whenever the market index rose or fell by 1% the
stocks would rise and fall by 1.5%. Beta is referred to as systematic risk to the market and α + E the
unsystematic risk. Beta is a useful piece of information both for individual stock as well as portfolios, but as
a measure of risk it is better used in the analysis of portfolios. Also Beta measures risk satisfactorily for
diversified efficient portfolios but not inefficient portfolios. The concept of efficient and inefficient portfolios will
be clarified later in the book. For the present it may be said that Beta is a satisfactory measure for portfolios
because risk other than that reflected by beta is diversified.
Beta has certain limitations within which it must be considered. While calculating past Betas the length
of time will affect Beta size. When estimating future Betas, the markets expected return should also be estimated.
If high Beta is accurately predicted and the market also goes up as predicted the relationship will work. On the
contrary high Beta estimation and low market or downward market will show that the Beta will drop much
faster than the market. Finally, its shortcoming as a measure for individual stock as already explained should
be realized while calculating stock. For the total portfolio Beta is effective. Figure 5.3 shows the Beta along with
alpha, Rho and Epsilon and Figure 5.4 establish the Alpha and Beta relationship between the stock and the
market. The stock has a Beta or systematic risk to the market at 99%. This shows that the stock does have as
much risk as the market but it has a slightly higher unsystematic risk. Based on it, the stock in the past has
provided a return and risk comparable to the market.
3. Alpha
The distance between the inter-section and the horizontal axis is called (α) Alpha. The size of the Alpha
exhibits the stock’s unsystematic return and its average return independent of the market’s return. If Alpha gives
4. For a greater detail on deviation of market model and its applications read Dyckman Downes, Magee, Efficient Capital Markets
and Accounting – A Critical Analysis, Prentice Hall Inc., Englewood Cliffs, New Jersey, 1975, p. 130.
5. The two main publishers of industry and company information are the Standard and Poor’s Corporation (S & P) and Moody’s
investor service (Moody’s). Their ratings are considered to be accurate. For further details see p. 90, op. cit., Jones Tuttle Heaton.
RISK 111
a positive value it is a healthy sign but Alphas expected value is zero. The belief of many of the investors is
that they can find stocks with positive Alphas and have a profitable return. It must be recalled, however, that
in an efficient market positive Alphas cannot be predicted in advance. The portfolio theory also maintains that
the Alphas of stocks will average out to 0 in a properly diversified portfolio. The third factor besides Alpha and
Beta is Rho.
ρ)
4. Rho (ρ
Rho (ρ) is the correlation coefficient which describes the dispersion of the observations around the regression
line. The correlation coefficient expresses correlation between two stocks, for example i and j. The correlation
coefficient would be +1.0 if an upward movement in one security is accompanies by an upward movement of
another security. Conversely, downward movement of one security is followed in the same direction, i.e.,
downward by another security. If the movement of two stocks is not in the same direction the correlation
coefficient will be negative and would show –1.0. If there was no relationship between the movements of the
two stocks the correlation coefficient would be 0. The correlation coefficient can be calculated in the following
manner:
Correlation Coefficient
Where,
n
Rxi − Ri Rxj − Rj
Pij = ∑ θi
−
θi
x =1
Rxi = xth possible return for security i. (Pxij Equation 7.2)

Rxj = nth possible return for security j.
Rij = expected return for i and j.
Pxij = joint probability that Rxi and Rxj will occur simultaneously.
n = total number of joint possible returns.
This formula is normally calculated through the computer. The relationship or degree of correlation among
securities indicates that if there is perfect correlation, diversification will not reduce portfolio risk below the
lower of the two individual security risks. If the securities are negatively correlated portfolio risk can be greatly
reduced. If the relationship is to be drawn between two security returns portfolio risk can be eliminated. When
actual equity shares are analyzed it will be found that usually these stocks are highly correlated but not perfectly
correlated. Correlation coefficients also help in determining the extent to which a portfolio has eliminated
unsystematic risk. For example, if a correlation with the market index is +0.95 on squaring the correlation the
result is 0.9025 which means that 90% of the portfolios risk is now systematic and 10% of unsystematic risk
remains. Figure 5.3 shows correlation relationships in terms of scatter diagrams and regression lines.
5. Co-variance
While standard deviation is an excellent measure for calculation of risk of individual stocks, it has its
limitations as a measure of a total portfolio. With the correlation the co-variance approach should also be
considered when there are 2 or 3 stocks on the portfolio. Co-variance can be used to achieve the highest
portfolio expected return for a predetermined portfolio variance level or the lowest portfolio return.
An individual security’s expected return and variance express return and risk for portfolios of stocks, the
expected return is the weighted average of the expected return on the individual securities. This is weighted
according to each securities’ rupee proportion in the portfolio. Since, stocks tend to cover or move together
portfolio risk cannot be expressed for an individual stock. The formula for calculation of co-variance of two
stocks I and J and the co-variance of stocks with beta coefficients is shown in Figure 5.6.
Fig. 5.3: Regression Equation and Beta, Alpha, Rho and Epsilon
y = .01 + .99x + E
Fig. 5.4: Beta of Stock to Market

RISK 113
β – 0.40
β – 2.50
Fig. 5.4(A): Low Systematic Risk, High Fig. 5.4(B): High Systematic Risk, Low
Unsystematic Risk Unsystematic Risk
Fig. 5.5 (A, B, C, D and E): Correlation Relationships in Term of Scatter Diagrams
6. Co-variance Equation
Cov.ij = pij θi θj (Equation 7.3)
Pij = joint probability that ij will move simultaneously
θi = standard deviation of i.
θj = standard deviation of j.
Fig. 5.6: Regression Lines for 4 Stocks with +1.0 Betas
Measurement of Systematic Risk

The formula used for calculation of Alpha ( α ) and Beta ( β ) is given below:
Y = α + βX
where
Y = Dependent variable.
X = Independent variable.
α and β = are constants.
The formula used for the calculation of α and β are given below:
α =Y – βX
nΣXY − (ΣX )(ΣY )

β=
nΣX 2 − (ΣX )2
where,
n = Number of items.
Y = Mean value of the dependent variable scores.
X = Mean value independent variable scores.

Y = Dependent variable scores.
X = Independent variable scores.
Monthly return data (in percent) for Company A whose stock and the NSE index for a 8 month period are
presented below:
RISK 115
Month Company A NSE

1 –0.75 –0.45
2 5.40 –0.52
3 –3.55 –1.08
4 3.41 1.64
5 9.25 6.67
6 2.36 1.21
7 –0.45 0.72
8 5.51 0.84
(a) Calculate alpha and beta for the Company A stock.

(b) Suppose NSE index is expected to move up by 20 per cent next month. How much return would you
expect from Company A?
Solution: Since alpha and beta of the stock are to be calculated, the regression model may be used.
Calculation of α and β of stock

Company A return NSE Index return X2 XY
Y (R i ) X (R m )
–0.75 –0.45 0.20 0.3375
5.40 –0.52 0.27 –2.808
–3.55 –1.08 1.17 3.834
3.41 1.64 2.69 5.5924
9.25 6.67 44.49 61.6975
2.36 1.21 1.46 2.8556
–0.45 0.72 0.52 –0.324
5.51 0.84 0.71 4.6284
21.18 9.03 51.50 75.81
nΣXY − (ΣX)(ΣX) (8 × 75.81) − (9.03 × 21.18) 606.48 − 191.26 415.22

β= 2 2
= 2
= = = 1.256
nΣX − (ΣX) (8 × 51.50) − (9.03) 412.00 − 81.54 330.46
α = Y − βX
21.18 9.03
= − (1.256) = 2.65 − 1.42 = 1.23
8 8
The expected return from Company A stock when NSE index moves up by 15 per cent can be calculated
from the regression equation which is R i = 1.23 + 1.256 = 2.486 R m
Substitution the value of R m as 20 in the equation, we get, R i = 1.23 + 1.256 (20) = 26.35
5.6 INVESTOR'S ATTITUDE TOWARDS RISK AND RETURN

Before concluding the discussion on risk and its measurement let us turn back to the investor’s attitude
towards risk and return. Understanding and measuring risk and return is fundamental to the investment process
and increases an awareness of the investment problem. Most investors are ‘risk averse’. They must be aware of
the risks in different investments whether they are confronted with high, moderate or low risk and the kinds of
risks investment are exposed to before making their investments. Table 5.4 gives a ready reference to the kinds
of risks an investor is exposed to. To have a higher return the investor should be able to accept the fact that
he has to be faced with greater risks. In commercial bank and life insurance savings most of the risks are low
but purchasing power risk is high. Figure 5.7 graphically establishes the attitudes of two investors about the
combination of risks and returns that they would be able to accept. The investor has to decide for himself
whether he would like to choose a group of securities which will give him 15% return with 10% risk or a return
of 25% with 20% risk.
Table 5.4 RISK RETURN OF VARIOUS INVESTMENT ALTERNATIVES
Management Investment Mutual Business Interest Purchasing

Decisions Risk Risk Risk Power Risk
Required
H Growth Equity Shares H H L L

H Speculative Equity Shares H H L L
M Blue Chips (High Quality Equity Shares) M M L L
M Convertible Preferred Stock M M L L
L Convertible Debentures M M L L
L Corporate Bonds L L H H
L Government Bonds L L H H
L Short-term (Government Bonds) L L L H
L Money Market Funds L L L H
O Life Insurance Savings L L L H
O Commercial Banks L L L H
H = High L = Low M = Moderate
HIGHER
J1
HIGHER J2
30 I1
J3
25 I2
I3
20 B
15
A
10 LOWER
LOWER
| | | | | |
5 10 15 20 25 30
Fig. 5.7: Attitude Towards Return and Risk
The curves I1,2,3 and J 1,2,3 show the attitudes of two different investors about the return and risk combination
they are willing to accept. The curves show that investors I and J are quite happy with combination of risk and
return at point A (I) and B (J). The first investor can with all his efforts only obtain that combination of
securities at point A, that is the best the investor can do within his limited ability, the market will not offer any
more. The second investor J is willing to shoulder greater risk to earn a higher return. This investor prefers to
take a higher risk for a higher return.
RISK 117
Within the framework of the analytical discussion on return and risk in Chapter 5 and 6 is presented the
different kinds of investments with their special features in Chapter 7. After which we will take a closer look
at the different approaches — fundamental, technical and modern portfolio theory.
SUMMARY
r Most investors are risk averse and attempt to maximize their wealth at the minimum risk.
r Risk, it is established, can be reduced to a minimum but cannot be completely erased or eliminated.
r Risk and return are related. The higher the risk a person is willing to accept the better the returns he is
able to achieve.
r Risks are of many kinds. They can be classified as systematic or unsystematic.
r Systematic risks cover the risks of market, interest rate risk and purchasing power risk, unsystematic risk
consists of business and financial risk.
r The systematic risk is, therefore, affecting the total environment and is outside the control of any one firm or
individual. Unsystematic risk is inherent to the system.
r It may be due to bad financial planning or wrong management decisions. These risks are internal and can
be avoided or controlled.
r Risk is fundamental to the process of investment. Every investor should have an understanding of the various
pitfalls of investments.
r For the convenience of the investors analysts measure risks to be able to combine securities and to reach
that portfolio which suits the individual needs of an investor.
r Risk can be measured through probability distribution and finer statistical techniques like standard deviation,
regression analysis measured through Alpha and Beta tests and through correlation or Rho.
r This chapter also gives an array of investment alternatives from which to choose from and the risks associated
with it. It indicates which risk is high, moderate or low with each investment.

(i) The distance between intersection and horizontal axis is called Beta risk.
(ii) The most important part of the regression equation is Beta risk.
(iii) The relationship between stocks, returns and market Index’s structures is called beta.
(iv) Correlation and co-variance techniques are complementary methods for calculation of risk.
(v) Rho describes the dispersion of the observations around the regression line.
(vi) Median is the statistical tool used to measure a company’s risk.
(vii) Systematic risk is a cost incurred by market forces.
(viii) Unsystematic risk is environment risk of the economy.
(ix) Purchasing power risk is systematic risk.
(x) Beta is systematic risk.
Answers: (i) F (ii) T (iii) T (iv) T (v) T (vi) F (vii) T (viii) F (ix) T (x) T.
QUESTIONS
1. What is risk? How do you distinguish between systematic and unsystematic risk?
2. ‘Systematic risk cannot be controlled but unsystematic risk can be reduced’. Elaborate.
3. What is financial risk? Is it possible to reduce it while planning an organization?
4. In what way can the relationship of risk and return be established?
5. Discuss the usefulness of regression equation and correlation in measuring risk.
6. ‘Most investors are risk averse’. Elaborate.
7. Explain the terms ‘Beta’, ‘Alpha’, ‘Rho’, ‘high systematic low unsystematic risk’, ‘risk averse’.
ILLUSTRATIONS
Illustration 5.1: The return from security Z can be provided in different time periods:
What would be the average expected risk and return of the security.
Time period - 2006 Return Probability
Jan 0.25 0.10

Feb 0.15 0.40
Mar 0.10 0.30
April 0.05 0.20
Solution: The expected risk and return of the security can be measured in terms of standard deviation and weighted
average return.
Column 1 2 3 4 (2 × 3) Col. 3 (Col. 2 – Avg. 0.125) 2

Time period Return Probability Avg. Return
Jan 0.25 0.1 0.025 0.1 (0.25 – 0.125) 2 = 0.0015625

Feb 0.15 0.4 0.060 0.4 (0.15 – 0.125) 2 = 0.00025
Mar 0.10 0.3 0.030 0.3 (0.10 – 0.125) 2 = 0.0001875
April 0.05 0.2 0.010 0.2 (0.05 – 0.125) 2 = 0.001125
Total 0.125 0.003125
Step 1: Average return = 0.125 or 12.5%
Step 2: Probability = (Return – Average) 2
Step 3: Risk = 0.003125 = 5.59%
Illustration 5.2: The return on two securities ‘X’ and ‘Z’ are given below select the security according to risk and
return:
Return on Security ‘X’ Return on Security ‘Z’ Probability

(%) (%)
5 1 0.5
4 3 0.4
0 3 0.1
Solution:
(i) Return = R1P1 + R 2P2 + R 3P 3
(ii) Security ‘X’ = 5 × 0.5 + 4 × 0.4 + 0 × 0.1
= 2.5 + 1.6 + 0
= 4.1
Security ‘Z’ = 1 × 0.5 + 3 × 0.4 + 3 × 0.1
= 0.5 + 1.2 + 0.3
= 2.0
The return on security ‘X’ is higher than security ‘Z’.
(ii) Risk Calculation:
(a) ‘X’ Security (R 1 – Er) 2
RISK 119
R P Security (R 1 – Er) 2 P 1(R 1 – Er) 2

5 0.5 (5 – 4.1)2 = 0 .81 0.405
4 0.4 (4 – 4.1)2 = 0.01 0.004
0 0.1 (0 – 4.1)2 = 16.81 1.681
Total 2.09
(b) Security ‘Z’
R1 P1 Security (R 1 – Er) 2 P 1(R 1 – Er) 2

1 0.5 (1 – 2.0)2 = 1 0.5
3 0.4 (3 – 2.0)2 = 1 0.4
3 0.1 (3 – 2.0)2 = 1 0.1
Total 1.0
Risk
Security ‘X’ = 2.09 = 1.44
Security ‘Z’ = 1.0 = 1.0
Security ‘X’ Return is higher but risk is also high. An individual who has an appetite for risk will prefer security ‘X’.
Illustration 5.3: An Investor has to choose from 2 securities. The following are their rates of return and probabilities.
Q P
Return % Probability Return % Probability
20 0.1 13 0.1
16 0.4 16 0.2
10 0.3 22 0.3
3 0.2 25 0.4
(a) Which is the better security Q or P?

Solution: An analysis of return and risk of the securities will show which security is the best. The securities are
named Q and P.
Analysis of Security Q
R P Average Return Prob. (Return – Average) 2

(1) (2) (3) (4)
0.20 0.10 0.020 0.1 (0.20 – 0.12) 2 = 0.00064
0.16 0.40 0.064 0.4 (0.16 – 0.12) 2 = 0.00064
0.10 0.30 0.030 0.3 (0.10 – 0.12) 2 = 0.00012
0.03 0.20 0.006 0.2 (0.03 – 0.12) 2 = 0.00162
Total 0.120 = 0.00302
Step 1:
Expected return = 0.120 or 12%
and risk ‘θ’ - 0.00302 = 0.054 or 5.4%
Analysis of Security P
R P Average Return Prob. (Return – Average) 2

(1) (2) (3) (4)
0.13 0.1 0.013 0.1(0.13 – 0.211) 2 = 0.000656
0.16 0.2 0.032 0.2 (0.16 – 0.211)2 = 0.000520
0.22 0.3 0.066 0.3 (0.22 – 0.211)2 = 0.000024
0.25 0.4 0.100 0.4 (0.25 – 0.211)2 = 0.000608
Total 0.211 = 0.001808
Expected return = 0.211 or 21.1%
and risk ‘θ’ = .001808 = 0.0425 or 4.25%
Choose security ‘P’ as it is the best. Return is high 21.1% and risk is 4.25%.
Illustration 5.4: Mr. Joshi has a portfolio of securities. These are as follows:
Amount (in Lakhs) 6 9 12 15 18

Return 7% 12% 19% 10% 2%
Find out expected return of portfolio.

Solution:
Security (i) Return (ii) Amount (iii) Weight (iv) (ii) X (iv)
I 0.07 6,00,000 0.110 0.007
II 0.12 9,00,000 0.15 0.018
III 0.19 12,00,000 0.20 0.038
IV 0.10 15,00,000 0.25 0.025
V 0.02 18,00,000 0.30 0.006
Total 60,00,000 Total 0.094
The expected return of the portfolio is = 9.4% Ans.
Illustration 5.5: Find risk and return of the following 5 securities. Give an analysis. Should the investor keep all
these securities?
Securities Return % Probability

1 25 0.05
2 30 0.15
3 35 0.40
4 40 0.15
5 45 0.25
Solution:
Return Prob. Return × Prob. P (Return – Avg.) 2
0.25 0.05 0.0125 0.05 (0.25 – 0.37) 2 = 0.00072
0.30 0.15 0.0450 0.15 (0.30 – 0.37) 2 = 0.000735
0.35 0.40 0.1400 0.40 (0.35 – 0.37) 2 = 0.00016
0.40 0.15 0.0600 0.15 (0.40 – 0.37) 2 = 0.000135
0.45 0.25 0.1125 0.25 (0.45 – 0.37) 2 = 0.0016
Total 0.3700 Total = 0.00335
Average expected return = 0.37 or 37% and risk or standard deviation is ‘θ’ = 0.00335 = 5.78%
Return is 37% and risk is 5.78% the investor should continue with this portfolio.
RISK 121
Illustration 5.6: The market price of a share is A 155. Following information is available about market condition,
dividends and market price after one year (year-end). Find the expected return of the share and the variability of the return.
Market Condition Probability Market Price Dividend (A)

Bullish 0.25 200 15
Stable 0.50 160 10
Bearish 0.25 150 5
Solution:
The expected return of the equity share may be as follows:
Market Probability Total Return = Market Price Net Return

Condition Market Price + Dividend of Share
Bullish 0.25 200 + 15 = 215 155 60
Stable 0.50 160 + 10 = 170 155 15
Bearish 0.25 150 + 5 = 155 155 0
Expected return = (60 × 0.25) + (15 × 0.50) + (0 × 0.25)
= 15 + 7.5 + 0 = 22.5%
The variability of returns will be studied in terms of standard deviation.
θ2 = 0.25(60 – 22.5) 2 + 0.50(15 – 22.5) 2 + 0.25(0 – 22.5) 2
= 0.25 × 1406.25 + 0.50 × 56.25 + 0.25 × 506.25
= 351.562 + 28.125 + 126.562
= 506.249 = 22.49% Ans.
Illustration 5.7: Calculate Risk and Return for the following:
Monthly Return x-x (x - x)2

3.17 –4.71 22.18
–14.63 13.09 171.35
3.27 –4.81 23.14
-3.27 1.73 2.99
–15.77 14.23 202.49
–4.15 2.61 6.81
2.36 –3.09 15.21
–7.33 5.82 33.87
–10.9 9.44 89.11
26.47 –28.01 784.56
8.01 –9.05 90.25
–5.62 4.08 16.65
–18.39 0.07 1458.61
Average: X = –18.39/12 = – 1.53
ΣX − x 1458.61
σ= = = 11.51
N −1 12 − 1
Company A
(ri) (Pi) (Pi)(ri)

6.00 0.10 0.60
7.00 0.25 1.75
8.00 0.30 2.40
9.00 0.25 2.25
10.00 0.10 1.00
8.00
Company B
(ri) (Pi) (Pi)(ri)

4.00 0.10 0.40
6.00 0.20 1.20
8.00 0.40 3.20
10.00 0.20 2.00
12.00 0.10 1.20
8.00
In the example given about the expected means are the same in both the companies. The A company’s return varies
from 6% to 10% while the B company’s return varies from 4% to 12%. To find out the variation, the standard deviation
technique is applied.
N
σ= ∑ P[r − E(r)]2
i =1
N
2 2
Variance σ = ∑ P[r − E(r)]
i =1
Hence σ = Variance(σ)
For Company A
ri Pi ri – E(r) ri – [E(r)] 2 P1[ri – [E(r)] 2
6 0.1 –2 4 0.4
7 0.25 –1 1 0.25
8 0.3 0 0 0
9 0.25 1 1 0.25
10 0.1 2 4 0.4
1.3
N
σ 2 = ∑ P[r − E(r)]2 = 1.30 = 1.14
i =1
For Company b
ri Pi ri – E(r) ri – [E(r)] 2 P1[ri – [E(r)] 2
4 0.1 -4 16 1.60
6 0.2 -2 4 0.80
8 0.4 0 0 0.00
10 0.2 2 4 0.80
12 0.1 4 16 1.60
4.80
N
σ2 = ∑ P[r − E(r)]2 = 4.80 = 2.19
i =1
Characteristic Regression Line (CRL)

The characteristic regression line or CRL is a simple linear regression model estimated for a particular stock against
the market index return to measure its diversifiable and undiversifable risks. The model is:
Ri = α i + β i R m + e i
Ri = Return of the i th stock
αi = Intercept
βi = Slope of the i th stock
Rm = Return of the market index
RISK 123
e i = The error term

The security return is:
Today's price – Yesterday's price

Today's security return= = ×100
Yesterday ' s price
Today's index – Yesterday's index

Today's market return= = ×100
Yesterday ' s index
Like daily returns, weekly returns can be calculated by using this week’s and last week’s prices instead of today’s
and yesterday’s prices in the above-mentioned formal. Monthly returns also can be calculated.
Let us consider the daily prices of Mahindra Auto stock and the index for the period 10 th January 2014 to 19 th
January 2014. The objective of this example is only to illustrate the computation of beta. Usually beta value have to be
calculated from data of a fairly long period to minimize the sampling error.
Date Index(X) Mahindra Auto (Y)

40,179.00 904.95 597.80
40,544.00 874.25 570.80
40,909.00 874.25 582.95
41,275.00 847.95 559.85
41,640.00 849.10 554.60
42,005.00 835.80 545.10
42,370.00 816.75 519.15
42,736.00 843.55 560.70
43,101.00 835.55 560.95
43,466.00 839.50 597.40
To calculate the beta, the returns have to be calculated. Then using the formal below, the beta and alpha co-efficient
can be calculated.
nΣXY − (ΣX)(ΣY)
β=
nΣX 2 − (ΣX)2
α = Y − βX
Index Return X X2 Mahindra Auto Y2 XY

Stock Return Y
–3.39 11.50873 –4.52 20.4 15.32
- 0 2.13 4.53 -
–3.01 9.049826 –3.96 15.7 11.92
0.14 0.018393 –0.94 0.88 –0.13
–1.57 2.453497 –1.71 2.93 2.68
–2.28 5.194996 –4.76 22.66 10.85
3.28 10.76692 8 64.06 26.26
–0.95 0.899411 0.04 0 -0.04
0.47 0.223485 6.5 42.22 3.07
–7.31 40.11526 0.78 173.39 69.94
β=
nΣX 2 − (ΣX)2
9 × 69.94 − (−7.30)(0.78) 629.46 − (−5.694) 635.154

= = = = 2.06
9 × 40.115 − (−7.30)2 361.035 − (53.29) 304.745
α = Y − βX
0.78
Y= = 0.087
9
7.30
X= = −0.81
9
α = Y − βX = 0.087 – [2.06 × –(–1.67)] = 1.76

The manual calculation seems to be laborious. At present beta can be calculated with the help of hand calculators
and computers very easily. When an investor has to calculate for a long period, a computer would be of great use. Along
with beta, other information also can be obtained. Given below is the computer spreadsheet for the previous example, i.e.,
for Mahindra Auto Stock return on NSE Index.
R i = α i + βi R m + e i
α i = 1.02
βi = 1.19 standard error is 0.0266
Standard deviation of stock return : 4.39
Variance of stock return : 19.27
Standard deviation of index return : 3
Variance of the index return : 9
Correlation coefficient : 0.795
r=
nΣX − (ΣX)2 nΣY 2 − (ΣY)2
2
9 × 91.32 − (−7.09)(0.78) 827.41

= = = 0.79
9 × 82.75 − (−7.09) 2 2
9 × 173.36 − (0.78) 1040.73
The square of the correlation co-efficient is the co-efficient of determination. It gives the percentage of variation in
the stock’s return explained by the variation in hte market’s return. In our example,
r 2 = (0.79) 2 = 0.62
Illustration 5.8: The following data give the market and the Sun company scrip’s return for a particular period.
Index Return (R m) Scrip Return (R i )

0.50 0.30
0.60 0.60
0.50 0.40
0.60 0.50
0.80 0.60
0.50 0.30
0.80 0.70
0.40 0.50
0.70 0.60
(a) What is the beta vale of the Sun Company scrip?

(b) If the market return is 2, what would be the scrip return?
Solution:
Ri = α i + βi Rm + ei
RISK 125
Calculations:
Rm R m −R m ( R m − R m )2 Ri R i −R i ( R i − R i )2 R m −R m × R i −R i
0.5 -0.1 0.01 0.3 -0.2 0.04 0.02
0.6 0 0 0.6 0.1 0.01 0
0.5 -0.1 0.01 0.04 -0.1 0.01 0.01
0.6 0 0 0.5 0 0 0
0.8 0.2 0.04 0.6 0.1 0.01 0.02
0.5 -0.1 0.01 0.3 -0.2 0.04 0.02
0.8 0.2 0.04 0.7 0.2 0.04 0.04
0.4 -0.2 0.04 0.5 0 0 0
0.7 0.1 0.01 0.6 0.1 0.01 0.01
5.4 0.16 4.5 0.14 0.12
∑ ( Ri − Ri )( Rm − Rm ) 0.12
β= = = 0.75
∑( Rm − Rm ) 2 0.16
ΣR m 5.4
Rm = = = 0.6
n 9
ΣR i 4.5
Ri = = = 0.5
n 9
R i − R i = β(R m − R m )
R i – 0.5 = 0.75 (–0.6)
= 0.05 + 0.75 R m
The beta value is 0.75
(a) If the Beta value is 2, the Sun Company Scrip value would be R i = α i + βR m = 0.05 + 0.75(2) = 1.55
SELF REVIEW PROBLEMS

1. An investor has the choice of two securities X and Z, Their rates of return and probabilities are given. Which
according to you should he buy for investment?
X Z
Rate of Return Probability Rate of Return Probability
–30 20 –20 20
0 40 10 40
30 30 40 30
70 10 80 10
Answer:
Risk X, Z = 0.084
Return X = 10%, Z = 20%
Z is better than X.
2. Find out Risk and Return in the following two securities R and P in different conditions of the market.
Market Conditions Return of Security Return of Security Probability

R P
Bull 25% 40% 0.30
Normal 20% 10% 0.50
Bear 15% –20% 0.20
Answer: Return of R = 20.5%, Risk of R = 3.5%

Return of P = 13%, Risk of P = 21%
3. The return on two securities A and D are given in different economic conditions of a country. Find out their
expected returns and standard deviation of return. Also calculate coefficient of variation.
Economic Conditions Probability Return of Security Return of Security

A D
Boom 0.20 5% –10%
Above Normal 0.40 30% 25%
Normal 0.30 20% 20%
Dull 0.10 10% 10%
Answer:
Expected Return = 20% for A and 15% for D
Standard Deviation = 9.745 for A and 13.22 for D
A = 0.487
D = 0.661
4. Find risk and return of the following 5 securities. Give an analysis. Should the investor keep all these securities?
1 30 0.8
2 40 0.4
3 50 0.5
4 60 0.6
5 70 0.7
Answer:
Average expected return = 1.5 or 150%
and risk or standard deviation is ‘θ’ = 3.07 = 1.75% or 175%
SUGGESTED READINGS
l Jones C.P., Tule D.L. Heaton C.P., Essentials of Modern Investments, Ronald Press Co., New York, 1977,
p. 452, Chapters 6 and 7.
l Conrad W. Thomas, Risk and Opportunity — A New Approach to Stock Market Profits, Dow Jones Irvin (Inc.),
Illinois, 1974, p. 543.
l Donald E. Fischer Ronald J. Jorden, Security Analysis and Portfolio Management, (Third edition), Prentice-
Hall, Englwood Cliffs, New Jersey, 1984, p. 634, Chapter 5.
l Fredrick Amling, An Introduction to Analysis and Management, Prentice-Hall Inc., Englewood Cliffs, New
Jersey, 1984, p. 684, Chapter 1.
l Smith K.V. & Eiteman D.E., Modern Strategy for Successful Investing, Dow Jones-Irvin Inc., Illinois, 1977, p.
552, Chapter 3.
l Thomas R. Dyckmar, David H. Downes Robert P. Magee, Efficient Capital Markets and Accounting: A Critical
Analysis, Prentice-Hall Inc., Englewood Cliffs, New Jersey, 1975, p. 130.
nnnnnnnnnn
Chapter
RETURNS
Chapter Plan
6.1 Measurement of Returns
6.2 Traditional Technique
6.3 Modern Technique
6.4 Holding Period Yield: Influence on Bonds and Stocks
6.5 Returns and Probability Distributions
6.6 Taxes and Investment
6.7 Inflation and Investment
6.8 Return: Statistical Techniques
6.1 MEASUREMENT OF RETURNS

A major purpose of investment is to set a return or income on the funds invested. On a bond an investor
expects to receive interest and on equity shares, dividends may be anticipated. The investor may expect capital
gains from some investments and rental income from house property. Return may take several forms. In this
chapter the basic concepts relating to return and the methods used in measuring returns on bonds and shares
are discussed. The purpose of investment is to get a return or income on the funds invested in different financial
assets. The most important characteristics of financial assets are the size and variability of their future returns.
Since, the return on income varies, various statistical techniques are used to measure it. Over the years many
methods were adopted for quantifying returns. These are now categorized as traditional and modern techniques
of measurement. Measurement of returns of bonds and shares can be done through both these techniques.
These are discussed in the following part of this chapter.
6.2 TRADITIONAL TECHNIQUE

Computation of yield to measure a financial asset’s return is the simplest and oldest technique of measurement.
Yield can be both expected or estimated and actual for a particular period, the formula used to find yield is:
127
Expected cash income

(a) Estimated Yield = Current price of asset
Cash income
(b) Actual Yield = Amount invested
The yield is calculated for a particular period to find out the return on the amount that is invested. For
example, the annual yield on a unit trust certificate is the dividend income divided by the amount invested.
Yields can be computed both for bonds and stocks and shares.
1. Bonds
Bonds usually have a maturity period. Yield on them can be calculated either for the current period or
to maturity. While it is advisable to find out yield to maturity and it is also the common practice, yet current
yield on bonds can also be found out. The current yield on a bond is the annual coupon return divided by the
bond’s purchase price.
(a) Current Yield
Example 6.1: An investor buys a 20-year bond at ` 80 and it carries a ` 100 annual return and its par
value is ` 1,000. What is its current yield?
Solution:
Annual return 100
Current Yield = Purchase price = = 1.25 or 12.5%.
80
Example 6.2: An investor buys a ` 100 bond of 10-year maturity with ` 80 return per year. The par
value of the bond is ` 1,000. What is its current yield?
Solution:
80
Current Yield = = 0.08 or 8%
1000
Note: The investor may sometimes buy the bond at par value. Then the coupon rate and current rate are
identical.
(b) Yield to Maturity
Yield on bonds is calculated to the date of maturity. (YTM), is the percentage yield that will be earned
on a bond from the purchase date to maturity date.:
Example 6.3: An investor buys a bond in 2000 having a maturity in 2010, at ` 900. It has a maturity
value of 10 years and par value of ` 1,000. It gives an annual return of ` 90. Calculate current yield and yield
to maturity.
Solution:
90
(i) Current Yield = = 0.10 = 10%
100
Shortcut Method
Average annual return
(ii) Yield to Maturity (YTM) = Average investment
I + (RV − B 0 ) / n
= (RV + B 0 ) / 2
Where, I = Annual Interest
RV = Redeemable value of bond
RETURNS 129
B 0 = Price of bond
n = Number of years to maturity
90 + (1000 − 900) /10 100

YTM = = = 10.5%
(1000 + 900) / 2 950
Or,
Interpolation Method
YTM = I (PVAF ni) + RV (PVF ni)
YTM at 11% = 90 (5.889) + 900 (0.352)
= 530.01 + 316.80 = 846.81
YTM at 10% = 90 (6.145) + 900 (0.386)
= 553.05 + 347.40 = 900.45
900.45 − 900
By Interpolation YTM = 10% = 900.45 − 846.81 = 10.01%.
This formula is a shortcut method and gives the approximate yield. If it is done by interpolation it gives
the exact answer. The shortcut method takes into account the values at par and the purchase price of bonds
and averages it.
The interpolation method discounts the values by finding out the present values and calculates the exact
yield as depicted in example 6.3.
Bonds may sell either higher or lower than their par values. When bonds sell above their maturity value
they are said to be at a ‘Premium’. It follows then that bonds selling below their maturity value are at a
‘Discount’. Yield to maturity takes into account ‘premium’ or ‘discount’ factors arising out of the difference in
purchase price and maturity value, since the yield to maturity takes several factors for finding out the returns
as opposed to taking only coupon interest rate and purchase price to find out current yield, the yield derived
from the two methods will differ. Return can also be found out for amounts invested in shares.
2. STOCKS AND SHARES
The return on (equity) stocks is measured by finding out dividend yields. Dividend yield can be estimated
on expected yield as well as actual yield and earnings yield.
(a) Estimated Yield
Expected dividend
Estimated yield = Current share price
(b) Actual Yield

Dividend recieved
Actual Yield = Pr ice of share in the beginning of the period
Another way of finding out returns in stock is by finding out ‘earnings yield’.
(c) Earnings Yield
Dividend yield does not consider the fact that earnings are retained in business for reinvestment. Accordingly,
earnings yield takes within its purview company growth, stock price appreciation and retained earnings. After
taking these factors into consideration the earnings yields cannot strictly be called a true measure but analysts
consider earnings yield a more accurate measurement, as it reflects both dividends and retained earnings.
Besides calculating for finding out the markets attitude towards a company’s growth prospects and for making
comparisons among different companies on that basis, the technique of ratio analysis is applied by calculating
price earnings ratios.
The Price Earnings (P/E) ratio and Earnings Price (E/P) indicate how many rupees must be paid to
purchase investment to earn one rupee and the E/P is earnings expected in the coming year divided by present
share price.
Example 6.4: A stock selling for ` 36 earns ` 3 annually. What are its earnings to price percentage and
what is its price to earnings ratio?
Solution:
E Earnings 3
E/P ratio of = P = Pr ice of share = 36 = 0.83 = 8.33%
P/E ratio = 36:3 =12:1

(d) E/P ratio
These ratios are useful and are sometimes also called capitalization rates. E/Ps presented in percentage
and depicts the gap between the earnings on shares and the price at which it is selling. The price of a share
varies from one company to another depending on the industry group to which it belongs. A computer manufacturing
company may sell its share at 30 times earnings whereas Public Utilities shares may sell at par.
(e) P/E ratio
The P/E method is used when the analyst would like to estimate future price to work back to justified
price. To determine current justified price an investor would have to use his own discount rate. Valuation model
to find out returns, gives current justified price of stock more directly. Earnings per share are estimated and a
reasonable capitalization rate must be applied to them. To find out the justified rate of the stock it will have
to be calculated with required rate of return of the investor. The analyst should try to estimate the rate at which
the market will capitalize the stock’s earnings. He must have a reliable capitalization rate so that he can find
out the future inclination of the investor.
6.3 MODERN TECHNIQUE

The ‘holding period yield’ is one of the new techniques in measuring returns. The traditional methods did
not provide a satisfactory returns measure. Some of the gaps that were identified are: (a) the traditional method
does not distinguish between dividends and earnings portion that the company retains (Earnings Yield Method),
(b) Dividend Yield Method ignores the possibility of price appreciation on retained earnings. It is useful only
for those shareholders who wish to retain shares always and are not interested in selling and anticipate that
dividends are not going to change, (c) the yield to maturity is useful only to those bond holders who will hold
it to maturity. All investors may not hold bonds till maturity. These methods are thus known to serve a limited
purpose only. The better method measures return through the holding period yield. This measure appears more
rational and clearly defined. It serves two purposes: (a) It measures the total return per rupee of the original
investment and (b) through this method comparisons can be drawn of any asset’s expected return. An asset can
be compared with another asset both historically and for future periods.
The holding period yield can be used for any asset. For example, returns from savings accounts, stocks
money, real estate and bonds can be compared through this measure. The formula for the holding period yield:
Income payments received + Capital change for the period
Original investment at the beginning of period
A look at this formula shows that HPY considers everything the investor receives over the specified period
during which the asset is held relative to what was originally invested in the asset. It also considers all income
payments and positive/negative capital changes during the period. These are then measured relative to the
original investment in rupees. The HPY also measures past receipts of payments as well as estimated future
income. It is a technique which can measure historically as well as for an unknown future. It is useful for
comparing any time period. It can be used on both Bonds and Stocks.
RETURNS 131
1. Bond: Holding Period Yield (HPY)

The holding period yield for bonds is measured in the following way:
Income payments during period (t) + Change price during period (t)
HPY = Pr ice at the beginning of period (t)
Or,
It + P
HPY = Pt
Where, t = holding period (time)
I t = Bond’s coupon interest during period t
P t = Bond’s price at the beginning of holding period
P = Change in bond price over the period.
Example 6.5: A company’s bonds are bought at ` 1,000. Its coupon interest rate is 9% per annum. It
is retained for a holding period of one year and sold for ` 1,100. Find HPY.
Solution:
90 + 100 190
HPY = = = 0.19
1000 1000
Or a holding period of 19 paise on each rupee invested can be used to find out the Holding Period Yield.
The holding period yield on bonds as seen from the formula consists of two parts – the coupon yield and the
percentage change in the bond price. This may alternatively be depicted as:
Dt + P
HPY = Pt
(D t = Dividends received during period t)
The formula, as in bonds can be broken into ‘income yield’ and percentage price measure:
Dt P
HPY = P + P
t t
While current yield, dividend yield, P/E and E/P has their limited uses, HPY has the maximum usefulness
as it makes comparisons for all types of assets.
6.4 HOLDING PERIOD YIELD: INFLUENCE ON BONDS AND STOCKS

The HPY makes a study of complex factors like income yield and percentage price change in a single
measure. It does not discuss within its boundaries the differences between the capital gains and dividend
factors. These differences are important to find out from the point of view of status of an organization. A
dividend income is different to capital gains and is treated accordingly for the purpose of tax. These are also
reasons for investors to alter or exercise their choice of stocks and bonds. It is, however difficult to distinguish
between capital gains and income aspect from the point of view of simplicity. It is assumed that the objective
of an investor is to maximize wealth and utilize his income in such a way that satisfaction is maximized. The
holding period technique adjusts with portfolio choice. Constant evaluation of security is made and the best
choice exercised. HPY is, therefore, a flexible technique. By using this technique as the returns measure it is
not important to liquidate the portfolio at the end of each period and reinvest funds afresh. It is only a method
to keep funds in the most beneficial investment opportunity.
6.5 RETURNS AND PROBABILITY DISTRIBUTIONS

Returns on assets vary from time to time. If return can be predicted, it results in receiving of a particular
amount of income. When there are two or more alternatives that an investor may or may not receive an amount
as return then uncertainty is involved. The work of the analyst begins in this uncertain condition. He considers
each particular outcome or a reasonable range of outcomes and attaches a probability to it. The group of
possible outcomes with their probabilities is called a probability distribution. The probability distributions help
in predicting possible rates of return.
A group of numbers is called a distribution. A group of numbers reflecting known past events shows how
frequently each number occurs. This kind of distribution of numbers is called a frequency distribution. A group
of numbers could also be for a future period. Estimates reflecting unknown future event is called a probability
distribution. A probability is sometimes equated with the same meaning as relative frequency and it is said to
reflect the likelihood of the happening of an event. The perceiver is usually able to estimate the chance of an
event happening or not happening. If an investor feels that there are two chances out of ten that a particular
event will happen, the event or outcome about a particular event has a probability of 0.2 and his probability
of the event not happening is 0.8. These distributions can be expressed at percentages or fractions. When the
chance of happening (0.2) and the chance of not happening (0.8) are added up the total will add up to (1.0)
the total number of chances. This can be soon both in frequency distributions as well as probability distribution
in any example. If the total does not add up the distribution is not correct.
An analyst is guided by the past behaviour of prices through their frequency distributions, but estimates
of future probabilities is always a rough and approximate calculation and exact rates of return cannot be
predicted. Moreover, probability distributions are, to some extent, subjective. The degree of preciseness depends
on how the individual uses the technique.
An analyst guided by past distributions analyses a particular situation. The price of a stock is selling at
A 40. The analyst thinks that this price would go as low as 25 by the end of the year or the other possibility
is that it will rise to A 50. He assigns probabilities from 25 to 50. He could even assign (25½, 25¼, 25 1 / 8 etc.)
as fractions or to every fifth number (20, 25, 30 etc.,). Even after laborious calculations the analyst would still
arrive at approximate results.
Holding period yield (HPY) is an important measure to find out returns. HPY is generally found out from
probability distributions either through measures of central tendency or through measures of dispersion. These
statistical methods enable an analyst to make predictions of expected return and risk.
Example 6.6: Return of a security is 25%, 26%, 27%, 28% and 29%. Probability is 0.10, 0.20, 0.40,
0.15 and 0.05.
Expected Return Probability P × Ex
25% 0.10 2.50
26% 0.20 5.20
27% 0.40 10.80
28% 0.15 4.20
29% 0.05 1.45
24.15
Solution:
Therefore, expected value of return ‘r’ = 24.15%
n
r = ∑ pi x i
i =1
Where, r = Expected return

p i = Probability of ith return
x i = Possible return
n = Number of years
Therefore expected value of returns is weighted average return. Where, the possible return is multiplied
by the probability of that return. Expected return can be calculated for discrete probability distribution and for
continuous series.
RETURNS 133
6.6 TAXES AND INVESTMENT

Taxes reduce returns of an investment. In India an investor looks for investments that are tax free because
that gives a higher rate of return. Public provident fund, dividends and tax free bonds are some of the choices
made by an investor to save tax.
The after tax rate of return depends on the marginal tax rate of the investor as well as the coupon
rate of a bond. For example if a bond gives a rate of return of 15% and the investor is in the tax bracket of
30% his after tax rate of return will be the following:
After tax rate = coupon rate (1 – tax rates) or 0.15 (1 – 0.3) = 0.105 = 10.5%.
To compare the tax free investments with the taxable return conversion can be made into taxable equivalent
yield.
Tax free rate
Taxable equivalent yield = 1 − Tax rate
If the tax free rate is 10% and the marginal tax rate of the investor is 30%.
0.10
Taxable equivalent yield = 1 − 0.30 = 14.28%
If tax free rate is 9% and marginal tax rate of the investor is 20%.
0.19
Taxable equivalent yield = 1 − 0.20 = 11.25%
Therefore, an investor must consider the effect of tax before making any investment.
6.7 INFLATION AND INVESTMENT

Inflation reduces the purchasing power if prices rise then the real return falls. Therefore, an inflation
adjusted return must be calculated to find out the real return. The following is the equation for calculating the
return.
1+R
r = −1
1+ i
R−i
or, r = 1 + i
Where, R = Nominal return

r = Inflation adjusted real return
i = Rate of interest
0.10 − 0.05
If R = 10% and i = 5% real rate of return will be r = 1 + 0.05 = 4.76%.
The real return is 4.76%. Therefore, the investor must calculate the real return before making his investment
strategy.
6.8 RETURN: STATISTICAL TECHNIQUES

Return as we have just described can be measured either through Central Tendency or Dispersion.
1. Central Tendency
There are various methods of central tendency, i.e., mean, median and mode. All these methods describe
the ‘average value’ of a distribution. The mean is also called arithmetic mean and is used to measure average
returns. Median is useful to find out the middle value. For example, in a distribution of seven numbers, the
value of fourth or middle number is the median. Mode is the number that occurs the maximum number of
times. In a distribution if 3 occur twice and the other numbers occur once, then 3 is the mode. Each of these
methods can be applied to find out average values. The method best suited to HPY distributions is the
arithmetic mean. Arithmetic mean is the most basic statistics of any distribution. To find out arithmetic mean,
the values in the distribution are added and divided by the total number of values. For example, the frequency
distribution of HPY on a particular stock in the ten-year period showed the following:
Example 6.7:
Frequency Distribution
0.10
0.00
0.10
0.20
0.30
0.10
0.50
0.40
0.10
0.00
Σx 1.80
Solution:
Σx 1.80
Mean = = = 0.18
n 10
Median = 0.20
Mode = 0.10
Mean is, therefore, considered a more accurate measure. Mean of any probability distribution is called its
‘expected value’. The mean of an HPY probability distribution is usually called its ‘expected return’. Mean may
be used to calculate returns for more than one security.
To summarize the above, ‘mean’ is the best measure to calculate returns. In comparison with median and
mode its superiority is established as a technique for calculating returns. Mean is used synonymously with
arithmetic mean, symbol HPY is used to denote mean, it is called expected value and expected return of
probability distribution and HPY probability distribution simultaneously.
2. Measure of Dispersion
Dispersion methods help to assess risk in receiving a reward or return on investment, the greater the
potential dispersion, the greater will be the risk. One of the simplest methods in calculating dispersion is range.
The range, however, has limited importance. It is useful when there are small samples. It loses its effectiveness
when the number of values in a sample increases. The best and most effective method to find out how the data
scattered around a frequency distribution is to use the standard deviation method. This method is related to
the mean deviation and implies in this case the mean as a point of reference from which deviation occurs. The
standard deviation is based on mean and it cannot show any result without first finding out the mean. The
standard deviation is recognized by the symbol q. The standard deviation is also related to variance.
Variance is square of standard deviation. In other words, standard deviation is the square root of the
variance. This relationship shows that they have similar statistical characteristics. Therefore, standard deviation
and variance are considered equivalent to each other as measures of risk. For a security analyst they help in
depicting dispersion of HPYs around HPY.
Computation of Standard Deviation for 100 HPYs is shown in the following steps:
1. Find HPY.
2. Calculate the difference between HPY and HPY 100% HPYs will show 100 differences. If HPY is .1
and HPY is .5 would have a difference from HPY of + .4 and HPY of – .2 would have a difference
from HPY of – .3.
RETURNS 135
3. Find the square of each difference. The squaring procedure eliminates the minus signs.
4. Find the sum of the squared difference.
5. Divide the squared difference by number of distributions.
6. Calculate the step-5 under square root. The result = standard deviation.
7. The square of squared deviation (HPY)2 divided by number of distributions equals variance.
Example 6.8: A probability distribution of HPY is given as: –0.10, 00, 0.10, 0.50, 0.40, 0.30, 0.10, 0.10,
0.20, 0.20. Find Standard Deviation and Variance:
HPY HPY (HPY) 2
–0.10 –0.28 0.0784

0.00 –0.18 0.0324
0.10 –0.08 0.0064
0.10 0.08 0.0064
0.10 0.08 0.0064
0.20 0.02 0.0004
0.20 0.02 0.0004
0.30 0.12 0.0144
0.40 0.22 0.0484
0.50 0.32 0.1024
Σ 1.80 0.2960
Solution:
1.80
Σx = = 0.18
10
0.2960
Standard Deviation = = 0.0296
10
= 0.172, Variance θ 2 = 0.0296
This can also be explained by a frequency curve: (6.1)
In a normal distribution 68% is in the centre, so 34% of the numbers lie within, on one side of the mean
and 34% lie within the standard deviation on the other side. Also, 47½ % of the numbers lie within 2q, of the
mean on each side. There q on each side of the mean span 99% of the numbers in a normal span. In Holding
Period Yield (HPY) terms for a normal HPY frequency distribution HPY ±20 includes about 95% of the HPYs.
REQUENCY
68%
95%
HPY
99%
Fig. 6.1: Normal Distribution as per Standard Deviation

Fig. 6.2: X = Financial variables, F = Frequency of X values in the distribution
Therefore, standard deviation of bonds at 3% can be translated as 34% of yield to maturity were within
the positive side and 34% within the minus side. Also, if an expected return of a company is forecast to be
0.15 but estimated standard deviation is 0.18, the investor should understand that the expected return figure
is not a reliable estimate because there is a 68% chance that actual HPY will be between +0.31 and –0.05
a 32% chance that it will be even beyond these outer limits. Thus the spread is quite wide.
Another statistical measure called ‘skewness’ can be used to indicate the average value of the distribution
and the degree of risk associated with the average value. Skewness is a measure of a distribution’s symmetry
around its centre. Figure 6.2 shows examples of negative and positive skewness and symmetry. If the distribution
is symmetrical, it means that it is not skewed and if a line is drawn straight down from the highest point on
the curve half the numbers will be to the left of the line and half to the right. A normal distribution is not
skewed. A normally distributed variable has a symmetrical frequency curve. A normal distribution will be
reflected by a perfect bell. The bell may be tall or flat but it will still reflect normal distribution. If it is not
normal it cannot be tested statistically. HPYs overlong periods of time have been found to be moderately
positively skewed.
Fig. 6.3 Frequency curve of long-term HPY Distribution: Common Stock Index.
It is constantly under various tests to find out if HPY distributions are normal enough to justify the use
of statistics like standard deviation and variance. So far, it has been believed that statistical tests are useful to
determine HPY. This is so because price of a stock keeps on increasing. It may double, triple or multiply but
it has a downside limit. If the stock becomes worthless at ‘O’ price during the holding period, the HPY will be
1.0 at the lowest point. Therefore, any graph of long-term HPY distributions will have an elongated tail sloped
towards the right. Although this type of curve is not completely normal in the statistical sense, the central
problem of investment is to obtain the highest net return without sacrificing those qualities essential to a
particular investor. The subject of return is a recurring one and will be taken up again later in the book. Return
RETURNS 137
on investments is related to risk. Studies have shown that firms with high systematic risk also have high average
rates of return. A study of risk and how it is related to returns is explained in Chapter 5.
SUMMARY
r This chapter discusses return which is one of the fundamental concepts of investments.
r Within the framework of return and risk the entire study on investment is based. Returns can be measured
in various ways. Traditionally current yield and yield to maturity indicated returns. A later approach towards
return is to find out the holding period yield.
r Return can also be measured statistically through probability distributions, mean and dispersion methods like
standard deviation and variance.
r The frequency curves show the limits within which the yield varies or is scattered.
r There is a controversy regarding the use of statistical tools for measuring returns.
r It is believed that stocks have no limit as far as price is rising but it has a limiting boundary when price falls.
r The value of stock is worthless or ‘O’ it cannot go below the value of –.1. Therefore, the curve on a frequency
distribution is moderately positively skewed. Such an elongated positive curve is perfectly normal for finding
out returns on stocks.

(i) Measurements of Returns are through traditional methods only.
(ii) The traditional method consists of mean and mode.
(iii) One of the modern techniques for measurement of returns is earnings yield.
(iv) Return is important therefore risk can be ignored.
(v) Coefficient of variation is a better measure for calculating risk in comparison with standard deviation.
(vi) Standard deviation is a useful measure of risk in a situation where two investment alternatives provide equal
returns.
(vii) Coefficient of variation is used effectively when two investments do not provide equal return.
(viii) Return is the maturity value minus the value of original investments.
Answers: (i) F (ii) F (iii) T (iv) F (v) T (vi) T (vii) T (viii) F
QUESTIONS
1. Why is return an important consideration for investment? Can it be measured?
2. What is the meaning of ‘Holding Period Yield’? How is it useful in measuring return?
3. How do statistical methods help in measuring returns on investments?
ILLUSTRATIONS
Illustration 6.1: Mr. Mohan invests ` 10,00,000 in 5 securities. He is interested in finding out his return.
Amount Return
Security A 3,00,000 15%

Security B 2,00,000 14%
Security X 2,50,000 9%
Security Z 1,50,000 12%
Security O 1,00,000 18%
Solution:
Amount Return Weight Return
Security A 3,00,000 15% 0.30 0.0450

Security B 2,00,000 14% 0.20 0.0280
Security X 2,50,000 9% 0.25 0.0225
Security Z 1,50,000 12% 0.15 0.0180
Security O 1,00,000 18% 0.10 0.0180
Total 1.00 0.1315
Return = 13.15%
Ans: 13.15% return
Illustration 6.2: Mr. Kumar has a portfolio of securities. These are as follows:
Return 5% 10% 12% 16% 4%
Solution:
Security (i) Return (ii) Amount (iii) Weight (iv) W × R [(ii) X (iv)]
I 0.05 12,00,000 0.13 0.0065

II 0.10 15,00,000 0.17 0.017
III 0.12 18,00,000 0.20 0.024
IV 0.16 21,00,000 0.23 0.0368
V 0.04 24,00,000 0.27 0.0108
Total 90,00,000 Total 0.0951
The expected return of the portfolio is = 9.5% Ans.

Illustration 6.3: Find risk and return of the following 5 securities. Give an analysis. Should the investor keep all
these securities?
1 30 0.8
2 40 0.4
3 50 0.5
4 60 0.6
5 70 0.7
Solution:
Return Prob. Return × Proab. P (Return – Average) 2

0.3 0.8 0.24 0.8(0.3 – 1.5)2 = 1.152
0.4 0.4 0.16 0.4(0.4 – 1.5)2 = 0.484
0.5 0.5 0.25 0.5(0.5 – 1.5)2 = 0.5
0.6 0.6 0.36 0.6(0.6 – 1.5)2 = 0.486
0.7 0.7 0.49 0.7(0.7 – 1.5)2 = 0.448
Total 1.50 3.070

Average expected return = 1.5 or 15%
and risk or standard deviation is ‘θ’ = 3.07 = 1.75 or 175%.
RETURNS 139
(i) Risk is very high so it would be better if the investor plans to sell some of these securities.
(ii) Return is 8.3% and risk is 9.2% the investor should not continue with this portfolio.
Illustration 6.4: The market price of an equity share is ` 60. Dividend paid at the end of the year is ` 2.40 and
the price at the end of the year is ` 69. What would be the return of this share?
Solution:
Dividend + (Pr ice at end of the year − price at the beginning of the year)
Pr ice at the beginning
2.40 + (69 − 60)

= 0.19
60
The expected return of the security is 19%.

1. The return on two securities ‘X’ and ‘Z’ are given below select the security according to risk and return:
Return on Security ‘X’(%) Return on Security ‘Z’(%) Probability
8 1 0.8
5 4 0.5
2 6 0.4
Answer:
(i) Return = 5.9, 2.9
(ii) Risk = 2.34, 2.02
2. The return from security A can be provided in different time periods:
Time period - 2010 Return Probability
Aug 0.3 0.1
Sep 0.2 0.4
Oct 0.1 0.5
Nov 0 0.3
What would be the average expected risk and return of the security?
Answer:
Risk of security A
Risk ‘θ’ = 0.01208 = 10.99%
Return of security A = 0.160 or 16%
3. An equity share is priced ` 50. The price at the end of the year and their probabilities are given below. The
company does not pay any dividend.
(a) What is the return that an investor can expect from this stock?
(b) Analyze the standard deviation of the returns.
(c) Calculate coefficient of variation.
End year Price Probability
60 0.1
65 0.2
70 0.4
75 0.2
80 0.1
Answer: Expected Return 5.47% , CV= 0.2735

4. Mr. Mohan invests ` 10,00,000 in 5 securities. He is interested in finding out his return.
Amount Return
Security A 1,50,000 15%

Security B 2,00,000 12%
Security X 2,50,000 9%
Security Z 3,00,000 15%
Security O 1,00,000 12%
Answer: 12.6% return

5. Mr. Ankit has a portfolio of securities. These are as follows:
Return 5% 10% 15% 20% 5%
Answer: The expected return of the portfolio is = 11.3%.
SUGGESTED READINGS
l Badger, Togerson, Investment Principles and Practices (6th edn.), Prentice Hall, Guthmann.: Inc., Englewood
Cliffs, N.J., U.S.A., 1969, p. 748.
l Clark Francis, J., Investment Analysis and Management, McGraw Hill, (2nd edn.), U.S.A., 1976, p. 710.
l Jones, C.P., Tuttle and Heaton, Essentials of Modern Investments, Ronald Press Co., New York, 1977, p. 452.
nnnnnnnnnn
Chapter
THE INVESTMENT ALTERNATIVES

(Bonds, Preference Shares and Equity Shares)
Chapter Plan
7.1 Investor Classification
7.2 Corporate Bonds
7.3 Convertible Bonds
7.4 Preference Shares
7.5 Equity Shares
This Chapter presents alternative security investments like bonds, preference shares, equity shares and
derivatives. Chapter 9 explains valuation of these investments and Chapter 10 discusses other investment
outlets.
These investments comprise of equity shares, preference shares, bonds and debentures, government
securities, convertible share, commercial banks schemes, life insurance policies, unit trust certificates,
national savings schemes, post office deposits, real estate, precious metals and art objects.
This chapter brings out the special characteristics of bonds including debentures, preference shares and
equity shares, investment as well as their tax benefits.
7.1 INVESTOR CLASSIFICATION

The investor classification is discussed under Risk Group and Income Group.
1. Risk Group
Investors can be classified into different groups depending on their attitude towards risk. Each Investor
also has an indifference point at which his own expectations of return match with the risk that he can take.
A well diversified portfolio carefully chosen from the numerous securities available in the market will help the
investor in achieving his objectives. The investor should also be able to assess his own behavior pattern before
he aims at a particular goal which he wishes to attain. Broadly, he should be able to identify whether he is
a risk averter, risk neutral or risk taker. If he identifies himself as risk averter his normal behavior patter will
141
show his preference for investments of low market rate risk and interest rate risk. He would prefer government
securities. Life insurance policies, unit trust certificates which he is sure will give him a continuous return. He
would not be able to pay any extra amount for any uncertain or unexpected action. Another class of investors
is called the risk neutrals. Such investors are willing to pay for making an investment, provided they get a return
of an equal value. Their investment trends show that they try to take some risky shares in their total investment
program, but have a larger number of securities which give them a firm return. The risk takers from the third
category of investors do not mind paying more than the expected value of an asset for an uncertain future.
They believe in high return for a greater risk. Such investors have the potentialities to be gamblers.
Table 7.1 CLASSIFICATION OF INVESTORS
Type Risk Acceptable Type of Investment Behaviour
Risk averters No risk Life Insurance, Will pay less for uncertain action.
Unit Certificates,
Govt. Certificates
Risk neutrals Some risk Equity shares, Will pay equal to expected return
Units, Life Policies of uncertain action.
Risk takers High risk Equity shares, Bonds, Will pay more than expected
Convertible Securities value for an uncertain action.
While investors can be classified in categories of high risk, medium risk and no risk takers, it can be said
that the major group of investors are those who can absorb medium risk. Most investors are willing to sacrifice
some expected income or return, if the income is certain.
2. Income Group
The income group of an investor evokes responses to the available investment outlets. The higher the
income group of an investor the greater will be his desire for purchasing assets which will give him a favourable
tax treatment. The source of income usually has a bearing on deduction of tax. Certain sources of income are
taxed like ordinary income. Other income may be exempted from income tax. Under Section 80C, life insurance,
provident fund, postal schemes have a reduction from gross total income upto ` 1 lakh of savings for calculation
of tax.
The investments must be geared in a manner that combines the features of low risk and low taxation to
the maximum benefit. Low income group investor will not look towards tax benefit. His maximum utility will
be at a point of greater reward. Table 7.2 depicts the expectation level of different kinds of investors.
Table 7.2 EXPECTATION LEVEL OF INVESTORS
Income Group Return Risk Tax Benefits

Low High Medium Nil
Medium High Medium Maximum
High High Medium Maximum
7.2 CORPORATE BONDS

Bonds are senior securities in a firm. They represent a promise by a company to the bondholder to pay
a specified rate of interest during a stated time period annually and the return of the principal sum on the date
of maturity. Date of maturity is also called the date of retirement of a bond. Bonds are of many kinds. The
difference in bonds is due to the terms, conditions and features each bond bears. Bonds may be distinguished
according to their repayment provisions, type of security pledged, time of maturity and technical factors.
THE INVESTMENT ALTERNATIVES 143
Bonds are an important source of funds to the corporate sector. They are usually an issue of long-term
debt of a corporate organization. Since no individual can fulfill the requirements of the firms, the loan is parts
of small denominations and sold to investors in the form of bonds.
Bond’s valuation is discussed in Chapter 9.
1. The Bond Indenture
The bond indenture is a legal instrument incorporating an agreement between the company which issues
bonds, the bondholder who lends money and the trustee which is either the commercial bank or trust company.
The trustee represents the company to the bondholder. Thus three parties are involved: the company, bondholders
and the trustee.
The bondholders acquire their bonds and automatically accept the indenture. The role of the trustee is
mainly co-ordination between the company and the bondholders.
A trustee represents all the bondholders and gives information on legal and financial problems. He is a
link between the company and bondholders. Through this conduit the company enters into an agreement with
each of the bondholders.
The indenture consists of the following important issues:
l The rate of interest or coupon rate
l Authorization of issue of bonds
l The specimen copy of a bond
l The Trustee’s certificate
l The mortgaged property as security
l Endorsement, Registration, Restrictions and Agreements with bond holders
l Remedies when problems occur between trustee and bondholder
l All legal terminologies for purposes of clarity
l In case of conversion, the rights of bondholders
l In case of redemption, the rights of bondholders
2. Features of Bonds
(i) Face value: Bonds are issued in denomination of ` 1,000 but there are also bonds of values of
` 500 and ` 100 and of values as high as ` 5,000 and ` 10,000, 20,000, financial institutions issue bonds
bearing higher values. The value of the bond is called the ‘face value, par value or maturity value’. The
face value of the bond represents the promise to repay the amount to the bondholder at the end of the specified
period. This, in other words, may be called the most important feature of bond, return of the principal to the
lender on a fixed date specified earlier.
(ii) Specified Time Period: The second feature is the maturity date of the bond. The time specified in
the bond is called the maturity date or date of re-payment of principal amount. The maturity date of bonds
varies according to the requirement of each organization. Some organizations issue bonds of a long-term
nature. The number of years of these bonds varies, but it is generally between 20 and 25 years maturity. Other
issues of bonds are for medium term and their maturity is between 5-10 years. Shorter-term bonds are identified
as those whose maturity is between 1 to 3 years. The bond indenture specifically gives the maturity date of
the bond. This is the promise to pay the principal amount on a specified date after the expiry of the number
of years for which it is issued.
(iii) Call: Bonds have an additional feature of ‘call’. This is a privilege to the issuing company to re-
purchase bonds at a slightly higher price above the par value. For example, a bond of face value of ` 1,000
and maturity of 20 years yields an interest of ` 70 annually. After the first 5 years of issue, the market rate
of interest on bonds falls considerably. The ruling rate being 5% the company may choose to use the call
feature and buy back the bond for ` 1,050. This is a little higher than the face value of ` 1,000. By calling
back the bonds the company saves money. It may call back the bonds yielding interest of ` 70 and issue fresh
bonds which will yield ` 50 per year. The firm has been able to save ` 20 per year per bond for the next 15
years till the maturity of the bond. By paying ` 50 higher than the face value on the bond for early redemption
of the bond the company saves a much higher amount. The bond holder is on the losing side because he gets
the return of the principal amount earlier than he expected. Since, the current market rate of interest is
prevailing at a lower rate he cannot buy any other bond which will fetch him an income of A 70 per bond per
year. This feature gives a right to the issuing company. The bondholder should be aware of the call feature
before he makes an investment in bonds. He can protect himself by investing in bonds of shorter durations.
Although there is risk of fluctuations in interest rates for short durations, a ten year period is considered to be
good life of a bond from the point of view of the bondholder.
(iv) Pledge of Security: The issuing company sometimes promises to pay to the bondholder by offering
some security like property. The pledge of security is a promise to the bondholders in writing and signed under
seal and presented to the trustee by the company. A simple promise to pay without the proper formalities is
not considered as a pledge of security.
(v) Interest: The rate of interest to be paid to bondholder and the time of payment is recorded in the
bond as well as in the indenture. ‘Interest rate’ is also called the ‘coupon rate’. Interest on bond may be
made by cheque or through electronic clearing system (ECS). Every clearing represents, the interest paid for
the period to the authorized banker the amount due as interest. Interest is paid on the face value of the bond.
The rate cannot be changed once it has been fixed.
Interest on bonds should be paid regularly by the issuing authority. Government bonds are very reliable
as they are paid in time. If interest is not paid by companies when it is due, in this case is considered to be
in default and both the interest and principal become due and payable to the bondholder. The trustees of the
bondholder at this point of time protect the interest of the bondholders. The market regulator SEBI also ensures
that such complaints do not take place and regular payments are made.
In order to be sure that interest and principal sum on the bond will be repaid, it is necessary that the
bonds are evaluated and analyzed before investing in them. An investor must look into the net operating profit
of the firm as well as its net income after taxes. This will to a great extent determine the quality of the bond.
It must be emphasized that bonds will be considered secure when the interest charges are low and the net
operating income is high. Sometimes the bond issuing companies offer security through assets and in writing,
assuring the bondholders of the payment of interest and the company promises to maintain a minimum working
capital position or a particular cash position. Interest is guaranteed in assumed bond, guaranteed bond or joint
bond.
Interest on bonds is also protected by the ‘acceleration clause’. When interest is due but not paid, this
clause gives the right to the bondholder to represent himself for dues. However, the bondholder should make
a fundamental analysis of the company’s position. If the company’s operating income is sufficient to cover all
expenses pertaining to the company’s account inclusive of all interest charges made on its issue of debt only
then he should make an investment in the company.
(vi) Covenants: Covenants are protective clauses in the bond indenture. Whenever, a company takes a
loan from a bank or a financial institution, it enters into covenants which restrain the company from entering
into any agreement which is detrimental to the interest of the bond holders or shareholders of the company.
Bond holders can enter into agreements between the company and the bondholders through the trustees.
Through these agreements the company binds itself to the bondholders. The company agrees to control its
operations and in this way offers some protection to bondholders. Sometimes, a company makes an agreement
to limit. Covenants protect the bondholder by ensuring a minimum cash balance to be maintained by the firm.
Certain covenants or agreements are specifically used on a particular class of bonds. For example, mortgage
bonds may include a covenant to limit the company’s expenses or debt position up to a fixed percentage of
the value of new purchases of property, for example, 75% of the property. Covenants are agreements or
promises which tone up the quality of the bonds and assure repayment of principal and interest. There are
different kinds of bonds based on these special, features such as payment of principal, maturity date, call,
pledge of security, interest, and covenants.
3. Types of Bonds
(i) Serial Bonds: Serial bonds are issued by an organization with different maturity dates. This is done
to enable the company to retire the bonds in installments rather than all together. It is less likely to disturb the
cash position of the firm than if all the bonds were retired together. From the point of view of the bondholder,
this gives him a chance to select a bond of the maturity date which suits his portfolio. He may select a short-
term maturity bond, if it meets his need or take a bond with a long-term maturity if he already has too many
shorter-term investments. Serial bonds usually do not have the call feature and the company retires the debt
when it becomes payable on the maturity date. Such bonds are useful to those companies that wish to retire
their bonds in series. Serial bonds resemble sinking fund bonds and have an effect on the yields of bonds.
Bonds with shorter-term maturity have lower yields compared to those of long-term maturities.
(ii) Sinking Fund Bonds: Sometimes, an organization plans the issue of its bonds in such a way that
there is no burden on the company at the time of retiring bonds. This has the advantage of using the funds
are well as retiring them without any excessive liquidity problems. The company sets apart an amount annually
for retirement of bonds. The annual installment is usually fixed and put in a sinking fund through the trustees.
The trustee uses his discretion in investing these funds. He may use the fund to call the bonds every year or
purchase bonds from them at a discount. Sinking fund bonds are commonly used as a measure of industrial
financing.
(iii) Registered Bonds: Registered bonds offer an additional security by a safety value, attached to
them. A registered bond protects the owner from loss of principal. The bondholder’s bond numbers, name
address and type of bond are entered in the register of the issuing company. The bondholder has to comply
with the firm’s formalities at the time of transfer of bonds. While receiving interest, registered bondholders
usually get their payment by cheque. The main advantage of registering a bond is that if the bond is misplaced
or lost the bondholder does not suffer a loss unlike the unregistered bonds. However, registered bonds do not
offer security of principal at maturity.
(iv) Debenture Bonds: Debentures in the USA are considered to be slightly different from bonds.
Debenture bonds are issued by those companies who have an excellent credit rating, but do not have security
in the form of assets to pledge to the bondholders. The debenture holders are creditors of the firm and receive
the full rate of interest whether the company makes a profit or not.
In India debentures can be issued with the specific permission of the Controller of Capital Issues. Bearer
debentures are not considered legal and permissible documents in India. Convertible debentures have become
popular in recent years. Convertible debentures have lower rates of interest, but the convertible clause makes
it an attractive investment. While permission has to be sought for the convertibility clause, it is not necessary
if they are solely offered to financial institutions. Debentures just like bonds can be of different kinds. They may
be registered, convertible, mortgage, guaranteed and may also combine more than one feature in one issue.
(v) Mortgage Bonds: A mortgage bond is a promise by the bond issuing authority to mortgage real
property as additional security. If the company does not pay its bondholders the interest or the principal, when
it falls due, the bondholders have the right to sell the security and get back their dues. The value of mortgage
bonds depends on the quality of property mortgages and the kind of charge on property. A first charge is the
most suitable and highly secure form of investment since its claims will be on priority of the asset. A specific
claim on a particular property is also an important consideration compared to a general charge. A second and
third charge on security of property is considered to be a weak form of security and is less sound than a first
charge.
A property of high value and immediately saleable because of its strategic placement should be considered
very valuable even if it offers a second and third charge. Another property offering no saleable features but
giving a first charge may be worthless to the bondholders. The quality of the mortgage is, therefore, an
important consideration to the mortgage bondholders. Mortgage bonds may be open end, close end and limited
open end. An open end mortgage bond permits the bond issuing company to issue additional bonds if earnings
and asset coverage make it permissible to do so. In close end mortgage bonds, the company can make only
one issue of bonds and while those bonds exist, new bonds cannot be issued. If additional bonds are issued
they get the ranking of junior bonds and the prior issue gets the first priority in receiving payments. The limited
open end bonds permit the organization to issue specified number of fresh bonds series distributed over a
number of years.
(vi) Collateral Trust Bonds: A collateral trust bond is issued generally when two companies exist and
are in the relationship of parent and subsidiary. The collateral that is provided in these bonds is the personal
property of the company which issues the bonds. A typical example of such bonds is when a parent company
requires funds; it issues collateral bonds by pledging securities of its own subsidiary company. The collaterals
are generally in the form of tangible securities like shares or bonds. These bonds have a priority charge on the
shares or bonds which are used as collaterals. The quality of the collateral bonds is determined by the assets
and earning position of both the parent as well as the subsidiary company.
(vii) Equipment Trust Bonds: In the USA, a typical example of Equipment Trust Bonds is the issue of
bonds with equipment like machinery as security. The property papers are submitted to trustees. These bonds
are retired serially. The usual method of using these bonds was to issue 20% equity and 80% bonds. The equity
issue is like a reverse to protect the lender in cases where the value of the asset falls in the market. The trustee
also has the right to sell the equipment and pay the bondholders in case of default.
(viii) Supplemental Credit Bonds: When additional pledge is guaranteed to the bondholders their
bonds are categorized as supplemental by an additional non-specific guarantee. Such bonds are classified as:
Guaranteed Bonds, Joint Bonds and Assumed Bonds.
(ix) Guaranteed Bonds: Guaranteed Bonds are issued as bonds secured by the issuing company and
they are guaranteed by another company. Sometimes, a company takes assets through a lease. The leasing
company guarantees the bonds of the bond issuing company regarding interest and principal amount due on
bonds.
(x) Joint Bonds: Joint bonds are guaranteed bonds secured jointly by two or more companies. These
bonds are issued when two or more companies are in need of finance and decide to raise the funds together
through bonds. It serves the purpose of the company as well as the investor. The company raises funds at
reduced cost. Since funds are raised jointly, dual operations of advertising and the formalities of capital issues
control are avoided. The investor is in a favourable position as he has security by pledge of two organizations.
(xi) Assumed Bonds: These bonds are the result of a decision between two companies to amalgamate
or merge together. For example, Company-X decides to merge into Company-Y. X’s issue of bonds prior to
merger then becomes the obligation of Company-Y when merger is effected. These are called assumed bonds
as Company-Y did not originally issue them but as a result of merger the debt was passed on to them. The
bondholder receives an additional pledge from Company-Y. He is more secured as his bonds due to merger get
the security of both Companies X and Y.
(xii) Income Bonds: Such bonds offer interest to the bondholders only when the firm earns a profit. If
profit is not declared in a particular year, interest on bonds is cumulated for a future period when the company
can sufficiently earn and make a profit. Income bonds are frequently issued in case of reorganization of
companies. When income bonds arise out of reorganization they are called adjustment bonds. They are also
used to recapitalize the firm and take the benefit of deduction of tax by changing preference shares with income
bonds.
(xiii) Bonds with Warrants: Bonds with warrants are also called Warrant Bonds. Each bond has one
warrant attached to it and it gives the right to the bondholder to pay a subscription price and exchange the
bonds for equity shares. This right is given, for a limited period of time. Usually a time period is put up in a
legal document with the trustee.
Warrant bonds may be detachable or non-detachable. Detachable warrants are used by the investor
(a) to sell the warrant during price increase in the market and (b) to buy share at an option price and to be
sold at market value. A non-detachable bond is slightly more complicated. It has to be sent to the company’s
trustee at the time of exercising an option. The warrant is detached by the trustee and sent to the investor.
Warrant bonds like convertible bonds offer a chance to the investor to share in the growth of the company,
but convertible bonds are more popular than warrant bonds. In India, convertible bonds are not as popular as
equity issues. The warrant bond gives the right to its holder to sell a warrant, if the price increases in the market
and retain the bond. If the price does not increase the bondholder may retain the bond with a warrant.
(xiv) Foreign Bonds: Bonds raised in India by foreign companies but for Indian investor will be called
a ‘foreign bond’. A foreign bond, for example, an American Bond or Japanese Bond in India may be very
attractive to investors because (a) the dollar yield is much higher than the rupee, (b) deposits in dollars are
considered a good investment and (c) risk on the portfolio is diversified.
(xv) Convertible Bonds: Convertible bonds have a dual feature of getting fixed interest till the redemption
period and then the company offers the bond holders to purchase equity shares of the company at a premium
price. Due to the nature of this bond and the feature it provides there are an investment value, conversion value
and market value of this bond. This particular bond is explained theoretically, graphically and with example
through table in a separate section after describing the objectives of issuing bonds and evaluating them.
4. Objectives of Issuing Bonds
(i) Minimum Risk: Bonds are considered to be less profitable than shares. They are usually expected
to provide a lower return than shares. Bonds are, however, purchased as they are supposed to be ‘less risky’
than shares. Bonds are exposed to some risk. These are interest rate risk, purchasing power risk, investment
risk and price risk. These risks are minimized as there is a promise to pay the principal sum at the end of the
maturity period coupled with fixed income return in the form of interest. It, therefore, gives an element of
stability of return which is not promised in the case of equity issues.
(ii) Tax Saving: Bond is one of the unique methods of saving in tax for business firms. While income
in the form of dividends is not deductible, interest on bonds can be deducted. The earnings per share of the
shareholder also increase. This is also the cheapest form of financing for the firm. This form of finance in terms
of interest is lower than the rate of interest at which loan will be obtained coupled with deduction of interest
for finding out the tax to be paid by the firm. Also, the issuing company has the benefit of using financial
leverage.
(iii) Unaffected Control Pattern: The Company’s control pattern from the point of view of voting
rights of equity investors remains undisturbed with the issue of bonds. Bonds do not carry either voting rights
or the rights of an equity shareholder. The price of the share also rules at a higher price in the market and the
dividend of the equity holder is not diluted. Therefore, from the existing shareholders’ point of view, bond issue
of a company is better than another equity issue. However, a bond should be issued in the larger interest of
the company and only if it does not affect the growth and risk conditions of a firm.
5. Evaluation of Corporate Bonds
Corporate bonds must be carefully analyzed before investing in them. The consideration before an investor
should be to find out the quality of the bond, credit position of the company, repayment facility of principal,
regular payment of interest risk and return on bonds.
(i) Quality of Bonds: The quality of bonds is judged by profitability of a firm. Profitability of the firm
is found out by finding out the earning power of a firm, the return on total assets and the return on net worth.
The financial leverage should also be found out by debt ratios and interest coverage ratios. Finally, an analysis
into working capital ratios will also determine the investment grade of bonds. These financial ratios predict the
future as well as present quality of the issue. The quality of bond has also to be found out by the type of
industry, location, grants received by it, government subsidies allowed, the size of the company, its rating in
the market and record of dividend paid to its shareholders.
The following ratios should be used in evaluating a firm:
Bond liability
(a) Debt to equity = Common stock + Paid up capital + Retained earnings
Before tax profit + Interest

(b) Coverage ratio =
Interest
(ii) Credit Position of Issuing Firm: Before investing in a bond, the financial position of a company
may be assessed. While it is difficult to find out the repayment of loans position of a company through its
Balance Sheet or Profit and Loss Account, the market reputation of a company can be evaluated through its
dealings with a bank and its dealings with other business firms. Apart from this if loan has been taken from
financial institutions, an assessment of the firm’s credit position is available from the credit rating of these
institutions.
(iii) Repayment Facility of Payment of Principal: A good indication of the quality of a bond is the
future rating of a company from its assets and the security offered to the bondholders. If a first charge of
property is issued in favor of bondholders and the value of property is likely to rise, the bondholders are amply
secured.
The company’s debt position should also be analyzed. If it has taken small amount of loans in comparison
to the market value of assets the bondholders is adequately protected.
Finally, the future of the company must be ascertained in terms of the product it manufactures, distributes
the expected growth and the potential demand for the product. These factors will determine the type of quality
of the firm and its ability to repay the principal amount to bondholders.
(iv) Regular Payment of Interest: The firm’s capacity to pay interest regularly should be measured
through an analysis of its cash flow and earning power. The ratio of debt to net worth and other debt to fixed
assets should be assessed. The total debt employed by the firm should not exceed net worth. It may also be
worthwhile to find out if there is adequate coverage of interest. The net income of a company should be at
least three times of the interest payment.
(v) Risk and Return on Bonds: Risk and return on securities have been emphasized in the previous
chapters. Every security is faced by systematic and unsystematic risk forces. Within the framework of risk, return
in the form of yields can be calculated. The yield of a firm, its stability and credit worthiness are indicators
for the quality of bond investments.
7.3 CONVERTIBLE BONDS

Convertible bonds are a future promise to existing bond holders by the issuing company to share the
growth in capital of the company. It is the right given to a bondholder to buy a bond at the time of issue and
later exchange it for equity shares of the same company. The price of the convertible bonds to a great extent
depends on the price of equity shares. The bond price increases, if the price of equity shares rises and vice
versa. The bond is exchanged into equity shares at a future date. The specifications of date of conversion into
equity as well as the rate at which it will be converted is usually in the form of a written clause in the bond
indenture. A convertible bond is often considered to be a trade off between, “the provision of protection
and expected future appreciation”. The investor prefers to buy bonds rather than equity shares because
the risk in bonds is lower than equity but it is higher than non-convertible bonds. A convertible bond is,
therefore, between an equity issue and a non-convertible bond. A convertible security should, therefore, be
evaluated in a dual manner. To analyze the adequacy of return on convertible bonds it should be evaluated
as a fixed income security as well as equity. The convertible bond at the outset is a fixed income security, then
at a later date a conversion rate is applied and it is changed into equity share. To arrive at the equity share
of the bonds, the price of share is multiplied by the conversion rate. For example, if the price of equity is
` 30 in the market and a bond can be changed for 15 equity shares, the conversion value will be 450 (15 ×
30) and whenever the share price changes the conversion value will change. The conversion can be applied
in this manner:
P = Price of equity.
S = Number of shares into which bond is convertible and the conversion value of bond is:
C = P × S
1. Features of Convertible Bonds
(i) Investment value: The convertible bond is said to have an investment value. This feature is not
present in non-convertible bonds. Straight value is synonymous with investment value and this is the value of
the bond equated with similar issues of bonds which do not have the convertibility feature. The investment
value also referred to as straight value or straight debt value can be illustrated by an example. A convertible
bond has a theoretical value which is based on the return value to the period of maturity of those issues of
bonds which are similar in all other respects, but do not have the features of convertibility added to it. For
example, if equity price rises from ` 30 to ` 35 the conversion rate for 15 bonds will be 525 (35 × 15).
(ii)Market Value: The market value is the market price of bond and the market premium is the market
price in excess of straight value. Figure 7.1 graphically describes the values and market premium of a convertible
bond. It depicts all the values which have been described: Market Value, Market Premium, Straight Debt Value
and Conversion Value.
The price of convertible bonds is shown on the Y-axis and X-axis represents the price share of equity. In
relative terms the premium can be calculated in the following manner:
Bond Price − Conversion Value

(a) Premium Over Conversion Value = Conversion Value
Bond Price − Investment Price

(b) Premium Over Investment Value = Bond Price
Bond Price
(c) Conversion Parity Price of stock = Number of Shares Upon Conversion
(iii) Conversion Value: Conversion value is the price of equity shares and the number of shares into
which bonds can be converted. S or number of shares into which a convertible bond is converted is fixed when
the bond is originally offered. The conversion value varies with P or price. The conversion value rises and falls
with P. The conversion value can be above, below or equal to the straight value of the bond in the above
examples, S = 15. If the market value of a bond as straight value is ` 500 the conversion value of the bond
at 15 × 33.34 would be equal to the straight value of the bond. If P falls to ` 20 the conversion value is
` 450 or below the straight debt value. If P rises to ` 35 the conversion value is ` 525 or higher than the
straight debt value. The excess of market value above the conversion value of a bond is called the ‘premium’.
Usually a convertible bond sells at a premium in the market. The premium values on bonds (which are
convertible) are due to the fact that it reduces the risk of buying equity share directly. At the same time there
is always a potential for reward whenever the conversion value is higher than the straight bond value. Moreover,
there is always, a premium on convertible bonds even when the conversion value is lower than the straight debt
value. This premium is based on a future expected share price movement. The bondholder in fact purchases
a convertible security on the expectation of a future rise in price.
Fig. 7.1: Graph showing Market Value, Market Premium, Straight Debt Value and Conversion Value
To sum up, there are three kinds of values in convertible debentures: (i) Investment Value or Straight Debt
(ii) Market Value or Market Premium and (iii) Conversion Value. These have been explained above theoretically
and graphically.
2. Evaluation of Convertible Bonds
The factors involved in evaluating convertible bonds are: (i) Quality of Issue, (ii) The current price of
convertible bond, (iii) The expected future appreciation of the equity (return and risk) and (iv) Tax benefits.
(i) Quality of Issue: The quality of issue is important from the point of view that it is a fixed income
security first and the issue must be such that the interest will be continuously received by the bondholder
without default. The quality of the issue is also important because ultimately the bondholder will own the equity
issue of that company and his income in the form of dividend will depend on the quality of equity issues and
work performance of the company.
(ii) Current Market Price: The current market price of the issue is usually above the conversion value
and straight debt value of a convertible bond. The straight debt value is like a floor which reduces the falling
risk of the issue. If the floor value is about 15% below market price, it is adequate for providing downside
protection. If it is more than 15% the straight value debt will not be adequate in providing protection.
(iii) Estimating Return and Risk on Convertible Bonds: The hypothesis is that the purchase of a
convertible bond is a method which will reduce risk and try to provide a greater return than on a non-
convertible equity share in which it is to be converted. This appreciation should be expected to appreciate
about 25% of the effective price which is paid for the equity. Also, the premium should be adequate and market
value should not be very high over the conversion values of a bond. If the premium is very high, it will reduce
the potential return on a convertible bond. The premium as a rule should be about 20%.
Return and Risk on Bonds has to be calculated from the point of view of the firm as well as the
bondholder. The firm issues convertible bonds as a measure of securing equity financing indirectly. The bondholder
buys convertible bonds with the view that he gets a hedge and his risk level falls because of the investment
value and its floor effect. Further, he also anticipates an appreciation in the near future. The return which the
bondholder expects is the discount rate which equates the sum of the annual interest payments till the year of
conversion (N) and the terminal conversion value in the year N. Therefore, the investor can use the following
equation:
n
1 TV
M = ∑ (1 + k) + (1 + k)n
t =1
Where M = Price of Bond.

TV = Terminal value of bond call price if surrendered on call-maturity value if redeemed. Conversion
value if converted.
I = Interest received yearly.
N = Number of years of holding the bond.
k = Discount rate.
(iv) Brigham Model: Brigham model 1 on convertible bonds is illustrated graphically.
Straight Debt Value: In the graph the straight debt value is shown by the line B, X and M. This is the
highest or maximum price at which the bond can sell without taking into account the associated equity shares
price. The B, X and M line slopes upwards till it is equal to the fair value M. The reason for this is that the
bond is first issued at an interest rate which is lower than the current rates on similar bond but which do not
have the convertible clause. The investor is interested in the convertible bond even at a lower interest because
of the convertibility feature. After a gap of some time the discount from the value of a non-convertible bond
gets erased. This is so because when the bond period is closer to maturity the redemption of the bond will be
at face value and there will be a neutralizing factor on the time value of money. At maturity, the waiting period
is over and there is no discounting of time. Therefore, the straight value of debt equals M.
1. E. Brigham, “All Analysis of Convertible Debentures: Theory and Some Empirical Evidence”, Journal of Finance, March 1966,
p. 33.
Y
VALUE OF THE BOND
O X
Fig. 7.2: Brigham’s Model of Convertible Debenture
Conversion Value: The conversion value of a convertible bond is given graphically as C, X and C t for
the benefit of the bondholder and the equity share price associated with the convertible bond is assumed will
rise at a constant rate of growth. Thus, conversion value C, X and C 1 rises and increases every year till the
bond is called in year N. Therefore, C, X and C 1 rises upward rapidly. J and M 1 represents the market price
of bond. This is the price at which the bond will be bought and sold. This will also rise with time in a similar
manner as conversion value (C, X and C 1 ). These will meet at M 1 because the market price has to rise with
conversion value. If it falls below the conversion value, the value of the bond would be nullified C, X and C 1
rises more rapidly than M and M 1 line. Premium is shown in the shaded area of the graph BX or the straight
debt value in the shaded area is larger than the conversion value (shaded area).
Call Price: VM is the call price line to be paid by a company, if the bonds are redeemed before maturity
and are not converted. The call price is more than the face value of the bond but if falls at periodic intervals
and becomes nil at maturity. The decline in the call premium show VM downward sloping. On the call date
N market value and conversion value become identical. If the bond is called, the premium is reduced because
such a bond can either be converted into share or redeemed at straight debt value. Either of these options is
lower than market value. With the passing of time the conversion value increases and it is likely that the issuing
company will call the bond. If the bond is to be called the bondholder would not like to pay a premium. Also,
when conversion value rises, the straight debt value falls far below. This depicts a higher potential loss, if the
equity share price falls. Another reason for decline in premium is analyzed in drawing out a relationship
between the return (yield) on a bond and on a share. If the conversion value is higher than the straight debt
value the increases in price of equity and bond move together. The only difference is that the bond gives a fixed
interest but a share promises a dividend. Dividend rise or fall will reflect the rise or fall of equity share. Due
to these reasons an investor would not be attracted to hold a bond in favour of equity and the premium on
a bond would fall.
(v) Tax Treatment: A convertible bond is treated as a capital asset under the Income Tax Act. The
convertibility clause constitutes a transfer from debenture bond to equity issues. When these bonds are converted
into equity issues the profit or gain is taxable, if these are quoted at a higher market price even though profit
has not been realized in terms of cash.
Any convertible bond which is held for less than 36 months is treated as a short-term capital asset.
Debenture bonds held as share in trade and resulting in profit are also taxable as normal profit.
When a convertible bond is held for more than 36 months and then converted into equity issues the
investor may claim exemption from income tax under Section 54E.
3. Advantages of Convertible Bonds

(i) Fixed Income: Convertible bonds offer the investor a fixed rate of interest in the beginning years of
investment. Most small investors are interested in a fixed income and would not worry about the corporate
image or growth in which they make an investment. A new company offering convertible bonds is of great
advantage to such investors. They are assured of a fixed income as well as ownership rights at a later date.
The expectation of an investor or is that a company stabilizes itself after some years of active working. At such
a time he would be able to get ownership rights and gain a profit also.
(ii) Expansion: A convertible bond is often issued by a firm when its capital structure does not permit
extensive expansion through further issue of equities or taking loans from the market at a higher rate of interest.
A firm makes an attempt to balance its capital structure as well as expand its business without delay. If
expansion cannot be postponed and a large amount is required to finance such an expansion, the best measures
to a company is to consider an issue of convertible security. Sometimes, convertible bonds may be used to
provide funds during the gestation period. Also, the floatation costs of convertible securities are lower than
equity issue as cost of underwriting is much lower. The cost of issue to the firm during the period of gestation
or expansion will be lower when convertible bonds are issued.
(iii) Depressed Capital Market: A capital market is very sensitive to conditions in the economy.
Political instability, riots, war, economic conditions depress the capital market equity issues do not evoke
responses from the general public as the value of shares in such conditions is very low. Convertible bonds may
be considered to be quite attractive in these conditions as to provide the twin objective of fixed income and
option for transfer at a later date. Public response to these issues helps to bring some activity in a dull capital
market.
4. Disadvantages of Convertible Bonds
Convertible bonds have disadvantages of price due to market risk, call feature and security.
(i) Price of the bond: A convertible bond has a particular disadvantage of price of the bond and it is
also linked to market risk. So long as these bonds are bought at a reasonable price keeping them on one’s
portfolio has all the advantages outlined above. If these bonds are bought at a very high price the return is
sometimes evaluated as negative. Also, there is an excessive danger of loss if the price of the bond falls due
to market risk or fall in the earnings.
(ii) Risk of call: Another disadvantage of convertible bond is the discretion of a company to call bonds.
Bondholders may at the will of the issuing company be forced to return their bonds at a small profit.
(iii) Security: Convertible bonds also have less security than other bonds. Because they are convertible,
these are treated as securities of less value than non-convertible bonds and are evaluated like equity shares.
In India, debentures — both convertible and non-convertible — have been popular since the years 1983-84.
An evaluation of non-convertible and convertible debentures is presented in Tables 7.3 and 7.4.
5. Analysis
Non-convertible debentures are not attractive to the investor for the following reasons:
(i) Fixed investment: Non-convertible debentures are a fixed investment for a long-term period. It is
usually redeemable after 10 years.
(ii) Capital appreciation: There is no capital appreciation on non-convertible debentures except at the
time of redemption. In this case it is 5%.
(iii) Non tradable: Non-convertible debentures cannot be sold in the stock exchange as they are not
popular. To induce investors to buy, the price has to reduce below the par value. In this illustration the price
at the open market is ` 75.
l As a rule the investor should buy, non-convertible debentures in the open market.
l Never buy non-convertible debentures through public issue.
If the debenture is priced higher than ` 156.30 it is overpriced. If it is below this price it is under-priced.
Table 7.3 EVALUATION OF INVESTMENT IN NON-CONVERTIBLE DEBENTURES PURCHASED

THROUGH PUBLIC ISSUE AND OPEN MARKET
Value of Debenture Value of Debenture

Through Through Open
Public Issue Market Purchase
` `
A. Par value of the debenture 100 100
B. Interest at 15% per annum (per debenture) 15 15
C Purchase price of debenture 100 75
D. Total interest earned by each debenture in 10 years 150 150
E. Redemption price at 5% premium 105 105
F. Capital appreciation per debenture 5 30
G. Total return per debenture after 10 years on redemption (D+F) 155 180
G 155 180
H. Percentage of return × 100 × 100 = 155 × 100 = 240
C 100 175
Table 7.4 EVALUATION OF INVESTMENT IN CONVERTIBLE DEBENTURES
`
A. Par value of convertible debenture of XYZ Ltd., @ 13.5% per annum 100.00
B. Value of convertible portion 40.00
C. Value of non-convertible portion 60.00
Assume that the convertible portion of ` 40 will be converted by the
company into 2 equity shares having a par value of ` 10 per share
D. Prevailing market price of shares 55.00
E. After conversion market value of shares of convertible portion will be 55 × 2 110.00
F. Interest earned by non-convertible portion of 60% @ 13.5% per annum 8.10
G. Value of non-convertible portion discounted at 17.5% discount 46.30
H. Market price of debenture (E+G) 156.30
Analysis
l Convertible bonds should be purchased during gestation periods of firms when bonds are less risky
than equity share. The investor gets a high rate of return (fixed) initially and on stability of the firm
becomes its equity shareholder.
l Convertibility clauses in debentures make it an attractive purchase in unstable conditions in an economy.
CREDIT RATING
Credit rating is the method of assigning some standard scores to a particular debt instrument. It facilitates
trading in debt securities as it helps participants to arrive at a quick estimate and opinion about various
instruments. There are 4 rating agencies in India. These are CRISIL (Credit Rating Information Services of
India), ICRA (Investment Information and Credit Rating Agency of India), CARE (Credia Analysis and Research
LTD) and Duff and Phleps. These rating agencies are registered and regulated by SEBI. CRISIL has about
42%market share and Care 36%.
The credit rating agencies are companies, in the business of rating of securities which are offered to public.
Rating is essentially an opinion which is expressed through standard symbols by the credit rating agencies. In
India credit rating first started in 1987 with the incorporation of CRISIL (Credit Rating Information Services of
India Ltd.)
Credit Position of Issuing Firm: Before investing in a bond, the financial position of a company may
be assessed. While it is difficult to find out the repayment of loans position of a company through its Balance
Sheet or Profit and Loss Account, the market reputation of a company can be assessed through its dealings
with a bank and its dealings with other business firms. Apart from this if loan has been taken from financial
institutions, an assessment of the firm's credit position is available from the credit rating of these institutions.
Repayment Facility of Payment of Principal: A good indication of the quality of a bond is the future
rating of a company from its assets and the security offered to the bondholders. If a first charge of property
is offered in favour of bondholders and the value of property is likely to rise, the bondholders are amply
secured.
The company's debt position should also be analyzed. If it has taken small amount of loans, in comparison
to the market value of assets the bondholders is adequately protected.
Finally, the future of the company must be ascertained in terms of the product it manufactures and
distributes, the expected growth and the potential demand for the product. These factors will determine the type
of quality of the firm and its ability to repay the principal amount to bondholders.
Regular Payment of Interest: The firm's capacity to pay interest regularly should be measured through
an analysis of its cash flow and earning power. The ratio of debt to net worth and other debt to fixed assets
should be assessed. The total debt employed by the firm should not exceed net worth. It may also be worthwhile
to find out if there is adequate coverage of interest. The net income of a company should be at least three times
of the interest payment.
Risk and Return on Bonds: Risk and return on securities have been emphasized in the previous
chapters. Every security is faced by systematic and unsystematic risk forces. Within the framework of risk, return
in the form of yields can be calculated. The yield of a firm, its stability and credit worthiness are indicators
for the quality of bond investments.
Objectives of Credit Rating are
l To provide credence to financial commitments made by a company.
l It provides information to the investor in selecting debt securities.
l It helps in providing the company with marketability as grading of debt securities is being done by well
known companies having technical exposure of arriving at the credit rating.
Grading system
Every rating agency has a different code for expressing rating of debt securities. CRISIL has four main
grades and many sub grades for long-term debentures/bonds/fixed deposits. The grades are in decreasing order
of quality. Their grades are AAA, AA, A, BBB, BB, B, C, D.
The following rating symbols are given by CRISIL and ICRA for rating the securities.
Rating Symbols of CRISIL
Debenture Fixed Deposit Commercial papers
rating symbols rating symbols rating symbols
AAA Highest Safety FAAA Highest Safety P1 Highest safety

AA High Safety FAA High Safety P2 High safety
A Adequate safety FA Adequate safety P3 Adequate safety
BBB Moderate safety FB Inadequate safety P4 Inadequate safety
BB Inadequate safety FC High risk P5 Default
B High risk FD Default
C Substantial risk
D Default risk
Rating Symbols of ICRA

Rating Debentures/bonds/ Fixed Deposits Commercial papers
preference shares
Highest safety LAAA MAAA A1
High safety LAA MAA A2
Adequate safety LA MA
Moderate safety LBBB —
Inadequate safety LBB MB A3
Risky LB MC A4
Substantial risk LC
Default LD MD A5
Credit rating depends on many factors which are dependant on the judgment of the rating agency. The
important factors influencing the safety or otherwise of the bond are
l The Earning capacity of the company and the volatility of its business.
l Liquidity position of the company.
l The overall macro position of business and industrial environment.
l The financial capability of the firm to be able to raise funds from outside sources for its temporary
requirement.
l Leverage existing with the firm and its financial risk position.
l Funds position of the firm to meet its irrevocable commitments.
l And support from financially strong companies and banks existing in the market.
l The credit rating agencies evaluate in detail
l Fundamental and
l Technical data of the firm before coming to any conclusions.
The importance of credit rating is three-fold:
l Investors: It is useful for the investors as data is presented to them to take decisions on investment
l Issuers: It helps the companies as they are ranked according to the security and safety of their
instruments. It provides them with credibility
l Intermediaries: Merchant Bankers, Market traders, brokers, financial institutions and other market
players use the information for pricing placement and marketing of issues.
Credit rating also has certain limitations. These are:
l Credit rating is an opinion. Often these opinions have gone wrong so buyer beware. These are not
offered as guarantees or protection against defaults and frauds.
l Rating is made specifically for an instrument and not a business house.
Bonds also require to be evaluated. The evaluation is by finding out basic values of the bonds. These are
based on the basic principles of time value of money. The time value of money is based on compounding and
discounting techniques.
7.4 PREFERENCE SHARES

Preference shares unlike bonds have an investment value as it resembles both bonds as well as equity
shares. It is a hybrid between the bond and equity shares. It resembles a bond as it has a prior claim on the
assets of the firm at the time of liquidation. Like the equity shares the preference shareholders receive dividend
and have similar features as equity shares and liabilities at the time of liquidation of a firm. The preference
share has the following characteristic features:
1. Features of Preference Shares

(i) Dividends: A preference shareholder has priority over equity shareholders in the payment of dividends
but the rate is fixed unlike the equity share holders. Preference shareholders usually get cumulative
rate of dividend, so that if, in one year the company does not pay a dividend, it pays in the next year.
These dividends also have a priority over equity shares. Equity share dividends vary from year to year
depending on the profits of the company.
(ii) Right to Vote: The preference shareholders in India do not have a right to vote in the annual general
meeting of a company and their dividends are usually fixed, but in the event of non-payment of
dividend for two years or more the preference shareholder can vote. Voting may be, in the form of
show of hands or ballot.
(iii) Right on Assets: The preference shareholders have a similar right to that of bondholders on the
assets of the firm. At the time of liquidation, the preference shares have a prior right to that of the
equity shareholders, but the payment and the face value of the preference shareholders are paid only
after the rights of the bondholders and other creditors are met. Their rights, therefore, come last
amongst the creditors, but before the equity shareholders.
(iv) Par Value: The preference share usually has a par value or face value or denomination by which it
is valued. This par value can also be changed by the corporate shareholders. In India, the preference
shares have only a par value.
(v) Retirement of Debt through Sinking Fund: A company usually retires its preference shares with
the help of a special fund created for the purpose. This fund is called the sinking fund. A sum of
money is annually set apart in this fund and is used to retire the preference shares when they become
due. This is specially so in the case of redeemable preference shares. If no right of redemption is given
the preference shares are usually redeemable.
(vi) Pre-emptive Right: The preference shareholders like the equity shareholders have a right of receiving
further issues from the company before it is advertised or offered to the other members of the public.
This right gives it a special resemblance to the equity shareholders. It also gives an additional right
above the right of the bondholders. A right to further issues is a chance given to shareholders to
receive the benefits of growth of the firm. This makes the value of preference shares higher than that
of the bonds. In India, however, the preference shares are not preferred and equity shares continue
to be of higher value than both preference share and bonds.
(vii) Convertibility: The preference shares are usually non-convertible unless otherwise stated in a clause
inserted at the time of issuing of these shares. The clause should mention the rights, privileges, the
convertibility aspect, the rate of conversion, the number of shares offered at the time of conversion
and put in a special legal document with the trustees-in-charge. The convertibility clause gives the
preference shareholders a share in the growth of the company. Also, it is rated at a higher value than
non-convertible preference shares.
(viii) Hybrid: The preference share is a hybrid between a bond and equity shares. As already stated, it
resembles both these types of share. Valued as a bond it has a greater claim on the assets of the firm
and is almost in the position of creditors. As equity share holder is entitled to rights of dividend. At
the time of liquidation also it has the rights given only after the bondholders are satisfied. These
features of a preference share give it an added value over bond and stability of income over equity
shares.
2. Types of Preference Shares
Preference shares, if not, described in a legal document are irredeemable non-participating but cumulative
in nature. The following varieties of preference shares are available depending on the clause inserted in the
agreement made at the time of issue of the shares:
(i) Cumulative or Non-Cumulative: Cumulative preference shares have the right of dividend of a
company even in those years in which it makes no profit. If the company does not make a profit in the year
2007, 2008 and 2009 but it makes a profit in 2010 it must satisfy its preference shareholders in the year 2010
and make full payment for the years for which it has not declared any dividend. This may be paid altogether
in 2010 with interest or in installments but before the rights of the equity shares holders have been satisfied.
If the preference shares are non-cumulative in nature they do not have a share in the profits of the company
in the year in which the company does not make profit. The advantage of preference shares is that they are
usually issued as cumulative.
(ii) Participating and Non-Participating Preference Shares: Participating preference shares get a
share of dividends over and above the share of dividends received at a fixed rate yearly. This special feature
arises when the company makes an extra profit and declares a higher dividend for the equity shareholders. This
gives a further advantage to the preference shareholders to participate in the growth of the firm. The preference
shares are usually non-participating in nature and do not receive a share higher than that fixed amount unless
it is specifically stated at the time of the issue of shares.
(iii) Redeemable and Non-Redeemable Shares: All preference shares are non-redeemable in nature.
Non-redeemable means like the equity shares its existence is permanent in nature and its shareholding is
continuous till the liquidation of the company. In this sense it resembles the equity shares but non-redeemable
preference shares do not have an investible value in the market so far as the investments are concerned. To
attract the investor, a clause is inserted for redeeming the preference shares after a certain number of years.
This redeemable quality integrates its rate in the market because it is considered a stable form of return. Also
hedge against inflation and purchasing power risk is avoided because of the nature of return of the preference
shares. Usually these preference shares are redeemed between 10 and 15 years from the time of issue. This
makes excellent investment for those who wish to get a stable rate of return and also fight the risk of purchasing
power as in the case of deposits in banks or provident funds. The small investor finds a redeemable preference
share an attractive form of investment. Redeemable preference shares are also callable at the option of the
issuing firm. The issuing firm may pay a higher rate to its shareholders than the face value of the preference
share and return the amount whenever it deems fit. This ‘call’ option is very unfavorable and the investor must
find optional investment deals in case this call is exercised. However, call option sometimes states the number
of years before which the company will not call the issue. This gives adequate protection to the investor and
before taking a redeemable preference share, he must value these optional facilities and deals. A non-redeemable
preference share would generally be avoided by an investor. The equity form of investment is more profitable
than a non-redeemable preference share because it gives the chance of share in the growth of a firm as well
as increase and decrease of dividends depending upon the capital market. It is a risky form of investment but
there is a potential appreciation of share. Preference shares do not receive this increase or appreciation in the
future whether redeemable or non-redeemable in nature.
(iv) Convertible and Non-Convertible Preference Shares: A convertible preference share is to be
evaluated both as a preference share as well as an equity share. It has the advantage of receiving a stable
income in the beginning of few years and then the conversion into an equity share. This gives it stability of
income, appreciation, premium and constant rate of growth. In the beginning it is a safe investment because
the dividend will be continuous and safe also. The investor receives a continuous stream of payments and it
will be evaluated with similar preference shares in the market but with those which do not have a convertibility
clause. In this sense the preference share will have an advantage of being converted into an equity share at
a later date. The premium in the case of convertible bonds should be expected to be about 20%. A higher
premium than this should not be expected because it will erode the value of preference shares. In the later years
of its life the convertible preference shares should be evaluated as equity share. For this it is important to find
out the conversion rate and the number of shares the preference shareholders will get when it is converted into
equity share. Once it is converted, the preference shareholder will have the same rights as the equity shareholder.
He will also have the right to vote and the right to receive dividends in case of declaration of dividend. He
will be evaluated as a part owner of the company. A convertible share which also has cumulative and participating
rights maybe considered to be an excellent form of investment from the point of view of a small investor. Non-
convertible preference shares do not enjoy the same status as a convertible share. It is an ordinary preference
share but such a share may be issued with features of participation in the dividends and may also be cumulative
in nature. Non-convertible preference shares may also be redeemable.
While these preference shares have been evaluated and described as different kinds of preference shares,
each type of preference share may be individually described or certain features may be added to it. It is not
necessary to add all the features of cumulative participating, redeemable and convertibility but a preference
share may also be issued with all the features. A preference share with all the features would be a favourable
investment. It is important to note that an investor should not purchase only preference shares because it suffers
from the drawbacks of purchasing power risk and there is less appreciation of price unless it is converted into
equity shares. In India, preference shares are not considered a useful medium for investment. Equity shares
have been a good form of saving for an investor. With the introduction of convertible debentures, derivatives,
new policies of Life Insurance, Unit Trust, Mutual Funds, Post Office Savings and new innovative financial
engineered securities, the investor finds an array of investment outlets. He may choose any investment from
the point of view of security, safety, price appreciation and share growth. As discussed earlier, an investor has
to make his investments on that point of incidence where his return and risk feature may meet. He also must
make an investment depending on the income group to which he belongs. An investor in a higher income group
must be careful to invest in those outlets when the maximum tax benefits can be taken care of. To a small
investor stability of income is more important than risky investments and tax benefits. Whoever be the investor
a balanced portfolio should be desired so that he should hedge against all possible unfortunate circumstances
and for an immediate and safe investment.
3. Return on Preference shares
The return on preference shares is usually higher than on bonds. From the point of view of analysis of
return of preference shares there should be a qualitative analysis of the environmental factors of a firm in which
it is classified, the state in which it is situated and the type of quality of the shares in which investment is made.
The following factors must be considered important for analyzing return on preference shares:
(i) High Quality Preference Shares: Preference shares of ‘Blue Chips’ are considered as high quality
preference shares. While it is important to encourage new issues and new companies in India, from the
investor's point of view, it is important to see that the grade of preference shares is qualitative. Shares become
high grade if the company has a standing or reputation and has maintained quality in its working. Reputation
of a firm is judged according to its rating by existing shareholders, brokers, financial institutions and other
institutions from which it has taken loans. In the case of new firms this quality cannot be judged.
An average investor should avoid risk and prefer the qualitative share even though the return is lower than
on other preference shares available in the market. Sometimes, the return is higher of lower credit shares in
the market or of companies which do not maintain a good reputation. Many such firms have promised to pay
a good dividend on cumulative preference shares. Premium on preference shares is never as high as equity
shares. The analysis of return, therefore, should be on the quality of the company as it affects both investment
and return of a shareholder.
(ii) Stability: An investor should be cautious while applying for preference shares. Stability of dividends
is an important factor for any shareholder, more so, for an average small investor who is interested in regular
income even without any tax benefits. Stability of dividends can be found out from the past record of a firm
in paying dividends to its equity shareholders and paying its annual rate of interest to bondholders. Stability
can be seen from the kind of operations of a firm and the type of business that it is conducting. If the firm
has a monopoly product for manufacturing, the return of share will be stable and sometimes even higher but
if it has some other products where a lot of manufactures are already in competition then the firm which has
established its products may be considered as stable. Some small and relatively new firms have also been stable
in giving dividends, but it is important to analyze the rate of dividend on equity shares of such firms in the
previous years before making a judgment for investment in preference shares.
(iii) Security: The return of preference shares must be analyzed by the type of security which is offered
by the firm. The amount of assets or shares may be analyzed to find out the asset coverage. The asset coverage
should be at least two to three times the book value of the asset. It is important to note that the book value
of the assets is much lower than the market value as is recorded after taking depreciation. The market value
of the assets is important to ascertain because the investor will get part of his share value only at the rate at
which it may be sold. If he finds that the market value of the asset holds a premium and his preference shares
are adequately covered by the assets of the firm he may think of investing from the point of view of return per
share.
(iv) Rights of Dividends: To find out the return on a preference share, it is a useful exercise to analyze
the rights attached to the dividends of preference shareholders. The rights of dividend that should be found out
are:
l Participating Rights: The shareholder should find out whether the dividend has participation rights.
If a preference shareholder is given a share in the growth of the company through participating rights
the value of the preference share is certainly higher and the return so expected is also greater than
a preference share which is non-participating in nature.
l Rights of Preference Shareholders: If a company issues bonds as well as preference shares then
the rights of the preference shareholders become subordinate to the bondholders. In this event he
should be sure that he will get a stable rate of dividend after payment of the bondholders’ rights.
Certainly his claim becomes secondary to the creditors. If only equity and preference shares are issued
then the preference shareholders' rights are higher than the rights of the equity shares holder and so
also the value of the share.
l Adequate Coverage of Dividend: The preference shareholder must check the interest coverage and
the coverage on preference share. This means that if the firm has to pay ` 3 lakh a year to the
bondholders and ` 2 lakh to the preference shareholders, the company should have at least ` 6 lakh
return every year in order to have adequate cover over the expenses incurred on the bondholders and
preference shareholders. Adequate coverage is desirable for a stable dividend.
(v) Investment: The analysis of return of a preference share must be made from the point of view of
investment. The preference shares must compare with similar preference shares ruling in the market. The
preference share should also be analyzed with the bond issues and equity issues in the market. The investment
will be of comparable equity if the dividend of preference shares is stable and is at a higher rate of return than
that of the bonds. At the same time, if the ruling rate of equity share is lower than that of the preference share
or bonds it is important to judge the future of the investment because equity share is highly valuable and better
from the point of view of investors although many consider it risky. In an equity share there is always a future
expectation of appreciation in prices. This has to be calculated from the point of view of the business, political
and social considerations in the country. Future of an investment can be judged from the past experience of
the share and cyclical fluctuations. Sometimes a share fluctuates with the type of political climate and economic
upheavals in the country. Shares also fluctuate according to the number of years of holding depending on the
cyclical changes. The investor will find that every fourth year or the fifth year of a cycle the price stands to
change. Although, these are not accrued according to mathematical methods, statistical trends can be drawn
through time series to find out the values and the risk attached to similar equity shares. Preference share may
be used as an investment when there is high fluctuation in the market on equity shares. If the return on equity
share has been found to be stable, then it would be a better possibility to buy growth shares rather than
preference shares. This analysis must be specific and categorical without any subjective feelings about likings
or dislikings of a firm.
(vi) Variability of Return: Return on the shares is judged not only by stability but by the annual rating
and continuous return on shares. A company which pays dividend in one year but varies this decision in the
next two years is not stable and quality of its preference issue falls. The rate of dividend plus the yearly stability
of return gives it a value and the investor may plan to buy these shares.
Preference shares in the words of L.C. Gupta 2 — “is a poor substitute for bonds and debentures.
In fact with respect to the risk of dividend default, our analysis of the relative frequencies of
dividend skipping on preference and equity shares indicated that the degree of such risk attached
to preference shares was a shade less than that attached to equity shares. At least from the
viewpoint of risk, therefore, preference shares show greater resemblance to equity shares than to
bonds and debentures. On the other hand, from the viewpoint of opportunity of gain the preference
2. L.C. Gupta, Preference Shares and Company Finance, IFMR, Chennai, 1975, p. 19.
shares bear no comparison to equity and debt instruments are characterized by marked asymmetry
between the chance of loss and the chance of gain to the investor”.
This apt description by Professor Gupta can perhaps be summarized with the words ‘Buyers Beware of
Preference Shares’.
7.5 EQUITY SHARES

Equity shares are also called common shares and are from the point of view of investment more risky than
both bonds and preference shares. They, however, afford greater advantage than both the other securities and
in the capital market enjoy a better position as far as the investor's attraction is concerned; Equity share gives
several rights to the shareholders. They have the right to vote, the right of dividend, the right of being offered
right shares, the right to bonus issues and certain tax-benefits. The following characteristics of equity shares are
discussed:
1. Characteristic Features of Equity Shares
(i) Voting Rights: The equity shares carry with them: A special right of voting for the members owning
equity shares, a right to receive a notice of the Annual General Meeting every year, the right to be elected
members of the executive committee and become a director of the company on purchasing qualification shares.
They are considered to be superior to both the bondholders and the preference shareholders.
(ii) Ownership Rights: The equity shareholders are also the owners of the firm. Each shareholder
receives an ownership right equivalent to the share that he holds in the firm. The total share of a company is
divided and every shareholder has the right to be a member of the company. He is, however, limited according
to the investment he makes in the company. His existence in the company is perpetual as there is no maturity
date or redemption date of an equity share. This right is released only, if the equity shareholder so desires by
transferring or selling his shares in the stock market. The equity shareholder has the right of ownership till the
lifetime of the company i.e., until it is dissolved after which he ceases to become a member. As the owner of
the firm he has the right to receive information regarding his firm, a right to inspect all the documents of the
firm, to receive a copy of the Profit and Loss Account and Balance Sheet every year. He has a right to share
in the growth of the firm and also has a liability during the time when the firm makes no profit. He does not
claim any profit during years of depression. His claims fall last in case the company loses its value and has
sold all its business but his liability is limited to the face value of the share of the amount of investment that
he makes in the company.
(iii) Par Value: An equity share has a face value which is also called the par value of the share. Equity
share may be sold or issued at a premium or at a discount but the face value will be the denomination. It shows
the liability of an investor. Equity share may be issued in denominations of ` 10, 5, 2 or 1. Thus ` 10
denomination is the face value. Any amount above which this is sold, i.e., ` 12, may be called in excess of
the face value and ` 2 may be considered as the premium. Similarly, if it is issued at ` 8, then the discount
may be considered as ` 2. The face value or the par value remains the same, but these shares may be actively
traded in the share exchange and their price may increase or decrease according to the marketability of these
shares. Multinational firms in India are rated at a very high price. Many shares of ` 10 face value are being
sold at ` 90, ` 120 or ` 150. This being the premium value, the shareholders' liability is, however, limited to
the face value or par value of the investment.
(iv) Right Shares: The shareholder has a right of receiving additional shares whenever they are issued
by the company. Shares are offered to the existing shareholders and only on their refusal can others be offered.
Sometimes, some amount is reserved for the existing shareholders and then an issue is made by the company.
These right shares are also called subscription rights and this right can be sold at cum-dividend or ex-dividend.
Cum-dividend right attaches the right of dividend to the share. The value of the right is given in the formula,
VCR = (M – S)/(R + 1)
Where, V = Value of the right
M = Market price of share
R = Number of rights to buy one new share of share

S = Speculative price.
Example, an investor has a right of one share for five shares at ` 35 per share. The market price of share
on announcement of the issue is ` 41, what is the value of the right?
VCR = 41 – 35/5 + 1 = 6/6 = ` 1
In addition to these rights of more shares at the time of new issue, an equity shareholder also receives
the right of bonus as well as receiving discount coupons as well as sometimes receiving more shares in the firm
in the form of an additional dividend. These give the right of share in the profits of the firm and the future
of the potential growth of the firm. These additional rights make the equity form of investment more attractive
than other forms of investments.
2. Equity Share as an Investment
Equity shares are evaluated below to find out the value of these shares as an investment.
(i) Easily Transferable: Equity Shares may be purchased and sold in the stock market immediately after
purchase. The transferability clause gives the shareholder a right of purchasing as well as transferring his shares
at will. This means that the asset or investment is highly liquid if it can be sold in the market. This liquidity
feature gives it the benefit of a profitable share. Investment in these shares becomes widespread rather than
limited because of easy transfer. Transferability feature also gives the shareholder a right of using the share as
collateral in banks for obtaining loans.
(ii) Liability: The liability of the shareholder is limited to the face value or par value of the denomination
at which the share has been issued. While the shareholder has the right of being the owner of the firm his
liability is limited only to the extent of his investment. If the company has a greater loss it will meet its losses,
from other sources. Also, the shareholders' rights of paying are attached only during consequence of urgency.
It is very rare that the equity shareholder is called to pay an amount either during dissolution, re-association
or re-construction of a firm. The limited liability makes equity investment a valuable form of investment.
(iii) Profit Potentiality: An investor can hope for a price appreciation and rise in the value of his equity
share. There is, however, a risk attached to the price appreciation. However, many shares do not appreciate
at all. It is a risky form of investment and these risks should be carefully considered before making an investment.
While profit potential is high in equity shares the risk of loss is also high. Care should be taken before making
an investment. An analysis of per share earnings of the firm must be made before considering its investment
potentiality.
(iv) Purchasing Power Risk: Equity share is considered a highly risky investment, but it is considered
safe from the point of view of purchasing power risk. Purchasing power risk is generally more in the case of
bonds and preference shares which offer annual fixed income. Equity share not only provides share in growth
of the firm but the purchasing power risk is minimized because these are easily transferable and can be sold
depending on the market value of the shares. Potential rise in price is accepted and if there is no price
appreciation then they can be sold. From the point of view of purchasing power risk, it may be considered safe
but, it is important to evaluate it with the feature of risk.
In the words of Markowitz risk in equity share can be minimized by diversification. Risk cannot, however,
be eliminated. The growth of equity share can be evaluated by the formula described in Chapter 9 Professor
L.C. Gupta in his research work on equity share found that the past performance of equity was not an indicator
of the future course of performance. Also, the price of equity showed changes from year to year and were
dependent on the amount of dividend declared each year. The variability of returns makes the evaluation of
equity share rather difficult for investors. 3
3. L.C. Gupta, Rates of Return on Equities, Oxford Universities Press, Mumbai, 1981.
SUMMARY
r This chapter has discussed three important forms of investment such as bonds, preference shares and equity
shares.
r Bonds are considered as a senior security and are in the form of creditor securities. These do not give a right
of ownership as in the case of equity shares or preference share.
r Many bonds have convertibility rights. This adds to the prestige of the bond.
r The different kinds of bonds show their nature and variability. Each form of bond has a different investment
value and can be combined also. For example, a debenture can also be convertible in nature. Bonds can be
callable depending on the clauses which have been entered into.
r All legal aspects of the bond are given in the bond indenture and are kept with the trustees of the firm.
r Bonds are usually redeemable in nature. The purchasing power risk is higher on a bond after it is kept for
a longer period of time. It is used as an investment by an investor who considers stability in income and also
wishes to have some security.
r Mortgaged bonds cover security in the form of property and are considered extremely safe.
r Bonds do not share in the growth of a company, an intelligent investor will; therefore, invest not only in bonds
but in other securities like equity shares and preference shares.
r Preference shares are a hybrid between the equity shares and the bonds.
r Preference shares resemble the bonds because they are stable and their dividends are cumulative in nature.
They do not enjoy voting rights, price appreciation or appreciation in the value of share prices.
r While stability of an investment is an important criteria, an investor also requires potential price appreciation.
This quality is made by investments in equity share. Equity share has the characteristics of limited liability,
potential, profit, minimum purchasing power risk, easy transferability, share in growth and tax advantage.
r Sometimes, options and warrants are also attached to bonds as well as preference shares and equities.
These are highly speculative in nature.
MULTIPLE CHOICE QUESTIONS

1. The Value of the bond depends on
(a) Coupon rate, yield to maturity and expected yield of maturity
(b) Face Value and treasury bills
(c) The market rate which gives the value of the bond
(d) Short term bonds
2. Risk is highest in
(a) Treasury bills (b) Government bonds
(c) Callable bonds (d) Short term bonds
3. Duration is the measure of
(a) Interest rate risk (b) Time structure and market risk
(c) Time structure and interest rate risk (d) Time structure of bond
4. Credit rating is a technique to provide
(a) Credit position of a company (b) Repayment facility of payment of principal
(c) An opinion on the quality of bonds (d) Regular payment of interest
5. A convertible bond consists of
(a) Present value of equity shares which will be received at time of conversion.
(b) Part equity, part preferences shares
(c) Part preference shares and part debentures
(d) Zero interest bond
6. Equity shares are very risky because
(a) They do not have capital appreciation
(b) Price of share keeps on changing in the stock market
(c) Shareholders do not have voting rights
(d) The equity shares are convertible into bonds after a period of time
7. What is the market price of a share if its growth rate is 15% and required rate of return is 10%.The expected
dividend for next year is 20%.Choose the market price from the following data
(a) ` 45 (b) ` 40
(c) ` 55 (d) ` 50
8. A share is expected to have a growth rate of 10% per annum. If cost of equity capital is 15% per year and expected
dividend is ` 3.50 and market price is ` 75, what should be the price of the share?
(a) ` 60 (b) ` 75
(c) ` 80 (d) ` 70
9. From the valuation viewpoint the following are relevant
(a) expected dividend (b) present dividend
(c) future dividend (d) past dividend
10. The par value of shares means
(a) book value of shares (b) premium on shares
(c) face value of a share (d) discount value on shares
Answers: 1 (a), 2 (c), 3 (c), 4 (c), 5 (a), 6 (b), 7 (b), 8 (d), 9 (a), 10 (c).
QUESTIONS
1. “Bonds do not give the right of ownership, yet they are considered to be senior securities” Comment.
2. How would you classify the different kinds of investors? Discuss the kind of security suitable for each of these
investors.
3. Discuss the different types of bonds. How would you evaluate a convertible bond?
4. What is a convertible bond? Discuss the advantage of buying such a bond. How do you estimate risk and return
features of convertible bonds?
5. Give some objectives of issuing bonds? How should the corporate bonds be evaluated?
6. How do the preference shares rank in terms of investment? Discuss the different types of preference shares
available in the market with their qualities.
7. 'Equity shares are a good investment'. Discuss.
8. What is a warrant? How is it different from right shares?
9. What are the features of an equity stock? Do you think an investor should purchase equity shares or invest in
Bonds?
10. In the stock market in India if there is a fall in the prices of shares and a downward trend in the stock market what
are the options before an investor? What would you advise an investor?
11. Explain the importance of earnings, dividends and required rate of return in estimating the value of equity stock.
SUGGESTED READINGS
l L.C. Gupta, Preference Shares and Company Finance, Institute for Financial Management and Research,
Chennai, 1975.
l L.C. Gupta, Rate of Return on Equities, The Indian Experience, Oxford University Press, 1981.
l Simha, Hemlata Balakrishnan, Investment Management, Institute for Financial Management and Research,
Chennai, 1979.
l W. Kolb Robert, Understanding Futures Market, 3rd edition, Prentice Hall of India, 1997.
l John C. Hull, Fundamentals of Futures and Options Markets, 4th edition, Pearson Education Inc., India, 2003.
nnnnnnnnnn
Chapter
DERIVATIVES
Chapter Plan
8.1 Derivatives
8.2 Financial Derivatives
8.3 Options
8.4 Black Scholes Model
8.5 Forwards
8.6 Futures
8.7 Swaps
8.8 Derivatives Market in India
8.1 DERIVATIVES
A derivative is a financial instrument whose value depends on underlying assets. The underlying assets
could be prices of traded securities of gold, copper, aluminium and may even cover prices of fruits and flowers.
Derivatives have become important in India since 1995, with the amendment of the Securities Contract
Regulation Act of 1956. Derivatives such as options and futures are traded actively on many exchanges.
Forward contracts, swaps and different types of options are regularly traded outside exchanges by financial
institutions, banks and corporate clients in over-the-counter markets. There is no single market place or an
organized exchange.
Organized exchanges began trading in options on securities in 1973, whereas exchange traded
debt options started trading in 1982. On the other hand, fixed income futures began trading in
1975, but equity related futures started trading in 1982. The reasons for debt options being stronger
than futures are that share exchanges tend to introduce those instruments that they think will be successful in
trading.
In the equity market a relatively large proportion of the total risk of a security is unsystematic. At the same
time, many securities display a high degree of liquidity that can be expected to be maintained for long periods
164
DERIVATIVES 165
of time. These two factors contributed to the viability of trading equity options on individual securities. This
is because, for the contracts to be successful, the underlying instruments have to be traded in large quantities
and with some price continuity so that the option related transactions need not create more than a minor
disturbance in the market.
In the debt market, a large proportion of the total risk of the security is systematic – in other words, the
risk in debt instruments cannot be diversified by investing in a number of securities. Debt instruments are
smaller in size in comparison to equity securities.
1. Derivatives can be classified as:
l Commodities Derivatives: These are derivatives on commodities like sugar, jute, paper, gur, caster
seeds. Commodities are traded in different exchanges. Futures contract in potatoes are made at Hapur,
coffee futures in Coffee futures exchange at Bangalore and pepper futures are made in Kochi. The
agricultural commodities, oils and metals futures are offered in Multi-Commodity Exchange of India
(MCX), National Multi-Commodity Exchange of India (NMCE) and National Commodity and Derivatives
Exchange Limited (NCDEX).
l Financial Derivatives: These derivatives deal in shares, currencies and gilt-edged securities. Financial
derivatives can have transactions in different exchanges in the world. They can be classified as currency
derivatives, interest rate derivatives, stock and stock index derivatives. Bombay Stock Exchange and
National Stock Exchange trade in Index Futures, Stock Index Futures, Stock Index Options and futures.
l Basic Derivatives: Futures and Options are basic derivatives. They can be distinguished from Swaps
and Interest Rate Futures which are called complex derivatives.
l Complex Derivatives: Interest rate futures and swaps are classified as complex derivatives.
l Exchange Traded Derivatives: (ETDs) are standard contracts traded according to the rules and
regulations of a stock exchange. Only members can trade in exchange traded derivatives and they are
guaranteed against counter party default. Contracts are settled daily. ETDs are traded in NSE and BSE
in India. These trades are transacted online. ETDs can be transacted between one party and another
the transactions can move from one party to another and in a crish cross manner. These trades are
regulated by the exchange rules. The value of the derivative and changes in the value are settled daily
or after a given period through the mark to margin method. This reduces the credit risk to the
minimum.
l OTC Derivatives are regulated by statutory provisions. Swaps, forward contracts in foreign exchange
are usually OTC derivatives and have a high risk of default. OTC derivatives consist of forward
contracts. Forward contracts dealing in foreign exchange are traded as OTC in India. Swaps are also
traded as OTC in India. OTC derivatives are between one party and another and the flow can be
reversed.
The distinction between exchange traded and OTC derivatives is according to the methodology of trade
carried out. As given above the OTC is between one party but ETD derivatives trade move in different
directions. The following table shows the difference between OTC and ETD.
Derivatives: Transactions at OTC and ETD
Party Party
OTC Party Party
ETD Party Party

2. Characteristics of Derivatives
The characteristics of derivatives are the following:
l Limit of transactions: Derivatives can have limitless transactions as no physical assets is transferred
or transacted.
l Settlement: Derivatives are settled by squaring or offsetting transactions of the same derivatives and
the cash is settled in the difference between the values of the derivative.
l Screen based transactions: Derivative contracts are online computerized contracts. There are no
physical exchanges of assets.
l Transactions in secondary market: Derivatives cannot be traded in the new issue market. They
are transacted only in the secondary stock market when shares and debentures have been already
issued in the new issue market.
l Liquidity: The derivative transactions are liquid in nature and contracts can be formed without any
delay.
l Hedging price risk: A derivative instrument is used for hedging price risk in financial transactions.
Cash is paid for settlement for the difference in price and it has to be settled in future. A derivative
is based on an underlying asset and derives its value from it.
l Type of instrument: A derivative instrument can be made according to the preference of an investor.
It is used for hedging risk and also for speculation. Through the instrument return can be enhanced.
It does not have any intrinsic value or physical existence because it represents an underlying asset.
l Functions: The main function of derivatives is to hedge risk through the application of techniques
of risk management. It also plays the role of price discovery of an underlying asset.
3. Participants in Derivatives Market
Participants of derivatives market consists of the following:
l Hedgers are those who try to minimize loses of both the parties entering into a derivative contract.
At the same time they protect themselves against price changes on the products that they deal in. They
use options and futures and hedge in both financial derivatives and commodities derivatives.
l Speculators participate in futures and options. They take high risks for potential gains. Their gains
are unlimited, but they can take positions and minimize their losses. They trade mainly in futures.
They are the major players of the derivatives market.
l Arbitrageurs enter into two transactions into two different stock markets. They are able to make a
profit through the difference in price of the asset in different markets. They make a riskless profit but
they have to analyze the market with speed to ensure profitability.
8.2 FINANCIAL DERIVATIVES

The distinction between different types of derivatives has already been explained above. In this section the
financial derivatives are discussed. These are Forwards, Futures, Options and Swaps.
1. FORWARDS
In a forward contract, two parties agree to buy or sell some underlying asset on some future date at a
stated price and quantity. The forward contract does not involve any money transaction at the time of signing
the deal. If a farmer enters into the contract, forward contract safeguards and eliminates the risk of price at
a future date. But the forward market has the problem of lack of centralization of trading, difficulty in liquidity
and counterparty risk in the case of one of the parties declaring their insolvency or bankruptcy.
2. FUTURES
In a futures contract, both parties are obligated to perform. In the case of futures, neither party pays a
premium. In the case of futures, the holder of the contract is exposed to the entire spectrum of risk of loss and
DERIVATIVES 167
has the potential for all the returns. The parties to a future contract must perform at the settlement date. They
are, however, not obligated to perform before the settlement date.
3. OPTIONS
In the case of options, only the seller (writer) is obligated to perform. In an options contract, the buyer
pays the seller (writer) a premium. In the case of options, the buyer is able to limit the downside risk to the
option premium but retains the upside potential. The buyers of an options contract can exercise their right any
time prior to that expiration date.
4. SWAPS
All swaps involve exchange of a series of periodic payments between two parties. In a swap contract there
is an agreement between two parties to exchange their respective cash flows through a swap dealer according
to some pre determined price formula. A swap transaction usually involves an intermediary who is a large
international financial institution. The two payment streams are estimated to have identical present values at
the outset when discounted at the respective cost of funds in the relevant markets.
The two most widely prevalent types of swaps are interest rate swaps and currency swaps. A third is a
combination of the two to result in cross-currency interest rate swaps. Of course, a number of variations are
possible under each of these major types of swaps.
5. TYPES OF TRANSACTIONS
Transactions can be spot or ready delivery contracts or they can be future delivery contracts.
l Spot or ready delivery: In such contracts the payment has to be made either in cash or credit. The
payment may be made with the physical delivery of the asset on an agreement. Credit can be allowed
for a few days, but immediate payments are preferred.
l Future delivery contracts: In a future delivery contract the delivery of the asset is made on a future
date and there is an agreement for the date and mode of payment. These future delivery contracts can
be either non-transferable or transferable future delivery contracts.
l Non-transferable future delivery contracts: These are also called forward contracts. The agreed
contracts have to be performed according to the predetermined terms and conditions of the contract.
l Transferable future delivery contracts: Such contracts are also called futures contract. The rights
and obligations of the parties under this contract can be transferred to a third party.
8.3 OPTIONS
Options or directions come with equity share. They are usually speculative in nature and are an indirect
way of selling in shares. Options are in the form of ‘puts’, ‘calls’, ‘straddle’, ‘strap’, ‘Put’ is, the right to
sell at a specified time and specified price, ‘call’ is the right to buy in a similar fashion and has to be for a
specified price at a specified time. The buyer and seller of options is called ‘writer’. The attracting price is
called the option price. ‘Straddle’ is a combination of a put and a call and is generally contracted by those
who trade on both sides of the market, a ‘strap’ means two calls plus 1 put or 2 puts and one call. The buyer
of options is interested in speculation and has inherited both the return and the risk of trading through options.
The basic reason for dealing in options is to control shares through a small investment. This may also be termed
as leverage. The person who buys pays excess amount in premium and in this manner is able to make the claim
for a particular period of time. Options may necessarily not be used and used only if they are rated and may
be sold at either a higher or a lower price in the next fortnight or the next month. If the option is not used
it expires and the premium is lost. Option buying is a risk and is made for a future expectation of price change
in the associated share price. Option buyer usually knows that if he exercises options he may also be at a risk,
of loss. In fact, the risk of loss is higher than the risk of gain. The writer of option can both sell and buy on
a share exchange. The ‘put’ and ‘call’ options may be sold at a particular strap. If the price of that share rises
and the share held is called away the option buyer may call and exercise his option to buy. The person who
writes the option makes a profit. If the share price falls, a public option is made and the writer is able to get
an additional share of a particular share. Sometimes, the price of share remains neutral and does not rise or
fall. The writer of options can hold the share and may make further contracts and right on them.
The price of an option in the form of premium generally rises —
(a) If the share is held for a longer time as this is a higher risk to the writer;
(b) If the rate of fluctuations on the share is higher than premium;
(c) When the shares have a very low face value, they usually have a higher premium because even the
price is lower in the share market but higher price share receives less-premium.
Options are usually exercised or ‘struck’ as a cover on the premium paid for an option. It should also
cover the cost of transactions; the consideration of tax should also be made before exercising an option.
Options are also used for hedging. An investor simultaneously buys 100 shares of a share and ‘puts’ on the
share. If share appreciates after twelve months this loss has gone. The loss on this would be only in the matter
of commissions and premiums. Puts are also used for tax planning. Even if the share prices fluctuate, the gains
and losses on the assured and long share offset judging.
An options agreement is a contract in which the writer of the option grants the buyer of the option the
right to purchase from or sell to the writer a designated instrument for a specified price within a specified period
of time.
The writer grants this right to the buyer for a certain sum of money called the option premium. An option
that grants the buyer the right to buy some instrument is called a call option. An option that grants the buyer
to sell an instrument is called a put option. The price at which the buyer can exercise his option is called the
exercise price; strike price or the striking price.
Options are available on a large variety of underlying assets like equity shares, currencies, debt instruments
and commodities. Options are also traded on share indices and futures contracts where the underlying asset
is a futures contract or futures style options.
Options are a versatile and flexible tool for risk management individually as well as in combination with
other instruments. Options help the individual investors with limited capital to speculate on the movements of
share prices, exchange rates and commodity prices. The main advantage of options is the feature of limited
loss. The underlying asset for options could be a spot commodity or a futures contract on a commodity or the
futures-style option.
An option on spot foreign exchange gives the option buyer the right to buy or sell a currency at a stated
price (in terms of another currency). If the option is exercised, the option seller must deliver or take delivery
of currency.
An option on currency futures gives the option buyer the right to establish a long or short position in a
currency futures contract at a specified price. If the option is exercised, the seller must take the opposite
position in the relevant futures contract. For example, suppose you had an option to buy a December Euro
contract on the IMM at a price of $0.58/Euro. You exercise the option when December futures are trading at
$ 0.5895. You can close out your position at this price and take a profit of $ 0.0095 per Euro or meet futures
margin requirements and carry a long position with $ 0.0095 per Euro being credited to your margin account.
The option seller automatically gets a short position in December futures.
Futures style options: Like futures contracts, futures style options represent a bet on a price. The price
being betted on is the price of an option on spot foreign exchange. The buyer of the option has to pay a price
to the seller of the option i.e., the premium or the price of the option. In a futures style option, you are betting
on the changes in this price, which, in turn depends on several factors including the spot exchange rate of the
currency involved. For example a trader feels that the premium on a particular option is going to increase. He
buys a future style ‘call option’. The seller of this ‘call option’ is betting that the premium will go down.
Unlike the option on the spot, the buyer does not pay the premium to the seller. Instead, they both post margins
related to the value of the call on spot.
DERIVATIVES 169
1. Types of Options
An option contract is an agreement between two parties representing the option buyer and the option
seller. The option seller receives a premium on the price of the option and grants the right to someone else
to buy or sell. He is also called the option writer. The option buyer pays a price in the form of premium to
the options seller for writing the option. When options are traded in a share exchange, as in the case of futures,
once the agreement is reached between two traders, the clearing house (share exchange) interposes itself
between the two parties becoming buyer to every seller and seller to every buyer. The clearing house guarantees
performance on the part of every seller. There are two types of options. These are Call options and Put options.
A call option gives the option buyer the right to purchase currency Y against currency X, at a stated
price X/Y, on or before a stated date. For exchange traded options, one contract represents a standard amount
of the currency Y. The writer of a call option must deliver the currency, if the option buyer chooses to exercise
his options.
A put option gives the option buyer the right to sell a currency Y against currency X at a specified price
on or before a specified date. The writer of a put option must take delivery if the option is exercised.
Strike Price is also called exercise price. If the striking price is high the call option price will be low
and the gain will be limited.
The price is specified in the option contract at which the option buyer can purchase the currency (call)
or sell the currency (put) Y against X.
The date on which the option contract expires is the maturity date. Exchange traded options have
standardized maturity dates.
Options can be either American or European: An American Option is an option, call or put, that
can be exercised by the buyer on any business day from initiation to maturity. An European option is an
option that can be exercised only on maturity date.
2. Features of Options
A Premium (Option price, Option value) is the fee that the option buyer must pay the option writer
at the time the contract is initiated. If the buyer does not exercise the option, he stands to lose this amount.
The intrinsic value of an option is the gain to the holder on immediate exercise of the option. In order
words, for a call option, it is defined as Max [(S-X), 0], where S is the current spot rate and X is the strike
rate. If S is greater than X, the intrinsic value is positive and is S is less than X, the intrinsic value will be zero.
For a put option, the intrinsic value is Max [_X-S), 0]. In the case of European options, the concept of intrinsic
value is notional as these options are exercised only on maturity.
The value of an American option, prior to expiration, must be at least equal to its intrinsic value. Normally
it will be greater than the intrinsic value. This is because there is some possibility that the spot price will move
further in favour of the option holder. The difference between the value of option at any time “t” and its
intrinsic value is called the time value of the option.
A call option is said to be at-the-money if S=X i.e. the spot price is equal to the exercise price. It is in-
the-money is S>X and out-of-the-money is S<X. Conversely, a put option is At-the-money is S<X, in-the-
money if S<X and out-of-the-money if S>X.
Relationship of Intrinsic value and call option price: The premium is the difference between the intrinsic
value and market price of the call option. With an increase in the share price, the intrinsic value increases but
the premium declines. This can be explained with the help of the Table 8.1.
Table 8.1 INTRINSIC VALUE (in ` )
Price of Striking Intrinsic Market price of Premium of

the share Price Value Option 4 option
1 2 (1) – (2) = 3 (4) – (3) = 5
40.00 40.00 0.00 10.00 10.00
41.00 40.00 1.00 10.50 9.50
55.00 40.00 15.00 21.00 6.00
62.00 40.00 22.00 26.00 4.00
70.00 40.00 30.00 32.00 2.00
93.00 40.00 53.00 54.00 1.00
118.00 40.00 78.00 78.50 0.50
3. Option Premium and Share Price

Option premium fluctuates as the share price moves above or below the strike price. Generally, option
premiums rarely move point to point with the price of the underlying share. This happens only at parity, when
the exercise price plus the premium equals the market price of the share.
Before attaining parity, premiums tend to increase less than point per point with the share price. One
reason for this is that point per point increase in premium would result in sharply reduced leverage for the
option buyers. Reduced leverage means reduced demand for the option. Also, a higher option premium will
bring about increased capital outlay and increased risk, thus reducing demand for the option.
If share prices decline, it does not result in a point per point decrease in option premium. Even a steep
decline in the share price in a span of few days has only a slight effect on the option’s time value. This term
to maturity effect exists, because the option is a wasting asset.
4. Call Options Profits
A call option buyer’s profit can be defined as follows:
At all points where S<X, the payoff will be –c
At all points where S>X, the payoff will S–X–c, where
S – Spot price
X = Strike price or exercise price
c = call option premium
Conversely, the option writer’s profit will be as follows:
At all points where S<X, the payoff will be c
At all points where S>X, the payoff will be –(S–X–c)
5. Put Options Profits
A put option buyer’s profit can be defined as follows:
At all points where S<X, the payoff will be X-S-p
At all points where S>X, the payoff will be –p, where
S – Spot price
X= Strike price or exercise price
p = Put option premium
Conversely, the put option writer’s profit will be as follows:
At all points where S<X, the payoff will be –(X–S–p)
At all points where S>X, the payoff will be p
DERIVATIVES 171
6. Profit and Pay offs from Options

On the expiration date of the option the profit of pay off can be examined. For example Mr. A has an
option with a strike price of ` 1000/- per share and option premium of ` 200/- per share. The pay off on the
expiration date in different situations is discussed through the following analysis:
(i) Buying a Call Option: When an investor is buying a call option he may or may not exercise his right
to buy at the strike price. If he has purchased a call option and it has a premium of ` 200/- as stated above
and his strike price is of ` 1,000/- he will exercise his option when the market price is more than ` 1,000. If
it is less than ` 1,000/- the investor would be keen to buy the asset. If the market price is ` 1,200/- the investor
would break even. Figure 8.1, shows that if the price in the market of the underlying asset is less than the strike
price the call option holder will have a constant loss of the premium amount that he has paid. However, if the
price increases and it is higher than the strike price his loss will be reduced and will become zero when the
price is equal to the strike price plus premium. Therefore the investors loss is restricted if he is a call option
holder, but he can make profits to any extent depending upon the rise in the market price on the maturity date.
(ii) Selling Call Option: Figure 8.2 shows the position of the call option writer. The call option writer
has the risk of unlimited losses that are dependent on the market price of the underlying asset but his gain will
be only ` 200/- as long as the price of the asset remains at ` 1,000. His price reduces when the price of the
asset increases and is above ` 1,000/-. He makes the limited profit of ` 200/- only when the asset is less than
the strike price plus premium. Any profit or loss of the call option holder is equal to the loss or profit
of the call option writer. In a European option the position shown in Figure 8.1 and 8.4 is possible only
on the specified date but an American option the call option holder can exercise the option at any time before
the specified date whenever, he has the opportunity to do so depending on the market conditions.
Fig. 8.1: Pay off on call option to option holder
Market Price of
0 Underlying Asset
Net Payoff on Call

(Profit or Loss)
Loss
Fig. 8.2: Pay off on call option to option writer
(ii) Buying a Put Option: Figure 8.3 depicts the position of the put option holder. When the market
price is less than ` 800/- if he exercises his option he will make a profit. If the price rises then the option holder
should sell in the market and not exercise his option because he would make losses. Therefore, the option
writer has a right to sell at the specified price at the strike price.
0 Market Price of the Asset
–
Net Profit or Loss
Loss
Fig. 8.3: Pay off on put option to option holder
Fig. 8.4: Pay off on put option to option writer
Selling a Put Option: Figure 8.4 depicts the position of the put option seller also called writer as long
as the market price is ` 1000/- or below if the put option will be exercised against the seller. The option writer
can have a reduction in his loss when the market price increases upto strike price minus premium that is ` 800.
Option Pricing — The Black Scholes Model
The theory of pricing the derivatives dates back to 1973 when Black and Scholes published a paper on
the pricing of options. This theory is based on certain assumptions.
DERIVATIVES 173
Assumptions
(i) The share underlying the call option provides no dividends or other distributions during the life.
(ii) There are no transaction costs involved in buying or selling the option.
(iii) The risk free rate of interest is assumed to be constant during the life of the option.
(iv) The call option can be exercised only on its expiration date.
(v) The movement of the share price is taken to be random.
The Black Scholes Option Pricing Model is based on the concept of riskless hedge i.e. an investor by
buying shares of a share can simultaneously enter into call option on the share, where gains on the share will
exactly offset losses on the option and vice-versa.
Distinction between Futures and Options
In a futures contract, both parties are obligated to perform. In the case of options, only the seller (writer)
is obligated to perform.
In an options contract, the buyer pays the seller (writer) a premium. In the case of futures, neither party
pays a premium.
In the case of futures, the holder of the contract is exposed to the entire spectrum of risk of loss and has
the potential for all the returns. In the case of options, the buyer is able to limit the downside risk to the option
premium but retains the upside potential.
The parties to a future contract must perform at the settlement date. They are, however, not obligated to
perform before the settlement date. The buyers of an options contract can exercise their right any time prior
to that expiration date.
8.4 BLACK SCHOLES MODEL

The Black Scholes model is given below:
V = P{N(d1)}–e RTS{N(d 2 )}
V = Current value of the option
P = Current price of the underlying share
N(1), N(d2) = Areas under a standard normal function
S = Risk free rate of interest
T = Option period
In(P / S) + (R + σ 2 )T
d1 =
σ∫ T
D2 = d1 – σƒT
σ = Standard deviation
e = Exponential function
This model is very complicated but it is of practical use in finance. It appeals to practitioners because of
the parameters of current share price, exercise price, risk free interest rate and length of time in years to
expiration date which are observable. These factors help to analyze the hedge position at no risk.
Warrants: Warrants are just like call options and are used to purchase equity share during a specified
period and at a specified time. Warrants are usually long-term options. Warrant prices also fluctuate just like
share prices. The value of a warrant depends on the amount which the investors are willing to pay for it. These
are detachable, attachable and are usually issued with bonds. Warrants are usually issued for a period above
five years and may even be perpetual. Those who hold warrants do not receive any dividends, but this does
not affect the price of a warrant. In India, warrants are not issued. Warrants have the privilege of transfer and
it is generally used for speculation. The value of a warrant is the value of call to actual market price of equity
shares minus option price per share depending on the number of times which warrant gives the right to
purchase.
An important dimension that has been brought about as reforms in the share market is the introduction
of derivatives. It is expected to bring development in the share market with increased activity, liquidity and
minimum risk for the investors.
8.5 FORWARDS
In a forward contract, two parties agree to buy or sell some underlying asset on some future date at a
stated price and quantity. The forward contract does not involve any money transaction at the time of signing
the deal. If a farmer enters into the contract, forward contract safeguards and eliminates the risk of price at
a future date. However, the forward market has the problem of lack of centralization of trading, difficulty in
liquidity and counterparty risk, in the case of one of the parties being declaring insolvent or bankrupt.
8.6 FUTURES
Futures are a financial contract which derives its value from the underlying asset. For example, mango,
walnut, apples, wheat or rice farmers may wish to make a contract to sell their harvest at a future date to
eliminate the risk of any negative change in price by that date. Transactions take place through the forward
or futures market. There are commodity futures and financial futures. In the financial futures, there are foreign
currencies, interest rate and market index futures. Market index futures are directly related with the share
market.
Futures markets are standardized contracts, involve centralized trading and settlements are made through
clearing houses. This reduces risk.
The following values determine the pricing of futures.
l Expected rate of return from investing in the asset.
l Risk free rate of interest.
l Price of the underlying asset in the cash market.
Index Futures
In 1982, the share index futures were introduced. The share index futures contracts are made on the major
share market index. It is an obligation, the settlement value depends on the value of share index, the price at
which the original contract is struck and on the specified times the difference between the index value at the
last closing day of the contract/original price of the contract. The basis of the share index futures is the specified
share market index. No physical delivery of share is made.
Standard and Poor contract is the most popular share index futures. Here the obligation is to deliver cash
equal to 500 times the difference between share index value at the close of last trading day of the contract and
the price at which the future contract was struck at the settlement date. For example, if the contract is struck
at the S & P share index level at 500 and the share index is 510 at the end of the settlement date, then the
payment that has to be made is equal to (510 – 500) × 500 = 5,000.
8.7 SWAPS
Financial swaps are a funding technique, which permit a borrower to access one market and then exchange
the liability for another type of liability. The global financial markets present borrowers, investors with a wide
variety of financing and investment vehicles in terms of currency and type of coupon – fixed or floating.
Floating rates are tied to an index, which could be the London Inter bank borrowing rate (LIBOR), US Treasury
bill rate etc. This helps investors’ exchange one type of asset for another for a preferred stream of cash flows.
Swaps by themselves are not a funding instrument; they are a device to obtain the desired form of
financing indirectly. The borrower might otherwise have found this too expensive or even inaccessible. Swaps
are used to transform the fixed rate loan into a floating rate loan.
DERIVATIVES 175
Swaps are popular because they work on the concept of comparative advantage. The basic principle is
that some companies have a comparative advantage when borrowing in fixed rate markets, while others have
a comparative advantage in floating rate markets. This may lead to some companies borrowing in fixed markets
when the need is of floating rate loan and vice versa.
Types of Swaps
All swaps involve exchange of a series of periodic payments between two parties. A swap transaction
usually involves an intermediary that is a large international financial institution. The two payment streams are
estimated to have identical present values at the outset when discounted at the respective cost of funds in the
relevant markets.
The two most widely prevalent types of swaps are interest rate swaps and currency swaps. A third is a
combination of the two to result in cross-currency interest rate swaps. Of course, a number of variations are
possible under each of these major types of swaps.
Interest Rate Swaps
An interest rate swap involves an exchange of different payment streams, which are fixed and floating in
nature. Such an exchange is referred to as an exchange of borrowings or a coupon swap. In this, one party,
B, agrees to pay to the other party, A, cash flows equal to interest at a predetermined fixed rate on a notional
principal for a number of years. At the same time, party A agrees to pay Party B cash flows equal to interest
at a floating rate on the same notional principal for the same period of time. The currencies of the two sets
of interest cash flows are the same. The life of the swap can range from two years to over 15 years. This type
of a standard fixed to floating rate swap is popularly called a plain vanilla swap London Inter- bank Offer
Rate (LIBOR) is often the floating interest rate in many of the interest rate swaps. LIBOR is the interest rate
offered by banks on deposits from other banks in the Eurocurrency markets, LIBOR is determined by trading
between banks and changes continuously as the economic conditions change. Just as the Prime Lending Rate
(PLR) is used as the benchmark or the peg for many Indian floating rate instruments, LIBOR is the most
frequently used reference rate in international markets.
Usually, two non-financial companies do not directly arrange a swap. They deal with a financial intermediary
such as a bank who then structures the plain vanilla swap in such a way so as to earn a margin or a spread.
In international markets, they earn about 3 basis points (0.03%) on a pair of offsetting transactions.
Swap spreads are determined by supply and demand. If more participants in the swap markets want to
receive fixed rather floating swap spreads tend to fall. If the reverse is true, the swap spreads tend to rise.
It is uncommon to find a situation where two companies contact a financial institution at exactly the same
with a proposal to make opposite positions in the same swaps. Most large financial institutions are engaged in
house interest rate swaps. This involves entering into a swap with a counter party, then hedging the interest
rate risk until an opposite counter party was found. Interest rate future contracts are resorted to as a hedging
tool in such cases.
Currency Swaps
Currency swaps involves exchanging principal and fixed rate interest payments on a loan in one currency
for principal and fixed rate interest payments on an approximately equivalent loan in another currency.
Suppose that a company A and B are offered the fixed five year rates of interest in U.S. dollars and
sterling. Also suppose that sterling rates are generally higher than the dollar rates. Also, company A enjoys
better creditworthiness, then company B as it is offered better rates on both dollar and sterling.
What is important to the trader who structures the swap deal is that difference in the rates offered to the
companies on both currencies is not the same. Therefore, though company A has better deal in both the
currency markets, company B does enjoy a comparatively lower disadvantage in one of the markets.
This creates an ideal situation for a currency swap. The deal could be structured such that company B
borrows in the market in which it has a lower disadvantage and company A in which it has a higher advantage.
They swap to achieve the desired currency to the benefit of all concerned.
The principal amount must be specified at the outset for each of the currencies. The principal amounts
are usually exchanged at the beginning and at the end of the life of the swap. They are selected in such a way
that they are equal at the exchange rate at the beginning of the life of the swap. Like interest rate swaps,
currency swaps are frequently warehoused by financial institutions, that carefully monitor their exposure in
various currencies so that they can hedge their currency risk.
Derivatives have been developed in India for the smooth flow of investments in the market and to attract
foreign capital. It is also expected the constant scams in the investment market will be reduced. The Harshad
Mehta scam and the Ketan Parekh scams have led to ensuring and bringing back discipline in the financial
markets through new aspects like eliminating the badla system and bringing about derivatives.
8.8 DERIVATIVES MARKET IN INDIA

The derivatives market in India began to be developed after the year 2000. Equity derivatives were
introduced with the submission of the L.C. Gupta committee report, which recommended derivatives for hedging
facility to the investors. Hedging in the share market is important because it saves the investors from losses.
It is like an insurance against risk from variations in the prices in the share market. Hedging also helps in
bringing about efficiency and liquidity in the capital market.
Derivatives were introduced in the Indian Capital Market in phases. In the first phase ‘Share Index
Futures’, ‘Share Index options’, ‘Index Share options’, and ‘Index Share Futures’ were adopted for trading in
the share market. SEBI gave permission for Index futures contracts to be based on the S&P, CNX, NIFTY and
the BSE SENSEX.
In 2003, Interest Rate Derivatives were introduced by SEBI. These are Exchange Traded Interest Rate
Futures. (IRF) These derivatives were to derive their value from a basket of dated Government Securities. The
IRF protects the buyers and sellers from the adverse effects of interest rate changes. It is an example of a
Futures Derivative. It is settled through a Clearing Corporation. The minimum size of the IRF is ` 2,00,000 and
it has a maximum maturity of one year or 12 months. NRI’s and FII’s are allowed to trade in IRF according
to the guidelines issued by the Reserve Bank of India.
Derivatives trading and settlement issues were to be made through the rules and byelaws of share exchanges,
Security Contracts Regulation Act as well as regulations and guidelines framed by SEBI.
The derivative products in India are being traded in two share exchanges the National Share Exchange
(NSE) and the Mumbai (Bombay) Share Exchange (BSE). The NSE allows trading according to a prescribed
set of provisions. The trading members and clients dealing in the share exchange have to trade under the norm
and regulations framed by NSE Futures and Options Regulations, 2001. National Share Exchange allows
trading in Nifty Futures, Nifty options, Individual Share Futures and Individual Share Options.
Individuals have a choice of Share Futures and Options in more than 50 shares. The trading system at NSE
is called NEAT-F&O. It is an order driven market. Orders are matched according to price, time and quantity
of the order. An NSE member can make an active order by trading through his terminal and online monitor
and generate a transaction by finding out a matching order by another member.
At the Mumbai Share Exchange trading is active in BSE Sensex Futures, BSE Sensex Options,
Individual Share Futures and individual Share Options
The value of a derivative contract for individuals depends on the market value of the share, which is
traded in and the number of shares in one contract. A contract for Futures and Options should be of 200 units
whether it is a Nifty Index or Sensex and the minimum value of a contract should be ` 2,00,000.
In India derivatives have the distinct feature of being European in nature in Index Option and American
in Share Options. Both Futures and Options are available for 1, 2 or 3 months and contracts expire on the last
Thursday of every calendar month. A March contract would expire on the last Thursday of March and April
contract would expire on the last Thursday of April. BSE offers trading even for very short periods like 1 or
2 weeks to allow shorter period maturity and liquidity in the market.
Settlement of Contracts: Derivatives contracts have the feature of paying margins. SEBI allows the
margins in contracts. Daily settlement margin is also possible by payment in cash on T+1 basis.
DERIVATIVES 177
A Futures Contract is settled through Mark to Market Method (MTM). This is a method of daily
settlement price of the contract at the end of the day, but carrying forward till the final settlement day of last
Thursday of each month.
Example: An investor purchases a futures contract in Nifty at ` 2,000. If Nifty closes at ` 1,900 at the
end of the day, the investor has made a loss of 100 × 200 = ` 20,000. He has to pay this margin money to
the share exchange and his contract can be carried forward the next day. The next day supposing NIFTY
increases to ` 2050, the investor has a gain of (2050–1950) 100 × 200 = 20,000. His contract would be
carried forward the next day at 2050 and this will continue till the last Thursday of the month which is the
final settlement day. It is not necessary to continue till the last day. The investor can square up or even take
counter-transaction on any day and close the contract.
An Options contract is settled by paying the option premium upfront. His loss is limited to the premium.
The gain or loss has to be settled on a daily basis. Margins are not required to be paid by the option writers
and the final gain or loss is settled on the last Thursday of the month.
SUMMARY
r This chapter discusses derivatives. A derivative is a financial instrument whose value depends on underlying
assets. The main purpose of derivatives is to minimize the risk of the investors.
r Futures are a financial contract to eliminate the risk of any negative change in price transactions that takes
place through the forward or futures market. In a futures contract, both parties are obligated to perform.
r In the case of options, only the seller (writer) is obligated to perform. In an options contract, the buyer pays
the seller (writer) a premium. In the case of futures, neither party pays a premium.
r The Black Scholes model is useful for option valuation and pricing.
r India had the unique system of forward trading through Badla system.
r The derivatives in the present form are quite new to India. On the recommendation of the L.C. Gupta committee,
derivatives were introduced in the share market in 2000. SEBI has provided guidelines for its trading. At
present the derivatives are being traded at National Share Exchange and Mumbai Share Exchange.

1. Equity related futures started trading in India in 1963.
2. Commodity derivatives are traded on items like jute, potatoes, sugar, and pepper.
3. Financial derivatives trade in shares, currencies and gilt-edged securities.
4. Derivatives are settled through the new issue market.
5. Hedgers minimize losses through the use of options and futures.
6. The types of financial derivatives are Forwards, Futures, Options and Swaps.
7. A future delivery contracts has to be settled immediately at the time of making the contract.
8. Forward contracts are called future delivery contracts.
9. Options can be ‘puts’ or ‘calls’.
10. A put option gives the right to the buyer to buy or to purchase currency.
Answers: 1 (F), 2 (T), 3 (T), 4 (F), 5 (T), 6 (T), 7 (F), 8 (T), 9 (T), 10 (F).
QUESTIONS
1. What is a Derivative? How would you distinguish between options and futures?
2. What do you mean by a swap? Discuss some types of swaps.
3. Distinguish between a call option and a put option. How do you exercise an option?
4. Discuss the derivative market in India.
5. Write notes on (a) Interest rate Futures, (b) American options, (c) Intrinsic value of option and (d) Forwards.
ILLUSTRATIONS
Illustration 8.1: In a cash market if an underlying asset Z is selling at ` 200. The expected return is 2% per quarter.
The risk free rate is 1% per quarter and the futures contract covers one quarter. What will be the price of the future?
Solution:
F = Price of Futures
y = Percentage yield on investment
s = Spot price of asset
r = Financing cost in % age
F = s + s (r- y)
Futures = 200 + 200 (0.01 – 0.02)
= 200 + 200 (– 0.01)
= 200 – 2
= ` 198
(i) If the price of ‘futures’ is more or less than ` 198 there would be arbitrage opportunity and then the demand
and supply forces would bring the price back to the equilibrium level of ` 198.
(ii) If the price of ‘futures’ falls in the market to ` 190 the investor should use the opportunity of purchasing a futures
contract for ` 190 and sell one unit of the asset ‘Z’ for ` 100 and invest in a deposit which will give him ` 101
return in 3 months. So his cost will be ` (190 + 2) = 192.He will gain ` (202 – 192) = ` 10.
(iii) When price of futures rises to ` 206 the investor should sell the Futures contract for ` 106 and should purchase
one unit of ‘Z’ in the spot market. After 3 months his return would be ` (206 + 2) = ` 208 and payment would
(` 200 + 2) = ` 202. He will have a gain of ` 7.
Illustration 8.2: An investor buys a sensex Futures at ` 6,000 in a lot of 100 futures. On the settlement day sensex
is 6,600. What would be his profit or loss?
Solution: The profit will be
Profit = (6,600 – 6,000) × 100
= 600 × 100
= ` 60,000
Illustration 8.3: Mr. Z wanted to sell his shares at a market price of ` 60.00 per share. The exercise price of the
call option is ` 58.00 ‘X’ paid a premium for these shares at the rate of ` 5.00 per share for a 6 months call option
` 500.00 for 100 shares.
What would Mr. X’s gain or loss in the following conditions:
(i) If Mr. Z’s price of stock is ` 52.00 when option is exercised?
(ii) If Mr. Z’s stock is ` 65.00 when option is exercised?
Solution:
(i) When Mr. Z’s stock is ` 52 at the time of exercising the option.
(a) Cost of call = ` 5.00 premium × 100 = 500
Loss is ` 500.00
(b) End value = ` – 500.00 + (` 52 – 58) × 100
= ` – 500 – 600 = ` 1,100 loss.
Mr. X the option holder will not exercise his right as there is a loss. He will minimize his losses at ` 500 which is
the premium paid for acquiring the rights of the option.
(ii) When Mr. Z’s stock is ` 65 at the time of exercising the option.
(a) Cost of call = ` 5.00 premium × 100 = 500
Loss is ` 500.00
(b) End value = –` 500.00 + (65 –58) × 100
= –500 + 7 × 100
= –500 + 700
= Gain ` 200.00
DERIVATIVES 179
Illustration 8.4: The market price of a share is ` 60. The exercise price of a share is ` 50. Maturity period is 3
months. Pramod purchases 5 put option contracts of this share at a premium of ` 5. If the price of this share falls to
` 40, what would be his profit in the 3 month period, if the investor sells 100 shares per contract?
Solution:
Cost of put = (Premium ` 5 per share) × 100 shares Per contract × 5 contracts = ` 2,500.
Puts intrinsic value = Strike price – End Price = 50 – 40 = ` 10 per share
Total value at maturity is (` 10 × ` 500) – ` 2,500
= ` 5,000 – 2,500
= ` 2,500
Illustration 8.5: Sanjay has brought call and put options of 100 shares
1. He has purchased one 3 month call with a strike price of ` 52 and ` 2 as premium.
2. He has paid Re. 1 per share premium for a three months put with a strike price of ` 50
(i) What would be Sanjays position if the share price moves up to ` 53 in 3 months?
(ii) What would be his position if the share falls to ` 46 in 3 months?
Solution: Cost of calls and put options. =
` 2 per share × 100 shares (call) + (Re. 1 per share) × (100 shares put)
= 2 × 100 + 1 × 100 = ` 300
(i) Price increases to ` 53. When market price is higher than strike price of the put, Sanjay will exercise it.
End Position = (–300 cost of option) + (` 1 per share gain on call) × 100 = –300 + 100
= Net Loss = ` 200
(ii) The price of share has fallen to ` 46. When market price is lower than strike price Sanjay may not exercise
the call options.
End Position = (–300 cost of 2 options) + (` 4 per gain on put) × 100 = –300 + 400
Gain = ` 100
Illustration 8.6: Mr. Inder buys a 3 months contract in March 2005 of NSE Index futures. NSE was ` 2,950 in
March. The contract size is 500. The NSE 50 in June has increased to 3,000.
(i) What is Inder’s profit?
(ii) What is his loss when Index falls to ` 2,920?
Solution:
(i) The price of the June contract = 2,950 × 500 = 14,75,000
The selling price = 3,000 × 500 = 15,00,000
The gain = 25,000
(ii) If Index falls to 2920
(2950 × 500) – (2920 × 500)
Loss = 14,75,000 – 14,60,000
= ` 15,000
Illustration 8.7: The price of equity shares of a non-dividend paying company Rajasthan & Co. is ` 50. The risk-
free rate is 15% p.a. with continuous compounding. An investor wants to enter into a 3 months forward contract. Find out
the forward price.
Solution:
The forward price of a non-dividend paying share can be found as follows:
F = S × ert
F = Forward price
S = Spot price
R = Risk-free rate
T = time
F = 50 × 2.7182815 × 0.25 = 51.91
Illustration 8.8: The market price of equity shares of Raj Ltd. is ` 50. It has not been paying any dividend. The
risk-free rate for the investor is 10%. The 6 months forward rate for the share is ` 55. Should the investor enter into the
6 months futures contract?
Solution:
The futures price for the share of a non-dividend company is calculated as follows:
F = S × e rt
F = 50 × 2.718280 .10×.5
= 50 × 1.0512 = 52.56
The equilibrium price of the futures is ` 52.56. If the market rate (of futures) is ` 55, the investor should sell the 6
months futures. He can borrow ` 50 now to purchase one share and to sell it in futures. He can make a profit of ` 2.56
per share over a period of 6 months.
Illustration 8.9: The NIFTY is 1,500 presently. The stock underlying this index provides a yield to 4% p.a. The
continuously compounding rate of interest is 6%. What should be the futures value of 4 months NIFTY?
Solution:
The futures value may be found as follows:
F = S × e(r-q)t
F = 1500 × 2.718280 (0.06 – 0.04)0.333
= 1571.67
Illustration 8.10: The stock index is currently 500 and the risk-free rate is 12%. Find out the futures price for a
6 months contract, if the dividend yield is 6%.
Solution:
The futures price for a dividend yield index is
F = S × e (r – q)t
= 500 × 2.71828 (0.12 – 0.06).5
= 515.22
Illustration 8.11: An investor buys a sensex future at 5,400 in market lot of 150 futures. On the settlement date,
the sensex is 6,000. Find out his profit or loss for one lot of futures. What would be his position, if the sensex is 5,300
on the settlement date?
Solution:
The investor has bought the sensex Futures at 5,400. On the settlement date, the Sensex will be 6,000. So, the profit
to the investor is:
Profit = (6,000 – 5,400) × 150
= 600 × 150 = 90,000
If the sensex on the settlement date is 5,300, in this case the loss to the investor would be:
Loss = (5,300 – 5,400) × 150
= 15,000
Illustration 8.12: The debentures of Kumar Ltd. are currently selling at ` 350 per debenture. The 9 months futures
contract on this debenture is available at ` 375. There is no interest due during this 9 months period. Should the investor
buy this future, if the risk-free rate of interest is 8%?
Solution:
The futures price in equilibrium is calculated by the following equation:
F = S × e rt
F = 350 × 2.71828 0.08 × 0.75
= ` 371.64
As the futures are available at ` 375, the investor should buy the 8 months futures.
Illustration 8.13: Equity shares of XYZ Ltd. are being currently sold for ` 88 per share. Both the call option and
the put option for a 3 months period are available for a strike price of ` 98 at a premium of ` 5 per share and ` 3 per
share respectively. An investor is interested in creating a straddle position in this share. Find out his net payoff at the
expiration of the option period, if the share price on that day is ` 88 or ` 108.
DERIVATIVES 181
Solution:
A straddle position is when the investor is interested to buy both the call option as well as the put option and pay
the premium on both. The net payoff position is as follows:
Total Premium paid = ` 5 + ` 3 = ` 8
(i) If share price is ` 88:
Net Payoff = Payoff on Put – Premium paid
= (` 98 – ` 88) – ` 8 = ` 2
Note: Call option will not be exercised
(ii) If share price is ` 108:
Net Payoff = Payoff on Call – Premium paid
= (` 108 – ` 98) – ` 8 = ` 2
Note: Put option will not be exercised
The investor is benefited in both conditions, that is when price is less than or more than the strike price on the expiry
day.
Illustration 8.14: An investor buys a NIFTY futures contract for ` 5,40,000 (lot size 150 futures). On the settlement
date, the NIFTY closes at 3,550. Find out his profit or loss, if he pays ` 2,000 as brokerage. What would be the position,
if he has sold the futures contract?
Solution:
The total value is ` 5,40,000 and the lot is 150. The NIFTY futures on the transaction date are 3,600. On the
settlement date, the NIFTY is 3,550. This means it has decreased by 50 points. The loss to the investor is
Loss = (3,600 – 3,550) × 150 + 2,000
= 9,500
If he had sold the futures contract, his profit would have been:
Profit = (3,600 – 3,550) × 150 – 2,000
= 5,500
Illustration 8.15: An investor buys 600 shares of ABC Ltd. ` 300 per share in the cash market. In order to hedge,
he sells 400 futures of ABC Ltd. ` 200 each. The share price and futures decline by 8% and 4% the very next day
respectively. He closes his positions next day by counter-transactions. Find out his profit or loss.
Solution:
600 Shares of ABC Ltd.
Buying Value = 600 × ` 300
= ` 1,80,000
Selling Value = 600 × (300 – 8%)
= 1,65,600
Loss = 1,80,000 – 1,65,600 = 14,400
400 Futures of ABC Ltd.
Buying Value = 400 × ` 200
= ` 80,000
Selling Value = 400 × (200 – 4%)
= ` 76,800
Profit = ` 80,000 – 76,800 = 3,200
Net Loss
= ` 14,400 – 3,200 = ` 11,200
Illustration 8.16: The market lot of NIFTY futures is 150 and the NIFTY futures of the next months are available
at 2,000. An investor creates a long position and buys 10 lots. On the settlement date, the NIFTY is 2,050. Find out the
profit or loss of the investor.
Solution:
The investor creates a long position. It means that he buys the NIFTY futures. His profit or loss is as follows:
The Buying Value = 2,000 × 10 × 150 = 30,00,000
Selling Value = 2,050 × 10 × 150 = 30,75,000
Profit = 30,75,000 – 30,00,000 = 75,000
SUGGESTED READINGS
l W. Kolb Robert, Understanding Futures Market, 3rd edition, Prentice Hall of India, 1997.
l John C. Hull, Fundamentals of Futures and Options Markets, 4th edition, Pearson Education Inc., India, 2003.
nnnnnnnnnn
Chapter
SECURITY VALUATION
Chapter Plan
9.1 Background
9.2 Approaches to Investment
9.3 Historical Developments of Investment Management
9.4 Basic Valuation Models — Fundamental Approach
9.5 Valuation of Bonds or Debentures
9.6 Valuation of Preference Shares
9.7 Valuation of Equity Shares
9.8 Valuation of Equity Shares — Dividend Concept
9.9 Valuation of Equity Shares — Earnings Concept
9.10 Capital Asset Pricing Model (CAPM Model): Share Valuation
9.1 BACKGROUND
The task of the present chapter is to explore the basic factors that affect all investment values. It first draws
a framework which gives the various approaches to investments and then discusses the valuation models. The
study of investments is concerned with the purchase and sale of financial assets and the attempt of the investor
to make logical decisions about the various alternatives, in order to earn returns on them dependent on varying
degrees of risk.
The management of investments is thus a complex study of maximizing return. It is also separated into
two parts:
l Security Analysis and
l Portfolio Management
183
1. Security Analysis
Traditionally, security analysis emphasizes the projection of prices and dividends. Accordingly, the potential
price of a firm’s common stock and the future dividend stream were to be forecast and then discounted back
to the present. The intrinsic value of the stock was then to be compared with the particular security’s current
market price (after making adjustments for commissions, taxes and other expenses). If the current market price
of the security was above the intrinsic value, the analysts recommended a sale, conversely, if current market
price showed at below the intrinsic value, the customer would be recommended to purchase a security.
These traditional views have shifted their emphasis to a more modern approach to analyze risk and return
of common stock rather than rely on price and dividend estimates.
2. Portfolio Management
Portfolios are combinations of assets. Traditionally portfolio management was the selection of securities
to suit the particular requirements of an investor. For example a middle aged person would be advised to buy
stocks of old and established firms or Government bonds which would give a stable and a fixed rate of return.
A young man of 25 years of age would be advised to buy stocks in ‘new’ growth firms.
Modern Portfolio Theory is based on a scientific approach, has scientific applications based on estimates
of risk/return of the portfolio and the attitudes of the investor towards a risk-return trade-off through analysis
and screening of individual securities. The return of the portfolio is based on weights on the percentage
composition of the portfolio. Portfolio theory will be discussed in greater detail in Chapters 16 to 19 of this
book.
The primary purpose of this chapter is to expose the notion of security values/the required rate of return
and how it is measured. Chapter 5 was an analysis of the types of risk and its measurement and Chapter 6
explained the methods of return.
9.2 APPROACHES TO INVESTMENT

The management of investments, security price and evaluation are based on three main schools of thought.
These different investment approaches are:
l The fundamental analysis approach,
l The technical approach and
l The modern portfolio theory approach
1. The Fundamental Approach
The Fundamental Approach is an attempt to identify overvalued and undervalued securities. The assumption
for undervalued stock is that the market will eventually recognize its error and price will be driven up toward
true value. Overvalued stocks are identified so that they can be avoided, sold or sold short. The investor should
select stocks based on an economic analysis, industry analysis and company analysis. Fundamental analysts
have four variants: (a) Present Value Analysis; (b) Intrinsic Value Analysis; (c) Regression Analysis and
(d) Special Situation Analysis. Some fundamental investors follow a ‘buy and hold’ policy by selecting quality
stocks and holding them for a relatively long period. Financial institutions usually follow the fundamental
approach. A fundamentalist does not look into the changeable prices, but he determines the price of the stock
at which he is willing to invest and then measures the stock with his own yardstick with that of the market to
find out, if the stock is selling at the required price.
Fundamentalists are of the opinion that importance should be given to earnings, dividends and asset
values of firms. The basic ingredient of this school of thought is the reliance on ‘intrinsic’ value of stock. Also,
according to them the price of a security is equal to the discounted value of the continuous stream of the
income from the security. The prices alter or change due to change in expectations and availability of new
information. The price is dependent on expected returns and expected capitalization rates corresponding to
future time periods.
SECURITY VALUATION 185
The fundamentalists who have contributed to this theory are John Burr Williams who gave a full exposition
to present value analysis in 1938. Benjamin Graham and David Dodd popularized the intrinsic value approach
in their widely known book ‘Security Analysis’. Another researcher by the name of Meader tested stock prices
through regression analysis in 1933.
2. The Technical Approach
The Technical Approach centres around plotting the price movement of the stock and drawing inferences
from the price movement in the market. The technicians believe that stock market history will repeat itself.
Charts of past prices, especially those which contain predictive patterns can give signals towards the course of
future prices. The emphasis is laid on capital gains or price appreciation in the short run.
The technicians believe that the stock market activity is simultaneously making different movements.
Primarily it makes the long-term movement called the bull or bear market. The secondary trend is usually
for short-terms and may last from a week to several weeks or months. The secondary trend is a movement
which works opposite the market’s primary movement, i.e., a decline in a bull market or rally in a bear market.
These are based on ‘Dow Theory’. The third movement is the daily fluctuation which is ignored by the Dow
Theory.
Technical analysis is based on the assumption that the value of a stock is dependent on demand and
supply factors. This theory discards the fundamentalist approach to intrinsic value. Changes in the price
movements represent shifts in supply and demand balance. Supply and demand factors are influenced by
rational forces and certain irrational factors like guesses, hunches, mood and opinions. The technicians’ tools
are expressed in the form of charts which compare the price and volume relationships. Technicians supplement
the analysis made by the fundamentalists on stock prices. Thus, technical analysis frequently confirms the
findings based on fundamental analysis. The technical analyst also believes that the price and volume analysis
incorporates one factor that is not explicitly incorporated in the fundamental approach and that is ‘the psychology
of the market’.
3. Efficient Market Theory
The Efficient Market Theory is based on the efficiency of the capital markets. It believes that market is
efficient and the information about individual stocks is available in the markets. There is proper dissemination
of information in the markets: this leads to continuous information on price changes. Also the prices of stock
between one time and another are independent of each other and so it is difficult for any investor to predict
future prices. Each investor has equal information about the stock market and prices of each security. It is,
therefore, assumed that no investor can continuously make profits on stock prices and securities will provide
similar returns at the same risk level.
The essence of portfolio theory as described in Jones Tuttle and Heaton is that “a portfolio’s total
characteristics are not merely the sum of the portfolio’s single security characteristics particularly with respect
to risk”. 1
From the above, it is clearly established that the portfolio analyst feels that the market cannot be influenced
by a single investor. He also feels that there is risk involved in managing a portfolio. His technique is, to
diversify between different risks classes of securities. If they are positive towards the market, they establish a
portfolio of risk choices that have higher risk and return than the market. Their attitude, is reflected by the
amount invested in risky and risk-less securities and is comparable to the return of the market as measured by
some market index. If the investor is successful he will be compensated by a higher gain.
The modern portfolio management is based on the ‘Random Walk Model’ which is generally studied
through the Efficient Market Hypothesis (EMH). The EMH has three forms: weak, semi-strong and strong. This
means that the market is weakly efficient, fairly efficient or strongly efficient as transmitters of information.
The EMH does not mean that investors should abandon investments, but it cautions investors to study the
implications of an efficient capital market theory carefully, rationally and in a more informed way. While the
efficient market hypothesis will be studied in greater detail later in the book, in a sketchy form it can be said
1. Jones, C.P., Tuttle, D.L. and Heaton, O.P., Essentials of Modern Investments, Ronald Press Company, New York, 1977, p. 5.
that the money making opportunities are maximum in the weak form of the market. According to the weak form
of the EMH, it is possible to use information before it becomes publicly available and on this score profits can
be made. A major assertion of the weak form of the EMH is that successive prices are independent and past
prices cannot be used to predict future prices successfully. The semi-strong form maintains that the market
provides all publicly available information. Therefore, insiders who have access to information can make gains
of short-term duration. In the strong form all information is incorporated into stock prices. Each investor then
has an equal and fair chance and cannot make profits continuously over a period of time.
The security analysts and portfolio managers’ depend on the weak form of the market. The tests that were
conducted on the weak form of the efficient market hypothesis formulated the ‘random walk theory’.
9.3 HISTORICAL DEVELOPMENTS OF INVESTMENT MANAGEMENT

Securities were first traded in an auction market at the foot of Wall Street in Lower New York in 1725.
This market was mainly for agricultural commodities like wheat and tobacco. The first market of securities was
established in 1792 and it was brought to notice by an insertion in the Diary or London’s register. The
importance of investments, however, grew only in the twentieth century.
1. Post-World War-I Period
The post world war period saw the development of the financial markets and changes in investor behavior.
Some of the changes and developments during this period are discussed below:
(a) Conservative Investors
During the World War-I period and after, the investors and the investment market was conservative. The
primary investment media consisted of bonds, not much reliance was given to common stocks as they were
considered highly speculative — common stocks were used for investments only if they were backed’ with
tangible assets, their dividends were stable, the company had a sound capital structure and adequate working
capital. Another requirement being that the market price was close to the book value of the share.
(b) Shift towards Common Stock Investment
The publication of a study by Edgar Lawrence Smith in 1924 regarding investments showed that equity
stocks consistently outperformed bond investments since the civil war. As a result the attitude of the investor
began to shift towards equity stocks. People also believed that the economy had stabilized and this further
strengthened their views on investments and began experimenting. These experiments and shift towards equities
culminated in the stock exchange “crash” of 1929. The period 1920 to 1929 was one of great activities for the
stock exchange. This time span was called the speculative period. Margin trading was commonly used, through
which investors borrowed up to 90% of the market value of stocks. The effect of low margin calls and
subsequent selling of securities was to pay off the borrower’s indebtedness. Conversely, in rising markets low
requirements led to high profits.
(c) Pools and Corners
During this time ‘pools’ and ‘corners’ were used for manipulation. While cornering was the method of
concentration of shares in a few hands and a device to trap unsuspecting investors, pool had the effect of
having adequate stocks and unloading them for making a profit. Unloading was done through inside tips and
forecasts. Corners were not commonly used. The last important corner was the Piggly Wiggly Corner in 1923.
Pools, however, continued to function. They flourished and made profits until the Securities Exchange Act of
1934.
(d) Leverage
Apart from the use of corners and pools for making profits another development during this time took
place. This was the use of ‘Leverage’ by firms. The Investment Companies and public utility companies were
especially noticeable for use of ‘leverage’ to obtain above average returns for their stock holders. Leverage was
a useful method of gains when common stock prices were rising. Once common stock prices fell, leverage
worked like disadvantage for the firm. At that time, it was fashionable to have the capital structure of the
company with as low as 11% to 12% of equity. When stock prices began falling, the return on total assets
declined, reverse leverage magnified the effect and leverage began to be considered as an abuse.
(e) Legislations
The abuses of pools, corners and leverage led to exhaustive studies, specially noted amongst it is the
senate committee on banking and currency. The findings of this study led to the enactment of special legislations.
The Banking Act of 1933, the Securities Act of 1933, the Securities and Exchange Act of 1934 and the Public
Utility Holding Company Act of 1935.
(f) Research Work in 1934
The research work of Benjamin Graham and David L. Dodd was widely publicized and acclaimed. The
results were published in a classical text entitled ‘security analysis’. This text laid the groundwork for the
security analysts’ profession and within this framework there were further developments in security analysis and
techniques were polished and refined. The basic techniques were established and it was considered the first
major work in the field of security analysis. More work on analysis of securities was conducted in the Post World
War-II period.
2. Developments of Security Analysis Post World War-II
During the Post World War-II period, several tests were conducted to try and find out new tools to control
the financial and economic environment. While most of the work was based on the fundamental approaches
as developed by Graham and Dodd, 2 further insights brought out the technical analysis as an alternative
approach to fundamental analysis. This was based on the work of R.D. Edwards and John McGee in 1948. 3
Technical analysts believe in market statistics and in past trends in prices and share volume as reflections for
the future.
3. The Portfolio Theory
Portfolio Management came into importance owing to the shift towards common stock investments. Harry
M. Markowitz provided a framework for the evaluation of portfolio decisions under conditions of uncertainty.
The shift to common stocks came about when it was found that effects of business cycles could be controlled.
Its importance was further enhanced with the interest shown by the financial institutions in common stock.
Financial institutions at that time dominated the bond market, but the influence of these institutions was also
felt in the stock market.
After Graham Dodd’s work on security analysis, the most important research work was that of Harry
Markowitz who for the first time attempted to quantify risk and developed a quadratic programming model. He
emphasized that the investor wanted to maximize his expected return but the general constraints were that of
his preference for risk. Therefore, a trade-off between risk and expected return and the method of providing
a mix between these assets through proper division was to be considered through the process of diversification
and portfolio composition. With this brief description of the history of investment management, the book now
proceeds towards an understanding of Basic Valuation Models.
9.4 BASIC VALUATION MODELS – FUNDAMENTAL APPROACH

The valuation models discussed below are through the time value of money.
Time Value of Money
The Basic Valuation Models are based on the idea that money has a ‘time value’. An amount of ` 100
received today is worth more than a 100 rupee-note two years later, since ` 100 can be invested today at a
6% interest. It will then fetch ` 106 in a year. For different securities, future benefits may be received at
different times. Even when the amount of future payment is the same, differences in the timing of receiving
2. Benjamin Graham and David L. Dodd: Security Analysis, McGraw Hill, New York, 1934.
3. Edward, R.D. and McGee John., Technical Analysis of Stock Trends, John McGee, Springfield, Mass, 1949.
them will create different values. The time value theory states that money received earlier is of greater value
than money received later even if both are equal in amount and certainty because money received earlier can
be used for reinvestment to bring in greater returns before the later returns can be received. The principle which
works in time value of money is ‘interest’. The techniques used to find out the total value of money are:
l Compounding, and
l Discounting.
1. Compound Value
An initial investment or input will grow over a period of time.
(a) Compounding Values
The terminal value can be seen as:
S = P(1 + i) n
S = Terminal value
i = Time preference or interest rate
n = Number of years
P = Initial value
Thus, for example, ` 100 placed in the savings account of a bank at 6% interest will grow to ` 106 at
the end of one year, since:
S = P (1 + i) n , ∴ S = ` 100 (1 + 0.06) 1 = 106
At the end of two years, we will have:
S = ` 100 (1 + 0.06) 2 = 112.4
At the end of three years, we will have:
S = ` 100 (1 + 0.06) 3 = 119.1
Table 9.1 shows the compounding procedure.
Table 9.1
1st Year 2nd Year 3rd Year

Amount (Principal) 100 106 112.4
Interest Rate 0.06 0.06 0.06
Amount of Interest 6 6.4 6.7
Beginning Principal 100 109 112.4
Ending Principal 106 112.4 119.1
This procedure will continue for a number of years. If these calculations are for longer periods of time the
problem of calculation arises. The compound value of Re. 1 is given in (Table A1 in the appendix) and the
compound value can be calculated easily with the help of this Table. For example, if it is required of find out
the value of ` 100 after 15 years at 6% interest, the Table will show at a glance that the amount will be
accumulated to ` 239.70. In this Table the values as calculated for ` 1 are shown.
Another example may be cited here. For example, if an amount of ` 20,000 is invested at 10% interest
for a period of 15 years, let us find out its terminal value with the help of compounding tables (Appendix Table
A1) . The table under year 15 and at 10% rate reads 4.177. Multiplying this factor with the amount invested
in the beginning of the period, i.e., ` 20,000, we get
` 20,000 × 4.177 = ` 83,540
(b) Compounding Periods within One Year
In the above example, we have assumed annual compounding of interest or that interest which was only
once a year but interest can be received every six months or semi-annually and every three months or
quarterly. For compounding within one year we simply divide the interest rate by the number of compoundings
within a year and multiply the annual periods by the same factor. For instance, in our first equation we had:
Annual compounding: S = P(1 + i) n ….(1)
The first equation would not change and the new equation which will be:
mn
1
Semi-Annual Compounding: S = P  
m
Where m is introduced, for the number of compounding during the period, supposing we wish to know
how much ` 100 would accumulate at the end of 5 years at 6% interest. The answer from the table and
equation is:
S = P(1 + i) n
Or, S = 100 (1 + .06) 5
Or, = 133.8
Let us apply semi-annual compounding. The equation would be as follows:
(5)(2)
 .06 
S = 100  1 + 
 2 
Thus, the new expression is equivalent to compounding ` 100 at 3% for 10 periods and shows that the
interest factor is 1.344 in Table A1 (Appendix). Our equation would, therefore, read:
mn
 i 
S = P 1 + 
 m 
(5)(2)
 .06 
Step 1 = 100  1 + 
 m 
Step 2 = 100(1 + .03) 10 = 100 (1.344) = 133.4
The semi-annual compounding of ` 100 at 6% interest for a two-year period is illustrated in the following
Table 9.2.
Table 9.2
Time period ` 100 at 6% interest Semi-Annual Compounding

6 months 1 year 18 months 2 years
Principal Amount 100 103 106 109.3

Interest Factor 0.03 0.03 0.03 0.03
Amount of Interest 3 3.1 3.2 3.3
Beginning Principal 100 103 106.9 109.3
Ending Principal 103 106.1 109.3 112.6
Since ‘m’ is the number of times per year when compounding is made, for semi-annual compounding ‘m’
would be 2, while for quarterly compounding it would be 4 and if interest is compounded monthly, weekly and
daily ‘m’ would equal 12,52,365 respectively.
(c) Future Value of a ‘Series of Payments’
So far we have considered only the future value of single payment made at a time 0. Sometimes, we may
have to find out the future values of a series of payments made at different time periods. For example, if the
following amounts are invested each year – ` 500, ` 1,000, ` 2,000 and ` 2,500 in a savings bank for 5 years.
If the rate of interest is 5%, what would be the total value of the deposit at the end of 5 years?
Table 9.3
0 1 2 3 4 5
` 500 ` 1,000 ` 1,500 ` 2,000 ` 2,500
2,100
1,654.50
1,158.00
608.00
Time period: 5 years 8,020.50
The future value of the entire stream of payment is 8,020.50. ` 500 put in at the end of first year
compounds for years and has a future value of ` 608. Similarly, ` 1,000 deposited at the end of 2nd year
compounds for years and amount to ` 1,158. ` 2,500 comes at the end of the 5th year and, therefore, the
future value remains at ` 2,500.
(d) Compound Sum of Annuities
Sometimes periodic sums are invested or received. These periodic sums or series of payments are called
annuities. An annuity is, therefore, a stream of equal annual cash flows. To find the sum of the annuity the
annual amounts must be multiplied by the sum of appropriate compound interest factors. Such calculations are
available in (Table A2 in the Appendix) which give the compound value of an annuity of ` 1 for N periods.
` 1 when deposited every year for five years at 5% will give a value of 5.526 at the end of five years. An
example may be cited of an amount of ` 2,000 deposited at the end of every year for 5 years at 5% interest
compound annually. The sum at the end of 5 years will be ` 2,000 × 5.526 = 11,052.00.
2. Present Values
Present values can be thought of as the reverse of compounding or future values.
(a) Discounting or Present Values
Present value can be found out in the following manner;
Step 1: Equations S = P (1 + i) n
Step 2: Divide both sides by (1 + i) n
 S 
Step 3: P =  n  divide both sides by (1 + i)
n
 (1 + i) 
For example, how much should we deposit in the bank today at 5% interest in order to have ` 200 after
one year.
 200 
P =  1  = 190.48
 (1 + .05) 
The present value tables are given in (Appendix Table A3) for reference. Present values cannot only be
considered as a single receipt, but a series or receipts received by a firm at different time periods. In this case
present value of each future payment is required to be determined and then aggregated to find the total present
value of the stream of cash flows:
C1 C2 C3 Cn
P = + + +
(1 + i)1 (1 + i)2 (1 + i)3 (1 + i)n
n
Ct
∑ (1 + i)t
t =1
P = sum of individual present values of the separate cash flows C 1, C 2, C 3, C n refers to cash flows in time
periods 1,2,3….n. Thus if PVF 1, PVF 2 , PVF 3 …. PVF n represent relevant present value factors in different time
periods 1,2,3….n the formula can be more practical oriented.
n
C1 (PVF1 )C 2 (PVF2 ) + C 3 (PVF3 )C n (PVFn )
P = ∑ C t (PVF)t
t =1
Example: Now if the time value of money is 10% the following series of yearly payments will be as
calculated in Table 9.4 for year 1, 2, 3, 4 and 5. The following cash flows are given for the respective years
i.e. 500, 1000, 1500, 2000, 2,500.
Table 9.4 METHOD OF CALCULATION
Year End Cash Flows Present Value(C) Present Value

(A) (B) (C) (B) × (C)
1 500 0.909 454.50
2 1000 0.826 826.00
3 1500 0.751 1,126.50
4 2000 0.683 1,366.00
5 2500 0.621 1,552.50
Total Present Value of Cash Flows 5325.50
Thus, the Present Values can also be calculated by the help of the Present Values (Appendix Table A3).
(b) Present Values of an Annuity
The Present Value of an annuity can be calculated by multiplying the annuity amount by the sum of the
present value factors for each year of the annuity. The Present Value Annuity tables are given in (Appendix
Table A4). The present value of the annuity is:
C1 C2 C3 C4
P = 1
+ 2
+ 3
+
(1 + i) (1 + i) (1 + i) (1 + i)n
1 1 1 1
= C 1
+ 2
+ 3
+
(1 + i) (1 + i) (1 + i) (1 + i)n
n
Ct
= = C∑ t
t =1 (1 + i)
PVAF: Present Value Annuity Factor
Table 9.5 PRESENT VALUE OF AN ANNUITY
0 1 2 3 4 5
90.9 100 100 10 100 100
82.6
75.1
68.3
62.1
379.0
Thus, sum of annuity of ` 100 at 10% discount = 3.791 in the annuity tables for the value of ` 1
multiplying it with the annuity amount 100 it is 379.1.
Thus P = 100 (3.791)
= 379.1
At any time the interest factors for the present value of an annuity is always less than the number of years
the annuity runs. In the case of compounding the relevant factor is larger than the number of years the annuity
runs.
Illustrations on Compounding and Discounting Techniques
1. Calculate the value of a sum of ` 50,000 deposited with Bank of India @ 10% interest for 5 years.
1.611 × 50,000 = 80,550
2. A person invests ` 40,000 @ 10% interest for 15 years. Find out its maturity value.
4.177 × 40,000 = 1,67,080
3. Lily invests ` 30,000 @ 8% interest for 20 years. The money at maturity will be
4.661 × 30,000 = 1,39,830
4. Mr. Ahmed deposited @ 12% interest a sum of ` 55,650 in State Bank of India for 10 years. Find
its terminal value.
3.106 × 55,650 = 1,72,848.9
5. Raj invests ` 30,000 @ 12% interest in Syndicate Bank for 5 years. What amount does he receive after
the end of 5 years?
If compounded (a) annually (b) semi annually (c) quarterly @ 6% interests for 10 years.
(a) 30,000 × 1.762 = 52,860
(b) @ 6% interest for 10 years is to be seen in Appendix Table 1 for semi-annual compounding
30,000 × 1.791 = 53,730
(c) Quarterly Compounding @ 3% for 20 years to be seen in Appendix Table 1.
30,000 × 1.806 = 54,180
6. Mrs. Lal is interested in investing an amount of ` 50,000 for 10 years. She will receive an annual
interest of 16%. Should she invest in (a) annual, (b) semi-annual and (c) quarterly compounding?
(a) In annual compounding she gets 4.411 × 50,000 = 2,20,550
(b) In semi-annual compounding she gets 4.661 × 50,000 = 2,33,050
(c) In quarterly compounding she gets 4.801 × 50,000 = 2,40,050
Mrs. Lal should make a contract for quarterly compounding as she gets a return of ` 2,40,050 which
is higher than annual and semi annual options.
7. A company deposits ` 5000 at the end of each year for 4 years @ 6% interest. This company would
like to know how much would this amount accumulate at the end of the fourth year.
(See Annuity Table) 4.375 × 5,000 = 21,875 therefore the company would have ` 21,875 at the end
of the fourth year.
8. Renu invests ` 15,000 for four years @ 9% interest with a chit fund. What will be the amount at the
end of four years?
1.412 × 15,000 = 21,180
9. The company wants to make a sinking fund to retire its debentures. The amount of debentures is
` 5 lakhs @ 6% interest. The maturity will be per 10 years. Find out the annual amount that it should
be deposited each year @ 6% interest. Sinking fund is the reciprocal of the compound value factor.
It is the reversal of annuity.
A = ` 5,00,000 (1/13.181) = 37,933.388
10. Rita would like to find out the present value of ` 50,000 to be received after 15 Years. The interest
rate is 9%. (Look at present value table in Appendix.)
0.275 × 50,000 = 13,750. The present value of Rita’s 50,000 is 13,750.
11. Mr. Jayan also wants to know the present value of ` 1,000 received 6 years later, if the rate of discount
is 10%.
` 1,000 × PV factor (0.564) = ` 564
12. Mr. Jayan also wants to know the present value of ` 1,000, if the discount rate is 8% and the amount
is receivable after 20 years.
1,000 × 0.215 = 215
13. Linda expects to receive ` 1,000 annually for three years at the end of each year. What is the present
value of this annuity at the discount rate of 10%?
(Look at annuity tables in Appendix)
1,000 × 2.487 = 2,487
Now find the present value of the 4 year annuity discounted at 10% from PV tables 3.170 × 10,000
= 31,700. This is the present value of Ms. Linda’s annuity.
14. If Rachna invests ` 1,000 how much will it grow at the end of 5 years? If interest is received at 1%
and quarterly compounding is done.
Now look at the Compound Value Tables.
Quarterly interest is 3%.
No. of period 5 × 4 = 20,
= 1,000 (1 +.03) 5 × 4,
= 1,000 (1.03) 20,

= 1,000 × 1.806 = 1806.
(Tables A1 to A5 are given in Appendix of the book).
The basic Mathematics of finance as we have seen are compounding and discounting techniques to find
out terminal values of money at a future date or to find out the value of money today. Also, the values can
be found out by compound value and present value tables. After considering the rudiments for taking the future
or present value of a single lump sum payment or a series of payments, there is now a need to develop a
valuation model for the bonds and shares of firms to identify the variables which influence the value of the
shares. The fundamental basis of value is the amount of returns (net cash inflows) and the risk that will differ
from the expected amount. Therefore, the value of the firm should depend on the expected returns measured
in terms of net cash inflows generated by the firm’s assets. A share will have more value if the amount and
timing of actual returns do not deviate much from that which was expected than if they are uncertain and vary
considerably from average expectation.
9.5 VALUATION OF BONDS OR DEBENTURES

A bond is an instrument of debt and resembles a promissory note. It may be issued either by the
Government or by a private institution. There are some important aspects of a bond.
Face Value: A Bond has a par value which is given on the face of the bond. This identity shows the value
of the bond and the amount the firm promises to pay at the time of termination of the bond. In India the face
value of the bond is generally ` 100 and ` 1000.
Coupon Rates: Coupon rate means the interest rate of the bond. The bond holder receives an annual
rate of interest. Sometimes this rate of interest is also given half yearly.
Maturity Period: Bonds in India are of recent origin. They have a normal maturity period of 10 years.
Government bonds in India have longer maturity periods ranging between 10-20 years. The bond holders
receive the face value and a nominal premium at the time of maturity.
Fixed Income: Bond earns a fixed income, but it is not necessary that all bonds have coupon rates or
carry a fixed rate of interest annually. Discount bonds give a fixed premium on the date of maturity.
Zero Interest Bonds: Zero interest Bonds are recently issued in Indian capital market. It does not yield
any interest, but provides conversion into shares at reduced premium on a future date. This is equivalent to
the interest, the investor would have normally earn on the bond. This bond is attractive because it offers tax
concessions available for long-term gains. Zero interest bonds also offer benefits to the issuing companies. The
interest on borrowing can be capitalized as a part of project cost. This reduces the project cost. These bonds
are helpful in case of new projects or expansionary projects as project costs are very high.
Risk: Bonds have risk involved in them since they have long maturity periods. The risk pertains to price
and interest rate changes. Bonds have purchasing power risk as the real value of the redemption price can be
wiped out by inflation. They also have interest rate risk when maturity period is long. Bonds may also attract
default risk. This risk arises out of delay or non-payment of interest and redemption value.
Bond and debenture values are easy to determine. If there is no risk of default the expected return on a
bond is made up of annual interest payments plus the principal amount to be recovered at maturity.
1. Bonds with a Maturity Period4
When a bond or debenture has a maturity date, the value of a bond will be calculated by considering the
annual interest payments plus its terminal value using the present value concept, the discounted value of these
flows will be calculated.
By comparing the present value of a bond with its current market value it can be determined whether the
bond is overvalued or undervalued.
While bonds carry a promise to maintain constant interest payment to maturity, I, and pay a fixed
Principal at maturity, P, the number of years to maturity n, and the required rate of interest, i, can vary. The
value of the bond can be determined in the following manner:
11 12 12 P
V = (1 + i) + +… +
(1 + i)2 (1 + i)n (1 + i)n
n
1n Pn
∑ (1 + i)n + (1 + i)n
n =1
Where, V = Value of bond

I = Annual Interest (`)
i = Required rate of interest (%)
P = Principal value at maturity
n = Number of years to maturity?
Example 9.1: If X purchases a 5 year ` 1,000 bond at par value and rate of interest is at 7% what he
should be willing to pay now to get a required rate of interest rate at 8%. The value of the bond is calculated
in Table 9.6.
Table 9.6 VALUATION OF BOND WITH MATURITY PERIOD
Year Annual Interest (` ) P.V. factor@ 8% Present Value
1 70 0.926 64.82
2 70 0.857 59.99
3 70 0.794 55.58
4 70 0.735 51.45
4. The calculations for bonds/debentures will be synonymously used as also its theoretical application.
5 70 0.681 47.65
Present value of interest flows 279.49
5 Maturity value 1,000 at 0.681 681.00
Value of bond: 960.49
The value of the bond is ` (279.49 + 681.00) = ` 960.49. This implies that ` 1,000 bond is worth
` 960.49 today if the required rate of return is 8%. The investor should not be willing to pay more than
` 960.49 for the purchase of the bond today. ` 960.49 is a composite of the present value of interest payments
` 279.49 and the present value of the maturity value ` 681.00.
2. Perpetual Bond
Bonds which never mature are very rare. In India such bonds or debentures are not found. In a perpetual
bond there is no maturity or terminal value. The formula for calculation of value of such bonds is:
I1 I2 1
V = 1
+ 2
+
(1 + i) (1 + i) (1 + i)
1 1
N = 1 (1 + i)n = i
V = Value of bond,
I = Annual interest
i = Required rate of return.
The value of the perpetual bond is the discounted sum of the infinite series. The discount rate depends
upon the riskiness of the bond. It is commonly the going rate or yield on bonds of similar kinds of risk.
Example 9.2: If a bond pays ` 80 interest annually on a perpetual bond, what would be the value if
the current yield is 9%? The value of the bond is determined as follows:
I 80
V = = = A 888.89
i 0.09
If the rate of interest currently is 8% the value of the bond is ` 1,000 and if it is 9% it is ` 888.88 and
if it is 10% the value is ` 800.
3. Bond Value and Interest Rate Theorem
The bond value theorem states that the value of the bond will decrease as the interest rate starts increasing
as explained through the following Table 9.7.
Table 9.7 VALUES OF PERPETUAL BOND AT DIFFERENT DISCOUNT RATES
Discount Rate (%) Value of Bond ( ` )

5 1600.00
6 1333.33
7 1142.85
8 1000.00
9 888.88
10 800.00
4. Price Change and Bond Maturity Theorem

The graph shows how the long-term bond and the short-term bond are sensitive and react to change with
the required rate of interest. If a long-term bond is a 8% perpetuity and short-term bond is a 5-year 8% issue.
The longer the maturity period of a bond, the greater will be the change in price. At 8% interest it may be
shown that its price changes with the change in the required rate of return.
In the example both perpetual and short-term bonds are at ` 1,000.

I 80
When the rate rises to 10% perpetual bond falls to 800, i.e., V = = = 800
i 0.1
The term bond will fall to 924.20. This difference between long and short-term bonds is true in all
situations. Thus even if the risk of default is known to be similar on two bonds, the value of one with the longer
maturity is affected by more risk from a rise in interest rates.
Table 9.8 SHORT-TERM (Bond values at different discount rates)
Year Value P.V. factor Annual Interest Value of Bond (` )

1 0.909 80 72.72
2 0.826 80 66.08
3 0.751 80 60.08
4 0.683 80 54.64
5 0.621 80 49.68
1000 0.621 5 years maturity value 303.20
Add value at maturity 621.00
` 924.20
5. Yield on Bond (Current Yield)

The discount rate or capitalization rate to be applied for bond valuation is generally the current market
yield available on bonds of similar risk. While finding out the value of the bond previously we assumed that
the discount rate is given.
The current market yield or ‘yield to maturity’ on a bond can be found out if the price of the bond is
known. In case of a (1) Perpetual Bond:
Annual Income Payment I

Yield = =
Price of Bond V
If the coupon rate of interest on a ` 1000 per value perpetual bond is 7% what is its current yield if the
bond’s market price is ` 700?
70
Current yield = = 10%
700
If the bond sells for ` 1400 the current yield will be 5%.
6. Yield on bonds with maturity period
I I2 1 + Pn
V = 1
+ 2
+…
(1 + i) (1 + i) (1 + i)n
A 5-year bond of ` 1,000 face value and 6% interest has a market value of ` 883.40, find its yield.
60 60 60 60 60 + 1000
883.40 = (1 + i) + + + +…+ = 10%
(1 + i)2 (1 + i)3 (1 + i)4 (1 + i)5
The value of a bond may be expressed as:
V = I(PVAF ni ) + RV (PVF ni)
Value of bond = (Annual interest payable) (Present value annuity factor) + (Redemption value)
(Present value factor)
The following relationship holds good in valuation of bonds:

(a) The value of bond is greater than its par value, when required rate of return is greater than the coupon
rate.
(b) The value of the bond is equal to its par value when required rate of return is equal to the coupon
rate.
(c) The value of bond is less than its par value, when required rate of return is greater than its coupon
rate.
(d) Value of the bond converges to its par value when the maturity date of the bond is approaching.
(e) The length of time of the maturity of the bond determines the price change of a bond. The longer the
maturity period greater will be the change in price in relation to a given change in the interest rate.
Bond valuation strategies are further illustrated to clarify bond valuation.
Example 9.3: Find present value of the bond when par value or face value is ` 100, coupon rate is 15%,
current market price is ` 90. The bond has a six year maturity value and has a premium of 10%. If the required
rate of return is 17% what will be the value of the bond? Should the investor buy the bond?
Solution:
Value of the Bond
End of the Year Interest Income Principal Repayment
1 15
2 15
3 15
4 15
5 15
6 15 110
= ` 15 (PVAF 17%, 6 Years ) + 110 (PVF 17%,6 Years ),

= ` 15 (3.589) + 110 (0.390),
= ` (53.84 + 42.9)
= ` 96.74
The value of the bond is thus ` 96.74. Investor should buy the bond at the market price of ` 90.
Example 9.4: Yield to Maturity (YTM)
Another example may be cited in case of a bond which has a market price of ` 83 and a par value of
` 100. It has an interest rate of 13% and matures after 5 years. The required rate of return is 19%. What rate
of return would an investor receive if he buys this bond and holds it till maturity?
Solution:
Shortcut Method:
I + (RV − B 0 ) / n
YTM = (RV + B 0 ) / 2
RV = Redeemable value
B 0 = Current market price of the bond
n = Number of years of life of bond
i = Interest
13 + (100 − 83) / 5 16.4

= = = 0.179 or 17.9% .
(100 + 83) / 2 91.5
Trial and Error Method:

To find the value of k the trial and error method will be used. If we take 18% as the factor it will be:
I (PVAF 18% 5 Years ) + RV (PVF 18% 5 Years )
` 13(3.127) + 100 (0.437) = ` 40.651 + 43.7 = ` 84.351
I (PVAF 19% 5 Years ) + RV (PVF 19% 5 Years )
` 13 (3.058) + 100 (0.419) = ` 39.754 + 41.9 = ` 81.654
(H −MV)
YTM = L i + (H − L) × Hi − L i
∴ k lies between 18 and 19% through interpolation
84.351 − 83 1.351
= 18% + = 84.351 − 81.654 × 1 = 18% + 2.697 = 18% + 0.50 = 18.50%
This investor will earn 18.50% on this bond if he buys it and holds it till maturity.
7. Semi-Annual Interest on Bonds
Most bonds give interest semi-annually. The techniques of compounding and discounting have been
illustrated to show how semi-annual interest can be calculated.
To recapitulate —
1. Semi-annual interest payments can be calculated by dividing annual interest by two.
2. The number of half-yearly periods must be calculated. This is done by multiplying the number of years
to maturity by two.
3. Divide the discount rate by two to get the discount rates of half yearly periods. The valuation of bonds
will be:
1
V = (PVAF in)+ (PVF in )
2
Example 9.5: A ` 100 par value bond carries a coupon rate of 12% interest payable semi-annually and
has a maturity period of 10 years. If an investor required return for this bond is 16%, what would be the value
of the bond? How much should he pay for the bond, if the interest is paid half yearly? If the price in the market
is ` 85 should he buy it?
Solution:
12
V = (PVAF 8%, 20 )+ (PVF 8%, 20 )
2
V = 6 (9.818) + 100 (0.215)
= 58.908 + 21.5
= ` 80.40
The value of bond which gives interest semi annually is ` 80.40. The investor should not buy the bond
for ` 85.
Realized Yield to Maturity: Realized yield to maturity of a bond is also considered by an investor. The
yield to maturity assumes that the cash flows received during the term of the bond is reinvested at a rate equal
to the yield to maturity. However, the reinvestment rates cannot always be equal to the yield to maturity.
Therefore, the realized yield to maturity has to be found out by defining the future reinvestment rates.
Let us take an example.
Example 9.6: The realized yield to maturity can be illustrated in the following manner:
Par value of bond : ` 1000
Coupon rate : 10% p.a.
Maturity : 5 years
Current Market Price : ` 600
Reinvestment Rate of future cash flows 12%. Calculate the future value of bond.
Solution:
The future value of the bond is calculated in the following manner:
FUTURE VALUE OF BOND
Information Years
0 1 2 3 4 5
Investment 600
Annual interest 100 100 100 100 100
Reinvestment period (in years) 4 3 2 1 0
Compound factor at 12% 1.120 1.254 1.405 1.574 1.762
Future value of cash flow 112.0 125.4 140.5 157.4 176.2
Maturity Value 1000.00
Total future value = 112.0 + 125.4 +140.5 +157.4 + 176.2 +1000 = 1711.5
The realized yield to maturity will be the value of the rate of interest calculated through the following
equation:
Present market price (1 + r) 5 = future value
600 (1 + r) 5 = 1711.5
(1 + r) 5 = 1711.5/600 = 2.8525
1 + r = 1.2323
r = 1.2323 – 1 = 0.2323 or 23.23%
8. Yield to Call
In a bond which has the option of call the issuing company can redeem the bond after a certain period
of time. A callable bond is matured before the time period of maturity. Due to the change in maturity period
there is a slight different in calculating YTC. For example, if a bond has to mature in 2015, but the company
makes a call for redemption in 2009 the yield to call has to be calculated till 2009. Therefore, if he has
purchased the bond in 2007 the yield to call will be 2 years. The yield to call is calculated upto the date of
exercising the call of the bond. That becomes the date of maturity. The equation for yield to call the following:
n
Int.i RV
YTC = B 0 = ∑ (1 + YTC)i + (1 + YTC)n
i =1
Note: The yield to call is the rate of discount at which the present value of cash flow to call is equal to the market
price of the bond.
Example of YTC
Example 9.7: Calculate yield to call when the following information of the bond is given.
Market price ` 110 Maturity date 31-12-2011
Face value ` 100 Callable on 31-12-2008
Coupon rate 11% Interest payable annually
Date of purchase 1-1-2006 Maturity/callable value of the bond ` 108
Solution:
3
11 108
108 = ∑ (1 + YTC)i + (1 + YTC)3
i =1
(i) Shortcut Method:
I + (CV − B 0 ) / n
YTC = (RV + B 0 ) / 2
11 + (108 − 110) / 3
= = 9.48%
(108 + 110) / 2
(ii) Trial and Error Method:

At 9% YTC = 11 (PVAF (3,9%) ) - + 108 (PVF (3,9%) )
= 11 (2.531) + 108 (0.772) = 27.841 + 83.376 = 111.217
At 10% YTC = 11 (PVAF (3,10%) ) - + 108 (PVF(3,10%) )
= 11 (2.487) + 108 (0.751) =27.357 + 81.108 = 108.465
At 11% YTC = 11 (PVAF (3,11%) ) - + 108 (PVF(3,11%) )
= 11 (2.444) + 108 (0.731) =26.884 + 78.948 = 105.832
Therefore, YTC lies between 10% and 11%.
(108.465 − 108) / 3 0.155

YTC = 10% + (108.465 − 105.832) / 2 = 10% + 1.3165 = 10.11%
9. Holding Period Yield

The holding period yield is the return of the bond for the time period that the investor holds the bond
as an investment. An investor is interested in finding out whether he makes loss or gain. Holding period return
(for equity shares) as already explained in chapter 4 is according to the following equation.
(B1 − B 0 ) + 1
HPR = B0
B0 = Market price at zero period (0)

B1 = Market price at time period (1)
I = Interest
Example 9.8: An investor buys a bond for ` 11,500 and holds the investment for 2 years during which
time he receives an interest of 10% per year from the company. After two years he sells the bond for ` 15,000.
What is his holding period return?
Solution:
(15,000 − 11,500) + 2,300 5,800

HPR = = = 0.504 or 50.4%
11,500 11,500
HPR is different to YTM because it does not calculate interest till the date of maturity. It takes into account
the interest for the time period of holding the investment, the price at which it is sold and the price at which
it is purchased and gives the investor the calculation of the gain or loss that he has made for during the period.
Note:
1. YTM is the rate of discount at which the present value is equal to the current price.
2. The holding period return is the return for the period for which the bond is held by the investor.
10. Zero Interest Bond

Example 9.9: Let us now take an example of the advantages of zero interest bonds/debentures. We have
seen from the features of a bond that zero interest bonds are relatively new in Indian capital market. A few
selected companies have introduced this concept and floated this issue. It is like a debenture or a bond but
it does not have any interest. The investor is compensated for this loss of interest at the time of conversion into
shares. Since at the times of conversion the shares are given at a reduced premium, the investor stands to gain,
however, it is the tax concession available to the investor that provides the compensation. The following
example may be cited to clarify the concept.
A Company offers two types of scrip:
(a) Debentures and (b) Zero bonds.
(a) 13% debentures of ` 120 each fully convertible into two shares of ` 10 each at a premium of ` 50
per share after expiry of 18 months.
(b) Zero bonds of ` 90 each fully convertible into two shares of ` 10 each at a premium of ` 35 per share
after the expiry of 18 months.
(c) An investor buys 100, 13% debentures and for 100 zero bonds.
(d) Assume that the investor sells the shares at ` 75. He bought the zero bonds at ` 10 face value and
` 35 premium, i.e., for ` 45 each.
Solution:
Information 13% Debentures(` ) Zero Bonds(` )
Selling price of 200 shares at ` 75 15,000 15,000
Less Cost Price (100 × 120) 12,000 9,000
Capital gains 3,000 6,000
Add interest for 18 months 2,925 —
Gross return before tax 5,925 6,000
Less deduction for long-term capital gains — —
Taxable return 5,925 6,000
Income Tax payable on capital gains at 20% 600 1,200
Interest income at 30% 877.5 —
1,477.5 1,200
Net returns after Tax 4,447.5 4,800
This example shows that after the taxes have been paid, the investor has a higher return in zero bonds
rather than in debentures. This difference will increase to a great extent, if the investor is in lower tax breakers.
Therefore, if an investor is in the high income tax bracket he will find it more beneficial to take zero bonds.
As explained earlier a zero interest bond has become of special interest to companies who are financing
themselves through raising funds. Zero bonds provide them with higher profits since there is no interest on this
account to be capitalized. The charge for depreciation is also much lower than through other financial avenues.
Many companies find that interest is very high when they are constructing or making a new project. The benefit
they derive through zero bonds is that they have a reduction in their project cost to the extent of the interest
that they would have to pay during the time the project is being completed.
The debentures and bonds are in the recent years becoming convertible at the time of redemption. In India
convertible bonds and debentures are of recent origin. The SEBI guidelines in 1992 have provided guidelines
for convertible bonds. The non-convertible bonds generally carry high rate of interest than that of convertible
debentures. The market price of convertible debentures depends on the price of the equity shares in which they
are convertible as well as the date of economy, it is safe to invest in convertible debentures. Convertible
debentures are ideally suited for conservative investors who are interested in safety of capital and high yield
with the opportunity of capital gains. Non-convertible debentures are better than fixed deposits and company
deposits can be liquidated before the due date. The choice between convertible and non-convertible debentures
and bonds depends on investor’s preferences and risk-taking ability. It can be said that convertible debentures
are being preferred by conservative investors because they are assured of a certain number of equity shares
on part/full conversion at the time of redemption. They also receive continued amount of interest till the time
of termination. SEBI has provided guidelines for convertible bonds; compulsory credit rating is required for
issuing such bonds in India.
To recapitulate:
l Convertible bonds provide equity shares at the time of conversion.
l An investor receives his principal amount with interest.
l A convertible bond consists of present value of the equity shares which will be received at the time
of conversion.
l It also contains the present value component of interest and principal payments which will be received
at termination.
11. Macaulay’s Duration of a Bond
It is useful to know the duration of the bond as these states the average life a bond. Duration is the
weighted average measure of a bond’s life. The various time periods in which the bond generates cash flows
are weighted according to the different proportions of the total value of the bond.
Example 9.10:
Face value : ` 1,000
Interest Rate : 10%
Years to maturity : 5
Redemption value : 1,000
Current Market Price : ` 850
Yield to maturity : 9%
Calculate Duration of bond.
Duration of this bond is:
Duration of a 10% Coupon
1 2 3 (4) = (2) × (3) (5) = (4)/P (6) = (1) × (5)
Year Cash Flow Present Value Present Value Present Value Duration
Factor at 9% Cash Flow Price
1 100 0.917 91.7 0.088 0.088

2 100 0.842 84.2 0.081 0.162
3 100 0.772 77.2 0.074 0.223
4 100 0.708 70.8 0.068 0.273
5 1100 0.650 715 0.688 3.441
P 0 = 1038.9 D = 4.187
Therefore, duration comes to 4.187 years. The bonds duration helps in showing how much its price will
change as a yield changes.
12. Accrued Interest
When bonds are purchased the seller will receive accrued interest from the buyer for the time that he was
holding the bond. This happens when bond is purchased between the semi annual interest payments. The seller
has a right to ask for the interest of the holding period. Interest for the number of days held is calculated
through the following formula:
Days sin ce last int erest payment

Accrued Interest = × Interest semi annual
Days between the last and next coupon payment
Example 9.11: If interest is 10% on the face value of ` 1,000 bond and interest is payable on March
31 and September 30 and a person sells the bond on June 30 what will be his accrued interest?
Solution:
The accrued interest will be for 3 months or 90 days.
90
× 500 = ` 250
180
This accrued interest will be calculated and adjusted between the buyer and the seller.
To sum up bond valuation models, it can be said that the strategies in bond management can help in
reducing risk due to changes in interest. The duration strategy can be used for neutralizing interest rate risk
through the process of immunization. The duration of the bond also helps in finding out the value of the bond
through realized yield. The maturity period of a bond can also be used. With strategies, maturities can be
lengthened, when interest rates are expected to fall, price to rise and the maturity should be reduced to shorten
length when the interest rate is expected to rise. The valuation of preference share is discussed below.
9.6 VALUATION OF PREFERENCE SHARES

Preference Shares give a fixed rate of dividend but without a maturity date. Preference shares are usually
perpetuities but sometimes they do have maturity dates also. The value of a preference share as a perpetuity
is calculated thus:
V = Value of preference share
D = Annual dividend per preference share
i = Interest rate on preference shares
D
V =
i
Example 9.12: A company sold its preference shares ` 50 last year. The company pays an annual
dividend of ` 4. The type of preference share is currently yielding 6%. What is the value of the company’s
preference shares?
Solution:
D
V =
i
4
V =
0.06
Yield on Preference Shares

Example 9.13: The yield on preference shares is calculated in the following manner:
D
i =
V
∴ If current price of a preference share is ` 60 and annual dividend is ` 4 what is the yield on preference
shares?
Solution:
D 4
i = =
V 60
9.7 VALUATION OF EQUITY SHARES

The valuation of bonds and preference shares showed that the rate of dividend and interest is constant
and reasonably certain. Bonds represent constant income flows with a finite measurable life and preference
stocks have constant return on their shares. The valuation of equity shares is comparatively more difficult. The
difficulty arises because of two factors.
(1) The amount of dividend and timing of cash flows expected by investors are uncertain.
(2) The earnings and dividends on common shares are generally expected to grow.
Valuations of shares are based on dividends and earnings.
9.8 VALUATION OF EQUITY SHARES – DIVIDEND CONCEPT

The value of the equity shares is equal to the present value of dividends expected by the shareholders plus
the present value of the sale price of the share when the equity share is sold. It is based on future dividends
and the sale price of an equity share. It comprises of two aspects of calculation for valuation: These are the
following:
l A stream of future dividends.
l Resale price of equity share when the investor sells the share.
The dividend approach assumes
l That dividends are paid annually by a company.
l The first dividend is received one year from the date of purchase or acquisition of the share.
l The sale of equity shares is at the end of the year.
1. Basic Valuation Model
The valuation of the equity share can be made through the following equation
D1 D2 D∞
P o = (1 + k )1 + (1 + k )2 + … + (1 + k )∞
e e e
If an investor expects to hold the share for two years and sell it the formula will be:
D1 D2 P2
Po = 1
+ 2
+
(1 + k e ) (1 + k e ) (1 + k e )2
Where P o = current price of equity share

D 1 = Expected dividend
k e = Required rate of return of equity share
P 2 = Price of share at year 2
The value of a common stock at any moment in time can be thought of as the discounted value of a series
of uncertain future dividends that may grow or decline at varying rates overtime.
2. One Year Holding Period
Equity stock valuation is easiest to start with when the expected holding period is one year. To the investor
the rewards from equity stock consist of dividends plus any change in price during the holding period.
Example 9.14: An investor buys a share at the beginning of the year for ` 100. He holds the stock for
one year. ` 5 in dividends is collected and the share is sold for ` 130. The rate of return achieved is the
composite of dividend yield and change in price (capital gains yield).
Solution:
D1 P1
P0 = 1 + k + 1 + k
e e
D 1 = Dividend to be received at the end of year one.

k e = Investor’s required rate of return or discount or (cost of equity capital)
P1 = Selling Price at the end of year one
P 0 = Selling price today
B = Retention ratio i.e., % of earnings retained
R = Rate of return on reinvestment.
5 130
Therefore, ` 100 = 1 + k + 1 + k
e e
135
1+k e = = 1.35
100
k e = 1.35 – 1.00 = 0.35 or 35%
The total rate of return achieved is 0.35 or 35%.
Example 9.15: At what price must we be able to sell the stock at the end of one year (if the purchase
price is ` 100 and the dividend is ` 5) in order to attain a rate of return of 40%?
A5 P1
` 100 = (1 + 0.40) + (1 + 0.40)
100 (1.40) = 5 + P 1
P 1 = 140 – 5 = 135
3. Multiple Years Holding Period
Suppose the buyer who purchases the share P holds it for 3 years and then sells. The value of the share
to him today will be:
D1 D2 D3 D4 P4
P0 = (1 + k ) + 2
+ 3
+ 4
+
e (1 + k e ) (1 + k e ) (1 + k e ) (1 + ke)4
The price at the end of the fourth year and all future prices are determined in a similar manner. The
formula for determining the value of the share at the present time can be written as follows:
D1 D2 Dn
P0 = (1 + k ) + (1 + k )2 + … (1 + k )n
e e e
It is obvious from the equation that the present value of the share is equal to the capitalized value of an
infinite stream of dividends D n in the equation is expected dividend. The investors estimate the dividends per
share likely to be paid by the company in future periods. These estimates are based on subjective probability
distributions. Thus, D n is expected values or means of these distributions. Calculating the rate that will solve
the equation is a tedious task requiring computation through trial and error method.
The valuation of equity shares through dividends can be:
(i) Constant dividends or zero growth in dividends
(ii) Constant growth in dividends
(iii) Variable growth in dividends
(iv) Valuation of share not paying dividends in some years
(i) Constant dividends or Zero growth in dividends

Valuation of an equity share in zero growth assumes that the dividend remains constant over the years.
Zero growth in dividends is likely to be the same over the years. D 1 = D 2= D 3 = D 4 = D. The value of equity
shares under this model is depicted through the rate of return of equity and the yearly dividend received. The
rate of return of the equity holders would be:
P 0 = D/k e
P 0 = Value of equity share
D = Annual dividend and
k e = Required rate of return
Example 9.16: A company declared a dividend of ` 5. Find the value of the share, if the expected rate
of return of the investor is 20% and dividend is expected to remain the same every year.
Solution:
P 0 = D/k e
5
P0 = = ` 25
0.20
Value of the share is ` 25.
(ii) Constant Growth in Dividends
A constant growth in dividends means that the growth remains the same in every year. Growth is represented
by g and dividend by D.
D 2 = D o (1+g) 2.
The valuation of the equity share under the constant growth model can be found out with the equation
D 0 (1 + g)1 D0 (1 + g)2 D 0 (1 + g)∞

P0 = + +
(1 + k e )1 (1 + k e )2 (1 + k e )∞
n
D 0 (1 + g)i
Or, P 0= ∑ i
i =1 (1 + k e )
D 0 (1 + g)
P0 = (k e − g)
D 1 = D 0 (1 + g)
D1
P0 = (k − g)
e
P 0 = Current market price

D 1 = expected dividend per share
k e = Cost of equity or return expected by shareholder
g = growth rate
D 0 = Dividend declared last year.
Example 9.17: A share that has a face value of ` 1 is expected to pay a dividend of 20% at the end
of year 1. Its growth rate in dividends is estimated to be 8%. If the investor has a required rate of return of
12%, what would be the value of the equity share?
Solution:
D1
P 0 = (k − g)
e
0.20 0.20
P 0 = (0.12 − 0.08) = 0.04
P0 = ` 5
Equity share is
(i) Positively co-related with growth rate
(ii) It is negatively co-related with required rate of return.
Constant growth model has a limitation because a firm cannot continue to have a constant growth in
dividends. Profitability increases or decreases and dividend behaviour is dependent on profits. To overcome this
limitation the variable growth is used to find out the value of the share.
The above equation can also be used to find out the equity capitalization rate or in other words the
D1
required rate of return of the investor. K e = P + g
0
(iii) Variable growth in dividends

Variable growth in dividends means that dividend growth may be different in different years. For the first
few years the dividend growth may be different to the next few years. For example growth rate in dividends
may be 3% for 3 years and then 6% for 5 years. It may again fall to 2% for the next 3 years.
This kind of problem can be solved through 4 steps.
Step 1: First find out the value of dividend at the end of each year.
Step 2: Find out the present value of the dividends by discounting at the required rate of return.
Step 3: Find out the value of the equity share at the end of the varying growth period.
Step 4: Add present value of the dividends to the present value of the share to get the value of the equity
share.
Example 9.18: Shivani received a dividend of ` 6 per share. Her expected rate of return is 10%. Find
out the value of a share, if the growth rate from year 1 to 3 years is 6%, 4th and 5th year it is 8% and in
the 6th year it is 9% constant.
Solution: Discounted value of dividends
Step 1:
Year Expected Dividend Discount Rate Present Value
@ 10% of Dividends
1 6.36 0.909 5.78
2 6.74 0.826 5.57
3 7.14 0.751 5.36
4 7.72 0.683 5.27
5 8.33 0.621 5.17
Present Value of dividends 27.14
Step 2:
Price of the share at the end of year 5 D 6 = 8.33(1 + 0.09) = 9.08
Step 3:
P 5 = D 6 / (k e – g)
= 9.08/ (0.10 – 0.09)
= ` 908
Present value of the share 908 × 0.621 = ` 563.86
Step 4:
Price of the share =563.86 + 27.14 = ` 591.00
(iv) Valuation of share not paying dividends in some years
When a firm is in a loss, it does not pay a dividend but resumes declaring a dividend once there is
sufficient profitability.
Example 9.19: A firm does not pay any dividend for the first 3 years and after that it makes a profit
and declares a dividend of ` 7 per share at a constant growth rate of 12%. The required rate of return is 14%.
Solution:
Step 1:
P3 = D 4 /(k e – g)
= 7/(0.14 – 0.12) = 7/0.02
= ` 350
This is the value of the share at the end of year 4.
Step 2:
This value is discounted at 14% to find out the present value.
P 3 × PVF 3, 14% = 350 × 0.675 = ` 236.25
Value of the share is ` 236.25
9.9 VALUATION OF EQUITY SHARES – EARNINGS CONCEPT

The value of the equity shares based on earnings of the firm are calculated because firms are interested
in growth through extension of their projects or through new projects. In this case the shareholders current
dividends will be affected, but they will get the benefit of capital appreciation. The retain earnings are used for
expansion purposes. The earnings per share can be calculated by the following methods:
1. Price Earnings Ratio
2. Intrinsic Value of a Share
3. Value Earnings Ratio
4. Walter’s Model
5. Gordon’s Model
1. Price Earnings Ratio (P/E Ratio)
The valuation of shares based on earnings is measured through the price-earnings ratio.
Accordingly, the value of the share = Earnings per Share (EPS) × Price Earnings Ratio (P/E).
EPS is calculated by taking profit after tax minus preference dividend divided by number of equity shares.
EPS = (PAT – Pref. Div.)/ No. of equity shares
Companies to show the value of their share use the P/E ratio for valuation of shares. They indicate the
ability of the firm to pay future dividends.
Example 9.20: The capital structure of a company is given below:
Equity share capital = ` 8,50,00,000.
Share premium = ` 45,00,000
Reserves = ` 1,00,00,000
Net worth = ` 10,00,00,000
The profit after tax is ` 5,00,00,000 and the face value of the share is ` 2
Find out the price earnings ratio.
Solution: EPS = 5,00,00,000/ 4,25,00,000= ` 1.176

No. of equity shares = 8,50,00,000/ 2 = ` 4,25,00,000
P/E ratio is 2.4.
Value of the shares = 4,25,00,000 × 1.176 = ` 4,99,80,000
The P/E ratio is used by the company to find out the value of its shares. It is used because it provides
price of the share on a particular date. A high P/E ratio gives the projection of a good performance of a
company to third parties. It improves the image of the company as investors feel that the company has good
future prospects through high returns. A high P/E ratio does not reflect that the future earnings will be better
than the current earnings. P/E ratios are used to indicate the ability of a firm to pay dividends in future. The
price of a share can be forecast by using the P/E ratio for valuation of shares based on earnings of the
company.
The multiplier is a short-cut approach to find out the present value. The security analyst estimates earnings
per share for the year ahead. He divides this figure into the current market price of the stock and the result
is an earnings multiplier. In other words multiplier and price earnings ratio (P/E) are synonymous.
Current Market Pr ice

Earnings Multiplier or P/E ratio = Estimated Earnings per Share
High multipliers are associated with high earnings growth. The multiplier, i.e., the P/E is determined by
the riskiness of the firm and the rate of growth. The price earnings approach is also determined statistically.
Current P/E on stock is also determined by some standard of comparison. The security should be analyzed by
ascertaining the means or media P/E as well as the range of the stock over a period of time. Weight is given
to a greater extent on the past occurrence this shows the boundaries or the range within which the P/E should
fall. The analyst can also determine within which the P/E should fall and the analyst can also determine
whether stock is selling at the higher end of P/E or upper limit of expectations. P/E/s are different for each firm
even within the same industry.
The price earnings ratio can be calculated in the following manner:
D/E
P/E = K − g
e
This equation takes the broad determinants of the prices of equity shares— the factors that are measured
are earnings, growth and time value of money, risk and dividend policy. These factors are measured through
the use of regression equations. As early as 1935, J.W. Meader tested his regression equation on actual stock
prices covering the year 1933. He found that prices were close to what the equation said that they would be.
Later, Meader discarded his regression analysis because he found that his multipliers did not remain constant
between one year and another. However, regression analysis was recognized as a technique, which had many
other users. Analysts are interested in finding out past relationships even if they cannot use it for finding out
future prices. Chapter 7 further deals with valuation of equity shares through fundamental analysis. It discusses
accounting method of valuing equity shares as well as through ratio analysis. It also projects market value, book
value, intrinsic price and price earnings ratio of equity.
When cash dividend rises, value of share rises.
2. Intrinsic Value
Intrinsic value = Earnings per share × price/earnings ratio
Net income after taxes
EPS = Number of shares outstanding
Price per share

P/E =
EPS
3. Value Earnings ratios

Present value per share
Value Earning Ratio V/E =
EPS
Cash dividends − EPS
= Discount rate − Growth rate
Relationship of Value Earnings and Price Earnings Ratios

Pr ice per share
Price Earnings ratio, P/E = Earning per share
(a) If P/E ratio is larger than V/E ratio the stock is overpriced. Investor should sell before price falls.
(b) If P/E ratio is smaller than V/E ratio, the stock is underpriced. Investor should purchase stock and
expect price rise.
(c) If P/E ratio is equal to V/E ratio the stock price is correctly valued. Prices are not expected to change
significantly.
Note: P/E Ratio is also called ‘Earnings Multiplier’.
Example 9.21: A company is expected to pay a dividend of ` 4 per share; the dividends are expected
to grow perpetually on a growth rate of 9%. Find the company’s shares price today, if the market capitalizes
dividend at 12%.
D0 4
P 0 = K − g = 0.12 − 0.09 = 133.33
e
4. Walter’s Model
The choice of an appropriate dividend policy influences the value of the firm. 5
The Model gives the relationship between the return on the firms’ investment or internal rate of return.
‘r’ and it’s cost of capital or the required rate of return ‘k’.
The model explains three situations r > k, r = k and r < k.
(i) Situation I: When r > k it is a growth firm and the optimum dividend payout ratio is when dividend
is zero. It means that the firm is able to earn a rate of return higher than its cost of capital. In this
situation it should retain its earnings as it can provide better returns than an individual shareholder
can invest on his own. When (r > k) price per share increases as dividend payout ratio decreases.
When such firms plough back the entire earnings within the firm and do not give dividends, the market
value of the shares will be maximized.
(ii) Situation II: When r = k it is considered to be a normal firm. Earnings may be retained or
distributed. The firm is indifferent. This is because for all D/p ratios between 0 and 100 market price
of shares will remain constant. Therefore, price per share does not vary with changes in dividend
payout ratio.
(iii) Situation III: When r < k the shareholders will be able to earn a higher return by investing the
funds elsewhere in their individual capacity. In this situation a 100% D/p ratio will be an optimum
dividend policy. When r < k the rate of return is less than cost of capital, the price per share increases
as dividend payout ratio increases.
Assumptions
1. Financing is done through retained earnings and external financing is not used.
2. R and k are constant. With additional investments business risk does not change.
3. There is no change in the key variables, earnings per share (E) and dividends per share (D)
5. Walter J.E. – Dividend Policy: Its influence on the value of the enterprise, Journal of Finance, 18th May 1963, P-280-291.
4. The firm has a perpetual life.

5. There are no taxes to be paid by the company.
r
D+ (E − D)
ke
P =
ke
P = prevailing market price of share
D = dividend per share
E = earnings per share
r = rate of return on the firm’s investment
Walter’s Model
Example 9.22: The following information is provided k e= 20%, earnings per share is ` 5, calculating
using Walter’s model the value of the share when expected return is 25%, 20% and 10%. And the dividend
is ` 5 and ` 4.
r > k r = k r < k
For example:
r = 25% r = 20% r = 10%
k = 20% k = 20% k = 20%
E = ` 5 E = ` 5 E = 5
1. D = ` 5 D = ` 5 D = ` 5
5 + (0) 0.25 / 0.20 5 + (0) 0.20 / 0.20 5 + (0) 0.10 / 0.20
p = p = p =
0.20 0.20 0.20
= 25 = 25 = 25
2. D = ` 4 D = ` 4 D = ` 4
4 + (1) 0.25 / 0.20 4 + (1) 0.20 / 0.20 4 + (1) 0.10 / 0.20
p = p = p =
0.20 0.20 0.20
= 26.25 = 25 = 27.5
5. Gordon’s Model
Gordon’s model agrees with Walter’s model on the fact that dividend is relevant. According to this model
dividend policy is related to the market value of the firm. It is based on the following assumptions:
1. The firm is an all equity firm.
2. No external financing is available. Like Walter’s model, this model also assumes retained earnings for
financing growth and expansion.
3. Gordon’s model and Walter’s model both are an agreement that dividend policy is relevant with
investment policy.
4. The appropriate discount rate K e remains constant. Thus, Gordon’s model also ignores the effect of
change in the firm’s risk class and its effect on K.
5. The firm and its stream of earnings are perpetual.
6. Corporate taxes do not exist.
7. The firm’s retention ratio b (E – E)/E is constant. Thus, the growth rate g = r is constant.
8. K e = br = g. If this condition is not fulfilled there can be no meaningful analysis.
Gordon’s model states that dividend policy affects the value of the firm in all conditions even when r =
k. This view is based on the fact that under conditions of uncertainty investors would prefer a firm which gives
dividend rather than a firm which does not pay dividend. The value of the share of the firm paying dividends
would, be higher than a firm which retains dividends because retention is risky. Investors argue that ‘a bird in
hand is worth two in a bush. 6
6. Krishman J.E. Principles of Investment, McGraw-Hill 1933, P-77

In two identical firms, a firm paying dividends will have a higher value. Investors would be ready to pay
more for a firm paying dividends
The formula for calculating price of the share as per Gordon’s Model
E(1 − b)
P = k − br
e
P = Price per share

E = Earnings per share br = g = growth rate
b = Retention ratio D/P = Ratio = 1 – b
1 – b = D/P, i.e., percentage of earnings distributed as dividends
k e = Capitalization rate cost of capital
r = Rate of return on investments
Example 9.23: Calculate the price of a share through Gordon’s model when k e = 8%, rate of return =
10%, 8%, 5%, the earnings per share are ` 8 and the retention ratio is 40% and 60%.
Answer: When r > k, price of the share = ` 120, ` 160 when r = k, price of the share = ` 100,
and when r < k price of the share = ` 80, ` 64.
Growth firm Normal firm Declining firm
r > k r = k r < k
r = 10% r = 8% r = 5%
k = 8% k = 8% k = 8%
E = 8 E = 8 E = 8
b = 0.4 b = 0.4 b = 0.4
(0.60) × 8 (0.60) × 8 (0.60) × 8
P = 0.08 − (0.40) (0.10) P = 0.08 − (0.40) (0.08) P = 0.08 − (0.40) (0.05)
= ` 120 = ` 100 = ` 80
b = 0.6 b = 0.6 b = 0.6
(0.40) × 8 (0.40) × 8 (0.40) × 8
P = 0.08 − (0.60) (0.10) P = 0.08 − (0.60) (0.08) s P = 0.08 − (0.40) (0.05)
= ` 160 = ` 100 = ` 64
9.10 CAPITAL ASSET PRICING MODEL (CAPM MODEL): SHARE VALUATION

The CAPM model is used to take decisions in conditions of risk and uncertainty. Equity shares are risky
securities. There are two kinds of risks around them. These are systematic and unsystematic risk. Systematic
risk is the market risk and cannot be eliminated, but a careful choice of securities helps to minimize the risk.
The CAPM model provides a solution to this problem by finding out beta risk through calculation by applying
a formula. The major factors in share valuation consist of dividends, growth and return. Due to risk the return
on equity shares is uncertain. The risk has to be adjusted in the valuation process through the required rate
of return. The market rate of risk or risk premium depends on (Beta) thus the market model is used for
adjustment of risk. It consists of the general model and the CAPM model as follows:
k e = I f + r p (General model)
k e = I f + beta (k m – I f ) (CAPM model)
Where, I rf = Interest risk free rate
k m = Market rate of return
Beta = Beta
r p = Risk premium
k e = Required rate of return
I f which is the risk free rate and k m which is the market rate of return, are both, constant in the above
models. The required rate of return or k e depends on the risk premium that is represented by r p and beta in
the above models. When the market risk increases then the required rate of return will also increase.
Example 9.24: A firm pays a dividend of ` 3 with a 10% growth rate, the risk free rate is 6% and market
rate of return is 12%. The firm has a beta factor of 1.50. (a) What would be the value of the share?
(a) If beta increases to 1.5 the value of the share will be the following:
Solution:
k e = I rf + beta (k m – I rf )
k e = 0.06 + 1.50(0.12 – 0.06)
= 0.06 + 0.09 = 0.15%
And the value of the share using the constant growth model is
3.3
D 1 = 3(1 + g 10 ) = 0.15 − 0.10 = 66.
(b) If beta factor increases to 2 then k e will be

k e = I rf + beta (k m – I -rf)
k e = 0.06 + 2(0.12 – 0.06)
= 0.06 + 0.12
= 0.18 or 18%
And the value of the share using the constant growth model is
P o = D 1 /(k e – g)
= 3.3/(0.18 –0.10)
= ` 41.25
SUMMARY
r This chapter is a background to the study of security analysis and portfolio management. It defines and
distinguishes between the terms security analysis and portfolio management.
r It establishes that the study of investments is based on three elements return, risk and time.
r Within the framework of these factors, there are different schools of thought which analyze investments.
r The three important approaches or schools are: (a) Fundamental (b) Technical and (c) Modern approach
towards portfolio management who also advocate the efficient market theory.
r A study of investments is almost impossible without learning the basic rules of compounding and discounting.
r The future value, the present value techniques and annuities have been discussed. These tables have been
given in the appendix as ready reference for the investor.
r The Basic Valuation Models for bonds, preference shares and equity shares have been introduced which
provide an insight into the analysis, which follows.
r The next chapter will discuss the factors of risk and return before the various approaches and further study
of stocks are detailed.

Match the following
1. Face Value (a) Coupon rates
2. Maturity value (b) Fixed Income
3. Bonds (c) Par Value
4. Interest rate (d) End value
5. Risk (e) Returns
Answers: 1. (c), 2. (d), 3. (b), 4. (a), 5.(e)
QUESTIONS
1. Write notes on (a) Zero interest fully convertible bonds (b) bond indenture (c) Intrinsic Value of bond.
2. Distinguish between (a) YTM and YTC, (b) Current yield and Holding period yield, (c) Coupon rate and required
rate of return.
3. What is credit rating? How is it relevant for investors?
4. What is YTM? Discussed its importance. How is it calculated?
5. ‘Equity shares are a good investment’. Discuss.
6. What are the features of an equity stock? Do you think an investor should purchase equity shares or invest in
Bonds?
7. In the stock market in India, if there is a fall in the prices of shares and a downward trend in the stock market
what are the options before an investor? What would you advise an investor?
8. Explain the importance of earnings, dividends and required rate of return in estimating the value of equity stock.
9. Discuss the different approaches in valuation of equity shares.
10. How does intrinsic value of a share provide investor information for taking decisions of investment?
11. What is a P/E ratio? How is it different from V/E ratio?
12. Write notes on
(i) Walter’s model for price of shares
(ii) Price Earnings Ratio
(iii) CAPM Model
(iv) Constant Dividend Model
(v) Gordon’s Model
ILLUSTRATIONS
Illustration 9.1: A bond of ` 5,000 bearing coupon rate of 10% and redeemable in 10 years is being traded at
` 5,300. Find the YTM of the bond.
Solution:
Method (1):
 Int + (RV − B 0 )/ N 
Approximate yield =  (RV + B )/ 2 
 0 
500 + (5,000 − 5.300)/10 500 − 30

= =
(5,000 + 5,300)/ 2 (10,300)/ 2
470
= = 0.0912
5,150
YTM = 9.12%
Alternative Method (2)
10
i RV
(i) 5300 = ∑ 1 + YTM + 1 + YTM
i =1
10
500 5000
5300 = ∑ (1 + YTM)i +
(1 + YTM)10
i =1
Or = 500 ( PVAF ni) + 5000 (PVF YTM 10)

at YTM =10% the value is 500 (6.145) + 5000 (0.386) = 5002.5
at YTM = 9% the value is 500 (6.418) + 5000 (0.422) = 5319
5319 − 5300 19
by interpolation = YTM =9% + 5319 − 5002.5 = 9% + = 9.06%
316.5
The answer differs slightly by the different methods. However, it is not significantly different. Method (i) answer is
9.12 and method (ii) is 9.06%. Any method may be used to solve this problem.
Illustration 9.2: A bond has a face value of ` 1000. It has a 10% coupon rate and a maturity period of 5 years.
What would be the price of the bond, if the yield declines to 8%?
Solution:
The price of the bond = ` 100 (PVAF 8% 5 years ) + 1000 (PVF 8% 5 years )
= 100 (3.993) + 1000 (0.681)
= 1080.3 Ans.
Illustration 9.3: A bond has a face value of ` 1,000. The coupon rate is 12% and it is redeemed after 10 years
at par. Find out the value of the bond, if required rate of return is 14%.
Solution:
Value of the bond is = 120 (5.216) + 1000 (0.270)
= 625.92 + 270
= 895.92 Ans.
Illustration 9.4: A bond has a par value of ` 1000. It has a coupon rate of 9%. It matures after 8 years. Its current
Market Price is ` 800. What is the yield to maturity of the bond?
Solution:
800 = 90 (PVAF 9%, 8 years) + 1000 (PVF 9%, 8 years )
 90 + (1000 − 800)/ 8 
YTM =   = 0.1277
 (1000 + 800) / 2 
= 12.77% Ans.
Illustration 9.5: The following information is available of a bond:
The face value is ` 1,000. It has an expected life of 5 years. Its coupon rate is 8% and its expected yield is 10%.
At what price should an investor buy the bond, if the interest is payable half-yearly.
Valuation of bond when interest is payable half yearly:
V = I/2(PVAF ni ) + RV(PVF ni )
(i) The life of the bond is double to 10 years and int. is paid semi annually.
(ii) Interest is also calculated semi annually
= 40 (PVAF 5,10% ) + 1,000 (PVF 5,10% )
= 40 (7.722) + 1,000 (0.614)
= 308.88 + 614
= 922.88
The value of the bond when interest is paid half yearly is 922.88. If interest was to be paid yearly the number of
years of the life of the bond would become 5.
V B = 50 (PVAF 10,5 ) + 1,000 (PVF 10,5)
= 80 (3.791) + 1,000 (0.621)
= 303.28 + 621
= 924.28
Since expected yield is 10% whereas coupon rate = 924.28 is lower at 8% value of bond will be lower than face
value.
Illustration 9.6: An investor wants you to evaluate the following bond.
Face value = 100
Coupon value = 12%
Maturity 3 Years
(i) The investor wants a yield of 15%. What is the maximum price that he should pay for it?
(ii) If the bond is selling for 95 rupees, what would be his yield?
Solution: The price which in the following way:
B o = ` 12 X PVAF (15,3) + ` 100 × PVF (15,3)
= ` 12 X 2.283 + ` 100 × 0.658
= 27.396 + 65.8
= ` 93.196 or ` 93.20
If the bond is selling @ ` 95 which is higher than the value the YTM would be less than 15%.
At 14% the value = ` 12 (PAVF 14,3 ) + 100 X PVF(14,3)
= ` 12 × 2.322 + 100 × .675
= 27.864 + 67.5
= 95.364
The value almost equal to ` 95 or selling price of bond. The YTM will be 14%.
Illustration 9.7: An investor has the following information of a bond:
Face value = 1,000
Coupon rate = 10%
Time to maturity = 10 years
Market price = 1250
Callable in 5 years = 1200
(i) Find the yield to maturity (YTM)
(ii) and yield to call (YTC)
Solution: Calculation of YTM
` 1250 = ` 100 X PVAF (10,10) + ` 1,000 X PVF (10,10)
(i) at 10% the value is = ` 100 × 6.145 + 1,000 × 0.386
= 614.5 + 386 = 1,000.50
(ii) at 9% the value is ` 100 × 6.418 + 1,000 × 0.422
= 641.8 + 422 = 1063.80
(iii) at 8% the value is ` 100 × 6.710 + 1,000 × 0.463
= 671 + 463 = 1134
(iv) at 7% the value is ` 100 × 7.024 + 1,000 × 0.508
= 702.4 + 508 = 1210.4
(v) at 6% the value is ` 100 × 7.360 + 1,000 × 0.558
= 736 + 558 = 1294
Interpolation between 6% and 7%
1.294 – 1,250
YTM = 6% + 1,294 − 1,210.4 × 1
44
= 6% + ×1
83.6
= 6% + 0. 5263
= 6.5263%
Yield to Call.
At 7% ` 1,250 = ` 100 X PVAF (k, 5) + 1200 X PVF (k, 5)
= ` 100 × 4.100 + 1200 × 0.713
= 410 + 855.6 = 1265.6

At 8% ` 1,250 = ` 100 X PVAF (k, 5) + 1200 X PVF (k, 5)
= 100 X 3.993 + 1,200 X 0.681
= 399.3 + 817.2
= 1216.5
1,265.6 – 1,250
YTC = 7% + 1,265 − 1,216.5 × 1
15.6
= 7% + = 7.31%
49.1
Illustration 9.8: A bond of the face value of ` 1,000 has a coupon rate of 10% and is redeemable in 5 years at
par. It is being traded in the market at ` 1,200 currently (i) find the YTM of the bond (ii) find the YTM if semi-annual
interest is given.
Solution:
(i) YTM of Annual Interest
Method (i) Shortcut Method:
I + (RV – B 0 )/ n
YTM = (RV + B 0 )/ 2
Where, RV = Redeemable Value

B 0 = Current market price of bond
n = Number of years of life of bond
I = Interest
10 + (1,000 – 1,200)/ 5
YTM = (1,000 + 1,200)/ 2 = 0.0545 = 5.45%
Method (ii) Trial and Error Method:

YTM = I (PVAF ni ) + RV (PVF ni)
` 1,200 = 100 (PVAF ni) + 1,000 (PVF ni)
At 5% YTM = 100 (4.329) + 1,000 (0.784)
= 432.9 + 784 = 1216.90
At 6% YTM = 100 (4.212) + 1,000 (0.747)
= 421.2 + 747 = 1168.20
Note: If 1,200 did not lie between 5% and 6% rate of interest then by trial and error 3% and 2% values will have
to be worked upon before interpolation can take place.
In the above calculation at 5% the value is 1216.59 and at 6% the value is 1168.20. Therefore, 1,200 which is the
market price lie between the two values. The next step is to interpolate.
YTM = = 5.347%
Illustration 9.9: A bond having a coupon rate of 10% is redeemable at par in 10 years. Find the value of the bond
of
(i) If required rate of return is 10%, 12% or 14%.
(ii) If required rate of return is 12% and maturity period is (a) 8 years (b) 12 years.
(iii) Required return is 14% and redeemable at ` 900 and` 1,100 after 10 years.
Solution:
int RV
B0 = +
(1 + k) (1 + k)n
i
or B 0 = I (PVAF i, n ) + RV(PVF i, n)
PVAF (i, n) = Present value maturity factor at the rate of interest ‘i’ and number of years ‘n’.
RV = redeemable value
PVF(i, n) = present value factor for given rate of interest ‘i’ and number of years ‘n’.
These values are given in the tables in the Appendix.
(i) The value of the bond when required rate of return is 10%, 12%,14%.
If required rate is 10%
B 0 = 100 (6.145) + 1,000 (0.386)
= 614.5 + 386
= 1,000.50
B 0 = 100 (5.650) + 1,000 (0.322)
= 565 + 322
= 887
B 0 = 100 (5.216) + 1,000 (0.270)
= 521.6 + 270
= 791.6
(ii) If required rate of return is 12% and maturity is (a) 8 years (b) 12 years.
Maturity = 8 years.
B 0 = 100 (4.639) + 1,000 (0.351)
= 463.9 + 351
= 814.9
If maturity is 12 years
B 0 = 100 (5.650) + 1,000 (0.208)
= 565.0 + 208
= 773
(iii) When redemption is ` 900 and required rate is 14%, coupon rate is 10%
B 0 = 100 (5.216) + 900 (0.270)
= 521.6 + 243
= 764.6
If redemption is ` 1100
= 100 (5.216) + 1,100 (0.270)
= 521.6 + 297
= 818.6
Value of the bond is a factor of required rate of return of the investor, coupon rate of interest and redemption value.
Illustration 9.10: Calculate the value and duration of the following bond:
Bond ‘X’ has a maturity value of 10 years at 8% rate of interest per year and maturity value of ` 1,000.
Solution:
Time Cash Flow PV at 8% PV × Time × Cash Flow
1 80 0.926 74.08
2 80 0.857 68.56
3 80 0.794 63.52
4 80 0.735 58.80
5 80 0.681 54.48
6 80 0.630 50.40
7 80 0.583 46.64
8 80 0.540 43.20
9 80 0.500 40.00
10 1080 0.463 500.04
999.72
999.72
=
1, 000
Duration = 0.9997
Illustration 9.11: Calculate yield to maturity and intrinsic value of the bond when the following data is provided.
Face value of the bond ` 10,000
Market Value ` 8,790
Coupon Rate 8%
Investor Yield 10%
Time to Maturity 4 years
Should the investor buy the bond?
Solution:
YTM 8,790 = I (PVAF ni) + RV (PVF ni )
At 11% = 800 (3.102) + 10,000 (0.659) = 9071.60
At 12% = 800 (3.037) + 10,000 (0.636) = 8789.60
Since at 12% the bond is approximately the same price as the market value YTM = 12%.
The intrinsic value of the bond
at 10% = 800 (3.170) + 10,000 (0.683) = 9366
The intensic value of the bond is higher than the market value. So the investor should buy the bond.
Illustration 9.12: A company has equity shares of the face value of ` 10. It just paid an annual dividend of ` 4.
The dividend is expected to grow at 9% per annum perpetually. The company is quite consistent. It has an equity
capitalization rate of 15%.
(i) What is the intrinsic value of the shares?
(ii) If the equity capitalization rate is 14%, what would be the value?
Solution:
(i) D 0 = ` 4
g = 9%
D 1 = H (1 + 0.09) = 4.36
D1 A 4.36
P 0 = ke − g = 0.15 − 0.19 = ` 72.66
(ii) If the company belongs to the risk class of 14% the value would be
A 4.36
P 0 = 0.14 − 0.09 = ` 87.2
Illustration 9.13: A company paid a dividend of ` 2. It is expected to grow at 6% per annum perpetually. What
is the value of the share when:
(i) Equity capitalization rate is 14%
(ii) Equity capitalization rate is 15%
(iii) When growth rate is 7% and equity capital is 15%
(iv) When equity capitalization rate is 14% and growth is 9%
Solution: D 0 = ` 2
Growth = 6%
k e (cost of equity) = 14%
∴ D 1 = 2 (1 + .06) = 2.12
(i) When cost of equity is 14%
D1 2.12
P 0 = k − g = 0.14 − 0.06 = ` 26.50
e
(ii) When cost of equity is 15% and growth rate = 6%
D1 2.12
P0 = =
k e − g 0.15 − 0.06 = ` 23.50
(iii) When growth rate is 7% and equity capital rate is

D 1 = 2 (1 + 0.07)
D1 2.14
P 0 = k − g = 0.15 − 0.07 = ` 26.75
e
(iv) When equity capitalization rate is 14% and growth rate is 9%.
D 1 = 2 (1 + 0.09) = 2.18
D1 2.18
P 0 = k − g = 0.14 − 0.09 = ` 43.6
e
Illustration 9.14: The earnings per share of a company is ` 2. The shareholders expect a P/E ratio of ` 40 as
appropriate for the company. What would be price of the share? If the shares ` 50 market price is currently buy some more
stocks of the company?
Solution:
EPS = ` 2
PE = ` 40
Value = 40 × 2 = ` 80
The value of the share is ` 80 but it is available for ` 50. The shareholder should certainly increase his shares by
purchasing them from the market.
Illustration 9.15: A company’s shares are selling at the market rate of ` 50. The company is expected to pay a
dividend of ` 4 after 1 year with a growth rate of 10%. Find out required rate of return of equity shareholders.
Solution:
D1 D1
P 0 = k − g or ke = P + g
e 0
4.00
= ` + 0.10
50
= 0.08 + 0.10
= 0.18% or 18%
Illustration 9.16: (i) A company paid a dividend of ` 15 per share. For the next two years there would not be any
dividend payment, as the company intends to go in for major expansion programme. After 3 years it will pay a dividend
of ` 12 per share and thereafter the company proposes a dividend growth of 13% per annum.
(ii) If the expansion programme does not take place the company has promised to continue payment of dividend for
the next two years at the present rate of 8% per annum. The return by equity shareholders is 18% and no change will occur
with expansion.
Calculate the value of the firm’s shares in (i) and (ii) situations above.
Solution: (i) The price of the share is
D0 (1 + g) 15(1 + 0.08)
P0 = =
ke − g 0.18 − 0.08
15(1.08) 16.2
= = = ` 162.00
0.05 0.10
Proposed Position:
(ii) The share price forecast of growth in dividends = Share Price at end of year 2.
D3
P2 = k − g
e
12
= 0.18 − 0.13 = ` 240.00
The present value of the price is = ` 240.00 × (1÷1.18) 2
= ` 240.00 × 0.7181
= ` 172.36
Therefore, the price is lower in the proposed situation so expansion programme is not suggested.
Illustration 9.17: A share has a face value of ` 10. It is expected to pay a dividend of 15% at the end of year
1 and growth rate in dividend is estimated to be 5%. If the shareholders required rate of return is 16%. What would be
the value of the equity share?
Solution:
0.15
P 0 = 0.16 − 0.05 = 13.6
Illustration 9.18: A firm does not pay any dividend for 3 years. After this gap it will pay a dividend of ` 5 with
a continuous growth of 10% perpetually. Calculate value of the share when required rate of return is 14%.
Solution: As per constant growth model,
D4 5
P 3 = k − g = 0.14 − 0.10 = 125
e
This is the value at the end of 3 years.

P o = P 3 × PVF (14%, 3 years) = 125 × (0.675) = ` 84.37
The intrinsic value of the share is ` 84.37
Illustration 9.19: An investor has expected rate of return of 25% from the following shares which one should he
choose?
Name of Shares Expected Dividend Price of Share on

01.04.2005 01.05.2006
X 35% 100 130
Y 15% 40 110
Z 10% 350 450
Solution:
P(t + 1) – P(i) + D × 100

Holding period return = P1
130 – 100 + 3.5 × 100

X = = 33.5%
100
110 – 40 + 1.5 × 100

Y = = 178.75%
40
450 – 350 + 1.0 × 100

Z = = 28.85%
350
The investor may buy all three stocks, as his required rate of return is 25%. All the stocks are giving at a rate of return
higher than his expectation.
Illustration 9.20: A firm has paid a dividend of ` 5 per share last year. The growth in the dividends is expected
to be 5% per annum. Determine the estimated market price of the equity share, if growth rate of dividend (i) rises to 10%
and (ii) falls to 2% (iii) Find the present market price of the share, if required rate of return of the investor is 15%.
Solution:
(i) The company paid ` 5.00 as dividend last year
(ii) Growth rate = 50%
(iii) Current dividend D 1 with growth rate of 5% will be
= D o (1 + g) = ` 5.25
D1 5.25
(i) Share Price = P o = k − g = 0.15 − 0.05 = 52.50
e
(ii) If growth rate rises to 10%

Dividend of current year would be = ` 5.50
5.5 5.5
Share Price = 0.15 − 0.10 = 0.05 = ` 110.00
If growth rate falls to 2% current year dividend will be

= D o (1 + g)
= 5 (1 + 0.02) = 5.1
D1 5.1
Share Price = k − g = 0.15 − 0.12 = ` 39.23
e
Illustration 9.21: A company pays a dividend of ` 4.00 per share. Dividends grow at 9% per annum and equity
capitalization rate of the company is 12%. Find out PE Ratio, if EPS of the company is ` 6.00.
Solution: The value of the share in the constant growth model is
D1
P0 = k − g
e
4(1 + 0.09) 4.36

= 0.12 − 0.09 = 0.03 = 145.33
∴ PE ratio for the company is ` 145.33

Illustration 9.22: The current market price of a share is ` 150 and expected to be 180 after 1 year. Dividend after
one year is ` 7. Find out equity capitalization rate.
Solution:
As per discounted cash flow model
D1 V1 P1
P 0 = (1 + k )1 + (1 + k )1
e e
7 180
150 = (1 + k )1 + (1 + k )1
e e
7 + 180 187
ke = −1 = − 1 = 24.66
150 150
Illustration 9.23: A company has declared a dividend of ` 3.00 receivable at the end of the current year. The
earning of the company are growing at 12%
(i) What is the intrinsic value of this share? The required rate of return or cost of equity capital is 15%.
(ii) What would be the investors holding period gain, if the investor purchases the share from the market now and
sells it after 1 year after receiving the dividend?
(iii) What is the dividend yield of this share?
Solution:
D 1 = P o (1 + g)
= 3 (1 + 0.12) = 3.36
D1 3.36
P 0 = k − g = 0.15 − 0.12 = ` 112.00
e
If market price is the same and the share is purchased at ` 112.00. After 1 year market price will be
P 1 = P o (1 + g)
= 112(1+0.12)
= ` 125.44
Dividend 3.36
Dividend Yield = Cost of share × 100 = 112 × 100 = 3%
Capital gain = 125.44 – 112.00

= 13.44
Holding Period
Total Re turn 3.36 + 13.44

Return = Cost of Share = 112
× 100
= 15%
Illustration 9.24: Mr. Nanda wishes to invest some of his funds in a company. His analyst have advised him to
buy shares of a company which has given a current dividend of ` 3.00. Dividends are expected to grow at 20% for 15
years and 8% perpetually. Find out the value of the equity shares. The required rate of return of Mr. Nanda is 10%.
Solution:
Dividends are expected to grow at 20% per annum for 10 years and 8% thereafter the value of the share will be
calculated in two steps:
D 1 = 3 (1 + 0.2) = 3 × 1.2 = 3.6
Step 1:
Present value of dividends for 15 years.
Year Dividend Growth 20% PVF @ 10% Present Value

1 3.6 0.909 3.2724
2 4.32 0.826 3.5683
3 5.18 0.751 3.8902
4 6.22 0.683 4.2483
5 7.46 0.621 4.6327
6 8.95 0.564 5.0478
7 10.75 0.513 5.5147
8 12.89 0.467 6.0196
9 15.48 0.424 6.5635
10 18.57 0.386 7.1680
93.42 49.92555
D 1 = 3 (1 + 0.20) = 36
Total dividends of ` 93.42 are expected from the company in the next 10 years whose present value @ 10% is
` 49.92
Step 2:
The value of the equity share at the end of the 10 th year depends upon and is as follows.
D 11 = D 10 (1 + 0.08)
=18.57 (1 + 0.08) = ` 20.0556 or = ` 20.26
D11 20.06
The share price is = k − g = 0.10 − 0.08 = ` 1,003.00
e
` 1003.00 will be realized after 10 years. Therefore the present value this amount at 10% (Expected rate of the
investor) is 1003 × 0.386 ` 387.16
∴ the value of the share is the sum of the present value of future dividend and the present value of expected price
at the end of year 10 is value = 49.92 + 387.16 = 437.08
Illustration 9.25: The following information is available. EPS = ` 10, k e = 10%. Assume the rate of return on
investment expected by the shareholders (r) = 15%, 10% and 6%. Show the effect of dividend policy on the market price
of a share using Walters Model when payout ratio is 0, 40%, 80% and 100%.
Solution:
Growth Firm Normal Firm Declining Firm

r < k r = k r > k
r = 0.15 r = 0.10 r = 0.06
k e = 0.10 k e= 0.10 k e = 0.10
E = 10 E = 10 E = 10
Payout Ratio 0%
(a) D = ` 0 D = ` 0 D = ` 0
0 + (0.15 / 0.10)(10 − 0) 0 + (0.10 / 0.10)(10 − 0) 0 + (0.6 / 0.10)(10 − 0)

P= P= P=
0.10 0.10 0.10
= ` 150 = ` 100 = ` 60
Payout Ratio 40%
(b)D = ` 4 D = ` 4 D = ` 4
4 + (0.15 / 0.10)(10 − 4) 4 + (0.10 / 0.10)(10 − 4) 4 + (0.06 / 0.10)(10 − 4)

P= P= P=
0.10 0.10 0.10
= ` 130 = ` 100 = ` 76
Payout Ratio 80%
(c) D = ` 8 D = ` 8 D = ` 8
8 + (0.15 / 0.10)(10 − 8) 8 + (0.10 / 0.10)(10 − 8) 8 + (0.06 / 0.10)(10 − 8)

P= P= P=
0.10 0.10 0.10
= ` 110 = ` 100 = ` 92
Payout Ratio 100%
(d)D = ` 10 D = ` 10 D = ` 10
10 + (0.15 / 0.10)(10 − 10) 10 + (0.10 / 0.10)(10 − 10) 10 + (0.06 / 0.10)(10 − 10)

P= P= P=
0.10 0.10 0.10
= ` 100 = ` 100 = ` 100
Illustration 9.26: The following information is given. Calculate the price of the share according to Gordon’s Model
and show that dividend policy has an effect on the price of the share. EPS = ` 10, DP ratio = 40%, 60% and 90%.
r = 15%, 10% and 6%, Cost of capital is 10%. Calculate the price of the share and show that dividend payout has an
effect on the price of the share in a growth firm when r > k, normal firm when r = k and declining firm when r < k.
Solution:
Dividend Policy and Price of the share
r > k r = k r < k
r = .15 r = .10 r = .06
k = .10 k = .10 k = .10

E = ` 10 E = ` 10 E = ` 10
Growth firm Normal firm Declining firm
D/P Payout Ratio (1 – b) = 40% Retention Ratio b = 60%
G = br = 6 × .15 g = br = 6 × .10 g = br = 6 × .06
= .09 = .06 = 0.36
10(1 – .6) 10(1 – .6) 10(1 – .6)

P = .10 − .09 P = .10 − .06 P = .10 − .36
4 4 4
= = =
.01 .04 .064
= ` 400 = ` 100 = ` 62.5
G = br = 4 × .15 G = br = .4 × .10 g = br = .4 × .06
= .06 = .04 = .024
10 (1 – .4) 10 (1 – .4) 10 (1 – .4)

P = .10 − .06 P = .10 − .04 P = .10 − .024
6 6 6
= = =
.04 .06 .076
= ` 150 = ` 100 = ` 78.94
g = br = .10 × .15 g = rb = .10 × .10 g = br = .10 × .06
= .015 = .01 = .006
10 (1 – .1) 10 (1 – .1) 10 (1 – .1)

P = .10 − .015 P = .10 − .01 P = .10 − .006
9 9 9
= = =
.085 .09 .094
= ` 106 = ` 100 = ` 95.74
Growth rate rb = rate of return × retention ratio = .6 × .15 = .090
Illustration 9.27: ABC Ltd. is currently paying dividend of Re. 1 and it is expected to grow at 7% p.a. infinitely.
What is the value if:
(a) The equity capitalization rate is 15%,
(b) The equity capitalization rate is 16%,
(c) The growth rate is 8% and instead of 7%, and
(d) The equity capitalization rate is 16% and the growth rate is 4%.
Solution:
(a) D 0 = Re. 1
g = 7%
ke = 15%
D 1 = D 0 ( 1 + g)
D 1 = 1 ( 1 + 0.07) = ` 1.07
D1 1.07
P 0 = k − g = 0.15 − 0.07 = ` 13.38
e
(b) k e = 16%
D1 1.07
P 0 = k − g = 0.16 − 0.07 = ` 11.89
e
(c) g = 8% (k e = 15%)
D1 1(1.08)
P 0 = k − g = 0.15 − 0.07 = ` 15.43
e
(d) g = 4% (ke = 16%)
D1 1(1.04)
P 0 = k − g = 0.16 − 0.04 = ` 8.67
e
Illustration 9.28: Equity shares of Badarpur Gas Ltd. are currently selling at ` 60. The company is expected to
pay a dividend of ` 3 after 1 year, with a growth rate of 8%. Find out the implied required rate of return of the equity
investors.
Solution:
Constant growth model
D1 D1
P0 = or ke = +g
ke − g P0
3
= + 0.08 = 0.13 or 13%
60
Illustration 9.29: A firm had paid dividend at ` 2 per share last year. The estimated growth of the dividends from
the company is estimated to be 5% p.a. Determine the estimated market price of equity share if the estimated growth rate
of dividends (a) rises to 8%, and (b) falls is 3%. Also find out the present market price of the share, given that the required
rate of return of the equity investors is 15.5%.
Solution:
The company has paid by a dividend of ` 2 during the last year. The growth rate, g, is 5%. Then, the current year
dividend (D1 ) with the expected growth rate of 5% will be ` 2.10.
The share price is
D1 A 2.10
P 0 = k − g = 0.155 − 0.05 = ` 20
e
In case the growth rate rises to 8% then the dividend for the current year (D 1) would be ` 2.16 and the market price
would be:
D1 A 2.16
P 0 = k − g = 0.155 − 0.08 = ` 28.80
e
In case the growth rate falls to 3% then the dividend for the current year (D 1) would be ` 2.06 and market price
would be:
D1 A 2.06
P 0 = k − g = 0.155 − 0.03 = ` 16.48
e
So, the market price of the share is expected to vary in response to change in expected growth rate in dividends

1. Calculate the duration of the following bond:
Bond ‘Z’ has a maturity period of 5 years. The rate of interest is 6% per annum and the maturity value is ` 1,000
and has a face value of ` 100. The bond is currently selling price at ` 950.
Answer: 4.81 years
2. A bonds current market price is ` 9,000. It will mature in four year’s time. The face value of the bond is ` 10,000
and its coupon rate is 8%. Investor yield is 10%.
(i) Calculate intrinsic value of bond.
(ii) Should the investor purchase it?
Answer: (i) Bond is underpriced at ` 9,000. The intrinsic value is 9,366. (ii) The investor should purchase it since
it is underpriced.
Answer: Bond is underpriced at ` 9,000. The intrinsic value is 9,366.03. Hence the investor should purchase it.
3. A bond has a face value of ` 1,000. It has a coupon rate of 12%. It will mature after 7 years. What is the value
of the bond when the discount rate is 12% and 15%.
Answer: 12% = ` 999.68
15 = ` 1,000.00
4. A deep discount bond (DDB) has a maturity period of 10 years. It has the face value of ` 1,00,000 (1 lakh). Find
out the value of the bond, if required rate of return is 15%.
Answer: ` 24,700.
5. A company proposes to issue 8% bonds of face value of ` 1,000 redeemable in 4 years installments of ` 250 each
over the 4 years period. If required rate of return is 7%. What would be the price of a bond that investor should
be offered?
Answer: ` 1021.83
6. An equity share is currently paying a dividend of ` 2.00 and its growth rate is 70% per annum perpetually. What
is the value of the share if k e is 20%, 15%, and 10%?
Answers: (i) ` 16.46 (ii) ` 26.75 (iii) ` 71.33
7. A company pays an annual dividend of ` 5.00 per equity share having a face value of ` 10.00. The dividend is
expected to grow at 6% for ever. The company has an equity capitalization rate of 15%.
(i) Calculate intrinsic value of the share.
(ii) Also calculate the intrinsic value when k e is 12%.
Answers: (i) ` 5.3 (ii) ` 58.88, 83.33
8. A dividend of ` 1.00 is paid currently by a company. The growth is expected to be 12% per annum for 5 years.
It is then expected to have a growth of 8% continuous. What would be the value of this share? The investors
required rate of return is 10%.
Answers: Value of the share after 5 years = ` 95.04
Present value = ` 59.87
Value of share = 65.13
9. A firm does not pay dividend in the first 5 years of starting its business after expansion. After 5 years it pays a
dividend of ` 2.00 growing at 10% per annum perpetually. What is the value the share? Cost of equity capital is
15%.
Answer: ` 19.88
10. A company paid a dividend of ` 2.00 per share. The dividend is expected to grow at 20% for next 3 years. After
that it is expected to grow at 10% per annum a return of 25% is expected by an investor. What is the value of
this share?
Answer: ` 15.80
11. The following information is available in respect of a firm. Capitalization rate k e = 15%. Earnings per share E =
` 14. Assumed rate of return on investments (i) 20% (ii) 15% (iii) 10%, show the effect of dividend policy on the
market price of shares using Walter’s model.
Answer: When r > ke, ` 124.13, 119.73, 115.53, 108.8, 102.13, 93.3
Walter’s model = Dividend Policy and Valuation of Share. When r < k e ` 62.2, ` 66.9, ` 71.11, ` 77.77, ` 84.5,
` 93.3, When r = k at all levels price of the share will be ` 93.3.
12. The following information is provided
r = (i) 15%, (ii) 14%, (iii) 10%
Ke = 14% E = ` 25.
Determine the value of the shares by Gordon’s model assuming the following:
DP Ratio Retention Ratio

(a) 10% 90%
(b) 20% 80%
(c) 30% 70%
(d) 40% 60%
(e) 50% 50%
(f) 60% 40%
(g) 70% 30%
Answers: When r > k e, 500, 250, 214.28, 200, 192.3, 187.5, 184.4. When r = k ` 178.57 at all levels and when
r < k, ` 50, ` 83.33, ` 107.14, ` 125, ` 138.88, ` 150 and ` 159.09
SUGGESTED READINGS
l Chandler, L.V., The Monetary Financial System, Harper and Row Publishers, New York, 1979, p. 407.
l Fischer & Jordan, Security Analysis and Portfolio Management, Prentice-Hall Inc., Englewood Cliffs, New
Jersey, 1983, p. 634.
l Jones, Tuttle & Heaton, Essentials of Modern Investments, The Ronald Press Company, New York, 1977,
p. 452.
l Kulkarni, P.V., Financial Management, Himalaya Publishing House, Mumbai, 1983, p. 869.
l Sprecher, C.R., An Introduction to Investment Management, Houghton Miffin Company, USA, 1975, p. 489.
l Van Home, J., Financial Management and Policy (Fifth ed.), Prentice-Hall of India, New Delhi, 1981, p. 808.
nnnnnnnnnn
Chapter
10
ALTERNATIVE FORMS OF INVESTMENT
Chapter Plan
10.1 Introduction
10.2 Government Securities
10.3 Life Insurance
10.4 Private Insurance Companies
10.5 Unit Trust of India
10.6 Commercial Banks
10.7 Provident Fund
10.8 Post Office Schemes
10.9 Fixed Deposit Schemes in Companies
10.10 New Instruments
10.11 Financial Engineering Securities
10.12 ADRs, GDRs & IDRs
10.13 Non-Bank Finance Companies
10.14 Mutual Funds
10.15 Land and House Property
10.16 Gold
10.17 Silver
10.18 Coins and Stamps Collection
10.19 Diamonds
10.20 Antiques
229
10.1 INTRODUCTION
This chapter describes the characteristics of government securities and the kind of investors who have
preference for such securities. It then makes a study of investment outlets like life insurance, mutual funds,
commercial banks, post office schemes and development bonds. It also makes an attempt to evaluate valuable
possessions like land and house property, gold, silver, coins, stamps, diamonds and antique collections.
The previous chapters 7 and 8 were an attempt to analyze the different securities that an investor is
offered by a corporate form of organization. The different kinds of bonds and preferred stock were analyzed
through security valuation. Special care was taken to analyze convertible bonds and preferred stock which has
the feature of being a bond first and equity stock later. Equity stock as a form of investment was most risky
but due to price appreciation and easy transferability was preferred by a large number of investors. This chapter
considers forms of investment which have certain special and peculiar features. They offer a number of
advantages but also have their limitations. As a form of investment they are of great importance in India. These
are analyzed in detail. The investor will be able to find the different kinds of plans offered, benefits of the plan
and tax advantages in this chapter. Let us take a closer look at these investments. First, Government securities
are analyzed. We then turn to life Insurance and mutual fund policies.
Government securities in India have a larger market than the industrial securities but it is not so well-
known to the investor of the economy.
10.2 GOVERNMENT SECURITIES
1. Types of Securities
Government securities are in the form of promissory notes, stock certificates.
(a) Promissory Notes: Promissory notes are the usual form of government securities. They are purchased
by banks and are highly liquid in nature. Promissory notes can be transferred, by transfer or endorsement.
Transfer can also be by delivery to the transferee. Promissory notes are registered promises of the government
and are usually entered in a register specially made for entering promissory notes. Government provides to the
investors a half-yearly interest which is given only on presentation of the promissory note at the office of
purchase. This is the most popular government security and finds favour with investors.
(b) Stock Certificates: A stock certificate is not a popular investment outlet for investors. It is not
transferable like the promissory note and the banks prefer promissory notes to stock certificates. The stock
certificate suffers from the defect of illiquidity and non-marketability. The investors usually keep it till the time
of maturity. The Life Insurance Corporation of India and Provident Funds are the biggest purchasers of stock
certificates and hold it till maturity. They purchase it partly because of legal restraints on them to invest in
government securities out of their investible surplus for the year and partly because they have large resources
available with them and after fulfilling the maximum limits permissible for investment in private sector they
invest their funds in government securities. Also, this form of purchase helps the national economic policies for
further development of the country in consonance with planned priorities of the government.
2. Characteristics of Government Securities
Government securities have the following basic characteristic features:
(a) Issuing Authority: Government securities can be issued only by the Central Government, State
Government and Semi-Government Authorities. The Central Government securities prevailing in India are Gold
Bonds, National Defence Bonds and Rural Development Bonds. The Central Government also issues Treasury
Bills, Special Rupee Securities, Payment of India’s Subscriptions to International Monetary Fund, I.B.R.D. and
International Development Agency.
Government securities are also categorized by issues made by local Government Authorities, City Corporations,
Municipalities, Port Trusts, Improvement Trusts, State Electricity Boards, Public Sector Undertaking and Metropolitan
Authorities. These authorities usually issue bonds.
ALTERNATIVE FORMS OF INVESTMENT 231
The third form of government securities are issued by the financial institutions like IDBI, IFCI, State
Financial Corporations, Small Industries Development Corporation, Land Development Banks and Housing
Boards. These authorities issue bonds and debentures.
(b) Government Securities and Stock Market: The stock market is to a large extent influenced by
government securities in India. The government securities are controlled by the Reserve Bank of India which
maintains the statutory liquidity ratio and uses open market operations for control. In India, government
securities do not affect the interest rates to any great extent in the private corporate sectors and industrial
securities. Government securities operate basically for creating funds for development and priority program of
the five year plans as well as for meeting deficit budgets for central and state plans.
(c) Government Securities and Commercial Banks: In India all commercial banks have to maintain
their secondary resources through government securities. The government securities also help them to get
accommodation from the Reserve Bank of India, whenever the need arises. Government securities are also
excellent means to obtain loans. These securities are kept as collateral.
(d) Issue Price: Government securities are issued in denominations of ` 100. It has been noticed that
these securities have usually been issued at a discount but not at a premium.
(e) Government Securities and Rate of Interest: Rate of interest on government securities is low.
In fact, it is lower than any other form of investment. This is so because government securities are considered
to be the safest at the time of maturity, government always meets its commitments and is never at default.
(f) Tax Exemption: Government securities offer certain tax exemptions which are revised in different
time periods.
(g) Government Securities and Financial Institutions: Financial Institutions have a legal constraint
to invest certain proportion of their investible surplus every year in government securities. This amount is
usually held by them till maturity because financial institutions find it difficult to switch from one security to
another. Also, they are not in any particular need or requirements of funds. Due to these reasons they usually
take their funds only after the maturity of the security.
(h) Government Securities and Underwriting: Government securities are not underwritten. In fact,
brokers also do not like to deal with these securities. Government securities are issued by the debt office of
the Reserve Bank of India. This office notifies all issues and subscriptions which can be opened for two to three
days. The issues are subscribed during the year and are concentrated during the slack season. Usually, the
Public Debt Office (PDO) tries to have a small portion of issues evenly spaced in the year according to the
needs of the government budget. The government securities are usually sold in ‘over the counter market’ and
each sale is separately negotiated.
Government securities thus have certain peculiar characteristics relating to mode of issue, price of issue
and issuing authority. They also have a relationship with the commercial banks and securities market. Government
securities offer tax exemptions also. Their operations are now discussed.
3. Operations of the Government Securities Market
Government securities market in India is narrow and unlike other countries inactive. The general investors
do not buy these securities. The Reserve Bank of India and financial institutions are the main investors of
government securities. The government securities market in India supports the capital market and has no
negative effect on it. The funds that it collects are mainly for minimizing the cost of servicing and for the
planned priorities of the economy. Government securities have been employed by the Reserve Bank of India
in such a way that it is able to maintain some clear pattern of yield and a proper maturity distribution policy.
It has also been considered safe by Reserve Bank to purchase securities before maturity in order to maintain
stability. The Reserve Bank of India has used open market operations to provide inexpensive finance for
government and has tried to maintain funds with the view of achieving stability in the future. The Reserve Bank
of India has also used the techniques of maintaining the reserve ratio and the statutory liquid ratio and the
technique of moral suasion. This it has done for controlling bank liquidity and for achieving the objectives of
debt management.
4. Prices and Yields on Government Securities

The prices of government securities remain stable, although the bank rate has been increasing. In India
usually the bank rate influences the security prices inversely and in opposite direction but the Reserve Bank
of India has tried to stabilize the prices of government securities. This it has been able to do by refraining from
making any change in the purchasing and selling rates of the different loans which are placed on its list. It has
also tried to manipulate the selling rate of Treasury Bills of government. The Reserve Bank of India has many
a time mopped up the surplus funds by lowering the rate of sale of Treasury Bills. This is an indication that
the Reserve Bank of India was concerned with the rate of term loans and wanted to continue with its stability.
The yields on securities can be studied if the investor holds the security continuously. An investor can then
observe year to year changes in the coupon rate, running yield and redemption yield. It is common practice
in India that the government securities are sold far below the face value. This shows that the redemption yield
is higher than the bond rate because the redemption yield is equal to the face value when the bond is
purchased at the face value or par value. In India, government securities have continuously increased the rate
of return. Also, there has been no ceiling rate on government securities. However, government securities show
that even with the continuous increase in interest over the years, coupled with price stability, the rates given
by government are far below than what the investor would hope to gain if he invested his funds in industrial
securities. The government securities, therefore, are not an attractive form of investment.
In India government securities have been an important or useful part of the monetary management and
fiscal policy. The Reserve Bank of India has executed the interest rate of government selling, borrowing,
purchasing, lending and has also influenced the prices as well as yields. It has also played an important role
in maintaining a statutory liquidity ratio with the commercial banks in the country. This has the effect of
reducing or improving the liquidity position of the bank. As has been pointed earlier, government securities
have not made a market for themselves. They have generally been issued for the reason of monetary, fiscal,
debt management and for using the funds for the planned priorities of the country.
Government securities in India are invested by financial institutions and commercial banks. Although it
comprises a larger segment than the industrial securities market in India very little knowledge is presently
available about its operation to the common man. As a measure of operation it does not influence the capital
market rates but it operates mainly to be able to get finance at lower rates from the market for achieving the
planned economic development of the country. Let us now discuss the other alternatives available for investment.
10.3 LIFE INSURANCE

Life Insurance is a contract between a person and an insurance company for a number of years covering
either the life time period or a fixed number of years. In India, life is protected by a monolithic institution called
the Life Insurance Corporation of India. Life insurance is called an investment because of a number of reasons:
it provides protection against risk of early death, it can be used as a collateral for taking loans from banks, life
of key men in an association can be protected, it provides tax advantages, it is a measure of protection at the
time of death because it gives provision for estate duty and it is a sum of money received at the end of a
particular number of years, i.e., “the termination period of the contract”.
1. Features of Life Insurance
Life insurance is called a contract with an element of protection and an element of investment.
(a) Element of Protection: Life Insurance provides protection against risk of early death. If a person
dies before a policy matures for payment, the Life Insurance Corporation of India undertakes to pay the sum
of the contract to representatives or the dependant members of the deceased person, it gives protection to the
family at the time when the requirement is the highest, i.e., loss of the earning member of the family. However,
to an investor, it is one of the best saving measures for the future.
(b) Element of Investment: It provides a sum of money at the expiry of a number of years. Usually
the life contract taken by a person is from 15 years to 25 years. The earlier (with respect to age) a person takes
the policy the lower the premium paid by him to the life insurance. This accumulates over the years and at
the time of maturity, he gets the total amount for which he has contracted with the Life Insurance Corporation.
Apart from this, Life Insurance also provides tax benefits to the individual as well as in the case of Hindu
Undivided Family. Life Insurance gives tax deduction under Section 80C of the Income Tax Act, 1961.
As per Section 5(1)(6) of the Wealth Tax Act, the right or interest of the assesses in income policy of
insurance before the money covered by the policy becomes due and payable to the assessee is not included
in the net wealth of assess provided that in the case of policy of insurance the premium or payments are
payable during a period of less than ten years:
Particulars Exempted Portion
Policy where premium period is 15 years The whole of the right or interest under the policy will be
exempted from Wealth Tax.
Policy with a premium period of 7 years 7/10th of the value of the right or interest under the policy will be
exempted and the balance will be included under the net wealth
of the assessee.
This exemption applies to tax of insurance policies including policies on the life of another person in
whom the assessed has insurable interest. This exemption applies to those policies during its lifetime or when
they are paid-up but they have not been terminated into claims or surrendered. Loans raised on the life policy
are not deductible for the purpose of determining net wealth.
These elements of protection in investment offered by the Life Insurance Corporation are a measure of
motivating the individual and a group of persons to take life policies. As an investment, it is of long time nature
and the risk of purchasing power must be carefully considered before planning to take it as an investment.
People of higher income group are attracted to it because of the tax benefit offered by it.
2. Procedure for Taking a Life Policy
Life policy is based on the principle utmost good faith. The procedure-filling in the form is quite simple.
It is almost like a home industry where the person who wishes to make an investment in the form of insurance.
(a) Proposal Form: The first thing to do is to fill in a proposal form. The proposal form contains the
following details:
l Name, nationality, permanent residential address, occupation, nature of duties, present employer’s
name, length of service, previous employment record, father’s name in full.
l Place of birth, date of birth, proof of age and district of birth.
l Term of insurance, nature of insurance, type of policy, amount to be insured, mode of premium
payable — yearly, half-yearly, quarterly and monthly.
l Personal information regarding height, weight, where the life is proposed.
l Details of any previous policies whether one or double insurance.
l Family history, history of father, mother, brothers, sisters and children.
l Information regarding diseases like epileptics, asthma, tuberculosis, cancer, leprosy etc.
l Information regarding previous records of accident, injury, operation diseases.
(b) Medical Examination: If the applicant has a family history of disease then the investment procedure
is more detailed description about permanent immunity and other family diseases have to be given including
habits, name, income, occupation and salary. A person of normal health almost goes through a medical
examination as a matter of formality.
(c) Medical Report: The next step after filling-in proposal form is to undergo a medical examination
from one of the doctors approved by the Life Insurance Corporation. The examination is usually of a routine
kind where the identification of the applicant, his appearance, measurement, weight, condition of teeth, eyes,
throat, tongue, ears, condition of heart, chest, digestion, nerve system, past operation is taken into consideration
to find out the life span of the individual.
(d) Agent’s Report: The third step consists of a report which is confidential in nature. It is made by the
agent who is underwriting the life of person. His report consist of the age of the person insuring himself, his
health, occupation, soundness of payment of premium, proper health and longevity of life.
(e) Acceptance of Proposal: The Life Insurance Corporation accepts the proposal of the insurer on the
commitment made by the agent and after taking into consideration the doctor’s medical report. The factors
which play a dominating role is the mode of premium, type of policy, the age of the applicant, his health,
occupation and habits. Once, these factors have been considered and the Life Insurance Corporation’s officers
are satisfied, the form is accepted. An investor’s form will be rejected only, if he suffers from serious diseases
or the longevity of life cannot be guaranteed.
(f) Proof of Age: The next step after accepting the proposal of a person is to ask him to submit the proof
of the age. The person who is interested in insuring himself may give this proof by submitting any of the
following documents:
l A copy of a certificate giving details of the school leaving examination with age or date of birth stated
therein;
l Municipal records;
l Original horoscope prepared at the time of birth, when no proof of age is available;
l In the case of uneducated families entry in the family record through birth register;
l Employer’s Certificate.
l Any other satisfactory proof.
3. Mode of Premium
When an investor takes a life policy on his portfolio he must pay some installment to the life insurance
company for this investment. This installment is called premium and may be paid periodically. It may be paid
annually, half-yearly, quarterly or monthly. Usually a period of 30 days is given as grace period beyond the
due date of payment of premium. The rates of premium are different for different kinds of policies offered as
investment.
4. Issue of Policy
When all these formalities are completed, the Life Insurance Corporation sends a life policy to the insured.
This legal document between the life company and the insured states the details of the policy. It gives details
regarding the age, address, sum assured, type of policy with or without profits, date of maturity, premium, mode
of payment of premium, name of person who is entitled to receive the ultimate sum, amount at the termination
of the policy, the surrender value of the policy, the settlement of claims of policy and all other conditions of
the contract. The Life Insurance Corporation sends this policy under its seal and signature of its officers. On
receiving this policy the investor begins his investment with the Life Insurance Corporation of India.
5. Kinds of Life Policies
The kinds of policies are dependent on the amount of premium payable, the amount promised by insurance
company at the end of the termination period and the circumstances in which the amount becomes payable.
Basically, the Life Insurance Corporation issues whole life policies, endowment policies and term policies.
These in turn may be with profits or without profits. All policies make available certain attractive benefits and
also have certain imitations. There is no best policy and the attractiveness of the policy will depend on the
requirements of the investor.
(a) Whole Life Policy: The Whole Life Policy is for the full life of the insurer and the amount of
insurance will be paid only at the time of death. The insurer, therefore, gets no benefit, but his family receives
the amount after his death. The premium of Whole Life Policy may be paid in three ways: Single Premium Plan,
Limited Premium Plan — where premium ceases at a stated age and Continuous Premium Plan where premia
are paid throughout the life time of the policy holder. The advantage of a Whole Life Policy is that it provides:
l The lowest rate of premium when compared to other policies. If a person insures himself at an early
age, he can obtain a large amount of insurance for small premium.
l It is useful for a person who would like to profit for payment of estate duty on his property, if he dies.
l It provides protection to the family after the salary earner’s death. The policy has many drawbacks.
l He does not enjoy the life policy as an investment for himself because the return will come only after
his death.
The Whole Life Policy continues till the death of the insurer. The sum which is insured is payable only
when the policy holder dies. Since, it is payable after his death the insurer’s nominees receive the policy money.
The Whole Life Policy may be issued in the following way: (i) Ordinary Whole Life Policy, (ii) Limited Payment
Whole Life Policy, (iii) Single Premium Whole Life Policy, (iv) Special Whole Life Policy, (v) Convertible Whole
Life Policy.
(b) Ordinary Whole Life Policy: Ordinary Whole Life Policy remains in force till the life of the assured
and the premium is paid till the lifetime of the assured. The premium charged under this policy is the lowest
and the minimum amount of this policy is ` 1,000. If the policy has completed 35 years or the person attains
80 years of age, whichever is earlier, further premium is waived by the Life Insurance Corporation.
(c) Limited Payment Whole Life Policy: Limited Payment Whole Life Policy is a measure for payment
of premium for a limited period only. After the expiry of the contract period and further to the retirement age,
the Whole Life policies continue if all the premiums have been paid, but after the expiry of a number of years,
further premiums need not be paid. The minimum amount for which this policy can be issued is ` 5,000.
(d) Single Payment Whole Life Policy: Single Payment Whole Life Policy is not very popular as large
premiums have to be paid and in one lump sum. This kind of insurance can be taken either by people who
have received income through windfall like a lottery or rich industrialists. The Whole of the amount on such
a policy is lost if the investor dies at an early age. This policy is of greater element of investment on the part
of the investor and a lesser degree of protection.
(e) Special Whole Life Policy: This policy can be surrendered and converted into a paid-up policy
under the terms of the Special Whole Life Policy. The payment of premium ceases at death if it takes place
earlier or on completion of a particular age, for example 70 years. The sum which is insured is paid on the
death of the life insured.
(f) Convertible Whole Life Policy: The Convertible Whole Life Policy gives the option of conversion
into Endowment Policy after the expiry of five years of the contract. This is useful as the protection to a person
is given at a lower rate and the benefit of conversion after a particular time is also allowed. At the time when
the option is exercised, the policy changes into Endowment Policy and the premiums increases.
(g) Endowment Policy: The Endowment Insurance is the best form of investment to an investor who
wish to take life policy as a form of investment with the benefit of: (a) saving his income, (b) protection to life
and (c) receiving tax benefits. Under this plan, the company promises to pay a stated amount of money to the
beneficiary, if the insured dies during the life of policy or to the insurer himself if he survives the endowment
period. For example, if an investor takes an endowment policy for 20 years for ` 1 lakh. In the event of death,
at any time, during the period of 20 years this sum becomes payable to his dependents. If he survives this
period the policy matures and he receives the payment of the sum assured on the expiry of 20 years. The
premium of this policy is higher than Whole Life Policies. The Endowment Policy is like a reservoir or a fund
which the investor needs on a particular date and will be payable to him or to his nominee. It combines both
investment and protection elements. Endowment Policies may be issued in different forms. These are Ordinary
Endowment Policy, Pure Endowment Policy, Optional Endowment Policy, Double Endowment Policy, Anticipated
Endowment Policy, Endowment Combined with Whole Life, Fixed Term Marriage Endowment Policy, Educational
Endowment Policy, Joint Life Endowment. Endowment Policies can be issued for a minimum sum of ` 5,000.
(h) Ordinary Endowment Policy: The Ordinary Endowment Policy is a promise by the Life Insurance
Corporation to pay the insured amount on death or attainment of a specified age of the insured whichever is
earlier. The premium is to be paid for a fixed number of years.
(i) Pure Endowment Policy: Pure Endowment Policy is issued for a specified period and the amount
on the policy is to be paid only if the insured person survives the endowment period. It is an extreme form
of Life Endowment Policy, because, if the insured died before the completion of the contracted period his
dependants do not receive the value of the policy. Investors who do not have dependants may invest their
surplus in this kind of policy.
(j) Optional Endowment Policy: The Optional Endowment Policy is a method of converting the Whole
Life Policy at any time after the completion of the first five years of payment of premium on the policy. This
policy is beneficial from the point of view of the investor as he can avail of the advantages of endowment
policy, although he has originally subscribed to the Whole Life Policy.
(k) Double Endowment Policy: The Double Endowment Policy is a promise by the insurer to pay
double the amount of the sum which has been insured, if the insured lives beyond the date of maturity. If the
insured dies before the expiry of the period the sum under the contract is given if he survives he gets double
the assured amount. The minimum amount under which this policy can be issued is ` 1,000. This policy can
be issued up to the age of 65 years.
(l) Anticipated Endowment Policy: The Anticipated Endowment Policy gained popularity recently.
Under this plan, if the insured survives the contract period, he receives certain advantages in terms of benefits
of holding this policy. These benefits, may be given at intervals of 5 years, 10 years, 15 years but if the investor
dies within the contracted period the full insured sum is paid by the Life Insurance Corporation without any
deductions for the amount paid on any benefit which the insured had already received. This kind of policy can
be issued for a minimum amount of ` 1,000, the term period of these policies ranges from 15 years to
25 years. If the investor has taken a policy of 15 years term and if he survives he gets benefit as follows:
(a) 1/5th of the sum insured after 5 years, (b) Next 1/5th after 10 years and the balance 3/5th after he survives
the 15 year period. An investor may find it beneficial to plan his investment by receiving payments in lump
sum at periodic intervals in addition to providing for his own old age.
(m) Endowment Combined with Whole Life Policy: This policy is a combination or a hybrid between
the Endowment and the Whole Life Policies. The sum which has been insured is payable at death whenever
the death occurs but an equal amount is provided to the insured if he lives till the expiry of the term. The
person insured under this scheme benefits by survival on the selected age pattern but if he dies before the
particular date his beneficiaries get the insured sum.
(n) Fixed Term Marriage Endowment Policy: This policy is provided by parents and guardians for the
marriage of their children. Premium ceases at the time of death of the parent but the policy matures at the end
of a specified period. The insured sum is payable either to the person who look the policy or his nominee, if
he dies during the time of the insurance contract. The policy can be taken by a parent from the age of 18 years
to 55 years and the maturity period of these contracts may be from 5 years to 25 years term. This policy is
taken without profit basis and the minimum amount that can be assured under this plan is ` 1,000. If the child
dies before the policy becomes matured then the parent is given the option to name any other child as
beneficiary or to take part of the premium with the exception of the first year’s premium.
(o) Education Endowment Policy: Under this plan the benefits are not payable in a lump sum but at
selected periods over a period of 5 years in ten equal half-yearly installments beginning at a specified date.
These installments provide finance for the education of a child whether the parent is alive or dies during the
period. This policy also extends from 5 years to 25 years and is a provision by the parent for the adequate
provision of education for his children.
(p) Joint Life Endowment Policy: This policy is taken usually by the husband and wife jointly. The
insured sum is payable at the end of specified period to either the husband or the wife or to them jointly if
both survive the contract period. In this policy the medical examination of both the husband and wife is taken.
The premium which is fixed on this policy depends on the ages of both the parties. This is useful to an investor
if he wishes to provide either for himself or for one survivor specifically.
(q) Term Insurance Policy: Term Insurance Policy is a method or contract for payment of amount
insured only if the insured dies during the term of the policy or a specified period stated within the contract.
If the insured does not die during the specified period the contract expires and is treated as cancelled. This
policy may be a Straight Term Policy, Convertible Policy, Decreasing Term Insurance, Renewable Term Insurance
and Yearly Renewable Policy.
(r) Straight Term Policy: Straight Term Policy is taken usually either for a year or a specified number
of years stated in the contract. This policy terminates automatically at the end of the contracted period of time.
This contract period may vary from 10 years to 50 years. Such a policy does not combine risk element because
the assured receives the amount only if he dies within the period. The premium to be payable on such a policy,
is required to be made either on the maturity of the policy or death of the insured person. These policies are
taken usually by people who travel from one country to another.
(s) Convertible Policy: This policy gives a right to change into Whole Life Policy or Endowment Policy.
When the insured opts for a change he pays the premium applicable to the kind of policy in which he requires
to be converted. The minimum amount for this policy is ` 5,000.
(t) Decreasing Term Policy: This insurance policy offers decreasing risk with each installment. Premiums
may be paid in a lump sum or periodically installment. This is useful for loan transaction where installments
are continued and paid every year.
(u) Renewable Term Policy: This policy can be renewed after the period of termination of the contract.
The rates of premium will be fixed only for the contracted period when the insurance is renewed, no medical
examination is required but premium will be paid afresh for the new contract.
(v) Yearly Renewable Policy: This type of term policy expires at the end of every year. The person
wishing to insure himself can request for renewing his policy every year but he does not have to go through
the formalities of filling in the proposal form and medical examination every year.
Most of the insurance policies fall under three categories — Whole Life, Endowment and Term Policies.
Each policy carries different terms and conditions such as Regular premium policy, Limited premium payment
policy, Single premium policy, Non-medical policy, Modified life payment increasing rate policy, policies with
profit and without profit policy, Group insurance policy, Grih Laxmi Policy, Guaranteed Triple Benefit Policy
and Contingent Assurance Policy.
There are many new policies falling under these plans. These are now discussed briefly:
6. Other Policies of LIC
(a) Jeevan Mitra: This provides the benefits of time shares policy. It has an additional insurance cover
in the event of death or during the term of policy. The total insurance cover in the event of death is double
the sum assured. Bonus will be given on the basic sum assured.
(b) New Jan Raksha: This scheme provides extra benefit of free insurance cover for 3 years, if for at
least 2 years life premium has been paid. This is an endowment policy.
(c) Jeevan Sathi: This has a maximum assured sum of ` 50,000, if wife is housewife and 2 lakhs if wife
is working. The minimum assured sum is 10,000. It has maturity after 15, 20, 25 & 30 years at the end of the
policy. Lives of husband and wife are under a joint cover and the age of maturity cannot exceed 70 years. If
one partner dies, the other partner need not pay any further premium till maturity. This scheme has a very poor
return.
(d) New Money Back Policy: This is quite a good policy and provides lump sum amount at regular
intervals. The minimum basic sum assured is ` 10,000 it has full benefits of protection of entire sum assured
through the term of the policy in the event of death assured, even if some of the installments have been paid.
(e) Bhavishya Jeevan: This is a special investment plan which is coming with profit and for the specific
need and is very beneficial. This is also for a term period of 15 to 20 or 25 years.
(f) Bima Sandesh: This is a low premium plan which has an attractive return on premiums on the safety
of the life assured at the end of the term period of the policy. This is a profit plan. It is quite popular and it
is called double ended plan.
(g) Jeevan Chhaya: This plan of LIC has been provided for the ‘higher education’ of children. The policy
is issued on the life of the parent — it has many benefits. It has bonus for the full sum assured but are paid
at the end of the term. ¼th of the same is payable at the end of each of the last 4 years. In addition to this
benefit, the sum assured will be paid on the death of the policy holder during the term of the policy. The policy
is for the term period of 20 to 25 years.
(h) Jeevan Griha Plan: This is useful for those who require housing loans. This is an endowment plan
which is without profit. But it has features of double cover plan and triple cover plan. Double the basic sum
assured is payable on the date of maturity under double cover plan and under triple cover plan thrice the sum
assured payable on the date of maturity.
(i) Jeevan Sukanya: This program is for the girl child between the age of 1 year and 12 years and this
scheme can be extended for the husband on the marriage of the girl. The policy participates with profits and
bonus on the date of maturity or death of person.
(j) Jeevan Akshay: This policy issued to people of 50 years and above. It is a full pension with return
guaranteed insurance along with bonus.
(k) Jeevan Surabhi: This is a money back plan. The premiums are paid for a limited period and sum
assured is paid in installments during the premium paying term of the policy. This also participates in profits
and bonus and it has a fair return. The minimum sum assured is ` 10,000 and there is no maximum limit.
Accident benefit is available and only between 15 to 55 years of age can join the policy.
LIC policies do not offer a high yield like other investments. However, the LIC policies provide other
benefits. They provide the protection of life to a person. They have other benefits of deduction of taxes and
loans can be taken on their policies.
(l) Jeevan Sanchay: This is a new money back policy. It provides an investor with ready cash at periodic
intervals. Cash receipt can be used for future events like marriages, holidays, and education costs. This plan
can be taken for a period of 12, 20 and 25 years. It also has an exclusive accident cover upto ` 5 lakhs.
(m) Jeevan Saral: LIC’s Jeevan Saral is a unique monthly recurring life insurance plan. It has the good
features of the conventional plans and the flexibility of unit linked plans. The proposer gets 250 times monthly
premium plus the total premium paid in case of death. The amount deposited in this scheme is exempted under
section 80C of the Income Tax Act. It has a low premium. The policy can be surrendered after 5 years without
any penalty.
(n) Jeevan Asha: This LIC plan is for healthy living. It is a plan that provides Insurance Cover for health
during emergencies. It provides financial support in surgical operations. It also has the benefit of health check-
up allows a periodic payment to the assured. The sum assured can be used between 20-25% of sum assured
for surgical operations and 2% of the sum assured or a lump sum can be paid during emergency. This plan
also covers accident benefits. In addition at the time of maturity the payment of sum assured is made with
guaranteed additions and loyalty additions.
Table 10.1 INSURANCE COMPANIES
LIFE INSURERS
Public Sector
Life Insurance Corporation of India
Private Sector
Allianz Bajaj Life Insurance Company Limited Birla Sun-Life Insurance Company Limited
HDFC Standard Life Insurance Co. Limited ICICI Prudential Life Insurance Co. Limited
ING Vysya Life Insurance Company Limited Max New York Life Insurance Co. Limited
MetLife Insurance Company Limited Om Kotak Mahindra Life Insurance Co. Ltd.
SBI Life Insurance Company Limited TATA AIG Life Insurance Company Limited
AMP Sanmar Assurance Company Limited Dabur CGU Life Insurance Co. Pvt. Limited
LIC policies do not offer a high yield like other investments. However, the LIC policies provide other
benefits. They provide the protection of life to a person. They have other benefits of deduction of taxes and
loans can be taken on their policies.
Life Insurance is an investment gives the benefit of both protection as well as capital fund at the age of
retirement. In India, in recent years, the Units through the Unit Trust of India have also provided several
advantages as a form of investment. Their special features and investment benefits derived in purchasing them
are stated now to evaluate them as an investment outlet.
10.4 PRIVATE INSURANCE COMPANIES

The private insurance companies in India have made insurance industry competitive. The Life Insurance
Corporation of India (LIC) is however still the largest in volume of its life fund.
The private insurance companies have invested in multiple and innovative distribution strategies. They
reach their customers through Internet and direct mailers. Bancassuarance, or distribution of insurance products
through the branches and multiple communication channels of banks, including ATMs, tele-banking and Internet
banking, is becoming popular in India.
The majority of India is rural. This market cannot be ignored. The private insurance companies have still
to create products for the rural market.
The opening up of the insurance sector with private companies offers competition and challenges to the
LIC which has to move into new product lines to keep pace with the growing private insurance sector. A list
of some important private insurance companies is given in Table 10.1.
10.5 UNIT TRUST OF INDIA

Units as a form of investment are issued by the Unit Trust of India which is a public sector financial
institution. The role of the Unit Trust of India is to fulfil the objectives of mobilizing savings especially from the
household sector and re-investing these funds into different investments outlets. Unit Trust of India is managed
by a competent Board of Trustees. Its Chairman is appointed by the Central Government. It also has an
Executive Trustee and four other members who look after the saving of the investors. These members are
appointed by the Industrial Development Bank of India, Reserve Bank of India, Life Insurance Corporation of
India, and sometimes by commercial banks.
Unit Trust of India began its operations with five crores of rupees jointly subscribed by Industrial Development
Bank of India, Life Insurance Corporation of India, State Bank of India, Commercial Banks and other financial
institutions. This was given as the amount of initial capital. Added to this the Unit Trust of India has a unit
capital also. The unit capital varies from year to year and depends on the subscription of the investors.
1. Objectives of Investing in Units
Units have an investment profit and several other advantages also. These are:
(a) Safety: Unit Trust of India assures to the investor a safe return of the investment whenever the
investor requires funds. The Trust provides daily price record and advertises it in the newspapers. Two
prices are quoted daily, the purchase price as well as the sale price of the units. This price fluctuates
daily, but the fluctuations are nominal on a monthly basis. The price, varies between the month of July
and the month of June. The purchase price of units is the lowest in the month of July and an investor
seeking investment may purchase his units at this time of the year and receive the lowest offer price
for the units. Every year dividend is declared on units on June 30. In June, therefore, price of units
is the highest. The face value of the unit is ` 10. At any time the re-purchase price of the units will
be lower than the price at which it will sell to the investor. The investor, however, is safe in this
investment because he may buy his units in July at the lower price and sell back to the Unit Trust of
India in June when the price is higher. This will offset any loss to him. The Unit Trust purchases back
the units at the operating price at the time of re-purchase of units. The investor can, thus, safely
purchase these units and sell them back to the Unit Trust of India, if need be. If he does not sell them
he is assured of the safety of the return in the form of dividends.
(b) Growth in Dividends: The Unit Trust of India has been in operation from 1964. Over the years, it
has added a number of plans to cater to the different kinds of investors. The first plan was called the
Unit Plan 1964.
(c) Liquidity: Investments made in units give the advantage of liquidity to the investor. The investor may
purchase the units and sell them at any time to the Unit Trust of India. The small investor does not
even have to find any other investor in the stock exchange or wait for the liquidity of his funds. On
application to the Unit Trust of India the amount will be paid according to the rate applicable on that
particular date as advertised in the newspaper. Unit can also be transferred from one person to
another easily.
The Unit Trust of India operated ten different schemes and plans. These are: (1) Unit Scheme 1964,
(2) Re-investment Plan 1966, (3) Children’s Gift Plan 1970, (4) Unit Linked Insurance Plan 1971, (5) Unit
Scheme for Charitable and Religious Trusts and Registered Societies 1981, (6) Capital Gains Unit Scheme
1983, (7) Income Unit Scheme 1982, (8) Monthly Income Unit Scheme 1983, (9) Growth and Income Scheme
1983, and (10) Unit Scheme 1985. There are many new schemes which have been discussed.
Unit Scheme 1964: The Unit Scheme 1964 was the first to be issued by the Unit Trust of India. It has
the face value of ` 10 and the sale price and re-purchase price moderately changes every day. Each year the
price keeps on changing. These units can be bought in multiples of tens with a minimum of ten units, under
this it has the additional advantages of tax deduction for calculating income under income tax law.
2. New Schemes of UTI (Since 1990)
(a) Rajlakshmi Unit Scheme 1992: Investment in this scheme can be made for a Girl child till the age
of 5 years. This scheme has a face value of each unit of ` 10. The investor can invest in multiples
of 10 in the minimum investment is 100 units. In 20 years this scheme grows 21 times.
(b) Children College and Carrier Fund Unit Plan (CCF 1993): This plan supports a child on
completion of school education. This scheme can be taken for a child till 15 years of age. The
minimum amount of investment is ` 2,000. The investment grows by 11 times in 18 years and 21
times in 23 years. The face value is ` 10. This helps a child in higher education or in setting up a
business.
(c) Grihalakshmi Unit Plan 1994: This plan is like a Gift to a daughter/granddaughter/niece/close
female relative. It has a limit of 1 lakh per year. The beneficiary gets a regular income. The face value
of the unit is ` 10 and minimum investment is 200 units. This plan is for 30 years. No dividend is
declared for the first year. After that annual dividends are paid.
(d) Senior Citizen Plan 1993: This plan is prepared with the collaboration of New India Assurance
Company. One of the main objectives of this scheme is to provide hospitalization benefits to senior
citizens. After the age of 58 years the senior citizen can approach all the hospitals in which UTI has
made the arrangements for free treatment. This scheme is applicable to both the applicant and spouse.
An investor between the age of 21 years and 51 years can join this plan. The investor is also entitled
to yearly return declared by UTI. The face value is ` 10.
(e) Scheme for Charitable and Religious Trusts and Registered Societies (CRTS 81): This
scheme is especially for religious and charitable trust and societies. The objective is to provide a good
rate of return with a minimum guarantee of 12%. The face value of the unit in this scheme is ` 100
and there should be a minimum of 100 units. But there is no maximum limit. The investment must
be for at least 3 years, after which repurchase of unit can be made by the investor in multiples of 10.
(f) Institutional Investors Special Fund Unit Scheme (IISFUS 1993): This scheme is designed for
large institutional investors. It provides a return of 16% per annum with scope of capital appreciation.
At the time of encashment it is open for re-investment. The units have a face value of ` 10 and
investment should be for a minimum of 2.5 lakh units. This scheme involves an investment multiples
of 50,000 units. The units cannot be transferred or pledged.
(g) Bhopal Gas Victims Mainly Income Plan 1992: This scheme has been formulated by the UTI
with the approval of Government of India and under the orders of Supreme Court. The victims
certified by the Commissioner can benefit by this scheme. This plan is for 8 years and distributes the
dividend of 15% per annum. All maturity schemes offers capital appreciation.
(h) Monthly Income Unit Scheme (MIVS): The first scheme of this nature was started in 1983. The
new scheme is called GMIS 91 of growing monthly unit scheme. This has a face value of ` 10 and
the minimum investment required is 500 units in multiples of 10. The units must be held by the
investor for at least 5 years. There are 2 options under this scheme. Under option (A), dividend is
payable every month and there is 2% capital appreciation on maturity. Under option (B), the amount
is re-invested every month and the original investment grows 21 times in 5 years. GMIS 92 was
introduced with the same features of profits and bonus at the end of 3 years.
(i) Seven Year Monthly Income Scheme (MSIG): This scheme was started in 1990 and modified in
1991. According to this scheme monthly income option (A) provides dividend of 12% per annum
payable every month plus 1% early bonus dividend at the end of each year. In cumulative option (B),
the dividend is re-invested automatically in a way that original investment grows 2.5 times in 7 years.
In this scheme the minimum investment is 100 units, if the scheme is of non-cumulative option. The
investor must make a minimum investment of 500 units.
(j) Income Unit Scheme (IUS): This scheme was introduced for lower and middle income group of
people, especially those of the salaried class. The main objectives of this scheme are to provide a
share income to the investors. The minimum investment in this scheme is ` 2,000 with a holding
period of 5 years. Under IVS scheme 1985 the ceiling of investment was raised to 1 lakh.
(k) Deferred Income Unit Scheme (DIUS 1991): This scheme offered investment of 5 years with 2
options. In the first option (A), it offered 18% dividend in the third year of investment, 24% in the
fourth year, and 30% in the fifth year. But no dividend is payable in the first 2 years. Bonus dividend
was to be declared at the end of 3rd and 4th year. Under option (B), ` 1,000 would grow to ` 2,000
in 5 years and there was no provision in bonus dividend.
(l) Unit Growth Scheme 2000 (UGS 2000): In this scheme the investors of unit scheme 1964 and
CGP 1990 could make the investment. The maximum investment could be 200 units and the minimum
investments would be 50 units. The face value of the units is ` 10 and can be purchased any multiples
of 50 units. There is no dividend for the first 2 years and the holding period of the scheme is 10 years.
UGS 5000 was introduced as a modification of UGS 2000.
(m) Mutual Fund Unit Scheme 1986 Master Share: This scheme was designed by UTI for long-term
capital appreciation. It provides a small dividend as well. The fund was offered for one month to the
public. There was no upper limit for investment. This scheme can be redeemed after 7 years. The
investors of master shares were given right issues in 1989 at premium of ` 2 per share in the ratio
of 1:2. It has been extended for 10 years. Master Shares unit scheme 1991 (Master Plus) introduced
in 1991 with similar features of Master Shares.
(n) Master Equity Plan 1991 (MEP 1991): The face value of the units in this plan is ` 10 and there
is no maximum limit. This option is available to all citizens of India above 18 years of age, Hindu
Undivided Family (HUF) as well as parents of minor children. This scheme has capital appreciation
and also provide dividend to investors depending on income realization. Master Equity Plan was also
further introduced in 1992 with modifications of MEP 91. MEP was also introduced in 1993 with the
same characteristics, with listing provided on major stock exchanges after initial locking period of 3
years. MEP was also introduced in 1995 for providing the benefits of tax rebate and growth. Re-
purchase of unit is allowed after a lock in period of years. The investor must purchase a minimum of
50 units in multiples of 50 units. The face value of the unit is ` 10.
(o) Capital Growth Unit Scheme 1991 (GVS Master Gain 1991): The investment in this scheme
is multiples of 10 and an investor has to take 50 units having a face value of ` 100. This scheme is
also for long capital appreciation and its holding period of 7 years and 15 years.
(p) Capital Growth Unit Scheme 1992 (Master Gain): This was introduced in similar to CGVS
scheme 1991. This scheme has a holding period 7 years. It has a face value of ` 10 and minimum
investment of 200 units in multiples of 100 units. Grand master 1993 was introduced on the same line
as Master Gain 1992.
(q) Unit Scheme 1992: This scheme introduced by UTI was also for the benefit of the investors for long-
term capital appreciation. This scheme is listed on major recognized stock exchanges in the country
and it declares a reasonable dividend after an initial lock in period of 3 years. The face value is of
` 10 and minimum unit has to be 500 in multiples of 100 units.
(r) UTI Long-term Advantage Fund (LTAF) 2007: It is a close ended scheme and has a lock in period
of three years. Its objective is to provide medium and long-term capital appreciation. It provides tax
benefits under Section 80C of the Income Tax Act. UTI will invest the amount of this fund in growth
companies which have the potential of higher return. The minimum investment in the scheme is of `
500 and investment can be in multiples of ` 500. It will invest 80% of the net assets in equity and
20% in money market and debt instruments.
(s) UTI Capital Protection Oriented Scheme (CPOS) 2007: This scheme has the objective of
protecting an investor from risk. It invests fixed income securities which are rated as good quality with
the objective of fixed income return. The plan comprises of two maturity dates and an investor has
the choice of 3 years or 5 years of maturity. The initial investment in this scheme for an investor would
be ` 10,000. In case the investor opts for growth option it would be ` 5,000 as investment.
UTI has provided a large number of schemes of investors. These are very popular in India, due to the
possibilities of providing suitable and riskless return. Although some schemes may have a greater return than
other, units by and large suit the needs of different kind of investors, and can cover a single small investor to
a large investor.
While evaluating the investments under the Unit Trust investments and life policies the risk and return
framework must be carefully studied. While these investments provide attractive benefits in the form of security,
annual returns, liquidity, the greater disadvantage of this scheme is the purchasing power risk that it provides
to an investor. Over the years inflationary trends have been increasing and especially so this has been noted
in Indian conditions. One of the greatest disadvantages in fixed time securities is that the increase in return in
investment is not high as the rise in prices. As a form of investment this is essential for every investor because
of family protection and stability of income and tax benefits but for the prospects of growth, other investments
may also be taken on a person’s portfolio. An investor should also include investments on growth securities like
equities which are highly risky as form of investment to provide capital appreciation.
10.6 COMMERCIAL BANKS

The third form of investments which in terms of prospects of investments have been not only popular but
have been growing because of the attractive kinds of investment plans provided by the different programs of
the commercial banks. Commercial banks provide to the investor both deposits which are liquid in nature,
which have stability and which also give an element of security. Commercial bank fixed deposits also qualify
as collateral for loans. While other forms of investments may be avoided by an investor, commercial bank
deposits cannot be eliminated from his portfolio nor can its use be underestimated from the point of view of
liquidity and stability of income. The following kinds of deposits are provided by the banks.
(a) Saving Bank Account: The most liquid form of investments are the deposits in savings banks
account. The deposits may be made at any time through the introduction of a person already having
a bank account or through the Manager of the bank on completion of the formalities of filling a form
and having it certified, the investor can begin to operate his account. He is supplied with a pass book
and a cheque book. Withdrawals can be made at any time during the year upto a limit of the saving
in the account. The advantages of savings bank account are to receive an element of investment as
it provides to the investor some return in the form of rate of interest after every six months. It also
offers to the investor the right to withdraw any amount at will.
(b) Current Account: An investor is also given the option of having a current account in the bank for
maintaining liquidity. A current account is usually opened by a business house. Of this current account,
the account holder is permitted to draw according to a fixed limit provided by the banker in agreement
with the account opening association. In India, it is not only prestigious but also convenient to open
a current account. This does not carry the benefit of any interest.
(c) Recurring Deposits: Recurring deposit is a method by which an investor may at regular intervals
deposit a fixed sum of money in a bank. This amount is to be paid for a stated number of years at
the termination of which the investor receives the principal sum with interest. The recurring deposits
are usually for a period ranging from 12 months to 120 months
(d) Fixed Deposit Scheme: Each bank has certain special schemes. These schemes vary from bank to
bank, but the maturity value is normally the same and the interest at a fixed deposit is specified from
time to time by the Reserve Bank of India.
(e) Mutual Fund Schemes: Commercial banks in India have also started mutual fund schemes. The first
bank to take this step was State Bank of India in 1987. It first launched Magnum Regular Income
Scheme 1987 which was opened for public subscription on 30th November 1987. This scheme was
introduced to collect resources from rural and semi-urban areas. Magnum certificates carry a buy back
facility and thus, it has easy liquidity. Magnum regular income scheme series were further issued in
1989. SBI capital funds have also launched Magnum Capital Venture Fund and Magnum Equity
Support fund for institutional investor like banks, financial institutions and companies.
Canara Bank was the next commercial bank to offer mutual fund schemes. It offered two schemes. The
Canstock scheme (Close ended income and growth scheme) of the face value of ` 100 with a buy back facility
after one year. The Canshare was of the face value of ` 100.
Indian Bank opened two schemes — Swarna Pushpa and Ind Ratna. These schemes offer 75% loan
facility on face value, buy back facility after 1 year. The minimum amount of subscription available is ` 1,000.
Since 1990, a large number of new mutual funds have begun to operate. There were several tax advantages
in these mutual fund investments depending upon the taxation policy of the country from year to year.
The presence of such a wide variety of securities available in the market gives the investor a choice to
make his investment.
10.7 PROVIDENT FUND

Another form of saving is through Provident Fund. There are mainly four types of provident funds —
Statutory Provident Fund, Recognized Provident Fund, Unrecognized Provident Fund and Public Provident
Fund.
(a) Statutory Provident Fund: Statutory Provident Fund was set-up in 1925. This fund is maintained
by government, semi-government organization, local authorities, railways, universities and educational
institutions. In statutory provident fund contribution from the employer is exempt from tax. Relief
under Section 80C of employee’s contribution is available to the interest credited to the provident fund
which is exempted from tax and the lump sum amount which is paid at the time of retirement is also
exempted from tax.
(b) Recognized Provident Fund: Recognized Provident Fund is given this name because it is recognized
by the Commissioner of Income Tax according to the rules which are contained in Part-A, Schedule-
IV of the Income Tax Act. When the Commissioner of Income Tax recognizes this fund it becomes
recognized also by the Provident Fund Commissioner. Recognized Provident Fund is also contributed
in the same way as Statutory Provident Fund, i.e., both by the employer and the employee. The
employer’s contribution is exempt upto 10% of the salary of the individual in excess of employer’s
contribution over 10% of salary makes it taxable.
The recognized Provident Fund and statutory provident funds have another advantage. Loans may be
taken from this account without payment of any interest. This, therefore, forms a very cheap means
of taking loans for the purposes of making a house, making additions to a house, house repairs, and
wedding in the family or illness.
(c) Unrecognized Provident Fund: Unrecognized Provident Fund is exempted from tax when the employer
contributes to it but relief under Section 80C is not available to the investor. The interest which is
credited to this account is, however, exempted from tax and the payment which is received in respect
of employee’s own contribution at the time of retirement is also exempt from tax.
(d) Public Provident Fund: In Public Provident Fund the employer does not contribute any amount. It
is a fund provided for non-salaries people to mobilize personal savings. Any person from the public,
whether salaried or self-employed, can open a Public Provident Fund Account at any branch of State
Bank of India. Any amount up to a maximum of ` 1,00,000 can be deposited under this account but
the amount so accumulated will be paid only at the end of maturity. In this fund employer does not
contribute, but relief Under Section 80C is available and the interest credited to this fund is exempted
from tax. The amount received at the time of termination of this contract is also exempt from tax.
10.8 POST OFFICE SCHEMES

Post Office schemes are generally like the commercial bank schemes. They have different kinds of accounts.
These are savings account, recurring accounts, ten years cumulative time deposit accounts. The savings accounts
operate in the same way as commercial banks through cheques and there is no restriction on withdrawals.
Those accounts which have a minimum balance of ` 200 in the months of April, September, October and
March have an additional benefit. They qualify for a prize on draw scheme which operates in the next June
and July.
(a) National Saving Schemes: National Saving Schemes have been started by the Government of India
mainly to finance its economic development plans through the mobilization of savings of smaller
income group. This scheme is operated mainly through the post offices. Because of the tax free nature
of the scheme, its main purpose is to attract higher income group of people also. These schemes
resemble that of the commercial banks. The mode of arrangement is basically the payment of a lump
sum amount to be received at the end of a certain period, the interest being paid annually or to be
paid altogether with the principal at the time of termination of the contract period. The National
Saving Schemes are uniform throughout the country. The investor has an exact picture of the amount
that he will receive at the time of encashment of security. The rate of interest on National Saving
Scheme is usually higher than the commercial banks. These schemes can also be transferred from one
post office to another if the investor so desires. The certificates have another advantage. They can be
used as collateral at the time of taking a loan from the bank.
(b) Saving Deposits: The public is encouraged to open accounts in the post office. They can also invest
their money in post office schemes. The post office saving deposits is popular amongst low income
group of people. Its schemes specially designed for the senior citizens are also attractive and since,
it gives a high rate of return, the retired people deposit in these deposits. Their certificates are readily
liquid and preferred by people of all income groups. Saving deposits offer interest as high as commercial
banks. They were very popular but now banks offer many benefits and higher rates of interest.
Therefore, banks are being preferred to post office saving deposits except in deposits of special nature
like those for pensioners.
(c) Fixed Deposit: Fixed deposit can be made for a fixed period between 1 to 5 years. The interest given
by Post Office on this fixed deposit is deductible as per the norms of Section 88 of the Income Tax
Act applicable in India.
(d) Recurring Deposits: The Post Office allows an individual to open an account up to 60 months. It
provides an interest that is compounded quarterly and paid at maturity. The individual pays a fixed
amount every month till maturity.
(e) Monthly Income with Fixed Investment: An individual can invest between ` 5,001 and ` 1 lakh
fixed amount for 741 months. Interest is paid at 13% monthly. It also provides a bonus of 10% at the
time of maturity. This scheme is now closed as interest rates were very high.
(f) National Saving Certificates: The investor of National Savings Certificates receives an interest of
12% compounded half yearly. The principal plus interest is payable at maturity.
(g) Savings Certificate: The rate of interest in this instrument is compounded half yearly, but it is
payable only at maturity. The interest accrued is reinvested but has the eligibility of receiving a rebate
in tax u/s 88. (Now Section 80C)
(h) Indira Vikas Patra (IVP): Post Offices also sell Indira Vikas Patra. These securities are freely
transferable and are like bearer bonds. They are sold at the face value of ` 100, 200, 500, 1,000,
5,000. In India these are very popular. They carry compound interest and have a maturity value of
5.5 years.
(i) Kisan Vikas Patra (KVP): Post Offices are also popularizing Kisan Vikas Patra. They have a face
value of ` 1,000, 5,000, 10,000 and give a compound interest. This investment doubles in 5.5 years.
The encashment of these certificates are possible after the holding period of 2.5 years. These instruments
cannot be transferred easily from one person to another. The investor can nominate any person who
can avail of this scheme in the event of the death of investor.
(j) National Saving Scheme (NSS): Section 80CCA of the Income Tax Act provide exemption from
tax to investor if they deposit a sum of money in NSS scheme. The rate of interest was 11% per
annum. The maximum amount to be deposited every year was ` 40,000. However, this scheme is
taxable at the time of withdrawal. This scheme was closed in 1992-93 and new NSS 1992 was
introduced with some changes in old program.
3. Comparison of Different Schemes
Post Office schemes have been prepared, carefully with the view that the small investor will take advantage
of easy accessibility due to the fact that Post Offices exist in every locally. Moreover, it was also to encourage
the saving habit of the uneducated class and small savers. These resources of the small savers help in mobilization
of savings in the economy.
The banks in India are partly nationalized and partly in the private sector but the mode of offering
investments are of the same kind. Life policies, Unit Trust Savings, banks, all other different kinds of saving
investment plans coupled with benefit or tax. As an alternative form of investment this may be put under one
category where returns are suitable, there is a measure of liquidity and Section 80C under the Income Tax Act
provide tax benefits but these investments provide purchasing power risk. To combat the purchasing power risk
the investor must avail of the opportunities and advantages of these schemes but also have on their portfolio
other growth-oriented investments which are risky but at the same time provide better returns.
The commercial banks provide liquidity and different forms of investments ranging in deposits of 30 days
to 10 years. Fixed deposits provide stability of income and the longer the period the higher the return on
investments, but the fixed deposits have fewer advantages than the Unit Trust in terms of tax benefits. An ideal
combination of commercial bank’s deposits, Unit Trust and life policies can be considered as they all qualify
under the same group under Section 80C and 80L of the Income Tax Act.
The National Saving Schemes and Post Office saving are particularly useful for the purpose of acceleration
of development in the Indian economy. These also provide benefits of exemption under the capital gains under
Section 54(E). An ideal combination of these investments is important for a balanced and suitable portfolio of
an investor.
10.9 FIXED DEPOSIT SCHEMES IN COMPANIES

Another type of investment is the fixed deposit investment schemes offered by various companies. These
schemes are generally offered by public limited companies in the private sector. Deposits may be cumulative
or non-cumulative. These fixed deposit schemes are offered through newspaper advertisement and are subject
to the provision of the Companies Rules of 1975. These are offered to the public as well as existing shareholders
and employees. An usual fixed deposit scheme of ` 2,000 is payable at ` 3,110 on maturity after three years
if it is a cumulative deposit. If it is non-cumulative then interest is paid @ 12.5% per annum in the first year,
per annum for two years and 15% per annum for three years.
The fixed deposit scheme announcement is required to give the following particulars:
(a) Name of the company.
(b) Date of incorporation.
(c) Type of business carried on by the company.
(d) Brief particulars of the company.
(e) Names, addresses and occupation of the directors.
(f) Particulars of profits and dividends.
(g) Summarized financial position of the company appearing in the latest audited Balance Sheet.
(h) Particulars of contingent liabilities.
(i) Amount to be raised under the fixed deposit scheme.
(j) Amount of deposits already held by the company.
(k) Declaration of the company that the fixed deposit is within the purview of the Deposit Rules of 1975.
The investor can apply for these schemes on the company’s prescribed application form. It has the
advantage of being a deposit for a short-term and offers a higher interest than the commercial banks. Retired
people find fixed company deposits a good investment.
10.10 NEW INSTRUMENTS

1. Zero Coupon Bonds: These bonds have a zero rate of interest. They are relatively new in the Indian
capital market. The importance of these bonds is that at the time of redemption they give a premium
in the form of capital gains to the investor.
2. Loyalty Coupons: The holder of this instrument of debt can change into equity shares at a discount
price. The original subscriber holds these coupons for the entitlement. The entitlement rights are given
when such coupons are held for a period of 2-3 years.
3. Floating Rate Bonds: In 1993 State Bank of India issued floating rate bonds. The rate of interest
is payable half yearly and is flexible depending on the bank deposit rate. For example, if bank rate
is 11% and this rate of changes the interest payable on the bonds will also change. These instruments
are debt instruments of duration of six months to one year and are renewable on the same terms for
longer periods. When floating rate bonds are issued abroad the interest rate is above 1-2% above
London Inter Bank Offer Rate (LIBOR).
4. Warrants: Warrants are instruments which entitle the holder after holding period of 2-3 years to buy
an equity at a concessional price. Although this instrument is a debt instrument it can be converted
into equity shares.
5. Discount Bonds: The most well-known discount bond is the deep discount bonds India. These are
sold at a discount on a current date to secure a maturity value of ` 1,000 and covers a period of 5-
30 years. The discount is given on the waiting period.
6. Flexi Bonds: The IDBI has issued flexi bonds in 1998. These bonds have a tax saving plan, interest
growth plan, Deep discount bond and regular income bond. The Tax saving plan has a benefit of
12.5% per annum, capital gains benefit and u/s 88 an investor can invest upto ` 70,000 and claim
tax rebate of 20% with a minimum lock-in period of 3 years.
The growing interest scheme provides interest rate of 10.5% for one year, 11% in the 2nd year, 12.50 in
the 3rd year, 15.25% in the 4th year and 18% in the 5th year.
The Deep discount bond ensures that ` 12,750 will provide ` 5,00,000 after 30 years. The rate of interest
is 13%. An investor has the option of getting his bond redeemed after 5 years and in multiples of 5 years also.
The regular income bond proposes a monthly interest of 12.25 per cent or annual interest at 13%. The
minimum investment is ` 5,000 and it is in multiples of ` 5,000. The maturity of the bond is 5 years.
10.11 FINANCIAL ENGINEERING SECURITIES

These are new type of securities which combine different features in one security. They are called innovative
instruments. Many companies have tried to innovate to give a choice to the investors. The financial institutions
and development banks in India have also issued such securities. The following are some financial engineering
securities issued in India.
(a) Participating Debentures have been issued by companies. The investors are given a part of the
excess profits that it has earned after giving a dividend to equity share holders.
(b) Convertible Debentures Redeemable at Premium: These securities are issued by a company at
par value but the holders have a ‘put option’. This enables the holders to sell the security at premium.
Zero Interest Fully Convertible Debentures (FCD’s): These debentures do not carry any interest
but on the specified date they are converted into shares.
(c) Floating Rate Bonds (FRB’s): These bonds are issued by financial institutions by linking the interest
on the bond to a benchmark interest rate. The benchmark may be the interest rate on Treasury Bills,
prime lending rate or interest rate of term deposits. The floating rate may be either above or below
the benchmark rate.
(d) Zero Interest Coupons Bonds: Such bonds do not pay interest but are offered at a low price. The
investor gets returns from the difference he receives between the acquisition and redemption amount.
(e) Deep Discount Bonds: Such bonds have a long-term maturity period between 20 to 25 years. They
carry the feature of ‘call’ which means that the company can call back the bond after 5 or 10 years.
It is sold at a discount but has no interest for example, a 25 year bond is issued at rupees 10,000 but
is redeemed at rupees 1,00,000. The discount makes up for not receiving any interest during the
waiting period.
(f) Regular Income Bonds: These bonds have ‘call’ and ‘put’ options. They are for a fixed period of
time and they pay interest after every 6 months. The period can also be monthly and the bond can
be called monthly income bonds. It also carries a front end discount.
(g) Retirement Bonds: These bonds are useful for investors who are in the retirement stage. They are
issued at a discount with the option of monthly income and for a specified fixed term period. On the
exit time of the bond the investor gets a lump sum amount.
10.12 ADRS, GDRS AND IDRS

An equity issue which is made in a country other than the home country is called a foreign equity issue.
For example, if an Indian company accesses the USA market through equity issues it would be called an
American Depository Receipt (ADR). If an Indian company raises an equity issue anywhere in the world it
would be called a Global Depository Receipt (GDR). International Depository receipt is an issue which becomes
global depository receipt if it issued outside USA and if issued in USA it is called American Depository Receipt.
The advantage of these issues is that the dividend is given in the currency of the country in which the issue
is floated.
10.13 NON-BANK FINANCE COMPANIES

The Non-Bank Finance Companies have played a positive role in providing alternative avenues of investments
in fixed deposits. This has improved the rate of savings in the economy. A list of Non-Bank Finance Company
is given with their rating, net worth and deposits allowed. The investor may invest in these companies after
carefully evaluating them.
The RBI has relaxed ceiling on NBFC deposits since 31st Jan. 1998. The ‘AAA’ rated companies are now
allowed to raise upto four times net owned funds and ‘AA’ rated funds can raise upto 2.5 times and ‘A’ rated
companies can raise upto 1.5 times their net owned funds. However, disclosure of ‘rating’ by non-bank financial
companies has become mandatory. They also have to disclose the name of the rating agency in their application
forms for public deposits. There is a ceiling on the rate of interest at 16%. The NBFC’s are fully regulated to
bring confidence to the investor.
10.14 MUTUAL FUNDS

In India, there are a large number of mutual funds. All mutual funds are under the regulatory framework
of the Securities Exchange Board of India with the exception of Unit Trust of India (UTI). All mutual funds
should have a net worth of ` 5 crores each, they have to set-up a board of trustees and appoint directors. The
mutual fund concept is based on sharing of risks and rewards. The income and capital appreciation arising out
of investments are shared among the investors. Their securities are subject to market risk. Share prices can
move up or down. The investor should be aware of these risks while making an investment decision. Even with
risks the mutual funds are able to perform better than an individual because a careful selection of securities
over a diversified portfolio covering large number of companies and industries is made and the portfolio is
constantly reviewed. Mutual funds select a large share of equities in the case of growth schemes. Although this
has a greater risk and potential for capital appreciation is higher in growth schemes.
Besides growth schemes mutual funds also have income schemes. When they have income schemes they
invest in securities of a guaranteed return. They generally select a large share of fixed income securities like
debentures and bonds. All growth schemes are closed/ended and income schemes are either closed/ended or
open ended. In India, a large number of mutual funds have been floated. Some of these are:
Table 10.2 MUTUAL FUNDS
Kothari Pioneer Mutual Fund Credit Capital Venture Fund Corporation Ltd.
20th Century Mutual Fund H.B. Leasing & Portfolio Ltd.
Prudential ICICI Mutual Fund Housing Development & Finance Corporation Ltd.
Morgan Stanley Mutual Fund (FII) Kotak Mahindra Finance Ltd.
Taurus Star Mutual Fund (FII) India Structure Leasing & Financing Co. Ltd.
Tata Mutual Fund Escorts Financial Services Ltd.
Birla Sun Life Mutual Fund Bank of Baroda Mutual Fund
Reliance Capital & Finance Trust Ltd. HDFC Mutual Fund
Videocon Venture Fund HSBC Mutual Fund
Apple Industries Ltd. ING Vysya Mutual Fund
Nedunadi Bank Ltd. Sahara Mutual Fund
UP State Industrial Development Corporation Ltd. DSP BlackRock
(PICUP) SBI Mutual Fund
This chapter now evaluates assets which have an intrinsic value and which are of a high value though they
are not easily sold. The appreciation is rather higher than the other kinds of securities but the rate at which
they are to be purchased is also much higher and, therefore, people with a greater income can think of investing
in these valuable investments. The first asset which is taken into account is:
10.15 LAND AND HOUSE PROPERTY

Land and house property is also called real estate. This investment is taken by a large number of people
for hedging the interest rates. Who are the people who should invest in real estate depends on some of the
following questions:
(a) Does the investor have a large sum of money which he would like to invest for a minimum of five
years? Also, if he wishes to sell his property he will not be able to receive an amount at a very short
notice. The holding period of the property is, therefore, important for an investor.
(b) The second question is: Is the investor likely to stay in one place or expect transfer of geographical
area as a settlement place for himself? Property cannot be left without supervision. A person who does
not have enough time to supervise his property should not invest in it.
(c) Property requires care. If it is rented out, there is a requirement of repair and maintenance. Tenants
also are not permanent and keep on moving. Can the investor accustom himself to the requirements
of changes in tenants? Can he find proper tenants to his liking to replace those who have left? Is it
possible for him to be able to enhance the rent as they increase? If the investor finds that he can take
care of these matters relating to property, only then he must involve himself in this situation.
(d) Investment in real estate is also very risky. Although the average rate of return is high a cautious
investor should not think of property, because it involves the exercising of a lot of pressures such as
tax payments, capital gains tax, annual property tax and so on.
1. Principles of Investing in Property
(a) Price: The price of property is most valuable for determination of real estate. The property must be
evaluated with regard to its price in relation to its position and its use. Regarding position, it should
be situated in a place where higher rent is available. For example, property situated in Connaught
Place in Delhi will be useful for departmental stores and hotels. A property situated in Greater Kailash
will be useful for residence, apartments or shops in the shopping area. Property in Delhi situated in
Brijwasan will be useful for farms. After the property for farms is being considered it must be found
out whether the land is given for growing crops or is the climate suitable for rearing fowls or poultry
farms. So, the productivity will determine the price. If the land is acquired for a price which gives a
less profitable return the price at which the investor purchases it will not be suitable for him. Therefore,
when an investor buys and sells property he should evaluate it according to its most productive use.
(b) Supply of Land: Land as an asset is fixed but its demand keeps on increasing every time. In areas
in Mumbai, land is being recaptured by reclamation methods but these are rare incidences. Therefore,
the land should be evaluated only in terms of what it actually is in terms of supply. The increasing
population and affluence will increase the rate and value of land. Land from the point of view of long-
term investment can be expected to be a good proposal because it is expected to cover purchasing
power risk with the prices of land which keep on increasing. On short-term basis, property cannot be
called as a good investment.
(c) Land as Collateral: Land is accepted as collateral by banks and other financial institutions. In India
it is found that almost all banks consider land as good collateral, but lending on property is restricted
by the banks to the market price as a collateral value. If an investor can purchase land and borrow
money on such an investment at a lower rate of interest it is a good form of investment.
(d) Tax: The purchase of land must always be determined after carefully examining the payment of tax
on property. Tax must be paid on house property as well as after property is sold under Capital Gains
Tax.
To compute taxable income of self-occupied property the following steps are to be conducted:
The first step is to find out the gross annual value. The gross annual value will be greater than:
(a) municipal value and (b) the fair rent or the rent which is applicable to a property similar to this one in any
adjoining locality.
The second step is to deduct the municipal taxes which are levied by any authority in respect of house
property.
The third step is to allow a statutory deduction of one-half on annual earning value or ` 3,600 whichever
is less. If the remaining balance exceeds 10% of gross total income of the assessee the excess may be ignored.
If property is sold then it is chargeable under the Capital Gains Tax. Capital gains arise from the transfer of
building or land whether self-occupied or let out. The aggregate value of consideration for which the transfer
is made would not be more than ` 25,000 and the aggregate floor value of a capital asset owned by the
assessee immediately before the transfer should not exceed ` 50,000.
2. Determining the Present Value of Real Estate
The present value of real estate should be determined by an investor at the time of purchasing a real
estate. The investor should examine the following areas:
1. (a) He should find out the cost on the funds which he borrows to buy property.
(b) He should add a risk premium at the rate of 2% to the cost of borrowing fund.
2. An investor is advised to estimate both the current rent and the future rate of rent on the property
that he is purchasing. If it is currently on rent then the present rates are easy to determine. If a future
rent is expected then similar units must be evaluated. Past rates can be used to give a rough idea of
anticipated future prices.
3. Besides income, the investor should also find out to some extent the cost of maintaining the property.
The cost should include repairs, renovations, taxes and cost of managing the property. To the total cost
mortgaged payments and income tax should also be added. The current expenses should also be
projected to find out the added expenses with rise in inflation and some unknown expenses.
4. The investor should also have some idea of the time period for which he expects to hold the property
and make a calculation of the future price which he may receive when he wishes to sell. It is very
difficult to estimate the future price of an estate because as has been seen from experience price of
land is extremely sensitive. It increases continuously, but the political instability and changes in economic
conditions sometimes also depress its prices.
5. The investor should take all the expenses discussed in the four points above and add them to find the
value of the property.
¾ Present Value: Determine the present value or each year’s expected net income for the selected
rate or value.
¾ Costs: Subtract the expected cost from expected income for each year to obtain an expected
cash flow.
¾ Sale Value: To find out the present value of a future sale price of the property.
¾ Additions: Add the present value of expected net income and the sale price to get a total of
the present value.
This is the value of the real estate by an elementary approach.
3. How can Land be purchased?
Land or property can be purchased: (a) directly from the seller, (b) from property agents, (c) from special
development companies and (d) contractors who are building apartments and offices.
10.16 GOLD
Gold is one of the most valuable assets in any economy. It has been used in India primarily as a form
of saving by housewives. Although it is said to appreciate many times yet in India it is more of a sense of
security and a fixed asset rather than for the use of sale or for the purchase of making profit or income on this
investment. Gold may be called a hedge against inflation or a well or reservoir for future use or substitute for
the rupees which are used as a means of transfer or exchange. Gold to the investor in recent years has been
important mainly because of rise in prices due to inflation. It has been used more for speculation rather than
for a long-term investment and for quick profits. Gold may be invested into, either in the form of gold shares
which are banned in India, gold coins, gold bars and gold jewellery.
1. Gold Coins
In India gold coins are not available now as a means of transaction. But there are old coins of 1800 to
1895 of the time of King George and Queen Elizabeth and special edition coins by banks on sale at current
rates. In the United States, the United States Treasury has a number of new gold coins. In South East and
Middle East Countries gold coins are issued. Gold coins can also be used as a form of jewellery. Some investors
prefer to trade them in the form of coins only. They use them for re-shaping and moulding to form new
jewelleries. Other investors use them in the form of lockets, rings and earnings.
2. Gold Bars
Gold bars also are not considered legal ownership in India. But in the United States of America it has been
legal to hold and make gold bars. Gold bars are sold by Swiss banks in denominations of 5 grams and up to
30 grams. Gold bars compensate for inflation, but it is an unproductive asset and is risky.
3. Gold Jewellery
Gold jewellery is a method of shaping pure gold into ornaments. The standard used in India is usually
22 carats for jewellery. Diamonds and precious stones are set in 18 carat gold. The price of gold has risen from
` 124 for 10 grams in 1960, in 1975 it was ` 565, in 1980 it was ` 1,765 and in 1984 it touched ` 2,000.
In 2008 it was 12,000 for 10 grams. In 2011, it is 21,000 for 10 grams in 24 carat gold. In 2012 it has
surpassed 30,000.This shows that the price of gold has been increasing during the last 51 years to a great
extent. From this point of view, it has been a great asset but it has been found that rate of return of gold moves
in the opposite direction with the rate of return of common stocks. This means that if the rate of return of
common stocks is high the return of gold is low. The price of gold changes erratically, sometimes sharply and
also equally dependent on the economic and environmental conditions. It is also sensitive to the speculation
of international money markets and the demand and supply conditions in a country.
10.17 SILVER
Silver is sold in form of weight by kilograms in India. Silver may be owned in the form of coins, utensils,
glasses, bowls, plates, trays or jewellery. This, like gold, has been a hedge during inflation. The price of silver
although less than gold also keeps on rising in the same way as gold. Silver utensils and trays, from the point
of view of use, are an excellent possession but it is difficult to re-sell them and get the value of the investments.
At the time of resale of these investments the silversmith takes away the expenses of polish and non-silver which
is used in shaping these beautiful vessels. As a result, the investor is able to get only 60% of the value of silver.
In India, it is considered a good investment to shape silver into coins and to buy them during Diwali. Silver
key chains and jewellery are also kept for use for re-sale purposes in future. Silver coins give a higher return
in the form of value. Silver bars are also legal and can be used for selling. The sale price of silver bars is the
price recorded for pure silver. The price of silver and gold is quoted daily in the stock exchange list.
10.18 COINS AND STAMPS COLLECTION

An investor may collect stamps and coins as an investment. Old coins have antique value and can be sold
for high prices. Old stamps also increase in value. But from the investor’s point of view coins and stamps should
be collected only after careful understanding of the subject and by seeking professional guidance, because they
are risky investments and the value increases only after holding them for a large number of years.
10.19 DIAMONDS
Diamonds purchased in raw form and through a wholesaler may be the best investment potential. Since,
the price of diamonds keep on increasing in the same way as the price of gold, they have good investment
value. The price of diamond increases as the diamond caret becomes higher. In gold 10 grams is the measure,
silver is sold in kilograms, diamond is valued in carets. Diamond is to be judged in terms of weight, size, shape
and luster. In India, the investor must be cautious to buy diamonds because each jeweller decides the value
of the diamond according to his own judgment. The investor must be careful that he is not cheated. It is an
extremely risky form of investment because to a large extent the value of diamond is based on judgment. The
marked-up retail price is also very high. Investing in diamonds should be done only through professional advice
and when an investor has money to hold for a number of years. Immediate acquisition and sale of diamond
will not fetch price increase. Holding a diamond for some years will give it an appreciation. It is used by money
speculators for earning profit.
10.20 ANTIQUES
For antiques demand is more and supply is very rare as this increases its value. It has been found that
the longer the time of holding this investment the greater the value of this asset. Antique may be in the form
of paintings, coins, stamps, flower vases, watches or cars. The basic advantage of an antique is that the investor
can sell it at any price which he propounds but it is very difficult to find these antiques and to give a price
for which it is worthy. A careful study of this subject and professional advice can give the investor a good
return. Antiques are very risky for long holding period investment. There are many whole time antique dealers.
For them the sale of only one piece makes a fortune. This sale may, however, take a whole year before it has
left his collection. These risks must also be guarded against before planning to invest in antiques.
SUMMARY
r This chapter briefly advises the investor on different kinds of investment outlets. Government securities, Life
Insurance, Unit Trust Schemes, Post Office Plans, National Saving Certificates and new instruments have
been evaluated and their features and tax benefits have been considered.
r Fixed company deposits which combine the advantage of commercial bank deposits coupled with a higher
rate of return through interest have also been evaluated.
r Valuable investments such as property, gold and silver jewellery, diamonds and antiques have been analyzed
and evaluated in the light of their special features.
r Property, gold and silver give a high rate of return to the investor. They have a common feature. This is that
the period of holding these investments is long and the return is high only if the investor spends a large sum
of money.
r The risky nature must be considered of different investment outlets as price instead of appreciation may fall
due to uncertain economic and political conditions of the country.
r All the investments have unique features of stability of return.
r Thus, the investor has a large number of investment outlets. The investor may choose from this list after
analyzing the advantages and disadvantages provided by each investment.

(i) Indra Vikas Patra and Kisan Vikas Patra were national savings schemes.
(ii) Land is taxed as short-term capital gain.
(iii) Gold is the best investment.
(iv) Silver has 100% resale value in shaped form.
(v) National scheme has been started by government for long-term investors.
(vi) The objective of investing in units is to provide liquidity and safety.
(vii) Private life insurance companies have been started to bring competition to Life Insurance Corporation of India.
(viii) Private mutual funds have been started on the same lines as the UTI mutual fund.
(ix) Financial engineering instruments provide the benefits of combination of different features in corporate instruments.
(x) Different forms of investment should be taken by an investor to form a portfolio.
Answers: (i) T (ii) F (iii) F (iv) F (v) F (vi) T (vii) T (viii) T (ix) T (x) T.
QUESTIONS
1. ‘Liquidity is better than safety’. Discuss.
2. How would you rate life insurance as investment?
3. What are the advantages of investing saving in the schemes of the Unit Trust of India? Do you think it is a wise
investment?
4. How would you estimate land as a form of investment?
5. What schemes do commercial banks offer to investors? Are mutual funds a good investment?
6. Compare the LIC and UTI as alternate forms of investment.
SUGGESTED READINGS
l Maclachlan, Guide to Share Investments, Longman Limited, London, 1977.
l Dougal and Corrigon, Investments, Prentice-Hall, Inc., Englewood Cliffs, New Jersey, 1978.
l Fredric Amling, Investments — An Introduction to Analysis and Management, (5th edn.) Prentice-Hall Inc.,
Englewood Cliffs, New Jersey.
l N.J. Yasasvy, Personal Investments and Tax Planning, Allied Publishers Pvt. Ltd., New Delhi, 1999.
l Sprecher, The Introduction to Investment Management, Haughton Mifflin Co., Boston, 1975.
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Chapter
11
DIVIDEND POLICIES AND THE INVESTOR
Chapter Plan
11.1 Types of Dividend
11.2 Stock Splits
11.3 Procedure for Payment of Dividends
11.4 Dividend Policy
11.5 Dividend Decisions
11.6 Factors Affecting Dividend Decisions of Firms
11.7 Limitation on Dividend Payments
11.8 Walter’s Model
11.9 Gordon’s Model
11.10 M.M. Hypothesis
The purpose of this chapter is to discuss the different kinds of dividend policies, and how they affect the
investor. Dividends paid to the shareholders are out of the firm’s profits. Dividends are paid in the ordinary
course of business and it refers to that part of the retained earnings of the firm which is paid to the shareholders.
Dividends in a firm are paid according to the policies and decisions of the management regarding the retained
earnings of the firm. A policy gives the direction to the directors of the firm to retain some part of the income
and to give the other part as dividends to the owners of the firm called shareholders.
11.1 TYPES OF DIVIDEND

There are different kinds of dividends. These are classified as annual dividend, stock dividend, scrip
dividend, property dividend, bond dividend, special dividend, optional dividend, depreciation dividend, dividend
from capital surplus, dividend from appreciation, and liquidation dividend.
254
DIVIDEND POLICIES AND THE INVESTOR 255
1. Annual Dividend
Annual dividend is the normal amount paid to the shareholders at the end of the year of the current
operations and profits of the firm. The distribution of cash reduces the net worth of the firm but these are paid
to the shareholders only after, careful cash planning of the firm. In India dividends must be paid only out of
current income except in the case of cumulative preference shares.
A company must pay annual dividends to the shareholders in the form of cash which is electronically
transmitted into the bank of the shareholder. Dividends which are not paid in this manner are generally called
supplementary dividend. Every year the Board of Directors declares the annual dividend which is to be paid
to the shareholder. This dividend should be declared after the closing of the accounts of the firm. It is necessary
to pass a resolution for declaring dividend at the annual general meeting.
2. Stock/Bonus Dividend
Shareholders do not always receive dividends in the form of cash. Sometimes a firm issues dividends in
the form of additional shares, called stock/bonus shares. Stock is usually paid to the existing shareholders of
the firm. Stock/bonus dividend is paid by the firm’s directors out of the retained earnings of the firm. Stock/
bonus dividends are paid in the following circumstances:
(a) If the company does not find sufficient amount to pay cash dividend to its shareholders.
(b) It gives the firm an effective technique of raising capital.
(c) The firm has larger resources of cash for productive use.
(d) It also helps in raising the future dividends of the existing shareholders.
(e) It has a psychological effect in the minds of the shareholders that the firm is competitive and is
profitable to them.
The investor while accepting the fact that the firm has issued stock/bonus dividend should know that stock/
bonus dividend is a permanent method of capitalization of earnings. Normally, it should not be used as a
method of distribution of corporate earnings because it divides the amount of existing equity into a larger
number of parts of shares. Through this method there is no increase in wealth and the shareholders also do
not receive any distribution in the form of cash. Stock dividend also has no effect on the assets of the firm
immediately. It only represents a typical example of transfer of credit in the firm’s surplus account to its capital
account. The surplus amount which is distributed in the form of stock dividends becomes a permanent investment
of the company. The existing shareholder’s equity shares are not affected. In fact, the shareholder receives a
large number of shares than he had before. A stock dividend may be issued by a firm either as a substitute
of cash form of distribution of dividend or supplementary to the cash dividend. Stock/bonus dividend has some
demerits also:
(a) It may sometimes lead to over-capitalization if a firm is not careful or efficient and does not increase
its rate of earnings proportionately.
(b) It also raises certain questions about the shareholder’s position. A stock/bonus dividend raises his
expectation about the company’s profitability, efficiency and his expectation about the future profits
becomes high. The company may not be able to satisfy the shareholder.
(c) The issue of stock/bonus dividend cannot be continuous process. It may be issued only sometimes
when the firm has surpluses. Also, it can be paid only if the firm expects a higher profit in the future.
Sometimes the company cannot maintain even its present rate of dividend after issuing a stock
dividend.
3. Scrip Dividend
Scrip dividend is a promise to a shareholder to pay a dividend at a future date. The scrip is in the form
of a promissory note with interest and it is useful as a security to bank for loans. Scrip dividend is a temporary
promise given to the shareholder when the position of the firm for declaring dividends is not sound. However,
the firm will be paying a dividend at a later date.
4. Property Dividend
Under unusual exceptional circumstances a firm sometimes pays property dividends to a shareholder.
These are non-recurring in nature and may be once in the lifetime of the firm. The directors would usually not
like to issue such a dividend. Distribution as property dividend is only made when the price of the company
stock falls to the extent that if the dividend is not given in this form its value will be nil. Property dividends
are not paid in India.
5. Bond Dividend
In place of annual cash dividends, bond dividends are declared by a firm in order to conserve their cash
and to include the preference shareholders in the payment of cash dividends.
6. Dividends from Capital Surplus
Cash dividend from the current sources of income is the best method of paying for investment in a
company. But sometimes the company also makes its payments of dividend out of capital. Dividends from
capital surplus can be paid to the shareholders only: (a) when the company’s Memorandum of Association and
Articles of Association permit it do so, (b) when such profits are received in the form of cash, (c) after
revaluation of assets some surplus is left and (d) the dividend distributed in this manner from capital surplus
does not affect the creditors of the firm.
7. Interim Dividend
Interim dividend is the income of the previous year in which the amount of such dividend is unconditionally
made available by the company to a shareholder. It is paid between two annual dividends. It can be paid when
the company is making a high profit, but it is not paid on a regular basis. It should be permitted by the articles
of association.
8. Dividend from Appreciation
Sometimes assets are sold by the firm and the price received by the firm is higher than the book value.
The company may decide to pay dividends out of the appreciation.
9. Liquidation Dividend
When a company fails or is dissolved then at the time of liquidation, if some distribution is made out of
assets, it is the distribution of dividend from liquidation. This liquidation dividend is first paid to the bondholders,
debenture holders and preference shareholders. When claims of creditors are satisfied, the equity shareholder
may also be given an amount of such dividend.
The investor should bear in mind that there are several sources for a firm to make the payment of
dividends. The firm can pay the dividends from its current earnings which arise out of the regular operations
of the firm. It may also pay all dividends from the past accumulation of profits. The firm is also permitted to
pay dividend, out of the income from its subsidiaries. In addition, the firm is sometimes allowed to pay
dividends out of other sources, but only under certain important considerations. These sources may be from
the sale of a property, price of the sale being higher than the book value. It may also be paid out of the sale
of securities at a premium and by conversion of some unused resources. When a company makes a surplus
from mergers or purchase of subsidiaries, it may also declare a dividend.
11.2 STOCK SPLITS

A stock split is not a dividend. It is only an increase in the number of shares that are outstanding. The
change does not affect the stated value of a stock or its surplus. It also does not affect the shareholder equity.
It is only the reformation of a shareholder’s equity in smaller units with the objective of providing:
(i) Reduction of the Market Price: A stock split helps in the stock exchange to make a round lot. By
reducing the stock price the firm is able to help the small investors to purchase and sell stock with easy
continuity. In the stock split it is noticed that only the par value and the number of outstanding shares are
affected. The amount contributed as capital as well as earnings which are retained do not change.
(ii) Future Growth: Stock split indicates or is in other ways information to the stock market of the
continued improved growth forecast of firms.
(iii) Reverse Split: Sometimes there is a reverse split in stocks. When a firm does not increase the
number of outstanding shares of stock but reduces its number it is called a reverse split which has the effect
of reducing the outstanding shares. The reverse split is effected by a firm, sometimes, when the stock price falls
far below the required level of the firm. The reversal split is an indication of financial problems faced by the
firm.
11.3 PROCEDURE FOR PAYMENT OF DIVIDENDS

Dividends can be declared by the Board of Directors only on fulfilling certain conditions. The dividend that
is declared should be out of a surplus. If the firm makes a deposit then dividend should only be declared after
the deposit has been absorbed. The directors should also be careful that dividend impairs the capital strength
of a firm which they are managing by declaring dividends. Sometimes directors declare dividends at the time
when the firm is insolvent due to the bad conditions of business. Dividends should be avoided in such
circumstances the rights of the creditors should be protected by dividend to the shareholders. The dividend
which is given to the shareholders is a profit, which is distributed out of the profits of the firm. A dividend
policy should, therefore, be carefully prepared by the management of the firm and guidelines issued for strict
adherence to dividend program.
Dividend is defined by the Income Tax Act as:
1. Accumulated profits including the development rebate but not the reserves provided for depreciation.
Dividend also refers to the book profits and not the accumulated profits which have been declared by
the Income Tax authorities. ‘Bonus issues’ are not a part of dividend and they do not also relate to
any asset of the firm.
2. Any distribution of debentures, stock, deposit certificates and bonus to preference shareholders.
3. Distribution on liquidation of company.
4. Distribution on reduction of capital.
5. Any payments by way of loans or advances by a closely held company to shareholders holding
substantial interest provided the loan should not have been made in the ordinary course of business
and money lending should not be a substantial part of the company’s business.
On the basis of different decisions, the following conclusions are drawn with respect to accumulated profit:
1. Accumulated profits do not include current profits.
2. They are computed on the basis of commercial profits and not on assessed incomes.
3. Balancing charge does not form part of accumulated profit, as it is not commercial profit, but it is
considered to be a withdrawal of depreciation after the asset is sold for a price which is higher than
the written down value.
4. Accumulated profits include all tax-free incomes, that is, for example, the agricultural income, but the
receipts of capital nature are included in the accumulated profits if they are chargeable to Capital
Gains Tax by the receiving company.
5. Accumulated profit also includes general reserve.
6. Provision for taxation and dividends are not considered to be a part of accumulated reserve.
7. Accumulated reserve should also not include the development rebate reserve, development allowance
reserve and investment allowance reserve.
Normally dividend is declared at the annual general meeting and is considered to be the income of the
previous year in which it is declared.
Deemed dividend is treated as income of the previous years when it is distributed or paid, but it is notional
dividend under Section 2(22).
11.4 DIVIDEND POLICY

Dividend policy is a method or technique or approach by the management of the firm towards some
constant payment to the shareholders out of the profits of the company. Dividend decisions, may be for a short-
term purpose, also called ad hoc decisions or may be made for a longer-term period. A dividend policy should
be made by the management with certain consideration in mind. It should take into account the position of
the firm and the economic environment and type of industry in which it operates. It should also take into
consideration the needs of the shareholders in the present position of the market and other considerations with
regard to capital gain, capital increase and maintenance of levels once achieved. Apart from this, the consideration
of tax should also be thought of. Dividend policy should also be oriented towards the firm’s considerations, its
need for future expansion, business cycle operating in the industry and the nature of business through which
the firm operates.
The determinants of a dividend policy should be towards regularity of income, stability of income, and
safety during the period of contingencies. The legal constraints should also be looked upon by the directors.
The determinants of the dividend policy should project the following factors:
1. Regular Dividend Payments
Regularity of dividends is significant for an investor, who wish to make purchase of shares in a company.
The confidence of investors is increased by taking a look at the past behaviour of companies. A regular
dividend establishes the company’s position in the stock market. It also provides a firm policy for taking
decisions about the future of the firm with regard to its expansion programmes. It also infuses strength and
confidence in the minds of creditors and it makes it easier for the firm to take loans from creditors on the
strength of its regularity of dividends.
Firms who pay a regular dividend should be careful to maintain it at a rate that they are able to achieve
every year. If the rate goes down the firm’s position in the stock market also falls. If too high a dividend is
declared the firm may not be able to achieve the same rate in the forthcoming years. If a company maintains
a regular balance in paying dividends, it will be established and the investor can also plan to make his
investments for a fairly long time.
2. Stability of Dividends
In addition to dividends being paid regularly to shareholders, stability of income through dividends also
play a major role for the satisfaction of the shareholders for the following reasons:
(a) Information: When a shareholder receives stable dividend, the information about their shares are
continuously received by the stock exchange. This gives the investor a chance to know about the future of the
company. It also is able to influence a larger number of investors to continue to keep their funds in that
particular firm.
(b) Current Income: Shareholders, when they invest in a particular company, desire not only capital
gains but also current income from the company. A large number of investors believe that income received
currently from the company in which they invest is a supplement to their income received from salary and other
sources. This also helps in making decisions for them so that they part with some of their money which is useful
for current consumption and forego it for the purpose of another investment which would give them income
annually. The investor can also sell his investment from one firm to another, but there are many types of costs
involved in it. Costs are due to transaction or due to switching over. There may be an element of brokerage
cost also. To avoid these costs the investor would like stable income so that he may continue to be a long-term
investor in one firm only.
(c) Legal Aspect: Legally a stable dividend has many advantages. It gives to the institutional investors
like financial institutions a chance to qualify for investment in their corporate organizations. One of the considerations
of the investment policy of the large number of financial institutions existing in India is that income should be
stable over the previous years. If the firm satisfies these conditions, the financial institutions like Life Insurance
Corporation of India and Unit Trust of India would prefer such a company to make their investments.
3. Regular and Extra Dividend

A company should have a policy of giving both regular incomes to its shareholders plus extra dividends
whenever the firm is able to do well. An extra dividend in the form of interim dividend is a good policy because
the interim dividend is not an expectation of the investors and when he receives it, he is rather optimistic about
the future of the company without expecting more than the stable regular income. Extra income need not be
declared annually but only when the company can make an extra earning. This gives the advantage to the
investor to share in the growth of the company without making it a legal restraint for continuous annual
payments.
4. Liquidity
The company should be careful while declaring dividend not to jeopardize the earning capacity of the
firm. Liquidity is an important criterion for the working of the firm. It is important to declare dividend only after
maintaining liquidity position of the firm. The company should not have too much liquidity because this means
that it is not profitably investing its funds for shareholders. Proper liquidity relationship in a firm will also help
to safeguard the funds of the shareholders. The firm may, however maintain less liquidity after it has the ability
to borrow at short notice or if the financial institutions extend credit whenever it has a demand for it. Small
companies should have a proper liquidity but large companies which are well established may be flexible about
liquidity requirements because they are in a better position to get liquidity from the capital markets.
5. Target Pay-Out Ratio
While declaring dividends that amount should be paid to the shareholders, which can be maintained by
the company. If the earning position of the firm goes down and it cannot pay the dividends in a particular year
then its position in the stock market will also go down. The pay-out ratio is the rate of dividends to earnings.
Although the amount will fluctuate in direct proportion to earnings the shareholders will be satisfied because
if a company adopts 20% pay-out ratio for every year then although the percentage will continue to be the
same the rupee earned will be higher. For example, if the company pays pay-out ratio of 40% and if it earns
` 1.50 per share the dividend per share will be 60 paise. If it earns ` 2 per share the dividend given to
shareholders will be 80 paise. The earnings will, therefore, increase for the shareholders although the target
pay-out ratio will be the same.
11.5 DIVIDEND DECISIONS

Dividend decisions may be projected by the company from the point of view of long-term financing
decision and maximization of wealth decision.
1. Long-Term Financing Decision
As long-term financing decision the significance of the profits of the firm after tax is to be considered in
paying dividends. Investor should know that annual cash dividends have the nature of reducing the funds of
the firm and firm is restricted to grow or to find other financing sources. If the firm desires to fund dividend
as a long-term decision then it should be guided by the following points.
(a) Projects available with the firm: When a firm has many large projects to put its investments then
instead of distributing a large amount of profit it may retain earnings of the firm and advance these
projects.
(b) Requirement of equity funds: A company may be able to finance itself either through long-term
loans or through raising of capital such as equity and preference shares. To raise capital also the firm
has to incur a large cost. The company may thus take a decision of retaining some part of the earnings
of the firm and may be guided by this view at the time of paying dividends to shareholders.
2. Wealth Maximization Decisions
While the firm regards the needs of investment, expansion programmes and is guided by the decision of
paying dividends as a long-term financing requirement, the other decisions that the firm may be guided by, is
the project of paying to the shareholders a high amount of dividend to satisfy them and also to raise the price
of its equity stock in the capital market. This project takes into consideration the expectation of both the
investors and the shareholders. The management may adopt any one of these methods after taking into
consideration the factors which affect the dividend decisions.
11.6 FACTORS AFFECTING DIVIDEND DECISIONS OF FIRMS

There are many factors affecting the decisions relating to dividends to be declared to shareholders. These
are discussed below:
1. Expectation of Investors
People who invest in the firms have basically done so, with the view of long-term investment in a
particular firm to avoid the necessity of shifting from one firm to another. The expectation of the investor has
been twofold. They expect to receive income annually and have a stable investment.
(a) Capital Gains: All investors who are less interested in speculation and more interested in long-term
investment do so with a view to making some capital appreciation on their investment. Capital gain
is the profit, which results from the sale of any capital investment. If the investor invests in equity
stock, the capital gain would be out of the sale of equity stock after holding it for a reasonable period
of time.
(b) Current Income: The investor would like to have some current earnings which are also continuous
in nature and it is the price of abstinence from current consumption to more profitable avenues. The
expectation of the shareholder should be considered before taking any appropriate decision regarding
dividends. In this sense, the company has to think of both maximization of wealth of the investor as
well as its own internal requirements for long-term financing.
2. Reducing of Uncertainty
Dividends should be declared in a manner that the investor is confident about the future of his earnings.
If he receives dividends annually and the amount is such that it satisfies him then the company is able to gain
his confidence because it reduces his uncertainty about future capital gains or appreciation of the company’s
equity stock. A current dividend is the present value cash in-flow to the investors. This also helps him to assess
the kind of future that his investments will carry for him. The decisions for paying dividend should also be
considered at this point.
3. Financial Strength
The payment of dividend which is regular, stable and continuous with a promise of capital appreciation,
helps the company in judging its own financial strength and it receives financial commitments from creditors
and financial institutions because they are in a position to find out the kind of working of the firm through the
information they receive regarding the amount of dividend and the market value of their shares. While all
investors would like to maximize their wealth, the company must also see its requirement for expansion
programmes. The company also has certain limitations or environmental constraints which enable it to pay
dividend in a limited form.
11.7 LIMITATION ON DIVIDEND PAYMENTS

The firm has the following limitations in paying dividends. The management of the firm while making
decision in paying out dividends to its shareholders should also analyze these problems:
(a) Cash Requirements: Many firms are unable to pay dividends regularly. A company which is going
through its gestation period or is small in nature and is trying to expand its business has the problem
of paying high dividends. If it does, it will be surrounded by inefficiency because of the insufficiency
of cash. Sometimes a firm has the problem of tying up all resources in inventories or in the commitment
of purchasing long-term investments. This acts as a restraint of the firm to pay-out dividends.
(b) Limitations Placed by Creditors: Sometimes a firm requires funds for long-term purpose and to
fulfill this obligation it makes, the use of funds on long-term loans. While taking these loans the firm
makes an arrangement with the creditors that it will not pay dividends to its shareholders till its debt
equity ratio depicts 2:1. Sometimes the firm also makes contractual obligations with its creditors to
maintain a certain pay-out ratio till the time that it is using the loan facilities. Under these contractual
obligations the firm cannot pay more than the dividends it can or is allowed to pay, under the
agreement.
(c) Legal Constraints: In India, there are many legal constraints in payment of dividends. The payment
of dividends is subject to government policy and tax laws. This restraint also covers bonds, debentures
and equity shares. There are regulatory authorities such as Reserve Bank of India, Securities Exchange
Board of India and Insurance Regulatory Development Authority of India. Income Tax Act of India and
Companies Act followed in India. These legal constraints should be carefully analyzed before paying
dividends to the shareholders.
Dividend Theories — Conflicting Opinions
Opinion-A: Consists of the fact that dividend given by a firm affects the value of the firm. It is supported
by Walter’s Model and Gordon’s Model.
Opinion-B: The payment of dividends has no effect on the value of the firm. This view is held by M.M.
Model.
Analysis of Opinions: Opinion A states that dividend has an effect on the value of the firm but dividend
decision is passive and is out of the residual value. If the company has investment opportunities, i.e., so long
as r (rate) is greater than k (cost of capital) the firm would keep on investing its funds and the investors would
not mind whether dividend is distributed or not as the opportunities of earning is higher in the firm. The
proposition is that the firm should be able to earn more than its equity capitalization rate. If returns on
opportune investment are less, then the investors would prefer a dividend. Walter’s and Gordon’s Model are
in agreement that dividend is relevant and important but the conditions of r > k, r = k and r < k should be
considered for taking a dividend decision. Opinion B held by M.M. Model states that dividends are irrelevant
because investors are indifferent between dividends and capital gains.
11.8 WALTER’S MODEL

Walter’s Model is in total agreement that the dividend policy affects the value of the firm. The dividend
policy is, therefore, inter-linked with the investment policy that affects the value of the firm.
Assumptions
¾ Financing is done only through retained earnings. There is no external financing through equity or
debt.
¾ With additional investments, firm’s business risk does not change. r and k are constant.
¾ There is no change in the key variables, earnings per share E and dividends per share D. The value
D and E may be changed in the model to determine results but any given value of E and D are
assumed to remain constant in determining a given value.
¾ The firm has a perpetual and long life.
Walter’s Model
r
D+ (E − D)
P = ke
ke
P = Price of equity
D = Dividend
k e = Cost of equity capital
E = Earnings of the firm
Implications of Dividend Policy:

(i) Walter’s Model (Relevance of Dividends)
The choice of an appropriate dividend policy influences the value of the firm. 1
The Model proposes a relationship between the return on the firm’s investment or internal rate of return
(r) and its cost of capital or the required rate of return (k).
The firm’s dividend policy should be optimized according to the relationship of r and k
(a) If r > k the firm should retain its earnings because it can earn well on its investments. In fact it can
provide better returns than single shareholders can manage to do so. Where rate of return is greater
than the cost of capital (r > k), price per share increases when dividend pay-out ratio decreases.
Where r > k they are called growth firms and the optimum d/p ratio is 0. Such firms should plough
back the entire earnings within the firm. The market value of the shares will be maximized.
(b) If a firm cannot earn profitably when r < k the shareholders will be able to earn a higher return by
using the funds elsewhere. In such a case a d/p ratio of 100% would give optimum dividend policy.
When r < k the rate of return is less than cost of capital, the price per share increases as dividend
pay-out ratio increases.
(c) If r = k, it is a (normal firm). It is a matter of indifference whether earnings are retained or distributed.
This is so because for all d/p ratios between 0 – 100 market prices of shares will remain constant.
Therefore, price per share does not vary with changes in dividend pay-out ratio.
Example 11.1: The following information is available. EPS = ` 10, k e = 10%. Assume the rate of return
on investment expected by the shareholders (r) = 12%, 10% and 6%. Show the effect of dividend policy on
the market price of a share using Walters Model when pay-out ratio is 0, 40%, 80% and 100%.
Solution:
Dividend Policy and Value of Share (Walter’s Model)
r > k r = k r < k
r = 0.12 r = 0.10 r = 0.06
k e = 0.10 k e = 0.10 k e = 0.10
E = 10 E = 10 E = 10
Pay-out Ratio 0%
(a) D = ` 0 D = ` 0 D = ` 0
0 + (0.12 / 0.10) (10 − 0) 0 + (0.10 / 0.10) (10 − 0) 0 + (0.6 / 0.10) (10 − 0)

P = P = P =
0.10 0.10 0.10
= ` 120 = ` 100 = ` 60
Pay-out Ratio 40%
(b) D = ` 4 D = ` 4 D = ` 4
4 + (0.12 / 0.10) (10 − 4) 4 + (0.10 / 0.10) (10 − 4) 4 + (0.6 / 0.10) (10 − 4)
P = P = P =
0.10 0.10 0.10
= ` 112 = ` 100 = ` 76
Pay-out Ratio 80%
(c) D = ` 8 D = ` 8 D = ` 8
8 + (0.12 / 0.10) (10 − 4) 8 + (0.10 / 0.10) (10 − 8) 8 + (0.6 / 0.10) (10 − 8)
P = P = P =
0.10 0.10 0.10
= ` 152 = ` 100 = ` 92
1. Walter J.E. – Dividend Policy: Its Influence on the Value of the Enterprise, Journal of Finance, 18 May 1963, pp. 280-291.
Pay-out Ratio 100%

(d) D = ` 10 D = ` 10 D = ` 10
10 + (0.12 / 0.10) (10 − 10) 10 + (0.10 / 0.10) (10 − 10) 10 + (0.6 / 0.10) (10 − 10)
P = P = P =
0.10 0.10 0.10
= ` 100 = ` 100 = ` 100
This example shows that:

l When r > k the price of the share is maximum when dividend is zero. The price of the share is ` 120
when dividend pay-out ratio is zero. It goes on decreasing and when the pay-out ratio is 100% the
price of the share is the minimum at ` 100.
l When r = k, the price of the share is ` 100 at all levels of pay-out ratio 0%, 40%, 80%, 100%.
l When r < k, the price of the share keeps on increasing with the dividend pay-out ratio. When dividend
pay-out ratio is zero the price is ` 60 it keeps on increasing with the pay-out ratio and when dividend
pay-out ratio is 100% the price of the share is maximum, i.e., ` 100.
Walters Model therefore, shows the relevance of dividends and price of the share.
Criticism of Walter’s Model
(a) r is assumed to be constant, but this is not realistic because when increased investments are made by
the firm r also changes.
(b) Financing of the firm is exclusively done by retained earnings. The model is not realistic. It is not
applicable in present day conditions where external financing becomes necessary to work on large
projects and retained financing is not enough to finance it. This model would be applicable only in
the case when a firm is an all equity financed firm.
(c) k e – By assuming k e constant Walter’s model ignores the effect of risk on the value of the firm.
This model does not explain the behaviour of share prices when the rate of return is equal to the cost of
equity.
11.9 GORDON’S MODEL

Gordon’s model related the market value of the firm to dividend policy. It is based on the following
assumptions:
l The firm is an all equity firm.
l No external financing is available. Consequently, retained earnings would be used to finance any
expansion. Thus, Gordon’s model and Walter’s model both discuss that dividend policy is relevant with
investment policy.
l The appropriate discount rate ke remains constant. Thus, Gordon’s model also ignores the effect of
change in the firm’s risk class and its effect on K.
l The firm and its steam of earnings are perpetual.
l Corporate taxes do not exist.
l The firm’s relation ratio R(E – E)/E is constant. Thus, the growth rate g = r is constant.
l k e = rR = g. If this condition is not fulfilled there can be no meaningful analysis.
According to Gordon’s model, dividend policy does affect the value of the firm even, where, r = k. This
view is based on the fact that under conditions of uncertainty investors would prefer a firm which gives
dividend rather than a firm which does not pay dividend. The value of the share of the firm paying dividends
would, therefore, be higher than a firm which retains dividends because retention in risky. Investors argue “that
a bird in hand is worth two in a bush”.
In two identical firms, a firm paying dividends will have a higher value. Investors would be ready to pay
more for a firm paying dividends —
E(1 − b)
P = k − br
e
E = Earnings per share P = Price per share

br = g = growth rate b = Retention ratio
D/P Ratio = 1 – b
1 – b = D/P, i.e., percentage of earnings distributed as dividends
ke = Capitalization rate cost of capital
r = Rate of return on investments
E = Earnings per share
To illustrate implications of Gordon’s Model
Example 11.2:
Dividend Policy and Value of the Firm

r > k r = k r < k
r = 0.12 r = 0.10 r = 0.06
k = 0.10 k = 0.10 k = 0.10
E = ` 10 E = ` 10 E = ` 10
D/P Pay-out Ratio (1 – b) = 40% Retention Ratio (b) = 60%
g = br = 0.6 × 0.12 g = br = 0.6 × 0.10 g = br = 0.6 × 0.06
= 0.072 = 0.06 = 0.036
10(1 − .6) 10(1 − .6) 10(1 − .6)
P = 0.10 − 0.072 P = 0.10 − 0.06 P = 0.10 − 0.036
4 4 4
= = =
0.028 0.04 0.064
= ` 142.85 = ` 100 = ` 62.5
g = br = 0.4 × 0.12 g = br = .4 × .10 g = br = .4 × .06
= 0.048 = 0.04 = 0.024
10(1 − 4) 10(1 − 4) 10(1 − 4)
P = 0.10 − 0.048 P = 0.10 − 0.04 P = 0.10 − 0.024
6 6 6
= = =
0.048 0.06 0.076
= ` 125 = ` 100 = ` 78.94
g = br = 0.10 × 0.12 g = br = .10 × .10 g = br = .10 × .06
= 0.012 = 0.01 = .006
10(1 − 0.1) 10(1 − 0.1) 10(1 − 0.1)
P = 0.10 − 0.012 P = 0.10 − 0.01 P = 0.10 − 0.006
9 9 9
= = =
0.088 0.09 0.094
= ` 102.27 = ` 100 = ` 95.74
Gordon states
l When r > k e, price of share is favorably affected with more retentions.
l Retentions do not affect the market price of shares when r = k.
l More retention leads to decline in market price when r is < k.
Under Gordon’s model (i) market value of the firm P 0 increases with the retention ratio (b) for firms with
growth opportunities rk.
(ii) Market value of the share increases with the pay-out ratio (1 – b) for declining firms (1 – b). The
market value of the share r = k in Gordon's model is unaffected. Gordon's conclusions are similar to Walter’s
model.
There is no optimum dividend policy, market price of share is not affected by D/P ratio whether firm
retains profits or distributes it is indifferent.
Gordon revised his model in which he has stated that when r= k e the dividend pay-out ratio is relevant
because investors prefer current dividends since, they are risk averse. Future dividends are uncertain and
investors feel that capital gains are uncertain and should be discounted at a higher capitalization rate. Thus,
current dividends are certain and should be preferred.
There is another opinion that dividends do not affect the value of the firm.
The argument is that dividend decision is passive decision and is out of the residual value. If the company
has investment opportunities, i.e., so long as r (rate) is greater than k (cost of capital) the firm would keep on
investing its funds and the investors would not mind whether dividend is distributed or not. The proposition
is that the firm should be able to earn more than its equity capitalization rate. Dividends are irrelevant because
investors are indifferent between dividends and capital gains. But if returns on opportune investment are less,
then the investors would prefer a dividend. Let us now discuss the second opinion given by MM Hypothesis
on the irrelevance of dividends.
11.10 M.M. HYPOTHESIS

M.M. Hypothesis explains that dividend policy has no effect on the value of the firm and its share prices
and is, therefore, of no consequence. What matters is the investment policy through which the firm can increase
its earnings and thereby the value of the firm. Splitting earnings into retention and dividends is a matter of
detail and not of any consequences.
Assumptions
The assumptions of M.M. Hypothesis are:
l (i) Perfect capital markets; (ii) investors are rational; (iii) there are no transaction costs; (iv) securities
are infinitely divisible; (v) no investor is large enough to influence market price of securities; (vi) there
are no flotation costs.
l There are no taxes. Alternatively, there are no differences in tax rates between capital gains and
dividends.
l A firm has a fixed investment policy which will not change over a period of time. Financing of new
investments will not change the required rate of return.
l There is perfect certainty by every investor as to future investments and profits of the firm. In other
words; investors are able to forecast future prices and dividends with certainty.
According to the M.M. Hypothesis the crux of the matter is the “arbitrage process” or the switching and
balancing operation. It also refers to the simultaneous movement of two transactions which exactly offset each
other. The two transactions involved are paying dividends and raising capital through external funds either
through the sale of new shares or raising additional funds through loans to finance investment programs.
Proposal I
If dividends are distributed, an amount will have to be raised through the sale of new shares. The
increased value per share through dividends will exactly offset by the external raising of shares. The terminal
value of shares will decline. Shareholders are indifferent between retention of dividend or payment, but they
are interested in the firm’s future earnings.
Proposal II
If instead of raising equity shares the firm raises amount in the form of loan there will be no difference
between debt and equity because of leverage and the real cost of debt is the same as the real cost of equity.
Therefore, according to the M.M. hypothesis, the dividend policy is irrelevant. The arbitrage process also
implies that the Dividend Pay-out ratio between two identical firms should be the same and so also the total
value of the firm. The individual shareholder can invest his own earnings as well as the firm would, dividend
being irrelevant. A firm's cost of capital would be independent of the dividend.
Finally, due to the arbitrage process the dividend policy would be irrelevant even under uncertainty.
Market price of the firm should also be the same for two identical firms.
Step 1:
The market price of a share at the beginning of the period is equal to the present value of the dividends
paid at the end of the period plus the market price of share at the end of the period.
1
Thus, P 0 = (1 + k ) (D1 + P1 )
e
P0 = current market price of share

ke = cost of equity
D1 = dividend to be received at the end of the period
P1 = market price of the share at the end of the period.
Step 2:
Assuming no external financing, the total capitalised value of the firm would be the number of shares (n)
times the price of each shares P 0.
1
Thus, nP 0 = (1 + k ) (nD1 + nP1 )
e
Step 3:
If the firm’s internal source of financing falls short, Xn is the number of new share issued at the end of
year 1 at price P 1 .
1
Thus, nP 0 = (1 + k ) (nD1 + ∆ n ) P1 − ∆ n P1 )
e
Equation 3 implies that the total value of the firm is the capitalized value of the dividends.
∆ = the change in the number of shares outstanding.
n = number of shares outstanding for the period to be receiving during the period plus the value of
the number of shares outstanding at the end of the period considering any newly issued shares
less the value of the newly issued shares.
∴ Step 3 is the same as Step 2.
Step 4:
If the firm were to finance all investment proposals, the total amount of new shares issued:
∆nP 1 = I – (E – nD 1 )
∆nP 1 = I – E + nD 1
∆nP 1 = the amount obtained from the sale of new shares to finance capital budget.
I = the total amount requirement of capital budget.
E = Earnings of the firm during the period.
ND 1 = Total Dividends paid.
(En – D 1) = Retained earnings.
Equation 4 states that whatever investment needs (C) is not financed by retained earnings must be through
the sale of additional equity shares.
Step 5:
If Step 4 is substituted into Step 3.
1
nP 0 = (1 + k ) nD1 + (n + ∆ n ) P1 − (I − E + nD1 )
e
Solving the equation:

nD1 + (n + ∆ n ) P1 − I − E + nD1
nP n = 1 + ke
There is a positive nD 1 , and a negative nD 1 . Therefore, nD 1 cancels, we then have
(n + ∆ n ) P1 − I − E
nP 0 = (1 + k e )
Step 6:
Since, Dividend D are not found in Step 5, M.M. Hypothesis concludes that dividends do not count and
that the dividend has no effect on the share price.
A company has an equity capitalization rate of 10%. Its current outstanding shares are ` 20,000 selling
at ` 100 each. The firm is planning to declare dividend of ` 5 per share at the end of the current financial
year. The company expects to have a net income of ` 2,00,000 and proposes to make new investments of
` 4,00,000. What will be the value of the firm’s share at the end of the year if: (i) a dividend is not declared
and (ii) assuming that the firm pays a dividend how may shares must be issued? Use M.M. model to answer
these questions.
(1) Value of the firm when dividends are paid
(a) Price per share at the end of year 1
1
P 0 = (1 + k ) (D1 + P1 )
e
1
100 = (1 + 0.10) (5 + P1 )
110 = ` 5 + P 1
` 105 = P 1
(b) Amount required to be raised from the issue
∆nP 1 = I – (E – nD 1 )
= 4,00,000 – (2,00,000 – 1,00,000)
= 4,00,000 – 1,00,000
= 3,00,000
(c) Number of additional shares to be issued
3,00,000
∆n = shares = 2857 shares
105
Existing shares equals 20,000 + new shares 2857 = 22,857
(d) Value of the firm

(n + ∆n)P1 − 1 + E
nP n = (1 + k e )
Or, Total number of shares X market price of the share = 22,857 × 105 = 23,99,985 rounded of to
` 24,00,000 = value of the firm.
(2) Value of the firm when dividends are not paid.
Price of the share at the end of the year 1
1 P
P 0 = (1 + k ) (D − P ) 100 =
e 1 1 1.10
P = ` 110.
Amount requires to be raised from the issue of new shares.
Substituting the value we have
 20,000 3,00,000 
=  +  105 – 4,00,000 + 2,00,000
 1 105 
 14,000 + 20,000 
=   105 – 2,00,000
 7 
 1,60,000 
=   105 – 2,00,000
 7 
= 24,00,000 – 2,00,000
= 22,00,000 approx.
22,00,000
nP =
1.10
= 20,00,000
Amount required to be raised from the issue of new shares:
∆nP 1 = (4,00,000 – 2,00,000) = 2,00,000
Number of new shares to be issued in both cases:
2,00,000
= 1818.18
1.10
= 20,000 existing shares + new shares 1818.18
= 21818.
Value of the firm = 21,818 × 110 = 23,99,980 = ` 24,00,000 approximately.
Thus, whether dividends are paid or not paid, the value of the firm is the same.
Method II: The same problem can be depicted through a table.
Step 1: Calculating the price of the share at the end of year 1, which is ` 110 when dividends are not
paid and ` 105 when dividends are paid as calculated above in Method I.
Step 2:
Particulars When dividends are paid When dividends are not paid
Net Income 2,00,000 2,00,000
Less Dividends paid 1,00,000 ––
Retained earnings 1,00,000 2,00,000
Investment 4,00,000 4,00,000
Amount to be raised by new issues 3,00,000 2,00,000

Market price 105 110
No. of new shares 3,00,000/105 = 2,857 2,00,000/110=1,818
Existing shares 20,000 20,000
New shares 2,857 1,818
Total shares 22,857 21,818
Value of the firm 22,857 × 105 21,818 × 110
= 23,99,985 = 23,99,980
Rounding off 24,00,000 24,00,000
Therefore, it makes no difference whether a firm declares a dividend or does not declare a dividend. The
value of the firm remains the same.
Limitations of M.M. Hypothesis
Modigliani and Miller have argued that it makes no difference to the investors if a firm retains earnings
or declares a dividend. According to them retained earnings and external financing balance each other. Their
assumptions appear to be unrealistic and unpractical although theoretically it is appealing. Some of the problems
of M.M. approach are due to imperfects markets, transaction costs, floatation costs and uncertainty of future
capital gains and the preference for current dividends.
1. Perfect capital markets: M.M. model assumes that there are perfect capital markets. Such perfect
markets do not exist in the practical world.
2. Flotation costs: M.M. model assumes that there are no floatation costs and no time gaps are required
in raising new equity capital. In the practical world flotation costs must be incurred, legal formalities must be
completed and then issues can be floated in the market.
3. Transaction Costs: Although the model assumes that there are no transaction costs in the real world
there is an expense leading to commission and brokerage to sell shares. Therefore, shareholders do have a
preference for current dividends.
4. Taxes: The model assumes that there is no tax. This assumption is not realistic as taxes have to be
paid when shares are sold and there is a capital gain. Thus, investor prefers current dividends.
5. Uncertainty: M.M. model states that a company is able to issue additional equity shares. This model
is not valid when there is under pricing or sale of shares at a price which is lower than the current market price.
This means that the firm will have to sell more shares if it does not want to give a dividend. In this condition
the firm should be retaining the profits and not pay dividends. Therefore, the model is not applicable in
uncertain conditions.
Residual Theory of Dividends (Irrelevance of Dividends)
This theory is in agreement with the MM approach and assumes that external theory cannot be used
because cost of financing of new investments is high through them. It also believes that external financing is
not available when required by the firm. Since, external financing is not possible the firm finances its projects
through retained profits. The profits that would be distributed as dividends are that amount which is not
retained for further use.
A profitable firm which has many new avenues of investments should retain the funds within the firm as
it is able to maximize the wealth of the shareholders by retaining the profits and reinvesting them in profitable
investment opportunities. In this situation, the firm should decide on how much profit it should retain and not
how much dividend should be paid to the shareholder. According to this theory, dividend decision should be
a passive decision to be taken after retaining profits for investment opportunities. This theory is called the
residual theory of dividends. The market price of the share is taken as the present value of all future dividends.
Since, residual theory believes in dividend as a passive decision, it states that dividend fluctuations do not
change the perception of the shareholders when a company has profitable investment opportunities.
SUMMARY
r This chapter has made an analysis of dividend policies and decisions of a firm.
r Investors require dividends for current income as well as capital appreciation.
r Dividends in a firm should be stable and regular but these should be paid to the shareholders only after
considering certain legal implications.
r The different dividend theories are briefly discussed and they give the investors some insight into the aspects
of dividend policies in a firm.
r There are two conflicting approaches of explaining whether it is important to pay dividends or to retain
earnings.
r Walter’s model and Gordon’s model explain the relevance of dividends in the valuation of shares and the
value of the firm. These models show the relevance of dividends as according to them, investors prefer
current income to future capital appreciation. Hence, current dividends are better than future dividends.
r M.M. hypothesis and the residual theory state that dividends are irrelevant for the value of the firm. M.M.
model explains the importance of retention of the profits of the firm as they are useful for making new
investments. According to M.M. model, dividends are distributed only when they are not retained, as it makes
no difference to the firm whether dividends are paid or not.
r M.M. model explains the irrelevance of dividends through the arbitrage process through which the value of
the firm remains unchanged whether dividends are given or not.
r The residual theory believes that dividend decisions do not matter to the shareholders when dividends fluctuate
as long as the firm has profitable investment opportunities. The shareholders are compensated for reduced
dividend through capital gains.

(i) An effective dividend policy helps in achieving wealth maximization.
(ii) M.M. model states that dividends are relevant to the valuation of a share.
(iii) Dividend pay-out ratio is the portion of earnings distributed amongst shareholders.
(iv) Walter’s model supports the view that dividend is irrelevant for the failure of the firm.
(v) Gordon’s model supports the view that dividend payment does not affect the market value of the share.
(vi) The residual theory is the same as Gordon’s model.
(vii) Dividend policy is one of the important interrelated decisions relating to maximization of shareholders wealth.
(viii) Shareholders prefer current income to future income.
Answers: (i) T (ii) F (iii) T (iv) F (v) F (vi) F (vii) T (viii) T.
QUESTIONS
1. Why is dividend important from the point of view of an investor?
2. What are the different types of dividend decisions taken by a company?
3. What are the conflicting opinions on dividend?
4. Write notes on:
(a) M.M. Hypothesis, (b) Walter's Model, (c) Gordon's Model.
5. What are the different kinds of dividends? Are there any limitations to the payment of dividends?
Illustration 11.1: The following information is available in respect of a firm.
Capitalization rate ke = 15%. Earnings per share E = ` 14. Assumed rate of return on investments (i) 20% (ii) 15%
(iii) 10%, show the effect of dividend policy on the market price of shares using Walter’s model when d = 0, 2, 4, 7
and 10.
Solution:
Where, r = 20%, i.e., r > k and dividends per share of ` 0, 2, 4, 7, 10.;
Walter’s model = Dividend Policy and Valuation of Share
(a) When D/P ratio is zero and dividend per share is zero
r
D+ (E − D)
P = ke
ke
0.20
0+ (14 − 0)
P = 0.15 18.60 = ` 124.44
=
0.15 0.15
(b) D/P ratio of 25% dividend per share is ` 2.
0.20
2+ (14 − 2)
P = 0.15 18 = ` 120
=
0.15 0.15
(c) When D/P ratio of 50% and dividend per share is ` 4
0.20
4+ (14 − 4)
P = 0.15 17.3 = ` 115.33
=
0.15 0.15
(d) When D/P ratio of 75% and dividend per share is ` 7
0.20
7+ (14 − 7)
P = 0.15 16.33 = ` 108.8
=
0.15 0.15
(e) When D/P ratio of 100% and dividend per share is ` 10
0.20
10 + (14 − 10)
P = 0.15 15.33 = ` 102.2
=
0.15 0.15
This shows that as pay-out ratio increases the market value of the share decreases with 14.2% pay-out ratio the value
of the share is 119.73, at 100% pay-out ratio the share value has fallen to ` 93.3. Walter’s model shows at 0% pay-out
ratio the value of the share is maximum, i.e., ` 124.13 when r is > k e.
Walter’s Model is also tested when r is < k e.
When r = 10 and ke = 14, E = 14
(a) When pay-out Ratio is 0 and dividend is zero
0.10
0+ (14 − 0)
P = 0.15 9.33 = ` 62.2
=
0.15 0.15
(b) When pay-out Ratio is 25% and dividend is ` 2
0.10
2+ (14 − 2)
P = 0.15 10 = ` 66.6
=
0.15 0.15
(c) When pay-out Ratio is 50% and dividend is ` 4
0.10
4+ (14 − 4)
P = 0.15 10.66 = ` 71.11
=
0.15 0.15
(d) When pay-out Ratio is 75% and dividend is ` 7
0.10
7+ (14 − 7)
P = 0.15 11.66 = ` 77.77
=
0.15 0.15
(e) When pay-out Ratio is 100% and dividend is ` 10
0.10
10 + (14 − 10)
P = 0.15 12.66 = ` 84.44
=
0.15 0.15
This shows that prices of share increases with dividend pay-out ratio when r < k e at zero pay-out ratio the value of
the share was 62.2 and at 100% pay-out ratio it is ` 93.3.
(iii) When r = k, r = 15%, k = 15%, e = 14%
(a) When DP Ratio is zero and dividend is zero
0.10
0+ (14 − 0)
P = 0.15 9.33 = ` 62.2
=
0.15 0.15
(b) When DP Ratio is 25% and dividend is ` 2
0.10
2+ (14 − 2)
P = 0.15 10 = ` 66.6
=
0.15 0.15
(c) When DP Ratio is 50% and dividend is ` 4
0.10
4+ (14 − 4)
P = 0.15 10.66 = ` 71.11
=
0.15 0.15
(d) When DP Ratio is 75% and dividend is ` 7
0.10
7+ (14 − 7)
P = 0.15 11.66 = ` 77.77
=
0.15 0.15
(e) When DP Ratio is 100% and dividend is ` 10
0.10
10 + (14 − 10)
P = 0.15 11.66 = ` 84.44
=
0.15 0.15
This shows that prices of share increases with dividend pay-out ratio when r < k e at zero pay-out ratio the value of
the share was 62.2 and at 100% pay-out ratio it is ` 93.3.
(iii) When r = k, r = 15%, k = 15%, e = 14%
(a) When DP Ratio is zero and dividend is zero
0.15
0+ (14 − 0)
P = 0.15 14 = ` 93.3
=
0.15 0.15
(b) When DP Ratio is 25% and dividend is ` 2
0.15
2+ (14 − 2)
P = 0.15 14 = ` 93.3
=
0.15 0.15
(c) When DP Ratio is 50% and dividend is ` 4
0.15
4+ (14 − 4)
P = 0.15 14 = ` 93.3
=
0.15 0.15
(d) When DP Ratio is 75% and dividend is ` 7
0.15
7+ (14 − 7)
P = 0.15 14 = ` 93.3
=
0.15 0.15
(e) When DP Ratio is 100% and dividend is ` 10
0.15
10 + (14 − 10)
P = 0.15 14 = ` 93.3
=
0.15 0.15
Where, r = K Walter’s model shows that price of share is indifferent to pay-out ratio. It is constant at 93.3.
Gordon's Model
Illustration 11.2:
r = (i) 15%, (ii) 14%, (iii) 10%
k e = 14% E = ` 25
Determine the value of the shares assuming the following:
DP Ratio Retention Ratio
(a) 10% 90%
(b) 20% 80%
(c) 30% 70%
(d) 40% 60%
(e) 50% 50%
(f) 60% 40%
(g) 70% 30%
Gordon States the Following:
1. More retentions lead to decline in market price when r < K.
2. Retentions do not affect the market price of share when R = K.
3. When R > ke market price of share is favourably affected with more retentions.
E(1 − R)
P = k e − br
(i) When R > k e r = 15, ke = 14

(a) When DP Ratio is 10% and Retention ratio is 90%
g = br 0.9 × 0.15 = 0.135
25 (1 − 0.9) 2.5
P = 0.14 − 0.135 = 0.005 = 500
(b) When DP Ratio is 20% and Retention ratio is 80%

g = br 0.8 × 0.15 = 0.12
25 (1 − 0.8) 5
P = 0.14 − 0.12 = 0.02 = 250
(c) When DP Ratio is 30% and Retention ratio is 70%

g = br 0.7 × 0.15 = 0.105
25 (1 − 0.7) 7.5
P = 0.14 − 0.105 = 0.035 = 214.28
(d) When DP Ratio is 40% and Retention ratio is 60%

g = br 0.6 × 0.15 = 0.09
25 (1 − 0.6) 10
P = 0.14 − 0.09 = 0.05 = 200
(e) When DP Ratio is 50% and Retention ratio is 50%

g = br 0.5 × 0.15 = 0.075
25 (1 − 0.5) 12.5
P = 0.14 − 0.075 = 0.065 = 192.3
(f) When DP Ratio is 60% and Retention ratio is 40%

g = br 0.4 × 0.15 = 0.060
25 (1 − 0.4) 15
P = 0.14 − 0.060 = 0.08 = 187.5
(g) When DP Ratio is 70% and Retention ratio is 30%

g = br 0.3 × 0.15 = 0.045
25 (1 − 0.3) 17.5
P = 0.14 − 0.045 = 0.095 = 184.2
(i) When r = Kr = 14, K = 14

In the above case when r > ke the price of the share is favourably affected with more retentions as can be seen from
the illustration. It is 500 at retention ratio 90% and 184.2 at 30%. Let us now analyse the position of the share when
r =14 and K = 14.
g = br 0.9 × 0.14 = 0.126
25 (1 − 0.9) 2.5
P = 0.14 − 0.126 = 0.013 = 178.57

g = br 0.8 × 0.14 = 0.112
25 (1 − 0.8) 5
P = 0.14 − 0.112 = 0.028 = 178.57

g = br 0.7 × 0.14 = 0.098
25 (1 − 0.7) 7.50
P = 0.14 − 0.098 = 0.042 = 178.57

g = br 0.6 × 0.14 = 0.084
25 (1 − 0.6) 10
P = 0.14 − 0.084 = 0.056 = 178.57

g = br 0.5 × 0.14 = 0.07
25 (1 − 0.5) 12.5
P = 0.14 − 0.07 = 0.07 = 178.57

g = br 0.4 × 0.14 = 0.056
25 (1 − 0.4) 15
P = 0.14 − 0.056 = 0.084 = 178.57

g = br 0.3 × 0.14 = 0.042
25 (1 − 0.3) 17.5
P = 0.14 − 0.042 = 0.098 = 178.57
This shows that when r = K the price of share of a different retention ratio is indifferent. It is 178.57 at every
retention level. Let us now take the situation of a declining firm where, r < K.
(iii) r < K r = 11, K = 14
g = br 0.9 × 0.10 = 0.090
25 (1 − 0.9) 2.5
P = 0.14 − 0.090 = 0.05 = 50

g = br 0.8 × 0.10 = 0.080
25 (1 − 0.8) 5
P = 0.14 − 0.080 = 0.06 = 83.33

g = br 0.7 × 0.10 = 0.070
25 (1 − 0.7) 10
P = 0.14 − 0.070 = 0.08 = 125

g = br 0.6 × 0.10 = 0.060
25 (1 − 0.6) 10
P = 0.14 − 0.060 = 0.08 = 125

g = br 0.5 × 0.10 = 0.050
25 (1 − 0.5) 12.5
P = 0.14 − 0.050 = 0.09 = 138.88

g = br 0.4 × 0.10 = 0.040
25 (1 − 0.4) 15
P = 0.14 − 0.040 = 0.10 = 150

g = br 0.3 × 0.10 = 0.030
25 (1 − 0.3) 17.5
P = 0.14 − 0.030 = 0.11 = 159.09
This shows that when DP Ratio is high and Retention Ratio is low, the price of the share is increasing.
Illustration 11.3: The following information is available about a company.
k e= 15%, EPS = 20
Assume that the return on investments r = 18%, 15%, 12%.
Show the effect of dividend policy on the market price of shares using Walter’s model when D/P ratio is 0%, 25%,
50%, 75%, 100%.
Solution:
Walter’s Model
Particulars R > ke r = ke r < ke

18%>15% 15%=15% 12%<15%
EPS 20
0.18 0.15 0.12
0+ (20 − 0) 0+ (20 − 0) 0+ (20 − 0)
(a) When D/P ratio is 0 P= 0.15 P = 0.15 P = 0.15
0.15 0.15 0.15
D = 0
P = 160 P = 133.33 P= 106.66
0.18 0.15 0.12

5+ (20 − 5) 5+ (20 − 5) 5+ (20 − 5)
(b) When D/P ratio is 25% P = 0.15 P = 0.15 P = 0.15
0.15 0.15 0.15
D = 5
P = 153.33 P = 133.33 P = 113.33
0.18 0.15 0.12
10 + (20 − 10) 10 + (20 − 10) 10 + (20 − 10)
(c) When D/P ratio is 50% P = 0.15 P = 0.15 P = 0.15
0.15 0.15 0.15
D = 10
P = 146.66 P = 133.33 P = 120
0.18 0.15 0.12
15 + (20 − 15) 15 + (20 − 15) 15 + (20 − 15)
(d) When D/P ratio is 75% P = 0.15 P = 0.15 P = 0.15
0.15 0.15 0.15
D = 20
P = 140 P = 133.33 P = 126.66
0.18 0.15 0.12
20 + (20 − 20) 20 + (20 − 20) 20 + (20 − 20)
(e) When D/P ratio is 100% P = 0.15 P = 0.15 P = 0.15
0.15 0.15 0.15
P = 133.33 P = 133.33 P = 133.33
Illustration 11.4: From the following information k e = 120%, EPS = 15. Assume rate on investments 10%, 20%,
12%. Show the effect of dividend policy on the market price of shares using Walter’s model when D/P ratio is 0%, 25%,
50%, 75%, 100%.
Solution:
Walter’s Model
Particulars r < ke r > ke r = ke
10% < 12% 20% > 12% 12% = 12%
EPS 15 15 15
0.10 0.20 0.12
0+ (15 − 0) 0+ (15 − 0) 0+ (15 − 0)
(a) When D/P ratio is 0% P = 0.12 P = 0.12 P = 0.12
0.12 0.12 0.12
D= 0
P = 104.16 P = 208.33 P = 125
0.10 0.20 0.12

3.75 + (15 − 3.75) 3.75 + (15 − 3.75) 3.75 + (15 − 3.75)
0.12 0.12 0.12
D = 3.75
P = 109.37 P = 187.49 P = 125
0.10 0.20 0.12

7.5 + (15 − 7.5) 7.5 + (15 − 7.5) 7.5 + (15 − 7.5)
0.12 0.12 0.12
D = 7.5
P = 114.58 P = 166.66 P = 125
0.10 0.20 0.12
11.25 + (15 − 11.25) 11.25 + (15 − 11.25) 11.25 + (15 − 11.25)
(d) When D/P ratio is 75% P = 0.12 P= 0.12 P= 0.12
0.12 0.12 0.12
D = 11.25
P = 119.79 P = 145.83 P = 125
0.10 0.20 0.12

15 + (15 − 15) 15 + (15 − 15) 15 + (15 − 15)
(e) When D/P ratio is 100% P = 0.12 P = 0.12 P = 0.12
0.12 0.12 0.12
D =15
P = 125 P = 125 P = 125
Illustration 11.5: The earnings per share of a company is ` 8 and the rate of capitalization applicable is 10%. The
company has before it an option of adopting (i) 50%, (ii) 75%, (iii) 100% dividend payout ratio. Compute the market price
of the company quoted share as per Walter’s model, if it can earn a return of (i) 15% (ii) 10% and (iii) 5% on its retained
earnings.
Solution:
Particulars r > ke r = ke r < ke

15% > 10% 10% = 10% 5 % < 10%
EPS 8 8 8
0.15 0.10 0.05
4+ (8 − 4) 4+ (8 − 4) 4+ (8 − 4)
(a) When D/P ratio is 50% 0.10 P = 0.10 P = 0.10
0.10 0.10 0.10
D= 4
P = 100 P = 80 P = 60
0.15 0.10 0.05
6+ (8 − 6) 6+ (8 − 6) 6+ (8 − 6)
0.10 0.10 0.10
D = 6
P = 90 P = 80 P = 70
0.15 0.10 0.05
8+ (8 − 8) 8+ (8 − 8) 8+ (8 − 8)
0.10 0.10 0.10
D = 8
P = 80 P = 80 P = 80
Illustration 11.6: A company earned a net profit of ` 10,00,000 and it has 1,00,000 equity shares of ` 1 each.
Out of the net profits, the company plans to distribute ` 2,00,000 as dividends to the shareholders. k e = 16% and rate
of return is 12%. Find market price of the share using Walter’s model. What will be the optimum dividend pay-out ratio?
Find out the market price of the share when dividend is 2, 0, 10. What would be the minimum price of the share and at
what situation?
Solution:
Market price of share
Net profit = ` 10,00,000
No. of outstanding share = 1,00,000
EPS = 10
Profit utilized for dividend = ` 2,00,000
ke = 16%
r = 12%
Substituting the values in [D + r/k e(E – D)]/ke
Since, ke > r, The price would be minimum when D/P ratio is (o).
Substituting the value when {D + r/k e(E – D)}/k e
= [0+ 0.12/0.16 (10-0)]/0.16 = ` 46.875
When DP ratio is 2
= [2 + 0.12/0.16 (10 – 2)] / 0.16 = 8/0.16 = ` 50
When DP ratio is 10
Since, ke > r, price will be maximum when D/P ratio is 100% substituting the values [D+r/k e (E–D)]/ke
= [10 + 0.12/0.16 (10–10)]/0.16 = ` 62.50
Illustration 11.7: The following data is available for a company:
The earnings per share E = ` 8
Rate of return on investment = 16%
Return expected by shareholders = 12%
Find price of the share according to Gordon’s model when dividend pay-out ratio is 25% and 50%.
Solution:
E(1 − b)
P = k e − br
(i) When dividend pay-out ratio is 25% and retention is 75%
br = 0.75 × 0.16
8(1 − 0.75)
= 0.12 − (0.75 × 0.16)
P = 2/0 = 0
The answer is indeterminate as g is higher than k e .
(ii) When dividend pay-out ratio is 50% and retention ratio is 50%
br = 0.50 × 0.16 = 0.08
8(1 − 0.50)
= 0.12 − (0.50 × 0.16)
= ` 100.
Illustration 11.8: Calculate price of share by Gordon’s model when D/P ratio is (a) 10% and (b) 20%, earnings
per share is ` 20. The expected rate of return is 12% and cost of equity is 20%.
Solution:
E(1 − b)
P = k e − br
(a) When D/P ratio is 10% and retention ratio is 90%.
20(1 − 0.9)
P = 0.20 − 0.108 = ` 21.73
br = 0.9 × 0.12 = 0.108

(b) When D/P ratio is 20% and retention ratio is 80%
20(1 − 0.8)
P = 0.20 − 0.096 = 38.46
br = 0.8 × 0.12 = 0.096

When retention ratio is more the price of the share will fall when r < k e.
Illustration 11.9: Given the data:
EPS = ` 7
P/E = ` 10
k e = 12%
No. of outstanding shares = 75,000
Expected dividend = ` 5
Expected net income = ` 5,00,000
New investment = ` 8,00,000
Show using M.M. hypothesis that the payment of dividends does not affect the value of the firm.
Solution:
Market price = P/E × EPS
= MV = 10 × 7 = ` 70
(A) Value of the firm when dividends are paid
Step 1: To calculate price of share at the year-end or P 1
Current price = (D 1 + P 1)/(1 + k e)
70 = (5 + P1) / (1 + 0.12)
P1 = ` 73.40
Step 2: Amount to be raised = I – (E – nD 1)
= 8,00,000 – {5,00,000 – (75,000 × 5)} = ` 6,75,000
Step 3: No. of additional shares to be issued
∆nP 1 = (n + ∆n) P 1
= 6,75,000/73.40
= ` 9196.19
Step 4: Value of the firm
V = (n + ∆n) P 1
= (75,000 + 9196.19) × 73.40
= ` 61,80,000.3
(B) Value of the firm when dividends are not paid
Step 1: Current price = (D 1 + P 1)/(1 + k e)
70 = (0 + P1)/(1 + 0.12)
P 1 = ` 78.4
Step 2: Amount to be raised = I – (E – nD 1)
= 8,00,000 –(5,00,000 – 0)
= 3,00,000
Step 3: No. of additional shares to be issued
∆n P 1 = (n + ∆n) P 1
= 3,00,000/78.40
= 3826.53 or 3827
V = (n + ∆n) P 1
= (78826.53) × 78.40
= ` 61,79,999.9 or ` 61,80,000
Note: Rounding off: Value of firm when dividends are paid 61,80,000.3 and when dividends are not paid 61,80,000.
Illustration 11.10: A company is planning to make an investment of ` 10,00,000 and it expects to earn ` 5,00,000
by the year end. Presently, the company has 50,000 outstanding shares and the share of the company is trading at a price
of ` 125. The company expects to pay the shareholders ` 10 as dividends next year. The company’s required rate of return
= 15%. Find the following:
(a) Value of the firm if dividend is declared
(b) Value of the firm when dividends are not declared
Solution:
Step 1: Price of the share= P 1
Current price = (D 1 + P 1)/(1 + k e )
125 = (10 + P 1) / (1 + 0.15)
P1 = ` 133.75
When dividend is not declared P 1
Current price = (D 1 + P 1 )/(1 + k e )
125 = (0 + P1)/(1 + 0.15)
P 1 = ` 143.75
Particulars When dividends When dividends

are distributed are not distributed
Earnings 5,00,000 5,00,000

Less: dividends paid 5,00,000 —
Total funds required 10,00,000 5,00,000
Fresh funds to be raised 10,00,000 5,00,000
Market price of the share 133.75 143.75
No. of shares to be issued 10,00,000/133.75 5,00,000/143.75
= 7,477 = 3,478
Existing shares 50,000 50,000
Total shares 57,477 53,478
Market price per share 133.75 143.75
Value of the firm 57,477 × 133.75 53,478 × 143.75
Value of the firm 76,87,548.75 76,87,462.5
Value of the firm is almost the same, but due to fractions and rounding off for issue of new shares some slight
differences occur. Hence, the value of the firm is the same whether dividends are declared or not declared.
Illustration 11.11: A company has 60,000 shares outstanding. The market price of these shares is ` 15 each. The
company expects a net profit of ` 3,00,000 and has a cost of equity of 20%. The company plans to declare ` 5 as dividend
per share for the current year. From M.M. model calculate: (a) Price of the share at the end of the year: (i) when dividend
is paid and (ii) when dividend is not paid.
(b) How many new shares should the company issue if the dividend is paid and the company needs ` 8,50,000 for
an approved investment expenditure?
Solution:
As per MM model, the current market price of the share P 0 is
1
P 0 = 1 + k (D1 + P1 )
e
(a) If the firm pays a dividend of ` 5, the price at the end of year 1 is:
1
(i) 15 = 1 + 0.20 (5 + P1 )
1
15 = 1 + 20 (5 + P1 )
18 = 5 + P1
=> P 1= 13
(ii) If dividend is not paid the price will be:
P 1= ` 18
(b) No. of new shares to be issued if the company pays a dividend of ` 5.
= I – (E – nD 1)/P 1
= 8,50,000 – (3,00,000 – 60,000 × 5)/13
= 8,50,000/13 = 65,385
Therefore, the company should issue 65,384 new shares at ` 13 to finance the proposal.
Illustration 11.12: A company earns ` 6 per share at a capitalization rate of 10%. It has a return on investments
at 15%. According to Walter’s model what should be the price per share at 30% dividend pay-out ratio? Is this the optimum
pay-out ratio as per Walter’s model?
Solution:
When dividend pay-out ratio is 30%, the price per share is the following:
r
D+ (E − D)
ke
P =
ke
1.8 + (0.15 / 0.10) (6 − 18)

P = = 81
0.10
When, r > ke the market price of the share will increase, if dividend pay-out ratio is reduced and is lower than 30%.
The optimum pay-out ratio is 0% and retention is 100%.
Illustration 11.13: The shares of a chemical company are selling at ` 20 per share. The firm has paid dividend
` 2 per share last year. The estimated growth of the company is approximately 5% per year.
(a) Determine the cost of equity capital of the company.
(b) Determine the estimated market price of the equity share if the anticipated growth rate of the firm: (i) rises to
8% and (ii) falls to 3%.
Solution:
(i) Determination of cost of equity capital
D0 (1 + g)
Ke = +g
P0
2(1 + 0.05)
= + 0.05 = 15.5%
20
(ii) Determination of estimated market price of the equity share if anticipated growth rate rises or falls.
D1
P0 = K − g
e
(a) If the growth rate raises to 8%,

2.16
= 0.155 − 0.08 = ` 28.8
(b) If growth rate of the firm falls,
2.06
= 0.155 − 0.03 = ` 16.48
Illustration 11.14: The earnings per share (EPS) of a company are ` 10. It has an internal rate of return of 15%
and the capitalization rate of its risk class is 12.5%. If Walter’s model is used:
(a) What should be the optimum pay-out ratio of the company?
(b) What would be the price of the share at this pay-out?
(c) How shall the price of the share be affected, if a different pay-out were employed?
Solution:
Calculation of share price under Walter’s Model
R
D+ (E − D)
P = ke
ke
(a) Since, ra > re (i.e. 15% > 12.5%), to maximize the share price the company should retain all its earnings and
its optimum pay-out ratio is zero.
(b) Calculation of share price at optimum pay-out rate, i.e., if no dividend is declared.
0.15
0+ (10 + 0)
P = 0.125 12
= = 96
0.125 0.125
(c) Impact on share price, if dividend is paid @ 30%.
0.15
3+ (10 + 3)
P = 0.125 11.4
= = 91.20
0.125 0.125
Illustration 11.15: Mr. A is contemplating purchase of 1,000 equity shares of a company. His expectation of return
is 10% before tax by way of dividend with an annual growth of 5%. The Company’s last dividend was ` 2 per share. Even
as he is contemplating, Mr. A suddenly finds that due to a budget announcement dividends have been exempted from tax
in the hands of the recipients. But the imposition of dividend Distribution Tax on the Company is likely to lead to a fall
in dividend of 20 paise per share. A’s marginal tax rate is 30%. Calculate what should be Mr. A’s estimates of the price
per share before and after the Budget announcement? [CA, 2004]
Solution:
D0 (1 + g) 2 × (1+ 0.05)
Price estimate before budget announcement: P 0 = = = ` 42.00
(k − g) (0.10 − 0.05)
D0 (1 + g) 1.80 × (1 + 0.05)
Price estimate after budget announcement: P 0 = = = ` 94.50
(k − g) (0.07 − 0.05)
Illustration 11.16: ABC Ltd. has 50,000 outstanding shares. The current market price per share is ` 100 each. It
hopes to make a net income of ` 5,00,000 at the end of current year. The company’s Board is considering a dividend of
` 5 per share at the end of current financial year. The company needs to raise ` 10,00,000 for an approved investment
expenditure. The company belongs to a risk class for which the capitalization rate is 10%. Show how the M.M. approach
affects the value of firm if the dividends are paid or not paid. [CA 2006]
Solution:
Market Price if Dividend is paid = P 1 = P 0 = (1 + k e) – D = 100 (1 + 0.10) – 5 = ` 105
Market Price if Dividend is not paid = P1 = P 0 = (1 + k e) = 100 (1 + 0.10) = ` 110
Particulars Dividend Paid Dividend not Paid
1. Net Income 5,00,000 5,00,000

2. Less: Dividend 2,50,000 —
3. Retained earnings 2,50,000 5,00,000
4. Fresh investment 10,00,000 10,00,000
5. Fresh issue 7,50,000 5,00,000
6. P1 105 110
7. No. of new equity shares 7,142.86 4,545.45
8. No. of existing shares 50,000 50,000
9. No. of shares after fresh issue 57,142.86 54,545.45
10. MPS 105 110
11. Value of firm (approx.) 60,00,000 60,00,000

1. The following information is available in respect of a firm.
Capitalization rate ke =15%. Earnings per share E = ` 14. Assumed rate of return on investments (i) 20%
(ii) 15% (iii) 10%, show the effect of dividend policy on the market price of shares using Walter’s model.
Where, r = 20%, i.e., r > k. The effect of different D/P ratios is 14.2%, 28.75%, 50%, 71.43% and 100%.
Corresponding to dividends per share of ` 0, 2, 4, 7, 10.
Answer: When r > k e , ` 124.13, 119.73, 115.53, 108.8, 102.13, 93.3
Walter's model = Dividend Policy and Valuation of Share. When r < k e ` 62.2, ` 66.9, ` 71.11, ` 77.77, ` 84.5,
` 93.3, When r=k at all levels price of the share will be ` 93.3.
2. A Company’s capitalization rate is 10%. It has 30,000 shares of the face value of ` 100. Dividend per share is
` 10. The company expects to invest ` 10,00,000 and get a net income of ` 5,00,000. Show that under M.M.
hypotheses dividend payment does not affect value of firm
Answer: Value of the firm is ` 38,00,000 whether dividends are declared or not.
3. Calculate Value of an equity share applying Walter’s Formula when DP ratio is: (a) 50% (b) 75% (c) 25%.Earnings
per share is ` 8 and the cost of equity is 10%. Their expected rate of return = 15%, 5%, 10%. What conclusions
do you draw?
Answers: When r > k, ` 100, ` 90, ` 110. When r < k ` 60, ` 70, ` 50. When r = k ` 80 at all levels.
4. Diamond Engineering Co. has ` 10,00,000 equity shares outstanding at the start of the accounting year 1997. The
ruling market price per share is ` 150. The board of directors of the company contemplates declaring ` 8 per share
as dividend at the end of the current year. The rate of capitalization appropriate to the risk class to which the
company belongs is 12%.
(a) Based on M.M. approach calculate the market price per share of the company (i) when dividend is declared
and (ii) when dividend is not declared.
(b) How many new shares are to be issued by the company at the end of accounting year on the assumption that
net income for the year is ` 2 crores. Investment budget is ` 4 crores, (i) the above dividends are distributed
and (ii) they are not distributed.
(c) Show that the total market value of the shares at the end of the accounting year will remain the same whether
dividends are distributed or not distributed. Also find out the current market value of the firm under both
situations.
[Answers: (a) (i) when dividends are declared ` 160 and (ii) when not declared ` 168. (b) No. of new shares
to be issued are 1,75,000 and 1,19,048; (c) (i)18,80,000 and 18,80,064 (ii) 15,00,000 and 15,00,00,057].
5. Sahu & Co. earns ` 6 per share having a capitalization rate of 10% and has a return on investment at the rate
of 20%. According to Walter’s model what should be the price per share at 30% dividend pay-out ratio? Is this
the optimum pay-out ratio as per Walter's model?
Answer: ` 102, 30% is not optimum pay-out ratio it should be reduced to make it optimum since r > k e.
6. A company has a total investment of ` 5,00,000 in assets and 50,000 outstanding ordinary shares at ` 10 per
share par value. It earns a rate of 15% on its investment and has a policy of retaining 50% of its earnings. If the
appropriate discount rate is 10%. Determine price of the share when the company has a pay-out of 80% and 20%.
Answers: (i) ` 30, (ii) ` 17 (iii) ` -15 (Negative)
7. Calculate the price of shares by Walter’s model when rate of investment is 15% and ke =15%. The earnings per
share is ` 5. Calculate when (i) there is 100% pay-out ratio (ii) 50% pay-out ratio and (iii) 100% retention.
Answers: (i) ` 50 (ii) ` 62.5 (iii) ` 75.
8. A company has a P/E ratio of ` 10. It plans to declare a dividend of ` 11. It has 50,000 shares outstanding selling
at ` 80 each. Given M.M. model assumptions calculate the following:
(i) Price of the share at the end of the year (a) if dividend is declared (b) if dividend is not declared.
(ii) The company pays a dividend and has a net income of ` 6,00,000 and makes new investment of ` 12,00,000
during the period, how many new shares be issued?
Answers: (i) When dividends are not declared ` 88. (ii) When dividends are declared ` 77. (iii) No. of new
shares to be issued ` 9,091.
SUGGESTED READINGS
l I.M. Pandey, Financial Management, (1st edn.), Vikas Publishing House, New Delhi, 1979.
l James C.Van Home, Financial Management and Policy, (4th edn.), Prentice-Hall of India Pvt. Ltd., 1981.
l John J. Hampton, Financial Decision-Making — Concepts, Problems and Cases, (3rd edn.), Prentice-Hall of
India Pvt. Ltd., 1983.
l M.Y. Khan and P.K. Jain, Financial Management, Tata McGraw-Hill Ltd., New Delhi, 1981.
l P.V. Kulkarni, Financial Management, Himalaya Publishing House, Mumbai, 1983.
nnnnnnnnnn
Chapter
12
INVESTOR AND INTEREST RATES
Chapter Plan
12.1 What is Interest?
12.2 Different Kinds of Interest Rates
12.3 Approaches to Interest Rates
— Static Form, Dynamic Form and Eclectic Approach
12.4 Yield Curve
12.5 Liquidity Premium Hypothesis
12.6 Market Segmentation Hypothesis
12.7 Unbiased Expectations Theory
12.8 Expected Interest Rates and Term Structure of Interest Rates
12.9 Eclectic Theory and Investors
12.10 Financial Intermediaries and Term Structure
12.11 Interest Rates in India
The aim of this chapter is to familiarize the investor with the large number of interest rates prevailing in
the stock market. It also helps the investor to assess the kind of investments that he should make in the Indian
Capital Market taking into consideration the various kinds of interest prevailing on the different types of
investment outlets available.
12.1 WHAT IS INTEREST?

Interest can be explained as an amount which is paid by a borrower for using funds belonging to someone
else. Therefore, it is a transaction between surplus and deficit units. The surplus units lend money because they
earn an attractive amount for parting with money. The waiting period involves a ‘reward’ which induces the
lender to forego the use of money. Secondly, a lender can part with money for some time limit as he would
like to use the money for his own requirements. Thus, timing is an important consideration in the borrowing
284
INVESTOR AND INTEREST RATES 285
and lending transaction as the time element should be suitable to the borrower and the lender. Interest also
has another dimension. It involves a rate at which funds are borrowed. This rate is need based, dependant on
market position of demand and supply of funds. To take a loan therefore, an interest rate is to be paid.
There are different opinions about the meaning of interest. The classical theorists like Alfred Marshall felt
that interest was the price paid for abstinence of money. Knut Wicksell related interest with productivity. He
later reformulated his theory and considered four factors for determining the rate of interest — saving, investment,
hoarding and money supply. Keynes contributed to the liquidity preference theory, i.e., reward paid for surrendering
preference for liquidity. He considered interest as a purely monetary factor. Finally Neo-Keynesians opined on
interest with a more logical reasoning. They showed interest as equilibrium between stock and flow variables
of the real monetary section. They developed the theory called the ISLM theory.
One of the most useful things in the capital market of the country is to be familiar with the kind of interest
rates that operate in the environment. The investor should know that he has to cope with the different kinds
of interest rates called by different names and to be a successful investor he should be able to recognize the
kinds of interest rates and by whom these rates are fixed.
12.2 DIFFERENT KINDS OF INTEREST RATES

Different kinds of interest rates prevailing in the market are described below:
1. Ceiling Rates of Interest
Ceiling rate is also the maximum rate of interest fixed by any authority. In India the ceiling rate is usually
fixed by the Government of India and the Reserve Bank of India. Ceiling rate depends on the face value of
a financial instrument and the rate is fixed according to the face value of an instrument. The ceiling rate
pervades a wide spectrum of the environment but usually does not include the market rate or yield rate. It may,
therefore, be said that the market rate and the yield rate are independent of ceiling rates and are not subject
to these restrictions.
2. Coupon Rate of Interest
This is the rate of interest which is paid on the face value of a bond or a debenture. A person who
purchases a long-term bond from a company or from a debenture expects an interest in the form of coupon.
3. Yield
The yield indicates the present value of the future cash flows which is generated by an investment with
the cost incurred on making such investment. It also includes the principal amount when the principal amount
is repaid. The yield is also called the market rate of interest. There are many kinds of yield such as:
4. Market Yield
Market yield is also called current yield or running yield and represents the annual interest which is paid
in proportion to the market price of a bond.
5. Yield to Maturity
This yield is called redemption yield. This is the payment of an annual rate of interest and it also includes
the average annual appreciation which arises out of difference between the face value of a bond and its
purchase value. Sometimes, there may also be a depreciation in price rather than appreciation.
6. Dividend Yield
This is the annual amount paid to the shareholders (gross of tax) in proportion to the current price of the
share.
7. Earnings Yield
Earnings yield represents the amount which is adjustable as earnings to shareholders of each share in
proportion to the market price of their share.
Yield may be gross yield or net yield. Gross yield is used to measure the cost of capital and net yield is
used for finding out the effective rate of return for an investor. The investor is advised to carefully approach
both gross and net yield of investment.
Interest may also be determined from the point of view of maturity date. Interest is usually paid on a long-
term basis, for a medium-term and for a short period of time.
8. Long-Term Interest
Long-term interest rates comprise of a period usually above five years or above ten years.
9. Medium-Term Interest
Medium-term interest rates may vary from a period of one year to five years.
10. Short-Term Interest
Short-term interest rates varies per day, per week, per month, per year and the maximum number of years
for which it may be considered can be said to be three years. But three years is usually too long a period of
time because short-term interest rates are extremely sensitive to changes in the capital market of a country. The
long-term and medium-term interest rates are said to be the interest paid on fixed deposits of banks, deposit
rates, term loans, yield rates on government securities, debenture yield, the dividend paid by the Unit Trust of
India on its units and the yields received by equity shareholders on their shares the short-term rates may be
said to comprise of the bank rate interest, the treasury bill rate, the call money market rate, the short-term
deposit rate, the commercial bill rate or the Hundi rate used by commercial organisations.
12.3 APPROACHES TO INTEREST RATES

There are three approaches through which the interest rates are usually looked upon. These approaches
are also the various theories of interest. The theories of interest are basically divided into the Classical Theory,
Keynesian Theory and the theory which combines both of them.
The Classical Theory was developed by Ricardo, Hume and Wicksell and it is discussed both in its static
form and dynamic form.
Forms of Interest: Static, Dynamic, Eclectic.
1. Static Form
The rate of interest is an indication of the real productivity of capital goods. The creation of capital
requires postponement of current consumption and therefore, it can be equated as a reward for abstaining or
postponement of consumption. It is also a reward for inducing some income earners to make a change in the
preference of time in favor of future consumption. In the static condition, interest is not affected by the level
of money and prices because changes in the quantity of money lead to a proportionate change in all prices
leaving percentage ratio of money yield to money. Also, interest rates are not influenced by the behaviour of
banks. Interest, according to this view, is the interplay of demand and supply. Demand raises the productivity
of capital and the goods supplied come from the current consumption. The rate of interest is called annual rate,
full stock equilibrium rate, classical real rate and true real rate.
2. Dynamic Form
Dynamic form adds the role of banks saving and creation of new money in the short-run. This is also
called loan-able funds theory of interest. (a) Equilibrium rate is independent of price and (b) that the market
rate or nominal rate is inversely related to the price level. High price level means low market rate and vice
versa. It also states that there is a difference between natural rate and market rate. While natural rate continues
to be stable, rise in the market rate occurs. When it exceeds the natural rate and a gap can be identified
between saving, desired investment and the price falls.
How is Market Rate Determined?

Wicksell’s view is that it is determined by a central bank which by setting some level below or above
generates inflation or devaluation. It may also do so by creation of money and excess of reserves bringing down
the level of interest rates.
Interest rates and prices have been identified often to move in the same direction. This is unlike the theory
stated by Wicksell and was found out by Gibson, Keynes named it the “Gibson’s Paradox”.
The positive relationship of prices and interest has also been pointed out by Wicksell and Fisher. Wicksell
pointed out that the market rate usually lags behind the natural rate, when banks try to adjust, there is an
expansion in bank credit and price rise. Fisher’s explanation is called Fishier Effect. According to him, the
cumulative rise in prices after a time lag creates further expansion and generates price rise. Investors lend at
higher rate of protection. Interest and price rise and fall together. Therefore, Fisher explained it as an expected
rise of interest with price rise and Wicksell explains interest rate as a matter of adjustment.
Keynes describes interest as the price to parting with liquidity. The rate of interest is determined by
demand and supply. According to him there is a negative relationship between money stock and rate of interest.
3. Eclectic Approach
The third approach is called an Eclectic approach. This was developed as the term structure of interest
rates theory and is explained by the Pure Unbiased Expectation Theory, Liquidity Premium Hypothesis and
Market Segmentation. These three approaches are integrated into an eclectic approach and take into consideration
that there are large number of interest rates in an economy. These prevail because of time or maturity period,
risk of default, the callable nature of investments. The term structure of interest rates is discussed below:
Term structure of interest rates is a theory developed to analyze: Pattern of yields of debt instruments
which are essentially similar in all respects except for terms of maturity.
The Objectives of eclectic approach are to explain determinants of changes in the term structure of interest
rates:
For example in case:
1. 2010, 3-month Treasury Bill yielded 4.30% while long-term Indian Bills yield 4.85. (Long-term yield
is more)
2. 2009, 3-month Bills accrue interest 5.33% while long-term bonds 5.25%. (Short-term yield is higher).
What is the reason for such interest changes?
This is explained by the following:
1. Theories of Term Structure Liquidity Premium, Market Segmentation, Expectation Hypothesis.
2. Role of financial intermediaries in the determination of term structure.
3. Examining the interaction between the term structure and the real sector of the economy.
12.4 YIELD CURVE

The relationship between yield and terms to maturity is described by means of a yield curve. The term
of maturity is in horizontal position (time) and the average yield to maturity is in a vertical position.
Curve A is called a ‘flat curve’ indicating approximately equality of short-term and long-term yields. Curve
B is a descending curve and shows short-term rates significantly above long-term rates. Curve C is an ascending
curve with short-rates significantly below long-term rates. This phenomenon raises one important question: why
should the patterns of the term structure differ so much at different times?
12.5 LIQUIDITY PREMIUM HYPOTHESIS

Investors are risk averse and would prefer liquidity and consequently short-term investments. The longer
they prefer liquidity the preference would be for short-term investments. The longer the maturity of the security,
YIELD TO MATURITY
AVERAGE ANNUAL
A YIELD
CURVES
Fig. 12.1
the greater will be the risk or the fluctuation in value of principal to the investor. For a long-term, therefore,
a risk or liquidity premium must be offered to induce investors to purchase long-term securities. This premium
is above the average of the current short rate and expected future short-rates. Therefore, the interest rates
would be higher for a longer period of time and the yield curve would be upward sloping.
Whilst lenders would prefer to lend money for a short period of time, borrowers would like to obtain funds
for longer periods of time. The fact that in the real world yield curves have been upward sloping lends credence
to the liquidity premium theory (Post-World War II period). Once liquidity premium exists, it is clear that
expected future short rates would have to be less than the current short rate by an amount greater than the
liquidity. (i) An increase in risk aversion will make the yield curve steeper by increasing the required premium
on long-term securities. (ii) Higher return or changes in supply of securities will cause term structure rates to
be altered. If supply of shorts decreases, an increasing number of people will enter the long-term bonds market.
The yield curve should then become steeper as a result of the postulated change in supply.
Questions that are not explained in liquidity premium hypothesis are the following:
(a) Why are short-term rates sometimes higher than long-term rates?
(b) It does not explain the fact that market may not be dominated by holders of liquidity preference and short-term
investments create problems in re-investments.
12.6 MARKET SEGMENTATION HYPOTHESIS

Market segmentation hypothesis is also called “preferred habitat hypothesis”. It suggests that the term
structure depends on the supply demand conditions.
Some investors will prefer to invest in short-term securities
and will move out to longer-term securities, if higher yield
is promised to them. Others will only move to short-term
investments to avoid cost of interest, life insurance and
Unit Trusts will prefer longer-term investments because
they are risk averse and would like to avoid costs of re-
investment. Commercial banks prefer short-term investments.
Obviously relative supplies help to determine the short-
and long-term structure as they are not perfect substitutes
for each other. Clearly if there is a change in supply,
some investors will be induced to invest in available securities.
The determination of the term structure is viewed as
the outcome of the supply and demand in the two segmented Fig. 12.2: Years of Maturity
markets of demand and supply, the markets for shorts
and markets for longs. The relative demand for “longs” and “shorts” are determined by the relative flows of
funds through intermediaries which invest only in longs compared with the flows of funds into those which
invest only in shorts.
The existence of a lump in the yield curve can be explained by the segmentation hypothesis. If institutions
have rigid maturity preference, it is quite possible that a large excess of an intermediate maturity security will
cause a lump in the curve. Transaction costs are more during short-term rather than long-term cyclical change.
12.7 UNBIASED EXPECTATIONS THEORY (IRVING FISHER AND FREDRICK LUTZ)

The expectation of the future course of interest rates is the sole determinant. When the yield curve is
upward slopping it implies that market participants expect interest rates to rise in the future. Downward slope
implies the expectation of interest rates to fall in future. Horizontal line suggests that interest rates are not
expected to change.
Traditional Theory (Explaining Term Structure).
Assumptions:
1. All securities are risk-less with respect to payment of interest and principal.
2. Investors have information which is uniformly accurate forecasts of future short-term rates.
3. There are no transaction costs (similarly bonds do not have any special tax or call feature).
4. Investors are interested in profit maximization.
5. Short-term and long-term maturities are substitutes for each other and are perfect substitutes at a term
structure of rates that will equalize their yields over holding periods of various lengths. You can derive
a return over a long holding period by purchasing a long maturity or by purchasing a succession of
short maturities.
Investors will choose to purchase that combination of investment which maximizes their return during the
period for which they wish to remain financially invested (holding period). The yield which the investor receives
over that period is called his holding period yield. Long-term rate is an average of current and expected
short rates.
If expected future short-term rates are above the current short rate then the yield curve will be ascending,
i.e., the rate of a bond with 2-year maturity will be above the rate on the bond with a one-year maturity. If
expected short rates are below the current short rate yield curve will be descending. Yield curve will be flat if
future short rates are expected to be the same as the current short rate.
If we allow compounding of yearly rates then we amend the above statement and say “the rate of interest
on any long-term security is a geometric average of price”.
For a Bond Price = Coupon Payment + Face Value Yield
You can derive a return over a short holding period by purchasing a longer maturity and selling it at the
end of the short holding period. You will be indifferent between long-term and short-term maturities only when
their net rates of return are equal for each holding period.
This theory is also called “Predominant Opinion Hypothesis.
12.8 EXPECTED INTEREST RATES AND TERM STRUCTURE OF INTEREST RATES

I. Interest rates expected at the beginning of year on 1-year maturities at the beginning of years 1 to 6.
Year Expected Rate on One Year Maturity
1 6
2 8
3 9
4 10
5 10
6 10
II. The term structure of interest rates at the beginning of year 1 consistent with the expectations shown
in 1 above:
Year of Maturity Yields on the Maturities
6
1 = 6.0
1
6 + 8 14
2 = = 7.00
2 2
6 + 8 + 9 23
3 = = 7.66
3 3
6 + 8 + 9 + 10 33
4 = = 8.25
4 4
6 + 8 + 9 + 10 + 10 43
5 = = 8.60
5 5
6 + 8 + 9 + 10 + 10 + 10 53
6 = = 8.86
6 6
Empirical testing on interest rates was made by:

1. Surveying market participants.
2. Deriving deviations from past and present interest rate data.
Edward J. Kane and Burton and Malkiel surveyed commercial banks, life insurance and non-financial
corporations. According to them, expectations of future interest rates were found to be diverse amongst respondents.
According to Fredrick R. Macaulay time money seasonal showed clear signs of attempted forecasting of
the call money seasonal. It tend to move ahead to the call money seasonal, thus anticipating known seasonal
movements in the latter. Macaulay concluded that this constituted evidence of relatively successful forecasting.
However, when seasonal factor was removed from both series, the evidence showed no attempted forecasting.
The Error Learning Model developed by David Meiselmane.
The error learning model showed that expectations are a function of past and present learning experience.
As new information is received expectations are adjusted in keeping with the learning process.
Unbiased expectations theory is based on accurate predictions of future. Empirical testing would bring out
if indeed this was true over different periods of time by examining the holding period yields on different
maturities of a security.
Expected rates were revised based on past forecasting errors.
Constant revision by investors would make this theory more viable.
An Eclectic Theory of term structure is a philosophy borrowed from three different schools.
Eclectic Theory assumes that investors have a well defined expectation of ‘normal’ range of interest rates.
This normal range is based on experience. For example, if normal range is between 2% and 5% and current
rate is 4% it may rise up to 5% and if it falls it will go down to about 3%.
12.9 ECLECTIC THEORY AND INVESTORS

Investors make no judgments whether rates will rise or fall. Each direction is equally likely. The presence
of high rate on shorts will bring a downward curve and low rates on shorts and high on longs will present an
upward slopping curve.
The investor is aware that he is faced by the risk on inflation and risk due to a change of interest rate.
It is also surrounded by other risks like the risk of default in the event of non-payment of borrowers. An investor
to be induced to make an investment should be offered a ‘risk premium’ in the form of an interest rate. The
higher the risk, the greater the interest rate offered. This is the reason that interest rates on government
securities are lower than on industrial securities. Other factors like liquidity and marketability also affect the rate
of interest.
12.10 FINANCIAL INTERMEDIARIES AND TERM STRUCTURE

Financial intermediaries are large investors. Markets are, therefore, strongly influenced by the portfolio
behavior of financial institutions. The theories of term structure concern themselves with the behavior of
financial institutions. (1) In pure expectations theory, financial institutions do not have maturity preferences and
do not act. (2) Segmentation hypothesis as arbitrage have preferences behavior of financial institutions. Institutions
respond to changes in deposits and interest rates, in allocating funds among alternative financial assets, they
do so with a time lag. They make adjustment to sell existing stock and buy new stock.
12.11 INTEREST RATES IN INDIA

Interest rates in India have been dependent on the planned investment and technological improvements
in the economy. It can be equated with the planned priorities of the country and it represents a high natural
rate and low market rate. The adjustments in the planning of the economy have led to the movement of prices
and interest rates in an upward direction.
Interest rates on government funds in India have been stable and low. The yields have also been stabilized.
This is in consonance with the planning of the economy.
The interest rates in India show a rise mainly in the short-term markets and call-markets where the Hundi
rates and Bazar rates are very high. Commercial organizations have found it difficult to cope with the interest
rates and many times in India it has been found that the short-term rates are higher than long-term rates of
interest. This has been explained as the, ‘Muranjan Paradox’.
The gap in the interest rates in India between long-term and short-term has been shortened or has been
affected due to the presence of large institutional investors, because the institutional investors have been given
the loans and funds at low rates of interest for long-term purposes. This in a way explains low interest rates
on long-term basis in India.
In the private sector the long-term rates have increased slowly because of the pressures of the financial
institutions like Life Insurance Corporation of India and Unit Trust of India but while rates of interest given by
the private sector on preference shares have been quite low, the yields on dividends have shown a rise. The
interest rates in India cannot be said to be determined by the market forces before 1991. Government played
a great part in the lending and deposit rates.
A large number of convertible debentures have also been issued but the raise in short-term rates has been
faster than these long-term investments. In 2011, the commercial banks have become customer friendly and
rates of interest on savings have improved even though they are dependent on Reserve Bank of India policies.
The Reserve Bank of India fixes the lending rates of commercial banks and SEBI controls the capital
market but interest rates are now competitive.
Government fixes the rates of its own long-term securities and Treasury Bills. The interest rates of financial
institutions are also fixed by the Government. Structure of interest rates was to a large extent predominantly
administered by government before 1991 but many changes have taken place post 1991 and market is oriented
towards demand and supply conditions for determining interest rates. The investor should bear these facts in
mind and analyze the interest rates before it makes its investment.
SUMMARY
r This chapter discusses the concept of interest in the industrial securities market.
r It also explains various terminologies of interest such as coupon rate, yield rate, redemption rate, rate to
maturity, dividend yield, gross yield/net yield.
r The subject matter of this chapter also concerns itself with the different theories prevalent related to interest
rates.
r The eclectic approach which takes into consideration various factors of maturity liquidity and legal constraints
is considered to be the best approach for making the study of interest rates.
r In India interest rates were largely dependent on the activities of the Government before 1991.
r Post 1991, in the liberalized environment in India, interest rates are predominately determined by demand
and supply conditions and guided by the monetary policy of Reserve Bank of India.
r The investor should carefully analyze the different kinds of interest rates available in the economy before he
makes his investments.

(i) Yield to maturity gives the annual rate of interest with appreciation.
(ii) Market yield gives the rate of interest at maturity.
(iii) Dividend yield is the annual amount paid to a shareholder in proportion to his shares.
(iv) Dynamic form is also called Loanable funds theory of interest.
(v) According to, Keynes interest is determined by a Central bank and moves in the same direction.
Answers: (i) F (ii) F (iii) T (iv) T (v) F.
QUESTIONS
1. What is interest? Discuss the different kinds of interest rates in the market.
2. Why is time an important aspect of interest? How is the market rate determined?
3. What is yield? Discuss the different types of yield.
4. Define interest and explain its static and dynamic form.
5. Give the different theories of interest.
6. What three aspects of interest are important for an understanding of interest factor? How are the interest rates
prevailing in the Indian market?
SUGGESTED READINGS
l Gail E. Makinen, Money Banking and Economic Activity, Academic Press, New York, 1981.
l James Van Home, The Funding and Analysis of Capital Market Rates, Princeton University Press, N.J., 1970.
l L.M. Bhole, Financial Markets, Institution and Growth Structure Innovations, Tata Macgraw Hill Publishing Co.
Ltd., New Delhi, 1982.
l Malkiel Burton, The Term Structure of Interest Rates, Princeton University Press, N.J., 1966.
l Murray E. Pallkoff, Financial Institutions and Markets, Hughton Miffin Co., USA, 1970.
nnnnnnnnnn
Chapter
13
FUNDAMENTAL ANALYSIS
Chapter Plan
13.1 What is Fundamental Analysis?
13.2 Economic Analysis
13.3 Industry Analysis
13.4 Company Analysis
13.5 Ratios Relevant for Equity Shareholders
13.6 Economic Value Added (EVA)
13.1 WHAT IS FUNDAMENTAL ANALYSIS?

The discussion now focuses on fundamental analysis, technical analysis and efficient market theories. This
chapter discusses the fundamental school of thought. It makes analysis of economic, industrial and company
factors. It is called the EIC approach or top bottom approach. The behaviour of stock prices as well as
forecasting the prices of stock help the investor to take certain decisions in the investment market. What factors
should be analyzed?
The investor while buying stock has the primary purpose of gain. If he invests for a short period of time
it is speculative but when he holds it for a fairly long period of time the anticipation is that he would receive
some return on his investment. Fundamental analysis is a method of finding out the future price of a stock
which an investor wishes to buy. The method for forecasting the future behavior of investments and the rate
of return on them is clearly through an analysis of the broad economic forces in which they operate the kind
of industry to which they belong and the analysis of the company’s internal working through statements like
income statement, balance sheet and statement of changes of income.
The significance of the economic indicators is primarily to try and form a strategy for making investments.
Investors need not necessarily make their own economic forecasts but they must be able to find out the price
movements in the economy to be able to invest effectively. Published forecasts may be used by the investor
293
for this purpose. A look into the monetary, fiscal and demographic factors will give a basic idea into the trends
in the economy.
13.2 ECONOMIC ANALYSIS

Investors are concerned with those forces in the economy which affect the performance of organizations
in which they wish to participate, through purchase of stock. From their point of view, a discussion of economic
environment is very important. This is so not from the point of view of a policy maker but an investor and this
should be borne in mind. A study of the economic forces would give an idea about future corporate earnings
and the payment of dividends and interest to investors. Some of the broad forces within which the factors of
investment operate are:
1. Population
Population gives an idea of the kind of labour force in a country. In some countries the population growth
has slowed down, whereas in India and some other third world countries there has been a population explosion.
Population explosion will give demand for more industries like hotels, residences, service industries like health,
consumer demand like refrigerators and cars. Increase in population, therefore, shows a greater need for
economic development of the country. It does not show the exact industry which will be expanding but in those
countries where there is a high rate of population growth the labour intensive industries will have a generation
of demand. Likewise, investors should prefer to invest in industries which have a large amount of labour force.
Capital being rare in these countries the labour intensive industries will grow. From the point of view of rate
of return in the future such industries will bring better rates of return. Those countries which have a high growth
in capital intensive and labour scarce industries relating to investments will invest in capital intensive industries.
2. Research and Technological Developments
The economic forces relating to investments would be depending on the amount of resources spent by the
government on the particular technological development affecting the future. Broadly the investor should invest
in those industries which are getting a large amount of share in the funds of the development of the country.
For example, in India in the present context automobile industries and spaces technology are receiving a greater
attention. These may be areas which the investor may consider for investment.
3. Capital Formation
Another consideration of the investor should be the kind of investment which a company makes in capital
goods and the capital it invests in modernization and replacement of assets. These, to a large extent are
dependent on the economic factors of the country. The gross national product (GNP) of a country should be
carefully analyzed. A particular industry or a particular company in which an investor would like to invest can
also be viewed at with the help of the economic indicators such as the place, value, property position of the
industry, group to which it belongs and the year-to-year returns through corporate profits.
4. Natural Resources and Raw Materials
The natural resources are to a large extent responsible for a country’s economic development and overall
improvement in the condition of corporate growth. The discovery of oil in middle-east countries, the discovery
of gas in America created great changes in the general economic pattern and the investment of those countries.
In Japan, government found raw material in the form of labour force much suited to a developing country.
Technological discoveries in recycling of materials, nuclear, solar energy and new synthetics should give the
investor an opportunity to invest in untapped or recently tapped resources which would also produce higher
investment opportunity.
5. Economic Forecasting
All industries in an economy do not grow at the same rate. After considering these broad economic forces
which are demographical in nature, the investor should make an economic forecasting for taking a decision on
investment in stocks. It is important to forecast the economic environment basically because if the investor
FUNDAMENTAL ANALYSIS 295
purchases an investment at the right time and when it is getting the proper resources to help it grow, the
investor will receive a gain on the amount which he has invested. Timing is crucial because if an investor
operates his investment during the time of strike or during a distributed state of the capital market then the rate
of return which he will receive will not be high. Favourable conditions will give him a good rate of return
because the profits in a company are based on the key economic factors like (a) labour, (b) government, (c)
political climate, (d) developments in technology, (e) availability of finance and (f) tax treatment.
6. Economic Indicators
Besides the demographic factors discussed above there are other significant economic indicators. These
indicators are sometimes identified as leading, coincidental, lagging indicators and their help is often sought in
forecasting, making an analysis of the economy.
The leading indicators help us to assess the future course of action. The leading indexes of an economy
relate to a country’s fiscal policy, monetary policy, stock prices, state of the capital market, labour productivity,
consumer activity and GNP.
The coincidental indicators are the economic factors relating to employment position in a country and
other GNP factors such as the state of industrial production, corporate profits, wholesale and producer price
index. Coincidental indicators unlike leading indicators do not indicate the future of the economy but present
a fairly accurate picture of the current state of the economy.
The change in coincidental indicators make the lagging indicators turn. Lagging indicators are identified
with consumer price index, capital expenses and commercial paper rates.
The leading, coincidental and lagging factors are a useful insight into the economy’s current and future
position. It is also important for an investor from the point of view of assessing long-term investment:
l A GNP growth rate of 6% would positively affect the stock market. Growth in GNP without the
associated evils of price increase and inflation is desirable for investment in bonds and equities.
l Another indicator relates to reduced unemployment. A rise in employment is favourable for the economy.
l Savings is a positive indicator during inflationary period. An attempt should be made to effectively
step it up.
l Consumer activity in terms of increase in purchase and sales may also be considered a positive
improvement in the economy.
l High interest rates are unfavourable for the stock market and their effect on equity shares. It has a
negative effect on equity shares.
l Buoyancy in the stock market is a good economic indicator and shows growth in the economy. The
following forecasting methods are suggested for preparing economic forecasts.
Economic forecasting, as already discussed, is a measure to find out the future prosperity of a pattern of
investment. The technique of economic forecasting is to measure either short-term or longer-term economic
developments well in advance. Long-term forecasts are usually for a period of above five years or ten or more
years and a study to be made in advance. A period shorter than the long-term period may be divided into:
(a) short-term period, (b) intermediate period. A short-term period generally ranges from one to three years.
Economic forecasts are easier to find out during short-term period. Therefore, forecasting techniques are also
built in such a way that the long-term forecasts are broken into shorter periods to forecast the long-term.
Longer-term forecast would give a brief idea about the changing tax laws, government priorities and quick
capital gains. Most of the economic forecasts are through the short-term forecasting techniques.
7. Forecasting Techniques
There are basically five economic forecasting techniques:
These techniques are surveys, economic indicators, diffusion indexes, economic model building and opportunistic
model building.
(i) Surveys: One of the methods of short-term forecasting is to make a survey of the type of business
that one is interested in. The method to do this is approximate because it is based on beliefs, intentions
and future budgeting of the government. It, however, broadly indicates the future course of events in
the economy. The method to forecast through surveys is either through (a) personal contact, i.e., to
meet the people and to record conversations about their intention to invest money by type of product,
and by type of industry in future and make analysis of it. A representative sample of people in the
same industry may be a good survey. The other method of survey is through the means of detailed
questionnaire which may either be filled in by meeting people personally or the respondent may fill
the form himself. The basic use of this method is to have insight of the kind of activity in the economy.
For example, if an idea was to be received about the construction activity of a country then surveys
may be made of contractors concerning: (a) private contracts, (b) government contracts, (c) contractors
of housing programmes such as Delhi Development Authority. (D.D.A)., (d) contractors of building
commercial complex. This will be representative samples and it will be of good use if their intention
is found out in the exact nature of expenditure they will make in the near future. These surveys may
be based on statistical sample method, but after processing and tabulation of these questionnaires an
analysis could be made. The limitation of this form of forecasting is that it is based on the observations
of a particular person and on an intention of the future. The intention may not be carried into reality
by the respondents. Many times a person may intend to build a house but may not do so because of
certain kinds of indicators in the economy. Similarly, if the surveys are made on the contractors and
they had every hope of building activity because of opportunity and better future, their intention may
not come into reality because of certain changes in circumstances distortions may take place. Strike,
political instability, changes in monetary and fiscal policies are some reasons for change in plans. The
survey would, therefore, be of no use in these changed conditions. The usefulness of these surveys
cannot be completely obviated and a number of financial weeklies make a survey of the kind of
economic activity which will be held in the country.
(ii) Indicators: The second approach behaves like a barometer. It gives indication of the economic
process through cyclical timings. This project is a method of getting indications of the future relating
to business depressions and business prosperity. This method helps in finding out the leading, lagging
and coincidental indicators of economic activity described earlier. Although, a very accurate estimate
is not possible, the barometers indicate the level of economic activity. This indication works geographically
and through different weekly and monthly periods. Also, because it gives the leading indication it
shows the kind of production activity, the changes in the direction of productivity and the turn of the
direction of change in the economic activity. This method although has its advantages of giving the
future indications of the economy is not an exact method of finding out the economic activity. It gives
results approximately and is at best an estimation of the future of the economic conditions.
(iii) Diffusion Indexes: The diffusion index is a method which combines the different indicators into one
total measure and it gives weaknesses/strength of a particular time series of data. The diffusion index
is also called a census or a composite index. The method adopted in this economic reading of the
future, is to take the leading, the coincidental, the lagging factors together to summarize them and then
to draw out and infer a particular composite answer. Usually both the micro aspect of the data and
the macro aspect are combined. This is a complex statistical method and the combination of various
factors in this technique makes it extremely difficult to draw out a proper understanding of the
forecasting methods.
(iv) Economic Model Building: This is a mathematical and statistical application to forecast the future
trend of the economy. This technique can be used by trained technicians and it is used to draw out
relationships between two or more variables. The technique is to make one independent variable,
dependent variable and to draw out a relationship between these variables. The answer of drawing
up these relationships is to get a forecast of direction as well as magnitude. This is a process technique
as it specifies a particular system, calculates the results through the simultaneous equations taking both
endogenous variables and exogenous variables. The endogenous variables are usually predetermined
and one equation is usually needed to find out the forecast value of the endogenous variables. The
economic model, however, also has its limitations in a country like India. The data collected and
processed through this method require a great deal of time and delays in formulating the data changes
the entire economic condition of the country by the time formulation results are out. The results and
analysis through the method often becomes obsolete even before it has been processed.
(v) Opportunistic Model Building: This method is the most widely used economic forecasting method.
This is also called sectoral analysis of GNP Model Building. This method uses the national accounting
data to be able to forecast for a future short-term period. It is a flexible and reliable method of
forecasting. The method of forecasting is to find out the total income and the total demand for the
forecast period. To this are added the environment conditions of political stability, economic and fiscal
policies of the government, policies relating to tax and interest rates. This must be added to gross
domestic investment, government purchases of goods and services, consumption expenses and net
exports. The forecast has to be broken down first by an estimate of the government sector which is
to be divided again into State Government and Central Government expenses. The gross private
domestic investment is to be calculated by adding the business expenses for plan, construction and
equipment changes in the level of business. The third sector which is to be taken is the consumption
sector relating to the personal consumption factor. This sector is usually divided into components of
durable goods, non-durable goods and services. When data has been taken of all these sectors, these
are added up to get the forecast for the GNP. They are then tested for consistency. This may also be
used in the form of a matrix to find out the flow of savings as well as the flow of investments. This
method is very reliable and it is often used for forecasting the economic conditions of an economy.
When an investor has made an analysis of the economic factors of the country taking into consideration
the leading, lagging and coincidental indicators, also taking into consideration the monetary, fiscal policies of
the country together with the demographic factors to find out the change of direction through indicators the
next step for the investor is to analyze the industry and more firmly the company in which he wishes to invest.
The analysis of this nature will indicate to an investor whether the industry is a growth industry or it is an
expanding industry or there is obsolescence in industry. It is important for the investor to put the value of his
money in the right kind of industry so that he may benefit from his investments. An insight to industrial analysis
will give the investor a choice of the industry in which the investments should be made.
13.3 INDUSTRY ANALYSIS

It is important to make an analysis of different industries as each industry has its own specific requirements.
An investor should be able to evaluate his risk and return before he takes a decision for making an investment.
The following factors should be considered by the investor regarding an industry:
1. Classification of Industry
The industry has been defined as a homogeneous group of people doing a similar kind of activity or
similar work. But industry broadly covers all the economic activity happening in a country to bring growth. A
broad concept of industry would include all the factors of production, transportation, trading activity and public
utilities. The broad classification of industry, however, would not be relevant for an investor who would like
to ensure that he does not lose from the investment that he makes. It is, therefore, essential to qualify the
industry into some characteristics homogeneous group. Usually, the industry is classified in processes and in
stages. It may also be classified according to work group that it identifies to. Sometimes, it is classified as
manufacturing, transportation and public utility. Classification into simple manufacturing, transportation and
public utility creates confusion. The confusion arises because under the table of manufacturing there may be
many kinds of industries which could also be classified in the group of transportation. For example, trucks are
used for transportation, the trucks are also manufactured. This kind of classification creates a confusion in the
mind of the investor. The concept of industry is, therefore, to be defined according to some clear-cut lines of
demarcation to give a clear idea to the investor before he makes an investment. In India, the broad classification
of industry is made according to stock exchange list which is published. The same list is also published in
Economic Times and Financial Express daily. This gives a distinct classification to industry to industry in
different forms such as (a) engineering, (b) electricity generation, (c) textiles, (d) cement, (e) steel mills and
alloys, (f) cable and electrical, (g) plantation, (h) chemicals and pharmaceuticals, (i) paper, (j) sugar, (k) rubber,
(l) automobiles, cycle and accessories, (m) miscellaneous. This classification broadly helps the investor to
analyze the industry and find out whether it is profitable to make an investment or not.
2. Technology
The characteristics of industrial growth begin with certain important factors. One of these factors is
technology. Technology keeps on changing. For instance, fountain pens have given way to ball pens. Similarly,
the electric radios have now changed into transistors, two-in-ones, three-in-ones, televisions — black and white,
colour television, and video systems, plazma, LCD’s and LED televisions. These technological changes should
be carefully viewed by the investor. A product with frequent technological changes may be useful for the
investor to notice as product obsolescence may erode his investment.
3. Competition
The second factor which an investor must consider in making an industrial analysis is to enquire about
the type of competitive pressure that an industry faces in the country. Every industry has large number of firms
comprising it. A study of representative sample may give a picture of the kind of competition that an industry
faces. For example, in India the pharmaceutical industry had a sudden boost and large number of small
companies had entered into the industry but with the change in law small companies and firms no longer exists
and pharmaceuticals are now represented by large reputed companies. The competition is of a different kind
and many retail outlets are now giving a discount for sale of their medicines.
4. Economic Environment
The third factor is the kind of economic environment and customer activity in a country. Poverty in a
country would have an economic climate where cheaper products would be sold and demand for these products
will be higher than quality and long lasting products. Economically advanced country will have customer
activity in higher price and better quality products. These factors should be carefully evaluated.
5. Industry Life Cycle
Industry should also be evaluated or analyzed through its life cycle. There are generally three stages of
an industry. ‘Grodinsky’ has defined these stages as the pioneering stage, expansion stage and stagnation
stage. 1
(i) The Pioneering Stage: The industry life cycle as defined by Grodinsky has a pioneering stage when
the new inventions and technological developments take place. During this time the investor will
notice a great increase in the activity of the firm. Production will rise and there will be a good demand
for the product. At this stage the profits are very high as the technology is new. Taking a look at the
profit many new firms enter into the same field and the market becomes competitive. The market
competitive pressures keep on increasing with the entry of new-firms, the prices keep on declining and
then ultimately profits fall. At this stage all firms compete with each other, only a few efficient firms
are left to run the business and most of the other firms are wiped out in the pioneering stage itself.
(ii) The Expansion Stage: The efficient firms which have been in the market now find that it is time
to stabilize. Although competition is there, the numbers of firms have gone down during the pioneering
stage itself and there are a large number of firms left to run the business in the industry. Prices begin
to stabilize; each firm finds a market for itself, develops its own strategy to sell and to maintain its
position. Even though there is a competition each firm is able to stand, sell and make huge profits.
This is the time when each one has to show its competitive strength and superiority. The investor will
find that this is the best time to make an investment. At the pioneering stage it was difficult to find
out which of the firm to invest in, but having waited for the stability period there has been a dynamic
selection process and a few of the large number of firms are left in the industry. At this particular
period each firm has established itself, developed its objectives, stabilized its financial position and
dividend policy has become stable. By this time the firm has been able to satisfy the investor also. At
this time the firms begin to expand themselves both through external means of financing through loans
1 For a detailed study read Grodinsky — Investments, New York, Ronald Press, 1963, p. 71.
and public issue of shares as well as through internally generated funds. This is the period of security,
safety and this is also called period of maturity for the firm. This stage lasts from five years to fifty
years of a firm depending on the potential, productivity and policy to meet the changes of competition
and rapid change in buyer and customer habit. After this stage, develops the stage of stagnation or
obsolescence.
(iii) The Stagnation Stage: During the stagnation stage, the investor will find that although there is
increase in sales of an organization, this is not in relation to the profits earned by the company. Profits
are also there, but the growth in the firm is lower than it was in the expansion stage. The industry
finds that it is at a loss of power and cannot expand. The transition of the firm from the stage of
maturity to the stage of stagnation is very slow and after a long time the internal management begins
to realize this state of complacency. While the owners of the firm are happy with their profits they do
not know that their growth is slow and they are slipping in the stagnation stage. They slip so slowly
from maturity to stagnation that they do not make an effort to expand or grow. During this stage most
of the firms who have realized the competitive nature of the industry and the arrival of the stagnation
stage, begin to change their course of action and start on a new venture. Investors should make a
continuous evaluation of their investments. In firms in which they have already received profits for
large number of years and have reached stagnation they can plan to sell away their investments and
find better avenues in those firms where the expansion stage has set in. There are many reasons for
a firm to come into the stagnation stage:
l Change in Social Habits: As a country develops, the social habits of people tend to change.
This change may arise from prosperity. For example, in India cotton textile has been replaced by
the more expensive polyester and terrycot with affluence in some section of the society. The
second change may occur due to certain medical means. For instance, ghee as a product has
shown a great decline in India in favor of groundnut, soya, and olive oil as a medium of cooking.
Improvement in medical science showed that large number of people suffered from heart attack
with the use of ghee. These factors brought about a change in social habits in the country.
l Government Regulation: There have been continuous changes in government regulations in
India. These changes can be seen by an evaluation of the textile garments trade. When government
fostered this industry there were a large number of firms, making a profit. Changes in government
regulations have shown a decline in the industry and fall in the employment potential in this
industry. Secondly, this change can also be observed from the recent government regulations
relating to non-resident Indian investments. A large amount of funds poured the field of residential
buildings in India from the non-residential foreign accounts maintained in the banks in the
country. Price support measures and government regulations have, therefore, supported or shown
decline in many industries in the country.
l Improved Technology: Changes in technology and new developments have shown pioneering,
expansion and stagnation stages of many industries. One of these industries is black and white
television. In India in the pioneering stage there was the entry of at least fifty different groups,
out of which three or four established themselves, some of them were EC TV, Weston, Uptron,
Crown and Texla. There is obsolescence and decline in the black and white television industry
and at present the demand is only for colour televisions. The leading brands are now Sony,
Samsung, LG, Philips and Onida. These are all international brands. All the earlier Indian brands
are completely out of the market. Similarly cassettes in India which were popular at one time
moved to CDs and DVDs. Currently the preference is for USBs.
l Labour Cost: One of the reasons which bring about a decline of industry is the labour cost. At
the time of expansion because of competition and high demand for the product firms begin to
give a higher wage to labour. This labour cost becomes expensive when the economic significance
of the industry declines. When demand decreases, the prices are reduced but the cost of labour
cannot be reduced. The firm begins a slow decline from its maturity stage.
Growth of the industry should be measured by the investor: (a) in terms of the GNP, and (b) by measuring
the growth rate of the industry. To the investor those industries which are growing faster than the national
economy is a useful investment proposition even if the industry grows with the GNP the prospects are good.
But if the industry has no relationship with the GNP, the investor should constantly evaluate his investment.
Growth rate of the industry is also useful for the investor to analyze so that he is sure of a good return. As
an investor his investments will be safe in those industries for a large number of years and then at the decline
stage he may plan to sell his investments and shift to companies with better prospects.
The economic and industry analysis is made by the fundamental analyst in order to have a broad idea
of the forces affecting the investment market. Apart from these two measures the third analysis called company
analysis is more precise, definite and accurate. This is a method of finding out the worth of the company
through an analysis of its financial statements. This analysis will help the investor in making the right choice
of an investment.
13.4 COMPANY ANALYSIS

Company analysis is a study of the variables that influence the future of a firm both qualitatively and
quantitatively. It is a method of assessing the competitive position of a firm, its earning, profitability, the
efficiency with which it operates its financial position and its future with respect to the earning of its shareholders.
The fundamental nature of this analysis is that each share of a company has an intrinsic value which is
dependent on the company’s financial performance, quality of management, record of its earnings and dividend.
They believe that the market price of share in a period of time will move towards its intrinsic value. If the
market price of a share is lower than the intrinsic value, as evaluated by the fundamental analysis, then the
share is supposed to be undervalued and it should be purchased, but if the current market price shows that
it is more than intrinsic value then according to the theory the share should be sold.
This basic approach is analyzed through the financial statements of an organization. The basic financial
statements which are required as tools of the fundamental analyst are the income statement, the balance sheet
and the statement of changes in financial position. These statements are useful for investors, creditors as well
as internal management of a firm and on the basis of these statements the future course of action may be taken
by the investors of the firm. While evaluating a company, its statement must be carefully judged to find out
that they are (a) correct, (b) complete, (c) consistent and (d) comparable.
The accuracy of a financial statement is usually identified if the statements have been certified by a
qualified Chartered Accountant. In India, all firms have to get their documents legally audited by a Chartered
Accountant before they are made available for public presentation. Care must be taken to see that a responsible
auditor has certified the accounts of the firm. The notes below the financial statements should also be carefully
studied.
Every investor in his own interest should see that the financial statements are complete in all respects. A
statement should be such that it can assist financial analysis and it also takes into consideration as many factors
as possible. One of the changes which often take place is the price level change. Financial statements, which
takes into account as many changes as possible to give accurate account to the investors, should be considered
a good statement, but it is rather difficult to find out whether a statement is complete because it works within
the framework of the rules that have been established for it. A number of people who are an authority of the
financial aspect of the firm have suggested that there should be changes in the financial statements to give more
information. From time to time some changes do take place. Changes suggested in financial statements have
been made by the United States General Accounting Office in their pamphlet outlining the opinion of the
Accounting Principal Board. 2
Financial statements should be comparable also because when information is to be compared between one
firm and another, type of information should be standard so that it can be evaluated in a uniform manner. The
Accounting Standard Association has set certain rules for evaluating accounting revenue costs and profits.
2. Washington D.C., 1971, pp. 81-91.

The fourth factor is relating to the consistency of accounts. This is important for making a comparison of
a firm’s performance over a period of time. Data should be continuous and financial statements should be
uniform for comparability.
The income statement is one of the best methods of finding out the future of a firm. It gives the past
records of the firm and this becomes a base for making predictions for the firm. Its importance as a statement
of analysis has come out only since the seventies and its significance is to assess the earnings of a firm.
When the income statement is being analyzed there are certain items which require particular attention:
1. Inventory Cost Methods
One of the areas which need specific attention is the method of evaluating inventory. There are a large
number of methods for evaluation of inventory out of which the last-in-first-out are the most popular. In the
first-in-first-out method the items of inventory which are first brought in the organization are consumed also
first. Alternatively, in the last-in-first-out method the inventory which is purchased last is first consumed.
The LIFO method is an attempt to provide an element of conservatism. The effect of this method when
prices rise is to show a profit at a lower rate by creating a low carrying value for inventory. The effect is
opposite at the time of falling prices.
The FIFO method shows greater earnings during time of inflation and rising prices. Thus it is important
to find out the kind of inventory method that a firm operates upon while analyzing the income statement to
make adjustments in the value of stock.
2. Depreciation
Depreciation method should also be uniform from year to year to find out the exact effect on a firm.
Depreciation is a means of reducing the life of an asset every year till depletion. The problem regarding
depreciation arises at the time of comparability of one firm and another because there is large number of
depreciation methods. Depreciation is dependent on three factors. These are the original cost of an asset, its
estimated life and the estimated residual value at the end of its life. Usually depreciation methods are on the
basis of time or on the basis of use. The straight line method of depreciation is usually used to write off asset
uniformly till it reaches the end of its useful life. When depreciation is based on the accelerated method, then
the asset depreciation is regulated. The effect of depreciation is that if a large amount of depreciation is written
off in the beginning of the life of the asset it reduces the taxable income of the firm and also the taxes which
it pays. On the other hand, during the later years of the life of the asset if the depreciation charges are small
then the taxable income becomes high. The tax rate usually does not change under both the methods of
depreciation but accelerated depreciation methods take into consideration, the time value of money which the
straight line method does not consider.
Every firm uses the method of depreciation which is stable and useful for its own official purpose. This
creates a complication for an investor while estimating the earnings through the financial statement.
3. Earnings from Regular Operations
Every business earns from its normal operations, which are recurring in nature. Sometimes, in a firm there
are extraordinary items which have entered in the business due to a certain material factor in the economy.
For example, in case of floods an item of non-recurring nature may arise. An investor must be careful to see
that a gain or a loss from this extraordinary item is disclosed in the financial statements. In a year in which
a firm has both earnings from regular operations and earnings from its other operations should be shown in
the income statement and also with greater explanations in the footnotes.
4. Intangibles
In every business there are certain characteristics factors which develop or show the worth of a firm, but
there is not physical form as it is intangible in nature. Some of these items pertain to copyrights, patents,
government limitations, trade marks. The accounting principal board has started that the intangibles should be
evaluated at cost and also amortized on a straight line basis. The estimated useful life has been expressed as
forty years for these intangibles. The investor should analyze the intangibles carefully and see that the company
has not written them off immediately after acquiring them. It has been found that in some firms there is
complete wiping out of these items without amortization.
5. Earnings Per Share
The most important item which the investors must take care to evaluate is the earning that a shareholder
receives on his share. This has to be calculated by finding out the total number of equity shares outstanding
in the firm. The investor should also analyze the number of equity shares which have the privilege of conversion
or with options. He may also calculate the price of convertible securities from the income statement. The
presence of bonds, preference shares and equity shares also create an element of confusion while analyzing
statements. These should be carefully noted from the income statement.
6. Financial Position — Balance Sheet
It is the interest of the investor that he reviews all the assets in the balance sheet. The accounting principle
of conservatism places a view that the evaluation of the assets should be on the original cost or the cost at
which they were first purchased. The balance sheet as a form of analysis received importance much before the
income statement. Its importance as a form of analysis came into operation since 1900. Balance sheet format
is generally in account form or a statement form. It shows both the assets and the liabilities of the firm added
up with the shareholders’ equity. It is important to take note of the footnotes which are given in the balance
sheet relating to certain important items like: (a) tax, dividends and contingent liabilities, (b) the basis of
valuation of assets, (c) the depreciation methods used,(d) changes in capitalization. These footnotes will reveal
much more than the investor gets an idea from the actual financial statements.
The third statement which is important from the point of view of an investor is the statement which shows
the changes in the financial position of a firm between the beginning and the end of an accounting period. The
statement of changes in financial position comprises all the data which comes from the balance sheet, the
income statement and the statement of retained earnings. These statements give an idea of the changes in the
working capital of the firm and also depict the changes in non-current assets, equity holders’ changes and
changes in the long-term liability. It gives the sources of finance and also takes into consideration both the
ordinary and the extraordinary incomes. It gives the effect of purchase and sale of long-term assets, conversion
of debt or preferred stock into equity stock, issue or redemption, assumption and re-payment of long-term debt
and dividends. The investor uses these statements to analyze the earning power of the company. Basically,
analysis is made through the use of liquidity ratios, profitability ratio, leverage ratio, activity ratio, solvency ratio
and financial ratios. (Table 13.1 depicts ratios at a glance for the investor).
Statements of income, balance sheet and statement of changes in financial position are depicted in
Examples 13.1. The statement of income and balance sheet are depicted in statement form and in account
form.
Table 13.1 RATIOS RELEVANT FOR EQUITY SHAREHOLDERS
Profits After Tax − Preference Dividend

(a) Earnings Per Share = Number of Equity Shares
Market Pr ice Per Equity Share

(b) Fixed Charges Coverage = Earnings Per Share
Earnings After Tax − Preference Dividend

(c) Cover for Equity Dividends = Total Amount of Equity Dividend
Dividend per Equity Share

(d) Pay-Out Ratio = Earnings per Equity Share
Equity Share Capital + Re serves

(e) Book Value Per Share = Total Number of Equity Shares
Market Pr ice of the Share

(f) P/BV Ratio = Book Value of the Share
Pr ofit After Taxes (PAT) + Interest

(g) Return of Capital Employed Net Worth = Net Worth + Debenture + Loan Funds Capital × 100
Highest Pr ice of Share − Lowest Pr ice of Share

(h) Volatility = × 100
Lowest Pr ice of Shares
Dividend per Share

(i) Yield (%) = Market Pr ice per Share
13.5 RATIOS RELEVANT FOR EQUITY SHAREHOLDERS
(i) Earnings Per Share

For equity shareholders certain standard terms are frequently used which are also defined here for facility
of reference.
Pr ofits after tax and preference dividends
Earnings per Share = Numbr of equity shares
An increasing tendency of earnings per share would enhance the possibility of increasing dividends or
bonus, after a time.
(ii) Price Earnings Ratio
This is defined as:
Market Pr ice per Equity Share
Price earnings Ratio = Earnings per Share
A high PE ratio indicates investor’s confidence in the stability and growth in the company’s income as
reflected in the market price of company’s equity shares. These ratios are also important for predicting the price
of equity shares on some future date and in knowing whether shares of the company are undervalued or over-
valued which can be done by comparing the PE ratio of the company with the PE ratio of other similar
companies.
Cover for Equity Dividend is defined as:
Earnings after tax+ Pr eference dividend
Cover for Equity dividend =
Total amount of equity dividend
(iii) Pay-out Ratio

This is defined as:
Dividend per Equity Share
Pay-out Ratio = Earnngs per Equity Share
This ratio reveals as to what portions of the earnings per share have been used for paying dividends and
how much has been retained for ploughng back into the working of the company. Obviously any investor
interested in price appreciation of the shares should invest in the shares of a company having a low pay-out
ratio, as retentions out of earnings per share will ultimately go to the increased fixed assets investment of the
company which may result in future improvements in work, dividends per share or bonus.
Example 13.1 (a): gives a consolidated balance sheet of XYZ Co. Ltd. for the year 2008 and Example
13.1 (b) gives a Profit & Loss Account of the same firm, the different ratios discussed above are computed to
assess operating profit margin, net profit margin, return on total invested capital, return on equity, earnings per
share, current ratio, earnings coverage, debt capitalization ratio and debt equity ratio. Examples give the
various ratios important for shareholders and some explanations about share values. The book value of the
share is described in Example 13.3.
Solution:
Example 13.1(a)
Analysis of Company XYZ Co. Ltd.
Balance Sheet as on 31st Dec, 2008
( ` in crores)
2008
ASSETS
Current Assets:
Cash 6.5
Marketable Securities 1.6
Accounts Receivable (net) 11.0
Inventories 24.4
Total Current Assets (CA) 43.5
Fixed Assets:
Property, Plant Equipment 26.0
Less Depreciation 13.1
Total Net Fixed Assets (NFA) 12.9
Total Assets (CA + NFA) 56.4
LIABILITIES
Current Liabilities:
Accounts Payable 1.4
Accrued Wages and Taxes 2.7
Bank Loan 1.9
Total Current Liabilities 6.0
Long-Term Loan 12.5
Stockholders’ Equity 9.0
Capital Surplus 2.7
Earned Surplus 26.1
Total Stockholders’ Equity 37.8
Total Liabilities and Stockholders’ Equity 56.3
Example 13.1(b)
XYZ Co. Ltd.
Financial Statements for the year ended 31st Dec, 2008
( ` in crores)
2008
Net Sales 57.4
Other Income 9.7
67.1
Cost of Goods Sold 45.2
Selling and Administrative Expenses 15.7
Depreciation Operation Income 1.3
Operating Income 4.9
Interest Charges 0.3

Earnings Before Tax 4.6
Provision for Taxes 3.4
Earnings after Taxes 3.7
ANALYSIS OF THE COMPANY

(in percentage)
2008
Net Sales − Cost of Goods Sold 57.4 − 45.2

1. Operating Profit Margin = = × 100 21.3
Net Sales 57.4
Earnings After Taxes 3.7

2. Net Profit Margin = × 100 = × 100 6.4
Net Sales 57.4
Operating Income 4.9

3. Return on Total Invested Capital = Total Assets − Current Liabilities × 100 = 56.3 − 6.0 × 100 9.7
Earnings after Taxes × 100 3.7

4. Return on Equity = = × 100 9.8
Stockholders' Equity 37.8
Earnings after Taxes − Pr eferred Stock 3.7

5. Earnings Per Share = Number of Shares of Common Stock Outs tan ding = 2.3 1.61
Current Assets 43.5

6. Current Ratio = Current Liabilities = 6.0 7.2
Operative Income 4.9

7. Earnings Coverage = = 16.3
Interest Ch arg es 0.3
Long Term Debt 12.5

8. Debt Capitalization Ratio = Long Term Debt + Stockholders ' Equity × 100 = 12.5 + 37.8 24.9
Current Liabilities+ Long-Term Debt 6.0 + 12.5

9. Debt Equity Ratio = = 0.49
Stockholders' Equity 37.8
Notes: An investor may compare these notes with the above example and analyze the company’s position.
Example 13.2
Analysis of a company through:
(a) Dividend Yield on Equity Shares;
(b) Cover for Preference and Equity Dividends;
(c) Earnings for Equity Share; and
(d) Price Earnings Ratios.
ABC company has a profit after tax at 60% ` 2,70,000. Its market price of equity shares is ` 40. It has
paid dividend to equity shareholders at the rate of 20%. The company has made depreciation on assets of the
value of ` 60,000. The capital structure of the company comprises equity shares of a value of ` 10 each, total
` 8,00,000. The preference shares are 9% of ` 10 each, total ` 3,00,000.
Solution:
Dividend per Share

(a) Dividend Yield on Equity Shares = Market Pr ice per Share × 100
2 or(20% of A 10)
= × 100 = 5%
40
(b) Dividend Cover Ratio
Profit after Taxes
(i) Preference Share = Dividend to Preference Shareholders
2,70,000
= = 10 times
27,000 (9% of Rs. 3,00,000)
Pr ofit after Pr eference Taxes − Shares

(ii) Equity share = Dividend Payable to Equity Shareholders
2,70,000 − 27,000 2, 43,000

= = = 1.518 times
1,60,000 (80,000 shares × A 2) 1,60, 000
Earnings available to Equity Shareholders

(c) Earnings for Equity Shares = Number of the Equity Shares Outs tan ding
2, 43, 000
= = ` 3.0375 per share.
80, 000
Market Pr ice per Share 40

(d) Price Earning (P/E) Ratio = = = Rs. 13.168
Earnings per Share 3.0375
(iv) Book Value and Par Value per Share

This ratio indicates the share of equity shareholders after the company has completed all its liabilities and
has paid creditors, debenture holders and preference shareholders. An analysis of book value is particularly
useful at the time of liquidation when each shareholder would like to know what he will receive. This is
indicated by the book values of the share.
Example 13.3
The ratio is analyzed thus:
Equity Share capital + Re serves
Book Value Per Share = Total Number of Equity Shares subscribed OR
Net Worth − Pr eference Share Capital

Book Value Per Share =
Total Number of Equity Shares Subscribed
Book Value must be distinguished from face value or par value in the following manner:
Example Showing Book Value and Par Value per Share
Company ‘A’ Company ‘B’

` `
A. Par Value or Face Value of Share 10 10
B. Number of Equity Shares issued and subscribed 3,00,000 5,00,000
C. Equity Share Capital (A × B) 30,00,000 50,00,000
D. Reserves 50,00,000 9,00,000
E. Book Value per Share 80,00,000 59,00,000
C+D
26.66 11.8
B
Book value of a share may be higher or lower than face value. Book value higher than face value indicates
that the company has made profits and has accumulated reserves also. Book value lower than the face value
is observed in new firms with long gestation periods or those who have made losses and also eroded their
reserves.
A high book value may be said to denote a high reserve, high profits and good historical performance.
The book value of a share can be brought down by issue of bonus shares and right shares.
The book value as derived from the balance sheet gives the original cost value or purchase value of the
asset minus depreciation. Book value is, therefore, not a true indicator of the current market value of shares.
The investor should bear in mind that at liquidation he may not be able to get the stated or book value of the
share.
The next example shows that an investor should be careful about the type of leverage of a company. A
low-levered company should be preferred.
Example 13.4:
Leverage of Companies
( ` in lakhs)
Equity Debt Total Debt Equity

Ratio
(i) Company A 20,00,000 10,00,000 30,00,000 1 : 2
(ii) Company B 15,00,000 15,00,000 30,00,000 1 : 1
(iii) Company C 10,00,000 20,00,000 30,00,000 2 : 1
Performance of Companies
Boom Year A B C
All companies earn 40% profit before interest and tax on
total funds invested ` 30,00,000
Profit Before Interest and Taxes 12,00,000 12,00,000 12,00,000
Less Interest on Debt @ 15% 1,50,000 2,25,000 3,00,000
Profit Before Tax 10,50,000 9,75,000 9,00,000
Less Tax at 50% Profit After Taxes 5,25,000 4,87,500 4,50,000
Profit After Taxes 5,25,000 4,87,500 4,50,000
PAT 5, 25,000 4,87,500 4,50,000
Return on Shareholders’ Funds = × 100
Equity 20,00,000 15,00,000 10,00,000
26.25% 32.50% 45%
Depression Year
All companies earn 10% profit before interest and
taxes of total funds invested ` 30,00,000 3,00,000 3,00,000 3,00,000
Less Interest on Debt @ 15% 1,50,000 2,25,000 3,00,000
Profit Before Tax 1,50,000 75,000 Nil
Less Tax @ 50% 75,000 37,500 Nil
Profit After Tax 75,000 37,500 Nil
Return on Shareholders’ Equity 75,000 37,500 Nil
20,000 15,000
3.75% 2.5% Nil
Notes: Company ‘A’ has a low leverage, Company ‘B’ is highly levered. In boom conditions Company C’s performance
is better than Company ‘A’ and ‘B’, the return being 45%. During depression, Company ‘C’ was worst affected
with nil profits. During recession, just after depression when there is recovery in the market the investor should
make his investments in high levered firms. When the boom period reaches its peak, he should invest in low-
levered firms to avoid losing money.
A long-term investor, who believes in safety of funds and has no plans of switching investments, should
invest his funds in low-levered firms. Debt equity ratio should generally be 2 : 1.
(iv) Dividend and Yield
An investor gains from both capital appreciation and dividends. He receives capital appreciation when he
sells his shares. Dividend as a regular income and capital appreciation comes on a particular date but both are
important from the point of view of an investor. The earnings cover ratio showed to what extent the dividend
rate is protected by the earnings of the company and the payment ratio indicated the percentage of earnings
distributed through dividends. The investor’s primary interest is the amount of return that he will get through
dividends in relation to the price that he paid for the share. Dividend yield as shown earlier can be computed
as
Dividend per Share
Yield = Market Pr ice per Share × 100
Example 13.5:
Illustration of Yield
Company X Y Z
I. Face Value of share ` 10 ` 50 ` 100

II. Dividend per share ` 1.5 ` 20 ` 25
II
III. Dividend as percentage of face value 15% 40% 25%
I
IV. Market price per share ` 20 ` 400 ` 200
II
V. Yield= × 100
IV
Yield 7.5% 5% 12.5%
Although Company-Y has the highest dividend of 40% its yield is as low as 5%. Company-Z pays dividends
of 25% and its yield is 12.5%. Company-X has a dividend rate of 15% and yield of 7.5%. Dividend rate and
yields do not bear a significant relationship. While Company-Y has the highest dividend yield, it has the lowest
return on investments. Company-Z has the highest return on investment. An investor looking for a good current
income should choose Company-Z in preference to Company-X or Y.
When a company ploughs back its earnings for growth and expansion its yields are low and companies
which distribute a high percentage of their earnings have higher yields. The investor should, therefore, be
guided by the earnings per share and earnings to equity also.
Example 13.6:
Illustration of Earnings per Share and Earnings to Equity
Company X Y Z
A. Face value of equity share ` 10 ` 10 ` 10
B. Total number of shares subscribed 2,00,000 3,00,000 5,00,000
C. Equity share capital (A × B) 20,00,000 30,00,000 50,00,000
D. Shareholders’ Reserve 40,00,000 10,00,000 30,00,000
E. Profit after Tax 10,00,000 12,00,000 30,00,000
F. Amount paid as Preference Dividends
(There is no Preference Issue) nil nil nil
G. Earnings per share
E−F 10,00,000 12,00,000 30,00,000
B 2,00,000 3,00,000 5,00,000
= ` 5 = ` 4 = ` 6
H. Earnings to Equity
E−F 10,00,000 12,00,000 30,00,000
× 100 × 100 × 100 × 100
C+D 60,00,000 40,00,000 80,00,000
= 16.7% 30% 37.5%
Company-Z has the highest earnings per share and the highest earnings to equity shareholders and the
number of shareholders is the highest. Its after tax profit is also the highest. Company-Z should be preferred
to Company-X or Y.
1. Market Value and Book Value of Shares
Book value of a share as discussed earlier is stated at an unrealistic amount. The investor can make a
profit in the stock market even if he buys a share at a price exceeding the book value. Market values of shares
are usually stated at a higher price than the book value.
2. Price Earnings Ratios
The market value of a share is dependent to a great extent on the earning power of shareholders’ funds
and earnings power of each equity share. Some shares have high price earnings ratios and as high as 20%,
30% or 35%. If the earnings per share remain constant, the investor would not gain because it may take, 15
to 20 years to recover his investment.
Investors buy shares which have high price earnings ratios because of the expectation that earnings per
share will grow very rapidly and at a high compound rate of growth. If the price increases at this rate the
investor will recover his investment in a short period of time.
3. Dividend and Market Price
Many investors determine the value of a share with the amount of dividend that it pays. The investor
should be cautioned that he should be interested in knowing the overall return on his capital invested i.e.,
dividend and capital appreciation. High dividend usually means that the capital appreciation is low. In the
investor’s market, the market price of shares is high because most investors do not like to wait for the capital
appreciation of their shares. They are more keen on receiving a regular income in the form of dividends. Stock
Exchange prices show that the market responds to changes in dividends of shares. A higher dividend increases
the price of a share.*
4. Intrinsic Price
Fundamentalists believe in the intrinsic value of true and inherent worth of each investor will consider a
different intrinsic price of a share according to his own judgment and, therefore, no two investors will be able
to agree on what the intrinsic worth of a share should be. Because investors do not agree on same value
(intrinsic) of a share, there occurs a gap between the market price and the intrinsic price. The intrinsic price
is based on personal judgment, hunches, likes, dislikes, other psychological, emotional reasons which are
subjective judgments and inactive in nature. The subjective judgments of a person are added to objective and
quantifiable data to calculate the intrinsic value. Although this is not completely accurate, yet it is a guide to
find out whether the price of a share is under-stated or over-stated in the market.
The P/BV and P/E ratios are good indicators for finding out the intrinsic values of shares. The intrinsic
value of a share should consider not only the present value of a share but future value of the share also.
Example13.7 gives the intrinsic value of a share.
* The change in price of share will increase or decrease in dividend is also observed by Professor L.C. Gupta in his study in Rates
on Return on Equities, Oxford University Press, Mumbai.
Example 13.7:
Intrinsic Value of a Share
A. Name of the company : ABC Co. Ltd.

1st January to 31st December, 2011
Accounting year: ABC Co. Ltd. : 1st January to 31st December, 2011
B. Face value of equity share : ` 10
C. Earnings per share (EPS) for the year ending 31st Dec. 2011 : ` 6 per share
D. Book value per share for the year ending 31st Dec. 2008 : ` 22 per share
E. P/E ratios for preceding 3 years:
(i) 2010 5.5
(ii) 2009 5.5
(iii) 2008 4.0
F. P/BV ratio for preceding 3 years:
(i) 2010 1.54
(ii) 2009 1.56
(iii) 2008 1.32
E(iii) + E(ii) + E(i)
G. Average P/E Ratio =5
3
F(iii) + F(ii) + F(i)

H. Average P/BV Ratio = 5 = 1.47
3
I. Intrinsic price on the Basis of P/E ratio G × C = 5 × 6 = ` 30 per share
J. Intrinsic price on the
Basis of P/BV ratio H × D = 1.47 × 22
= ` 32.34 per share
The intrinsic price of the share should be between ` 30 and ` 32.33 per share. If we take an average of
the two values it comes to 31.2 per share.
The example may be explained by the objective of three investors T, V, Z:
(a) Investor T has the objective to double his investment in 3 years.
(b) Investor V has the objective of multiplying his investment by 2½ times in 3 years.
(c) Investor Z has the objective of making his investment triple in 3 years.
It is expected that the value of the share will be ` 75 after 3 years.:
(a) Investor T’s objective will be fulfilled if he can buy the share of the company below ` 32.50. He will
then double his investment in 3 years when the value of his share according to the market price of
share will be ` 75. He, therefore, gains in his investment.
(b) Investor V has the objective of increasing his investment by 2½times. He will be able to do so only
if he can buy the share at ` 30 or below it.
(c) Investor Z will be able to triple his investment by buying the share at ` 35.
The intrinsic value of the share in Example 13.7 is ` 25 for investor Z, ` 30 for investor V and ` 32.50
for investor T.
13.6 ECONOMIC VALUE ADDED (EVA)

EVA is a new concept developed by Stern Stewart & Co. to compare the after tax profits with cost of
capital. The amount of earning above the amount of capital employed is called EVA. In other words its wealth
added to the net worth of the shareholders. EVA is a measure of profitability of a company in excess capital
employed by the company.
EVA = EBIT – Taxes – Cost of funds employed

EVA increases when
l A company is efficient and its profits increase due to its operations.
l The return is greater than the cost of procuring new funds.
l Capital that is not productive is liquidated by the company.
An investor can analyze EVA as a profitability measure for investment in a company.
The equities of the company should also be evaluated by the manner in which it is able to control the
cost of a firm. A management which is professional, is able to break-even and reach the profitable position at
an early date means that its fixed costs are low. Companies which have low fixed costs are able to withstand
depression faster than the companies with high fixed costs. If management can control the cost of the company
then it is able to project a greater profit.
The equities of the company should also be evaluated by the manner in which it is able to control the
cost of a firm. A management which is professionally able to break-even and reach the profitable position at
an early date means that its fixed costs are low. Companies which have low fixed costs are able to withstand
depression faster than the companies with high fixed costs. If management can control the cost of the company
then it is able to project a greater profit. The Break-Even Chart given in Fig 13.1 depicts the total fixed and
variable cost of a firm, the loss area and the profit area. The break-even point is at production of 40 units and
a revenue of ` 30 lakhs. Similar break points may be drawn while evaluating the company for making investments.
The management should also make a projection of the earnings per share through a trend effected line
showing future earnings effected to past earnings per share. This is illustrated in Fig. 13.2.
PROFIT
EARNINGS PER SHARE IN A
E
BREAK NU ND
E DA
REVENUE
EVEN V XE TOTAL
POINT RE LF
I TS
TA C OS FIXED
TO E COST
BL
RIA
VA
TOTAL
LOSS CAPACITY
1980 1981 1982 1983 1984 1985 1986 1987
ACTUAL ESTIMATION FUTURE

UNITS PRODUCED % OF PLANT CAPACITY ESTIMATION
Fig. 13.1: Break-even Chart for a Company Fig. 13.2: Projection of Future Earnings
the records of the firm and ascertaining its past performances and an insight to its future projections:
13.7 SOURCES OF FINANCIAL INFORMATION

the records of the firm, ascertaining its past performances and an insight to its future projections:
(a) Annual Report: Annual report indicates: (a) the company’s name, (b) location of company’s factories,
(c) number of shareholders, (d) company’s expansion programmes, (e) analysis of company’s operations
in the current year, (f) analysis of previous year’s performance through consolidated balance sheets,
(g) company’s prospects for the next year, (h) the economic and business involvement of the firm,
(i) dividend policies, (j) proposal for issue of right shares, bonus shares, debentures.
(b) Financial Dailies: In India, the daily newspapers also give information about the financial news of
the leading firms. These firms are generally quoted on the stock exchanges of the major centres in the
country. Most important financial dailies in the country are ‘Economic Times’ and the ‘Financial
Express’. These papers give an in depth study of the share prices, quoted in the stock exchanges,
economic, business, commercial and industrial information about different firms from time to time.
There are some investment magazines also and other corporate magazines, which give details about
the economic, industrial performance of companies. These may be listed as (a) Business World,
(b) Business India, (c) Directors’ Digest, (d) Industrial Times, (e) India Today, (f) Economic and
Political Weekly, (g) Investments Today and (h) Investments India.
(c) Directories: Besides, these sources of information there are important directories available to give
information, indications of growth shares and income shares. They also give case studies and analyse
the performance of different firms with projection of future. Valuable guides which are sources of
information also are listed below:
(d) Stock Exchange Directory: This is bound in eighteen volumes and give information about all listed
public limited companies and major public sector corporations.
(e) Kothari’s Economic and Industrial Guide of India: This gives relevant financial information and
analysis of more than 3,000 companies. It is designed in a manner to make the investor aware of the
problems of investment and depicts the nature of investments available for current investment.
(f) Times of India Directory: Time of India has also a directory which gives full information about
many industrial companies and groups. It makes an analysis of the different companies on stock
exchange.
The buyer of share should be careful in making an analysis of company and he should generally buy
shares which are listed on the stock exchange. Listed shares have some kind of predictions from the stock
exchange brokers of the solvency, profitability investment value and price of the shares. Moreover, listed shares’
information is available, whereas the unlisted shares suffer from grave risk as no information is available on
them. As a rule, the investor should also buy those investments which are actively traded on the stock exchange.
An active share is one which is transacted in the stock exchange at least three times a week. While activity of
a share price will depend on the depressed or prosperous conditions of the market, yet the trend can be gauged
by the investor by following the rule of number of times it is transacted on the stock exchange. Inactive shares
are priced at a very low rate and it gives the investor a chance of investing his money at a cheap rate but these
shares have no value and the investor will find that his capital becomes eroded if he purchases these shares.
A share is inactive because there are no buyers and this is why the prices are quoted at very low rates. It also
indicates that since there are no buyers in the market, it is not a worthwhile investment. Active shares offer
attractive investments for the future. They are priced at higher rates. Investor is sure of either capital appreciation
or good dividend income. In India, the price of a share rises in relation to dividend that is declared on it. Active
shares can be discerned from two categories of listed shares, cleared securities and non-cleared securities.
These securities are usually known in the stock exchange as Group A shares and Group B shares. Group A
shares are considered to be the most active shares. Group B shares are generally negative in nature. Group
A shares are periodically analysed by the stock exchange officials.
Fundamentalists, therefore, make a careful analysis of shares. According to them, there should be a
preliminary screening of investment, the economic, industrial analysis, analysis of the company to find out its
profitability, efficiency and a study of the different kinds of company’s management.
The fundamental school of thought has developed certain valuation models to show the effect of business
decisions based on the market value of a firm. The fundamental valuation models were first laid by Timbergen
and William. They were further developed by Graham Dodd Bodenhorn, Ezra Solomon and Modgiliani Miller.
The models are briefly described:
A. Timbergen Model
P = f(x,y,z)
Where,
P = share price
x = long-term interest rates
y = dividend yield on normal investment
z = rate of change in share price
This model indicates: (a) That the stock prices vary directly with dividends and inversely with interest
rates. (b) This method determines share prices in such a way that it is quite similar to measurement of
debenture prices.
B. William’s Model
William values the share prices in the following manner:
Where P = share price
Rt = expected value of return during period
k = discount rate
C. Graham Dodd Model
The Graham Dodd Model is represented by the model given below:
According to Graham and Dodd the dividends of a firm determine market value of a company’s equity.
P = share price
M = earnings of firm paying a normal dividend
D = dividends per share
A = adjustment for asset values
D. Walter Model
Walter’s model is also described in the Chapter on Dividend Policies of this book. It may be described in
the following manner:
P = share price
K = market discount rate
b = growth rate
D = dividends per share
E. Earnings Model
The Earnings Model assumes that the market value of a security is determined by the present value of all
the anticipated earnings.
n
E −I
Pt = ∑ (1 t− k)t
t =1 t
Pt = market price during period t

Et = earnings per share during period t
It = investment per share during period t
F. Bodenhorn’s Model
This model based on the discount cash flow approach assumes that a firm’s equity is equated with the
present value of all future cash flows, cash flows are represented through dividend and stock purchases.
n
Cf
Pt = ∑ (1 − tk)
t =1 t
P t = market share price during period t

Cf t = new cash flow anticipated in time period t
G. Ezra Solomon’s Model
This model is represented as the investment opportunities approach. According to this model.
P = V1 + V 2
Where P = market value of firm’s share
V 1 = present value of earnings from current investments
V 2 = present value of earnings of future investments
Ezra Solomon, therefore, takes into account existing, future investments and represents the market value
of a share as the sum of two discounted values.
H. Modgillani Miller Model (MM Model)
This is the approach which presents the cost of capital approach. It takes into account dividends, earnings
and capital gains.
D0
K−b
It assumes that the rate of growth is constant, that corporates taxes do not exist, that the number of
investments in infinite. In the above example,
P0 = share price
D = dividend
K = rate of return
b = growth rate
SUMMARY
r Fundamental school of thoughts makes an analysis of shares through economic industrial and company
analysis.
r It is a method of finding out the future price of stock. It help the investors to take important investment
decisions.
r It analysis balance sheet, statement of income and income of changes to find out the overall position of a
company.
r The technique followed by an analyst is to analyze different kinds of ratios like liquidity ratios, profitability
ratios, activity ratios and leverage ratios. For a simple investor the ratios are equity price, book value per
share, price earnings ratios, yield and intrinsic value of shares.
r Financial information is available in company annual reports, financial dailies like Economic Times and Financial
Express.
r Information is also available in directories like stock exchange directory and Times of India Directory.
r Listed shares can be analyzed but no information is available on unlisted shares.
r Share are categorized group ‘A’ shares are most active and group ‘B’ are generally negative. An active share
means that there is trading activity and people are interested in making an investment into such shares.
r Fundamental school of thought has developed certain valuation models to show effect of business decision
on the market value of a firm.
r Fundamentalists thus believe in careful analysis and preliminary screening of a firm and its share values
before making an investment.

1. The price earnings ratio of a stock reflects:
(a) The growth of the company.
(b) Earnings retained and invested.
(c) Dividends paid to equity shareholders.
(d) Market expectation for future.
2. The intrinsic value of a share shows:
(a) Cash dividends expected in future.
(b) Market expectations of a share.
(c) True economic value of a share.
(d) The performance of a company in the market.
3. Increase in book value per share shows:
(a) Increase in assets of a firm.
(b) Increase in net worth.
(c) Increase in profits and accumulated reserves.
(d) Risk in share prices.
4. Price earnings ratio =
Market Pr ice per Share

(a) Earnings per Share
Equity Share Capital + Reserves

(b) Total No. of Shares Outstanding
Profit after Tax

(c) No. of Equity Shares
Earnings per Share

(d) Dividends per Share
5. Valuation of equity shares can be calculated

(a) By the same valuation model as for bonds is by valuing.
(b) Risk and return relationship.
(c) On the basis of dividends and earnings.
(d) With the help of mutual funds.
6. Fundamental Analysis consists of
(a) Reading bar charts and graphs to find out the future value of shares.
(b) Efficient Market Theories.
(c) Combining a set of securities through Markoistz Model for an efficient Portfolio.
(d) Making an analysis of economic factors and company analysis.
Answers: 1 (d), 2 (c), 3 (c), 4(a), 5 (c), 6 (d).
QUESTIONS
1. How is a fundamental analysis useful to a prospective investor?
2. What is the meaning of company analysis? What financial statements in your opinion are helpful in undertaking
the company’s prospects?
3. In what way is ratio analysis an indicator of a company’s health? Give example.
4. Distinguish between
(a) Dividend and yield.
(b) Market value and Book value of shares.
5. Is intrinsic value of a share important? How would you calculate it?
ILLUSTRATIONS
Illustration 13.1: A company has a profit after tax @ 30% ` 3,30,000. The market price of equity shares is ` 95.
It has paid a dividend to equity shareholders at the rate of 15%. The capital structure of the company comprises of 80,000
equity shares of ` 10 each.
Analyze
(i) Dividend yield on equity shares.
(ii) Earnings for equity shares.
(iii) Price earnings ratios.
(iv) Cover for equity dividends.
Solution:
Dividends per Share
(i) Dividend Yield on Equity Shares = Market Price per Share
15% of A 10.00
= × 100
95
1.5
= × 100 = 1.57%
95
Earnings available to Equity Shares

(ii) Earnings for Equity Shares = × 100
No. of Equity Shares Outstanding
3,30,000
= = 4.125 per share.
80,000
Market Priice per share 95

(iii) Price Earning Ratio = = = ` 23.03
Earnings per share 4.195
Pr ofit 3,30,000
(iv) Dividend Cover ratio = Dividend Payables = 80,000 × 1.57 = 2.63 times
Illustration 13.2: The following information is available of company ‘X’ and ‘Z’.
Sl. No. Company ‘X’ Company 'Z’
1. Face Value of a share 10 10

2. No. of equity shares issued 5,00,000 8,00,000
3. Equity Shares Capital 50,00,000 80,00,000
4. Reserves 6,00,000 65,00,000
Find the book value per share.

Solution:
Equity share capital + Re serves
Book value of a company = Total No. of Equity Shares
50,00,000 + 6,00,000
Book value of company ‘X’ = = A 11.2
5,00,000
80,00,000 + 65,00,000
Book value of company ‘Z’ = A 18.125
8,00,000
Illustration 13.3: From the following information, find Dividend Yield of companies A, B, C and D.
Sl. No. Company

A B C D
1. Face value of a share 1 1 5 10
2. Dividend per share (in `) 0.50 0.40 2.00 2.00
3. Market price per share (in `) 30.00 100 200.00 300.00
Solution:
Dividend per Share

Dividend Yield = Market Pr ice per Share
0.50
Dividend yield of company ‘A’ = = 1.67%
30
0.40
Dividend yield of company ‘B’ = = 0.4%
100
2
Dividend yield of company ‘C’ = = 1%
200
2
Dividend yield of company ‘D’ = = 0.66%
300
Choose company ‘A’ for dividend yield.
Illustration 13.4: From the following data show (i) earnings per share and (ii) earning to equity of company X and
Y.
(in ` )
Sl. No. Company ‘X’ Company ‘Y’
1. Face value of a share 1.00 1.00
2. No. of shares subscribed 10,00,000.00 15,00,000.00
3. Reserve 20,00,000.00 30,00,000.00
4. Profit after Tax 8,00,000.00 10,00,000.00
Solution:
Pr ofit after Tax

(i) Earnings per share = Equity Share Capital
Equity Share Capital = (No. of shares subscribed) × (Face value of a share)

8,00,000
Earnings per share of company ‘X’ = 1 × 10,00,000 = Rs.0.80
10,00,000
Earnings per share of company ‘Y’ = 1 × 15,00,000 = Rs.0.67
Pr ofit after Tax

(ii) Earnings to equity = Equity Share Capital Reserve × 100
8,00,000
Earning to equity of company ‘X’ = 10,00,000 + 20,00,000 = 26.67%
10,00,000
Earning to equity of company ‘Y’ = 15,00,000 + 30,00,000 = 22.22%
Illustration 13.5: Find the intrinsic value of a share from the following data of companies P and Q.
(in ` )
Sl. No. Company ‘P’ Company ‘Q’

1. Face value of a share 1.00 2.00
2. Earnings per share for the year, 30/03/2012. 4 5.00
3. Book Value on 31st Mar 2012 20.00 25.00
4. P/E Ratios
(i) 2012 6 8
(ii) 2013 7 8
(iii) 2014 8 8
Solution:
Company 'P’
Intrinsic value on the basis of P/E ratios = (6+ 7+ 8) ÷ 3 = 7 Average P/E
Intrinsic Value = (Average P/E ratio × Earnings per Share)
= 7 × 5 = ` 35.00
Company 'Q’
Intrinsic value on the basis of P/E ratio = 24 ÷ 3 = 8 Average P ÷ E
∴ Intrinsic Value = 8 × 5 = ` 40.00
Intrinsic Value can also be found out on the basis of Book Value.
Illustration 13.6: Find out the value of a share.
Equity share capital face value Rs 1.00 each 50,00,000.00
Reserves 10,00,000.00
20% secured loans 10,00,000.00
Fixed Assets 50,00,000.00
Investments 5,00,000.00
Operating Profits 30,00,000.00
Tax rate 30%
P/E price earnings ratio 14%
Solution: (in ` )
1. Earnings per Share = operating profit EBIT = 30,00,000.00
20
Less interest on × 10,00,000 = 2,00,000.00
100
Profit before Tax (PBIT) = 28,00,000.00
Tax @ 30% = 8,40,000.00
Profit after Tax = 19,60,000.00
No. of Equity shares 50,00,000/1 = 50,00,000.00
Earnings per share (EPS) = 0.392
EPS × P/E = 0.392 × 14 = 5.488
Illustration 13.7: The data is given for the following 3 companies. Find out price of share, dividend yield, capital
gains yield.
Companies
X Y Z
Expected Dividend 'D1’ ` 2.00 ` 2.00 ` 2.00
ke or cost of equity capital 20% 20% 20%
Growth 5% 10% 15%
Solution:
D1
Price of the share = Ke − g
X Y Z
2.00 2.00 2.00
(i) Price of Share P 0 = 0.20 − 0.05 0.20 − 0.10 0.20 − 0.15
= ` 13.33 = ` 20.00 = ` 40.00
2.00 2.00 2.00
(ii) Dividend Yield = (D 1/P 0 ) =
13.33 20 40
= 15% = 10% = 5%
2.00 (1 + 0.05) 2.00 (1 + 0.10) 2.00 (1 + 0.15)
Price of Share P 1 = 0.20 − 0.05 0.20 − 0.10 0.20 − 0.15
Rs.14.00 ` 22.00 ` 46.00
(14 − 13.33) (22 − 20) (46 − 40)
(iii) Capital gains yield (P 1 – P 0)/P 0 =
13.33 20 40
= 0.05 = 5% = 10% = 15%

1. Calculate dividend yield to help the investor to see if the dividend rate is protected by the company. Information
is given of following 4 companies. Which one he has to choose?
Sl. No. Company P Q R S

1. Face value per share ` 1.00 ` 1.00 ` 2.00 ` 2.00
2. Dividend per share ` 0.50 ` 0.60 ` 2.00 ` 1.50
3. Market value per share ` 20.00 ` 22.00 ` 30.00 ` 50.00
Answer: Investor may choose company R or S. P = 2.5%; Q = 2.7%; R = 3.33%.

2. Calculate Book Value of the share in the following cases:
Sl. No. Company ‘X’ Company ‘Y’

1. Face value of a share (in `) 10.00 5.00
2. No. of shares subscribed 10,00,000 15,00,000
3. Reserve 20,00,000 30,00,000
4. Profit after Tax 8,00,000.00 10,00,000.00
Answer: Book Value of company ‘X’ = ` 27.50 and ‘Y’ = ` 16.67
3. In the following companies the investor would like to find out (i) earnings per shares and (ii) earning to equity.
Sl. No. Company ‘P’ Company ‘Q’

1. Face Value of a share (in `) 10.00 10.00
2. No. of shares 20,00,000 30,00,000
3. Reserve 50,00,000 10,00,000
4. Profit after Tax 30,00,000.00 15,00,000.00
Answer: (i) Earnings per share (P) = ` 15.00 and (Q) = ` 0.50
(ii) Earning to equity (P) = 12% and (Q) = 4%
4. Calculate the value of an equity share from the following data:
Sl. No. Company 'A’

1. Face Value (in `) 10.00
2. Equity Share Capital of ` 10.00 each 50,00,000
3. Operating Profit 20,00,000
4. Tax 30%
5. P/E Ratio 15
Answer: ` 42.00
SUGGESTED READINGS
l Amling, Investment, An Introduction to Analysis and Management, Prentice Hall, Englewood Clifts, New Jersey,
U.S.A., 1984.
l Fischer & Jordan, Security Analysis and Portfolio Management, Prentice Hall, Englewood Clifts, New Jersey,
U.S.A., 1983.
l Fred Benwick, Introduction to Investments and Finance Theory and Analysis, Macmillan Company, New York,
1971.
l Graham, Dodd and Cottle, Security Analysis, McGraw-Hill (Fourth edition) U.S.A., 1962.
l Hayes and Hauman, Investments Analysis and Management, (Third edition), Macmillan Publishing Co. Ltd.,
New York, 1976.
l Jack Clark Francis, Investments: Analysis and Management, (Second edition), McGraw-Hill, U.S.A., 1976.
l Steven Bolten, Security Analysis and Portfolio Management — An Analytical Approach to Investments, Holt
Rinehart and Winston Inc., New York, 1972.
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Chapter
14
TECHNICAL ANALYSIS
Chapter Plan
14.1 Introduction
14.2 Dow’s Technical School of Thought
14.3 Assumptions of the Theory
14.4 Market Movements
14.5 Charts
14.6 Construction of Charts
14.7 Analysis of Charts
14.8 Short Sales
14.9 Confidence Index
14.10 Breadth of the Market
14.11 Relative Strength
14.12 Trading Volume
14.13 Moving Average Analysis
14.1 INTRODUCTION
Technical analysis has an important bearing on the study of price behaviour and has its own method in
predicting significant price behaviour. This chapter presents the opinions of the technical school of thought. It
also discusses the methods in which they predict prices and their opposing views to fundamental analysis.
The technical school of thought developed its own theory for determining the behaviour of stock prices.
According to them, the fundamental school of thought gave importance to the intrinsic value of the share.
Intrinsic value is different for each investor and to find out the intrinsic value, the fundamental analysis
undertook financial statement analysis. This gave them an insight into the performance of the company and
helped to identify its efficiency and profitability. Further, an analysis was to be done to compare it with other
321
companies in the same industry and thus to evaluate it and then to choose the most suitable company for
making investments.
The technical school of thought comprises of the following theories:
l Dow Theory
l Eliott Wave Theory
l Theory of Contrary Opinion
l Odd Lot Theory
These are explained briefly before the analysis of the school through charts and diagrams are discussed.
1. Dow Theory: Charles Dow who was editor of Wall Street Journal in 1900 is known for the most
important theory developed by him with technical indicators. In fact, the theory gained so much significance
that it was named after him. The Dow Theory has been further developed by other technical analysts and it
forms the basis of the technician’s theory. This theory predicts trends in the market for individual and total
existing securities. It also shows reversals in stock prices.
2. Eliott Wave Theory: Besides Dow another technical analyst called Elliott Wave also contributed to
explain the technical analysis theory. His contribution was to explain long term patterns of price behaviour of
share prices. He has termed the major patterns in five successive waves or steps. The first wave is upward, the
second steps being downward, the third moving up , fourth moving down and again moving upwards in the
fifth wave. This would explain the Bull Market. The reverse pattern would show the bear market. The following
charts explain the methods adopted by technical analysts to study the trends in the stock market and show the
direction of overall market.
3. Theory of Contrary Opinion: The assumptions of the theory of contrary opinion are (a) the common
man cannot make predictions of price movements, (b) techniques should be adopted in such a manner that the
forecast of prices are made in exactly an opposite direction to what the common man feels. This would give
a correct indication of prices and ultimately give confidence and profitability to the investor. The odd-lot theory
is explained in the following manner:
4. Odd Lot Theory: The Odd-Lot Theory is a prediction of tops in the bull market price direction and
the price reversals of each security. Odd-lot is a method of trading shares in groups which are less than 100
shares. These become round-lots if they are traded in groups of 100 shares, 200 shares, 300 shares or more.
The odd-lot theory suggests that it is important to find out information about groups of less than 100 because
such investments are usually not made by professional investors. This would, therefore, reflect the views of the
common man daily. The method of finding out the daily record of odd-lots is by gathering information on the
number of shares which are purchased each day, those which are sold in the market and also those shares
which are sold short (Example 14.6). The theory suggests that by charting out the ratio of odd purchases to
odd sales it is possible to find out the direction of prices because it indicates the buying activity of the common
man. If the odd purchases are less than the odd sales then it indicates that there is a positive purchase, on the
other hand there can be a negative purchase also. The odd purchases minus the sales are shown in the chart
against a market index. The net purchases by the odd-lot according to the technical chartists show the movement
of prices in the market. The analysis of the technical school is that a fall in the market prices is reflected if net
purchases made by the common man are positive. If the net purchases are negative then it reflects that the bear
markets are at a close.
The theory of odd-lot had been tried by the Dow Jones Industrial Average some time during the years
1969-70 when there was a presence of a bear market. The chart showed just the opposite of analysts’ analysis.
It showed that the common man or the person interested in odd-lots was purchasing net when the charts
showed a low print. The theory has been opposed by the odd-lotters because they buy low and sell high and
make profits and this is a contrary to the odd-lot theory.
14.2 DOW’S TECHNICAL SCHOOL OF THOUGHT

The technical school of thought though developed by different thinkers is popularly called Dow’s Technical
School of Thought. The theory has been based by his understanding and presentation of the analysis.
TECHNICAL ANALYSIS 323
The technical school believes that it is a waste of time to look into the intricacies of the internal management
of a firm. According to them, the prices are determined in the following manner:
l Prices of securities are determined by the demand and supply of securities in the market. Demand and
supply of securities are considered to be the main essence of the changes in security analysis.
l Technical analysis is a method of presenting financial data of the past behaviour and to find out the
history of prices movements and depict these on a chart.
l The charts have a method of prediction of significant price movements, project meaningful patterns
and the practical applications of these patterns help in determining future prices.
l Typical charts are made for making prediction about a single security.
l Charts are also used to find out the total broad spectrum of the market.
l Charts also determine the individual security prices and show the total market index.
14.3 ASSUMPTIONS OF THE THEORY

The technical school of thought has certain assumptions. These are:
l The market value of a security is related to demand and supply factors operating in the market.
l There are both rational and irrational factors which surround the supply and demand factor of a
security.
l Security prices behave in a manner that their movement is continuous in a particular direction for
some length of time.
l The movement of security prices if going upward will continue to do so for a while barring certain
minor fluctuations in stock prices.
l Trends in stock prices have been seen to change when there is a shift in the demand and supply
factors.
l Whenever there are shifts in demand and supply, they can be detected through charts prepared
specially to show market action.
l Patterns which are projected by charts record price movement and these recorded patterns are used
by analysts to make forecasts about the movement of prices in future.
The fundamental analysts believe in the intrinsic value of a share. Technical Analysis makes a forecast of
demand and supply factors operating in a market and their discussions centre around the short-run shifts in
these factors. They do not believe in the firm’s risk and earning potential. The fundamental analysts believe
that the intrinsic value of a share, as seen by the fundamental analyst, does not depict the true value of a share.
The technical analysts do believe that the prices of stock fluctuate around the true intrinsic value of stocks but
they feel that the method of finding out the intrinsic value is very difficult as done by the fundamental analysts.
Technical analysis is a simple and useful method to find out the fluctuations of price around the intrinsic value
of a share. Therefore, technical analysis is:
l A simple and quick method in forecasting behaviour of stock prices whereas fundamental method is
tedious in nature.
l According to the technical analysts, their method is more superior to the method adopted by the
fundamental analysts because the method of dealing with financial statements is according to them
inconsistent with the presentation of data.
l According to technical analysts the fundamental analysts wait for the market price to recognize the
value of the security to raise the price of the security. This, in their view, may take a long time and
is a longer term approach. Technical analysts criticize the fundamental analysts and feel that their role
is very subjective in finding out the price behaviour with the earning ratios used by them.
Technical analysts while defining their own theory about stock price behaviour and criticising the fundamental
school do feel that there is some merit in the fundamental analysis also. According to them the method is very
tedious and it takes a rather long time for the common man to evaluate stocks through this method. They
consider their own techniques and charts as superior to fundamental analysis. Some of their theories, techniques
and methods of stock prices are given below:
14.4 MARKET MOVEMENTS

According to ‘Dow Theory’, the market always has three movements and the movements are simultaneous
in nature. These movements may be described as: (i) the narrow movement which occurs from day-to-day,
(ii) the short swing which usually moves for short time like two weeks and extends upto a month; this movement
can be called a short-term movement and (iii) the third movement is also the main movement and it covers
four years in its duration. According to the type of movements, they have been given special names.
l The narrow movement is called ‘fluctuations’.
l The short swing is better known as ‘secondary movements’.
l The main movement is called the ‘primary trend’.
l Narrow movements or the ‘fluctuations’ are called “random wiggless”.
l Secondary movements are those which last only for a short while and they are also known as “corrections”.
l Primary trends are, therefore, the main movement in the stock market. It is also called ‘Bulls’ and
‘Bears’ market.
14.5 CHARTS
According to the Dow Theory, the price movements in a market can be identified by means of a line-chart.
Fig. 14.1: Line Chart Showing Dow Theory Signals
1. Line Charts
Charts used by fundamental analysts are usually in the form of line charts. These charts are drawn to
predict the future price of stocks. They are prepared in a method that it connects the successive days, closing
prices. These charts are also called line charts. In this chart the technical analyst should plot the price of the
share. With it, he should also mark the market average every day.
(a) Primary and Secondary Movements: These movements help in identifying the primary and secondary
movements. Figures 14.1, 14.2 and 14.3 depict upward, downward primary trends, abortive recovery, secondary
movements, tops, bottoms and closing prices per trading days. Figures 14.2 and 14.3 indicate some chart
patterns as identified by fundamental analysts. The description on the figure 14.1 shows primary upward trend
or period ‘T’ to time of peak price before T + X of trading day. T+X and ‘abortive recovery’ is noticed showing
a change in the direction of the market’s primary trend. Abortive recovery means secondary movement does
not rise above the preceding top and after the abortive recovery the tops descend till they find their place at
T+Z. When secondary movement falls to reach a new bottom it signals the beginning of bull market. The
majority of the Dow theorists feel that a new primary trend will emerge only after ascending and descending
top occurs simultaneously in industrial and transportation averages.
Fig. 14.2: Chart Patterns
(b) Support Areas and Resistance Areas: Dow theorists believe in ‘momentum’ which, according to
them, keeps the price moving in the same direction. They believe in primary trends which according to them
are momentum or bear and bull markets. The momentum will carry the prices further but momentum of
primary trend will be halted by the terminology used by technical analysts called ‘support areas’ and ‘resistance
areas’. The peak price of the stock is called the resistance area. After that the stock moves downwards.
Speculators do not usually sell at one peak price. They wait for the next peak and because of this selling cost
resistance is met and the price does not move above the previous peak or resistance area. If price rises above
the peak it breaks its level of resistance and moves upwards under the power of bullish momentum.
Support areas show the previous low price of stock. If price goes below previous support area then it
penetrates support and stock price will continue to fall. This is also the ‘sell’ signal.
According to technical analysts, an investor should ‘buy’ when prices go higher than peak level and sell
when it is lower than previous low price.
Technical analysts limit primary trends and resistance support area for complicated patterns. The patterns
used by the technical analysis are popularly called line charts, bar charts, point and figure charts.
2. Bar Charts
Bar charts are prepared in vertical lines and made to show the closing price of each day and the closing
price movements.
DELAYED ENDING TOP
Fig. 14.3: Chart Patterns
3. Point and Figure Charts

The point and figure charts are represented by Xs and Os. These are more difficult to calculate the stock
prices than the line charts and bar charts. These are drawn by the technical analysts to make a forecast of
prices and also to find out the trend in prices. It is usually the reversal in trend which can be found out by
sub-charts. The price forecasts made by the point and figure charts are called price targets. Figure 14.4 gives
the point and figure chart and shows sell and buy signals.
o= Sell
x= Buy
x xo
x x xo
x x x oxo
xo x x xo xoxoxo
xoxo x o xo x xoxoxoxoxox
xoxo x x o xo x x xoxoxoxo ox
xoxo xox x o xo x x xo x o x o x o x o x ox
oxo xoxxx o xo xo xo xo xo xo xo xo xo ox
o xoxxx o x o xo x o x o x o x o xo x o o
xoxxx oxo x o xo ox o x o x o o
o xo xox ox o x o o
oxo xo ox xo
oxo o
Fig. 14.4: Point and Figure Chart

14.6 CONSTRUCTION OF CHARTS

Line charts and bar charts are simple projections of prices. They show the amount of shares which are
traded at each time when the price changes. These charts represent the volume of trading of shares. These can
be prepared even by an ordinary investor because they are represented only by lines. These charts do not
represent the security prices but only show trading volume. For a technical analyst the security prices are more
important than the trading volume. Both the chart and bar chart for vertical columns which represent a trading
day and how they are related to time.
The construction of point and figure charts is more difficult to a line and bar chart. It forecasts prices and
is, therefore, more important to the analyst. This chart takes into consideration only significant changes in
prices which are made note on point and figure method. The points that are used for present securities are
numbered for high prices of securities and 3 to 5 years of price changes are noted. The low price charts are
noted between half and one point changes. The point and figure charts thus represent what is called 0.5 point,
1.0 point, 3.0 and 5.0 points. The point and figure charts is related to time of particular trading day and each
column of the chart shows a significant reversal, but does not take note of a trading day. The result is that the
trading day which shows two significant reversals would be showing as generating two new columns on the
chart.
The chart patterns as used by the technical analysts have been depicted in Figures 14.2 and 14.3. These
are in the form of ‘Saucer’, ‘Fulcrum’, ‘Component Fulcrum’, ‘Delayed Ending Bottoms’, ‘Inverse Head and
Shoulders’, ‘Vertical Base’, ‘Vertical Extend’ and ‘Duplex Horizontal Bottoms’.
The Figure 14.3 shows the patterns. These are also called the Head and Shoulder top and related to the
movement of stock prices and the volume of the shares which are traded. These tops are engaged in Line Bar,
Point and Figure Charts and indicate both individual and marked index. Tops like bottoms are of various kinds
and these are called ‘Saucer’, ‘Inverse Fulcrum’, ‘Inverse Compound Fulcrum’, ‘Delayed Ending Tops’, ‘Head
and Shoulders’, ‘Inverted Vertical’, ‘Inverted Vertical Extended’ and ‘Duplex Horizontal Top’.
14.7 ANALYSIS OF CHARTS

The line and Bar charts and Point and Figure charts are analyzed in the following way:
1. Head and Shoulders Top
The Head and Shoulders Top is supposed to have two shoulders, left and right and a head. This is
depicted in Figure 14.5, which indicates the action of the market and in technical terminology it is called left
shoulder then head, after head the right shoulder and then confirmation.
2. Left Shoulder
The left shoulder is seen during the time when there is a lull in the trading market followed by heavy
purchases. The quiet time in trading called lull is such to raise the price by pushing it to a new peak after which
the price begins slowly.
Fig.14.5: Bar Chart Showing Heads and Shoulders Top Formation

3. Head
The head faces with time when there are heavy purchases in the market and this brings the price in a
manner that it raises it and then it falls back to indicate that it is far below the top of the left shoulder.
4. Right Shoulder
The right shoulder indicates that the price rises moderately by the activity in the market but it does not
rise in such a manner that it reaches higher than the top of the head. While it is almost reaching the top of
the head it begins to fall again and a decline is indicated.
5. Confirmation
This is indicated by drawing a line which is tangent to the left and right shoulders. This represents the fall
in prices below the neckline. Confirmation is also called in other words ‘Break Out’. Break out is the name
given to it because it is supposed to come before the price falls and it should be a useful signal for those who
wish to sell stock.
Technical analysts analyse the price movements through means of different kinds of patterns, geometrical
names and unusual chart names. The usual names and methods that are used by them to indicate the price
movements are called triangles, rectangles, domes, flags, double tops, triple tops and wedge forms. These have
been illustrated in Figures 14.2 and 14.3.
The point and figure chart is analyzed through the means of
finding out what is popularly called congestion area. The Xs and
Os described earlier are drawn out to indicate the changes usually
in reversal form close to a price level indicated. These X’s and O’s
when knotted together to form a horizontal, represent the congestion
area. The analysis of congestion area is an equalization of supply
of security and demand for it. When there is a change in demand
and supply and the X’s show a rise on top of the congested area
analysts say that a break out has come. Sometimes, the congestion
area is broken from the bottom also through the O’s column. This
indicates that there is a break out and shows the signal to sell
because there is a bearish trend. The tops and bottoms break out
through penetration and is shown in Figure 14.4.
The Point and Figure Chart shows a forecast of price and
tries to estimate it through the congestion areas. The investor
should look for a break out in the upward or downward direction
and sometimes even in the same direction to find out what the
new price will be? The analysts although quite sure of their superiority
of method are still not able to completely and accurately measure
even the prices. This is so because according to them their method Fig. 14.6: Odd-Lot Trading and Stock
of prediction is flexible in nature. Price in the Industrial Securities Market
The following theories are elucidated to give further understanding
of the technical analysts and their price movements. These theories are called Elliott Wave Theory. The theories
of contrary opinion and comprise the odd-lot theory.
14.8 SHORT SALES

Short sales are a method of covering up speculators’ short position in the market by buying securities at
a lower price than the price at which the seller would sell them. Short sales are a means of covering up by
the individual after finding out relevant information about the security in which the position is likely to be
covered up. The buyer and the seller both analyse the situation of the short positions to indicate the demand
for the securities and thus try to cover their short positions which are outstanding. But when the demand
increases then the outstanding short positions also increases and these are indications of future rise in price.
These indications have also been tested on Dow Jones Industrial Averages. These indications cannot be exactly
correct and are only a general indicator. The technical analysts thus believe that short sales is a sophisticated
technique and it is difficult for an average investor to understand its technique. According to them those who
follow the short sales theory are not clear because when they expect a price decline it does not decline
immediately and follows slowly. This technique can only broadly give certain indications.
14.9 CONFIDENCE INDEX

The technical analysts analyze the market through a calculation of the confidence index. This index shows
the ratio of yields between the types of bonds. These bonds are the high grade bonds, the low grade bonds
and the confidence index shows the willingness of the investor to invest in the market. This technique shows
that the purchase and sale of investment from high grade to low grade bonds depends on the kind of confidence
that the investor gains about the stock market price movements. When the investor is confident that the
economy is stable and the stock market is reflecting boom, gain and peak period, then they would like to take
a risk in the market and try to gain high yields in the purchase of bonds. The investors would make a gain
by shifting their investments in such a manner that they are high yielding. This they are able to do by shifting
their investments which they are already holding in high grade bonds to low grade bonds. High grade bonds
are higher in equity but do not yield high returns. Low grade bonds while risky will offer a higher yield. When
the investor makes this change then the price of the low grade bond rises. When the prices rise the yield also
falls and because the price of the low grade bond has increased this gives a boost to the investor and he
becomes more confident of the low grade bond.
Usually large institutional investors make portfolio choice in the bond market but it is the influence of the
small investor and the change in his prices which is marketed by the technical chartists to find out the
confidence index.
The confidence index is limited to points to upper limit being limited to one. When the confidence index
is rising it indicates optimism and the technical analysts predicts that the money market is showing a chance
for making speculative profit. At this time most of the investors do not mind taking heavy risks and buying even
low grade bonds. The assumption is that the yields which are received on a high quality bond will be lower
than the yield on low quality bond at all times. The technical analysts analyses the indicator of the confidence
index to measure in a time period from two months to a maximum of eleven months.
But the confidence index also indicates a fall in the stock prices and shows that the low grade yields rise
faster and fall slower than the high grade yields. A depression in the movement causes the investors to become
risk averse and short time speculators do not take advantage of shift in prices from high grade to low grade
bonds. This is so because they expect a downward trend in the economy to follow. Research has shown that
confidence index is not always positively correlated with the stock market. Although this gives some indications
and signals about the stock market trend because it is called a leading indicator, yet the signals which are
formed by it show errors. According to the technical analysts, signals will always show some errors in them and
complete accuracy can never be predicted.
14.10 BREADTH OF THE MARKET

This indicator measures the strength of declines or advances in the stock market. The techniques and tools
measure the stocks are yielding high profits and in finding out how often the stock prices are changing their
movements. The breadth of the market is calculated by subtracting the number of issues whose prices have
increased or advances that is by measuring the volatility by stock prices. This is also referred to as plurality.
This measures the breadth of the market. If the breadth becomes negative the technical analyst feels that the
speculator should not think that this is a negative direction. The measurement of the breadth of a market
depends only on the direction which is taken or shown by the breadth. Line charts are used to show the breadth
of the market. The indication that is shown by the breadth in a downward period is that the prices of known
shares and risky shares are falling. However, the prices of growth and income shares called blue-chips are stable
or even rising but downward trend shows that the market is weak and there is a signal that the prices in the
market are falling. The breadth of the market moves in the same direction as the market average. The market
advance line would show optimism in the market.
14.11 RELATIVE STRENGTH

Relative strength is the technical name which technical analysts have formulated to show that those
securities which have continued to be stable historically in the past will give an investor a higher return because
the security has stability and is able to withstand both the depression and peak periods. According to the
analysts, the investor should make a choice of investing in those securities which have constant strength in the
market. This can be done by comparing the prices of those securities which rise and fall faster than the price
of other securities. One of the technical analysts Levy suggests that all stocks do not move with prices in the
same manner, some move in both directions faster than the other. Some securities move in the same manner
showing strength and stability of securities. These are the securities that an investor should plan to purchase.
The relative strength market has been applied to measure an individual security or future securities in
industries. But this method is not useful for making a market analysis. The relative strength can be calculated
(i) by measuring the rate of return of securities, (ii) by classifying securities, (iii) by finding out the high average
return of securities, (iv) by using the technique of ratio analysis to find out the strength of an individual security.
Technical analyst measures relative strength as an indication for finding out the returns of securities. According
to them, those securities which have relative strength show high returns in bull markets but not in the bear
markets, that is, that when the market is falling these securities show weakness when compared to similar
securities in the industry. Those securities which are encompassed by systematic risk will be highly volatile, i.e.,
that they will rise and fall faster than the market because risk covering them cannot be diversified. Relative
strength is thus explained by technical analysts as a relationship between risk and return of a security following
the trends in the economy.
14.12 TRADING VOLUME

Another indicator according to the technical analysts to find out the behaviour of stock prices in the
market is by checking the daily list of stock exchange quotations. This index is generally on market condition
and measures the intensity with which the investors purchase or sell the security. The volume according to the
technical analysts measures the intensity of the emotion of the investor. The technical analysts who measures
the volume of trading of stocks is careful in watching the demand and supply of securities, whenever there is
a change in equilibrium. When the prices move up and fall this reflects and also shows an upward trend then
it is a signal that the market is operated by bulls. A high trading volume in the share market when prices are
falling indicates that the volume of trading shows a bear’s signal. The technical analysts believe that when the
volume of purchase and sale is high but the prices are falling then bullish market can be considered to have
come to an end and the market operating for bears is close at hand. When the volume of selling is shown by
liquidation of stocks by investors it is called a “selling climax”. This climax eliminates the bears and clears the
market. It shows that the market for the bears is at end and the trends are for a rise in the market.
Technical analysts also mark the bull market is at an end through a ‘speculative blow off ’. When the
volume of purchases is maximum and the price is also very high then the bullish speculators come to an end
and pave the way for the bears to walk into the market. This is called the speculative blow off that is the death
of the bull market with a loud sound and change towards bear market as the bull market is completely
exhausted.
14.13 MOVING AVERAGE ANALYSIS

The technical analyst also forecasts the price of shares by using the statistical method of moving averages.
The moving averages smoothen the daily fluctuations and show the trend for individual securities as well as
for market indexes.
The analysis of moving averages is the incorporation of signals which are made through penetration.
Moving averages, as discussed, show daily prices. When these show a continuous fall there is a downward
penetration and it is a sign to sell, when the prices are moving above the moving average line but falling the
differences is said to be narrowing thus showing that the bull market is at an end. According to the investors,
the stocks should be purchased by a speculator when the moving average is flat and the stock price rise through
moving average. According to the analysts, if the prices of stock shown on the line indicate that they are below
the moving average line which is rising the speculator should also buy when the stock price is above the moving
average line but it is falling and turning around and again begins to reach a higher place before it reaches the
moving average line.
The technical analysts also extend opinion that speculators should sell the stock when the moving average
line is flat and the stock price are below the moving average line. They should also sell when the stock prices
rise above the moving average line which is declining. Again when the stock prices fall downward but turn to
rise falling again before it reaches the moving average line.
The moving average trend is quite a useful method in finding out the trends in security prices when it is
based on long-term approach. These results are not always correct and technical analysts are usually true to
only a certain extend but not mathematically accurate.
SUMMARY
r This chapter analyses the behaviour of stock prices through the technical analyst’s viewpoint. According to
them, the fundamental analysts look for intrinsic prices of the share just like the technical analysis do, but
the fundamental analysts have a tedious method of finding out the stock prices.
r The technical analysts believe that their method was simple and give an investor a bird’s eye on the future
of security price by measuring the past moves of prices.
r The technical analysts predicted price behaviour through line charts, bar charts and point and figure charts.
They have a large number of patterns which predict the upward and downward swing in the market.
r There are a large number of theories which also predict the future of prices like the Theory of Contrary
Opinion which encompasses the opinion of old-lot theory and short sales. The measures which are used by
the technical analysts to predict and analyze the prices are the confidence index, the breadth of the market,
the relative strength, the trading volume and moving average analysis.
r The technical analysts do not believe that the fundamentalist approach is to find out the value of the security
but their method is to find the intrinsic value of the share through market operations. This method is not
accurate but it gives the general indication of the behaviour of prices in stock market.
r The next chapter would discuss the Random Walk Theory and its assumptions and projections.

Match the following:
1. Odd-lot 1. Confirmation
2. Historical stability 2. Moderate price rise
3. Left shoulder 3. Short sales
4. Right shoulder 4. Group less than 100
5. Breakout 5. Lull
6. Technique of cover-up 6. Below left shoulder
7. Predition of trends 7. Ratio of yields
8. Peak price of stocks 8. Relative strength
9. Confidence index 9. Dow Jones theory
10. Head 10. Resistance Area
Answers: (1) 4; (2) 8; (3) 5; (4) 2; (5) 1; (6) 3; (7) 9; (8) 10; (9) 7; (10) 6

1. In the bull market
(a) Stock prices are increasing.
(b) Each peak is higher than the previous peak.
(c) Prices are falling.
(d) There is stability in prices of stock.
2. The market value of shares is determined by
(a) Demand and supply of shares.
(b) Beta.
(c) Historical past data.
(d) Unsystematic risk.
3. Technical analysis is useful
(a) To make an estimate of growth in a stock market
(b) To find out the market forces influencing stock market.
(c) To indicate the direction of the overall market.
(d) To analyze the economic activity of government.
4. A support level exist
(a) When considerable demand is created at a particular price.
(b) When SEBI fixes the price at the stock exchange.
(c) When stock exchange broker fix a price.
(d) When the price of stock is stable.
5. The Dow Theory was developed by
(a) Stock broker by the name of Dow.
(b) An editor of Wall Street Journal by the name of Dow.
(c) It was developed by Markowitz and Dow.
(d) It was developed by Sharpe.
Answers: 1(b), 2 (a), 3 (c), 4 (a), 5 (b).
QUESTIONS
1. How is technical analysis different from fundamental analysis in investment management?
2. Technical analysis is based on Dow Jones Theory. Elucidate.
3. What are charts? How are they interpreted in technical analysis?
4. Discuss the Odd-lot Theory and its importance in technical analysis.
SUGGESTED READINGS
l Amling, Investment: An Introduction to Analysis and Management, Prentice Hall, New Hersey, 1984
l Jack Clark Francis, Management of Investments, McGraw-Hill, New York, 1983.
l Jones Tuttle Heaton, Essential of Modern Investments, Ronald Press Company, New York, 1977.
l Sprecher, An Introduction to Investment Management, Miffin Company, Boston, 1975.
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Chapter
15
EFFICIENT MARKET THEORY
Chapter Plan
15.1 Background
15.2 Concept of Efficient Market Theory
15.3 Efficient Market Hypothesis
15.4 Empirical Analysis
15.5 The Random Walk Model Comparison with other Theories
15.6 Random Walk — Conclusions
15.1 BACKGROUND
There are three basic theories of investment within the purview of which the investment analysts study the
behaviour of stock prices. Fundamentalists approach, is the theory of investments through the intrinsic value
analysis. This was discussed in Chapter 13. The technical analysts believed in past behaviour prices. Chapter
14 amply elucidates this theory. The subject-matter of this chapter is to discuss the efficient market theory in
its three forms — weak form, semi-strong form and strong form.
The previous chapters have discussed the behaviour of stock prices in different ways. The essence of both
the theories — fundamental analysis and technical analysis is to find out the state of the economy continuously,
the description of the company whose stock is to be traded in on the stock exchange, its industrial classification
and growth of the industry to which the company belongs. In addition, the fundamental analysis is related to
the company’s financial statements through ratio analysis, earnings per share and intrinsic value of a share. The
technical analysts repudiated the work of the fundamental analysts and discarded it on the ground that it did
not take into account the behaviour of stock prices in the market. Technical analysts believe that the past
behaviour of stock prices gave an indication about the future of the stocks. They studied the pattern of stock
prices through charts and drew inferences through patterns which were found on the charts. Their method was
an indication of the kind of stocks that were to be purchased, when the bull or bear market begins to operate.
On the basis of the technical analysis many researchers asked the question — Do today’s stock prices contain
any indication of tomorrow? This is the question, described and analyzed through the Random Walk Theory.
333
Random Walk Theory was developed later but there were lot of empirical tests before the theory existed. The
theory discusses the efficiency of the capital market operating in any financial set up.
15.2 CONCEPT OF EFFICIENT MARKET THEORY

The efficient market theory is described in three forms. The random walk theory is based on the efficient
market hypothesis in the weak form that states that the security prices move at random.
The Random Walk Theory in its absolute pure form has within its purview. Some of the concepts of the
efficient market theory are described below.
1. A perfectly competitive market which according to it, operates in an efficient manner in order to bring
about the actual stock prices with its present discounted value. This means that the equilibrium value
of a stock determined by its demand and supply features represents the value of stock based on the
information that the investors have.
2. It further states that since the market is in its most efficient form the participants in the market have
free access to the same information so that the market price which is prevailing reflects the stocks’
present value.
3. If there is any deviation from this equilibrium theory it is quickly corrected and the stock find its way
back to the equilibrium price. The analyst who is professional in trading of stock takes the advantage
of deviations and this forces stock back to its equilibrium price.
4. This theory also states that a price change occurs in the value of stock only because of certain changes
which affect the company or the stock markets.
5. The change in price alters the stock prices immediately and the stock moves to a new equilibrium
level.
6. This rapid shift to a new equilibrium level whenever new information is received is the Random Walk
Theory.
7. The instant adjustment is recognition of the fact that all information which is known is truly reflected
in the price of stock.
8. Further change in the price of stock will be only as a result of some other new piece of information
which was not available earlier.
9. According to this theory the changes in prices of stock show independent behaviour and are dependent
on the new pieces of information that are received but within themselves are independent of each
other. Whenever new piece of information is received in the stock market, the stock market independently
receives this new information and this is independent and separate of all other pieces of information.
For example, if a stock is selling at ` 25 per share based on existing information known to all investors.
Soon the news of a textile strike will bring down the stock price and the value goes down to ` 20 the
next day. The value goes down further to ` 10. The first fall in price from ` 25 to ` 20 per share was
caused because of some information about the strike. The second fall in the price from ` 20 to ` 10
came only because of additional information on the type of strike. So each stock exchanges are
separately disseminated. Of course, independent pieces of information when they come together
immediately after each other show that the price is falling, but each price fall is independent of the
other price fall.
The basic essential fact of the Random Walk Theory is that the information on stock prices is immediately
and fully spread so that other investors have full knowledge of the information. This response makes the
movements of price independent of each other. Therefore, the price of a security two days ago has no information
about the price two days later. It may, therefore, be said that since the prices have an independent nature, the
price of each day is different, it may, be unchanged or higher or lower from the previous price. The Random
Walk Theory points out the institutional factors and thus brings the theory to some state of logic. According
to the theory, the financial markets are so competitive that there is immediate price adjustment. This is as a
result of good communication system through which information can be distributed almost anywhere in the
country. It is this speed of spreading of information which determines the efficiency of the market.
EFFICIENT MARKET THEORY 335
15.3 EFFICIENT MARKET HYPOTHESIS

The Random Walk Theory is based on the efficient market hypothesis which is supposed to take three
forms — weak form, semi-strong form and strong form.
Strong form of market

(All information is reflected
Semi Strong form of market in share prices)
(All past and public information is
reflected in share prices)
Weak form of market

(Only past information is
reflected in share prices)
Fig. 15.1: Efficient Market Theory
1. Weak Form
The weak form of the market says that current prices of stocks reflect all information which is already
contained in the past. The weak form of the theory is just the opposite of the technical analysis, because
according to it the sequence of prices occurring historically does not have any value for predicting the future
stock prices. The Technical Analysts rely completely on charts and past behaviour of prices of stocks. In the
weak form of efficient market the past prices do not provide help in giving any information about the future
prices. The short-term trader in this form of the market is in a similar position as another investor who adopts
the approach of ‘buy and hold’ strategy. Although, some traders will be able to earn a positive rate of return
but on an average their performance in the market will not in any way be better than an ordinary native
investor who follows the strategy of buying and holding securities.
2. Semi-Strong Form
This form of the market reflects all information regarding historical prices as well as all information about
the company which is known to the public. According to the theory any analyst will find it difficult to make
a forecast of stock prices, because he will not be able to get superior and consistent information of any
company continuously. No one can, therefore, take undue advantage of the market. The semi-strong market
maintains that as soon as the information becomes public, the stock prices change and absorb the full information.
Therefore, the stock prices adjust with the information that is received. This information may not be correct but
the analyst will still not be able to make superior judgments consistently because the correct adjustment of stock
price will soon take place. Sometimes there will be over adjustments in the market, while some other time there
will be under-adjustments. This makes it difficult for the analyst to form any particular kind of strategy based
on the quick adjustment to information received in the market. If the analyst has superior internal information
then there is a possibility of making profits if he can use the superior information which he has acquired, he
must use it quickly. Again, the profits will not be consistent or continuous in nature because (a) changes and
returns are independent and price changes are independent of each other, (b) that the successive price changes
are identically distributed and the distribution will repeat themselves over time.
3. Strong Form
The strong form of the efficient market hypothesis suggests that it is not useful to any investor or analyst
to make any future forecast of prices because he can never make any returns which are superior to others
consistently. Each investor is fully aware of the new pieces of information in the market and so even if the
analyst has inside information he cannot continuously earn superior investment returns. The strongly efficient
market hypothesis is not found to be fully acceptable.
The efficient market model acknowledges that the stock exchange has many imperfections and all information
may not be immediately reflected in stock prices due to delays in communication, also transaction cost and
delays in information dissemination to far of places. It is possible to have some profit above the normal profit
by developing a kind of trading strategy. However, the Random Walk Theory is not merely based on price or
return levels but all changes of prices between successive levels.
15.4 EMPIRICAL ANALYSIS

There have been several empirical tests on the Efficient Market Theory. These are:
A. RESEARCH ON WEAK FORM OF THE MARKET
The weak form of the market as stated is that no investor can use any information of the past to earn
a return of portfolio which is in excess of the portfolio’s risk. This means that the investor who develops the
strategy based on past prices and chooses his portfolio on that basis cannot continuously out perform another
investor who ‘buys and holds’ his investments over a long term period. In other words, technical analysis or
market index will not be indicative of superior portfolio performance.
1. Random Walk Test
Many research studies were carried on to test the weak form of the efficient market hypothesis. The
question which has rapidly been studied by the researchers is whether “security prices follow a random walk”.
A random walk when it is applied to security prices means that all price changes which have occurred today
are completely independent of the prices prior to this day in all respects. The weak form of the efficient market
theory takes into consideration only the average change of today’s prices and states that they are independent
of all prior prices. The evidence supporting the random walk behaviour also supports the efficient market
hypothesis and states that the large price changes are followed by larger price changes, but they do not change
in any direction which can be predicted. This observation in a way violates the random walk behaviour but it
does not violate the weak form of the market efficiency. Researchers have studied that the evidence which
supports the efficient market behaviour is based on the random walk behaviour of security prices, but there is
evidence which contradicts the random walk hypothesis. This does not mean that it contradicts the efficient
market hypothesis also.
2. Behaviour of Commodity Prices
Research was first conducted in 1900 by Bachelier. He developed a theory for the behaviour of commodity
prices and his research analysis showed that these commodity prices followed a random walk. In 1934 Cowles,
Jones in 1937 and Kendall in 1953 further supported that the security prices went round a random walk.
Research by these analysts was purely on economic series data through which they analyzed statistically
properties of data and provided evidence of efficient market in its weak form.
3. Simulation Test
Research was later conducted in 1959 by Roberts and Osborne. Roberts took the Dow Jones Industrial
Average and compared its level with a variable generated by a random walk mechanism. He concluded that
the mechanism of the random walk showed patterns which were very similar to the movements of stock prices.
He also showed that a series of cumulative random numbers closely resembled in actual stock price series and
that changes in the random numbers closely resembled an actual stock price series and that changes in the
random principles series as expected do not exhibit pattern as it exhibits in the case of stock price changes.
Robert’s research is also called Simulation Test.
4. Brownian Motion Test
Osborne’s research showed that stock prices moved similar to Brownian Motion. Brownian Motion is the
method of movement of particles in solution where movements of different magnitudes occur at any time
independent of any previous movements. Brownian Motion is described as a particular kind of random walk.
According to Osborne’s research, the security prices move constantly with the Brownian Motion Model which
showed that the price changes in one period were independent of the price changes in the previous period.
5. Robert’s and Osborne’s Serial Correlation Test
Robert’s and Osborne’s articles became very popular about the study of the stock market prices. Many
more researches tried to test if security prices follow a random walk. In 1964, Moore took up a test called
‘Serial Correlation Test’. He found out the ‘Serial Correlation of Weekly security prices’. Serial Correlation is
said to measure the association of a series of numbers which are separated by some constant time period like
the association of the level of Gross National Product in one year with the level of Gross National Product of
the previous year. Moore measured correlation of price change of one week with the price change of the next
week. His research showed average serial correlation of – 0.06 which indicated a very low tendency of security
price to reverse dates. This means that a price rise did not show the tendency to follow the price fall or vice
versa. The evidence was not considered or interpreted to being different from an average correlation of zero
because the evidence was extremely weak which indicates that there is no association. Moreover a price
reversal of a correlation coefficient of – 0.06 would not be able to indicate returns to be able to compensate
for the cost involved in transaction.
6. Fama Serial Correlation Test
Fama also tested the serial correlation of daily price changes in 1965. He studied the correlation for 30
firms which composed of the Dow Jones Industrial Average for five years before 1962. His research showed
an average correlation of –0.03. This correlation was also weak because it was not very far away from zero
and therefore, it could not indicate any correlation between price changes in successive periods.
7. Run Test
Run Test was also made by Fama to find out if price changes were likely to be followed by further price
changes of the same sign. He made the Run Test because correlation coefficient were too often dominated by
extreme values and they influence the results of calculations to determine the correlation coefficient. Run Test
ignored the absolute values of numbers in the series and took into the research only the positive and negative
signs. The Run Tests are made by counting the number of consecutive signs or “Runs” in the same direction.
For example, the sequence of +O+ is said to be have 4 runs. The actual number of runs are observed and
compared with the number that are expected from the price changes are randomly generated. No difference
which was significant was observed while making this test. The random walk hypothesis was separated by this
research. Hagerman and Richmond made a similar study for price changes observed on security which were
treated in ‘over the counter market’. They found that the returns of ‘over the counter securities’ were not serially
correlated. In 1972, Black and Scholls tested the efficiency of the options market. Their research work showed
that the option contacts were significantly mispriced and their transaction cost was so high that those trading
in the market could not make any abnormal return by taking advantage of the mispricing. Granger and
Morgenstern used a statistical technique called Spectral Analysis in 1963 in order to test the random nature
of stock prices. They did not detect any significant relationship between the returns of security in one period
and the returns in prior periods to make a conclusion that the security prices followed a random walk.
8. Filter Test
Filter Tests were made because the technical analysts believed that the serial correlation tests were not of
good measure as these were extremely narrow to prove the complex nature of the stock price behaviour.
According to them, such test did not prove the complex strategies to earn an abnormal rate of portfolio return.
They also argued that if there was no statistical significance in serial correlation there could be no economic
significance in price changes. The tests which were made showed that the serial correlations were not significantly
different from zero. The “Filter Rule Test” was made by Alexander in 1961 to find out “if any abnormal return
could be earned using past price data”. The Filter Rule was made to work in the following manner when a stock
price was administered by a certain percentage over a previous point of its purchases. If the stock declined from
the previous high point, then it should be sold when the decline is in excess of the specified percentage.
According to Alexander, the Filter Rules showed large rates of return. He tested different filters and he found
that small filters of 4.5% produced large rates of return, but when the transaction costs were taken into
consideration the abnormal returns disappeared for filter rules. Filter rules were again tested by Fama in 1965
and by Fama and Blume in 1970. But they failed to show any abnormal rates of return for the filter rules that
they studied. Alexander’s results thus contradicted the random walk hypothesis that security changes are
independent of prior price changes but they did not contradict the weak form of efficient market hypothesis that
changes in adjustments may not be used to earn abnormal portfolio return.
9. Relative Strength Method
Levy in 1967 used a relative strength method which was based on the ratio of a stock current price to
its average price. His research analysis showed a rule which yielded abnormal portfolio return. In 1967, Jensen
found that Levy’s results were biased because his results were tested on some data that were used to select the
model. These brought about a bias in the test results in favour of the model. In 1970, Jensen and Bennington
further tested Levy’s research on different sets of data and found that there was no significant abnormal return.
B. RESEARCH ON SEMI-STRONG FORM OF THE MARKET
According to the Semi-Strong Form of the market, the security prices reflect all publicly available information
within the purview of the efficient market hypothesis. In this state the market reflects even those forms of
information which may be concerning the announcement of a firm’s most recent earnings forecast and adjustments
which will have taken place in the prices of security. The investor in the semi-strong form of the market will
find it impossible to earn a return on the portfolio which is based on the publicly available information in excess
of the return which may be said to be commensurate with the portfolio risk. Many empirical tests have been
made on the semi-strong form of the efficient market hypothesis “to study the reaction of security prices to
various types of information around the announcement time of that information”. In the semi-strong market any
new announcement would bring a reaction immediately upon the announcement. This reaction could be even
prior to the announcement in the market. This reaction prior to or immediately after the announcement would
be caused by the additional information which is not anticipated by the stock exchange participants. This
information would also not be disclosed to the market participants. The semi-strong form of the efficient market
hypothesis would immediately indicate a change in the price of the securities but the price would be adjusted
immediately by the market participants and in this way remove any possibility for abnormal returns in the
future.
1. Market Reaction Test
Semi-strong efficient market hypothesis was empirically tested in 1969 by Fama, Fischer, Jensen and Roll.
They made the following study, “they considered the behaviour of abnormal security returns at the announcement
of stock splits”. In a stock market a stock generally indicates increased dividend payouts. Stock splits announcement
contains economic information. The research study showed that the stock splits information brought in market
reaction just before the split announcement. The average cumulative abnormal security return for thirty months
upto the month of announcement was in excess of 30%. This showed that the return was far above the normal
rate of return which was achieved by the method of buying and holding a portfolio for long-term investments
of similar risky securities. The behaviour of the security prices in the market after the split announcement
showed exactly the predictions of the efficient market hypothesis. After the public announcement the investors
could achieve in abnormal returns on the basis of the information of the stock split. The average cumulative
abnormal return which was going higher and increasing just before the announcement stopped increasing or
decreasing in any significant manner in the following period after the split announcement was made.
2. Price Change Test
In 1972, Scholes conducted a study to observe “the reaction of security prices to the offer of secondary
stock issues”. The research studies showed that the price of security decreases when the issuer was a company
which indicated to the market that such an offer contained some bad news. But secondary offerings by investor,
banks and insurance companies were not viewed in a negative manner and the security prices did not significantly
fall. Price change which was associated with the secondary offerings occurred usually within six days of the
issue and showed that these changes were more or less permanent. The price behaviour of secondary issues
lent support with the market just to a new piece of information in an unbiased manner and almost immediately.
3. Effect of Large Trade on Prices
Kraus and Stoll conducted a research study in the same year as Scholes to examine “the effect of large
block trades on the behaviour of security prices”. According to them, the study showed that there was a
temporary effect on share price which were associated with the block trade. The trades which were known to
effect large transactions were shown by a decrease in price but the price rose almost immediately and was
totally reactionary by the end of the day. But the price did not return to the previous position because the
market has received information which was negative to the image of the security. There was also no price
behaviour which could be predicted after the day on which the block trade occurred. This was constant with
the semi-strong form of the efficient market hypothesis. Pettit and Watts examined the market reaction when
an announcement was made about changes in dividends. They found that there was no evidence that a firm’s
dividend announcement affected the firm’s price in the period which followed the announcement. Wauds
further made an examination relating to the size and direction of changes of prices of stock which were
surrounded immediately after the announcement of changes in the Federal reserve discount rate. The price
change on the date of announcement was significant and the manner in which it could be predicted. But after
even three days there was no indication of price changes.
4. Announcement Effects
Another study was conducted by Beaver which looked into the information of the announcements of
annual earnings and the speed of changes in security prices. He examined the level of the trading volume and
the size of price changes. According to him, the absolute values of price changes and levels of trading was
significantly higher during the announcement week. In the week following the announcement week it returned
to pre-announcement levels. The market announcement effect was also studied by Patz and Boatsman. Both
of them examined the reaction of the market to counting principles bold release of a memorandum which was
concerned with the cost centre used by some oil companies for accumulating certain material cost. They found
that there was no significant reaction in the market to the announcement and it was consistent with the efficient
market hypothesis that the market saw the changes in keeping with the temporary announcement leaving no
great economic impact. This was further tested by Foster. He tested the preliminary estimates made by company
officials and the market’s reaction to it. He also found that the volume of trading increased in the week of
announcement but went back to the pre-announcement level in the next week. All the above results have some
indication that price changes accompany the announcement but abnormal returns cannot be made after following
the announcement.
C. RESEARCH ON STRONG FORM OF THE MARKET
In the strong form of the market, it is stated that all information is represented in the security prices in
such a way that there is no opportunity for any person to make an extraordinary gain on the basis of any
information. This is the most extreme form of the efficient market hypothesis. Most of the research work has
indicated that the efficient market hypothesis in the strongest form does not hold good.
1. Collins Test
In 1975, Collins tested the strong form of the market. Collins showed that the consolidated earnings of
a multi-product firm could be accurately predicted by using segment and profit data rather than by using
consolidated historical earnings data. He formulated a test by adopting a strategy of two sets of estimates of
annual earnings for multi-product firms numbering 92 for 3 years — 6, 8, 9 and 70. One set used historical
segmented data and the other the historical consolidated number. His study was conducted by buying stock of
those companies for which the segment base earning forecast exceeded the consolidated based forecast and to
sell short first stock of those firms for which the segment based earnings forecast was less than the consolidated
based forecast. Collins attempted his research work by using the market model through which he eliminated
the market related movements in the stock prices. He found that in 1968 and 1969 he could earn a statistically
significant abnormal return. But in 1970 results were repudiated. In this way he showed that the market was
not efficient to know public segment review and profit data of multi-product firms. For these data could be used
to anticipate changes in total earnings “which were otherwise unexpected”.
2. Mutual Fund Performance
The strong form of the efficient market hypothesis is separated by the performance of the mutual funds.
The performance of mutual funds have been tested by Friend in 1972, by Sharpe in 1966 and by Jensen in
1969. Further studies were also made by Blume and Crockett and Williamson. The hypothesis was “that the
mutual funds could earn extraordinary return and constantly achieve a higher than average performance
because they are likely to have excess inside information which is not otherwise publicly known”. The research
studies made to test this were based on different samples of firms and time periods, but the results are almost
similar. The research study showed that the mutual funds were not better in performance than an individual
investor who purchases the same securities with the same risk. The funds’ expenses showed that the majority
of the funds did badly and were worse than randomly selected portfolio. Mutual funds should constantly be able
to earn an extraordinary return, but empirical evidence does not indicate this if the evidence is given contrary
to the strong form of the efficient market hypothesis. The mutual fund performance is not an indication of
inside information being otherwise propounded in the market price of securities. An alternate conclusion is
suggested that no mutual fund has consistent access to non-public information. Since mutual funds are usually
competing with each other for such information at an average, these funds will be better than an ordinary
investor will perform or than any other mutual fund performing in the market.
15.5 THE RANDOM WALK MODEL COMPARISON WITH OTHER THEORIES
1. Random Walk Model and Technical Analysis

The random walk hypothesis is contrary to the technical analyst’s view of behaviour of stock prices. It
does not believe that the past historical prices have any indication to the future of stock prices. According to
the technical analyst, history repeats itself and by studying the past behaviour of stock prices, future prices can
be predicted. The random walk hypothesis is in direct opposition to the analysis of the technical school of
thought.
2. Random Walk Model and Fundamental Analysis
The random walk hypothesis is in conjunction and to some extent believes in fundamental analysis. It
believes that changes in information help the superior analyst who has the capability of using inside information
to out-perform other investors of the buy and hold strategy during the short runs. This is entirely possible
because of some super analytical power like financial statement analysis or knowledge about inside factors
which the public do not know. Therefore, Random Walk Theory in its semi-strong form supports the fundamental
school of thought. The Random Walk Theory states that Fundamental Analysis which is superior in nature will
definitely lead to superior profits.
15.6 RANDOM WALK – CONCLUSIONS

Any conclusion which may be reflected with the random walk suggests that the successive price changes
are independent. Independence means that the prices at any particular time usually reflect the intrinsic value
of a security at an average. If the stock price moves away from its intrinsic value different investors will evaluate
the information which is available differently into the prospects of the firm and the professional investors will
be able to make a short-term gain on the random deviations from the intrinsic value but in the long run the
stocks will be forced back to its equilibrium position. Also, according to this theory historical information about
price changes alone will be useless for making a gain. In addition to past prices of stocks the investor or the
analyst should also have other relevant information which is superior to the information available to other
investors to make a profit.
The random walk is not an attempt at selecting securities or giving information about relative price
movements. It does not give any information about price movements of market, industry or firm factors. The
random walk hypothesis is consistent with upward and downward movements in prices and to some extent it
supports the fundamental analysis because according to it certain short-run profits can be made by finding out
inside information which is superior to publicly available information. According to the theory it is also possible
to find out trends in stock prices by taking away the market influences but these trends do not provide a basis
for forecast for the future.
The Random Walk Theory does not discuss the long-term trends or how the levels of prices are determined.
It is a hypothesis which discusses only the short-run change in prices and the independence of successive price
changes. They believe that short-run changes are random about true intrinsic value of the security. The random
walk theory, therefore, suggests that analysis should be able to look in for superior analysis of the firm by
making the following considerations:
(a) by finding out the risk and return characteristics of each security;
(b) by trying to combine the risk and return characteristics of securities into an adequate portfolio;
(c) by holding a portfolio for a reasonable length of time and making a continuous evaluation of the
securities held by him;
(d) by planning a well diversified portfolio and by revising it, if need be, after consistent evaluation.
Although the random walk hypothesis has discarded the Technical School of thought, there has been some
research conducted on the analysis of stock behaviour through technical analysis. The following results have
been reported form the Journal of Future Markets 1 “historical data generated by a random walk process,
therefore, will have trends over certain time periods”. Such a trend in one-time period does not preclude the
possibility of a trend in the next period. Thus technical analysis applied to random series should sometimes be
successive. 2
SUMMARY
r There are three forms of the efficient market theory — the weak form, semi-strong form and the strong form
of the market.
r These hypotheses were developed after a considerable number of research evidences.
r According to this theory, fundamental analysis is more valuable than technical analysis.
r When the market is perfectly efficient, all investors have fully available information and the market is in
continuous equilibrium, i.e., the market prices of securities are equal to their intrinsic value.
r In the semi-strong form the current prices reflect past movement of stocks and also the company information.
r No analyst is continuously able to make superior and consistent profits by taking undue advantage of the
situation.
r As soon as the information is publicly available it becomes absorbed in stock prices and is immediately
reflected. Information is adjusted immediately even though sometimes there is under-adjustment and over-
adjustment.
r Many tests have been conducted to support the semi-strong form of market hypothesis.
r The weak form of the market represents the Random Walk Theory. According to which the current prices of
stock reflect all information which is already contained in the past.
r Both the efficient and semi-strong market hypothesis has been supported by the research findings, but the
strongly efficient market hypothesis is not supported by facts.
r The fundamental analyst plays a major role in evaluating security prices in an intrinsic value random walk
market.
r All analysts who are able to find out new information and also evaluate it by careful analysis will be able to
earn a higher return than the other investors.
r Only those analysts will earn a profit that will be able to outwit the market by a careful analysis of the stock
prices.
r The information acquired by them should also be very quick before the others can take advantage of it.
1 William G. Tomek, Scott, F. Quenin, Random Process in Prices and Technical Analysis, Vol. IV, No. 1, Spring, New York, 1984.
2 For further details see Buron G. Malkiel’s, A Random Walk, Down Wall Street, W.W. Norton & Co. Canada, 1973.
r It may amply be conducted in the words of Fama that an efficient market is defined “as the market where
there are large number of rational profit maximizers actively competing with each trying to predict even the
market values of individual securities and whether current information is almost freely available to all participants”.

(i) In the weak form of the market, historical prices are reflected.
(ii) Random Walk theory suggests that stock market readjusts itself quickly to new equilibrium levels.
(iii) The strong form of the market states that no investor can continuously make profits on the stock exchange by
future forecasts.
(iv) Run test and Filter tests showed market.
(v) Mutual fund performance has been tested by Friend in 1972, Sharpe in 1966 and Jensen in 1969 efficiency.
Answers: (i) F (ii) T (iii) T (iv) F (v) T.

1. In the weak form of the efficient market the stock price indicates
(a) the trading volumes and past prices of the shares
(b) the past price of the shares
(c) demand and supply position of the company
(d) the financial position of a company
2. The efficient market theory states that
(a) the price movement of shares depends on previous prices
(b) prices of shares are indicated through patterns like line charts
(c) each successive change does not depend on previous share prices
(d) share prices move in the form of a trend.
3. In the strong form of the efficient market
(a) stock prices show the performances of the firm
(b) the stock prices reflect past prices of the share
(c) all information is reflected on the price of the share
(d) mutual funds are consistently superior to other investors
4. An efficient market can be recognized as
(a) a fully automated stock exchange
(b) information which is fully reflected in the stock prices
(c) a regulated market closely monitored by regulatory agencies
(d) one with the presence of savers and investors
5. The efficient market hypothesis gives credence to
(a) technical analysis theory
(b) fundamental school of thought
(c) purchase of mutual funds securities to out perform the market.
(d) Individual investors trends of historical prices.
Answers: 1. (a), 2 (c), 3 (c), 4 (b), 5 (b).
QUESTIONS
1. What is Random Walk Theory? What does it project in its weak form, semi-strong form and strong form?
2. Discuss the empirical tests conducted on the different forms of the random walk.
3. Write notes on:
(a) Filter test.
(b) Serial correlation test.
(c) Efficient market hypothesis.
4. The random walk hypothesis resembles the fundamental school of thought but is contrary to the technical analysis.
Discuss.
SUGGESTED READINGS
l Bolten, Security Analysis and Portfolio Management, Holt Rinechart and Winston Inc., New York, 1972.
l Eugene F. Fama, Random Walks in Stock Market Prices, Readings and Issues in Investments, edited by
Frank K. Reilly, Illinois, 1975.
l G. Malkiel, A Random Walk, Down Wall Street, W.W. Norton & Co., Canada, 1973.
l Jones Tuttle, Heaton, Essentials of Modern Investments, Ronalt Press Co., New York, 1977.
l Thomas R. Dyckman, Downes, Magee, Efficient Capital Markets and Accounting — A Critical Analysis, Prentice
Hall, U.S.A., 1975.
nnnnnnnnnn
Chapter
16
PORTFOLIO ANALYSIS
Chapter Plan
16.1 Traditional Versus Modern Portfolio Analysis
16.2 Modern Portfolio Theories
16.3 Investor Attitude towards Risk and Return
16.4 The Rationale of Diversification of Investments
16.5 Markowitz Theory
16.6 Capital Market Line (CML)
16.7 Limitations of Markowitz Model
16.8 Sharpe’s Single Index Model
16.9 Sharpe’s Optimal Portfolio
16.1 TRADITIONAL VERSUS MODERN PORTFOLIO ANALYSIS

The book has related to the analysis of individual securities within the framework of return and risk. This
chapter now makes an analysis of securities in the combined form. Various groups of securities when held
together behave in a different manner and give interest payments and dividends also which are different to the
analysis of individual securities. A combination of securities held together will give a beneficial result if they
are grouped in a manner to secure higher return after taking into consideration the risk element.
(i) Style of Functioning: Traditional portfolio analysis has been of a very subjective nature, but it has
provided success to some people who have made their investments by making analysis of individual securities
through evaluation of return and risk conditions in each security. In fact, the investor has been able to get the
maximum return at the minimum risk or achieve his return position at that indifferent curve which states his
risk condition. The normal method of calculating the return on an individual security was by finding out the
amount of dividend that has been given by the company, the price earnings ratio, the common holding period
and by an estimation of the market value of the shares.
344
PORTFOLIO ANALYSIS 345
The modern portfolio theory believes in the maximization of return through a combination of securities.
The modern portfolio theory discusses the relationship between different securities and then draws inter-
relationship of risk between them. It is not necessary to achieve success only by trying to get all securities of
minimum risk. The theory states that by combining a security of low risk with another security of high risk,
success can be achieved by an investor in making a choice of investment outlets.
(ii) Measurement of Risk: Traditional theory was based on the fact that risk could be measured on each
individual security through the process of finding out the standard deviation and that security should be chosen
where the deviation was minimum. Greater variability and higher deviations showed more risk than those
securities which had lower variation. The modern theory is of the view that by diversification, risk can be
reduced. Diversification can be made by the investor either by having a large number of shares of companies
in different regions, in different industries or those producing different types of product lines. Diversification is
important, but the modern theory states that there cannot be only diversification to achieve the maximum
return. The securities have to be evaluated and thus diversified to some limited extent within which the
maximum achievement can be sought by the investor. The theory of diversification was based on the research
work by Harry Markowitz. 1 Markowitz is of the view that a portfolio should be analyzed depending upon —
(a) The attitude of the investor towards risk and return and
(b) The quantification of risk.
(iii) Theories of Analysis: Thus traditional theory and modern theory are both framed under the
constraints of risk and return. The former analyzing individual securities and the latter believing in the perspective
of combination of securities.
Traditional theory believes that the market is inefficient and the fundamental analyst can take advantage
of the situation. By analyzing internal financial statements of the company he can make superior profits through
higher returns.
The technical analyst believed in the market behaviour and past trends to forecast the future of the
securities. These analyses were mainly under the risk and return criteria of single security analysis.
Modern portfolio theory, as brought out by Markowitz and Sharpe, is the combination of the securities to
get the most efficient portfolio. Combination of securities can be made in many ways. Markowitz developed the
theory of diversification through scientific reasoning and method.
16.2 MODERN PORTFOLIO THEORIES

(i) Analysis and selection of portfolio: A portfolio should be constructed by diversifying risk through
different securities. It can further be analyzed and the proportion of securities can also be diversified. Each
portfolio will have to be analyzed and selected to suit the requirements of a particular investor according to
his risk and return profile.
(ii) Revision of Portfolio: A portfolio has to be reviewed and revised according to the changes in the
financial environment and capital market considerations. An investor should make his calculations and replace
his securities, if they are high risk and low return.
(iii)Evaluation of Portfolio: A portfolio construction is made for a period and it is revised according
to the investor’s requirement of risk and return. However, it is a dynamic world and therefore the portfolio has
to be evaluated periodically to provide a feedback of the return and risk consideration to make changes for
achieving the desired return.
16.3 INVESTORS ATTITUDE TOWARDS RISK AND RETURN

As has been discussed in earlier chapters, all investors prefer those securities which have a high return
but at the same time the risk attached to it is low. At the time of combining the securities and constructing a
portfolio of different combinations of securities, an investor is faced with the same question of risk and return.
1. Markowitz, Portfolio Selection, Yale University Press, Yale, 1959.

There are three kinds of investors. An investor who prefers more return and least risk is called a risk-averse
investor. High return with comparatively higher risks is a balanced investor and high return with a high risk is
a risk lover. These are depicted as desirable conditions for an investor through the use of utility curves called
indifferent curves. Indifferent curves are usually parallel and linear. When it is drawn on a graph, it shows that
the higher the investor goes on the growth the greater is his satisfaction. In Figure 16.1 these utility graphs are
drawn. These are positively sloped for a hypothetical investor ‘X’ and the indifferent curves are from 1 to 6.
The investor ‘X’ is faced with the problem of finding out the indifferent curve or portfolio tangent which will
give him the highest return. In Figure 16.2 it shows that there is a combination of securities on the indifferent
curves and is the best portfolio in terms of (a) efficiency and (b) that it represents a tangent to the indifferent
line.
As has been seen earlier, most of the investors are happy when they get a higher return even though they
have to take some additional risk along with it. All indifferent curves which are given higher satisfaction and
higher return will show positively sloped lines. Figure 16.3 depicts (a) the positive sloping curves for a risk
fearing investor ‘X’.
Rp Rp
U6
U6 U5
U5 U4
U3
U4
U3 U2
U2 U1
U1
θp θp
Fig. 16.1 Fig. 16.2
Investor ‘X’ Investor ‘X’
Indifferent Curves – Parallel and Linear Indifferent Curves Showing Best Portfolio ‘A’
The higher the curve the greater the satisfaction of (1) ‘A’ portfolio is efficient.
investor ‘X’ (positively sloped), higher return for (2) The efficient frontier is tangent to the indifferent curve (Line)
greater risk.
Rp
U6
U5 U1
U4 U3 U2
θp
Fig. 16.3
Investor ‘Y’ (a) Positive Sloping Curves – Risk Lover
Rp Rp
U1 U2 U3 U4 U5
U4
U3
U2
U θp θp
Fig. 16.4 Fig. 16.5

Investor ‘Y’ Investor ‘Z’
(b) Negative Sloping Curves – Risk Fearing (c) Less Risk Fearing
The investor ‘X’ has positive sloping curves from U.1 to U.6 and his satisfaction shows that slopes are
positive and the higher he goes the greater the satisfaction. In the same figure (b) depicts the indifferent curves
of a risk lover. An investor of this type will have negative sloping curves with lines convex to the origin. Curves
from U.1 to U.4 show the investment preference of a risk lover. Investor ‘Z’ is showing that he is less risk fearing
and U.1 to U.5 show his indifferent curves and his investment preferences. An investor who is a risk averter
is happy when his θ p is low in his portfolio, but an investor who enjoys taking a risk is happier when the θ p
is higher. The slope of the growth, that is the degree with which the indifferent curves are associated show the
kind of risk that an investor has in mind. Figure 16.6 shows that there are different curves of three different
kinds of slopes. There are three graphs — curve ‘A’, curve ‘B’ and curve ‘C’. Each of these graphs represents
a particular meaning in the graph. Curve ‘A’ shows that the investor is a risk lover and his marginal utility is
increasing. Curve ‘B’ shows that the investor is a risk neutral and he has constant marginal utility. Curve ‘C’
represents a risk averse investor whose marginal utility is decreasing. Curve ‘C’ also represents an average
investor who would not like to take much risk and at the same time he is able to get a return for his satisfaction.
Most of the investors are categorised in curve ‘C’. Therefore each investor will have his own preference and
will make his own indifferent curve suitable to his preference for risk and return.
A B
Fig. 16.6: Marginal Utility Curves

Curve A = Increasing marginal utility — Risk Lover.
Curve B = Constant marginal utility — Risk Neutral.
Curve C = Decreasing marginal utility — Risk Averse.
16.4 THE RATIONALE FOR DIVERSIFICATION OF INVESTMENTS

Before the development of Markowitz theory combination of securities was made through “simple diversification”.
The layman could make superior returns on his investment by making a random diversification in his investment.
A portfolio consisting of 10 securities with simple diversification combined at random is expected to bring a
superior return than a portfolio consisting of one security because the portfolio is ten times more diversified.
The simple diversification would be able to reduce unsystematic or diversifiable risk. In securities both diversifiable
and non-diversifiable risk is present and an investor can expect 75% risk being diversifiable and 25% to be non
diversifiable. Unsystematic risk was considered to be independent in each security. Many research studies were
made on diversification of securities. It was found that 10 to 15 securities in a portfolio would bring adequate
returns. Too much diversification would also not yield the expected return.
Some experts have suggested that diversification at random does not bring the expected return results.
Diversification should, therefore, be related to industries which are not related to each other. Many industries
are correlated with each other in such a way that if the stock of ‘X’ increases in price, the stock of ‘Y’ also
increases and vice versa. By looking at the trends industries should be selected in such a way that they are
unrelated to each other.
If systematic risk is reduced by simple diversification, research studies have shown that an investor should
spread his investments but he should not spread himself in so many investments that it leads to “superfluous
diversification”. When an investor has too many assets on his portfolio he will have problems. These problems
relate to inadequate return. It is very difficult for the investor to measure the return on each of the investments
that he has purchased. Consequently, he will find that the return he expects on the investments will not be upto
his expectations by over-diversifying. The investor will also find it impossible to manage the assets on his
portfolio because the management of a larger number of assets requires knowledge of the liquidity of each
investment, return, tax liability and this is not possible without specialized knowledge. An investor will also find
it both difficult and expensive to look after a large number of investments. This will also have the effect of
cutting into the profits or the return factor on the investments. If the investor plans to switch over investments
by selling those which are unprofitable and purchasing those which will be offering him a high rate of return,
he will involve himself in high transaction costs and more money will be spent in managing superfluous
diversification. The research studies have shown that random diversification will not lead to superior returns
unless it is scientifically predicted. Markowitz theory is also based on diversification. He believes in asset
correlation and in combining assets in a manner to lower risk.
1. The Effect of Combining Two Securities
It is believed that holding two securities is less risky than having only one investment in a portfolio. When
two stocks are taken on a portfolio and if they have negative correlation then risk can be completely reduced
because the gain on one can offset the loss on the other. The effect of two securities can also be studied when
one security is more risky as compared to the other security. The following example shows a return of 17.5%.
A combination of 1 and 2 will produce superior results to an investor rather than if he was to purchase only
security 1. The average return of the portfolio is weighted average return of each security in the portfolio.
Example 16.1 depicts proportion of security 1 multiplied by its expected return and it is added to proportion
of security with its return.
Example 16.1
When there are two securities in a portfolio:
Security Expected Return Proportion
R1% X 1%
1 10 25
2 20 75
Solution:
The return on the portfolio on combining the two securities will be
Rp = R 1X 1 + R 2X 2
= 0.10 (0.25) + 0.20 (0.75)
= 17.5%
By investing in different proportions a better return can be achieved. The effect of holding two securities
in a portfolio does reduce risk but research studies have shown that it is important to know what proportion
of the stock should be brought by the investor in order to get a minimum risk, the portfolio returns can be
achieved at the higher point by setting of one variation against another. The investor should be able to find
out two investments in such a way that one investment is giving a higher return whereas the other investment
is not performing well even though one of the securities is more risky it will lead to a good combination. This
is a difficult task because the investor will have to continue to find out two securities which are related to each
other inversely (like in example 16.2) given for Stocks ‘A’ and ‘B’. But securities should also be correlated to
each other in such a way that maximum return can be achieved.
Example 16.2
In example 16.2, there are two stocks A and B. The following information is given. Calculate (a) return
and risk of individual securities stock A and stock B. (b) Return and risk of the portfolio with 2/3rd of A and
1/3rd of B.
Stock A Stock B
Return % 7 or 11 13 or 5
Probability 0.4 each return 0.4 each return
Expected Return % 7.2 7.2
Variance 4 16
Standard Deviation 2 4
Formula:
N
Rp = ∑ X1R1
i =1
Rp = the expected return to portfolio

X1 = proportion of total portfolio invested in security 1
R1 = expected return to security 1
N = total number of securities in portfolio
Solution:
Expected Return of Stock A = 0.4 × 7 + 0.4 × 11 = 7.2
Expected Return of Stock B = 0.4 × 13 + 0.4 × 5 = 7.2
Stock A Variance = 0.4 (7 – 7.2) 2 + 0.4 (11 – 7.2) 2 = 5.792
Stock B Variance = 0.4 (13 – 7.2) 2 + 0.4 (5 – 7.2) 2 = 15.392
Stock A standard deviation = Variance = 5.79 = 2.40
Stock B standard deviation = Variance = 15.39 = 3.92

Stock A and Stock B have the same expected return of 7.2 but Stock A is less risky than Stock B because
the standard deviation of A is 2.40 and B is 3.92. If an investor holds only stock A or stock B, he will have
more risk when the performance of the company is not good. However, if the investor has 2/3rd of A and
1/3rd of B the return will be as follows:
The range of fluctuations in a portfolio will be calculated in the following manner:
In the following situation:

When Stock ‘A’ in a given investment is taken at 2/3 proportion and ‘B’ is 1/3. The following two
possibilities are there:
Possibility I: Rp = (2/3) × (7) + (1/3) × (13) = 9.0
Possibility II: Rp = (2/3) × (11) + (1/3) × (5) = 9.0
In both of the possibilities the investor gets a higher return than expected, if he holds a portfolio of two
securities rather than an individual security. A two securities portfolio can also reduce portfolio risk. The
portfolio risk can be calculated from the following formula:
σp = X12θ12 − X 22θ22 + 2X1X 2 (rxθ1θ 2 )

θp = standard deviation of the portfolio
X1 = weight of Stock A
X2 = weight of Stock B
rX 1 X 2 = co-efficient of correlation A and B
è1 = standard deviation of times the security A
è2 = standard deviation of times the security B
r 12 = Correlation coefficient of stock A and stock B
Covariance X12
r 12 = σ1σ 2 Correlation coefficient of stock A and stock B.
To calculate portfolio risk assume stock A as X 1 and stock B as X 2 . The covariance is X 12.
1 N
Covariance X 12 = ∑(R1 − R1) (R 2 − R 2 )
N i =1
1
= [(7 − 9) (13 − 9) + (11 − 9) (5 − 9)]
2
1
= [(−8) + (−8) = − 8 ]
2
Covariance X12
Correlation (r) = σ1σ 2
−8
r = 3.85 × 3.92 = – 0.53
The correlation coefficient indicates similarity of difference in the behavior pattern of stocks X 1 and X 2.
When correlation is -0.53 the risk of the portfolio will be the following:
sp = X12θ12 − X 22θ22 + 2X1X 2(rx θ1θ 2 )
= (2 / 3)2 (14.86) − (1 / 3)2 (15.39) + 2 × 2 / 3 × 1 / 3(−0.53 × 3.86 × 3.92)
= 6.60 − 1.71 − 3.56

= 1.15
It shows how much two securities vary together as a proportion of combined individual variations that is
measured through standard deviation 1 and 2. In the above example correlation coefficient is – 0.53. This
shows that negative correlation exists between two securities. Risk can be eliminated with negative correlation.
In the example above the risk is low and it depicts 1.15. But risk will be completely eliminated if negative
correlation exists which is –1 because then the risk will be 0. This means that portfolio risk can be eliminated
further if 0 risk is desired. Thus, by putting some part of the amount in stock which is riskier stock, i.e., ‘B’,
the risk can be reduced rather than if the investor was to purchase only Stock ‘A’. If an investor was to purchase
only Stock ‘A’, his return would be according to his expectation, an average of 7.2% which becomes as low
as 7% in depression periods and rises to 11% in boom periods. The investor will make a return of higher than
7.2% by combining two-thirds of Stock ‘A’ and one-third of Stock ‘B’. Thus, the investor is able to achieve a
return of 9% and bring the risk to the minimum level.
(i) Inter-Active Risk through Covariance: Apart from the measurement of securities through standard
deviation and co-efficient of variation, when two securities are combined the investor should find out the
covariance of each security. Covariance of the securities helps in finding out the inter-active risk. When the
covariance is positive then the rates of return of securities move together either upwards or downwards.
Alternatively, it can also be said that the inter-active risk is positive. Secondly, covariance will be zero on two
investments, if the rates of return are independent. Therefore, when two stocks are inversely related to each
other the covariance will become negative. The following formula is given for calculating covariance:
When probabilities are equal:
1 N
Covariance X 12 = ∑(R1 − R1) (R 2 − R 2 )
N i =1
Cov. xy = covariance between two securities 1 and 2
R 1 = return on security ‘1’
R 2 = return on security ‘2’
R1 = expected return to security ‘1’
R 2 = expected return to security ‘2’

N = number of observations
Example 16.3:
Taking the above example of security A and B:
Range of Expected Return Deviations
Return of portfolio
Stock ‘A’ 7 9 – 2
Stock ‘B’ 13 9 + 4
Stock ‘A’ 11 9 + 2
Stock ‘B’ 5 9 – 4
Covariance = 1/2 [(7 – 9) (13 – 9) + (11 – 9) (5 – 9)] = 1/2 [(– 8) + (– 8)] = – 16/2 = – 8
In this example the investments of stock A and B are taken at the same point of time to determine the
variation of each stock from its expected value and the deviations are multiplied together. If each deviation is
negative, their products will become positive. The covariance will be an average of the positive values and the
total values will be added. Alternatively, it can be said that when values of one variable will be higher and the
value of the other variable will be small then the resulting deviations will also show one positive and other
negative.
(ii) Co-efficient of Correlation: The coefficient of correlation is also designed to measure the relationship
between two securities. It gives an indication of the variable being positively or negatively related to each other.
The coefficient of correlation indicates, as discussed above, the relationship between two securities and
also determines the variation of two securities that helps in finding out the kind of proportion which can be
combined and measured. It is measured by the standard deviation of two securities, namely, x and y. The
coefficient of correlation between two securities are shown when it is + 1.0, it means that there is perfect
positive correlation and if it shows – 1.0, it means that there is perfect negative correlation. If the coefficient
correlation is zero then it means that the return on securities is independent of one another. When the correlation
is zero an investor can expect deduction of risk by diversifying between two assets. When correlation coefficient
is –1 the portfolio risk will be the lowest.
Markowitz has shown the effect of diversification by reading the risk of securities. According to him, the
security with covariance which is either negative or low is the best manner to reduce risk. Markowitz has been
able to show that securities which have less than positive correlation will reduce risk without, in any way,
bringing the return down. According to his research study a low correlation level between securities in the
portfolio will show less risk. According to him, investing in a large number of securities is not the right method
of investment. It is the right kind of security which brings the maximum results.
The following formula has been given by Harry Markowitz for a two security portfolio. The formula
includes the standard deviation.
Example 16.4:
Measure the risk from the following information when coefficient correlations are:
– 1, – 0.5, 0 and 1.
When, θ x = 4
θy = 7
Xx = 0.5
Xy = 0.5
Solution:
σp = Wx2θx2 − Wy2θy2 + 2Wx Yy (rxy θx θy )

θp = standard deviation of the portfolio
WX = weight of stock x
Wy = weight of stock y
r xy = co-efficient of correlation of security x and y
èx = standard deviation of times the security x
èy = standard deviation of times the security y
r xy = correlation coefficient of stock x and stock y.
Covariancexy
σx σ y = Correlation coefficient of stock x and stock y.
(1) When r x = –1
θp = (0.5)2 (4)2 + (0.5)2 (7)2 + (2) (0.5)(0.5) (−1)(4) (7)
θ p = 1.5
(2) When r x = – 0.5
θp = (0.5)2 (4)2 + (0.5)2 (7)2 + (2) (0.5)(0.5) (−0.5)(4) (7)

θ p = 3.04
(3) When r x = 0.0
θp = (0.5)2 (4)2 + (0.5)2 (7)2 + (2) (0.5)(0.5) (0.0)(4) (7)
θ p = 4.03
(4) When r x = + 1.0
θp = (0.5)2 (4)2 + (0.5)2 (7)2 + (2) (0.5)(0.5) (1)(4) (7)

θ p = 5.5
In this example standard deviation is the lowest when correlation is negative –1. The standard deviation
increases when the degree of correlation is positive. When co-efficient of correlation is +1 the advantage of
diversifying becomes nullified. At this point of time, the standard deviation of the portfolio becomes equal to
the weighted sum of standard deviations of each individual security when x = – 1, the risk is the lowest, risk
would be nil if the proportion of investment in security x and y are changed so that standard deviation becomes
0 and x = –1.
To illustrate, the weighted sum of the standard deviations:
θ x θ y = (w x )θ x + (w y )θ y
= 0.5 (4) + 0.5 (7) = 5.5
1. When correlation is less than + 1 risk can be reduced by diversification. At this point, for a given risk
will be reduced below the weighted sum of the standard deviation of each security.
2. When two securities are positively correlated (perfectly +1 positive) its standard deviation will be
identical with the standard deviation of the securities when calculated independently.
3. To find out the ideal combination
X x = θ y / (θ x + θ y )
7
= 4+7
When X i = 0.636 = 0.64

and X j = 0.36
Now when r x = – 1
= (0.64)2 (4)2 + (0.36)2 (7)2 + 2) (0.64) (0.36) (−1) (4) (7)
= 0.4096 (16) + 0.1296(49) + (0.2304) (−28)2
= 12.90 − 12.90 = 0
2. Risk Return in a Third Security

The portfolio effect of two securities is also applied to three securities to find out the effect on the
portfolio. It is done through the method of standard deviation of returns, correlation coefficient and the
proportion in which the security is invested. The following is the formula. It is similar to the two securities,
formulae:
N
Rp = ∑ Wx Wy Wz
i =1
The standard deviation of the portfolio determines the deviation of the returns and the correlation co-
efficient of the proportion of securities that are invested.
N
θ2p = ∑ Wx Wy Wzθx θyθz rxyz
i =1
θ2
q 2 p = Portfolio variance (expected)
P
p = Portfolio standard deviation.
Wx = Proportion of portfolio which is invested in security x
Wy = Proportion of portfolio which is invested in security y
Wz = Proportion of portfolio which is invested in security z
rxyz = Xo-efficient of correlation between x, y and z
x = Standard deviation of security x
y = Standard deviation of security y
z = Standard deviation of security z
Example 16.5:
(a) What is the Expected Return to a Portfolio composed of the following securities?
Security Expected Return % Proportion %
1 10 20
2 15 20
3 20 60
(b) What would be the expected return if the proportion of each security in the portfolio were 25, 25, 50%
respectively?
(a) R = R1 X1 + R2 X2 + R3 X 3
= 10(.20) + 15(.20) + 20(.60)
= 2.00 + 3.00 +12.00 = 17%
(b) R = R1 X1 + R2 X2 + R3 X 3
= 10(.25) + 15(.25) + 20(.50)
= 2.50 + 3.75 + 10.00 = 16.25%
Example 16.6:
Compute the risk on each portfolio from the following information:
Security Expected Return % Proportion % Standard Coefficient of
Deviation Correlation
1 10 20 0.2 1&2 = 0.5
2 15 20 0.3 1&3 = 0.1
3 20 60 0.5 2&3 = – 0.3
R = 17%
Solution:
θ 2 p = w x2 θ x2 + w y2 θ y 2 + w z 2 θ z 2 + 2w xw y 1&2θ x θ y + 2w y w z 1&3θ y θ z + 2w x w z 2&3θ x θ z
θ 2 p = (0.20) 2 (0.20) 2 + (0.20) 2 (0.30) 2 + (0.60) 2 (0.50) 2 + 2(0.20)(0.20)(0.60) (0.20) (0.30)
+ 2 (0.20) (0.60) (0.10) (0.30) (0.50) + 2 (0.20) (0.60) (0.20) (0.50) (-0.30)
= 0.04 × 0.04 + 0.04 × 0.09 + 0.36 × 0.25 + 0.00288 + 0.0036 – 0.0072
= 0.0016 + 0.0036 + 0.09 + 0.00288 + 0.0036 – 0.0072 = 0.1016 – 0072
= 0.0944 = 0.30
16.5 MARKOWITZ THEORY

Markowitz theory is based on the modern portfolio theory under several assumptions. The assumptions
are:
1. Assumptions under Markowitz Theory
(i) The market is efficient and all investors have all the facts in their knowledge about the stock market
and so an investor cannot continuously make superior returns either by predicting past behaviour of
stocks through technical analysis or by fundamental analysis of internal company management or by
finding out the intrinsic value of shares. Thus all investors are in equal category.
(ii) All investors have a common goal before making an investment. This is the avoidance of risk because
they are risk averse.
(iii) All investors would like to earn the maximum rate of return that they can achieve from their investments.
(iv) The investors base their decisions on the expected rate of return of an investment. The expected rate
of return can be found out by finding out the purchase price of a security dividend by the income per
year and by adding annual capital gains. It is also necessary to know the standard deviation of the
rate of return expected by an investor and the rate of return which is being offered on the investment.
The rate of return and standard deviation are important parameters for finding out whether the
investment is worthwhile for a person.
(v) Markowitz brought out the theory that it was a useful insight to find out how the security returns are
correlated to each other. By combining the assets in such a way that they give the lowest risk
maximum returns could be brought out by the investor.
(vi) From the above it is clear that every investor assumes that while making an investment he will
combine his investments in such a way that he gets a maximum return and is surrounded by minimum
risk.
(vii) The investor assumes that greater or larger the return that he achieves on his investments, the higher
the risk factor surrounds him. On the contrary, when risk is low the return can also be expected to
be low.
(viii) The investor can reduce his risk, if he adds investment to his portfolio.
(ix) An investor should be able to get higher return for each level of risk “by determining the efficient set
of securities”.
2. Markowitz Model
Markowitz approach determines for the investor the efficient set of portfolio through three important
variables, i.e., return, standard deviation and co-efficient of correlation. Markowitz model is called the “Full
Covariance Model”. Through this method the investor can, with the use of computer, find out the efficient
set of portfolio by finding out the trade-off between risk and return, between the limits of zero and infinity.
According to this theory, the effects of one security purchase over the effects of the other security purchase are
taken into consideration and then the results are evaluated.
Markowitz model can be explained through three steps:
l Risk return opportunities
l Constructing the efficient set
l Selecting the optimum portfolio
(a) Risk return opportunities: There are many securities in this stock market. These can be combined
in different ways to attain a different level of risk and return through a combination of securities. Figure 16.7
depicts securities such as a, b, c, d, e, f with different levels of risk and return. The investor has to find out
the best portfolio suitable to his own interest of risk and return. Portfolio d is called the maximum return
portfolio but investor preferences have to be considered to see the level of risk and return that an investor can
take.
R1 R2 R3 R4
Fig. 16.7: Markowitz Theory — Efficient Frontier

In Figure 16.7, (i) Shaded area = attainable portfolios.

(ii) Arc of budge a,b,e,d = efficient portfolios or efficient frontier.
(iii) All points on efficient frontier dominate other points to the right of the frontier like portfolio b
dominates portfolio f Portfolio c dominates portfolio e because the return is the same but risk is greater
at f and e for the same return.
(iv) Markowitz shows more than one portfolio on the efficient frontier. Anyone can be selected by the
investor depending on his preference for risk and return.
(v) According to Markowitz there are a large number of portfolios which could be called feasible or
attainable. Out of these portfolios only those were selected which were superior and dominated others
in terms of risk and return characteristics. Through quadratic programming efficient set of portfolio can
be selected. In this sense lies the difference between Markowitz efficient set and feasible or attainable
set.
(vi) The most efficient portfolio will be on the capital market line (CML) the portfolios on the efficient
frontier will be good but the best portfolio will be only on the CML.
(b) Constructing the efficient set: When there are two securities in a portfolio it is depicted in Figure
16.8.
l The example shows inverse relationship between T and Z. Risk is reduced to zero. T has higher return
than Z with equal risk.
l Securities at BOX provide better return than ACX where correlation is 0.
l A and B are positively correlated and one cannot be offset against another to get minimum risk and
maximum return.
In Figure 16.7 According to the graphical representation of the securities which stand on the efficient line
are called the portfolios on the efficient frontier. Markowitz shows the efficient frontier by calculating the risk
and return of all individual assets and by plotting them by means of data on a graph. Only portfolios which
lie on the efficient frontier should be taken by an individual because this will give the effect of diversification
and will help in bringing down the risk on different assets. The efficient frontier will show a bulge towards the
vertical axis.
R
= –1.0 B
E LATION
T CORR CORRELATION = 0
O
X
Z CO C CORRELATION = + 1. 0
RRE
LAT
ION A
= –1.0
O q
RISK
Fig. 16.8: Markowitz Theory – Graphic Example of Two Securities
(c) Selecting the optimum portfolio: There are many efficient portfolios and amongst them the
investor has to select the optimum portfolio based on his own preferences of risk and return. The Markowitz
model presents many portfolios and does not specify one single portfolio as the best because this depends on
the combination of risk and return desired by the investor. The following are the indifferent curves showing
investor preference of risk and return.
Fig. 16.9: Indifferent Curves
Figure 16.9 shows three indifferent curves for the same investor. The investor gets the maximum satisfaction
at C 3 with the risk of 5%. If the investor shifts from point A to B his return increases but along with it the risk
also increases. Further, if the investor moves to X his return will be even higher but his risk will increase more
than before. Although risk and return will change, the satisfaction of the investor will remain the same. This
is called the indifferent curve and it slopes upwards because with return the increase in risk can be noticed.
The investor becomes indifferent to the increase in return by shifting because he also has additional risk to take.
An investor can have many indifference curves and higher curves are better than the lower ones.
Once the investor has the desired indifferent curve he can then determine his optimum portfolio. The
optimum portfolio of an investor is at the tangent point between the efficient frontier and the indifference curve.
The tangent point O in Figure 16.10 is the highest level of satisfaction of an investor. Another investor with
his indifferent curves connected to the efficient frontier will have a different efficient portfolio maximizing his
satisfaction.
16.6 CAPITAL MARKET LINE (CML)

The capital market line shows the combination of risk and return that have the highest return for a level
of risk. It represents only efficient portfolios. Figure 16.11 depicts line I rf to O it is tangent to the efficient
frontier at O. It is a vertical intercept at I rf when there is only risky investment then O will be the most efficient
portfolio of risky investments. If there is a risk free investment then the capital market line will depict a
combination of risk free borrowing or lending and portfolio O will have the highest return for a less amount
of risk. The investor can choose their funds in portfolio O and riskless investments.
The CML states that the expected return on a portfolio is equal to the risk free rate plus a risk premium.
The risk premium is the market risk based on market price. Therefore, the capital market line depicts the
expected return and risk for efficient portfolios measured by standard deviation of a portfolio. The following
equation is used for calculating the capital market line.
σp
R p = I RF + (R M − I RF )
σM
Where, R P = Expected return of a portfolio

I RF = Risk-free rate of interest
R M = Return on the market portfolio
σ p = Standard deviation of the portfolio
σ M = Standard deviation of the market portfolio
The slope of the capital market line is (R M – I RF ) / σ M. The slope is the excess of market return over risk
free return. It is the premium for having a risky portfolio in place of just risk free investments. The slope of
CML depicts risk of the market portfolio in the denominator. Only efficient portfolios consisting of risky and
riskless investment lie on the CML and portfolio O is the optimum combination of risky investments. Portfolio
O is the tangent point. CML is only upward sloping because an investor has to be compensated for the risk
that he takes. The CML depicts the required rate of return at each level of risk.
If an investor does not have any choice of risk free securities, his selection of portfolio will depend on his
indifferent curves on the efficient frontier. Markowitz model presumes that an investor invests in risk free
securities and in the optimal portfolio. The risk free securities are government securities and treasury bills whose
returns are certain and have no risk. If the standard deviation of the returns is calculated, it will be zero. The
portfolio which has a choice of risk free securities can buy from the risk free rate and invest in the optimum
portfolio or lend portion of the total portfolio. It is also called the lending portfolio. Figure 16.11 shows the
risk free rate at I RF and O is the optimum portfolio. If the investor chooses a complete risk free portfolio his
return would be X I RF . In case he decides to invest a part of his funds in the optimum portfolio then his portfolio
will be I RF O. This is a lending portfolio. The investor has the choice of using his own funds and borrowing
funds at the risk free rate to get the maximum return. The lending portfolio is depicted in the figure as the line
from I RF to O and the borrowing portfolio from O to M. In Figure 16.10 curve C 2 will give the maximum
satisfaction to the investor. C 3 is unattainable and C 1 gives satisfaction below C 2.
Fig. 16.10: Determination of Optimal Portfolio
Fig. 16.11: Capital Market line

The investor will thus gain if he takes a portfolio of risk free and risky portfolio on the capital market line
rather than borrowing on the efficient portfolio of JOP. Therefore, whenever risk-free assets are present the
investor should prefer to invest in the capital market line that is the straight-line rather than on the efficient
frontier. The capital market line is thus a linear relationship between the required rate of return for an efficient
portfolio and its standard deviation. Although the possibility of efficient portfolios is there on the efficient
frontier yet the most efficient securities are on the capital market line (CML).
The reason for this is that the correlation coefficient lies between zero and one. Only those assets which
are perfectly positive correlated will generate an efficient frontier which is represented by means of a straight-
line. It is difficult to find negatively correlated assets. Therefore, the efficient frontier will very rarely occur in
a curve over the vertical axis.
All portfolios will not lie on efficient frontier which is represented by a straight-line. Some portfolios will
dominate others. Selected through Markowitz diversification pattern will be planned and scientifically oriented.
This will lie in a manner that they dominate portfolios which are simply diversified.
In Figure 16.11 there is a combination of securities to obtain the best portfolio. Point ‘O’ shows the best
portfolio. The investor’s problem of portfolio is simplified. He has to make a decision with regard to factors of
borrowing and lending only because at the point ‘O’, the investment is the most efficient and he has to make
his decision of having a complete investment programme at this point. Borrowing at the riskless asset by buying
it or lending is a definite decision, which the investor is making. This particular decision brings out a new theory
called the “Separation theorem.” According to this research theory, the efficient set represents the best mix of
stocks and all investors belonging to different categories; whether they are conservative or aggressive, have to
choose the combination of stocks selected from the efficient set to get the maximum benefit.
The following example 16.7 selects the most efficient portfolios.
Example 16.7: The following portfolios are available to an investor:
Portfolio Return Risk
A 16% 4%
B 21% 6%
C 24% 10%
Find out whether these portfolios are efficient or not, given that the risk-free interest rate is 12%. Return
of the market portfolio is 21% and risk of the market portfolio is 9%.
Solution:
As far as portfolio A is concerned, its expected return should be:
σA
(i) R A = I RF + (R M – I RF ) σ
M
4
= 12% + (21% – 12%)
9
= 12% + 4% = 16%
The portfolio has an expected return of 16% and its given return is 16%. So, it is situated on the CML.
σB
(ii) R B = I RF + (R M – I RF ) σ
M
6
= 12% + (21% – 12%)
9
= 12% + 6% = 18%
Portfolio B has an given return of 21% but it’s actual return is 18%. So, it is not an efficient portfolio.
This portfolio is lying above the CML.
(iii) For portfolio C, the expected return is

σC
R C = I RF + (R M – I RF ) σ
M
10
= 12% + (21% – 12%)
9
= 12% + 10% = 22%
The portfolio has return of 22% but it’s given return is 24%. So, it appears to be situated above the CML.
Portfolio A has the same return as the expected return, so this is an efficient portfolio but portfolio B and
C cannot continue to prevail on the stock market. The investor would like to invest in portfolio A which is an
efficient one.
All investors are surrounded with the same risky portfolios and they can achieve the ideal combination
of securities at point ‘O’ by lending and borrowing in a different manner. Since all investors will have the
portfolio of risky assets and will hold the same investments, the equilibrium will be the market portfolio ‘O’,
‘O’, will, therefore, comprise the total portfolio of all risky assets. All the assets on the market value will be
held in proportion of all risky assets. All investors will, therefore, get a chance to choose from a combination
of only two portfolios — (a) the market portfolio, (b) the risk less securities. The straight-line at the tangent
of the efficient frontier is called the capital market line. On this line, all the efficient portfolios would be lined
up. But there are a large number of portfolios, which are not efficient and lie either below or above the capital
market line. The capital market line chooses only the most efficient portfolio and this indicates the market price
of risk.
16.7 LIMITATIONS OF MARKOWITZ MODEL

Markowitz model is useful but difficult to use as it requires a lot of information. The following number of
securities and bits of information are required for calculations:
No. of Securities Bits of Information

10 65
50 1325
100 5750
1000 501500
The Markowitz model is very tedious because when the number of investments increase then the help of
a computer is required because it is an arduous task to find out the securities which lie on the efficient frontier.
To summarize the above discussion, Markowitz model showed the ideal combination of securities through
the efficient frontier. It was also called the Full Covariance Model. The problem faced by the model was that
an observation increased it became cumbersome.
16.8 SHARPE’S SINGLE INDEX MODEL

William Sharpe tried to simplify the Markowitz method of diversification of portfolios. Sharpe’s Index
Model simplified the process of Markowitz model by reducing the data in a substantive manner. He assumed
that the securities not only have individual relationship but they are related to each other through some index
represented by business activity. Sharpe has improved the method of Markowitz and in addition he has also
put in some additional inputs. He made estimates of the expected return and variance of indexes which may
be one or more and are related to economic activity. Sharpe’s index showed that the return of each security
is correlated by some securities markets in the U.S.A. It is generally the Dow Jones Industrial Average or the
Standard and Poor’s 500 stock index. In India it is Dalal Street Index which may be applied. Sharpe’s index
takes into consideration 3N + 2 kinds of information which is different to the Markowitz. Markowitz assumption
of N(N + 3)/2. According to Markowitz, a portfolio of 100 securities would require the following bits of
information: 100 (100+3)/2 = 5150, and Markowitz covariance shows that 100 securities would require (N 2
– N)/2 = (100 2 – 100)/2 = 9900/2 or 4950 covariance.
Sharpe first made a Single Index Model. This was compared to multiple index models for conducting
reliability test in finding out the full variance efficient frontier of Markowitz. Many researchers have taken into
consideration the Sharpe Index Models. They have preferred the stock price index to the economic indexes in
finding out the full covariance frontier of Markowitz for stake of simplicity. The multiple index models are
extremely cumbersome, if they are related to the economic indexes.
The following table shows the difference in calculation between Markowitz covariance model and Sharpe’s
Index Co-efficient as observations increase.
Example 16.8:
Number of Securities Markowitz Covariance Sharpe Index Coefficients
10 45 10
50 1225 50
100 4950 100
1000 499500 1000
2000 19990 2000
According to Sharpe, it is important to simplify the index formulae by taking away from the formula the
covariance of the securities with other securities and instead to give the information of each security and find
its relationship with the market. According to Sharpe’s index, the formula is:
Ri = α + βiI + ei
R i = expected return on security ‘i’.
α= intercept of a straight line or coefficient.
βi = slope of straight line or Beta Coefficient.
I = level of market.
e i = error.
The regression coefficient as explained comprises of the value of alpha through the equation
y = α + β
Alpha (α) is the value of y when X in the equation is 0. Thus in a hypothetical case if the return on the
stock index is 0 (zero) X will be represented by 0 and the expected return would be 9.0% y = 9.0 – 0.05 (0).
The beta coefficient helps in measuring the stocks return with the changes in the market’s returns.
When beta is + 1.0 it means that 1% return on the market index moves with a 1% return on the stock.
A 5% return on the index shows a greater responsiveness to change (i.e., 2.5 times 5%) or 12%. If the value
12 –
25.0
10 – 1
8 – α = 9.0 5
y=9
6 –
.0-0 10
.5x
14
4 –
2 – 15
0 10 20 30 40
θp
Fig. 16.12: Fig. 16.13:
Security Returns with Regression Equation Frontier Showing Connecting Corner Portfolio
of alpha and beta are known, Sharpe’s Index takes into consideration the regression analysis through beta (β)
coefficient and alpha (α) analysis α + β are utilised by the Sharpe’s Index to find out systematic and unsystematic
risk.
The following example gives an analysis of alpha, beta and residual risk of a company. The Sharpe’s
model generated series of “corner portfolios” along the efficient frontier. The corner portfolios can be calculated
either when a security enters or leaves portfolio. The number of stocks increases until it reaches the corner
portfolio. The corner portfolio provides the minimum risk of the lowest return. Figure 16.12 shows the regression
equation and Figure 16.13 depicts frontier connecting the corner portfolio.
Corner portfolio = Stock with highest return and high risk.
The return on stock can be calculated in the following manner:
Example 16.9:
Find return on the stock when:
(a) Expected Index I = 30%
(b) Alpha (α) = 9.00
(c) Beta (β) = 0.05
Expected Return on Security:
R i = 9.00 – 0.05 (30%)
= 9.00 – .015
= 8.985
It is expected that α and β will remain constant. When the Expected Return of the portfolio is to be
calculated the following data will be required:
(a) Alpha (α) of each security.
(b) Beta (β) of each security.
(c) The proportion or weight of each security.
(d) Index (I) estimate.
(e) Weighted average of estimated return of every security.
N
∴ Rp = ∑ X1 (α1 + β1I)
i =1
R p = Expected Return of Portfolio in each stock.

X i = Proportion of Portfolio.
N = Total number of stocks.
The movement of return on a security, whether upward or downward, i.e., higher return or lower return,
is dependent to a great extent on the market index.
(a) The movement of security return shows the correlation with the market index.
(b) The variance depicts, ‘Systematic Risk’.
(c) Residual variance or unexplained variance indicates ‘Unsystematic Risk’.
(d) Unsystematic risk = Total variance of security return — Systematic Risk.
(e) Coefficient of determination (r 2) gives percentage of variance of security return in comparison with
market index.
(f) 3.5% variance on Return of Security is indicated by market index. 96.5% of the variance is not
explained by the index.
∴ (i) Systematic risk = β 2 X Variance of Index.
(ii) Unsystematic risk = e 2
(iii) Total risk = β 2 θI + e 2
2 N  2  N 2 2
(iv) Portfolio variance = θ p =  ∑ X i B i  θ I +  ∑ X i ei 
 i =1   i =1 
θ 2 p = Variance of Portfolio Return.
θ 2 I = Expected variance of Index.
θ i 2 = Variation in security return not caused with the relationship to the market index.
Example 16.10:
Given below are the Return Xerox and the Standard and Poor’s 500 stock Index for a 5-year period.
Year Return on Xerox Return on S & P 500
1 .29 .10
2 .31 .24
3 .10 .11
4 .06 .08
5 .07 .03
Calculate: (a) Beta, (b) Alpha, (c) Residual Variance, (d) Correlation, (e) Total variance for Xerox,
(f) Proportions that are explained and not explained by S & P 500.
How is the regression equation to be explained?
α measures the systematic risk. If beta is higher than 1.00 the stock is said to be riskier than the market.
If beta is less than 1.00 the indication is that stock is less risky in comparison to the market. In the case of
(α alpha) which measures unsystematic risk if it is positive its performance is better than the market. If it is
negative, its performance is not good. In fact the market is better. Epsilon or Error (E) indicates that if it is high,
the unsystematic risk will also be high. The alpha-beta equation is summarized in the following manner:
Variable Relationship to market Interpretation
α (alpha) Positive Stock is better than market
0 Stock performance same as market
Negative Stock performance worse than market
β (Beta) Higher than 1 Very risky (more than market)
0 Same as market
Lower than 1 Less risky
ε (epsilon) Higher than 0 Worse than market
0 Same as market
Lower than 1 Less risky
Calculation of Alpha, Beta and Residual Variance:

X = S&P 500 annual rate of return.
Y = Xerox Co. annual rate of return.
N = Number of observations.
Sharpe has identified the best portfolio or the optimal portfolio through his research study and has called
it the single index model. According to him, the ‘beta ratios’ are most important in a person’s portfolio. The
optimal portfolio is said to relate directly to the beta. It is the excessive return to beta ratio.
Ri − RF
βi
Where, R i = expected return on stocks ‘i’.

R F = return received from risk-less.
βi = rate of return in expected change on stock ‘i’ with 1% change in market return.
According to this method, the optimal portfolio will be selected by finding out the ‘cut-off rate’.
Cut-off Rate
The cut-off rate consists of various subjects which have been constructed. The following subjects help in
finding out the cut-off rate:
(a) Finding out stocks of different return risk ratios.
(b) Ranking securities from higher excess return to â to less return to β.
(c) Selecting to high rank securities above the cut-off rate.
(d) Making a comparison of (R i – R F) β i with ‘C’ and investor in all stocks in which (R i – R F ) β i achieve
the cut-off point ‘C’.
(e) Find cut-off rate ‘C’. A portfolio of ‘i’ stocks C i is calculated by:
(R j − R F )β1
θmΣ j = 1
θ2
(f) After finding out the securities difference included in optimal portfolio calculate the percentage invested
in each security. This is calculated according to the following formula:
Zi
N
Xi = ∑Zj …(1)
i =1
When
βi  R i − R F 
Zi = 2 
'C' … (2)
θ ei  β1 
The first equation gives the rate of each security on adding the total sum should be equal to ‘1’ to ensure
full investment. The second equation gives the relative investment in each security.
The residual variance èei determines the amount to be invested in each security. The desirability or
satisfaction of an investor of any stock will always be the excess return to beta ratio. The following example
shows ranking of an optimum portfolio finding out the cut-off rate and how to arrive finally at the optimal
portfolio.
Example 16.11:
The following illustration will show the optimum portfolio. How it is selected and what proportion of each
security will make it optimum, what is the optimum portfolio in choosing among the following securities and
assuming R F = 5%.
Security Expected return Beta Unsystematic Risk
A 15 1.0 30
B 12 1.5 20
C 11 2.0 40
D 8 0.8 10
E 9 1.0 20
F 14 1.5 10
Solution:
Optimal Portfolio (R F = 5%)
Step 1:
Security Expected Excess i Unsystematic Excess ReturnOver
ReturnR i Return Risk BetaRatio
Ri – R F (R i – R F ) /  i
(1) (2) (3) (4) (5) (6)
A 15 10 1.0 30 10/1.0 = 10
B 12 7 1.5 20 7/1.5 = 4.7
C 11 6 2.0 40 6/2.0 = 3.0
D 8 3 0.8 10 3/0.8 = 3.75
E 9 4 1.0 20 4/1.0 = 4.0
F 14 9 1.5 10 9/1.5 = 6.0
Step 2:
Rank Highest Excess Return to Beta to lowest. This will show the securities in the optimum portfolio. All
securities with higher ranks above the cut-off point will be selected for inclusion in the portfolio. To select the
portfolio, Ri – RF /will be compared with C. All securities whose excess to beta ratios (Ri – RF /i), are above
'C' will be selected in the portfolio.
Optimal Portfolio = R i – R F / i .
Step 3:
Calculate cut-off with 3m = 10
1 2 ( Ri  RF )i  I 1
( Ri  RF ) 1 2
Security   j ei 
ei
 ei
  j C
j1 ei j1 j 1 ei
(1) (2) (3) (4) (5) (6) (7)

A 10.00 3.33/10 3.33/100 3.33/10 3.33/100 2.56
F 6.00 13.5/10 22.5/100 16.83/10 25.83/100 4.69
B 4.70 5.25/10 11.25/100 22.9/10 37.08/100 4.68
E 4.00 2/10 5/100 24.08/10 42.08/100 4.62
D 3.75 24/10 64/100 26.48/10 48.48/100 4.52
C 3.00 3/10 10/100 29.48/10 58.48/100 4.30
Step 4:
R i  R F )i
 2ei
Stocks
(10)1 3.33
1. A 
30 10
(7)1.5 5.25
2. B 
20 10
(6)2 3
3. C 
20 10
(3)0.8 2.4
4. D 
10 10
(4)1.0 2
5. E =
20 10
(9)1.5 13.5
6. F =
10 10
Step 5:
β2I
θ2ei
Stock
1 3.33
1. A =
30 100
(1.5)2 7.5
2. B =
30 100
(2)2 10
3. C =
40 100
(.8)2 6.40
4. D =
10 100
(1)2 10
5. E =
10 100
(1.5)2 22.5
6. F =
10 100
1 (R j − R F )
θ2 m∑
j=1 θej2
C = 1
β12
2
1 + θm ∑ 2
j=1 θej
Step 6:
 3.33 
10  
 10 
1.  3.33  = 0.76
1 + 10  
 10 
 8.58 
10  
 10 
2.  4.58  = 5.88
1 + 10  
 100 
 11.58 
10  
 10 
3.  24.58  = 3.34
1 + 10  
 100 
 13.98 
10  
 10 
4.  30.98  = 3.41
1 + 10  
 100 
 15.98 
10  
 10 
5.  35.98  = 3.47
1 + 10  
 100 
 29.98 
10  
 10 
6.  58.48  = 4.30
1 + 10  
 100 
1 (R j − R F )βi
∑ 2
θei
j=1
Step 7:
1 (R i − R F )β j
2
θm ∑ θei2
j=1
C = 1
β12
2
1 + θm ∑ 2
j =1 θej
 3.33 
10  
 10 
1.  3.33  = 2.50
1 + 10  
 100 
 16.83 
10  
 10 
2.  25.83  = 4.69
1 + 10  
 100 
 22.08 
10  
 10 
3.  37.08  = 4.69
1 + 10  
 100 
 24.08 
10  
 10 
4.  42.08  = 4.62
1 + 10  
 100 
 26.48 
10  
 10 
5.  42.48  = 6.23
1 + 10  
 100 
 29.48 
10  
 10 
6.  58.48  = 4.30
1 + 10  
 100 
Step 8:
Compare Column 2 with Column 7 where the excess return to beta ratio is greater than cut-off rate, the
stocks should be selected for inclusion in optimal portfolio.
Now Stock A, F, B should be selected as Column 2 is greater than Column 7. The stocks in which the
ratio is below cut-off rate should not be selected.
Step 9:
To form the optimum portfolio the following formula should be used.
First find out the percentage which should be invested in each security. The following formula will help
to find it out:
Z1
N
X iθ = ∑ Zi
j=1
βi  R i − R F 
When Z 1 = 2 
− C
θei  βi 
Step 10:
βi
θei2
1 3.33
A. =
30 100
1.5 1.5
B. =
10 100
1.5 7.5
C. =
20 100
Step 11:
R − RF
βi
A 10
F 6
B 4.7
Step 12:
3.33
A = (10 − 4.68) = 0.177
100
15.0
F = (6 − 4.68) = 0.198
100
7.5
B = (4.7 − 4.68) = 0.0015
100
3
∑ Z1 = 0.9325
i =1
Next divide every Z 1 by the total sum of Z 1
0.245
= 57%
0.4325
0.175
= 40%
0.4325
0.0105
= 3%
0.4325
To have an optimal portfolio the investor should invest 57% of Security A, 40% of Security F and 3%
of Z.
Cut-off Rate and New Securities
An investor may either add new securities or remove from his investment some other security. In this case
the cut-off rate will change and this would lead to change in the optimum portfolio. Cut-off rate determines
not only the value of the existing securities but also helps in assessing the new securities with the change in
beta. An example may be given to illustrate this. If cut-off rate was equal to a given amount at the existing
moment, with the change in the securities the return to risk ratio may be more or less other than the previous
cut-off rate. This may or may not enter in the optimum portfolio. To determine whether it enters the portfolio
again the same process or ranking the securities and finding out the excess to beta ratios above the cut-off rate
would have to be chosen to find out the optimum portfolio.
A new security, whenever it is introduced in a portfolio will have its importance. It will have the effect
on either adding to the result of the existing portfolio or making a change from it. The results will show whether
with the addition of the new security the optimum portfolio will also affect the change in those securities which
were quite close to the existing cut-off rate.
16.9 SHARPE'S OPTIMAL PORTFOLIO

The portfolio selected by the introduction of a borrowing and lending line making the efficient frontier a
straight line. Figure 16.13 shows a risk-free security of 6% with a standard deviation of 6.90. The graph
represents a portfolio return and risk and the best portfolio is the corner portfolio of ‘9’. The corner which is
beyond ‘9’ and to its left, i.e., from 10 to 17 can be introduced to a greater efficiency and made efficient by
selecting ‘9’ with an addition of the act of lending. The choice of portfolio which are on the right side of ‘9’,
i.e., from 1 to 8 show borrowing and are in some way dominated by ‘9’. ‘9’ is the stage in which the maximum
benefit can be derived after using the formula (R p – R t/β p).
Sharpe finds the beta relationship to be the most significant in the portfolios; it shows the volatility or
movement of stock. According to him, a portfolio has unsystematic risk as well as systematic risk but although
unsystematic risk can be reduced to zero the systematic portion of the risk is determined by the behaviour of
stocks in the market and can in no way be absolutely reduced or dominated to zero. Sharpe also gives
Fig. 16.14: Efficient Frontier with Borrowing – Lending Line
importance to the presence of both beta coefficient (β) and systematic risk. In the selection of a portfolio both
negative and positive betas should be considered. While assessing a portfolio on beta the negative beta should
be preferred to positive beta. The presence of negative beta in a portfolio is efficient. Also, there is reduced
or eliminated amount of risk when negative betas are present.
SUMMARY
r This chapter discusses the portfolio analysis under traditional methods and modern methods.
r Traditionally portfolio was analyzed by the method of analyzing a single security but modern theory states that
an investor should combine his portfolio to achieve maximum returns.
r Combination of securities can be done either through simple diversification or by diversifying across various
industries but simple diversification is not analytical or scientific.
r Modern portfolio management deals with the selection of an optimal portfolio theory a careful consideration
of risk and return on investments.
r Markowitz model presumes that an investor invests in risk free securities and in the optimal portfolio.
r Markowitz has designed a mathematical formula through the use of variables like return, standard deviation,
co-efficient of variation and correlation to draw relationships between different securities.
r He has established a relationship between two securities, three securities and ‘N’ number of securities.
r Every investor according to Markowitz has his own perception of risk and return and forms his own indifference
curve.
r According to him, all securities lying on efficient frontier should be preferred to the securities which are not
dominated by the efficient frontier.
r Capital market line (CML) will depict combination of risk free borrowing or lending and portfolio and will have
the highest return for less risk.
r CML projects only efficient portfolios.
r Markowitz model is tedious and can be used only through a computer.

Fill in the Blanks:
1. Markowitz Theory is called …………… Model.
2. Negative correlation between two securities helps in …………..
3. Covariance of securities helps in finding out …………
4. Sharpe's Model is known as ………..

5. The corner portfolio provides an analysis of ……….. and ……….
Answers: 1. Full covariance, 2. Reducing risk, 3. Efficient set of portfolios, 4. Index Model, 5. Risk, return
QUESTIONS
1. How does Markowitz Theory help in planning an investor's portfolio?
2. Do you think that the effect of a combination of securities can bring about a balanced portfolio? Discuss.
3. What is Markowitz 'efficient frontier'? Explain with illustrations.
4. Is Sharpe's Model is improvement over Markowitz Portfolio Theory?
5. Discuss the Single Index Model as described by Sharpe to get the optimum portfolio.
6. What statistical techniques would you choose to calculate risk? Why?
ILLUSTRATIONS
Illustration 16.1: Stocks Y and Z display the following parameters:
Stock Y Stock Z
Expected Return 15 20
Expected Variance 9 16
Covariance YZ = +8
What is the correlation of holding some of Y and some of Z? Should the investor combine the stocks?
Solution:
θy = 9 = 3
θz = = 4
r xy = Covariance/θ y θ z
Coefficient of correlation = +8/(3)(4)
= +8/12
= .66
Correlation is positive and very high. There is high degree of risk in combing the two securities. Therefore, Y and
Z should not be combined.
Illustration 16.2: The data is as follows:
Year Stock Return

1 R 10
1 S 12
2 R 16
2 S 18
(a) What is the Expected Return on a portfolio made up of 40% R and 60% S? (b) What is the standard deviation
of each stock? (c) What is the Covariance of R and S?
Solution:
(a) To find out Expected Return:
 10 + 16   12 + 18 
40 / 100 
2  + 60 / 100  2 
  
= (0.4) (13) + (0.6) (15)
= 5.2 + 9
= 14.2
26
(b) R = = 13
2
∑ x2 13 2
= = 9.1
n 2
30
S = = 15
2
15 2 225
= = = 10.6
2 2
(c) Covariance
Return Expected Return Difference Product

Stock R 10 14.2 – 4.2 9.24
Stock Nitin T 12 14.2 – 2.2
Stock R 16 14.2 + 1.8 6.84
Stock D 18 14.2 + 3.8
Covariance = ½ (10 – 14.2) (12 – 14.2) + ½ (16 – 14.2) (18 – 14.2)
= ½ (-4.2) (-2.2) + ½ (1.8) (3.8)
= ½ (9.24) + ½(9.24)
= 4.62 + 4.62
= + 9.24
Illustration 16.3: The risk and return of two projects is given below.
A Z
Expected Return 15% 20%
Risk 5% 7%
An investor plans to invest 70% of his funds in Project A and 30% in Z. the correlation coefficient between the returns
of the projects is +1.0.
Find risk and return of the portfolio A and Z.
Solution:
The expected return of the portfolio A and Z.
Investment Expected Return Proportion Weighted Return

A 15% 0.7 10.5
Z 20% 0.3 6.0
16.5
This risk of the portfolio is
θp = X i2 θi2 + X 2j θ2j + 2X i X j θi θ j rx
= {(5) 2
× (0.70)2  + (0.3)2 × (0.7)2  + 2 × 5 × 7 × 0.7 × 0.3 × 1
   }
= (25 × 0.49) + (0.09 × 0.49) + 14.7
= 12.25 + 0.441 + 14.7
= 26.99
= 5.19
This risk of the portfolio is 5.19and return is 14.7%.
Illustration 16.4: Construct a portfolio of two investments X and Z. Calculate risk and return. Which is the best,
out of the three portfolios? The following information is given of the investments
Coefficient of correlation r = 0.15
X Z
θ of Returns 9% 18%
Calculate when
(i) 50% of funds are in X and 50% in Z
(ii) 75% in X and 25% in Z
(iii) All funds invested in Z.
The expected return of the portfolio is the weighted average of the returns of the securities. The weights are
proportion of the security in the portfolio.
Solution:
Portfolio X Z
Portfolio Return Portfolio Return
1 0.50 0.11 0.50 0.20
2 0.75 0.11 0.25 0.20
3 0 0.11 1.00 0.20
∴ Expected return on portfolio = 0.055 + 0.1 = 0.155

= 0.825 + 0.05 = 0.875
= 0 + 0.2 = 0.2
∴ Expected returns on portfolio (i) is 15.5% (ii) 8.75% and (iii) 20%.
The risk is measured in terms of standard deviation of the portfolio
Portfolio X θ2 Z θ2 r 12 θ p2 θp
1 0.50 0.09 0.50 0.18 0.15 0.0222 0.149 =14.9%
2 0.75 0.09 0.25 0.18 0.15 0.005517 0.074 = 7.4%
3 0 0.09 0.10 0.18 0.15 0.0405 0.20 = 20%
(i) θ 2 = (0.50)2 × (0.09) 2 + (0.50) 2 × (0.18) 2 + 2 (0.50) × (0.50) × (0.9) × (0.18) × (0.15)
= 0.25 × 0.0081 + 0.25 × 0.0324 + 0.01215
= 0.002025 + 0.0081 + 0.01215
= 0.022275
= 0.022275 or 14.9%
(ii) θ 2 = (0.75)2 × (0.09) 2 + (0.25)2 × (0.09) 2 + 2(0.75)(0.25)(0.09) × (0.18)(0.15)
= 0.5625 × 0.0081 + 0.0625 × 0.0081 + 0.000911
= 0.00455625 + 0.00050625 + 0.000911
= 0.0059735 = 0.077 = 7.7%.

(iii) θ2 = (0)2 × (0.09) 2 + (1)2 × (0.18) 2 + 2(0)(0.09)(1) × (0.18)(0.15)
= 0 × 0.0081 + 1 × 0.0324 + 0
= 0.0324 = 0.18 = 18%
The best portfolio is portfolio 3, which has a return of 20% when 100% funds are invested in ‘Z’ portfolio.
θ S tan dard deviation

Coefficient of variation = r = Expected return
(i) = 0.961 → Moderate risk.

(ii) = 0.845 → Least risk.
(iii) = 1 → High risk.
Choose portfolio 1, moderate risk and Moderate return 50% invested in ‘X’ and 50% in ‘Z’.
Illustration 16.5: A person has invested ` 1,00,000.00 in two companies. Company ‘X’ gives a return of 15% and
company ‘Y’ has a return of 12%. He has invested 50% in ‘X’ and 50% in ‘Y’. What is the expected return of this investor?
Solution:
The following way:
Company Weight Return W × R Amount Return

Shares
X 0.50 0.15 0.075 50,000 7,500
Y 0.50 0.12 0.060 50,000 6,000
0.135 13,500
(i) Return in ` 13,500
(ii) Percentage Return = 13.5%
13,500
% Return = = 13.5%
1, 00,000
Illustration 16.6: Ms. Shiela is planning her portfolio. She is taking both high risk and high return as well as plans
to put 70% in high risk as it promises high return and only 30% in low risk government securities. The expected return
on securities is 15% in high risk and only 5% in low risk securities. The standard deviation (risk) of risky investments is
(7%). Find out return of the portfolio.
Solution:
The expected return Rp of the portfolio can be calculated as follows:
Rp = (0.15 × 0.70) + (0.05 × 0.30)
= 0.105 + 0.015
= 0.12
= 12%
Illustration 16.7: The risk and return of two projects is given below. The correlation coefficient is +1.0. Mr. Ran
plans to invest 70% of his funds in project 'A' and 30% in project 'B'. Find out risk and return. Project 'A' has an expected
return 12% and risk of 3% whereas project 'B' has a return of 20% and risk of 7%.
Solution:
Investment Expected Return Proportion Weighted Return
A 12% 0.70 8.4

B 20% 0.30 6.0
14.4
The risk of the portfolio = θp = A12θ12 + B12θ2 + 2A1 A 2 × θA θB r
= (0.03)2 × (0.7)2 + (0.07)2 + 2(0.03 × 0.07 × 0.81 × 0.03 × 1)
= (0.0009 × 0.49) + (0.0049 × 0.09) + 0.0010206
= 0.000441 + 0.000441 + 0.0010206
= .0019026
= 0.043 = 4.3%
Return of the portfolio = 14.4%
and risk = 4.3%
Illustration 16.8: Mr. Narain has invested in the following two shares ‘P’ and ‘T’. The expected return on ‘P’ is
12% and the standard deviation on this return is 7%. Whereas share ‘T’ has a return of 20% and the standard deviation
of this return is 15%. The correlation between ‘P’ and ‘T’ is equal to 0.15.
(i) He wishes to invest either 50% in each fund or
(ii) 25% in ‘P’ and 75% in ‘T’ advise him.
Solution:
Portfolio P T Expected return

Prop. Return Prop. Return on portfolio
1. 0.50 0.12 0.50 0.20 0.06 + 0.10 = 16%
2. 0.25 0.12 0.75 0.20 0.03 + 0.15 = 18%
Expected return on 50% proportion will bring a return of 16% but 25% in ‘P’ and 75% ‘T’ will bring a higher return
of 18%.
(i) Portfolio P Q1 T Q2 r = 0.15
1 0.50 0.07 0.50 0.15 0.15
2 0.25 0.07 0.75 0.15 0.15
Portfolio 1:
= (0.50)2 × (0.07)2 + (0.50)2 × (0.15)2 + 2(0.50 × 0.50 × 0.07 × 0.15 × 0.15)
= 0.25 × .0049 + .25 × .0225 + 0.0007875
= .001225 + .005625 + 0.0007875
= 0.0076375
= .0874
θ p = 0.087 or 8.7%. Risk for 50% in ‘P’ and 50% funds in ‘T’.
(ii) Portfolio 2: 25% in 'P' portfolio and 75% in portfolio ‘T’.
θ p2 = (0.25)2 × (0.07)2 + (0.75)2 × (0.15)2 + 2(0.25 × 0.75 × 0.15 × 0.07 × 0.15)
= 0.00030625 + 0.01265625 + 0.000590625
= 0.013553125
θP = 0.1164 or 11.64%
Illustration 16.9: The following portfolios are available. How should the investor take a decision for making an
investment?
Portfolio Expected Return Risk ( θ )
A 12% 2%
B 16% 5%
C 35% 7%
The risk free interest rate is 6%. Return of the market portfolio is 16% and the risk of the market portfolio is 4%.
Solution:
(i) In order to choose a portfolio the investor has to check the capital market line.
(ii) B portfolio shows that it has the same rate as the return on the market portfolio i.e., 16% and the risk (5%) is
more than the risk of the market portfolio 4% in order to be an efficient portfolio its return must be
θB
R n = I RF + (R M – I RF ) θ
M
5%
= 6% + (16% – 6%)
4%
= 6% + 12.5% = 18.5%
RB = Return on Portfolio B.
I RF = Risk Free Rate of Return.
RM = Return on Market Portfolio
θB = Standard Deviation of Portfolio B.
θM = Standard Deviation of Market Portfolio.
Portfolio B has a return of 16% only so it is not an efficient portfolio. As the portfolio lies below the capital market
line.
(iii) Expected return of Portfolio ‘A’ should be:
θA
R A = I RF + (R M – I RF ) θ
M
= 6% + 5% = 11%.
The given return is 12% so it is above capital market line.
θC
R C = I RF + (R M – I RF ) θ
M
= 6% + 17.5% = 23.5%
Security C is above the capital market line.
Hence, none of the 3 portfolios lie on the efficient frontier but if the investor has the appetite of risk he can chose
portfolio C as it has a return of 35%.
Illustration 16.10: Mr. Roy has a portfolio with an expected return of 20% and standard deviation of 25%. He
purchases another portfolio B which has an expected return of 15% and standard deviation of 18%. The market values
of the two portfolios are in the ratio of 2:3. Find expected return and standard deviation of the correlation coefficient of
0.7.
Solution:
The market values of Mr. Roy are in the ratio of 2:3. The weights of the combined portfolio would be 40% and 60%.
The expected return ‘R’ = W 1r 1 + W 11r 11
= 0.4 × 0.20 + 0.6 × 0.15
= 0.08 + 0.09
= 0.17 or 17%
The standard deviation of the portfolio
θp = W12 q12 + W22 q 22 + 2W1 W2q1q 2r1r2
= (0.4)2 (0.25)2 + (0.6)2 (0.18)2 + 2 × .4 × .6 × .25 × .18 × .7
= (0.16 × 0.0625) + (0.36 × 0.0324) + 0.01512
= 0.01 + 0.011624 + 0.01512
= .036744
= 0.1916 or 19.16%.
Illustration 16.11: Find Risk and Return and correlation between two securities X and Y.
X Y
Standard Deviation 10% 15%
Weight 0.60 0.40
Covariance 100
Solution:
Expected return of the portfolio:
R = W X R X + W YR Y
= 0.60 × 0.15 + 0.40 × 0.20
= 0.09 + 0.08 = 0.17 or 17%.
Standard deviation of the portfolio:
= θp2 = W 12 θ 12 + W22θ 22 + 2 Cov. XZ
= (0.60) 2 × (0.10) 2 + (0.40) 2 × (0.15) 2 + 2 × 100
= (0.36 × 0.01) + (0.16 × 0.0225) + 200
= 0.0036 + 0.0036 + 200
= 200.0072
p = 14.14%
Correlation between the returns:
Co var iance XY
r XY = θX θY
100
= 10 × 15
100
= (+)0.667
150
Problem 16.12:
From the following data calculate the slope of the Capital Market line.
Sunrise (θ) = 15%
Sunset (θ) = 12%
The expected return on the market portfolio =18%
Risk free rate (IRF) = 5%
Standard deviation = 0.25
Solution:
θ
CML = I RF + ( R M – I RF ) P
θM
0.25
Sunrise = 0.05 + (0.18 – 0.05)
0.15
= 0.05 + 0.217 = 0.27 or 27%
0.25
= 0.05 + (0.18 – 0.05)
0.12
= 0.05 + 0.270 = 0.32 or 32%
Illustration 16.13:
(a) Calculate risk from the coefficient of correlation given below with proportion of 0.50 and 0.50 for XY.
(b) What would be the least risky combination, if the correlation of the returns of the two securities is (i) 0, (ii) 0.8,
(iii) 1, and (iv) –1
Solution:
Security No. Expected Return Standard Deviation
1 5 2
2 15 8
Return = (.50) 5 + (.50) 15 = 10.00
When r = 0
θp = (0.05)2 (2)2 + (0.5)2 (8) + (2) (0.5) (0.5) (0) (2) (8)
= (25) (4) + (.25) (64)
= 1.0 + 16.0 + 0 = 17 =
θp = 4.123
When r = 0.8
θp = (0.5)2 (2)2 + (0.5)2 (8)2 + (2) (0.5) (.8) (2) (8)
= (0.25) 4) + (0.25) (64) + (0.8) 16
= 1 + 16 + 12.8 − 21.4 = 4.62

When r = 1
θp = (0.5)2 (2)2 + (0.5)2 (8)2 + (2) (0.5) (0.5) (1) (2) (8)
= (0.25) (4) + (0.25) (64) + 16
= 1 + 16 + 16 = 33 = 5.76
When r = –1
θp = (0.5)2 (2)2 + (0.5)2 (8)2 + (2) (0.5) (0.5) (−1) (2) (8)
= (0.25) (4) + (0.25) (64) − 8
= 17 − 8 = 3
The least risky portfolio combination is when correlation is –1
(b) 80% X
20% Y
θp = (0.8)2 (2)2 + (.2)2 (8)2 + 2 (8) (.2) (−1) (2) (8)
= (0.64) (4) + (0.04) (64) − 5.12
= 2.56 + 2.56 − 5.12

θp = 0
The least risky combination is when standard deviation is 0.
To find out proportion:
θx 8
(a) Weight of X x = θ + θ − 8 + 2 = 80%
x y
θy 2
Weight of Y x = θ + θ − 2 + 8 = 20%
y x

1. The expected rates of return and probability of occurrence has been given in the following information of two
companies. If Mr. Neeraj decides to invest 50% in 'A' company and 50% in 'B' company. What would be the return
on his portfolio?
Probability Stock A Stock B
0.05 3 2
0.20 + 6.0 +9.0
0.50 +11.0 +12.0

0.30 +14.0 +15.0
0.06 +19.0 +26.0
Answer: Expected return of A =11.89%, B =13.76%, Rp = 12.825%.
2. A security has a standard deviation of the share Z is 2.6%. The return from risk free government securities is 10%
and market portfolio is 18%. what is the required return on the portfolio.
Answer: β = 0.904 required return on portfolio is 17.23%
3. A market portfolio was a risk of 12% and return of 19%. The risk free interest rate is 10%
Portfolio Expected Return Risk ( θ )
A 25 32%
B 22 16%
C 16 10%
Answer: Portfolio B is an efficient portfolio. Its expected return is 22%. A and C are not efficient. Their returns are 34%
and 17.5%. They do not lie on the Capital market Line.
4. Stocks A and B yield the following returns in the last two years.
Year Return in (%)
A B
1 10 14
2 20 12
(i) What is the expected return on portfolio with 60% A and 40% B stocks?
(ii) Find out standard deviation of each stock
(iii) Calculate co-variance and coefficient of correlation between stocks A and B.
(iv) Indicate the portfolio risk.
Answer: (i) 14.2
(ii) σ A = 4.123 and σ B = 1
(iii) Co-variance between stocks = 0.05
(iv) Portfolio risk = 2.78
SUGGESTED READINGS
l Amling, Investments — An Introduction to Analysis and Management.
l Dyckman, Downes and Magee, Efficient Capital Markets and Accounting (A Critical Analysis), Prentice Hall,
New Jersey, 1975.
l Markowitz, Portfolio Selection, Yale University Press, Yale, 1959.
l William F. Sharpe, Portfolio Theory and Capital Markets, McGraw-Hill, U.S.A., 1970.
nnnnnnnnnn
Chapter
17
PORTFOLIO SELECTION AND

INTERNATIONAL DIVERSIFICATION
Chapter Plan
17.1 Introduction
17.2 Importance of Beta
17.3 Capital Market Theory —Capital Asset Pricing Model
17.4 Security Market Line
17.5 Limitations of CAPM Model
17.6 Distinction between Capital Market Line and Security Market Line
17.7 Validity of CAPM Model
17.8 Arbitrage Pricing Theory
17.1 INTRODUCTION
This chapter helps an investor to assess different portfolios and select from among the alternatives, those
investments which fulfill his requirements. It also gives the construction of an optimal portfolio by establishing
a cut-off rate. Capital market theory is aligned with Markowitz behaviour pattern as an investor. In other words,
if the investors behaved in a particular manner the theory would show how the assets could be priced. The
Capital Asset Pricing Model (CAPM) takes into consideration the results which have been drawn by Markowitz
and uses them to find out a relationship between systematic risk and expected returns of both portfolios and
individual securities.
The last chapter discussed the different alternatives of portfolio analysis. It gave the efficient frontier as
brought out by Markowitz and by Sharpe. This chapter helps to assess the best option of a portfolio through
the Capital Asset Pricing Model. It also makes a distinction between the Capital Market Line and the Security
Market Line.
380
PORTFOLIO SELECTION AND INTERNATIONAL DIVERSIFICATION 381
17.2 IMPORTANCE OF BETA

Portfolio betas are used to measure risk in a portfolio but with proper diversification and elimination of
unsystematic risk, portfolio can become efficient. Betas on a portfolio are, therefore, the weighted average of
the betas of each of the securities on the portfolio. Beta can be used to move systematic risk above or below
and since beta is measured by the market movements, therefore, betas move either above or below the
movement in the market. If there is a presence of a high beta then the investor can be expected to be aggressive
as this indicates an aggressive portfolio.
1. Beta and its Significance in the Portfolio
We have just seen that beta is a measure which has been used for reducing risk or determining the risk
and return for stocks and portfolios. A number of research studies have been made to give indications of beta
coefficient for selection of stock. When beta is used significantly for stock selection, it is to be compared with
the market. The investor can construct his portfolio by drawing the relationship of beta coefficient with the
prices prevailing in the market. When there is buoyancy in the market then beta coefficient which are large can
be selected. These betas would also carry with them a high risk but during the boom period high risk is
expected to give a maximum return. If the market is bear market and the prices are falling then it is possible
to sell “short” stocks which have high positive beta coefficient and the stocks which have a negative beta.
When the beta is +1.0 the volatility, which is relative to the market, would indicate an average stock.
When the beta changes to +2.0 it is excluding the value which is provided by alpha, the stock would be
estimated to show a return of 20% when the market return is forecasted at 10%. This is in the case of a rising
market. When the prices show a decline and the future is expected to provide a decline of 10% then a beta
which shows +2.0 would show that it is providing a negative return of 20% if the stock is held by the investor
for very long. If the investor sells ‘short’ stock then he can plan to gain 20%. If the beta is negative 1.0 then
there would be a gain of a positive 10%.
Although betas help in selecting stock, care should be taken to select the stock with the beta approach
because selection of portfolio with beta is followed only when the following assumptions are considered:
(a) The market movement in positive and negative directions have to be carefully analyzed;
(b) The past historical consideration of beta must be analyzed for future prediction of beta.
If portfolio selection is not made by an accurate reading of the movement of markets then the portfolio
selection will be incorrect and will not determine the preferences of the investor. The market movements explain
between 15% and 65% of the movement of the individual securities. The variability of returns is explained
further between 75% and 95% in the measurement of betas. The technique of beta, therefore, although it is
useful, has to be conducted with precision.
2. Beta and Research Findings
Beta has been found useful by Smith Barney’s research work and by a study conducted by Barr Rosenberg
and also another study by Levy. All the three research studies have shown that beta can be used for prediction
but it has to be analyzed very carefully. Levy’s research study followed that beta was not good when securities
were to be selected individually. They were partially useful in the selection of small portfolios but portfolio
selection through beta was very useful in the case of large portfolios which were kept by the investor for a
greater length of time.
Smith Barney found that beta gives an indication for selection of stock but it must be predicted with care.
They made a study of fifty-six stocks and found out the difference of movement of stocks during two-time
periods. This proved that when portfolios of long-time and stable securities were analyzed then beta was found
useful. Betas have also been found to change and that change is related to certain factors. One of the most
important factors which have been found to change or move betas are the economic factors in a country. The
information has been found to be one of the factors which have caused changes in the beta. To find a result
by predicting beta is found to be useful when beta is quantified and the changes of the return of individual
securities and the market have been related to expected rate of inflation. It can be safely said that the
relationship between market and security returns are an indicator for finding out the beta changes because
return, as already studied, is related to risk and both these factors are linked with the market behaviour of
stock. The relationship between the returns of the security and changes in the economic activity of the country
are related by finding out “fundamental betas”.
The fundamental betas were found out by Barr Rosenberg’s research study. According to him, the fundamental
betas could be predicted by finding out “relative response coefficient”. The relative response coefficient quantify
between market return and security return. They give —
(a) The sensitivity of the security to inflation;
(b) Economic events as Market Index causes systematic change;
(c) Risk and return with portfolio.
The relative response coefficient depends on the events that are happening in the economy and a reaction
in favour of inflation shows high relative response coefficient. Also, betas in order to be useful have to be
predictive and cannot be upward looking. A well diversified portfolio is linked with securities and with the
market movement. But the market movement can be considered only when a survey of fundamental factors is
taken into consideration. The fundamental factors are the following:
(a) The earnings of a firm;
(b) The movement of the market;
(c) Continuous valuation of stock;
(d) Survey of stock, whether it represents large or small firms, old/established and new firms;
(e) Growth of firms historically and
(f) The capital structure of the firm.
These factors are to be projected with the movements of the stock by assigning probabilities for the
occurrence of the particular factors. These fundamental factors would also represent the changes in the returns
of securities over the years, the variability in their structure of earnings and the kind of success that is made
by each stock when the stock is valued, a firm which has continuous high market valuation will be considered
as a good stock. The small firm’s analysis as opposed to analysis of an established firm will show whether the
stock in that firm is risky or safe and the financial structure will be a means of finding out the kind of operations
of a firm relating to its liquidity position and the coverage of fixed charges. Rosenberg found that these
fundamental factors help in making an optimum portfolio. According to him, risk is not only systematic and
unsystematic but the unsystematic risk can be also sub-divided as “specific risk and extra market covariance”.
Specific risk which is a unique risk is independent to a particular firm. It comprises the risk and uncertainty
of only one particular firm in isolation. The extra market covariance is independent of the market and it shows
a tendency of the stock to move together. The extra market covariance shows the covariance of a homogenous
group of finance group. It is in-between the systematic and specific risk. The specific risk covers about 50% of
the total risk and the covariance and systematic risk together comprise the other half of 50%. While systematic
risk covers all the firms, the extra market covariance is in-between and covers one group classification of
industries. A portfolio which is properly selected and is well diversified usually consists of 80% - 90% of the
systematic risk out of the total risk involved in those securities.
Example 17.1: A security has a standard deviation of 4%. The correlation coefficient of the security with
the market is 0.8 and market standard deviation is 3.5%. The return on risk free securities is 12% and from
the market portfolio is 16%. What is the required rate of return of the portfolio?
Solution:
According to CAPM Model
r×θ
b = θm
.8 × .04 .032
= = = 0.0091
3.5 3.5
β
R p = I rf + (R m – I rf )β
= 0.12 + (0.16 – 0.12) 0.0091

= 0.12 + 0.000364
= 0.1203
= 12.03%.
Example 17.2: If risk free rate is 6% and market risk premium is 12% and b of the security is 1.5. What
is the expected return of the security under CAPM? What would be the expected return if b was 2.
Solution:
(i) Risk premium = Beta × Risk premium
= 1.5 × 12 = 18.0
(ii) Expected return on Security = 18.0 + 6 = 24%
R = I rf + (R m – I rf )β
= 6% + (12% – 6%) 1.5
= 6% + (6%) 1.5
= 9% + 6%
= 15%
When Beta is 2;
Return = Risk × Beta
= 12 × 2.0 = 24.0%.
Expected return on security
24% + 6% = 30%.
∴ Return = I rf + (R m – I rf )β
= 6% + (12 – 6) × 2
= 6% + (6) × 2
= 6% + 12%
= 18%
3. Traditional Portfolio Building
Portfolio building models have traditionally been modelled for an average investor who has a particular
risk aversion with the hope of achieving maximum returns. The objective of each investor is to have two
different kinds of stocks on his portfolio so that the combination would eliminate the risk and would give him
the kind of return that he would require. The determinants of an investment policy are basically within the risk
and return consideration but each investor has different objectives and he has to reconcile himself by building
a portfolio of total securities in a manner to achieve minimum risk and maximum return. The traditional
investors were concerned with the achievement of the highest income, some growth in capital and the preservation
of the principal. It is rather difficult to achieve all these goals for an investor together. Many variables have to
be considered like the life cycle approach, other constraints which have to be considered are the nature of
investments themselves. Then there are considerations of time, liquidity of stock, the tax environment and risk
around a person.
4. Life Cycle Approach
All investors have to plan achieving of an optimum portfolio by taking into consideration the age factor
and familiar considerations. An individual at the age of 25 can take a large amount of risk and can plan to
achieve high returns through risk but an individual between the ages of 40 to 50 must find an investment
programme which will give him pension benefits also because his working life span is reduced. At the time of
retirement the investor has to consider the stability of his return and also some regular income. Such an
investor would prefer low risk and low return but stable income.
The investor while considering his investment proposals at different age groups is likely to be surrounded
by certain important considerations:
l Liquidity: All investors have different objectives. A person who is young in age does not require high
liquidity and can save at a great speed then keep a low rate of liquidity with him. A middle aged
investor may consider both liquidity as well as saving for long-term. He would, therefore, consider
short-term maturity securities as well as long-term aspect. An investor who is surrounded by responsibility
and his working span is not long should consider the liquidity prospect of the asset. Purchase of
security though brings him high return does not bring ready liquidity but stocks in the Unit Trust and
in other shares and securities will bring liquidity. These things should be carefully estimated.
l Tax Environment: Those investors which have a high income should take into consideration those
securities which will fetch them deductions from their total income under Section 80C to Section
80VV. Other investment may be evaluated with alternatives of tax. An investor with a lower income
may consider those securities which will fetch him high return and he will still be able to achieve some
benefit in tax.
l Risk Properties: All investors have their own utility margins of risk. There are three categories of
investors — risk lovers, risk averse and risk neutral. Their requirement should be taken into consideration
before constructing a portfolio. An aggressive businessman will be able to take a high risk but a retired
person of the same category will not be able to take the same risk. Personal choice and selection to
arrive at an optimal portfolio is to be considered only under the objective of planned portfolio and
the risk consideration that can be attached by an investor.
Diversification, it may be summed up, is useful for minimizing risk. The usefulness of diversification can
be measured internationally also.
The international diversification of an investor, through assets to bring about low covariance, is discussed
first by taking into consideration the “capital market theory” and the “asset pricing model”.
17.3 CAPITAL MARKET THEORY — CAPITAL ASSET PRICING MODEL

The capital market theory has been propounded by Sharpe and is sometimes considered to be an extension
of the portfolio theory. It indicates the behaviour pattern of investors and pricing of assets on the capital
market. This theory was also developed by John Lintner and Ian Mossin. It has been observed that an investor
takes a combination of securities consisting of risk free and risky assets. The CAPM theory can help the investor
in finding out if the securities are underpriced or overpriced to form a portfolio.
CAPM model is considered to be based on the portfolio theory of Markowitz. In CAPM theory the effect
of the security on portfolio risk is only through systematic risk. Through CAPM the investors can measure the
risk of each security with his portfolio. Each security has a different level of systematic risk that affects it and
varies from one security to another based on the sensitivity of the particular security to market fluctuations.
Therefore, CAPM is calculated through the following equation.
1. CAPM Model
β
R S = I RF + (R M – I RF)β
Where, R S = The expected return from a security/asset

I RF = The risk-free interest rate
R M = Expected return of market portfolio
β = Measure of systematic risk of security
l Risk-free rate: I RF is the risk-free rate of return that an investor gets out of money invested by him.
l Systematic risk: This is measured by Beta and it shows the risk of a specific security relative to other
securities.
l Risk premium: This is the premium for investing in securities which have a systematic risk. This is
represented by (R M – I RF)β.
Systematic risk measures the price sensitivity of a security to the market movement. It measures volatility
of the systematic risk. This means that risk increases with an increase in the difference between (R M – I RF) and
for the risk that the investor takes, he gets a higher return on his security. Therefore if Beta is 3 and market
index rises by 10% then the price of a security will rise by 30%. If the market falls by 10% then the security
price falls by 30%. However, if Beta is 1the rise and fall in price will be the same as the index.
The CAPM Model has been explained as it provides a mechanism for the investor to assess portfolio risk
and return. It explains the theory graphically through security market line (SML) which provides a benchmark
for evaluating the investments. While Markowitz theory is based on total risk the CAPM is based on Beta or
systematic risk.
2. Assumptions of CAPM
Capital market theory brings out its result by making the following assumptions:
(a) Decision of the investors depends on their judgement of risk and return of securities and these are
measured by standard deviations.
(b) All investments are infinitely divisible units and can be freely purchased and sold in the market.
Therefore, an investor has a choice of shifting into any security that is desired.
(c) Shares can be sold short at any time in the stock market and without any limit.
(d) Individual investors do not affect the price of security. All investors operate under perfect competition.
(e) There are no transaction costs.
(f) The investor makes an investigation of securities without taking into consideration the amount of tax
to be paid.
(g) At any time there is a riskless rate at which the investor can buy or lend any quantity of funds.
To analyze the CAPM, let us review the understanding of systematic and unsystematic risk explained in
chapter 5.
(i) Systematic Risk: This is the part of total risk comprising of systematic and unsystematic risk.
Systematic risk cannot be eliminated. It is part of market risk, government policies, economic situations
like inflation or recession and other policies of tax and credit. Since this risk cannot be eliminated
securities may be diversified to minimize it. Systematic risk is also called market risk and it is measured
by Beta. According to William Sharpe the Beta coefficient is the relative measure of sensitivity of an
asset change, to the change in the return of the market portfolio. Beta is calculated as the securities
covariance with the market portfolio divided by the variance of the market portfolio. When Beta factor
increases the expected return also increases.
COV (S, M) σS σM rSM σS

β = = = × rSM
σ2M 2
σM σM
Where, COV (S,M) = Covariance between the return of security S, and the return on the
market Portfolio, M
= Standard deviation of the security, S
σ M = Standard deviation of the market portfolio, M
σ M2 = Variance of the return of market portfolio, M
rSM = Correlation between the return of the security and the market portfolio.
(ii) Unsystematic Risk: This risk can be eliminated by diversification. It is based on individual risk
specific to a particular company or industry. Some examples are labour strike, change in consumer
preferences and company policies in financial or marketing matters. This risk can be diversified and
eliminated unlike the systematic risk.
(iii) CAPM and Risk: A portfolio which does not have any unsystematic risk will be called an efficient
portfolio. Therefore, in a portfolio constructed through CAPM only systematic risk is relevant. Total risk
can be measured by standard deviation but Beta measures systematic risk. In CAPM Beta risk or
systematic risk is considered for pricing of securities.
(iv) Market Portfolio: The portfolio comprising of different securities in the market is called the market
portfolio. The return of the market portfolio is the difference between the expected market return and
risk-free interest multiplied by Beta factor.
17.4 SECURITY MARKET LINE

The security market line gives an explanation about the relationship between the required rate of return
on a security/portfolio and its Beta factor. It is the graphical version of the CAPM. In Figure 17.1 the required
rate of return is depicted as R 1 , R 2 and R 3 with the respective Beta factors b 1, b 2 and b 3. When the Beta factor
is zero it is represented by the intercept OR or the risk-free rate of return. When Beta factor increases the
premium on return also increases. Therefore, low Beta provides low risk and also low return. The risk and
return of securities is determined by beta. All portfolios lie along a straight-line on which the beta is measured.
The point which is a riskless asset of beta O is the first point. Beta 1 is the second point on the market line
of the portfolio. This draws out the return which an investor expects on his assets on this portfolio whether they
are efficient portfolio or inefficient portfolio. The security market line as shown Figure 17.2, shows that the
security market line depends on the risk-free rate of return and the change in the required rate of return due
to changes in the Beta factor. Therefore, the security market line depends on the required rate of return and
the change in Beta factor. Figure 17.1 depicts that upto β1 the securities are called defensive securities and
beyond β1 they are called aggressive securities. The point where β = 1 has an expected market return. The
securities that have β < 1 do not have risk and because of this they are defensive. β > 1 show that the
securities are riskier than the market. That is why they are called aggressive securities. Thus, SML is associated
with positive slope which shows that the expected return increases with Beta.
Rate of
Return R3
(%)
R2
R1
Risk-free
Rate, IRF
Fig. 17.1: Security Market Line

SML2
Required SML1
Rate of
Return
IRF
IRF
Beta Factor
O
Fig. 17.2(A): Location and Slope of Security Market Line
SML2
Required SML1
Rate of
Return
IRF
Beta Factor
O
Fig. 17.2(B): Location and Slope of Security Market Line
Figure 17.2 (A) shows that if there is a change in any one variable the security market line (SML) will
change it shape and there will be a new level or shape. If the risk-free rate changes from I RF1 to I RF2 the security
market line will also change its position and shift to a new level that is SML 1 to SML 2. Figure 17.2 (B) depicts
the change in the slope of the SML due to changes from I RF1 to I RF2. The SML has plotted its return on the
part of the risk that cannot be diversified.
This difference is related and measured by the difference in beta. As stated earlier, the expected return
will be higher when Beta is high in any security because the relationship which is drawn between the expected
return and beta is linear. Beta estimates the systematic proportion of the risk. Systematic risk is perhaps more
important than the unsystematic risk because it affects that part of the return which may not be eliminated even
by diversification.
Beta has been given a lot of importance in portfolio analysis. It is a measure which has been used for
determining risk and return for stock and portfolios. Beta gives an indication for selection of stock. In the CAPM
Model Beta may be calculated in the following ways. After Beta is calculated the required return on the
portfolio can be found out. Examples 17.3 and 17.4 are given below.
Example 17.3: A security has a standard deviation of 5%. The correlation coefficient of the security with
the market is 0.10 and market standard deviation is 4.0%. The return on risk-free securities is 15% and from
the market portfolio is 50%. What is the required rate of return of the portfolio?
Solution: According to CAPM Model

r×θ
β = θm
0.10 × 0.05 0.002

= = = 0.0014
4.0 3.5
Rp = I RF + (R M – I RF) β
= 0.15 + (0.20 – 0.15) 0.0125
= 0.15 + 0.000625 = 0.150625
= 15.06%.
17.5 LIMITATIONS OF CAPM MODEL

The CAPM theory provides and understanding of measuring the return of a security depending on its
systematic risk. It has certain limitations:
1. The assumption in the CAPM approach that investors have no transaction cost in purchase and sale
of securities is not realistic.
2. It measures only market risk and gives importance to Beta or systematic risk and examines the
historical returns to the market portfolio. Therefore Beta is difficult to measure for future returns until
it is updated. This is problematic to calculate. Many calculations are involved and training is required
for measurement.
3. The CAPM theory assumes that the investor can borrow or lend at the risk-free rate at any time and
for any amount, this is not realistic.
4. The CAPM assumes that every investor has equal information and is available to all the investors. This
is possible when the market is in the strong form of efficiency. Therefore information is uneven and
cannot exist at the same level for every investor.
17.6 DISTINCTION BETWEEN CAPITAL MARKET LINE AND SECURITY MARKET LINE
The distinction between Capital Market Line and Security Market Line can be explained graphically
through the following figures. In the last chapter the CML was described through the efficient frontier. Briefly
following from that explanation the CML is explained through the efficient frontier.
1. Capital Market Line
Figure 17.3 shows the efficient frontier of A, B, C, D. If the lender can invest at a particular rate given
at I RF , this point is representation of the risk-free investment. The investor although surrounded by different
kinds of investments could place all his investments in a risk-less security or divide his investment in such a
way that he places some part of his funds in a risk-less assets. If 50% of the funds were in risk-less assets and
the other 50% in risky assets the combination would give the result as shown in Figures 17.3 to 17.6.
It is further illustrated in the following example where:
R p = XR m + (1 – X)R f
R p = expected return of portfolio.
X = percentage of funds in risky portfolio.
1 – X = percentage of funds in risk-less assets.
R m = expected return of risky portfolio.
I RF = expected return of risk-less assets.
θ p = Xθ m
φ p = expected standard deviation of the portfolio.
Rp
C
D
B
IRF
A
θp
Fig. 17.3: Lending Factor and Efficient Frontier
X = percentage of funds in risky portfolio.

θ m = expected standard deviation of risky portfolio.
When the borrowing and lending factors are taken into consideration, then the shape of the efficient
frontier as shown in Figure 17.5, goes down to point ‘A’
The following three cases may be considered by an investor:
(A) when X is = 1;
(B) when X is less than 1;
(C) when X is greater than 1.
If X is the percentage of amount which is invested then in (A) the investor has put his amount in a manner
as to have the highest risk. In (B) the investor put some amount in a risky share portfolio and some amount
he has been able to give on loan at the lending rate I RF . When X is greater than that, the theory states that
the investor is borrowing funds.
Rp
R
e Borrowing
t
u
r M
n
Lending
IRF
Risk θp
Fig. 17.4: Efficient Frontier with Borrowing and Lending
Figure 17.4 shows that the efficient frontier is new. There is a new combination of securities to combine
into the best portfolio. Point ‘M’ shows the best portfolio. In this Figure the investor’s problem of portfolio is
simplified. He has to make a decision with regard to factors of borrowing and lending only because at that point
‘M’ the investment is the most efficient and he has to make his decision of having a complete investment
programme at this point. Lending at the risk-less asset by buying it or borrowing is a definite decision which
the investor is making.
This particular decision brings out a new theory called the “Separation theorem”. According to this
research theory, the efficient set represents the best mix of stocks and all investors belonging to different
categories; whether they are conservative or aggressive, have to choose the same combination of stocks selected
from the efficient set. The only method to distinguish the investors is by putting in the technique of lending
resources or borrowing them for achieving the category of risk that they belong to.
This is shown in Figure 17.4. All investors are surrounded with the same risky portfolios and they can
achieve the ideal combination of securities at point ‘M’ by lending and borrowing in a different manner. Since
all investors will have the portfolio of risky assets and will hold the same investments the equilibrium will be
the market portfolio ‘M’, ‘M’, will, therefore, comprise the total portfolio of all risky assets. All the assets on
the market value will be held in proportion of all risky assets. All investors will, therefore, get a chance to
choose from a combination of only two portfolios — (a) the market portfolio, (b) the risk-less securities. The
straight line at the tangent of the efficient frontier is called the CML. On this line all the efficient portfolios
would be lined up. But there are a large number of portfolios which are not efficient and lie either below or
above the CML. The Capital Market Line chooses only the most efficient portfolio and this indicates the market
price of risk through the following equation:
IRM − IRf
θm
R e = IRF +
θm
The equation gives the return on efficient portfolios. The returns on individual securities and on non-
efficient portfolios are studied below:
Figure 17.5 shows the efficient frontier, the investor can invest either in point A and B or in point B and
C. According to this figure the preference of the investor would be to invest in securities between B and C. The
reason for this is that A and C have the same level of risk. However, point C provides a higher return than
A. Therefore C should be preferred over A.
Rp
A
σp
O
Fig. 17.5: Efficient Frontier
Rp
S
Rp
CML
IRF
θp
Fig. 17.6: The Capital Market Line
The investor should combine the risky and risk-less securities and prepare his portfolio. In Figure 17.6 the
straight line showing I RF S / is called the Capital Market Line. I RF S shows risk-free assets and the line from S
to S / consists of borrowing portfolio and risky investments. Thus, the Capital Market Line depicts a linear
relationship between the required rates of return for efficient portfolios and their standard deviations.
Therefore the portfolios which are presented on the Capital Market Line show the price of the risk through the
slope of the line and the expected rate of return which is in excess of the risk free rate will be in proportion
to the standard deviation of the portfolio in terms of the market called market portfolio.
σp
R p = IRF +(R M − IRF )
σM
Where, R P = Expected return of a portfolio
I RF = Risk-free rate of interest
RM = Return on the market portfolio
σp = Standard deviation of the portfolio
σM = Standard deviation of the market portfolio
COVim
IR i = IRF = 2 [R m − IRF ]
σm
E(Ri ) = I RF + β iE (R m) – I RF
2. Security Market Line
The risk and return of securities is determined by beta. All portfolios lie along a straight line on which
the beta is measured. The point which is a risk-less asset of beta O is the first point. Beta 1 is the second point
on the market line of the portfolio. When these results are combined it becomes the Security Market Line
(SML). This draws out the return which an investor expects on his assets on their portfolio whether they are
efficient portfolio or inefficient portfolio. The Security Market Line (SML) is shown in Figure 17.7. The expected
return is different on any two different assets (Figure 17.8).
This difference is related and measured by the difference in beta. As stated earlier the expected return will
be higher when beta is high in any security because the relationship which is drawn between the expected
return and beta is linear. Beta estimates the systematic proportion of the risk. Systematic risk is perhaps more
important than the unsystematic risk because it affects that part of the return which may not be eliminated even
by diversification.
EXPECTED RETURN
Fig. 17.7: Security Market Line
The Security Market Line in addition to the efficient portfolios measured by the Capital Market Line shows
the risk and return trade-off for portfolios which are efficient and those that are inefficient. It also analyses
individual securities. Since the inefficient portfolios are not depicted on the Capital Market Line (CML), their
risk and return relationship is not analyzed by the CML.
The major contribution of the Security Market Line (SML) is that it measures individual securities whether
efficient or inefficient. The Security Market Line determines the expected returns for or given security beta and
the systematic risk can be measured by beta. The unsystematic risk can be diversified as it is not market related
but beta risk cannot be diversified and therefore it requires analysis.
The SML determines the security that is overpriced and the security which is under-priced. The under-
priced securities should be purchased by the investors. Figure 17.8 shows that those securities which are above
the SML are under-priced. Thus securities XYZ are under-priced as they are above the SML and UVW below
the Security Market Line are over priced. The reason for this is that XYZ have the same risk as UVW but they
offer a higher return. To prove that XYZ are under-priced the following formula can be used. P i is the present
price P 0 is the purchase price and dividend. The securities ABC are on the Security Market Line and they are
correctly priced. Their return is in proportion to their risk.
Fig. 17.8: Evaluation of Securities with SML

Pi + P0 + Div
Ri = P0
When information is imperfect the valuation of securities becomes affected because in a perfect market,
information is complete and all the securities lie on the Security Market Line. However, when there are market
imperfections the Security Market Line becomes a band instead of a single line. This is indicated in Figure 17.9.
Y
Rp
Rf
X
Beta
Fig. 17.9: SML in Imperfect Market
(i) The capital market line (CML) depicts the relationship of the required rate of return of the portfolio
with the total risk of the portfolio but the security market line (SML) discusses the relationship of
required rate of return with Beta or systematic risk.
(ii) CML measures the risk and return of efficient portfolios only but SML measures both efficient and
inefficient securities on the portfolio. It gives the minimum rate of return for the satisfaction of an
investor in lieu of the risk undertaken.
(iii) The CML does not discuss risk-return relationship of single securities but SML is used for analyzing
single securities.
(iv) The CML discusses an optimum portfolio from the different sets of portfolios that are given whereas
SML can draw out overvalued and undervalued securities.
(v) CML represents the portfolio theory or the efficient market theory as propounded by Markowitz; SML
is part of the CAPM theory.
17.7 VALIDITY OF CAPM MODEL

The validity of CAPM can be summarized as:
(i) The CAPM focuses on the market risk.
(ii) It helps the individual to select securities and prepare a portfolio.
(iii) The assumption of CAPM is that investors consider only the market risk. In the risk free rate, the beta
of the firm, stock, the required market rate of return can be estimated and individual is able to
calculate the expected returns for a firm’s security. This expected return is useful to estimate the cost
of retained earnings.
(iv) CAPM has been regarded as a useful tool to financial analysts but empirical tests and analysis have
estimated through ex- post or past data.
(v) Betas vary for historical data regarding the market return and risk free rate of return in different
periods.
Criticism of CAPM
(i) MODEL IS EX-ANTE. It is based on expectation the inputs are Ex-Post based on Past Data.
(ii) Historical Data regarding market return, risk free rate of return and betas vary differently for different
periods.
Therefore expected return cannot be found out precisely.
17.8 ARBITRAGE PRICING THEORY

Arbitrage pricing theory is useful for investors and portfolio managers for evaluating securities.. The
capital asset pricing theory is explained through betas that show the return on the securities. Stephen Ross
developed the arbitrage pricing theory to explain the nature of equilibrium in pricing of assets in a simple
manner. It has fewer assumptions in comparison to CAPM.
1. Arbitrage
Arbitrage is a technique of making profits by differential pricing of an asset. It helps in earning a risk-less
profit. Price is manipulated by selling a security at a high price and the simultaneous purchase of the same
security at a relatively lower price. Trading activity creating price advantages without any risk continues until
the profit margin is reduced due to competition from other traders. When this occurs, a situation arises where
the profit is nil. At this stage the market price is at an equilibrium level.
2. Assumptions of the Theory
The theory assumes the following:
(i) All investors have homogenous expectations;
(ii) Investors are generally interested in maximizing their utility at minimum risk;
(iii) There is perfect competition in the market;
(iv) There are no transaction costs in the market.
The CAPM theory assumes the following assumptions but these assumptions are not acceptable to arbitrage
pricing theory.
(i) The CAPM theory assumes single period investment horizon but the arbitrage pricing theory believes
in multi period investment.
(ii) The CAPM theory assumes that there are no taxes to be considered where as the arbitrage pricing
theory does not believe in it.
(iii) The CAPM also has the unrealistic assumption that investors can borrow and lend at risk free rate of
interest but arbitrage pricing theory does not assume the borrowing and lending at the risk free rate
of interest.
(iv) The selection of portfolio is based on the mean and variance analysis according to CAPM but not
arbitrage pricing.
Arbitrage pricing equation is a single factor model, the linear relationship between the return Ri and
sensitivity bi can be given through the following formula.
R i = λ0 + λ ib i
Ri = return from stock A
λ 0 = risk-less rate of return
λi = the sensitivity related to the factor
λi = slope of the arbitrage pricing line
APT One Factor Model
Fig. 17.10: One Factor Model
The arbitrage pricing theory has been estimated by Burmeister and McElroy to test its sensitivity through
other factors like Default risk, Time premium, Deflation, Change in expected sales and market returns are not
due to the first four variables.
Salomon Brothers have made a fundamental factor model in which they have identified five factors. These
are Inflation, Growth rate in gross national product, Rate of interest, Rate of change in oil prices and Rate of
change in defense spending.
SUMMARY
r This chapter has discussed the construction of the best portfolio depending on the need factor of the investor
and the constraints around him.
r The study is based on Markowitz Efficient Market Hypothesis. It takes into consideration the different kinds
of investors that are present. These are basically the risk lovers, risk averse and risk neutrals.
r The best portfolio is constructed by ranking the securities and by establishing a cut-off rate.
r The CAPM model is based on the assumption that the investors can freely borrow and lend any amount of
money at risk-less rate of interest.
r All investors purchase risk free securities and only those securities on the market portfolio.
r Market portfolio means the composition of the investments in all securities of the market. The proportion
invested in each security is equal to the percentage of the total market capitalization represented by the
particular security.
r The Capital Market Line depicts the relationship between the expected return and the standard deviation of
the portfolio.
r The risk of an individual security is calculated through its covariance with the market portfolio.
r Security Market Line indicates that there is a linear relationship between the expected returns and betas of
the securities.
r Beta is an important and useful ingredient for portfolio selection and building of portfolio for an investor but
beta must be predicted and the changes in beta should also be analyzed.
r The asset pricing model assesses and identifies the equilibrium asset price for expected return and risk.
r Arbitrage is possible when the asset prices are not equal.
r With the same financial commitment an arbitrage portfolio can be constructed.
r When arbitrage is possible investors move the price upwards if securities are held long and driving down the
price of securities if held in short position. This trade will continue to take place until the arbitrage is eliminated.
r Arbitrage model indicates the responsiveness of a security’s return to a particular factor.
r The Arbitrage Pricing Theory provides a simplification of the CAPM.
r The expansion of securities by diversifying internationally will bring about good results, if the co-relationship
between two markets is low.

State whether TRUE or FALSE
1. The risk and return of securities is marked by Beta.
2. Traditional investors build maximum risk and return.
3. Beta is measured by market movements.
4. Cut Off rate determines values of existing and new securities with the change in Beta.
5. Portfolio selected by borrowing and lending line makes the efficient frontier a straight line.
6. Beta is directly related to the optimal portfolio.
7. Sharpe’s Model is called the Single Index Model.
8. Indifference curve measures risk and return.
Answers: (1) T (2) F (3) T (4) T (5) T (6) T (7) T (8) T.
QUESTIONS
1. Discuss the significance of ‘Beta’ in an individual’s portfolio.
2. How can an individual make an analysis of different curves to get the most beneficial portfolio?
3. What is an efficient frontier? How does it establish an optimum portfolio?
4. Write notes on (a) Capital Market Theory, (b) Security Market Line, (c) Beta.
ILLUSTRATIONS
Illustration 17.1: Calculate:
(i) Expected return of a security from the following information.
Beta = 0.8
Rate of return on Market Portfolio = 15%
Risk free interest = 5%
(ii) Beta for a security, which has an expected return of 18%.
Solution:
Risk free rate (R F )= 5%
Market Return = 15%
β = 0.8
R= I RF + ( RM − I RF ) β
= 0.05 + (0.15 – 0.05) 0.8
= 0.05 + (0.1) 0.8
= 0.13 or 13%
(ii) Calculate (β) with a return of 18%.
R = I RF + (R M – I RF )β
= 0.05 + (0.15 – 0.05)β
0.18 = 0.05 + 0.10β
0.13
0.10β = 0.18 – 0.05 = = 1.3
0.10
β = 1.3
Illustration 17.2: A security has a standard deviation of 3.2%. The correlation coefficient of the security with the
market is 1.2 and market standard deviation is 2.4. The return from government securities is 15% and from the market
portfolio is 20%. What is the required rate of return on the security?
Solution:
The required rate of return on the security may be found with the help of CAPM, for which Beta is as follows:
rsm × σs
β = σm
1.2 × 3.2
= = 1.6
2.4
R p = I RF + (R m – I RF )β
= 0.15 + (0.2 – 0.15) 1.6
= 0.23 = 23%
The required return on the security is 23%.
Illustration 17.3: The risk-free rate, IRF, is 8% and the market risk premium is 12% and β of the securities is 2.
What is the expected return of the security under CAPM? What would be the expected return if the β were to double?
Solution:
This can be presented as follows:
Rs = I RF + (R m – I RF ) β
= 8% + (12% – 8% ) 2 = 16%
R m = Risk premium + Risk free rate of return
= 8% + (12% – 8%) 4 = 24%
Illustration 17.4: The riskless securities are offering a return of 6%, while return of the market portfolio is 12%.
The standard deviation of the market portfolio is 3%, An investor has constructed a portfolio which has a standard
deviation of 1.2% and a correlation with the market return of 0.75. Find out the expected return of the investor.
Solution:
In view of the information given, the â of the investor’s portfolio can be calculated as follows:
rσP 0.75 × 1.2

B = = = 0.3
σM 3
The expected return of the portfolio is:

R P = I RF + (R M – I RF )β
= 6 + (12 –6) .3 = 7.8%
Illustration 17.5: From the following data calculate (a) Beta, (b) Alpha, (c) Residual Value, (d) Correlation, (e)
Variance and (f) Coefficient of determination.
Year X Y
1 0.10 0.29
2 0.24 0.31
3 0.11 0.10
4 0.08 0.06
5 0.03 0.07
Solution:
Year X Y XY X2 Y2
1 0.10 0.29 0.0290 0.0100 0.0841
2 0.24 0.31 0.0744 0.0576 0.0961
3 0.11 0.10 0.0110 0.0121 0.0100
4 0.08 0.06 0.0048 0.0064 0.0036

5 0.03 0.07 0.0021 0.0009 0.0049
Σx = 0.56 Σy = 0.83 Σxy = 0.1213 Σx 2 = 0.0870 y 2 = 0.1987
When, x = 0.11, y = 0.17

(a) Beta or slope of the line
nΣ xy − (Σ x ) (Σ y )
β = nΣ 2x − (Σx)2
5(0.1213) − (0.56) (0.83)

=
5(0.0870) − (0.56)2
0.6065 − 0.4648
= 0.4350 − 0.3136
0.1417
=
0.1214
= 1.167
(b) Alpha (the intercept of the line)
αy − β x = 0.17 – (+1.167) (0.11)
= 0.170 – 0.12837
= 0.042
(c) Residual variance (unsystematic risk)
Σ 2y − αΣ y − βΣ xy
ε2 =
n
0.1987 − (0.042)(0.83) − (1.2) (0.1213)

=
5
0.1987 − 0.03486 − 0.1455

=
5
0.01834
=
5
= 0.00367
(d) Correlation
nΣ xy − (Σ x ) (Σ y )
= nΣ x2 − (Σx)2 nΣ y2 − (Σy)2
5(0.1213) − (0.56) (0.83)

=
5(0.0870) − (0.56)2 5(0.1987) − (0.83)2
0.6065 − 0.4648
= 0.4350 − 0.3136 0.9935 − 0.6889
0.1417
=
0.1214 0.3046
0.1417
=
0.1922
= + 0.737
(e) Variance
Return on Xerox Deviations dx dx 2

0.29 + 0.12 0.0144
0.31 + 0.14 0.0196
0.10 – 0.07 0.0049
0.06 – 0.11 0.0121
0.07 – 0.10 0.0100
Σ0.83 Σdx 2= 0.0610
0.83
Sx = = 0.17
5
.0610
q = = .0122 = 0.11
5
Variance = 0.0122 from security when = r + 0.737
(f) Coefficient of determination r2 = 0.543
Explained by Index = 0.0122 × 0.543 = 0.0066.
Not explained by Index = 0.0122 × 0.192 = 0.0023
Variance Explained by Index = Systematic risk
Variance not Explained by Index = Unsystematic risk or Residual risk.
Illustration 17.6:
Serial No. Security Return Index Return

1 3 10
2 4 20
3 = β.05, α (alpha) = 9.0 12 25
Solution:
Year Security % Index % Security x2 Index y2 x’y’

Return Return Return Return
(x) (y) Deviations Deviations
(x’) (y’)
1 3 10 – 4 16 – 8 64 32
2 4 20 – 3 9 + 2 4 – 6
3 12 25 + 5 25 + 7 49 35
19 55 50 117 61
Average=7 Average=18
Variance from α = 12.9
38 50
(a) Security x 2 = Market Index =
3 3
12.67 = 3.6 16.7 = 4.1

(b) Variance = 12.9 Variance = 16.8
xy 35 35 35
= = =
(c) Correlation coefficient = 2 2 38 × 50 1900 43.6 = + 0.80
x ×y
(d) Coefficient of determination r2 = 0.64

(e) Variance explained by Index 12.96 × .64 = 8.29
Variance not explained by Index 12.96 × .36 = 4.67
(f) Systematic risk for individual security:
Systematic risk = β 2 × Variance of Index
= β 2 θ2 I
= (– 0.5) 2 (16.8)
= (.0025) (16.8)
= .042
(g) Unsystematic risk for individual security:
= Total Variance — Systematic security return
= e2
= 12.96 – 0.042 = 12.92
Total risk = β θ 2I + e 2
= 0.42 + 12.92
= 13.34
To summarize Sharpe’s Index Model requires e 2 for finding out portfolio risk and return. These in turn are to be
compared with some market index.
N
Return on Portfolio ∴ R p = Σ X i (α1 + βi I)
i =1
Illustration 17.7: Following is the data for several stocks. The data result from correlating returns on these stocks-
versus-returns on a market index:
Stock α β e2
MNO –0.05 +1.60 0.02
PQR +0.08 –0.30 0.00
LUV +0.00 +1.10 0.10
(a) Which single stock would you prefer to own from a risk return viewpoint if the market index were expected to
have a return of + .10?
(b) What does the value for e 2 PQR imply?
(c) What is the alpha value for LUV?
Solution:
(a) Return on portfolio MNO = [–0.05 + (1.60)]0.10] + .02
= – 0.05 + 0.16 + 0.02 = 0.13
(b) Return on portfolio PQR = [+0.08 – (0.30) 0.10] + 0.00
= + 0.08 – 0.03 + 0.00 = + 0.05
(c) Return on portfolio LUV = 0.00 + 1.10 (0.10) + 0.10
= 0.11 + 0.10 = + 0.21
(a) Return on portfolio MNO is lower than PQR and LUV and the risk in MNO is also very high.
(b) The performance of PQR is the same as the market.
(c) The performance of LUV is the same as the market.
(d) LUV may be selected as it is and indicates that its performance is lower than MNO and risk is also lower. Under
the risk return condition it may be preferred.
SELF REVIEW PROBLEM

1. The risk free rate is 5% and market risk premium is 8% and b of the security is 1.5 (i) what is the expected return
of the security under CAPM? (ii) What would be the expected return if Beta was to double?
Answer: R p (i) 9.5%, (ii) 14%
2. The riskless security have a return of 8% whereas market portfolios have a return of 12%. The standard deviation
of the market portfolio is 3%. An Investor portfolio has a standard deviation of 1.5% and has correlation with the
market return of 0.80. Find out the expected return of the investor.
Answer: (i) Beta = 0.4 (ii) Return on Portfolio = 9.6%
SUGGESTED READINGS
l Fischer and Jordan, Security Analysis and Portfolio Management (3rd Edition), Prentice-Hall, Englewood
Cliffs, New Jersey, U.S.A., 1983.
l Markowitz, Portfolio Selection, Yale University Press, Yale, 1959.
nnnnnnnnnn
Chapter
18
TECHNIQUES OF PORTFOLIO REVISION
Chapter Plan
18.1 Formula Plans
18.2 Rules for Formula Plans
18.3 Constant Rupee Value Plan
18.4 Constant Ratio Plan
18.5 Variable Ratio Plan
18.6 Modifications of Formula Plans
18.7 Rupee Cost Average
18.1 FORMULA PLANS

The portfolio which is once selected has to be continuously reviewed over a period of time and then
revised depending on the objectives of the investor. The important factors to take into consideration are the
timing for revision. The timing for revision is found out by the use of formula plans. These plans are predetermined
with distinctive objectives and rigidity of rules. Each of these has its own methodology and is useful for
investors to make a profit. These are Constant Rupee Value, Constant Ratio Value and Variable Ratio Formula
Plans. These are discussed in this chapter.
An investor purchases stock according to his objectives and risk-return framework. The prices of the stock
that he purchases fluctuate, each stock having its own cycle of fluctuations. These price fluctuations may be
related to economic activity in a country or due to other changed circumstances in the market. If an investor
is able to forecast these changes by developing a framework for the future through careful analysis of the
behavior and movement of stock prices, he is in a position to make a higher profit than if he was to simply
buy securities and hold them through the process of simple diversification. The investor uses formula plans to
help him in making decisions for the future by exploiting the fluctuations in prices, the three-formula plans
which are useful in making decisions are (a) the Constant Rupee Value, (b) the Constant Ratio and (c) the
Variable Ratio Formula Plans.
402
TECHNIQUES OF PORTFOLIO REVISION 403
The formula plans give the basic rules and regulations for purchasing and selling of investments. It helps
the investor to assess the total amount that he should spend on purchases. One of the aspects of these formula
plans is to have a set of rigid and ground rules which are devoid of any emotions or feelings of the person
who is making purchases. These plans are action-oriented and eliminate the feelings of a person who wishes
to make investments. A normal average investor is emotional and would not be able to act rationally in this
manner. The formula plans make the average investor who adopts these techniques superior to other investors.
Very often a person using these techniques will make superior profits to other investors because he will be
acting under the control of the method which he adopts in so much as when others are buying stock he will
probably be selling it depending on the formula plan that he is using. The formula is an attempt to draw a path
or a course of action within which investor will not have the problems of forecasting fluctuation in stock prices
and will continue to act according to the formula which is given to him. The investor must note that these
formula plans do not help in the selection of securities. The selection of securities will have to be done by some
other technique. The technique helps in the timing of security purchase for the construction of a portfolio so
that the investor does not make a loss. The following basic rules of formula plans are given:
18.2 RULES FOR FORMULA PLANS

1. The formula plans are useful for making a decision on the timing of investments. These plans, however,
do not help in the selection of securities. Selection can be made according to the economic industry
company framework which is the methodology adopted by the fundamental school of thought.
2. The formula plans are strict, rigid and straightforward and they are not flexible. The investor has to
bear in mind that by adopting these for in mind plans he will have some problems of adjustment with
the changing environmental conditions.
3. The formula plans cannot be used or found useful for short periods of time. They have to be adopted
for a fairly long period to see their results. The longer the period of holding the investments the easier
for formula plans to work.
4. The formula plans do not eliminate the need for making forecast. Although the investor will have to
forecast, the kind of forecasting technique will be different.
5. The formula plans work according to a methodology which is related for the working of each plan.
The formulations of these plans are discussed below:
(a) There should be a pool of funds which the investor has with him and would like to invest. If there
are no funds the formula plans or techniques are useless.
(b) The investment fund of an investor should be divided through the technique of formula plans to
achieve the highest possible return and to meet the investors’ expectations. The usefulness of the
formula requires the application of the formula plans artfully and scientifically.
(c) The formula plan will be able to work when an investor has two portfolios. The art of applying
the formula plans is by having (i) aggressive portfolio and (ii) conservative portfolio. An aggressive
portfolio will determine the volatile nature of the portfolio and will have large number of fluctuations.
This portfolio will rise very rapidly and will be faster than the prices of conservative portfolio
when it rises. Similarly, when they fall they will fall more quickly than the conservative portfolio.
An aggressive portfolio will consist of the common stocks and thus it will help the investor to
have high profits and capital gains but at the same time will be very risky. The conservative
portfolio will be planned to complement the aggressive portfolio and will consist of bonds. These
will give stability to the investor’s portfolio. Also, there will be a continuous stream of stable
income. A conservative portfolio will move slowly upwards when the prices are rising and will
fall very slowly when the prices are falling. The conservative portfolio is, therefore, a mechanism
of defensive operations.
(d) The methodology adopted by the formula plans is to find out the difference in the movements
of the aggressive portfolios as well as the conservative one and also helps to assess the future
course of action.
(e) After assessing the difference in the movements between the aggressive and conservation portfolios,
the investor should find out whether the difference in movements is large or small. The larger and
greater the difference between the movements of the two portfolios the higher the profit that is
derived from the formula plan.
(f) Bonds are useful investments for current income. Their prices fall in a boom period. Their interest
rates also rise. The situation is just the opposite during depression. Stock prices fluctuate more
than the bonds and give good capital appreciation. In boom periods the prices of stock combination
of safety in capital and capital appreciation is to be derived under the formula plan.
(g) The methodology adopted by the formula plans is to transfer the securities from conservative
portfolio to aggressive portfolio when the value of aggressive portfolio falls (Buy stocks when
prices are low).
(h) The investor should also transfer his securities from aggressive portfolio to conservative portfolio
when the value of the aggressive portfolio rises in the market. (Sell stocks when prices are rising).
(i) The formula plans also show when the stocks should be purchased and sold. According to the
plans the stock should be sold when the prices rise and the investor should only be interested
in purchasing stocks when the prices are falling.
(j) Formulae indicate the greater profits are determined when it is noticed that the stock prices and
bond prices move in the opposite directions than if the movement is in the same direction and
is falling. For instance, if the price of stock rises, the prices of bond should fall. Similarly, when
the stock prices are falling bond prices should rise to give the maximum benefits.
(k) The movements of stocks determine the profits of an investor. If stock prices continue to be
constant then the profits will also be very small. When the stock prices continue to move and
there are greater fluctuations, stocks are said to be volatile in the market and the investor will
make large profits.
(l) The investor should note that fluctuations in prices will not always move in opposite directions
between bonds and stocks. This is a desired situation but not a realistic situation. Very often in
the market both the stocks and bonds move in the same direction.
(m) The investor should note that the ‘turning points’ show the direction which the investor should
take regarding purchase or sale of stocks. These turning points sometimes coincide and sometimes
do not coincide.
(n) When the turning points do not coincide it means that the bond and stock prices are moving
together in the same direction. This narrows down the difference between the movement of
stocks and bonds and makes the formula plan unsatisfactory.
(o) Portfolio managers are of the opinion that every investor should have some amount maintained
as cash or savings balance accumulated in the conservative portfolio. This constant accumulated
amount helps the investor in bringing about a difference between the movements of an aggressive
and conservative portfolio.
(p) The formula plans suggest that there should be two portfolios of an investor, aggressive portfolio
and conservative portfolio. It should be recalled that the formula plans do not have a selection
procedure for the stocks. The aggressive portfolio represents common stock and the conservative
portfolio bonds. These have to be selected through some other procedure as it does not form the
purview of the formula plans.
(q) If the investor chooses to have a good current income, which is stable, he should consider the
choice of a more conservative portfolio which is less volatile in nature.
(r) The investor should be aware that if he wants to make a higher profit he is faced by greater risk
and higher volatility.
(s) Apart from using the formula plans the investor should consider every stock that he puts in his
portfolio with respect to growth potential of the securities. A study of the growth of securities will
depend on the type of the stable dividends given to shareholders, the amount retained by the
company, the reserves and surpluses, the expansion, the market value per share, yield, earning
cover and the amount of bonuses given by each company. The quality of the investments will
depend upon the kind of the company and its reputation in the capital market.
(t) The investor before conducting the formula plans should be aware that he is to make a reading
of the history of the movements of stocks with the movement in market index. This will help in
assessing the volatile nature of the stocks.
The three basic plans — the Constant Rupee Value, the Constant Ratio and the Variable Ratio Plans are
now discussed bearing in mind the basic rules have been drawn about the formula plans.
18.3 CONSTANT RUPEE VALUE PLAN

The constant rupee value plan has the following advantages:
1. It is the simplest form of formula plan and every investor can work according to this plan without
making complicated calculations. An average investor would find it easy to cope with this formula
plan.
2. This plan brings before the investor a fund which is ready for investment.
3. It has the advantages of specifying the percentage of the aggressive portfolio in the investment fund.
The aggressive portfolio will be a percentage of total fund which has a constant amount. This amount
will be different at different or varying levels of stock value. But it will be continuously constant to the
total fund.
The methodology of the Constant Rupee Value Plan is as follows:
(a) This plan indicates the rupee value which remain constant in the stock portfolio of the total portfolio.
The aggressive portfolio should remain constant in the total portfolio.
(b) This formula indicates to the investor that whenever the stock value rises his shares should be sold
to maintain a constant portfolio. The investor, according to this formula should buy shares when prices
fall to maintain a constant portfolio.
(c) Although the aggressive portfolio has to remain constant to the total portfolio, according to this plan,
a portion of the total funds should be invested in a conservative fund.
(d) According to this plan, the investor is guided by “action points”. These action points are also called
revaluation points. These action points helps the investor to make their transfers from aggressive to
conservative portfolio and vice versa in order to be able to maintain the constant rupee value.
(e) According to this formula, fluctuations in stocks should take place before the investor makes changes
for re-adjustments.
(f) This plan states that timing of stocks and their turning points are the most crucial.
(g) This formula plan also indicates to the investor how to place the action points, i.e., the period of time
when action should be taken. If the action points are too close together then there will be no profit
as the transfers will be expensive and the transaction cost will be high. The action points should not
be too far because they lose their value and no profit will be indicated if the action points are too far.
These action points will be related to the market index or economic activity of aggressive portfolio and
will vary according to the percentage change of the stock.
(h) The action points can be said to be a trade-off between stock and profitability. A certain range of
fluctuations is specified. If the fluctuations of stocks are within this range no change will be made by
the investor from aggressive to conservative portfolio. For example, if 20% is the range specified, the
investor will make no changes from conservative portfolio to the aggressive portfolio within this range.
But when the fluctuations move out beyond this range the investor will have to plan a change or
transfer.
(i) The investor under the constant rupee value will require knowledge of how ‘low’ the fluctuations may
go but it does not require the forecasting of an upward movement or limit of price rise. So the
forecasting by the investor is required even under the constant rupee value formula but the knowledge
will be regarding the lower limits or the depression values of the fluctuations.
(j) If the investor begins his constant rupee fund when the stock he acquires is not priced too high above
the lowest values to each, they might fluctuate. The investor can get better overall result from the
constant rupee plan.
(k) All formula plans are applied usually to a single common stock. This single common stock is a rate
of the total stock. The movement of the single common stock is similar to the movement of the total
common stock. The investor has to use the formula plan for a full identical circle to make his plans
useful. Using the formula plan for a full circle helps the investor to make comparisons of the plan
adopted by him in different conditions. Whether the formula plans is computed for one stock of full
portfolio the effect will be the same because the total portfolio changes but the value of a plan changes
only after a full cycle is completed and then reaches back to the beginning price. It must be noted that
a “full cycle” covers movements on both directions, i.e., upwards as well as downwards. When this
full circle is completed the investor can change the stocks which he finds are not appropriate for his
requirement and purchase those stocks which meet his objectives.
18.4 CONSTANT RATIO PLAN

This ratio plan is slightly different from the constant rupee value plan. This plan is a method of identifying
the ratio of the value in the aggressive portfolio to the value of the conservative portfolio. The aggressive
portfolio divided by the market value of the total portfolio should be held constant.
Market Value of Common Stock

K = Market Value of Total Portfolio
Methodology
1. According to this method the stock should be sold when value rises to make it constant with the value
of the conservative portfolio. The investor should transfer funds to common stock when the stock value
falls. In this way he should also change from conservative to aggressive value.
2. Under this plan the aggressive value is always to be kept by the investor constant of the portfolio’s
total value. The investor will according to the rule, have to shift from conservative to aggressive value
if the prices of stock fall.
3. The formula plan based on constant ratio does not require the investor to make forecasts of the lower
levels at which the prices fluctuate.
4. The constant ratio plan differs from the constant rupee value plan. While the constant rupee value
plan was operated and the principle of constant aggressiveness in the transfer to and fro the stock
portfolio, the constant ratio plan draws a relationship which results in the purchasing of stock in a less
aggressive manner as the prices fall down because constant ratio plan is applicable in the case of a
total fund which is decreasing in value.
5. The constant ratio plan operates in a less aggressive manner when the stock prices move up in a rising
price level, also it consists of sales which are less aggressive in nature. The reason for being less
aggressive in nature is that under the constant ratio the value of the total fund increases in a manner
to allow large rupee value in the stock portfolio.
6. The middle range of fluctuations is deciding factors for the sales and purchases of aggressive stocks
in the constant ratio plan. When the fluctuations are just above the middle range of the sales that take
place it is identified as the most aggressive point. Similarly, when the fluctuations are just below the
middle range it is considered to be the most aggressive.
EXAMPLE OF CORISTART RUPEE VALUE FORMULA PLAN
Value of Value of Value Value of Total value Revaluation Total No. of

Price Long-term Conservative Stock of Constant Action Shares in
Investments Portfolio Portfolio Rupee Stock
(100 Shares (col. 5 – (col. 7 × Portfolio Portfolio
× col. 1) col. 4) col. 1) (col. 3 +
col.4)
1 2 3 4 5 6 7
25 2,500 1,000 1,500 2,500 60
22 2,200 1,000 1,320 2,320 60
20 2,000 1,000 1,200 2,200 60
20 2,000 900 1,600 2,500 Buy 20 shares at 20 80
22 2,200 900 1,760 2,660 80
24 2,400 900 1,920 2,820 80
24 2,400 820 1,680 2,500 Sell 10 shares at 24 70
imbalances are checked
at various parts and the
Re. Value is constant.
7. The most optimum formula plan is when the stock prices are sold aggressively as their prices fluctuate
above the middle range of fluctuations and by purchasing aggressively when the prices move below
the middle range of fluctuations.
8. In the constant ratio plan if the fluctuations of stock take a long time to move in a direction which
is either upward or downward then this plan does not work at its optimum value.
9. This formula plan will work optimally and with the maximum utility if it is predicted carefully. But if
an investor begins to forecast then it goes against the assumption of the constant ratio plan which is
to rest on the fact that there is no requirement for forecasting.
10. In the constant ratio plan, the investor will get high profits if there is a continuous sustained rise or
fall in prices. These profits would be higher under this plan rather that under the constant rupee value
plan or the variable ratio plan. This large profit due to sustained rise or fall of prices under this
formula is due to the fact that the ratio under this formula itself leaves the investor into a more
optimum position as there is a large investment during boom and lower investment in depression
periods under this formula plan.
11. Taking into consideration the full cycle of fluctuations it has been found that the constant ratio plan
does not work with full efficiency when it has been noticed under the full cycle of fluctuations or
movements both upwards and downwards. The reason for this inefficiency is that the plan does not
have aggressive purchase and sale during the turning points. These aggressive movements are made
during the middle level of fluctuations.
12. The methodology adopted in this plan is to reach the fluctuations and its readjustments made by the
percentage fluctuations and time of readjustment just like the constant rupee value plan.
13. It has been found that there will be a large number of fluctuations because the range is small and
many transactions will take place. On the contrary a few transactions will take place when the range
of fluctuations is large. Experts are of the opinion that the fluctuations should be neither too small nor
too large. If it is small then the adjustment action will not have enough time.
18.5 VARIABLE RATIO PLAN

The variable ratio plan is considered by the investor under the following methodology adopted for its
study.
Methodology
1. The investor should sell stock when the price of stock rises and bond should be purchased. When stock
prices fall they should be bought and the bonds should be sold.
2. The methodology of the formula plan should have a pre-determined set of rules and consist of
different proportions of stock prices.
EXAMPLE OF CONSTANT RATIO PLAN
Month Investment in Equity k = market value of common stock

fixed Income Stock Total Actual Common Stock
Securities Aggressive Portfolio k Strategy
Conservative
1 5,000 5,000 10,000 0.50 buy sell
2 5,000 7,000 12,000 0.58 buy neither
3 6,000 8,000 14,000 0.57 buy neither
4 7,000 7,000 14,000 0.50 buy sell
5 7,000 5,000 12,000 0.42 sell neither
6 6,000 4,000 10,000 0.40 sell neither
It is desired to maintain
k at 0.50
Variable Ratio Plan
Month Market Index Direction Ratio Desired Actual Ratio Strategy for
(Calculated from Purchase or Sell of
portfolio) Common Stocks
1 Moderate prices upwards 0.70 0.95 Buy
2 High prices upwards 0.50 0.75 Buy
3 Very high prices downwards 0.00 0.60 Buy
4 Moderate prices downwards 0.30 0.00 Sell
5 Moderate prices upwards 0.70 0.25 Sell
6 High prices upwards 0.50 0.80 Buy
Data Prices of Previous 5 months
Estimated stock Desired level of K

Market level Upward Downward
1. Very high prices 0.30 0.00
2. High prices 0.50 0.10
3. Moderate prices 0.70 0.30
4. Low prices 0.90 0.50
5. Very low prices 1.00 0.70
1. If stock prices move upward it would be good to hold 30% of stocks in equity and 70% in fixed income
securities.
2. When prices move downwards and prices are low as shown in (4) then 50% of the portfolio should
consist of equity and 50% in fixed income securities.
3. In variable ratio the ratio can be adjusted to suit each investor.
4. Under this plan the ratio of value of aggressive portfolio, the value of conservative decreases when
the aggressive portfolio rises in value. Similarly the ratio increases when the aggressive portfolio value
decreases.
5. The aggressive portfolio consists of the total amount which the investor is able to risk in investing in
common stock taking a median round which the future fluctuations will move.
6. The complete programme of investments will be drawn by the investor from this median.
7. The investor under this formula plan will have to make forecasts in the range of fluctuations which
move both above and below the median to find out the different ratios at different levels of stock.
8. These stocks will have to be predicted with absolute accuracy or the investor will not succeed in
making profits. He will be left with a large number of stocks when prices are falling or either he will
find himself without any stocks when prices are rising.
9. The most important tool of the variable ratio plan may be said to be “forecasting”.
10. Under this plan the ratio has to be varied if purchases and sales have to be made more aggressive.
The varying ratio would lead to the movement of prices in different directions which are either
upwards or downwards and are away from the median.
11. This plan is most profitable for an investor when there are a large number of fluctuations.
12. Under this plan the ratios are varied, whenever there is a change in the economic or market index.
The most important factor after forecasting is that this plan takes into consideration “change”. Whenever
there is a growth trend for common stocks then the variations can be accounted for by exploring the
fluctuations around the long-term trends.
The variable ratio plan moves and works with indicators. These indicators are the market index or the
economic activity index and the moving averages are determined by the market index. The biggest disadvantage
of this formula plan is the dependency on a forecast. Whenever he is faced with the risk of change the very
fact that formula plans are given to an investor to remove forecasting is not considered under this plan. This
is, therefore, not a simple plan like constant ratio plan or the constant rupee value plan. It requires a knowledge
of market indicators and economic indicators. The investor under normal conditions will find it difficult to
operate under this plan.
18.6 MODIFICATIONS OF FORMULA PLANS

The formula plans can be modified under the following assumptions:
(a) The formula plans are not flexible and many times changes occur when the investor desires some
change and flexibility according to the change in circumstances.
(b) The formula plans work under assumption that the emotions and feelings of an investor are not taken
into consideration. Any investor who wishes to put a large fund in investments is somewhat emotional
because it is his hard-earned money which he requires for investment. Some modifications and feelings
are, therefore necessary in a formula plan.
(c) The stock prices do not always fluctuate in the same manner. Adjustments may be necessary to be
made by the investor.
(d) The reflection of historical data will not always indicate the same norms and the investor may require
some re-adjustments.
The methodology adopted for modifications in formula plans are the following:
(a) The investor can delay in making changes during the action points. This will modify the basic formula
plan under which he is operating.
(b) The investor may continue to invest in the same securities although the action point has arrived
because he has a feeling and his emotions are involved that there will be an exploitation of the trends.
(c) The formula plans can be modified by putting some flexibility in it according to the requirements of
the investor and the environment in which he is operating.
So far the formula plans have discussed the funds which are accumulated in nature. Another plan is called
the Rupee Cost Average.
18.7 RUPEE COST AVERAGE

This is a technique which is specifically studied for those investors who do not have a sum of investment
but who would require to build a fund and invest some money for a future date. Under this technique the
investor should continuously invest a constant sum of rupees in a specified stock of specified portfolio at
periodic differences.
A rupee average can be made by an investor by making a study of a complete school of stock prices. He
would be advised to buy when the securities are selling at a low rate and when the prices are reaching high.
It also helps in reducing the cost of transaction and the cost of commission. Through this technique, the
intervals of purchasing stocks can be large and may be dependent on the prices of stocks. A short interval for
conducting the purchases and sale of stock is considered ideal but if it is not possible to buy the best at short
intervals the investor can wait for longer intervals thus bringing in flexibility in time through variations in length
of time between investments. The methodology in a rupee averaging plan is to be successful at a lower average
cost per share when the fund is at its beginning and is small. The accumulations of the fund at different prices
is made and an average is found out on purchases to find out ‘the average cost per share’. Such an investor
can shift to other formula plans accumulating his fund because his average cost per share is very low.
The rupee averaging plans like other formula plans do not help the investor in making a selection of
securities on his portfolio. It only helps him to combine his portfolio in a manner to draw out the best results.
This technique is useful when it is implemented for long periods of time. Greater fluctuations in prices lead to
high profit in a full cycle. Such a programme is not useful for short intervals as it can lead the investors to
losses. The most important factor in this programme is the selection, the right quality of stocks and the timing
which is maintained for liquidating the stocks. The investor should have knowledge of the economic industry
company framework of investments when he is investing under this plan.
SUMMARY
r This chapter discusses formula plans which help the investor to make a profit. The three main formula plans
for investors who have already an accumulated fund are the Constant Rupee Value Plan, the Constant Ratio
Plan and the Variable Ratio Plan.
r The formula plans have a method of building two portfolios – the conservative portfolio and the aggressive
portfolio. A ratio is developed between these programmes to the total fund invested by investor.
r The most important factor in these programmes are action points or turning points at which the investor
should buy or sell the securities.
r These plans are not flexible but are predetermined course of action specified for the investor.
r Sometimes these programmes are modified to bring in an element of flexibility.
r While these plans are built for an already planned and accumulated investment fund, a fourth plan called the
Rupee Averaging Plan is also drawn for an investor who wishes to build his investments.
r The Rupee Averaging Plan is useful over a long period of time. Under this plan investment changes can be
made at varying lengths of time.
r The shorter interval changes are more successful in the Rupee Average Plan.
r This plan is useful only for those investors who wish to keep their investments over a length of time.
r Investors, who prefer more liquidity in their investments, should consider the first three formula plans namely
Constant Rupee Value Plan, the Constant Ratio Plan and the Variable Ratio Plan.

(i) Rupee cost average helps to get a combination of portfolio for best results.
(ii) Formula plans can be modified by delaying changes during action plans.
(iii) Rupee cost average is a technique to build and invest for a future sum.
(iv) The Formula plans can work without any funds.
(v) The Formula plans state that stock should be sold when prices fall and purchased when they begin to rise.
(vi) Formula plans suggest that an investor should have two plans. These are aggressive and conservative portfolios.
(vii) In a constant Rupee value plan a portion of the total funds should be invested in a conservative fund.
(viii) The formula plans cannot be modified.
Answers: (i) T (ii) T (iii) T (iv) F (v) F (vi) T (vii) T (viii) F.
QUESTIONS
1. What are formula plans? How do they help in portfolio revision?
2. Discuss Rules to be followed by an investor who wants to follow plans for portfolio decision.
3. How is a constant Rupee Value Plan different to a constant Ratio Plan? Discuss.
SUGGESTED READINGS
l Fischer and Jordan: Security Analysis and Portfolio Management, (3rd edition), Prentice Hall, Englewood
Cliffs, New Jersey, U.S.A., 1983.
l Jack Clark Francis, Management of Investments, McGraw-Hill, International Student Edition, New York, 1983.
nnnnnnnnnn
Chapter
19
PERFORMANCE MEASUREMENTS OF
MANAGED PORTFOLIOS
Chapter Plan
19.1Introduction
19.2Structure of Mutual Funds
19.3Features of Mutual Funds
19.4Classification of Mutual Funds
19.5Net Asset Value
19.6Costs in Mutual Fund Investments
19.7Return from Mutual Fund
19.8SEBI and Mutual Fund Regulations
19.9Management Performance Evaluation
— Sharpe’s Performance Measure
— Treyner’s Performance Measure
— Jensen’s Model
19.10 Mutual Funds as Investments
19.1 INTRODUCTION
The investments within the criteria of risk and return have been discussed for individual securities and for
a total combination of securities. This chapter discusses the validity of the performance of managed fund
investments. It goes into the question of whether the managed funds perform better than an average investor
because of the superior knowledge and diversification pattern that they indulge in.
It has been discussed in the previous chapters that diversification is an important aspect in investment of
securities within the framework of risk and return of an investor. This chapter raises an important question, that
412
PERFORMANCE MEASUREMENTS OF MANAGED PORTFOLIOS 413
is, whether the managed funds are better performers than the portfolios of a simple investor with a buy and
hold strategy. This is analyzed by taking into consideration the performance of different types of managed funds
such as investment companies/mutual funds. The investment companies/mutual funds operate under the advantages
of (a) diversification, (b) quality of management and (c) liquidity of funds. These investment companies are of
different kinds. The most important difference between them is that of closed end companies and open end
investment companies.
Mutual Fund is a mechanism of pooling resources by issuing units to investors and investing their funds
in securities to get a good return. Out of the returns received by investors, the mutual fund keeps a margin for
its costs and distributes the profits to the investors. These funds have to be invested according to the objectives
provided in offer documents. Investments in securities are spread across a wide cross-section of industries,
sectors and thus the risk is reduced. Unit Trust of India was the first mutual fund started in India. Units as a
form of investment are issued by the Unit Trust of India which is a public sector financial institution.
19.2 STRUCTURE OF MUTUAL FUND

The SEBI regulation act of 1996 has defined a mutual fund as one, which is constituted in the form of
a Trust under the Indian Trust Act 1882. The structure of a mutual fund consists of the following:
(i) Asset Management Company: It manages the funds of a mutual fund by diversifying the investments
of a company in different type of securities. The company has to be registered with SEBI and is setup
as a trust. It works under the guidelines of SEBI.
(ii) Sponsor: Is a person or a body corporate which establishes a mutual fund. It also appoints a Board
of Trustees to manage the Trust according to the provisions provided by SEBI.
(iii) Board of Trustees: This is a position of trust and confidence mainly for the benefit of the unit
holders. The trustees select stock according to the price, quantity of stock and their investment policy.
They operate upon the fact that the investors have limited knowledge of the environment as well as
of the quality of the investments. Its management is superior to the investment in funds by a single
naive investor. They are able to draw upon the special dividend as well as capital appreciation factors
of a particular security. Their specialized knowledge helps them to diversify in those stocks which give
the ideal combination of securities.
(iv) Custodian: Bankers, Registrar and Transfer Agents are appointed by Trustees to provide financial
services to the mutual funds.
19.3 FEATURES OF MUTUAL FUNDS

Mutual funds provide an attractive investment choice because they generally offer the following features:
(i) Management: The professional consultants have the specialized knowledge due to expertise and
training in evaluating investments. They have superiority in managing the portfolios due to experience
of investing and continuous learning on the job.
(ii) Small Saver: Mutual funds accommodate investors who don’t have a lot of money to invest by setting
relatively low rupee value for initial purchases, subsequent monthly purchases or both. They also offer
schemes that easily fit into the budget of the investor.
(iii) Liquidity: Mutual fund investors can readily redeem their shares at the current NAV plus any fees and
charges assessed on redemption at any time. Investments made in units give the advantage of liquidity
to the investor. The investor may purchase the units and sell them at any time in an open ended
scheme. The small investor does not even have to find any other investor in the stock exchange or
wait for the liquidity of his funds. The terms of payment on re-purchase are low.
(iv) Diversification: Diversification reduces the risk because all stocks may not move in the same direction,
in the same proportion at the same time. Share prices can move up or down. The investor should be
aware of these risks, while making an investment decision. Even with risks it is expected that the
mutual funds are able to perform better than an individual stock, because a careful selection of
securities over a diversified portfolio covering large number of companies/industries is made and the
portfolio is constantly reviewed. Spreading investments across a wide range of companies and industry
sectors can help to lower risk.
(v) Analysis and Selection of Securities: Mutual funds select a large share of equities in the case of
growth schemes. Although this has a greater risk and potential for capital appreciation is higher in
growth schemes. Besides growth schemes, mutual funds also have income schemes. When they have
income schemes they invest in securities of a guaranteed return. They generally select a large share
of fixed income securities like debentures and bonds. All growth schemes are close ended and income
schemes are either close ended or open ended.
(vi) Professional Management: Professional money managers research, select and monitor the performance
of the securities the fund purchases. This helps the investor in achieving a higher return than he would
gain by investing in individual securities without professional help.
All mutual funds in the public sector, private sector and those promoted by foreign entities are governed
by the same set of Regulations by SEBI, which is the controlling authority.
l Unit Trust of India was the first mutual fund set up in India in the year 1963.
l In 1987 Government allowed public sector banks and institutions to set up mutual funds.
l In 1992 Securities and Exchange Board of India (SEBI) Act was passed to formulate policies and
regulate the mutual funds to protect the interest of the investors.
l In 1993 mutual funds sponsored by private sector entities were allowed to enter the capital market.
l In 1996 SEBI revised its regulations to protect the interest of the investors.
l SEBI has also issued guidelines to the mutual funds in order to make the mutual funds as secure as
possible for the investors.
19.4 CLASSIFICATION OF MUTUAL FUNDS

The Mutual Funds operate under the advantages of (a) diversification, (b) quality of management and (c)
liquidity of funds. These companies are of different kinds. The most important difference between them is that
of closed-ended and open-ended funds. The following classification is given of mutual funds:
(a) Open-Ended: The Unit Trust of India has the most popular open-end fund company. The open-ended
fund is one that is available for subscription and repurchase on a continuous basis. These schemes do
not have a fixed maturity period. In such a fund the purchase price and sale price change daily
because of fluctuations in stock prices. The mutual funds repurchase shares directly from the investing
public. The Investors can conveniently buy and sell units at Net Asset Value (NAV) related prices,
which are declared on a daily basis. The key feature of open-end schemes is liquidity. The investors
should take loads into consideration, while making investment as these affect their yields/returns. A
load is a charge or a percentage of NAV for entry or exit. That is, each time one buys or sells units
in the fund a charge will be payable. This charge is used by the mutual fund for marketing and
distribution expenses. Suppose the NAV per unit is ` 10. If the entry as well as exit load charged is
1%, then the investors who buy would be required to pay ` 10.10 and those who offer their units for
repurchase to the mutual fund will get only ` 9.90 per unit. Efficient funds may give higher returns
in spite of loads. Mutual funds cannot increase the load beyond the level which is printed in the offer
document. If there is any change in the load it will be applicable only to prospective investments and
not to the existing investments. In case mutual funds want to increase loads, they are required to
amend their offer documents before approaching new investors.
Sometimes there are no-load funds, which means that, there is no charge for entry or exit. It means
the investors can enter the scheme at NAV and no additional charges are payable on purchase or sale
of units.
(b) Closed Ended: The closed end fund has its main objective to sell shares to the public, through public
subscription. It has its own memorandum of association and articles of association and prospectus. It
is listed on a stock exchange and its stocks and shares are traded on the stock exchange. A mutual
fund with closed ended schemes can make additional issues to the public. They can sell their shares
at any value above or below the net asset value of their shares. The Net Asset Value (NAV) of the
shares is the total market value of funds, performance minus its liabilities divided by total number of
shares outstanding. The shares often sell at a discount because the closed end companies are considered
to be highly risky from the investor’s point of view. A close-ended fund or scheme has a stipulated
maturity period e.g., 5-7 years. In India, these funds usually belong to part of a group company and
use the amount collected by it to invest into expansion programmes of other group companies by
giving them this amount as loan. The shares of these companies are very often traded at a great
discount. When the discount is very high it is worthwhile for an investor to make investment. In these
companies, units are listed in order to provide an exit route to the investors. Some closed-ended funds
give an option of selling back the units to the mutual fund through periodic repurchase at NAV related
prices. According to SEBI regulations there should be at least one exit route for investors.
(c) Income Fund: The aim of income funds is to provide regular and steady income to investors. Such
schemes generally invest in fixed income securities such as bonds, corporate debentures, Government
securities and money market instruments. Such funds are less risky compared to equity schemes
because they are not affected with fluctuations that may take place in equity shares. Income Fund has
the limitation that it is restricted with certain opportunities. They promise a regular income in the form
of dividends but they do not have the advantage of capital appreciation.
(d) Growth Funds: The aim of growth funds is to provide capital appreciation over medium to long term
period of time. Such schemes normally invest a major part of their corpus in equities. Such funds have
comparatively high risks. These schemes provide different options to the investors like dividend option,
capital appreciation and the investors may choose an option depending on their preferences. The
investors must indicate the option in the application form. The mutual funds also allow the investors
to change the options at a later date. Growth schemes are good for investors having a long-term
outlook seeking appreciation over a period of time.
(e) Dual Funds: The dual funds are also close-ended. It operates with two different kinds of shares. It
has both capital shares as well as income shares. If an investor wishes to buy stocks in such a company
he must specify the kind of stock which he wants to purchase. If he purchases stock of capital gains
then the return from the company to him will be only in the form of gains on capital. Thus, investors
who purchase income shares will receive from the company only dividends and interest, which the
company earns. This, it will pass on to the investor. Such a company has a dual role and because of
these roles it is thus named as the dual fund investment company. The investor in such a company
thus specifies the kind of interest that he has — capital appreciation or income appreciation. Such
companies work well, but the quality of management is very important because it is responsible for
proper diversification and maintaining the balance of investments. The company has to have a proper
combination of diversification into stocks of capital gains as well as stocks of dividend-yield companies.
(f) Index Funds: Index Funds are invested by a mutual fund according to a particular index such as the
BSE Sensitive index, S&P NSE 50 index (Nifty). These schemes invest in the securities in the same
weight as that of an index. NAVs of such schemes are expected to rise or fall in accordance with the
rise or fall in the index, by the same percentage. Information is given through the offer document of
the mutual fund scheme. In the United States a new type of fund called the index fund is being
operated. These funds are based on the fact that the costs are made as low as possible. The costs are
taken into consideration by calculating beta. This is based on the Random Walk theory and investments
are made according to the index fund by bringing down the unsystematic risk, by proper diversification
and reducing systematic risk through a study of the market factors with the risk and return factors.
(g) Exchange Traded Funds (ETF): These securities are listed on the stock exchange. They are similar
to index funds and can be traded in the stock exchange. Such funds are different from mutual funds
because they do not sell ETF directly to retail investors. An asset management company sponsors the
ETF, takes the shares of the company and in turn, it issues a block of ETF units. The ETF portfolio
value changes with the index therefore NAV of an ETF is usually higher than that of index fund of
a similar portfolio. The price of ETF is determined by demand and supply conditions and market value
of the shares. In India UTI mutual fund has an ETF called SUNDERS listed in Mumbai Stock Exchange.
Some of the ETFs traded in American Stock Exchange are called QUBES (this represents NASDAQ
100) SPIDERS (SNP 500) DIAMONDS (Dow Jones Ind. Average)
(h) Money Market Funds: The money market funds are operative, namely, in the United States Government
Securities relating to short-term maturities. Large amounts are used for the purchase of these securities.
These securities involve complete safety but the yields are not so high. For safety, investment companies
make investments in these funds and pass on the benefits to the investors. In India the SEBI regulation
1996 has allowed money market funds to operate in commercial papers, treasury bills and commercial
bills. They are open-end funds for short-term use and they are completely safe.
(i) Municipal Bond Funds: These funds are also exempt from tax in the Unites States and in the Unites
States these are called Unit Trusts. Unlike the Indian Unit Trust, the United States Unit Trust does not
make a continues offering to the public like open end funds. These are sold to the public from time
to time whenever there is a new offering and the interest is paid monthly. In India, the income from
municipal bonds are in the form of Post Office Savings, Pension Funds.
(j) Pension Funds: The pension funds are operative both in India as well as in the United States. These
funds are kept aside by an employer so that he can make payments to his employees after their
retirement. In this fund also the method is to diversify a large pool of resources into income yielding
securities and capital appreciation securities. It requires management of funds through proper financial
analysis, as it requires care and combination of securities.
(k) Off Shore Funds: Domestic Funds are usually open within the country, but off shore funds are those,
which are subscribed in other countries. They bring foreign exchange to a capital market. In India
there are off shore funds.
(l) Balanced Fund: The aim of balanced funds is to provide both growth and regular income as such
schemes invest both in equities and fixed income securities in the proportion indicated in their offer
documents. These are appropriate for investors looking for moderate growth. They generally invest
40%-60% in equity and debt instruments. These funds are also affected because of fluctuations in
share prices in the stock markets. However, NAVs of such funds are likely to be less volatile compared
to pure equity funds.
(m) Gilt Fund: These funds invest exclusively in government securities. Government securities have no
default risk. NAVs of these schemes also fluctuate due to change in interest rates and other economic
factors as are the case with income or debt oriented schemes.
(n) Sector Specific Fund: These are schemes, which invest in the securities of those sectors or industries,
specified in the offer documents. For example. Pharmaceuticals, Software, Consumer Petroleum stocks.
The returns in these funds depend on the performance of the industries. These funds usually give
higher returns, but they are considered to be high risk compared to diversified funds.
(o) Tax Saving Schemes: These schemes offer tax rebates to the investors under specific provisions of
the Income Tax Act. Government offers tax incentives for investment in specified avenues. For example,
Equity Linked Savings Schemes and Pension schemes launched by the mutual funds offer tax benefits.
These schemes are growth oriented and invest pre-dominantly in equities.
(p) Fund of Funds: This scheme invests mainly in other schemes of the same mutual fund or other
mutual funds and is known as a ‘fund of funds scheme’. This scheme enables the investors to
achieve greater diversification. It spreads risks and provides diversification.
The mutual funds have specific objectives for the investor. They have certain representatives called trustees
who look after their funds and diversify them into proper portfolio. This diversification is made in the combination
of dividend income and capital growth. The diversification pattern involves common stocks, preference shares
and bonds. They also diversify according to companies, industries, size of companies, age of companies and
have a combination of both risky and non-risky portfolios. Mutual funds are established in the form of a Trust.
The Trust consists of Sponsor, Board of Trustees, Asset Management Company (AMC), a Custodian and a Trust
Agreement.
These factors can be summarized in the following manner. The professional consultants have the superiority
in managing the portfolios through management, liquidity, diversification, analysis and selection of securities
has specialized knowledge due to expertise and training in evaluating investments.
19.5 NET ASSET VALUE

The question, however, is whether the performance of open end mutual fund companies of managed
funds in terms of performance is better than the performance of investments made by an individual because
portfolios are equally important whether they are invested by a managed trust or by an individual. Mutual funds
invest the money collected from the investors in securities market. Market value of securities changes every day.
This is the reason that NAV also varies from day to day. The NAV per unit is the market value of securities
of a scheme divided by the total number of units of the scheme on any particular date. NAV can be calculated
in the following manner:
Example 19.1:
Value of Securities - Liabilities

NAV = No. of Outstanding Units
A mutual fund collected ` 75,00,000 by issuing ` 7,50,000 units of Rs.10 each. The amount has been
invested in different securities. The market value of these securities is ` 1,00,00,000 and the mutual fund has
a liability of 6,00,000. Calculate Net Asset Value of the fund.
Solution:
1,00,00,000 − 6,00,000
NAV =
7,50,000
94,00,000
= = 12.53
7,50,000
19.6 COSTS IN MUTUAL FUND INVESTMENTS

Mutual funds have different kinds of expenses in order to run the business enterprise. These costs are
called operating costs. These costs are administrative expenses, consultation fees given to trustees and expenses
on brokerage. These are calculated as shown in example 19.2: these are also called Expense Ratio. The
operating costs are deducted from the closing NAV assets. This cost is spread out on the unit holders as they
receive a reduced NAV to cover the costs of the mutual funds.
Example 19.2: A mutual fund has an annual expense of ` 25,00,000. Assets in the beginning of the year
were ` 1,50,00,000 and ` 5,00,00,000.
Total Annual Operating Expense

Expense Ratio = Average Assets under Management
25,00,000
The expense ratio = 1,50,00,000 + 5,00,00,000 = 3.85%
19.7 RETURN FROM MUTUAL FUND

A mutual funds investment provides a return in a form of annual dividends and distribution of capital
gains. Returns are calculated by taking into consideration dividends, capital gains, NAV in the beginning of the
period and NAV in the end of the period. This is depicted in example 19.3.
Div + CG +(NAV1 − NAV0 )

Return = NAV0
Div = Dividends.
CG = Capital gain.
NAV 0 = NAV in the beginning.
NAV 1 = NAV at the end of the year.
NAV 1 – NAV 0 shows change over the period.
Example 19.3: A mutual fund has NAV of ` 10.60 in the beginning and ` 10.90 at the end of the period.
Calculate the return of the mutual fund.
(i) When dividend of ` 1.50 distributed
(ii) If there is a capital gain also distribute of 0.50 Paisa.
150 + (10.90 − 10.60)

(i) Return = × 100
10.60
1.80
= × 100 = 16.98%
10.60
(ii) When capital gain is distributed
1.50 + 0.50 + (10.90 − 10.60)
= × 100
10.60
= 21.69%
19.8 SEBI AND MUTUAL FUND REGULATIONS

SEBI regulated the mutual funds to protect the interest of the investors. In 1996 new guidelines were
issued to regulate the mutual fund investments in India. Some of the important provisions are:
l All mutual funds must be compulsorily registered with SEBI.
l The sponsors of mutual funds should have contributed a minimum of 40% of the net worth of the
Asset Management Company and should have a record of good reputation in financial services for at
least 5 years.
l All new mutual funds schemes have to be approved by the trustees of the mutual fund.
l Mutual funds have to follow investment norms provided by SEBI to protect the investor from high-risk
exposure.
l A report has to be published by the mutual fund for each new scheme that it launches.
l A mutual fund has to publish sale price and repurchase price of a unit in open-ended schemes at least
once a week.
l The repurchase price of a unit should not be less than 93% of NAV and sale price should not be more
than 107% NAV. In closed ended scheme the repurchase price should not be less than 95% of the
NAV.
l SEBI permits mutual funds to participate in its Security Lending Scheme.
l SEBI permits mutual funds to invest in Indian and Foreign ADRs and GDRs within its guidelines.
l SEBI has provided that 90% of the mutual fund profits should be distributed every year and the
earnings have to be shown as current income, short term capital gains and long term capital gain.
l To protect the investors SEBI can impose monetary penalties on mutual funds for violating regulations
and guidelines.
Mutual Funds have many benefits for investors but there are other investments which lend diversification
elements due to the features that they provide to an investor in terms of risk and return.
19.9 MANAGEMENT PERFORMANCE EVALUATION

The question to be decided in this chapter is whether selecting of securities and purchasing and selling
them is better than random purchase of stocks? It is expected that the management’s performance is measured
by comparing the yield of managed portfolios with the market index or with a random portfolio. The following
equation is used for finding out the performance of portfolios:
NAVt + D t
−1
NAVt −1
NAV t = per share net asset value at year ‘t’ (end)

D t = total of all distribution, both income and gains, per share during year ‘t’
NAV t-1 = per share net asset value at end of previous year.
If NAV t = ` 14, D t = 1, NAV t-1 = ` 10.
14 + 1 15
−1= − 1 = 1.5 − 1 = .5 or 50%
10 10
When two portfolios are compared, managed and not managed, the portfolio with the higher holding
period yield should be considered the best portfolio. Through this method it can be found out if the returns
on management portfolios have performed better than any unmanaged portfolios. In comparing these portfolios
the cost of commission and the riskiness has to be compared also. There are several models for comparing the
performance of portfolios. These are Sharpe’s, Treyner’s and Jenson’s models.
(i) Sharpe’s Performance Measure
The Sharpe’s performance measure makes a measurement of the risk premium of portfolios. His measure
adjusts the performance of risk. Thus, Sharpe’s Index is given by the following equation:
Rt − r *
St = θt
S t = Sharpe Index
R t = Average return of portfolio ‘Y’
r* = Riskless rate of interest
θ t = Standard deviation of risk of the returns of portfolio ‘t’.
Fig. 19.1: Performance Measurement by Sharpe Index S t
The risk premium is the return required by the investors for assumption of risk relative to the total amount
of the risk in the portfolio.
Figure 19.1 gives a graphic presentation of Sharpe’s Index, Larger the S t the better the performance of
the portfolio, according to the Sharpe Index. The graphical representation shows the amount of S t on the
portfolio.
Sharpe Index is explained in Example 19.4 with Treyner’s Performance Measure for Portfolios.
(ii) Treyner’s Performance Measure for Portfolios
Treyner’s Model is based on the concept of the characteristic straight line. Figure 19.2 gives the graphical
description of Treyner’s performance measure. It gives both the linear and curvilinear relationship. According
to his model, the inter-section at 45º angle represents that return which is equivalent to the return on the
market portfolio. The ideal fund is shown to the left at 45º line. The return on this line is higher than that which
is earned on the market portfolio. According to this model, if the market portfolio that shows a negative return,
the return under this method is positive but if the market return is positive the return under the model of the
characteristic line is still higher. This line is filled with the least square regression model, as shown by the
Sharpe’s Single Index Model in Chapter 16. The characteristic line draws a relationship between the market
return and a specific portfolio without taking into consideration any direct adjustment for risk.
Fig. 19.2: Treyner’s Performance Measurement – Ideal Fund
This line has a slope which consists of the beta coefficient which, as already discussed, forms the part of
the systematic risk. The systematic risk fluctuates and changes because it is volatile. When the investors make
a comparison of the characteristic lines by taking into consideration, their slopes, then the steeper the line the
higher the volatility or the movement in the fund. This has been measured by Treyner through the following
equation:
Rn − rt
Tn =
βn
T n = Treyner’s Index
R n = Average return of portfolio ‘n’
r t = Riskless rate of return
β n = Beta coefficient of portfolio ‘n’
The Treyner’s performance measurement measures the
systematic risk or the risk premium of the portfolio and
takes into consideration difference on the return of a portfolio
and the riskless rate. His index is summarized as a single rn − r * βn
index number and it is graphically represented in Figure Tn =
β
19.3. Fig. 19.3: Treyner Index T n
Both Sharpe’s Model and Treyner’s Model are explained through example 19.4.
Example 19.4:
The following data is provided calculate the return on the portfolios by Sharpe’s Model and by Treyner’s
Model. State which portfolio should be selected A or B.
Portfolio Return Standard Riskless β
deviation rate of return
A 20% 4% 10% 0.5
B 24% 8% 10% 1.0
(i) Sharpe’s Model

rt − r *
S = θt
rt = Average return on portfolio
r * = Riskless rate of return
θ t = Standard deviation at time period ‘t’.
0.20 − 0.10 0.10

A = = = 2.5
0.04 0.04
0.24 − 0.10 0.14
B = = = 1.75
0.08 0.08
∴ A ranked as better portfolio because the index is higher.
2.5 > 1.75 although portfolio B has a higher return 24 > 20.
(ii) Treyner’s Index
rn − r *
Tn = βn
T n = Treyner’s Index.
r n = Average return of portfolio ‘n’.
r* = Riskless rate of return.
βn = Beta coefficient of portfolio ‘n’.
0.20 − 0.10 0.10
A = Tn = = = 0.20
0.5 0.5
0.24 − 0.10 0.14
B = Tn = = = 0.14
1.0 1.0
Portfolio A performs better than portfolio B.
Beta coefficient of A and B = 0.5 and 1.0 (under Sharpe and Treyner’s Index portfolio A is better than
portfolio B).
(iii) Jensen’s Model
Jensen’s model is similar to the Sharpe’s index model and the Treyner’s index model but it shows that the
performance of a portfolio can be on any point including the origin. It graphically draws out the performance
models and shows that there should be positive, negative or neutral lines of indication. Figure 19.4 shows three
lines showing negative, positive and neutral values. The negative line shows that the management of the
performed portfolio is inferior. The positive values show higher quality of management funds. This also shows
the relationship of the risk adjusted returns of the portfolio with the risk adjusted returns of the market. The
neutral values show that it is performing in the same manner as a market portfolio.
Fig. 19.4: Jensen’s Measurement of Management Ability
Jensen’s Model
R jt – R Ft = αj + β j (R MT – R Ft )
Where,
R jt = Average return on portfolio ‘j’ for period ‘t’
RFt = Riskless rate of interest for period ‘t’
αj = Intercept that measures forecasting ability of portfolio manager
βj = Measure of systematic risk
RMT = Average return of market portfolio for a time period ‘t’. Intercept can be at any point including
origin.
αj = Positive = superior performance of management
βj = 0 = neutral performance = negative = inferior managed firms.
These three measures have shown that according to the examples, the managed portfolios did not behave
in any manner which was better than the portfolio selected by an individual investor. Empirical tests have been
conducted on the mutual fund performances to find out if the managed portfolios are better than a simple buy
and held strategy of a single individual investor. Extended examples have been taken of Sharpe’s Model,
Treyner’s Model and Jensen’s Model and compared to best portfolio with the average percentage of returns.
The inputs of these extended models have been the best portfolio compared with the average rate of return.
Sharpe’s, Treyner’s and Jensen’s equation, is given below in Example 19.5.
EMPIRICAL TESTS OF PERFORMANCE

Example 19.5:
The following data has been provided: Calculate the return of the best portfolio through Sharpe’s, Treyner’s
and Jenson’s Equation of managed portfolio and best portfolio.
Alpha = 2.55
Beta on managed portfolio = 1.00
Average beta on managed portfolio = 2.85
Average return on managed portfolio = 3.30
Standard Deviation of returns on managed portfolio = 4.92
Beta on best portfolio = 1.00
Average Return on best portfolio = 6 %
Standard Deviation on best portfolio = 15.24

Riskless rate of return = 3%
(i) Sharpe’s Model

rt − Irf
Sharpe’s Model = θt
rt = Average return of ‘best’ portfolio
rm = Average return on managed portfolio
θt = Standard Deviation of returns on best portfolio
θm = Standard Deviation of returns of managed portfolio
I rf = Riskless Rate of return
6.00 − 3.00 3.00
Best Portfolio = = = 0.19
15.24 15.24
3.30 − 3.00 0.30
Managed Portfolio = = = 0.06
4.92 4.92
Superior: Best Portfolio out-marks/out ranks Managed Portfolio.
(ii) Treyner’s Model
rt − Irf
Tn =
β
Tn = Treyner’s Model
rt = Average return on portfolio
I rf = Riskless rate of return
β = Beta
6.00 − 3.00 3.00
Best Portfolio = = = 3.00
1 1
3.30 − 3.0 0.30
Managed portfolio = = = 0.30
1 1
The Best Portfolio out ranks Managed Portfolio.
(iii) Jensen’s Model
R p = α + β (R m – I rf )
Best Portfolio = 2.55 + 1 (6.00 – 3.00) = 5.55
Managed Portfolio = 2.55 + 1 (3.30 – 3.00) = 2.85
Best portfolio is the individual invested portfolio and not the managed portfolio by mutual fund operators.
19.10 MUTUAL FUNDS AS INVESTMENTS

Several studies have been conducted and research workers have shown that there is no difference between
the performance of mutual funds and an ordinary diversified buy and hold policy of investors, if it is properly
invested into equity investments. It can, however, be said that open end investment companies/mutual funds
are still good investment for an average investor because it is difficult for an investor to manage a large group
of investments on his own for lack of specialized knowledge on the performance of market investments. An
average investor may invest in these open end trusts and get the advantages of diversification. Whether he
invested these funds or they were managed by the mutual funds, the results will be the same if there is superior
knowledge. It is, therefore, better for the average investor to leave it to the trustees who with their superior
knowledge would be able to make the same kind of diversification possible.
Mutual funds have both open-end and closed-end schemes. The closed ended schemes should be invested
into by an investor only if he can retain the scheme up to the time of redemption and ideally it should be
purchased by him if there has been an appreciation in the past and high discounts are being quoted to their
net asset values. Mutual fund schemes did quite well due to the fall out of non bank finance companies in India.
The equity mutual fund schemes did better than its debt schemes due to bullish trend in the stock market in
2007. To protect investors from volatile debt markets, mutual funds introduced floating fund rates. Since there
is high inflation in 2008 debt fund did not perform well.
Mutual funds have introduced new products like arbitrage funds, which will help in hedging to avoid
losses. They have also brought about commodity based schemes. The process has already begun with the first
application of State Bank of India to SEBI. The Mutual Funds also plan to enhance their investor base by
expansion and consolidation within the industry. Consolidation has already begun with mergers. Franklin
Templeton Mutual Fund merged some of its schemes. Principal mutual fund enhanced its base by 4,000 crores
through takeover of all ten schemes of Sun and four schemes of Punjab National Bank. Bank of India merged
with its parent. Birla mutual fund acquired eleven schemes of US base alliance mutual fund and became the
fifth largest mutual fund.
The mutual fund shares should be purchased by investors if the mutual fund shares are being sold at a
discount, i.e., at a price below their net asset value and shares can be sold at a price above the net asset value.
Therefore, when the share price index is at cyclically low levels then the investor may buy mutual fund shares.
SUMMARY
r This chapter of the book has examined the different classifications of mutual funds / investment companies.
r These are grouped into closed end companies and open end companies.
r A Mutual fund is a financial intermediary. It collects funds from small investors and then invests the same in
a wide variety of investments.
r Mutual funds may be open ended or close ended with income or growth schemes.
r Open-ended Mutual funds are more popular because purchase and repurchase units are on a continuous
basis.
r The sale and purchase of mutual fund units are on the basis of Net Asset Value (NAV), which is a price,
calculated according to the market Value of the portfolio minus liabilities and divided by outstanding number
of units.
r Mutual funds have certain expenses like administrative, advisory fees brokerage. These costs are called
loads.
r Loads are inbuilt in the cost of the asset. There can be a load in the entry or exit of units.
r A return on units can be seen through dividends paid capital gains distributed and change in NAV.
r The structure of mutual funds consists of Asset Management Company (AMC), Board of Trustees, Sponsor
and Custodian.
r UTI was the first mutual fund in India. Since 1996 SEBI has made a regulatory framework and guidelines
whereby all mutual funds have to be registered and work under the guidelines of SEBI.
r The Sharpe’s, Treyner’s and Jensen’s Models were shown and examples drawn from their equations to show
that the managed portfolios performed in the same manner as an average intelligent investor would make his
investments.
r It was considered whether these investments are better for an average investor or should he make his own
investments.
r The managed portfolio to a large extent helps an average investor because he does not have to look into the
quality of the securities.
r The superior knowledge of the special trustees and consultants make it favourable for an average investor
to put his investments in an open end investment company.
QUESTIONS
1. “Mutual Funds are better performers than individuals”. Examine this statement.
2. What are the different kinds of investment companies? Do their strategies in portfolio management differ from
individuals?
3. Write notes on:
(a) Treyner’s Ideal Fund.
(b) Sharpe’s Performance Measure.
(c) Jensen’s Model.
Objective Type Questions (TRUE or FALSE):
(a) Mutual funds are brokers.
(b) Mutual funds do not have a regulatory body in India.
(c) NAV is the market price of units.
(d) Many schemes of mutual funds are based on entry and exit loads.
(e) SEBI makes it compulsory for mutual funds to be registered before any operations can be taken up.
(f) An open ended mutual fund is popular because of liquidity feature.
Answer: a (F), b (F), c (F), d (T), e (T), f (T).
ILLUSTRATIONS
Illustration 19.1: A mutual fund has an NAV of ` 10.90 in the beginning of the month there is no change in the
end of the month and the unit holders benefited by receiving a return of ` 0.05 and capital gains of ` 0.50. What is the
monthly rate of return?
Solution:
0.05 + 0.50
Return = × 100
10.90
0.55
= × 00 = 5.04%
10.90
Illustration 19.2: Calculate Net Asset Value of a mutual fund when the following information is provided.
Cash balance 4,00,000
Bank balance 2,00,000
Bonds (Realizable Value Equity Shares) 10,00,000
Equity Shares (Realizable Value) 10,00,000
Expenses 1,00,000
No. of Units Outstanding 2,00,000
Solution:
Cash Balance = 4,00,000
Bank Balance = 2,00,000
Equities = 10,00,000
Bonds = 10,00,000
Total Realizable Value = 26,00,000
Less expenses increased = 1,00,000
= 25,00,000
25, 00, 000
Divided by No. of Unit Outstanding =
2,00, 000
NAV per unit = ` 12.50
Illustration 19.3: A mutual fund has an NAV of ` 30 in the beginning of the year and ` 35 at the end of the period.
It increased an expenditure of ` 0.50 per unit find its expense ratio.
Solution:
Expenses
Expense ratio = Average Assets × 100
0.50 0.50
= (30 + 35) / 2 × 32.50 × 100 = 1.53% = 1.53%
Illustration 19.4: A mutual fund has a new scheme each unit is of R 100 whereby investors are looking for a return
of 15%. How much should the mutual fund earn if its initial expenses are 5% and annual recurring expenses are 2% to
cover its costs and expectation of investors.
Solution:
(Re turn to Investors + Re curring Expenses)

Required Rate of Return = (1 − Initial Expenses) ×100
Return of investors = Rs.15.00

Recurring Expenses = 2% × (100 –5%)
2 × 95% = 1.90
Total Return Required = 16.90
Funds available (100-5%) = 95%
Return (16.90 ÷ 95) =17.79%
It can also be calculated in the following way,
15 + 1.90
× 100
100 − 5
= 17.79%
Illustration 19.5: An investor earns a return of 15% in equity shares. A mutual fund has floated a scheme which
will give a return of 17% but it has an issue expense of 5%. How much should be the mutual fund expenses to be equal
to the return in equities.
Solution:
An investor invests ` 100 and gets a return of ` 15. The mutual fund invests ` 95 after expenses of ` 5 @ 17%.
Income of mutual fund (17% × 95) = 16.15
Less return to investor = 15.00
Amount available for expenses = 1.15
= 1.15 ÷ 95
= 1.21%
Expenses should be 1.21%.
Illustration 19.6: A mutual fund made an issue of 20,00,000 units of ` 10 each on January 1st 2009. It did not
charge any entry load. The following were investments made by it.
15,00,000 Equity shares of ` 10 ` 1,50,00,000
10% Govt. Securities 10,00,000
Listed 10% Debentures 8,00,000
Unlisted 10% Debentures 8,00,000
1,76,00,000
The mutual fund received dividends of ` 25,00,000 from its investments. It also received interest on its investments.
The equity shares in which it made investments is quoted at 150% and (listed) 10% debentures at 90% of the total value
invested.
The operating costs of the mutual fund for the year are ` 8,00,000. Calculate the (i) NAV per unit and (ii). Also
calculate the NAV of the mutual fund, if it paid a dividend to its unit holders at ` 1.50 each.
Solution:
(i) NAV per unit
1. Cash balance in the beginning of the year (2,00,00,000 – 1,76,00,000) ` 24,00,000
2. Dividends received during the year ` 25,00,000
3. Interest on 10% government securities ` 1,00,000
4. Interest on 10% unlisted debentures ` 80,000
5. Interest on 10% listed debentures ` 80,000
` 51,60,000
6. Less operating expenses ` 8,00,000
7. Net cash balance ` 43,60,000
Calculation of NAV
1. Cash balance ` 43,60,000
2. 10% Govt. Securities at par ` 10,00,000
3. 1,50,00,000 Equity shares at 150% ` 2,25,00,000
4. 10% listed debentures at 90% ` 7,20,000
5. 10% unlisted debentures at par ` 8,00,000
6. Total Assets ` 2,93,80,000
7. No. of units ` 20,00,000
8. NAV per unit (6÷7) ` 14.69
(ii) Calculation of NAV when ` 1.50 is paid as dividend.
1. Net Assets (` 2,93,80,000 – 30,00,000) ` 2,63,80,000
2. No. of Units 20,00,000
3. NAV per Unit ` 13.19
Illustration 19.7: An investor earns a rate of return of 15% if he invests in equity shares. A mutual fund announces
scheme whereby the investor will earn 16%. The expenses of the mutual fund on the new issue are 2%. What in your
opinion should be the expenses of the mutual fund for the investor to be indifferent between equity investment and mutual
fund investment?
Solution:
1. The required rate of return of the investor is 15%. Therefore the mutual fund would satisfy him if this minimum
rate of return is given to the investor.
2. Let us see the mutual funds investment after expenses of 2% which means that it is investing ` 98.
3. Income of mutual fund 16% × 98 ` 15.68
4. Less return to be paid to the investor ` 15.00
5. Amount available for expenses ` 00.68
6. The expenses that it can actually avail (0.68 ÷ 98) 0.0069 or 0.69%
The mutual fund should not have more than 0.69% expenses in order to give 16% return to the investor.
Illustration 19.8: A mutual fund announces a new scheme in which its expenses of issue are 2% and it has an
annual recurring expense of 1%. Investors who buy equity shares require a minimum rate of return of 10% from the mutual
fund to be indifferent to its other investments. What in your opinion should be the mutual funds earnings to satisfy the
investors?
Solution:
If mutual fund issues unit of ` 100 each then the expenses will be ` 2 and the recurring expenses will be ` 1. It also
has to pay ` 10 to the investor. The required rate of return of the mutual fund is the following:
Method I:
Return to the investor ` 10.00
Recurring expenses 1% of ` 98 ` 0.98
Total return required ` 10.98
Funds available (` 100 – 2) ` 98.00
% return 10.98 ÷ ` 98 11.2%
Or,
Method II:
Re turn to Investors + Re curring Expenses

Alternatively Minimum Return = 1 − Initial Expenses
10 + 0.98
= × 100 = ` 11.20
100 − 2
SUGGESTED READINGS
l Fischer and Jordan, Security Analysis and Portfolio Management (3rd edition), Prentice Hall Inc. Englewood
Cliffs, New Jersey, 1983.
l Fredrick Amling, Investments — An Introduction to Analysis and Management (5th edition), U.S.A., 1984.
l Jack Clark Francis, Management of Investments, International Student Edition, McGraw Hill Series, New York,
1983.
l Markowitz, Portfolio Selection, Yale University, Yale, 1959.
nnnnnnnnnn
GLOSSARY
ACCRUED INTEREST – Interest, which is accrued (earned) for the period but not yet received.
AMERICAN DEPOSITORY RECEIPT – A security, which is issued to investors in the United States of America. It represents
equity shares in foreign companies.
AMERICAN OPTION – An option, which can be exercised any time before, and upto the expiration date of the contract.
ANNUITY – A fixed annual payment with equal installments in equal spacing of time periods
ARBITRAGE – It is a method of hedging a loss or making a gain by entering into two contracts of purchase and sale
simultaneously. The price difference in two markets brings about an advantage.
ARBITRAGEUR – is a person who is a participant in the contract involving arbitrage activity in two markets.
ARBITRAGE PRICING THEORY – A theory to describe the security prices. It depicts the relationship between expected
returns on securities given that there are no opportunities to create wealth through risk-less arbitrage investments.
ASK PRICE – The price at which a market maker is willing to sell a particular quantity of Stock.
ASSET ALLOCATION –Spreading investment amount into different alternatives like direct and indirect securities to get the
maximum benefit.
AT-THE-MONEY-A put or call option where the current price of the underlying asset is approximately equal to the present
value of the exercise price.
BAR CHART – is used by technical analysts for showing the daily price movements of a share.
BEAR MARKET – When prices in the stock market are pushing down it is called a bear market.
BENCHMARK PORTFOLIO – A portfolio which has a good investment performance and it can be used for the purpose
of investment by other investors with similar risk exposure.
BETA FACTOR – The slope of a security’s characteristic line. The expected change in security’s rate of return divided by
the accompanying change in the rate of interest to the Portfolio. It is a relative measure if sensitivity of assets return
to changes in the return on the market portfolio.
BID-ASK SPREAD – The difference in the price a market maker is willing to pay for a security and the price at which he
is willing to purchase a specified quantity of a particular security.
BIDDER – The person who has placed a bid in the Book Building process.
BID PRICE – The price which is acceptable to the bidder to purchase a specified number of shares.
BINOMIAL OPTION-PRICING MODEL – American or European option-pricing model which finds the value of the option
required to deliver a risk-free return to a hedged position assuming there are two possible returns to the stock each
period.
BLACK-SCHOLES OPTION-PRICING MODEL – A model to value European put or Call options. The model provides an
option price that produces the risk-free rate of return
BLUE CHIP SHARES – Shares of stable and growth companies known for their past record of good earnings and distribution
of dividends.
BOND RATING – Means finding out the credit rating of the bond. It is compulsory in India.
BOOK-BUILDING – This is a process of deciding an issue price of a security through market forces
BROKER – An individual who acts as an agent to execute a trade for an investor and receives compensation in the form
of a commission.
BULL MARKET – When share prices continue to rise in a stock market. It is said that the market is bullish.
BUTTERFLY SPREAD – A spread position using call options where you buy options with relatively large and small exercise
prices and sell options with intermediate exercise prices. The spread positions pays off when the value of the
underlying asset falls within a certain range.
429
CALL OPTION – A contract which gives the holder the right to buy a specified number of shares of stock at a given price
on or before a given date.
CALLABLE BOND – A callable bond that can be redeemed by the issuer at a stated price before the maturity date.
CAPITAL ASSET PRICING MODEL (CAPM) – A theory which describes the structure of security prices and states that the
expected return of a security is a linear function of the securities sensitivity to changes in market portfolio return.
CAPTIAL MARKET LINE – A line showing the portfolio positions of individual investors in expected return and standard
deviation. It represents the efficient set of portfolio by combining market portfolio with risk free borrowing or lending.
CHARACTERISTIC LINE – A line shows the relationship between the rates of return to a security or portfolio and the
corresponding rates of return of the market portfolio.
CIRCUIT BREAKERS – These are a set of upper and lower limits on the movements of market price if prices change beyond
these limits trading closes for a particular time period.
CLEARING HOUSE – An organization associated with an organized exchange for trading options or futures contacts. It
calculates net amount of securities and cash to be distributed to the members at the time of settlement at the end
of trading day.
CLOSING PRICE – The price at which the last trade of the day takes place in a particular security.
COEFFICIENT OF DETERMINATION – The fraction of the variability in the one variable that can be associated with the
variability in another.
COLLATERAL – It is a security which is given at the time of taking a loan.
COMMERCIAL PAPER – Short-term unsecured promissory note issued by a company.
COMPOUND INTEREST – It is the interest calculated for a future period it is based on principal plus accrued interest.
CONSOL – A perpetual bond with a constant periodic interest payment and no maturity date.
CONSTANT GROWTH MODEL – Dividend discount model in which growth in dividends is expected to be constant in
perpetuity.
CONSUMER PRICE INDEX – It is accost of living index, which represents goods and services purchased by consumers.
CONVERTIBLE BOND – A bond giving its holder the option of exchanging the bond for a stated number of common shares
of the issuing firm.
CORRELATION COEFFICIENT – A Statistical tool showing relationship between two variables. The correlation coefficient
is equal to the covariance between the variables divided by the product of their standard deviations.
COUPON – The interest payment on a bond. A coupon rate is the fixed rate on the bonds par value.
COVARIANCE – Statistical tool roughly describing the relationship between two variables.
COVERED CALL WRITING – A call option on an asset owned by the option writer.
CREDIT RATING – Is an opinion of credit worthiness of a borrower offering a particular security.
CUMULATIVE PREFERENCE SHARES – A security with a fixed periodic claim that must be paid before dividends can be
paid on the common stock. If the payment is not made in a particular year it must be paid up in full in the next year.
CURRENT YIELD – Is the annual amount of interest paid by a bond and it is expressed as percentage of the bonds current
market price.
DEBENTURE BOND – A bond that is unsecured by real property.
DEEP DISCOUNT BOND – Bond issued at discounted value it is redeemed at face value on maturity.
DELIVERY PREMIUM – Premium in the futures market : A seller of a futures contract has the option to deliver various types
or grades of commodities under the contract. The premium is the value of this option.
DELTA – The expected change in the market value of option position accompanying a small change in the market value
of the common stock underlying the position.
DELIST – Removal of securities eligibility for trading in a stock exchange.
DEMAT – A mechanism through which securities are converted from physical mode to electronic mode.
DEPOSITORY – A registered company which keeps securities in an electronic mode on behalf of beneficiary holders.
DERIVATIVE SECURITIES – These securities derive their value from some underlying asset.
DIVIDEND DISCOUNT MODEL – Stock valuation model which assumes that intrinsic value of a common stock as the
present value of future dividends expected to be received.
DISCOUNTING FACTOR – Discounting is the process of calculating present value of future cash flows. The discounting
GLOSSARY 431
factor is the present value of a given value of Re.1 to be received in specified number of years.
DIVERSIFICATION – Spreading Securities in different alternatives to avoid risk.
DIVIDEND/PRICE RATIO – Ratio of the dividend per share of a stock to its market price per share.
DOW THEORY – Explains and identified long term trends in price behaviour through technical analysis. These are analyzed
through charts.
DURATION – Duration is weighted average measure of a bonds life.
EFFICIENT SET – The set of portfolios of a given population of securities which offer the maximum possible expected
return for given level of risk.
EARNINGS PER SHARE (EPS) – The after tax earnings of a company divided by its equity Shares.
EARNINGS YIELD – Earnings per share divided by the market price of the share
EFFICIENT DIVERSIFICATION – Selection of securities through statistical measures of standard deviation and correlation
of the securities to get the maximum returns.
EFFICIENT MARKET – Information on securities is fully and immediately reflected in market prices.
EFFICIENT PORTFOLIO – An investment of different securities selected scientifically through models of investment management
The most well known being Markowitz and Sharpe’s models.
EFFICIENT SET (FRONTIER) –It is the set of efficient portfolios. Markowitz theory is popularly called the efficient frontier
theory.
EUROPEAN CALL ( PUT ) OPTION – Contract giving the holder the right to buy (sell) a specified number of shares of
a give stock on, but not before, a given date.
EXERCISE PRICE – The price at which you have the right to buy (sell) a security under a call (put) option contract.
EXCHANGE RISK – The uncertainty in the return of a financial asset because of the unpredictability of foreign currency
exchange rate.
EXCHANGE TRADED FUNDS – This is an index fund holding a portfolio of securities in the same proportion as the market
as they are a part of an index.
EX-DIVIDEND DATE – Purchase of shares or holding of shares which do not entitle the holder a dividend
EXERCISE PRICE also called striking price. It is the price at which an option buyer may purchase the underlying asset from
the option writer..Alternatively option seller may sell at this price to the option writer.
EXPECTED RATE OF RETURN – Sum of the product of the possible rates of return on an Investment and their associated
probabilities.
EXPIRATION DATE –The date on which the option writer or buyer must settle their accounts as after this contract ceases
to exist.
FINANCIAL ENGINEERING – Designing, developing and programming a financial contract creatively.
FINANCIAL INTERMEDIARY is also called a financial institution. Such an organization issues financial claims against itself
to purchase financial assets issued by individuals, companies, government and other financial institutions.
FINANCIAL MARKET –A market, which deals with the purchase and sale of financial assets. For example a stock market.
FINANCIAL RISK – A risk, which is due to, factors like price changes, interest, capital, change in policies.
FIXED INCOME SECURITY – A security with a definite limited money claim.
FLOATING RATE- It is also called a variable rate. It is based on the rate of interest on a financial asset, which may vary
over the lifetime of the asset. The change occurs due to change in market rates.
FLOOR BROKER – Individuals buying and selling on the floor of an organized exchange.
FOREIGN EXCHANGE MARKET –A market comprising of a network of dealers and brokers who are buying and selling
foreign currencies.
FORWARD RATE – Interest rate agreed to at a point in time at which the settlement will be made in the future.
FORWARD CONTRACT – A contract that obligates you to buy (if you buy the contract) or sell (if you sell a contract) at
a given time. There are no interim cash flows associated with a forward contract.
FUNDAMENTAL ANALYSIS – It is a form of security analysis to determine the intrinsic value of the share. It is based on
economic factors, industrial factors and financial ratios. These are compared to current market price.
FUNDAMENTAL BETA – An estimate of the beta factor for an individual security that employs information about the nature
of the company issuing the security (earnings stability, financial leverage, etc) in addition to the past relationship
between the security’s returns and the market portfolio.
FUTURES CONTRACT- It is similar to a forward contract except that futures contracts are traded on organized exchanges,
and the futures price is amended from period to period to keep the current market value of the contract at zero.
GLOBALMINIMUM VARIANCE PORTFOLIO – The lowest-variance portfolio achievable, given a population of securities.
GROWTH HORIZON – Length of time that the growth rate in earnings or dividends for a particular stock can be considered
in the valuaton process.
HEDGE – Transaction made with the intention of eliminating risk.
HEDGER – is a person whose main objective is to eliminate loss in futures contracts by offsetting his risky position through
price difference in different markets.
HOLDING-PERIOD RETURN – The rate of return of an investment over the length of time – (holding period) in which
money has been invested.
IMMUNIZATION CURVE – Curve showing the duration of liabilities for different values of the discount rate.
IN THE-MONEY OPTION – A call (put) option where the underlying asset value is greater (less) than the present value
of its exercise price.
INCOME EFFECT OF A CHANGE IN THE MONEY SUPPLY – Change in real rate of interest moving in the same direction
as the change in the money supply.
INDENTURE – It is a legal relationship between bond issuer and bond holder.
INDEX ARBITRAGE – Taking a simultaneous hedge position in stock index futures and a cash position in the index itself
to take advantage of pricing of the futures contract.
INDEX FUND – A diversified portfolio of financial asset prepared according to specific market index.
INDIFFERENCE CURVE – Curve tracing portfolios defined in terms of expected return, standard deviation and risk
showing investors preference of satisfaction level.
INFLATION – It is the rate of change in price index over a certain period of time. It generally shows a rise in prices.
INFLATION PREMIUM – The difference between the nominal and real rates of interest. The inflation premium compensates
investors for the loss of purchasing power due to inflation.
INITIAL MARGIN REQUIREMENT – Minimum percentage that the investor ranges out of his own funds.
INITIAL PUBLIC OFFERING (IPO) – The first offer of shares by a company to the general public.
INSIDER – A person who has access to unpublished price sensitive information as he is connected to the company as an
employee, director, officer or relative of owners of the business.
INSTITUTIONAL INVESTOR – Banks, Insurance Companies, Mutual Funds. These are large investor of securities.
INTEREST IMMUNIZATION – An investment strategy that ensures that a portfolio will generate sufficient cash flows to meet
a series of cash payments having the same present value as the portfolio.
INTEREST RATE SWAP – A contract between two agents where one pays the other a stream of fixed cash flows and
receives varying cash flows.
INTERNAL YIELD – The rate that will discount the cash flows associated with an investment to a present value of the
investment. The internal rate of return relates beginning to ending wealth levels if you assume that cash flows can
be reinvested at the internal yield when received.
IN THE MONEY – A call option where exercise price is less than current market price of its underlying asset. In a put option
where exercise price is greater than current market prices of an underlying asset.
INTRINSIC VALUE OF AN OPTION – Market price of the asset in which a call option is written less than the exercise price
of the option. In a put option exercise price is less than market price of the asset
INVESTMENT COMPANY – is a financial intermediary which collects money from investors by issuing shares and purchases
financial assets in the market.
JANUARY EFFECT – Market anomaly whereby stock prices in most of the stock exchanges in the world have a propensity
to rise sharply during the month of January.
JENSEN INDEX – Risk-adjusted measure of portfolio performance given its risk and its designated position on the security
market line.
GLOSSARY 433
JOINT PROBABILITY DISTRIBUTION – Distribution showing the probabilities of a simultaneously getting various pairs of
returns on two investments.
LIMIT ORDER – A trading order or a price limit given by the investor to the broker to execute an order.
LISTED SECURITY – A security which is registered with SEBI and on the stock exchange for trading.
LOAD CHARGE – A small fees charged by a mutual fund to an investor.
LOCKED-IN EFFECT – Propensity for the investors to hold on securities on which they have accrued capital gains in order
to avoid realizing them for tax purposes.
LONG POSITION – A contract to buy securities in the market.
MACAULAY DURATION – Duration is a measure of responsiveness of market value to a change in interest rates.
MARGIN ACCOUNT – An amount maintain by an investor with a brokers firm in which he purchases and sell securities
by borrowing a small amount on the purchase price from the broker/Selling short by borrowing securities.
MARGINAL PROBABILITY DISTRIBUTION – Distribution which shows the probabilities of getting various rates of return
on a particular investment.
MARKED TO THE MARKET – Margin calculated on an investor account daily and adjusting the equity to reflect changes
in the market value of assets and liabilities in his account.
MARKET INDEX – A collection of securities averaged to reflect the overall investment of financial assets.
MARKET EFFICIENCY – The extent to which the market prices securities so as to reflect available information pertaining
to their valuation.
MARKET-MAKER – A person who facilitates trading of financial assets. He profits between buying and selling prices of
securities.
MARKET PORTFOLIO – The ultimate market index, containing a common fraction of the total market Value of every
capital investment in the economic system.
MARKET RISK – It is also called systematic risk. It cannot be controlled as it depends on the forces of demand and supply.
MATURITY DATE – The date on which the principal of the bond has to be paid.
MINIMUM VARIANCE ZERO BETA PORTFOLIO – The portfolio in the minimum variance set that is completely uncorrelated
with the market index.
MONEY MARKET – A financial market with a short term maturity.
MORTGAGE BOND – A bond secured by the pledge of a specific property.
MULTI-INDEX MODEL – Model purporting to explain the covariances that exist between securities on the basis of unexpected
changes over time in two or more indices, such as the market, the money supply, or the growth rate in industrial
production.
MULTISTAGE GROWTH MODEL – Dividend discount model in which growth in dividends is expected to change in one
or more stages.
MUNICIPAL BOND – A bond issued by a state or municipality, the interest income of which is usually exempt from
taxation. A bond backed by the full faith and credit of the issuing state or municipality.
MUTUAL FUNDS – A portfolio of securities owned collectively by a group of investors called unit holders. To invest in
securities on behalf of unit holders.
NAKED CALL WRITING – Writing a call option on a stock that the option holder does not own.
NATIONAL ASSOCIATION OF SECURITIES DEALERS AUTOMATED QUOTATIONS (NASDAQ) – It connects dealers and
brokers only over the counter market . it also provide current market price quotes to market participants.
NET ASSET VALUE – The market vale of a mutual funds assets minus liabilities divided by number of shares outstanding.
NIFTY– Its full name is S&P CNX NIFTY. It is an index of closing prices of 50 shares listed on the stock exchange.
NO-LOAD FUND – A mutual fund which does not have a load charge.
NOMINAL INTEREST RATE – The nominal rate is comprised of the real rate and the inflation premium or the expected
rate of inflation over the life of the investment.
NORMAL PROBABILITY DISTRIBUTION – Systematic, bell-shaped distribution which can be completely described on the
basis of its expected value and its variance.
ODD LOT – A number of shares which is less than the standard unit of trading. For example if a lot is of 50 shares then
9 shares would be called an odd lot.
OPEN-END INVESTMENT COMPANY- This is a mutual fund which is a managed investment company it continuously
offers new shares to the public and also has the provision of buying back it shares.
OPERATING EXPENSE RATIO – This is the percentage of management fees, administrative expenses and operating
expenses of a company.
OPTIMAL PORTFOLIO – This is the portfolio which offers satisfaction to an investor.
OPTION – An option is a contract between two investors. An option writer is the person who sells the option for a
premium. The option holder purchases the option by paying a premium. He may or may not exercise the option.
Option is an specific asset, specific price and specified time period.
OUT OF THE MONEY – In a put option when exercise price is less than market price of the underlying asset. In a call
option the exercise price is greater than the market price of the underlying asset.
OVER-THE-COUNTER MARKET (OTC MARKET) – This is a secondary market for purchase and sale of security. A trading
network of thousands of dealers in particular securities.
PAR VALUE OF STOCK – It means the Face value of share. For example a share’s face value may be ` 10 and it sells
for ` 15. Five rupees is the premium and 10 rupees is the face value.
POINT AND FIGURE CHART – A chart prepared by technical analyst showing significant changes in the price of a security.
PORTFOLIO – Portfolio is a basket of different securities selected through proper identification of asset and determining
the proportion of each asset to get the maximum value.
PORTFOLIO INSURANCE – Using option-pricing models to dynamically allocate funds between a risky portfolio and a
riskless investment to provide a lower limit to the market value of the overall position.
PORTFOLIO PERFORMANCE EVALUATION – A periodic analysis to find out the performance of a portfolio in terms of
risk and return and revision of the portfolio to get the maximum return.
PORTFOLIO WEIGHT – The fraction of your money that you invest in a particular security in the portfolio.
PREFERRED STOCK –A security with a defined, fixed, periodic claim on the income from a firm. The claim isn’t mandatory,
but it must be paid before dividends are paid on the firm’s common stock.
PRICE EFFECT OF A CHANGE IN MONEY SUPPLY – The effect of a change in the supply of money on the inflation
premium in the nominal rate of interest.
PRICE-EARNINGS RATIO – Ratio of the market price per share of a stock to its earnings per share.
PRIMARY MARKET – A new issue market is called the primary market.
PRIMARY SECURITY – Security issued to finance a real economic investment.
PRIVATE PLACEMENT – A security that is issued to a small number of investors. The terms of the offering are typically
tailored to the needs of the investors.
PROGRAM TRADING – The simultaneous purchase or sale of an entire portfolio of stocks using the Dot computerized
trading system.
PROSPECTUS – It is an official document registered with SEBI. It provides information about financial condition, nature
of business, details of the security offered. It is compulsory to be given to the purchaser of new securities.
PUT OPTION – A contract which gives the holder the right to sell a specified number of shares of stock at a given price
on or before a specified date.
PUT-CALL PARITY – Relationship between the market values of puts and calls written on the same stock, with the same
exercise price and time to maturity, that prevents the investor from making pure arbitrage profits by taking simultaneous
positions in the put, the call, and underlying stocks.
RANDOM WALK – It is a situation referred to common stock where security price changes are independent of historical
prices. The Random Walk is in the weak form of the market
REAL RATE OF INTEREST – The rate of return on an investment adjusted for changes in purchasing power. The real rate
compensates investors for delaying consumption.
REPO RATE – The rate of interest in a repurchased agreement
RESISTANCE LEVEL – A price level which resist the breach of a security.
RISK ADJUSTED PERFORMANCE MEASURE – Measure of performance which is unaffected by the risk of the portfolio
or the performance of the of the market.
RISK-RETURN TRADE-OFF – This means that additional risk must be commensurate with additional return.
SEBI – Security Exchange Board of India is the market regulator in India.
GLOSSARY 435
SECONDARY SECURITY – A security, such as a futures contract, issued by one financial investor and sold to another. The
net supply of secondary securities is zero.
SECURITY MARKET LINE – Line showing the relationship between the expected returns and betas for all portfolios and
securities under the capital asset pricing model.
SEMI-STRONG EFFICIENT MARKET HYPOTHESIS – Security prices fully reflects all information that has been made
publicly available.
SENSEX – is a sensitive index of closing prices of 30 shares listed at the Mumbai Stock Exchange.
SETTLEMENT DATE – Means the date on which the buyer pays cash to the seller. In return the seller delivers the securities
to the buyer.
SHARPE INDEX – Risk-adjusted performance measure reflecting both breadth and depth of the performance and equal to
the risk premium earned on the portfolio divided by its standard deviation.
SHORT SALE – Act of selling securities without owning them, to repurchase them at a later date, and return them to the
lender of the shares.
SINGLE-INDEX MODEL – Model, which explains the covariance between the returns on different securities on the basis
of the relationship between the returns, and a single index, which is generally the market.
SOFT FLOOR – Floor underlying the value of a call option equal to the market value of the underlying asset and the
present value of the option’s exercise price.
SPECIALIST – Individual on the floor of an organized exchange who keeps an inventory of one or more stocks and trades
with floor brokers out of that inventory.
SPOT MARKET – In a spot market there is an immediate exchange of asset by cash.
STANDARD DEVIATION – The square root of the variance. It describes the propensity to deviate from the expected value.
STOCK SPLIT – It is an increase in the number of shares held by existing share holders due to deduction in the par value
of the company’s shares.
STOP LIMIT ORDER – This is a trading order when security’s price passes the stop order then a limit order on a limit price
is created.
STOP ORDER This is also called stop loss order. It specified a stop price.
STRADDLE – Simultaneous long positions in put and call options written on the same stock with the same exercise price
and time to expiration.
STRIKING PRICE – It is the same as exercise price.
STRONG EFFICIENT MARKET HYPOTHESIS – Security prices fully reflect all information that is known including inside
information.
SUPPORT LEVEL – A price below which the price of security will not fall.
SWAP – This means that there is a exchange of cash by two parties.
SYSTEMATIC RISK – That part of a security’s variance that cannot be diversifiedThe capital asset pricing model states that
systematic risk is equal to the square of the product of the beta and the market’s standard deviation.
TECHNICAL ANALYSIS – Forecast of movement of prices based on historical prices and volume and trend of securities
through charts and diagrams as well as statistical measures.
TENDER OFFER – This offer is publically advertised describing the bid to the share holders.
TERM STRUCTURE OF INTEREST RATES – The relationship between yield to maturity and term to maturity for securities
of a given risk and tax status.
TIME-WEIGHTED RETURN – Concept of rate of return on an investment in which the portfolio is divided into units, as
with a mutual fund, and the return calculated for each unit.
THETA – The expected change in the market value of an investors options position assuming the market price of the
underlying stock remain constant.
TREASURY BILL – Security issued by the government with a short term maturity of
TREASURY BOND – Security issued by the U.S. Treasury with no maximum maturity and promising semiannual interest
payments and return of principal at maturity.
TREYNER INDEX – Risk-adjusted performance measure reflecting depth but not breadth of performance and equal to the
risk premium earned by the portfolio dividend by its beta factor.
TWO-STATE OPTION PRICING MODEL – Model valuing put and call options that assumes, in any given period of time,
two rates of return are possible for the underlying asset. The model values the option so as to give anyone hedging
with it the risk-free rate of return.
UNSYSTEMATIC RISK – This risk can be diversified as it is unique to a company or an industry.
VARIANCE – Propensity to deviate from the expected value. These are squared deviations from the expected value.
WARRANT – A contract giving the holder the right to buy a specified number of shares of a given asset at a given price.
The major difference between a warrant and a call option is that the former is a warrant and a call option is that
the former is a primary security, while the latter is a secondary security.
WEAK-FORM EFFICIENT MARKET HYPOTHESIS – Security prices fully reflect any information concerning the future of
the price series that can be obtained by analyzing the past behavior of the series.
YIELD-TO-MATURITY – The discount rate that equates the present value of future promised cash flows from the security
to the current market price of the security.
ZERO-COUPON BOND – It is a security where no interest is payable.
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APPENDICES 437
Table A-I COMPOUNDED VALUE OF AN AMOUNT i.e., CVF (r.n)
Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1,090 1.100
2 1.020 1.040 1.061 1.082 1.102 1.124 1.145 1.166 1.188 1.210
3 1.036 1.061 1.093 1.125 1.158 1.191 1.225 1.260 1.295 1.331
4 1.041 1.082 1.126 1.170 1.216 1 .262 1.311 1.360 1.412 1.464
5 1.051 1.104 1.159 1.217 1.276 1 .338 1.403 1.469 1.539 1.611
6 1.062 1.126 1.194 1.265 1.340 1 .419 1.501 1.587 1.677 1.772
7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949
8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993 2.144
9 1.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172 2.358
10 1.105 1.219 1.344 1.480 1..629 1.791 1.967 2.159 2.367 2.594
11 1.116 1.243 1.384 1.539 1.710 1.898 2.105 2.332 2.580 2.853
12 1.127 1.268 1.426 1.601 1.796 2.012 2.252 2:518 2.813 3.138
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.066 3.452
14 1.149 1.319 l.513 1.732 1.980 2.261 2 .579 2.937 3.342 3.797
15 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 4.177
16 1.173 1.373 1.605 1.873 2.188 2.540 2.952 3.426 3.970 4.595
17 1.184 1.400 1.653 1.948 2.292 2.693 3.159 3.700 4.328 5.054
18 1.196 1.428 1.702 2.025 2.407 2..854 3.380 3.996 4.717 5.560
19 1.208 1.457 1.7.53 2.107 2.527 3.026 3.616 4.316 5.142 6.116
20 1.220 1.486 1.806 2.191 2.653 3.207 3.870 4.661 5.604 6.727
21 1.232 1.516 1.860 2.279 2.786 3.399 4.140 5.034 6.109 7.400
22 1.245 1.546 1.916 2.370 2.925 3.603 4.430 5.436 6.658 8.140
23 1.257 1.577 1.974 2.465 3.071 3.820 4.740 5.8T1 7.258 8.954
24 1.270 1.608 2.033 2.563 3.225 4.049 5.072 6.341 7.911 9.850
25 1.282 1.641 2.094 2.666 3.386 4.292 5.427 6.848 8.623 10.834
30 1.348 1.811 2.427 3.243 4.322 5.743 7.612 10.062 13.267 17.449
35 1.417 2.000 2.814 3'.946 5.516 7.686 10.676 14.785 20.413 28.102
40 1.489 2.208 3.262 4.801 7.040 10.285 14.974 21.724 3tA08 45.258
45 1.565 2.438 3.781 5.841 8.985 13.764 21.002 31.920 48.325 74.354
50 1.645 2.691 4.384 7.106 11.467 18.4 19 29.456 46.900 72.888 117.386
Table A-1 FACTORS FOR COMPOUNDED VALUE OF A GIVEN AMOUNT, i.e., CVF (r%n)
Period n 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 1.110 1.120 1.130 1.140 1.150 1.160 1.170 1.180 1.190 1.200
2 1.232 1.254 1.277 1.300 1.322 1.346 1.369 1.392 1.416 1.440
3 1.368 1.405 10443 1.482 1.521 1.561 1.602 1.643 1.685 1.728
4 1.518 1.574 1.630 1.689 1.749 1.811 1.874 1.939 2.005 2.074
5 1.685 1.762 1.842 1.925 2.011 2.100 2.192 2.288 2.386 2.488
6 1.870 1.974 2.082 2.195 2.313 2.436 2.565 2.700 2.840 2.986
7 2.076 2.211 2.353 2.502 2.660 2.826 3.001 3.185 3.379 3.583
8 2.305 2.476 2.658 2.853 3.059 3.278 3.511 3.759 4.021 4.300
9 2.558 2.773 3.004 3.252 3.518 3.803 4.108 4.435 4.785 5.160
10 2.839 3.106 3.395 3.707 4.046 4.411 4.807 5.234 5.695 6.192
11 3.152 3.479 3.836 4.226 4.652 5.117 5.624 6.176 6.777 7.430
12 3.498 3.896 4.335 4.818 5.350 5.936 6.580 7.288 8.064 8.916
13 3.883 4.363 4.898 5.492 6.153 6.886 7.699 8.599 9.596 10.699
14 4.310 4.887 5.535 6.261 7.076 7.988 9.007 10.147 11.420 12.839
15 4.785 5.474 6.254 7.138 8.137 9.266 10.539 11.974 13.590 15,407
16 5.311 6.130 7.067 8.137 9.358 10.748 12.330 14.129 16.172 18.488
17 5.895 6.866 7.986 9.276 10.761 12.468 14.426 16.672 19.244 22.186
18 6.544 7.690 9.024 10.575 12.375 14.463 16.879 19.673 22.901 26.623
19 7.263 8.613 10.197 12.056 14.232 16.777 19.748 23.214 27.252 31.948
20 8.062 9.646 11.523 13.743 16.367 19.461 23.106 27.393 32.429 38.338
25 13.585 17.000 21.231 26.462 32.919 40.874 50.658 32.669 77.388 95.396
30 22.892 29.960 39.116 50.950 66.212 85.850 111.065 143.371 184.675 237.376
APPENDICES 439
Table A-1 FACTORS FOR COMPOUNDED VALUE OF A GIVEN AMOUNT, i.e., CVF (r%n)
Period n 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
1 1.210 1.220 1.230 1.240 1.250 1.260 1.270 1.280 1.290 1.300
2 1.464 1.488 1.513 1.538 1.562 1.588 1.613 1.638 1.664 1.690
3 1.772 1.816 1.861 1.907 1.953 2.000 2.048 2.097 2.147 2.197
4 2.144 2.215 2.289 2.364 2.441 2.520 2.601 2.684 2.769 2.856
5 2.594 2.703 2.815 2.392 3.052 3.176 3.304 3.436 3.572 3.713
6 3.138 3.297 3.463 3.635 3.815 4.001 4.196 4.398 4.608 4.827
7 3.797 4.023 4.259 4.508 4.768 5.042 5.329 5.629 5.945 6.275
8 4.595 4.908 5.239 5.590 5.960 6.353 6.767 7.206 7.669 8.157
9 5.560 5.987 6.444 6.931 7.451 8.004 8.595 9.223 9.893 10.604
10 6.727 7.305 7.926 8.549 9.313 10.086 10.915 11.806 12.761 13.786
11 8.140 8.912 9.749 10.657 11.642 12.708 13.862 15.112 16.462 17.921
12 9.850 10.872 11.991 13.215 14.552 16.012 17.605 19.343 21.236 23.298
13 11.918 13.264 14.749 16.386 18.190 20.175 22.359 24.759 27.395 30.287
14 14.421 16.182 18.141 20.319 22.737 25.420 28.395 31.961 35.339 39.373
15 17.449 19.742 22.314 25.196 28.422 32.030 36.062 40.565 45.587 51.185
16 21.113 24.084 27.446 31.243 35.527 40.357 45.799 51.923 58.808 66.541
17 25.547 29.384 33.758 38.741 44.409 50.850 58.165 66.461 75.862 86.503
18 30.912 35.848 41.523 48.039 55.511 64.071 73.869 85.071 97.862 112.454
19 37.404 43.735 51.073 59.568 69.380 80.730 93.813 108.890 126.242 146.190
20 45.258 53.357 62.820 73.864 86.736 101.720 119.143 139.380 162.852 190.047
25 117.388 144.207 176.857 216.542 264.698 323.040 393.628 478.905 581.756 705.627
30 304.471 389.748 497.904 634.820 807.793 1025.904 1300.477 1645.504 2078.208 2619.937
Table A-2 FACTORS FOR COMPOUNDED VALUE OF AN ANNUITY I.e., CVAF (r%n)
Period n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.010 2.020 2.030 2.040 2.050 2.060 2.070 2.080 2.090 2.100
3 3.030 3.060 3.091 3.122 3.152 3.184 3.215 3.246 3.278 3.310
4 4.060 4.122 4.184 4.246 4.310 4.375 4.440 4.506 4.573 4.641
5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105
6 5.152 6.308 6.468 6.633 6.802 6.975 7.153 7.336 7.523 7.716
7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8.923 9.200 9.487
8 8.286 8.583 8.892 9.214 9.549 9.897 10.260 10.637 11.028 11.436
9 9.369 9.755 10.159 10.583 11.027 11.491 11.978 12.448 13.021 13.579
10 10.462 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937
11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.531
12 12.683 13.412 14.192 15.026 15.917 16.870 17.888 18.977 20.141 21.384
13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523
14 14.947 15.974 17.086 18.292 19.599 21.015 22.550 24.215 26.019 27.975
15 16.097 17.293 18.599 20.024 21.579 23.276 25.129 27.152 29.361 31.772
16 17.258 18.639 20.157 21.825 23.657 25.673 27.888 30.324 33.003 35.950
17 18.430 20.012 21.762 23.698 25.840 28.213 30.840 33.750 36.974 40.545
18 19.615 21.412 23.414 25.645 28.132 30.906 33.999 37.450 41.301 46.599
19 20.811 22.841 25.117 27.671 30.539 33.760 37.379 41.446 46.018 51.159
20 22.019 24.297 26.870 29.778 33.066 36.786 40.995 45.762 51.160 57.275
25 28.243 32.030 36.459 41.646 47.727 54.865 63.249 73.106 84.701 98.347
30 34.785 40.568 47.575 56.805 66.439 79.058 94.461 113.283 136.308 164.494
APPENDICES 441
Table A-2 FACTORS FOR COMPOUNDED VALUE OF AN ANNUITY I.e., CVAF (r%n)
Period n 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.110 2.120 2.130 2.140 2.150 2.160 2.170 2.180 2.190 2.200
3 3.342 3.374 3.407 3.440 3.473 3.506 3.539 3.572 3.606 3.640
4 4.710 4.779 4.850 4.921 4.993 5.066 5.141 5.215 5.291 5.368
5 6.288 6.353 6.480 6.610 6.742 6.877 7.014 7.154 7.297 7.442
6 7.913 8.115 8.323 8.536 8.754 8.977 9.207 9.442 9.683 9.930
7 9.783 10.089 10.405 10.730 11.067 11.414 11.772 12.142 12.523 12.916
8 11.589 12.300 12.757 13.233 13.727 14.240 14.773 15.327 15.902 16.499
9 14.164 14.776 15.416 16.085 16.786 17.518 18.285 19.086 19.923 20.799
10 16.722 17.549 18.420 19.337 20.304 21.321 22.393 23.521 24.709 25.959
11 19.561 20.655 21.814 23.004 24.349 25.733 27.200 28.755 30.404 32.150
12 22.713 24.133 25.650 27.271 29.002 30.850 32.824 34.931 37.180 39.580
13 26.212 28.029 29.985 32.089 34.352 36.786 39.404 42.219 45.244 48.497
14 30.095 32.393 34.883 37.581 40.505 43.672 47.103 50.818 54.841 59.196
15 34.405 37.280 40.417 43.842 47.580 51.660 56.110 60.965 66.261 72.035
16 39.190 42.753 46.672 50.980 55.717 60.925 66.649 72.939 79.850 87.442
17 44.501 48.884 53.739 59.118 65.075 71.673 78.979 87.068 96.022 105.931
18 50.396 55.750 61.725 68.394 75.836 84.141 93.406 103.740 115.266 128.117
19 56.939 63.440 70.749 78.969 88.212 98.603 110.285 123.414 138.166 154.740
20 64.203 72.052 80.947 91.025 102.44 115.380 130.033 146.628 165.418 186.688
25 114.413 133.334 155.620 181.871 212.793 249.214 292.105 342.603 402.042 471.981
30 199.021 241.333 293.199 356.787 434.745 530.321 647.439 790.748 966.712 1181.882
Table A-2 FACTORS FOR COMPOUNDED VALUE OF AN ANNUITY i.e., CVAF (r%,n)
Period n 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.210 2.220 2.230 2.240 2.250 2.260 2.270 2.280 2.290 2.300
3 3.674 3.708 3.743 3.778 3.813 3.843 3.883 3.918 3.954 3.990
4 5.446 5.524 5.604 5.684 5.766 5.848 5.931 6.016 6.101 6.187
5 7.589 7.740 7.893 8.048 8.207 8.368 8.533 8.700 8.870 9.043
6 10.183 10.442 10.708 10.980 11.259 11.544 11.837 12.136 12.442 12.756
7 13.321 13.740 14.171 14.615 15.073 15.546 16.032 16.534 17.051 17.583
8 17.119 17.762 18.430 19.123 19.842 20.588 21.361 22.163 22.995 23.858
9 21.714 22.670 23.669 24.712 25.802 26.940 28.129 29.369 30.664 32.015
10 27.274 28.657 30.113 31.643 33.253 34.945 36.723 38.592 40.556 42.619
11 34.001 35.962 38.039 40.238 42.566 45.030 47.639 50.399 53.318 56.405
12 42.141 44.873 47.787 50.985 54.208 57.738 61.501 65.510 69.780 74.326
13 51.991 55.745 59.778 64.110 68.760 73.750 79.106 84.853 91.016 97.624
14 63.909 69.009 74.528 80.496 86.949 93.925 101.465 109.612 118.411 127.912
15 78.330 85.191 92.669 100.815 109.687 119.346 129.860 141.303 153.750 167.285
16 95.779 104.933 114.983 126.011 138.109 151.375 165.922 181.868 199.337 218.470
17 116.892 129.019 142.428 157.253 173.636 191.733 211.721 233.791 258.145 285.011
18 142.439 158.403 176.187 195.994 218.045 242.583 269.885 300.252 334.006 371.514
19 173.351 194.251 217.710 244.033 273.556 306.654 343.754 385.323 431.868 483.968
20 210.755 237.986 268.783 303.601 342.945 387.384 437.568 494.213 558.110 630.157
25 554.230 650.944 764.596 898.092 1054.791 1238.617 1454.180 1706.803 2002.608 2348.765
30 1445.111 1767.044 2160.459 2640.916 3227.172 3941.953 4812.891 5873.231 7162.785 8729.805
APPENDICES 443
Table A-3 FACTORS FOR PRESENT VALUE OF A FUTURE AMOUNT, i.e., PAF (r%,n)
Period n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.889 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.838 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.276 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149
25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092
30 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057
Table A-3 FACTORS FOR PRESENT VALUE OF A FUTURE AMOUNT, i.e., PVF (r%,n)
Period n 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.226 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026
25 0.074 0.059 0.047 0.038 0.030 0.024 0.020 0.016 0.013 0.010
30 0.044 0.033 0.026 0.020 0.015 0.012 0.009 0.007 0.005 0.004
APPENDICES 445
Table A-3 FACTORS FOR PRESENT VALUE OF A FUTURE AMOUNT, i.e., PVF (r%,n)
Period n 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
1 0.826 0.820 0.813 0.806 0.800 0.794 0.787 0.781 0.775 0.769
2 0.683 0.672 0.661 0.650 0.640 0.630 0.620 0.610 0.601 0.592
3 0.564 0.551 0.537 0.524 0.512 0.500 0.488 0.477 0.466 0.455
4 0.460 0.451 0.437 0.423 0.410 0.397 0.384 0.373 0.361 0.350
5 0.386 0.370 0.355 0.341 0.328 0.315 0.303 0.291 0.280 0.269
6 0.319 0.303 0.289 0.275 0.262 0.250 0.238 0.227 0.217 0.207
7 0.263 0.249 0.235 0.222 0.210 0.198 0.188 0.178 0.168 0.159
8 0.218 0.204 0.191 0.179 0.168 0.157 0.148 0.139 0.130 0.123
9 0.180 0.167 0.155 0.144 0.134 0.125 0.116 0.108 0.101 0.094
10 0.149 0.137 0.126 0.116 0.107 0.099 0.092 0.085 0.078 0.073
11 0.123 0.112 0.103 0.094 0.086 0.079 0.072 0.066 0.061 0.056
12 0.102 0.092 0.083 0.076 0.069 0.062 0.057 0.052 0.047 0.043
13 0.084 0.075 0.068 0.061 0.055 0.050 0.045 0.040 0.037 0.033
14 0.069 0.062 0.055 0.049 0.044 0.039 0.035 0.032 0.028 0.025
15 0.057 0.051 0.045 0.040 0.035 0.031 0.028 0.025 0.022 0.020
16 0.047 0.042 0.036 0.032 0.028 0.025 0.022 0.019 0.017 0.015
17 0.039 0.034 0.030 0.026 0.023 0.020 0.017 0.015 0.013 0.012
18 0.032 0.028 0.024 0.021 0.018 0.016 0.014 0.012 0.010 0.009
19 0.027 0.023 0.020 0.017 0.014 0.012 0.011 0.009 0.008 0.007
20 0.022 0.019 0.016 0.014 0.012 0.010 0.008 0.007 0.006 0.005
25 0.009 0.007 0.006 0.005 0.004 0.003 0.003 0.002 0.002 0.001
30 0.003 0.003 0.002 0.002 0.001 0.001 0.001 0.001 0.000 0.000
Table A-4 FACTORS FOR PRESENT VALUE OF FUTURE ANNUITY, i.e., PVAF (r%,n)
Period n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.783 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.312 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.789 5.582 5.389 5.206 5.033 4.868
8 7.652 7.326 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.858 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.746 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.560 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.002
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.362 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514
25 22.023 19.524 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077
30 25.808 22.397 19.601 17.292 15.373 13.765 12.409 11.258 10.274 9.427
APPENDICES 447
Period n 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.850 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.487 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.303 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.669 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.893 7.366 6.938 6.500 6.198 5.877 5.585 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870
25 8.422 7.843 7.330 6.873 6.464 6.097 5.766 5.467 5.195 4.948
30 8.694 8.005 7.496 7.003 6.566 6.177 5,829 5.517 5.235 4.979
Period n 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
1 0.826 0.820 0.813 0.806 0.800 0.794 0.787 0.781 0.775 0.769
2 1.509 1.492 1.474 1.457 1.440 1.424 1.407 1.392 1.376 1.361
3 2.074 2.042 2.011 1.981 1.952 1.923 1.896 1.868 1.842 1.816
4 2.540 2.494 2.448 2.404 2.362 2.320 2.280 2.241 2.203 2.166
5 2.926 2.864 2.803 2.745 2.689 2.635 2.583 2.532 2.483 2.436
6 3.245 3.167 3.092 3.020 2.951 2.885 2.821 2.759 2.700 2.643
7 3.508 3.416 3.327 3.242 3.161 3.083 3.009 2.937 2.868 2.802
8 3.726 3.619 3.518 3.421 3.329 3.241 3.156 3.076 2.999 2.925
9 3.905 3.786 3.673 3.566 3.463 3.366 3.273 3.184 3.100 3.019
10 4.054 3.923 3.799 3.682 3.570 3.465 3.364 3.269 3.178 3.092
11 4.177 4.035 3.902 3.776 3.656 3.544 3.437 3.335 3.239 3.147
12 4.278 4.127 3.985 3.851 3.725 3.606 3.493 3.387 3.286 3.190
13 4.362 4.203 4.053 3.912 3.780 3.656 3.538 3.427 3.322 3.223
14 4.432 4.265 4.108 3.962 3.824 3.695 3.573 3.459 3.351 3.249
15 4.489 4.315 4.153 4.001 3.859 3.726 3.601 3.483 3.373 3.268
16 4.536 4.357 4.189 4.033 3.887 3.751 3.623 3.503 3.390 3.283
17 4.576 4.391 4.219 4.059 3.910 3.771 3.640 3.518 3.403 3.295
18 4.608 4.419 4.243 4.080 3.928 3.786 3.654 3.529 3.413 3.311
19 4.635 4.442 4.263 4.097 3.942 3.799 3.664 3.539 3.421 3.311
20 4.657 4.460 4.279 4.110 3.954 3.808 3.673 3.546 3.427 3.316
25 4.721 4.514 4.323 4.147 3.985 3.834 3.694 3.564 3.442 3.329
30 4.746 4.534 4.339 4.160 3.995 3.842 3.701 3.569 3.447 3.332
INDEX
A Contact Note
Contango
Accelerator Clause
Conversion Value
Alpha
Convertible Bonds
Arbitrageur
Cornering
Arbitrage
Correlation Co-efficient
Arbitrage Process
Covariance
Assumed Bonds
Covenants
B Coupon Rates
Cum Dividend
Badla Cut Off Rate
Badliwala
Bear D
Beta
Debenture Bonds
Blank Transfer
Depositories
Bodenhorn's Model
Depreciation
Bombay on Line Trading (BOLT)
Development Banks
Bond Indenture
Diversification
Bonds
Dividend
Bought Out Deals
Dividend Policies
Brokers
Dow Theory
Bull
Dual Funds Company
Business Risk
Buyback of Shares E
C Earning Model
Earning Yield
Call
Eclectic Theory
Call Money Market
Efficient Market Theory
Cal Option
Equity Shares
Capitalization
Ex-Dividend
Capital Asset Pricing Model
Ezra Solomon's Model
Capital Gains
Capital Issues control F
Capital Market Theory
Face Value
Carry over
Filter Test
Central Tendency Charts
Financial Guarantees
Clearing House
Financial Markets
Closed End
Financial Risk
Commercial Banks
Floor Broker
Commercial Bills Markets
Foreign Bonds
Common Stock Valuation
Foreign Exchange Market
Confidence Index
Foreign Institutional Investors (FII's)
Confirmation
Formula Plans
Constant Growth
Forward Contacts
Constant Ratio Plan
Full Covariance Model
Constant Rupee Value Plan
449
Fundamental Analysis M
Fundamental Approach
Management Portfolio
G Mandiwalla
Margin Money
General Insurance Corporation
Marketing
Gordon's Model
Market Reaction Test
Government Securities
Market Risk
Government (Gift Edged) Securities Market
Market Segmentation
Graham Dodd
Market Value
Guaranteed Bonds
Markowitz Theory
H Maturity Value
Member Stock Exchange
Hand Delivery Merchant Banker
Head M M Hypothesis
Hedging M M Model
Holding period yield Mortgage Bonds
Hybrid Mortgage Market
Moving Average Analysis
I
Multiple Year Holding Period
ICICI Multiplier Approach
Income Bonds Mutual Funds
Income from Other Sources
Income Groups N
Index Futures National Saving Scheme
Industries Development Bank of India (IDBI) National Stock Exchange
Industrial Finance Corporation New Issue Market
Industrial Securities Market Non Convertible Debentures
Interest Rate Risk
Internal Diversification O
Intrinsic Value
Odd Lot Dealers
Investor
Odd Lot Theory
Investment
Offer for Sale
Investment Analysis
Open End Investment Companies
Investment Companies
Optimal Portfolio
Investment Media
Options
Investment Policy
Order
Investment Program
Origination
Investment Value
Over The Trading Counter
J P
Jensen's Model
Par Value
Joint Bonds
Placement
Jobber
Portfolio
L Portfolio Revision
Portfolio Analysis
Lame Duck Portfolio Theory
Left Shoulder Post Office Scheme
Legislation Pools
Leverage Preference Share
Life Insurance Promissory Notes
Life Insurance Corporation Property
Limit Orders Provident Funds
Listed Securities Public Issue
Public Sector Bonds
Purchasing Power Risk
Put Option
INDEX 451
R Stock Splits
Straddle
Random Walk Theory
Strong Form
Ratios
Strike Price
Relative Strength
Swaps
Registered Bonds
Systematic Risk
Reserve Bank of India
Stock Market Indices
Return
Rho T
Rigging
Taraniwalla
Right Issues
Tax Planning
Right Shoulder
Technical Analysis
Risk
Technical Model
Risk Group
Time
Run Test
Trading Value
Rupee Average
Treasury Bill Market
S Treyner's Model
Securities Exchange Board (SEBI) U

Securities Market
Unbiased Expectations Theory
Security Dealers
Uncertainty
Security Trading
Underwriting
Security Market Line
Unsystematic Risk
Semi Strong Form
Unit Trust of India
Separation Theorem
Serial Bonds V
Serial Correlation Test
Settlement Valuation Model
Shares Valuation Share
Sharpe's Model Variable Ratio Plan
Short Sales Volatility
Simulation Test
W
Single Index Model
Sinking Fund Walters Model
Sinking Fund Bonds Warrants
Special Delivery Wash Sales
Spot Order Weak Form
Spread Williams Model
Stag
Standard and Poor's
Y
Standard Deviation Yields
State Financial Corporation Yield on Bond
Stock Exchange Market
Stock Certificates Z
Stock Dividends Zero Interest Bond
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INVESTMENT

NINETEENTH REVISED EDITION : 2015

MUMBAI z NEW DELHI z NAGPUR z BENGALURU z HYDERABAD z CHENNAI z PUNE z LUCKNOW

First Edition : 1988 Tenth Revised Edition : 2002

Dr. PREETI SINGH

2. FINANCIAL INSTITUTIONS AND MARKETS IN INDIA 14–53

3. INDIAN SECURITIES MARKET 54–91

4. SECURITIES EXCHANGE BOARD OF INDIA 92–99

9. SECURITY VALUATION 183–228

10. ALTERNATIVE FORMS OF INVESTMENT 229–253

11. DIVIDEND POLICIES AND THE INVESTOR 254–283

12. INVESTOR AND INTEREST RATES 284–292

13. FUNDAMENTAL ANALYSIS 293–320

14. TECHNICAL ANALYSIS 321–332

15. EFFICIENT MARKET THEORY 333–343

16. PORTFOLIO ANALYSIS 344–379

17. PORTFOLIO SELECTION AND INTERNATIONAL DIVERSIFICATION 380–401

18. TECHNIQUES OF PORTFOLIO REVISION 402–411

19. PERFORMANCE MEASUREMENTS OF MANAGED PORTFOLIOS 412–428

1.2 WHAT IS INVESTMENT?

1.3 FINANCIAL AND ECONOMIC MEANING OF INVESTMENT

1.4 INVESTMENT AND SPECULATION

Table 1.1 DISTINCTION BETWEEN INVESTMENT AND SPECULATION

1.5 INVESTMENT AND GAMBLING

1.6 INVESTMENT AND ARBITRAGE

1.7 REAL AND FINANCIAL ASSETS

Table 1.2 DISTINCTION BETWEEN REAL AND FINANCIAL ASSETS

Real Assets Financial Assets

1.8 WHY IS INVESTMENT IMPORTANT?

1.9 FACTORS FAVOURABLE FOR INVESTMENT

3. Existence of Financial Institutions and Services

6. Risk-less Vs Risky Investments

1.10 INVESTMENT MEDIA

Table 1.3 INVESTMENT MEDIA

Direct Investment Alternatives Indirect Investment Alternatives

1.11 FEATURES OF AN INVESTMENT PROGRAM

5. Legality and Freedom from Care

Table 1.4 FEATURES OF INVESTMENT AVENUES

Particulars Risk Return Capital Liquidity/ Tax benefit

Equity Shares High Low High High High

1.12 THE INVESTMENT PROCESS – STAGES IN INVESTMENT

Table 1.5 THE INVESTMENT PROCESS

Investment Policy Determination of investible wealth. Determination of portfolio objectives.

Analysis of Industries Consideration of debentures, equity shares, quantitative analysis

OBJECTIVE TYPE QUESTIONS

FINANCIAL INSTITUTIONS AND

2.1 BACKGROUND OF THE FINANCIAL SYSTEM

2.2 FINANCIAL SYSTEM: AN INTRODUCTION

2.3 LEGISLATIVE MEASURES

2.4 STRUCTURE OF THE FINANCIAL MARKETS

¾ Industrial Securities Market

Table 2.1 ORGANIZED AND UNORGANIZED MARKET

Organized Market Unorganized Market

Control of a recognized controller ex; SEC. No control on transactions as no rules operate.

1. Treasury Bills Market

6. Foreign Exchange Market

Table 2.2 MONEY MARKET AND CAPITAL MARKET

Money Market Capital Market

(iii) Commodity Markets

2.5 IMPORTANT STOCK MARKETS IN INDIA

2.6 FINANCIAL INSTITUTIONS

Table 2.3 STRUCTURE OF BANKS IN INDIA

STRUCTURE OF BANKS IN INDIA