Fundamentals of Investment - Vanita Tripathi

Dedicated to my parents
Late Shri N.P. Tripathi

&
Late Smt. Soubhagya Laxmi Tripathi
© All rights reserved
Fourth Edition : December 2019
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Preface to Fourth Edition
Investment is a skill and mastering its tools and techniques requires lots
of efforts in this VUCA (Volatile, Uncertain, Complex and Ambiguous)
environment surrounding investment. Investment in financial assets has seen
unprecedented growth especially in the last two decades despite turbulent
financial environment. Growth in securities market has been parallel to
the growth of economy. A larger portion of household savings is now being
invested in financial instruments to provide the much needed capital for
growth. Securities markets have also witnessed a number of innovations in
terms of innovative financial products, innovative financial practices and
conducive policies at domestic and global level.
The main motivation of writing this book has been my students, many of
them are now teachers and investment professionals. I have been teaching
the paper of Security Analysis and Portfolio Management at post graduate
level for about 18 years and doing research in various areas of Investment
management including market efficiency, stock market anomalies, mutual
funds, derivatives, socially responsible investing etc.
The present book “Fundamentals of Investments” is written with objective
of providing the user a comprehensive understanding of the investment
environment and investment decision process. It explains various concepts,
tools and techniques related with investment in financial assets with lively
examples and suitable illustrations. The focus of the book is investment
management. There is a comprehensive discussion on the concept of risk and
returns, their sources and measurement, valuation of securities, approaches
to security valuation, portfolio analysis, selection and management including
performance evaluation. The book takes to the reader on a journey of
investment process.
The book comprises of 12 chapters :
Chapters 1 & 2 discusses the investment environment. The entire discussion
presented in Chapters 1 and 2 revolves around the types of investment
I-5
Preface to fourth edition I-6
alternatives, risk return trade off and structure and trading in Indian
Securities Market. Special attention has been given to the role of SEBI and
prohibition of Insider Trading. Latest developments like Algorithmic Trading
and Direct Market Access are also discussed along with the reforms initiated
in the past three decades. The updated information in Chapter 2 is provided.
Chapter 3, Security Analysis, provides at one place the concepts and
measurement of various types of returns and risks in financial investment.
The reader will definitely have an enriching experience and will have a better
understanding of risk and returns concepts which are largely misunderstood.
Chapter 4, presents a comprehensive explanation of fixed income securities,
various types of fixed income securities, valuation of bonds and convertible
debentures, and various types of bond yields. Advanced concepts such as
Bond Duration and Immunisation have also been discussed.
Chapters 5 to 8 provide various approaches to equity analysis such as -
Fundamental analysis, Technical analysis and Efficient Market Hypothesis
with suitable examples. An attempt has been made to provide the necessary
skills and tools for Fundamental Analysis as well as Technical Analysis. The
reader can apply these models and tools and techniques in real life decisions.
Equity valuation models have also been explained with suitable illustrations.
Chapters 9 & 10 deal with portfolio management & portfolio analysis,
portfolio construction and portfolio selection. Capital market theory
is also elaborated. Further these provide detailed explanation of
CAPM (Capital Asset Pricing Model), the most popular model of asset pricing in
finance as well as explanation of need and measure of portfolio performance
evaluation such as Sharpe index, Treynor’s Index and Jensen’s alpha.
Chapters 11 & 12 explain Financial Derivatives and Investor Protection in India.
The salient features of the text presented in this book are:
1. Learning outcomes - Every chapter begins with a list of learning
outcomes which the reader will achieve after successful completion
of the chapter. Its sets the broad framework for the chapter.
2. Main Text - Various concepts and techniques have been explained
in a lucid and well knit manner. Wherever required the explanation
is supplemented by suitable illustrations and examples.
3. Solved Problems - Each chapter provides sufficient number of solved
problems for better understanding and application of the concepts
explained in the main text.
4. Summary - Each chapter provides summary points to recapitulate
the concepts and tools explained in the chapter. It helps the reader
to glance over the entire discussion presented in that chapter.
I-7 Preface to fourth edition
5. Test Yourself - Every chapter provides a variety of assignments to test

the knowledge of the reader. It comprises of True/False statements,
theory questions and numerical problems.
6. Project work - The topic of Investments is very lively and the reader
may want to apply various concepts and techniques in real life. For
this “project work” is provided at the end of every chapter. Project
work helps the students and other readers of this book to actually
apply various concepts of investments in real life.
Sufficient care has been taken while preparing the manuscript for the book.
However there may be some unintentional errors. Readers are welcome
to send all comments & suggestions at vanitatripathi.dse@gmail.com
Happy reading !
Prof. Vanita Tripathi
(December 2019)
Acknowledgements
The contribution of the omnipresent, omnipotent and omniscient
invisible hand cannot be expressed in words. I can only say that my
faith in Him becomes more and more intense by each passing day.
I gratefully acknowledge the support and best wishes of my teachers and
students. Special thanks to the following colleagues in Delhi University-
Dr. Neeta Tripathi and Dr. Madhu Sehrawat (DSC), Dr. Pankaj Chaudhry,
Sh. H.N. Tiwari, Dr. Vandana Jain, Sh. Harish Kumar, Ms. Namita Jain,
Ms. Sarita Gautam and Dr. Abhay Jain (SRCC), Dr. Megha Aggarwal,
Ms. Anshika Aggarwal (Rajdhani College), Dr. Deepak Sehgal, Dr. Shalini
Bhatia, Dr. Renu Aggarwal (DDU), Dr. Loveleen Gupta (Hindu College),
Dr. Bhawna Rajput, Ms. Nitu Dabas (AMV), Dr. V.K. Arora, Dr. Naresh
Dhawan (ARSD College), Dr. Sushma Bareja DSC(E), Dr. Renu Aggarwal,
Ms. Renu Yadav, Ms. Mandeep Kaur, Ms. Priyanka (SPM), Dr. Manju
Tanwar (SBSC), Dr. Phoolchand, Dr. Shuchi Pahuja, Sh. Ramesh
Kumar (PGDAV College), T. Jeya Christy (I.P. College), Dr. Vipin Kumar
(AUR), Dr. Vibha Jain (JDM), Dr. Vidisha Garg (Maitreyi), Dr. Gurmeet
Bakshi (JMC), Ms. Sonia Kamboj (Kalindi), Dr. Shalini Pawar (KMV),
Dr. Rajnikant Verma [ZHC(E)], Dr. Sadhna Gupta (ANDC), Dr. Mansi
Bansal, Dr. Sukhvinder Singh, Dr. T. Venugopala [SGTB(D)], Mrs.
Deepa Garg (CVS), Dr. B.R. Sachdeva (DBC), Dr. Vandana Gupta,
Dr. Abha Wadhwa (DDU), Dr. V.K. Aggarwal, Dr. Kavita Arora (SLC),
Dr. Gurcharan Singh), Dr. S.S. Lamba, Dr. Harvinder Kaur, Sh. Balkrishan
(SGGSCC), Dr. Sonali Dua (Gargi College), Dr. Sonal Sharma (Hansraj),
Dr. Anupama Rajput (JDM), Dr. Sarika Bhatnagar, Dr. Janaki (LBC),
Dr. Alka Agarwal (KNC), Dr. Sunaina Sardana (LSR), Dr. Nirmal Jain (MAC),
Dr. Monika Gupta, Ms. Rashmi Shingh (MLN), Dr. G.K. Arora (SGND),
Mrs. Priti Rai (SPM), Dr. Shruti Mathur (ZHC) and Dr. G.R. Luthra (SSC),
Dr. Bawna Rajput (Aditi Mahavidyalaya).
I-9
Acknowledgements I-10
Special thanks to Ms. Priti Aggarwal, Ms. Roshni Garg and Ms. Neerza for
their help. I am also thankful to Dr. Ashu Lamba and Varun Bhandari for
their help.
The book could have never taken its present shape without the great
support and encouragement provided by my family especially my husband
Mr. Yogesh Misra. I cannot forget acknowledging my sons, Advay and
Atulya who received much less attention from their mother, during the
period of manuscript preparation, than they actually deserved.
I am grateful to the staff of Ratan Tata Library for making available
necessary reference material, help and facilities timely.
Last but not the least I am thankful to the publisher Taxmann for bringing
out this book timely.
Prof. Vanita Tripathi

Syllabus
I
B.Com. (Hons.): Semester VI
Paper: BCH-6.3 DSE Group (a):
FUNDAMENTALS OF INVESTMENT
Objective: To familiarize the students with different investment alternatives,

introduce them to the framework of their analysis and valuation and
highlight the role of investor protection.
COURSE CONTENTS
Unit I:
The Investment Environment
The investment decision process, Types of Investments-Commodities,
Real Estate and Financial Assets, the Indian securities market, the market
participants and trading of securities, security market indices, sources of
financial information. Return and risk: Concept, Calculation, Trade off
between return and risk, Impact of taxes and inflation on return.
Unit II:
Fixed Income Securities
Bond Fundamentals, Estimating bond yields, Bond Valuation, Types of
bond risks, default risk and credit rating.
Unit III:
Approaches to Equity Analysis
Fundamental Analysis, Technical Analysis and Efficient Market Hypothesis
Valuation of Equity Shares using various models.
I-11
SYLLABUS I-12
Unit IV:
Portfolio Analysis and Financial Derivatives
(a) Portfolio and Diversification, Portfolio Risk and Return (b) Mutual Funds
(c) Introduction to Financial Derivatives-Forwards, Futures & Options,
Financial Derivatives Markets in India.
Unit V:
Investor Protection
Role of SEBI and stock exchanges in investor protection; Investor grievances
and their redressal system, insider trading, investors’ awareness and activism.
Spreadsheet is the recommended software for doing basic calculations
in finance and hence can be used for giving students subjects related
assignments for their internal assessment purposes.
II
B.Com. : Semester VI
Paper BC 6.2 (e): Fundamentals of Investment
Objective: To familiarize the students with different investment alternatives,

introduce them to the framework of their analysis and valuation and
highlight the role of investor protection.
COURSE CONTENTS
Unit I:
The Investment Environment
The investment decision process, Savings, Investment and Speculation,
Types of Investments-Commodities, Real Estate and Financial Assets, the
Indian securities market, the market participants and trading of securities,
security market indices, sources of financial information, Concept of return
and risk: Calculation, Tradeoff between return and risk, impact of taxes
and inflation on return.
Unit II:
Fixed Income Securities
Bond Fundamentals, Estimating bond yields, Bond Valuation, Types of
bond risks.
I-13 SYLLABUS
Unit III:
Approaches to Equity Analysis
Fundamental Analysis, Technical Analysis and Efficient Market Hypothesis,
Valuation of Equity Shares.
Unit IV:
Portfolio Analysis and Financial Derivatives
(a) Portfolio and Diversification, Portfolio Risk and Return (b) Mutual funds
(c) Introduction to Financial Derivatives-Forwards, Futures & Options,
Financial Derivatives Markets in India.
Unit V:
Investor Protection
Role of SEBI and stock exchanges in investor protection; Investor grievances
and their redressal system, insider trading.
Spreadsheet is the recommended software for doing basic calculations
in finance and hence can be used for giving students subjects related
assignments for their internal assessment purposes.
III
SCHOOL OF OPEN LEARNING,
UNIVERSITY OF DELHI
[B.COM. (HONS.)]
PAPER XX - YEAR III
FUNDAMENTALS OF INVESTMENTS
Objective : To familiarize students with different investment alternatives,

introduce them to the framework of their analysis and valuation and high-
light the role of investor protection.
COURSE CONTENTS
UNIT I:
1. The Investment Environment - The investment decision process, Types
of investments - commodities, real estate and financial assets, the Indian
securities market, the market participants and trading of securities, security
market indices, sources of financial information, concept of return and
risk, impact of taxes and inflation on return. (18 Lectures)
SYLLABUS I-14
UNIT II:
2. Fixed Income Securities - Bond features, types of bonds, estimating bond
yields, types of bond risks, default risk and credit rating. (12 Lectures)
UNIT III:
3. Approaches to Equity Analysis - Introduction to fundamental analysis,
technical analysis and efficient market hypothesis, dividend capitalisation
models, and price earnings multiple approach to equity valuation.
(20 Lectures)
UNIT IV:
4. Portfolio Analysis and Financial Derivatives - Portfolio and diversifica-
tion, portfolio risk and return, commodities, real estate, and mutual funds.
Introduction to financial derivatives, financial derivatives markets in India.
(12 Lectures)
UNIT V:
5. Investor Protection - SEBI & role of stock exchanges in investor protection,
investor grievances and their redressal system, insider trading, investors’
awareness and activism. (13 Lectures)
Chapter-heads
Page
Preface to Fourth Edition I-5

Syllabus I-11
Contents I-17
Chapter 1 Investments : An Overview 1
Chapter 2 Indian Securities Market 26
Chapter 3 Analysis of Return and Risk 75
Chapter 4 Fixed Income Securities - Valuation, Yields 134
and Risks
Chapter 5 Equity Analysis - Fundamental Analysis 207
Chapter 6 Technical Analysis 227
Chapter 7 Efficient Market Hypothesis 258
Chapter 8 Valuation of Equity Shares 270
Chapter 9 Portfolio Analysis and Selection 309
Chapter 10 Portfolio Performance Evaluation and Mutual 387
Funds
Chapter 11 Financial Derivatives - Forwards, Futures and 426
Options
Chapter 12 Investor Protection 482
B.Com. (Hons.) 2015 Paper : Fundamentals of Investment 515
B.Com. (TYUP) 2016 Paper : Security Analysis & Portfolio 525
Management
I-15
chapter-heads I-16
Page

B.Com. (H)/III/NS 2017 Paper XX : Fundamentals of 548
Investment (C-305)
B.Com. (Hons.) 2018 Sem. IV : Fundamentals of Investment 557
B.Com. 2018 Sem. VI : Fundamentals of Investment 565
B.Com. (Hons.) 2019 Sem. VI : Fundamentals of Investment 574
Mathematical Tables 591
Contents
Page
Preface to Fourth Edition I-5

Syllabus I-11
Chapter-heads I-15
Page
1
INVESTMENTS : AN OVERVIEW
Learning Outcomes 1
1.1 Investment 2
1.2 Financial Investment vs. Real Investment 2
1.3 Objectives of Investment 3
1.3.1 Features (or Factors affecting Investment) 4
1.4 Speculation 6
1.5 Risk Return Trade off 8
1.6 Investment Environment 9
1.7 Investment Decision Process 13
1.8 Direct Investing and Indirect Investing 16
1.9 Approaches to Investing - Active Investing 18
(Investment) and Passive Investing (Investment)
1.10 Diversification, Hedging and Arbitrage 19
1.11 Impact of Taxes on Investment 20
1.12 Impact of Inflation Investment 21
Summary 22
Test Yourself 22
I-17
CONTENTS I-18
Page
2
Indian Securities Market
Learning Outcomes 26
2.1 Structure of Indian Securities Market 27
2.1.1 Market Participants 27
2.1.2 Market Segments 29
2.2 Trading Mechanism on Exchanges 34
2.2.1 National Securities Clearing Corporation Limited 35
(NSCCL)
2.3 Stock Indices 37
2.4 Sources of Financial Information 41
2.4.1 Types of Information 41
2.4.2 Sources of Information 41
2.4.3 Precautions while using financial information sources 43
2.4A Regulation of Securities Market in India (SEBI) 44
2.4A.1 Reforms Introduced by SEBI 45
2.5 Latest Developments 52
2.6 Other developments in Indian stock market since 1990 54
2.6.1 Screen based trading and Online (Internet based) 54
trading system
2.6.2 Depository system, dematerialisation and scrip less 55
trading
2.6.3 Book building 59
2.6.4 Derivatives 61
2.6.5 Rolling settlement 61
2.6.6 Securities lending scheme 63
2.6.7 Regulation regarding prohibition of Insider Trading 65
2.6.8 Regulation of Unpublished Price Sensitive Informa- 67
tion
Summary 70
Test Yourself 72
3
ANALYSIS OF RETURN AND RISK
3.1 Return 77
3.2 Types of Returns and their Calculation 80
3.2.1 Average Return 80
I-19 CONTENTS
Page
3.2.2 Expected Return (Based on probability distribution) 85
3.2.3 Return of a portfolio 86
3.2.4 Holding Period Return 88
3.2.5 Limitations of HPR 88
3.2.5A Effective Annualized Return 89
3.2.6 Absolute Return 90
3.2.7 Risk-adjusted Return 90
3.3 Risk 91
3.3.1 Causes (or Sources) and Types of Risk 91
3.4 Systematic Risk 92
3.5 Unsystematic Risk 94
3.6 Types of Investors 98
3.6.1 Risk Aversion, Utility Analysis and Indifference 98
Curves
3.7 Calculation of Total Risk 101
3.7.1 Coefficient of Variation: A relative measure of Risk 103
3.8 Calculation of Systematic Risk 104
3.9 Unsystematic Risk 107
3.10 Expected Return (based on Capital Asset Pricing Model) 108
3.10.1 Abnormal Return 109
3.11 Impact of Taxes on Investment Return 109
3.12 Impact of Inflation on Return from Investment 111
Solved Problems 112
Summary 126
Test Yourself 127
Project work 133
4
FIXED INCOME SECURITIES - VALUATION,
YIELDS AND RISKS
4.1 Bond Fundamentals 135
4.2 Types of Bonds 137
4.3 Bond Valuation (or Valuation of a fixed income security) 143
4.4 Interactions between Bond Value, interest rate 150
(required rate of return) and time to maturity
4.5 Valuation of Convertible debentures 157
CONTENTS I-20
Page
4.6 Valuation of Deep Discount Bonds (or zero coupon bonds) 159
4.7 Bond Yields 160
4.8 Risks in Bonds 171
4.9 Malkiel’s Properties regarding Bond Pricing (Bond Prices, 173
interest rate (or yields) and Time to maturity)
4.10 Bond Duration (Frederick Macaulay Duration) 174
4.11 Credit Rating 177
4.11.1 Credit Rating Agencies in India 179
4.11.2 Credit Rating Methodology 181
4.11.3 Advantages of Credit Rating Agencies 182
4.11.4 Limitations of Credit Rating Agencies 183
Solved Problems 184
Summary 198
Test Yourself 199
Project work 206
5
EQUITY ANALYSIS - Fundamental Analysis
5.1 Approaches to Security Analysis 208
5.2 Fundamental Analysis 210
5.3 EIC Framework 211
5.3.1 Economic Analysis 211
5.3.2 Industry Analysis 214
5.3.3 Company Analysis 217
Summary 224
Test Yourself 225
Project work 226
6
TECHNICAL ANALYSIS
6.1 Technical Analysis 228
6.2 Difference between Fundamental Analysis and Technical Analy- 228
sis
I-21 CONTENTS
Page
6.3 Basic Tenets (Propositions) of Technical Analysis 230
6.4 Tools of Technical Analysis 231
6.4.1 Charts 231
6.4.2 Technical Indicators and Technical Chart Patterns 236
6.5 Specific Stock Indicators 245
6.6 Limitations of Technical analysis 253
Summary 254
Test Yourself 255
Project work 257
7
EFFICIENT MARKET HYPOTHESIS
7.1 Random Walk Theory (RWT) 259
7.2 Efficient Market Hypothesis 259
7.3 Forms of Market Efficiency 260
7.3.1 Weak Form Hypothesis 260
7.3.2 Semi Strong Form 261
7.3.3 Strong Form of Market Efficiency 262
7.4 Implications of EMH 262
7.5 Tests of Market efficiency 263
Summary 267
Test Yourself 268
Project work 269
8
VALUATION OF EQUITY SHARES
8.1 Peculiar features of Equity shares 271
8.2 Valuation of Equity share 272
8.2.1 Discounted Cash Flow Models’ Dividend Discount 272
Models
8.2.2 Earnings Multiplier Approach or Price-Earnings Mod- 284
el (P/E based model) for share valuation
8.2.3 Capital Asset Pricing Model (CAPM) 288
CONTENTS I-22
Page
Solved Problems 289
Summary 302
Test Yourself 302
Project work 307
9
PORTFOLIO ANALYSIS AND SELECTION
9.1 Portfolio Management Process 310
9.2 Portfolio Analysis - Markowitz Model 313
9.2.1 Portfolio return 313
9.2.2 Portfolio risk 314
9.2.3 Limitation of Markowitz Model of Portfolio Analysis 316
9.3 Portfolio Selection 328
9.3.1 Portfolio Theory of Harry Markowitz (1952) or Mean 329
Variance Optimisation Model
9.3.2 Capital Market Theory 334
9.3.3 From Capital Market Theory to Capital Asset Pricing 340
Model (CAPM)
9.4 Capital Asset Pricing Model 344
9.5 SML and CML 351
9.6 Uses of CAPM 352
9.7 Criticism/Limitations of CAPM 352
Solved Problems 353
Summary 380
Test Yourself 381
Project work 386
10
Portfolio Performance Evaluation
and Mutual Funds
10.1 Portfolio Performance Evaluation 388
10.2 Risk Adjusted Measures or techniques for Evaluating Perfor- 389
mance of Portfolios
I-23 CONTENTS
Page
10.3 Mutual Funds 395
10.4 Evolution of Mutual Funds in India 396
10.5 Mutual Fund Schemes 400
10.6 Latest Developments Regarding Mutual Funds 405
10.7 Evaluating Performance of Mutual Funds 410
Solved Problems 414
Summary 420
Test Yourself 420
11
Financial Derivatives - Forwards,
Futures and Options
11.1 Introduction to Derivatives 426
11.2 Classification of Derivatives 427
11.3 Participants (or Traders) in Derivatives Market 428
11.4 Forwards 429
11.5 Futures 431
11.5.1 Futures contract terminology 432
11.5.2 Comparison between forwards and futures 433
11.5.3 Types of financial futures contracts 433
11.5.4 Pricing (or valuation) of futures contract (or a for- 435
ward contract)
11.6 Options 438
11.7 Financial Derivatives Market in India 462
Solved Problems 465
Summary 476
Test Yourself 477
12
Investor Protection
12.1 Role of Sebi in investor Protection 483
12.2 Investor’s Grievances and Redressal System of sebi 484
12.3 Scores (sebi Complaints Redress System) 486
CONTENTS I-24
Page
12.4 Securities Ombudsman 488
12.4.1 Grounds of complaints 489
12.5 Other Regulators/Authorities to approach for complaints 490
other than those dealt by SEBI
12.6 Reforms brought up by SEBI 491
12.6.1 Amendments in Listing Agreement 491
12.6.2 Regulation regarding prohibition of Insider Trading 495
12.6.3 Regulation of Unpublished Price Sensitive Informa- 497
tion
12.7 Investors’ Awareness 500
12.7.1 SEBI Investor Protection and Education Fund 502
12.8 Role of Stock Exchanges in Investor Protection 504
12.8.1 BSE initiatives for Investor Protection 504
12.8.2 NSE initiatives for Investors’ Protection 507
12.9 Investors’ Activism 509
12.9.1 Investors’ Activism in India 510
Summary 512
Test Yourself 512
B.Com. (TYUP) 2016 Paper : Security Analysis & Portfolio 525
Management
B.Com. (H)/III/NS 2017 Paper XX : Fundamentals of Investment 548
(C-305)
B.Com. (Hons.) 2018 - Sem. VI : Fundamentals of Investment 557
B.Com. 2018 - Sem. VI : Fundamentals of Investment 565
B.Com. (Hons.) 2019 Sem. VI : Fundamentals of Investment 574
Mathematical Tables 591
1 INVESTMENTS : AN OVERVIEW
C H A P T E R
leaRnInG oUtcomes
After reading this chapter you will be able to
 Understand the concept of investment
 Differentiate financial investment from real investment
 Know various features and objectives of investment
 Differentiate between investment and speculation
 Analyse investment environment
 Understand investment decision process
 Differentiate between direct and indirect investing
Investment is the backbone of any economy. Savings of an economy must

be channelized into productive investment to generate income. The higher
the level of investment in an economy the greater will be its gross nation-
al income and economic growth. A conducive business environment is
essential for boosting investment and investors confidence. In fact the pri-
mary source of funds for investment in an economy is household savings.
These savings are channelised into productive investment avenues to gen-
erate more income. An individual may keep his savings in a bank account
or invest in financial and/or real assets. In India savings bank account does
not provide high interest income. Therefore the investors, who wish to earn
higher returns, have to explore other avenues for investment such as equity
shares, bonds, gold, property etc. Hence the need for financial literacy on
the part of individual investors. This chapter provides an overview of the
basic concept of investment, investment decision process and investment
environment.
1
Para 1.2 Investments : An overview 2
1.1 Investment
The term investment implies employment of current funds to earn com-
mensurate return in future. It implies sacrifice of current consumption
for expected income in future because the amount which is not spent on
current consumption is saved and invested. An investor foregoes current
consumption and invests his savings in investments in anticipation of higher
future consumption. It is important to note here that investment does not
always guarantee higher future returns. At times losses are also incurred.
Hence the environment of investment is quite uncertain. We are in fact
facing a VUCA (Volatile, Uncertain, Complex, Ambiguous) environment in
the context of investments.
“In 1986, Microsoft Corporation first offered its stocks to public and with-
in 10 years, the stocks value had increased over 5000%. In the same year,
Worlds of Wonder also offered its stock to public and ten years later the
company was defunct.”
The word ‘investment’ connotes different meanings to different people.
To a layman, it may mean purchase of shares, bonds or others financial
instruments. To an economist it implies purchase of fixed productive assets
(Capital assets) such as plant and machinery. To a businessman as well,
investment refers to purchase of fixed assets such as land, building, plant,
machinery etc.
Irrespective of its context, the word investment requires commitment of
funds in some assets at present so as to be able to generate higher income
in future.
1.2 Financial Investment vs. Real Investment

Depending upon the type of asset, all the investments can be classified as
financial or real investment :
u Financial investment is investment of funds in financial assets. Finan-
cial assets are claims over some real/physical assets. The examples of
financial assets are shares, bonds, mutual fund units etc. The return
of financial investment is in the form of interest, dividend and/or
appreciation in value.
u Real Investment (or Economic Investment) is investment in real
assets or physical assets. Real assets are those long term (or fixed)
assets which are used in the production process. The examples of
real assets are plant, machinery, equipments, building etc.
An individual investor invests in financial assets and commodity assets (e.g.
gold, silver etc.). Now-a-days real estate investment has also become an
3 Objectives of investment Para 1.3
important part of individual investor’s portfolio. Real estate is investment

in tangible house/commercial properties to get income in the form of rent
and/or capital gain due to price appreciation.
Security analysis and portfolio management is primarily concerned with
investment in securities. A security, as defined under “The Securities
Contracts (Regulation) Act, 1956” include the following—
(i) shares, scrips, stocks, bonds, debentures, debenture stock or other
marketable securities of a like nature in or of any incorporated
company or other body corporate;
(ii) derivative;
(iii) units or any other instrument issued by any collective investment
scheme to the investors in such schemes;
(iv) security receipt as defined in clause (zg) of section 2 of the Securiti-
sation and Reconstruction of Financial Assets and Enforcement of
Security Interest Act, 2002 (54 of 2002);
(v) units or any other such instrument issued to the investors under any
mutual fund scheme;
(vi) any certificate or instrument (by whatever name called), issued to an
investor by any issuer being a special purpose distinct entity which
possesses any debt or receivable, including mortgage debt, assigned
to such entity, and acknowledging beneficial interest of such investor
in such debt or receivable including mortgage debt, as the case may
be;
(vii) Government securities;
(viii) such other instruments as may be declared by the Central Govern-
ment to be securities; and
(ix) rights or interests in securities.
This book primarily deals with investment in financial assets or securities.
1.3 objectives of Investment

Individual investors make investment keeping in mind certain objectives.
After all they forego current consumption in order to avail of higher income
and hence consumption in future. The ultimate objective of investment is
to minimize risk and maximize return. However due to the fact that risk
and return move hand-in-hand, it is not always possible to get very high
return at very low risk. Other objectives which are kept into mind while
making investment may be regular income, tax benefits, safety of capital.
An investor’s investment objectives depend upon his risk tolerance, which

in turn depends on his age, marital status, family responsibilities, education
and investment experience. The following is the list of certain objectives
kept in mind while making investment.
(i) Return : Total return from an investment is the main objective kept
in mind while making investment in a particular asset. Every investor
wants to maximise total return given the constraints in terms of risk
tolerance, investment horizon etc.
(ii) Regular income or stability of Income : Some of the investors,
especially, old aged and retired persons may have the objective of
regular income or stability of income from the investment. Therefore
they prefer fixed income securities over equity shares.
(iii) Capital Appreciation : Another objective of investment may be capital
appreciation or growth of capital. Young people, who do not want
regular income and can take risk may have the objective of capital
appreciation and prefer equity shares and real estate over fixed in-
come securities.
(iv) Tax Benefits : Some people invest in securities so as avail of the tax
benefits attached to it. Investment in mutual funds in India is primarily
guided by the objective of tax benefits.
(v) Safety of Capital : In every investment, safety of capital should be
the primary objective. Other objectives can be achieved only when
capital is safe.
1.3.1 Features (or Factors affecting Investment)

Every investment possesses certain common features or factors. These
are explained below –
(i) Return
Every investment is expected to provide certain rate of return over a peri-
od in future. Return is the income generated by investment expressed as
a percentage of the cost of investment. For example if a person buys an
equity share at a cost of Rs.100 and gets Rs.10 as dividend at the end of
10
the year, his return on share would be × 100 = 10% . Here we assume no
100
change in share price at the end of the year. If the share price also increases
10 + (105 − 100 )
to Rs.105 then his return would be × 100 = 15% .
100
5 Objectives of investment Para 1.3
Different investment instruments have different returns depending on their

level of risk. For example Treasury bills (T-bills) and govt. securities carry
low return as compared to equity shares.
Moreover, return can also be calculated as holding period return, annu-
alized return, etc. Detailed discussion about returns is given in Chapter 3.
(ii) Risk
Risk is defined as variability in expected return. If return from an invest-
ment is certain, fixed and 100% sure then there is no risk attached to it.
Generally, Government securities are considered to be risk-free. However
recent sovereign debt crisis (in which European Countries government failed
to repay the public debt) casts doubt on government securities being risk
free. Risk can be calculated as standard deviation of the expected returns
from an investment. Different individuals have different risk taking abili-
ties. For example young entrepreneurs may take higher risk than old and
retired people. Therefore investment must be done keeping in mind the
risk bearing ability of the investors. Hence risk assessment is an integral
part of portfolio management.
(iii) Liquidity
It is the “moneyness” of investment i.e. the ease with which investment can
be converted into cash with no or little risk of loss of capital. Some assets
are highly liquid (e.g. equity shares, mutual fund units etc.) and some are
less liquid (e.g. bonds, debentures). It is important to mention here that the
development and efficiency of financial markets depends to a great extent
on the liquidity of the securities traded in it.
(iv) Marketability
A related aspect is marketability i.e. the ease with which an asset can be
bought or sold. An asset may be highly marketable but less liquid (e.g. dis-
tress sale of property). For being marketable it is important that there is a
ready market for the security, where it can be bought or sold.
(v) Tax Benefits
Some of the investments provide tax benefits to inverters. Section 80C of
Income Tax Act, 1961 provides certain investment alternatives (e.g. PPF, NSC
Mutual Funds (ELSS-Equity Linked Savings Schemes etc.) which qualify
for deduction from taxable income upto Rs. 1,50,000. Assessment of tax
benefits is important while undertaking investment because it affects the
actual effective return from investment.
For example Rural Electrification Corporation (REC) has come out with
tax-free bonds at a coupon rate of 8.12% p.a. for 10 years. It implies that
interest income from these bonds will be exempt from tax. If an individual
is in 30% tax bracket then the effective pre-tax interest rate would be
8.12%
= 11.6%
1- 0.30
(vi) Hedge against Inflation
A good investment should provide hedge against the purchasing power
risk or inflation. The investor must ensure that the return generated by
his investment is higher than the prevailing inflation rate. Then only he is
benefited by making investment, otherwise he is worse off. For example if
the prevailing inflation rate is 8%, the investor should look for investment
options which provide more than 8% return otherwise his real worth of
investment will go down. Inflation erodes purchasing power of money and
hence hedge against inflation is an important consideration in investment.
Generally, equity shares are considered to be a good hedge against inflation
because of their varying return. It is expected that in times of inflation, equity
shares generate higher return. On the other hand fixed income securities
like bonds are not a good hedge against inflation due to the fact that their
interest incomes are fixed and do not increase in times of rising inflation.
(vii) Safety of Capital
Safety of capital should come first. The investor must secure his principal
amount which he invests. That is, he should not be impressed by very high
rate of return on an investment if the amount invested is not safe. For this
credit rating agencies play an important role in providing bond-ratings.
Generally bonds which have lower than AAA ratings are considered to be
not so safe. For example many NBFCs come out with fixed deposit schemes
at an attractive interest rate but safety of investment is less.
1.4 Speculation
Speculation is investment in an asset that offers a potentially large return
but is also very risky; a reasonable probability that the investment will
produce a loss. It can be defined as the assumption of considerable risk
in obtaining commensurate gain. Considerable risk means that the risk is
sufficient to affect the decision. Commensurate gain means a higher risk
premium. Speculative assets are high risk-high return assets and hence
should be invested in with caution. Generally large investors hold specu-
lative assets so as to make quick gains.
Stock market is identified with two types of speculators - bulls and bears.
Bull speculators expect increase in stock prices while bear speculators expect
decline in prices. It must be noted here that speculation, per se is not bad.
Rather it is essential for smooth functioning of stock market and to maintain
7 Speculation Para 1.4
price continuity and liquidity. However excessive speculation is bad as it takes

the prices away from their true fundamental values. Therefore SEBI keeps
a check on excessive speculation in Indian stock market, through various
rule and guidelines under SEBI Act, 1992.
It must be noted here that the same asset can be held by an investor for
investment and by the other for speculation. For example shares of RIL,
if held by a small investor for long term, amounts to investment, but if it
is held by an FII for making quick return over short run then its implies
speculation.
Speculation vs. Investment

Investment and speculation can be distinguished on the following grounds :
Basis of Investment Speculation
Difference
1. Time horizon Long, generally exceeding Short may be as short as
one year intra-day
2. Risk Low to Moderate Very high
3. Return (expected) Low to moderate and consis- Very high and inconsistent
tent
4. Funds Here own funds are used for Speculators also borrow
investment funds and/or do margin
trading
5. Income Dividend, Interest etc. Change in price of asset
6. Source of Fundamental factors of the Herd instincts, inside infor-
Information company are analysed mation etc.
Gambling
Gambling is a game undertaken for someone’s excitement e.g. horse race,
card games, lotteries. Here although the winner makes big money but that
cannot be classified as return because that is not consistent or regular.
Gambling is a zero sum game – someone’s loss is other party’s gain. It is
purely by chance that one party wins over the other. Therefore gambling
is highly uncertain and may involve complete loss of funds put in it.
Have you ever thought that in a bull market everybody is making profit
and become happy. Then why is it that in a bear market everybody is
sad? In that market also bear speculators make profit.
Hint : In a bull market, investors net worth increases while in a bear
market company’s market capitalization falls and hence investors wealth
decline. Only speculators make money in such a market.
1.5 Risk Return Trade off

Investors like returns but they dislike risk. All the investors are risk averse
as they try to avoid risk. However returns cannot be certain or fixed. The
value of investment also varies overtime due to uncertainties prevailing in
the investment environment. Hence returns cannot be separated from risk.
In the process of investment, the investor may first decide about the level
of risk he is willing to undertake. Once the risk tolerance level is decided
then the objective should be maximization of return for that level of risk.
In order to earn higher returns, investors have to assume high risk. This
is because there is a positive relationship between risk and return. Both
return and risk move together. Let us assume that there are two securities
available in the market. Security A and B. Both the securities have same
level of risk but security A has higher return. In such a case every investor
will sell security B and instead invest in security A. There will be selling
pressure on security B which will drive its price downwards and hence
the cost of investment will be lower. Since return from an investment is
negatively related with the cost of investment, the returns from security B
will rise. Decline in purchase price will result in higher return from Security
B. On the other hand there will be heavy demand for security A and this
would push its price upward. Increase in price will result in higher cost
of investment and hence lower returns from security A. This process will
come to an end when the returns from both security A and B become equal.
If the risk level of two securities is same then both of them must provide
same return, otherwise investors will never chose to buy security providing
less return. Hence risk and return move together. Higher return is possible
only if investor assumes higher risk. But investor wants to maximize return
and minimize risk. This is known as Risk Return Tradeoff. The expected
return from an investment must be commensurate with the risk of that
investment. If returns are abnormally higher there will be mad rush for that
security and if returns are abnormally lower then no investor will choose
that security. Hence investors must always make investment decisions after
careful consideration of Risk-Return Tradeoff. A variety of securities are
available in capital markets which have different return-risk relationships
or Return risk tradeoff as shown in Table 1.1:
Table 1.1 : Risk Return Relationship of different
types of Investments
Investment Return Risk
Treasury bills Very low Nil (or negligible)
Bonds and debentures Low Low
Preference shares Medium Medium
Equity shares High High
9 Investment environment Para 1.6
The return from an investment has two components:

i. Risk free rate of return which is actually the time value of money.
It is the compensation or reward for time. It is common for all the
investments. Every investment including a risk free asset like Trea-
sury bills must earn this much of return.
ii. Risk premium : risk premium is the compensation for assuming risk.
It is specific to an individual investment. If risk in an investment is
higher, risk premium must be higher and if risk in an investment is
lower, then risk premium will be lower. It is the risk premium that
varies across different types of investments.
Required Return from an Investment = Risk free return + Risk premium
An investor may select an investment depending upon his risk return
preferences. He may select equity shares if he is willing to assume higher
risk for higher expected returns. On the other hand a retired person, who
wants lower risk, may select to invest in bonds and debentures.
1.6 Investment Environment

The investment environment implies various types of securities which are
available for investment and the entire mechanism or process through
which these securities can be bought or sold.
The investment environment comprises of three main aspects - securities
(also referred as financial assets or financial instruments); securities mar-
kets (i.e. financial market) and intermediaries in securities markets. The
investment environment now a days is characterized as VUCA(Volatile,
Uncertain, Complex, Ambiguous).
i. Securities :
An investor can invest in a variety of securities such as equity shares,
bonds, debentures, derivatives, mutual funds, exchange trade funds
etc. One may also invest in commodities and bullions (such as gold
and other precious metals). However, here we are primarily concerned
with investments in financial assets or securities as defined under Sec.
2(h) of Securities Contracts (Regulation) Act, 1956. The term security
means that the holder of the security has a claim to receive future
benefits under certain conditions. These securities may be transferred
from one owner to the other without much difficulty. Various types
of securities can be classified into the following categories on the
basis of their peculiar features as well as risk return relationships.
a. Equity shares : Equity shares are also known as ‘Common

stocks’ in western economies. An equity share represents an
ownership claim in a company. The owner of the equity share
is termed as equity shareholder in the company and enjoys all
voting rights in corporate matters. Equity shareholders get fu-
ture benefits in the form of dividends (i.e. the amount of profit
distributed as dividends) and in the form of price appreciation
(or capital gains). However it is not obligatory on the part of
the company to declare dividends every year and the amount
of dividends, if any, may also vary from year to year. Hence
equity shares are also referred to as ‘variable income securities’
and do not promise fixed return. Due to variability in returns,
equity shares are highly risky securities. They may generate a
very high return or very high loss during the investment hori-
zon. Worldwide equity shares are expected to generate higher
returns (as they have higher risk) over long term.
b. Bonds and debentures : Bonds and debentures are fixed income
securities. A bond is an IOU (I Owe You) of the borrower. It
arises out of a lending-borrowing contract wherein, the borrow-
er (or the issuer of the bond) promises to pay a fixed amount
of interest to the lender (or the bond holder) periodically and
repays the loan either periodically or at maturity. Most of the
bonds and debentures are redeemed at maturity only and they
carry a fixed coupon rate or fixed rate of interest. Bonds may
be corporate bonds or government bonds, short term bonds or
long term bonds, secured bonds or unsecured bonds etc. Bonds
and debentures may also be convertible or non-convertible.
Since bonds and debentures carry a fixed rate of interest, their
future benefits are known in advance, Therefore they have
relatively lower risk than equity shares. At the same time they
generate relatively lower return.
c. Treasury Bills : Treasury bills are the securities issued by
Central Government in the context of a lending- borrowing
contract. An investor in Treasury bills actually lends money
to the central government. This type of security carries min-
imum (or negligible risk) risk of non-payment of the amount
as promised. Hence the default risk in case of Treasury bills
is negligible. These bills are issued at discount and redeemed
at par and hence the rate of return is known with certainty in
the very beginning of the investment. Because of this feature,
Treasury bills are also referred to and used as “Risk free asset”
in research studies.
11 Investment environment Para 1.6
d. Other securities : Besides above, a number of new securities

have been introduced in securities market over the past two de-
cades. These securities include- mutual funds, exchange traded
funds (ETFs), derivatives (financial derivatives and commodity
derivatives), warrants, mortgaged backed securities, deep dis-
count bonds, catastrophe bonds, collective investment schemes,
REITS (Real Estate Investment Trusts) etc. These securities
have enriched the investment environment and provided a
variety of choice to the investors.
ii. Securities Market:
Securities market bring together the buyer and seller of securities
and provide operational mechanism to facilitate the exchange of
securities. An efficient and developed security market is a prerequisite
for increased investment in securities. There are many types in which
securities market can be classified. The basic classification is in terms
of time or tenure of securities. On the basis of time securities market
is classified as - Capital Market and Money Market. Capital market is
the market for long term financial investment and instruments (more
than one year), while money market deals with short term securities
(one year or less). Capital market primarily deals with equity shares,
long term bonds and debentures, while money market deals with
Treasury bills, short term debts such as commercial paper, certificates
of deposits etc. Capital Market in India is further classified into the
following two segment - Equity Market and Wholesale Debt Market.
Capital Market Money Market
1 It is the market for long term capital It is the market for short term
instruments such as equity shares, financial instruments having
debt etc. These instruments have a maturity in less than 1 year. These
period of 1 year or more. instruments are certificates of
deposits, commercial papers,
Treasury bills etc.
2 Capital market can be further sub- Money market can be sub-divided
divided into the following three into the following segments—
segments— (i) Treasury bills market
(i) Equity market (ii) Commercial papers market
(ii) Wholesale Debt market (iii) Certificate of Deposits market
(iii) Derivatives market (iv) Call money market
3 Capital market instruments have Money market instruments have
medium liquidity except equity very high liquidity
and derivatives.
Capital Market Money Market

4 Capital market is used by Money market is used by
participants for the purpose of participants as a means for
raising funds or capital for medium borrowing and lending in short
to long term term, with maturities that usually
range from overnight to just under
a year
5 The rates of return in capital The rates of return in money
market is relatively high due to market is relatively low due to short
longer maturity period maturity period
6 Capital market is essential for Money market is essential for
overall growth of the economy maintaining liquidity in the
economy.
A security market can be further classified as Primary market or
Secondary market. Primary market is the market where new
securities are issues for the first time; while secondary market provides
the platform where existing (or second hand) securities are bought
or sold. A well functioning primary market is essential for the growth
of investments in an economy. At the same time a transparent and
efficient secondary market that ensures speedy transfer of ownership
of securities, is a prerequisite for investment in a particular security.
For example in India, secondary market for bonds is not properly
developed and hence growth in bond market in India is lagging behind
as compared to growth in other countries bond markets.
Every security is characterized by market intermediaries which are
positioned between the buyer and seller of securities. Stock exchange,
its brokers and sub-brokers act as market intermediaries in secondary
market.
Difference between primary and secondary market
Sl. Basis Primary Market Secondary market
No.
1 Meaning It is a market where new It is the market for trad-
securities are issued for ing of already issued and
the first time by an existing existing securities.
or new company.
2 Price deter- The issuer company itself Price of securities is deter-
mination decides the price of securi- mined by the interplay of
ties for the first time using market forces of demand
the book building method. and supply operating at
It can decide the amount the stock exchange.
of premium also.
13 Investment decision process Para 1.7
Sl. Basis Primary Market Secondary market

No.
3 Variability in Prices (the issue price) of Prices of securities vary
prices securities are fixed. on the basis of demand
and supply forces.
4 Buying and The new securities are The buying and selling of
selling parties sold by the company and securities usually happens
involved bought by investors. between investors.
5 Financing for Primary market is a plat- There is no fund raising by
business form for companies to companies because there
raise finance for expan- is no issue of securities in
sion, diversification, etc. secondary market. Only
trading of existing secu-
rities is done here.
6 Capital for- Primary market directs Secondary markets pro-
mation v/s the flow of funds to provide liquidity to investors,
Liquidity ductive use in business, thereby indirectly leading
thereby directly resulting to capital formation.
in capital formation.
7 Financial in- Main intermediaries oper- Secondary market has in-
termediaries ating in primary market termediaries like brokers,
are merchant bankers, sub-brokers, etc.
underwriters, registrar
to issue, collection banks,
etc.
iii. Regulation of securities Market:
The investment environment and hence securities market is well
regulated. Securities market is not a laissez faire market but ade-
quately regulated by regulatory bodies such as SEBI (Securities and
Exchange Board of India), RBI (Reserve bank of India), Department
of Company affairs, Ministry of finance etc. The multiplicity of reg-
ulatory agencies sometimes prove detrimental to the growth and
efficient regulation of securities market. Hence recently there is a
move towards reducing the number of regulatory bodies in India.
On 28th September 2015, Forwards markets Commission has been
merged with SEBI.
1.7 Investment Decision Process

The process of investment broadly comprises of the following steps :
1. Setting up the investment policy
2. Building up an inventory of securities
3. Performing security analysis
4. Constructing portfolios, analyzing portfolios and selecting the optimal

portfolio
5. Portfolio revision
6. Portfolio performance evaluation and management
These steps are discussed in detail as under :
Setting up the Investment Policy : The first step involves setting
1.
up the investment policy for the investor. The investment policy
is based on investment goals or objectives, investible funds, tax
status and investment horizons. Different investment objectives
of an investor may be capital appreciation, regular income, tax
benefits etc. The investment objectives are framed as per the
risk return preferences of the investors. Every investor has
a different risk appetite or risk profile which is an essential
ingredient in investment policy. The investment objective is
also related to the period of investment or investment horizon.
Investment policy sets the broad framework for investment
decision making by an individual investor.
Building up an inventory of securities : This step involves build-
2.
ing up a list of all available securities wherein an investor may
make his investment. Depending upon investment objectives
and investment horizon, the securities may be filtered. For ex-
ample, if an investor’s objective is to receive regular income at
low risk, then equity shares which do not pay regular dividends
may not be included in the list of securities where an investor
may invest.
Performing Security Analysis : Once an inventory or list of
3.
available securities has been made, the next step is to analyze
these securities primarily with respect to risk and return char-
acteristics. This is known as security analysis. The main idea in
security analysis is to estimate the expected return and risk of
individual securities. This may also help investors in detecting
undervalued or overvalued securities and timing of buy or sell
decision.
There are various approaches of security valuation - Fun-
damental analysis, Technical analysis and Efficient Market
Hypothesis (EMH). As per fundamental analysis, in the long
term, the price of a security is equal to its intrinsic value or
true worth. Intrinsic value of a security is the present value
of all future cash inflows associated with the security. Hence
the investor first calculates the intrinsic value of the security
15 Investment decision process Para 1.7
using some appropriate discount rate and then compares it with

the prevailing market price to ascertain whether the security
is undervalued (intrinsic value> market price) or overvalued
(intrinsic value <market price). The investor should choose
undervalued securities for investment purposes. Fundamen-
tal analysis comprises of analysis of Economy, Industry and
Company level factors in order to ascertain the expected cash
inflows from the security. This is termed as Top Down approach
or EIC framework of analysis.
Technical analysis, on the other hand, is based on the premise
that ‘history repeats itself’ and hence future price behaviour is
predictable on the basis of past prices and volume information.
Past trend analysis, chart patterns and a number of technical
indicators can be used to predict future prices. On the basis of
future prediction of prices, an investor may decide whether it
is the right time to buy or sell. Hence technical analysis helps
an investor in market timing. Efficient Market Hypothesis
(EMH) assumes that current security prices fully reflect all
available information about that security. Hence the market
price is nothing but the fair price or true price of a security. As
per EMH anytime is a good time to buy or sell as there is no
consistent overpricing or underpricing in an efficient security
market.
Constructing portfolios, portfolio analysis and portfolio
4.
selection : A portfolio is a combination of two or more securities
in which an investor may prefer to hold investments rather
than in all the securities available for investment. Therefore,
after security analysis, the next step is to construct all feasible
portfolios or portfolio opportunity set and selecting optimal
portfolio for the concerned investor. Portfolio opportunity set
is also termed as Investment opportunity Set. It must be noted
that there may be many feasible portfolios by combining various
securities in different proportions, but all of them may not be
efficient. An Efficient portfolio is one which provides maximum
return for a given level of risk or which has minimum risk for
a given level of return. Such efficient portfolios may also be
large in numbers. Hence in order to select the optimal or best
portfolio for the investor, one needs to consider risk return
preferences of the investor. For example for a young person,
who is willing to undertake risk to maximize return, we may
have an optimal portfolio comprising 70% of equity and 30%
of bonds. On the other hand for a retired, old aged investor

the optimal portfolio may be 10% equity and 90% bonds and
debentures or fixed deposits.
Portfolio Revision : The fifth step in investment decision process
5.
is portfolio revision. It consists of the repetition of the previous
four steps in the light of changes in investment environment.
Moreover the investment objectives of the investor may also
change overtime and hence there is a need to revise the origi-
nally selected portfolio periodically. Due to changes in security
prices, the originally built portfolio may not remain optimal
and hence the investor needs to revise it or build up a new
portfolio. Changes in security prices may also make certain
securities attractive, which were not selected earlier due to
higher prices or may make certain securities already include
in the portfolio, unattractive. All this calls for periodic revision
of the portfolio.
Portfolio performance Evaluation and Management : The last
6.
step in the investment process is to evaluate the performance
of the portfolio. It implies determining periodically whether the
portfolio has performed better than the benchmark portfolio
or other similar portfolios or not. Portfolio performance evalu-
ation may be done using absolute return as well as various risk
adjusted return measures such as Sharpe ratio, Treynor’s ratio
or Jensen’s alpha. Sharpe ratio is calculated by dividing excess
return (i.e. risk premium) by the total risk of the portfolio. It
is a measure of excess return per unit of risk. The higher this
ratio the better is the performance of the portfolio. Detailed
discussion about portfolio performance evaluation is provided
in Chapter 10.
1.8 Direct Investing and Indirect Investing

An investor can invest in securities directly or indirectly.
Direct investing involves the purchase or sale of securities by the investors
themselves. In this case the investor has the entire control over the invest-
ment decision i.e. which securities are to be purchased and sold as well as
when to purchase or sell. The securities may be securities of capital market
(such as equity shares, bonds, debentures), or of derivatives markets (such as
futures and options) or of money market (such as treasury bills, certificates
of deposits, commercial papers etc.). The investor is required to perform all
the steps of investment decision process, as explained above, on his own.
17 Direct Investing and Indirect Investing Para 1.8
Therefore direct investing requires investing skills and expertise. Moreover

it is a time consuming process of investing. In case of direct investment,
the cost of analysis and monitoring is incurred by the investor directly.
Indirect investing involves investing in mutual funds (open ended as well
as closed-ended funds), exchange- traded funds or collective investment
schemes including Alternative Investment Funds (such as venture capi-
tal funds, hedge funds, REITs, SME fund etc.). In this case, the investor
does not invest directly in various securities. He has no control over the
composition of the fund’s investment; the investor only controls whether
to buy or sell the shares or units of the fund. Therefore, the investor only
decides which mutual fund or investment company to invest in. The ulti-
mate investment decision is made by the fund or investment company in
case of indirect investing. The investor buys or sell the units (or shares)
of the Fund, which in turn makes investment in securities and build up
portfolios as per investment objective of the Fund or Scheme. The investor
becomes unit holder in the fund and has ownership interest in the asset of
the fund or investment company and is entitled to interest, dividends and
price appreciation (or decline). Thus Indirect investing in a mutual fund,
ETF or investment company or even in alternative investment funds, is
an alternative route for investor to invest. It is convenient and ideal form
of investing for investors who are not skilled enough or who do not have
time to perform security analysis and portfolio management process. In
case of investment in mutual funds or any other investment company,
the investment costs are incurred by the fund or company but ultimately
these costs are passed on to the investors in terms of management fees
or expenses. These expenses or fee reduce the value of the portfolio or
investment done by the fund or company.
Direct Investing Indirect investing
Meaning Direct investing involves pur- Indirect Investing implies invest-
chase or sale of securities by ment in mutual fund or other
the investors themselves. investment companies rather than
directly in securities.
Instruments of Capital Market - such as equity Mutual funds - open ended, closed
Investment shares, bonds, debentures etc. ended
Money Market - such as trea- Exchange traded funds
sury bills, certificates of depos- Collective Investment Schemes
its, commercial papers etc.
Alternative Investment Funds-
Derivatives Markets - such as such as Venture capital funds,
futures and options hedge funds, SME funds, Real
Estate Investment Trusts (REITS)
etc.
Direct Investing Indirect investing

Control Investor has the entire control Fund or investment company has
over the investment decision direct control over the investment
i.e. which securities are to be decision i.e. which securities are to
purchased and sold as well as be purchased and sold as well as
when to purchase or sell. when to purchase or sell.
Costs Costs of analysis and monitor- Costs are incurred by the Fund or
ing is incurred by the investor Company but ultimately passed on
directly to the unit holders in terms of fee
or management expenses.
Skills and Time Direct investing requires in- Indirect investing does not require
vesting skills and expertise. investing skills and expertise by the
Moreover it is a time consum- individual investor. The fund or the
ing process of investing by an investment company where inves-
individual investor. tor invests is expected to provide
such expertise and professional
funds management. They have
professional fund managers.
Convenience Direct investing may not be Indirect investing is very con-
convenient to small investors venient and preferred mode of
who do not possess requisite investment to small investors who
investing skills and who do not do not possess requisite investing
have much time to perform skills and who do not have much
security analysis. time to perform security analysis.
1.9 Approaches to Investing - Active Investing

(Investment) and Passive Investing (Investment)
Besides the classification of investing as direct investing and indirect
investing as explained above, another popular classification of investing
is active investing (or Active Investment) and passive investing (or Passive
Investment).
Active Investing implies making investment in securities after actively and
carefully analyzing all the securities and portfolios. Such an approach to
investing requires that the investor is actively engaged in the task of security
analysis, selection and building up suitable portfolios. Portfolios are then
revised and their performance is assessed at regular intervals. The choice of
securities is made in such a manner that the investor gets maximum return
for a given level of risk. The idea behind active investing is that investment
analysis can yield superior returns to the investors. Active investing requires
investment skills and is a time consuming and continuous process.
Passive Investing implies making investment in Index Funds or Exchange
traded funds. An index funds is a fund that tracks the performance of a
19 Diversification, Hedging and Arbitrage Para 1.10
broad based market index. Buy and hold is also termed as passive invest-
ing. In case of passive investing the investor is content with the market
return at market risk. He does not expect to earn returns over and above
the one that is given by the market. The idea behind passive investing is
that nobody can earn superior returns in an efficient market. Hence it is
better to buy and hold the market portfolio or market index which is the
underlying asset of the Index Funds or ETFs. Passive investing does not
require much investment skills and is not a time consuming or continuous
process. Once investment is made in Index fund, the investor holds it over
the investment horizon.
1.10 Diversification, Hedging and Arbitrage

Investment in securities may involve the following three strategies - diver-
sification, hedging and arbitrage.
Diversification : Investors are risk averse i.e. they avoid risk and assume
risk only when it is adequately rewarded in terms of higher returns.
Diversification means investment in a large number of unrelated securities
so as to reduce risk. The basic idea behind diversification is “Don’t put all
your eggs in one basket”. Hence investors choose a variety of securities and
build up diversified portfolios so as to reduce risk. If an investor invests all
his funds in only one type of security then he would incur huge losses if
that security performs badly. By having a diversified portfolio of a variety
of securities, it is possible to reduce risk because if some securities perform
badly then there are others which might perform well. Hence portfolio risk
will be lower.
Hedging : Hedging means investing in a security or contract that can fully
or partially offset some risk. When an investor already has an existing
security, he is exposed to price risk i.e. the risk that the price of that security
may decline in future. In order to eliminate or reduce such a risk, he may
take a counter position in derivatives market such as futures or options.
He may sell futures or he may decide to buy a put option. This is termed as
Hedging. A hedge asset or security is one which has negative relationship
with the existing security. A perfect hedge security is perfectly negatively
correlated with the existing security. Hedging is sometimes also referred
to as matching positions.
Arbitrage : In general, arbitrage is the riskless exploitation of price differ-
entials in different markets. It refers to a situation where an investor takes
a buy and sell position on the same asset simultaneously but in different
markets so as to make risk free profits. For example if the market price of
SBI share is Rs. 2500 on NSE but Rs. 2450 on BSE, then there is an arbitrage
opportunity. An investor may take a buy position on BSE, buy the share at
Rs. 2450 and simultaneously take a sell position on NSE and sell the share
at higher price of Rs. 2500. By doing this he makes a risk less profit of
Rs. 50 (i.e. 2500-2450). However this arbitrage opportunity will be exploited
by all the active investors and hence soon the price of SBI share will decline
on NSE (due to selling pressure) and rise on BSE (due to demand pressure).
This arbitrage will come to an end when the market price of SBI becomes
equal in both the exchanges. Therefore arbitrage in fact works as a process
of bringing equilibrium. It must be noted that here we assume that there
is no restriction on short selling.
1.11 Impact of Taxes on Investment

Taxes play an important role in investment decision making. Personal taxes
are levied on individual’s income under the head salary, house property,
business and profession etc. Income from investment is also subject to
tax. However the rate of tax differs from investment to investment. Some
incomes from investments are also exempt from tax such as tax free bonds.
Besides, there are some investments which are deductible while calculating
taxable income and hence provide tax savings.
In order to compare alternative investments, one needs to take into con-
sideration the impact of taxes and compare the alternative investment’s
benefits either pre-tax or post-tax.
Post Tax rate = Pre tax Rate (1-Tax rate)
Or alternatively
Post tax rate
Pre Tax rate =
(1- Tax rate)
Taxable Equivalent Yield : In case of Tax free investments (such as Tax
free bonds) no tax is to be paid on the annual interest income. The interest
income is exempt from tax in such a case. Here we can calculate taxable
equivalent yield to compare it with an investment the yield of which is tax-
able. Taxable equivalent yield is the equivalent pre tax yield of a tax free
investment. It can be calculated using the following formula
Tax free rate
Taxable equivalent yield = (1 − Tax rate)
If tax free rate is 10% and the investor is in 30% tax bracket, then taxable
equivalent yield will be 14.3%.
0.10
Taxable equivalent yield = = 0.143 or 14.3%
1- 0.30
21 Impact of Inflation Investment Para 1.12
1.12 Impact of Inflation Investment

Inflation erodes the purchasing power of money. Therefore it is necessary
to consider prevailing inflation rate while making investment. Now-a-days
inflation is very high around 9 to 10%, and hence any investment alterna-
tive which generates less than this much of the return is actually making
a loss in real terms.
We can understand the impact of inflation on investment by calculating real
rate of return rather than nominal rate of return. Real rate of return is the
return adjusted for inflation i.e. it does not have any element of inflation
rate. Nominal rate of return is the prima-facie rate of return earned on an
investment and contains the element of inflation rate. We can calculate
real rate of return as given below :
 1 + Nominal Rate of return 
Real Rate of Return =   -1
 1 + Inflation Rate
As an approximation
Real Rate of Return = Nominal Rate of Return - Inflation Rate
Hence if nominal rate of return on investment is 12% and inflation rate is
9% then real rate of return is
(1 + 0.12)
Real Rate of Return = -1 = 0.0275 or 2.75%
(1 + 0.09)
It implies that in real terms the investment is generating only 2.75% return,
although it appears to a layman that the return is 12%. That is the real net
worth of individual is increased only by approx. 2.75% return and not by 12%.
In times of higher inflation the amount of investment falls in an economy
because individuals prefer current consumption to future consumption
due to decline in the purchasing power of money.
In times of increasing inflation, a rational investor should search for
securities, the returns of which increase with increase in inflation. In such a
case the real rate of return may not decline. It must be noted that in times
of inflation bond or other fixed income securities are not so appropriate
because the return on fixed income securities is fixed in nominal terms
and does not increase with increase in inflation. Hence every year the real
rate of return declines as inflation increases.
Equity shares are generally considered to be good hedge against inflation
and hence an appropriate investment in times of increasing inflation. The
underlying reason is that return on equity shares (in the form of dividend
and capital gain) increases in times of inflation and hence real rate of return
is not affected much by inflation.
Investments : An overview 22
Summary
1. Investment is employment of current funds to earn commensurate return in
future.
2. Investment may be classified as Real investment and Financial Investment.
3. Real investment is investment in tangible assets which are physical assets
such as plant, machinery, equipments etc.
4. Financial assets are assets that represent claims against the investee or own-
ership claims over real assets such as equity shares, bonds, debentures etc.
5. Speculation is taking high risk in expectation of high and quick returns.
6. Risk and return move together. Hence there is a risk return tradeoff.
7. The investment environment comprises of - securities, securities markets and
intermediaries in securities market.
8. There are six steps in Investment decision process - setting up of investment
policy, making an inventory of securities, security analysis, portfolio con-
struction, analysis and selection, portfolio revision and portfolio performance
evaluation.
9. All feasible portfolios are not efficient.
10. Selection of portfolios is as per risk return preference of the investor.
11. There are two modes of investing - direct investing and Indirect investing.
12. Direct investing means buying and selling of securities by the investor himself.
13. Indirect investing means investment in a mutual funds, ETF or investment
company.
14. Diversification is the process of investing in a large number of unrelated
securities so as to reduce risk.
15. Hedging means taking a counter position so as to reduce risk.
16. Arbitrage means taking simultaneous positions in different markets to exploit
price differential across markets.
17. Arbitrage brings in equilibrium in security market.
18. Investment decisions are affected by taxes and inflation.
Test Yourself
True/False
i. Speculation is always bad.
ii. No asset is risk-free.
iii. Financial investment is done in tangible physical assets.
iv. There are only two features of investment -return and risk.
23 Test yourself
v. Same asset cannot held for the purpose of investment and speculation.
vi. Investment is employment of current funds to earn commensurate return in
future.
vii. Speculation is taking high risk in expectation of high and quick returns.
viii. Risk and return do not move together.
ix. Optimal portfolios are same for all investors.
x. All feasible portfolios are efficient.
xi. Direct investing means investment in a mutual funds, ETF or investment
company.
xii. Diversification is the process of investing in a large number of same type of
securities so as to reduce risk.
xiii. Hedging is possible when securities are negatively related.
xiv. Arbitrage means taking simultaneous positions in different markets to exploit
price differential across markets.
xv. Arbitrage brings in equilibrium in security market.
xvi. Arbitrage opportunities exist for long term in securities market.
xvii. Taxes do not affect investment decisions.
xviii. In times of inflation equity shares is a better investment than bonds.
(Ans i. F, ii. T, iii. F, iv. F, v. F, vi. T, vii. T, viii. F, ix F, x. F, xi. F, xii F, xiii. T, xiv.
T. xv. T, xvi. F, xvii. F, xviii. T)
Theory Questions
1. Explain the term ‘Investment’ and its various types. [Paras 1.1, 1.2]
2. What is Financial Investment? How is it different from real investment?
[Para 1.2]
3. What are the objectives of investment? Explain in detail. [Para 1.3]
4. Differentiate between investment and speculation. Can the same asset be
held for investment by one investor and speculation by the other? [Para 1.4]
5. Define the term Investment. How is it different from speculation?
[Paras 1.1 & 1.4]
6. Explain the following :
i. Diversification [Para 1.10]
ii. Hedging [Para 1.10]
iii. Arbitrage [Para 1.10]
iv. Direct investing [Para 1.8]
v. Indirect investing [Para 1.8]
Investments : An overview 24
7. State investment decision process. What factors should an investor consider

while making investment decisions?
[B.Com (H)DU2009, 2013] [Paras 1.7 & 1.3.1]
8. What do you mean by Investment environment? Explain various constituents
of investment environment. [Para 1.6]
9. What do you mean by investment decision process? How is it going to help
the investor in making sound investment decisions?
[B.Com (H)DU 2012] [Para 1.7 ]
10. Differentiate between real and financial assets. Are they independent?
[Para 1.2]
11. What do you mean by Risk Return Trade off. Do high risky investments
always provide higher returns? [Para 1.5]
12. What do you mean by risk premium? Is it same for all the securities?
Why? [Para 1.5]
13. “Risk free return is compensation for time”. Explain. [Para 1.5]
14. Speculation is equivalent to gambling. Do you agree? Explain. [Para 1.4]
15. Briefly explain different kinds of investment outlets available to an investor.
[B.Com (H)DU 2008] [Paras 1.1, 1.2 & 15]
16. Differentiate between Direct investing and Indirect investing. Which mode
of investing is suitable for an old aged investor who wants regular income?
[Para 1.8]
17. Distinguish between active investing and passive investing. Which type of
investing is appropriate in an efficient market? [Para 1.9]
18. How do taxes impact investment decisions? Explain with example.
[Para 1.11]
19. Investments involve long term commitments. Comment.
[B.Com (H)DU 2007] [Paras 1.1 & 1.2]
20. All investors are risk averse. Does it mean that they do not assume risk?
[Para 1.5]
21. Investment is carefully planned speculation. Comment.
[B.Com (H)DU 2007] [Paras 1.1, 1.2 & 1.4]
22. Compare the following investments in terms of return, risk, liquidity and tax
shelter
i. Equity shares ii. Residential house. iii. Non-convertible debentures
iv. Gold. [B.Com (H)DU 2010] [Para 1.5]
23. Define investment. How does inflation affects investment decision? Give
examples. [B.Com (H)DU 2011] [Para 1.12]
24. Define investment. Discuss the steps involved in the investment decision
process. [B.Com (H)DU 2015] [Paras 1.1, 1.7]
25 Test yourself
25. Distinguish between financial and economic meaning of investment.

(B.Com. (H), GGSIPU, 2015)
26. “Investment is well grounded and carefully planned speculation”. In the light
of the above statement, explain and differentiate between investment and
speculation. How do they differ from gambling? (B.Com.(H), GGSIPU, 2016)
27. (a) An investor’s motives to invest are inherently different from those of a
speculator yet both are key to efficient functioning of the market. Explain.
(b) Fixed income securities and equities are two totally different classes of
investment avenues. Discuss. (B.Com. (H), GGSIPU, 2017)
2 INDIAN SECURITIES MARKET
C H A P T E R
LearnInG outcoMeS
 Understand the structure in Indian securities market
 Know various participants and segments of Indian securities
market
 Differentiate between primary and secondary markets
 Explain BSE, NSE and OTC market in India
 Explain SME exchanges such as EMERGE of NSE
 Explain trading mechanism in stock market
 Explain screen based trading and trading mechanism of NSE
 List out and Explain various stock indices in BSE and NSE
 know about SEBI, the securities market regulator in India
 know various reforms and latest developments in Indian securities
market
 understand the concept and process of depository, book building,
rolling settlement, stock lending scheme, insider trading etc.
Securities market is a component of the wider financial market where

securities can be bought and sold between parties, on the basis of demand
and supply. Securities markets encompasses equity markets, bond markets
and derivatives markets where prices can be determined and participants
both professional and non-professionals can meet. Securities markets can
26
27 Structure of indian securities Market Para 2.1
be split into two levels. Primary markets, where new securities are issued
and secondary markets where existing securities can be bought and sold.
Secondary markets can further be split into organised exchanges, such
as stock exchanges and over-the-counter where individual parties come
together and buy or sell securities directly. Another classification of securities
market is on the basis of the tenure of the securities. Such a classification
has two markets- Capital market and Money market. Capital market is the
market for long term securities or funds while money market is the market
for short term funds or securities. Although Stock market is a part of Capital
Market, in practice the terms capital market, securities market and stock
market are used interchangeably.
2.1 Structure of Indian Securities Market

The securities market of a country is considered to be the barometer of the
economy of that Country. The basic structure of Indian Securities Market
can be studied in respect of its participants and segments.
2.1.1 Market Participants

The securities market has three categories of participants :
i. The issuer of securities
ii. The investors in the securities
iii. The intermediaries
The issuers are actually borrowers or deficit savers, who raise funds by
issuing securities in the market. The investors are the surplus savers, who
deploy their saved money by subscribing to the issued securities. The in-
termediaries are the agents who match the needs of savers and borrowers
and in return they get a commission. There is a large pool of intermediaries
providing various services in the Indian securities market. The resource
mobilisation and channelization is continuously supervised and monitored
by the regulators. The regulators ensure the adoption and compliance of
fair market practices by every participant, particularly the issuer and the
intermediaries. They work towards ensuring high quality of services are
provided by the intermediaries and protecting the interest of the investors.
TABLE 2.1 SEBI REGISTERED MARKET INTERMEDIARIES/INSTITUTIONS
Market Intermediaries 2014- 2015- 2016- 2017- Apr-

15 16 17 18 Aug
2018
Stock Exchanges (Cash Market) 15 5 5 5 5
Stock Exchanges (Derivatives Market) 3 3 3 3 3
Para 2.1 Indian Securities Market 28

15 16 17 18 Aug
2018
Stock Exchanges (Currency Derivatives) 3 3 3 3 3
Stock Exchanges (Commodity Deriva-
Na 12 10 6 5
tives Market)
Brokers (Cash Segment) 5,899 3,199 3,192 3,038 2,851
Corporate Brokers (Cash Segment) 3,677 2,780 2,775 2,647 2,529
Brokers (Equity Derivatives) 2,761 2,760 2,651 2,549 2,509
Brokers (Currency Derivatives) 2,404 1,985 1,985 2,245 2,162
Brokers (Debt Segment) Na Na 6 162 180
Brokers (Commodity Derivatives) Na 295 1,162 1,200 1,206
Sub-brokers (Cash Segment) 42,409 34,942 30,610 25,579 23,143
Foreign Portfolio Investors (FPIs) 1,444 4,311 7,807 9,136 9,375
Deemed FPIs 6,772 4,406 974 0 0
Custodians 19 19 19 18 18
Depositories 2 2 2 2 2
Depository Participants - NSDL 282 273 276 276 276
Depository Participants - CDSL 572 585 588 594 595
Merchant Bankers 197 189 189 195 198
Bankers to an Issue 60 62 64 66 66
Underwriters 2 2 2 1 2
Debenture Trustees 32 31 32 32 32
Credit Rating Agencies 6 7 7 7 7
KYC Registration Agency (KRA) 5 5 5 5 5
Venture Capital Funds 201 200 198 195 195
Foreign Venture Capital Investors 204 215 218 240 231
Alternative Investment Funds 135 209 303 394 462
Registrars to an Issue & Share Transfer
72 71 73 73 72
Agents
Portfolio Managers 188 204 218 270 285
Mutual Funds 47 48 45 45 45
Investment Advisors 271 427 577 918 1,029
Research Analysts 26 261 351 467 553
Infrastructure Investment Trusts (In-
Na Na 6 1 1
VIT)

15 16 17 18 Aug
2018
Real Estate Investment trusts (REITs) Na Na Na 6 6
Collective Investment Management
1 1 1 1 1
Company
Approved Intermediaries (Stock Lend-
2 2 2 2 2
ing Schemes)
STP (Centralised Hub) 1 1 1 1 1
STP Service Providers 2 2 2 2 2
Source: SEBI Handbook
2.1.2 Market Segments

The Securities Market has two inter-dependent and inseparable segments,
the new issues (primary) market and the stock (secondary) market. The
primary market provides the channel for creation and sale of new securities,
while the secondary market deals in securities previously issued.
a. Primary Market
The issuer of securities sells the securities in the primary market to raise
funds for investment and/or to discharge some obligation. In other
words, the market wherein resources are mobilised by public limited
companies or government agencies through issue of new securities
is called the primary market. It enables the corporate entities, public
sector institutions and the government to raise resources through
issuance of debt and equity based instruments. These resources may
be required for new projects as well as for existing projects with a
view to expansion, modernisation, diversification and upgradation.
These resources are mobilized through either of the following two
routes:
i. Public issue where anyone and everyone from the public is
eligible to subscribe for the issue. IPO is the most common
way for companies to raise capital in the primary market.
ii. Private placement where only a selected group of people can
subscribe to the issue.
In addition, the primary market also provides an exit opportunity to
private equity and venture capitalists by allowing them to offload
their stake to the public.
The Primary Market holds great significance to the economy of a
country. It is through this market that funds flow for productive
purposes from investors to entrepreneurs. The latter use the funds

for creating new products and rendering services to customers. The
primary market creates and offers the merchandise for the secondary
market.
TABLE 2.2 CAPITAL RAISED FROM THE PRIMARY MARKET THROUGH
PUBLIC AND RIGHTS ISSUE
Year 2014-15 2015-16 2016-17 2017-18 Apr-Aug 2018
No. of Amount No. of Amount No. of Amount No. of Amount No. of Amount
Issues (Rs. Issues (Rs. Issues (Rs. Issues (Rs. Issues (Rs.
Crore) Crore) Crore) Crore) Crore)
Category Wise
Public 70 12,453 95 48,928 121 58,433 207 88,740 72 31,953

issue
Rights 18 6,750 13 9,239 12 3,415 21 21,400 4 1,127

issue
Total 88 19,202 108 58,167 133 61,848 228 1,10,140 76 33,080
Issue Type
Listed 42 15,892 34 43,351 28 32,753 29 26,366 11 22,176
IPO 46 3,311 74 14,815 105 29,095 199 83,774 65 10,904
Total 88 19,202 108 58,167 133 61,848 228 1,10,140 76 33,080
Source : SEBI
b. Secondary Market
The secondary market is the market for sale or purchase of already
issued securities. A well functioning secondary market is a prerequi-
site for the growth of primary market. An efficient secondary market
provides the much needed liquidity and marketability in financial
system. The secondary market enables those who hold securities to
adjust their holdings in response to changes in their assessment of
risk and return. Investors also sell securities for cash to meet their
liquidity needs. The price signals, which subsume all information
about the issuer and his business including, associated risk, generated
in the secondary market, help the primary market in allocation of
funds.
Secondary market essentially operates through two mediums:
i. Over the counter (OTC) market - This market is informal and
trades are negotiated here. Most of the trades in government
securities take place in this market. Further, all the spot trades
where securities are traded for immediate delivery and payment
occur in OTC market.
ii. Exchange traded market - Stock exchanges provide platform for
purchase and sale of securities by investors. The stock market
ensures free marketability, negotiability and price discharge.

All the trades taking place over a trading cycle (day=T) are
settled after a certain time T+ 1 Days). The trades executed
are cleared and settled by a clearing corporation.
A variant of the secondary market is the Derivatives Market where
the securities are traded for future delivery and payment.
Out of all the stock exchanges in India, BSE and NSE are the leading
stock exchanges. Given below is a brief description about them:
i. BSE
Established in the year 1875, BSE Ltd. (formerly known as
Bombay Stock Exchange), is Asia’s first stock exchange and
one of India’s leading stock exchange. Over the past 140 years,
BSE has facilitated the growth of the Indian corporate sector
by providing an efficient capital-raising platform. Popularly
known as BSE, the bourse was established as “The Native Share
& Stock Brokers’ Association” in 1875. BSE is a corporatized
and demutualised entity now. BSE provides an efficient and
transparent market for trading in equity, debt instruments,
derivatives, and mutual funds. It also has a platform for trading
in equities of small-and-medium enterprises (SME).
More than 5500 companies are listed on BSE making it world’s
No. 1 exchange in terms of listed companies. The companies
listed on BSE command a total market capitalization of USD
1.68 Trillion as of March 2015. It is also one of the world’s lead-
ing exchanges (5th largest in March 2015) for Index options
trading.
BSE also provides a host of other services to capital market
participants including risk management, clearing, settlement,
market data services and education. It has a global reach with
customers around the world and a nation-wide presence. BSE
systems and processes are designed to safeguard market integ-
rity, drive the growth of the Indian capital market and stimulate
innovation and competition across all market segments. BSE is
the first exchange in India and second in the world to obtain an
ISO 9001:2000 certification. It is also the first Exchange in the
country and second in the world to receive Information Security
Management System Standard BS 7799-2-2002 certification for
its On-Line trading System (BOLT). It operates one of the most
respected capital market educational institutes in the country
(the BSE Institute Ltd.). BSE also provides depository services

through its Central Depository Services Ltd. (CDSL) arm.
BSE’s popular equity index - the S&P BSE SENSEX - is India’s
most widely tracked stock market benchmark index. It is traded
internationally on the EUREX as well as leading exchanges of
the BRCS nations (Brazil, Russia, China and South Africa).
ii. NSE
The National Stock Exchange (NSE Ltd.) is India’s leading stock
exchange covering various cities and towns across the country.
NSE was set up by leading institutions to provide a modern, fully
automated screen-based trading system with national reach.
The Exchange has brought about unparalleled transparency,
speed & efficiency, safety and market integrity. It has set up fa-
cilities that serve as a model for the securities industry in terms
of systems, practices and procedures. NSE was promoted by
leading Financial Institutions at the behest of the Government
of India and was incorporated in November 1992 as a tax-paying
company unlike other existing stock exchanges in the country.
It began its operations in the year 1994.
The National Stock Exchange (NSE) operates a nation-wide,
electronic market, offering trading in Capital Market, Derivatives
Market and Currency Derivatives segments including equities,
equities based derivatives, Currency futures and options, equity
based ETFs, Gold ETF and Retail Government Securities. At
present NSE network stretches to more than 1,500 locations in
the country and supports more than 2, 30,000 terminals.
NSE has played a catalytic role in reforming the Indian securi-
ties market in terms of microstructure, market practices and
trading volumes. The market today uses state-of-art informa-
tion technology to provide an efficient and transparent trading,
clearing and settlement mechanism, and has witnessed several
innovations in products & services viz. demutualisation of stock
exchange governance, screen based trading, compression of
settlement cycles, dematerialisation and electronic transfer of
securities, securities lending and borrowing, professionalization
of trading members, fine-tuned risk management systems,
emergence of clearing corporations to assume counterparty
risks, market of debt and derivative instruments and intensive
use of information technology.
iii. SME Exchange

Small and Medium Enterprises (SMEs), particularly in deve-
loping countries, are the backbone of the nation’s economy.
They constitute bulk of the industrial base and also contribute
significantly to their exports as well as their Gross Domestic
Products. India has high entrepreneurial potential and the SME
sector has been a key engine of economic growth, job creation,
wealth distribution, and effective mobilisation of resources
(capital and skills).
“Small and Medium Enterprises (SMEs), including start-up
companies, are now permitted to list on the SME exchange
without being required to make an initial public offer (IPO), but
the participation will be restricted to informed investors. This
is in addition to the existing SME platform in which listing can
be done through an IPO and with wider investor participation”.
The SME platform is a regulated platform under the purview of
the SEBI. The two stock exchange of India i.e. Bombay Stock
Exchange (BSE) and National Stock Exchange (NSE) have
begun their SME listing platforms. While BSE SME Exchange
began its operation in March, 2012, NSE’s SME exchange titled
EMERGE commenced operations in September, 2012.
The basic indicators in cash segment are summarised in the Table: 2.3
Table 2.3 Indicators in Indian stock market (cash segment)
Particulars 2014-15 2015-16 2016-17 2017-18 Apr-Aug 2018

Indices (closing value)
S&P BSE Sensex 27957.5 25,342 29,621 32,969 38,645
CNX Nifty 8606.6 7,738 9,174 10,114 11,681
Market capitalisation (In Rs. crore)
BSE 1,01,49,290 94,75,328 1,21,54,525 1,42,24,997 1,59,34,696
NSE 99,30,122 93,10,471 1,19,78,421 1,40,44,152 1,57,30,918
Gross Turnover (in Rs. crore)
BSE 8,54,845 7,40,089 9,98,261 10,82,968 3,44,217
NSE 32,06,392 42,36,983 50,55,913 72,34,826 33,01,886
No. of listed companies
BSE 5,624 5,911 5,834 5,619 5,233
NSE 1,733 1,808 1,817 1,931 1,916
(Source: SEBI Monthly Bulletins)
2.2 TRADING MECHANISM ON EXCHANGES

Over the years, trading on stock exchanges has witnessed a great revolu-
tion. There was hardly any information technology usage in initial days.
The investor used to place an order with a broker, then this broker would
contact the dealer and if things work out for both parties, the order was
executed. However, this process was time consuming, non-transparent
and inefficient.
NSE for the first time introduced a nation-wide fully automated screen based
trading system in India in the year 1994. The system allowed a member
of NSE to enter the price and the desired number of shares he wanted to
buy (or sell) and the order would be executed as soon as the system could
find a matching sale (or buy) order. The trading system, known as National
Exchange for Automated Trading (NEAT) operates on a strict price/time
priority. It enables members from across the country to trade simultaneously
with enormous ease and efficiency. It provides tremendous flexibility to the
users in terms of kinds of orders that can be placed on the system. Several
time-related (Good-till-Cancelled, Good-till-Day, Immediate-or-Cancel),
price-related (buy/sell limit and stop-loss orders) or volume related (All-
or-None, Minimum Fill, etc.) conditions can be easily built into an order.
Orders are sorted and matched automatically by the computer keeping the
system transparent, objective and fair. The trading system also provides
complete market information on-line, which is updated on real time basis.
Due to Computerised trading NSE emerged as the largest stock exchange
in India in 1995. The successful idea of screen based trading was followed
by many other innovations in 1990s. One of them is the reduction in trad-
ing cycle period. Earlier, the trading cycle used to vary from 14 days to 30
days. Not only the time was a bit long, it also allowed investors to default
in the times of adversely moving stock prices. To reduce such problems,
the trading cycle was reduced to one week and it was replaced by rolling
settlement subsequently. The rolling settlement was first introduced on
T+5 basis; which has now shortened to T + 1 rolling settlement
The third major innovation in 1990s was the use of technology to provide
nation-wide trading. NSE, once again, introduced the concept of satellite
trading in India. It used the satellite technology to allow trading through
2,849 VSATs from around 340 cities. This move encouraged investors to
access the same market and book orders from anywhere in India. This
resulted in wider market participation and increased liquidity.
Following the footsteps of NSE, BSE switched to a fully automated comput-
erised mode of trading system called as BOLT(BSE On Line Trading) and
many other exchanges followed suit. In on-line trading system orders are
35 Trading Mechanism on exchanges Para 2.2
electronically matched on price-time priority and hence cut down on time

and cost. It enables market participants to see the full market on real-time,
making the market transparent.
2.2.1 National Securities Clearing Corporation Limited (NSCCL)

The National Securities Clearing Corporation Ltd. (NSCCL), a wholly owned
subsidiary of NSE, was incorporated in August 1995. It was the first clear-
ing corporation to be established in the country and also the first clearing
corporation in the country to introduce settlement guarantee.
It was set up with the following objectives:
u to bring and sustain confidence in clearing and settlement of secu-
rities;
u to promote and maintain, short and consistent settlement cycles;
u to provide counter-party risk guarantee, and
u to operate a tight risk containment system.
NSCCL commenced clearing operations in April 1996. It has since
completed more than 2400 settlements (equities segment) without
delays or disruptions.
Clearing Mechanism
Trades in rolling segment are cleared and settled on a netted basis. Trading
and settlement periods are specified by the Exchange/Clearing Corporation
from time to time. Deals executed during a particular trading period are
netted at the end of that trading period and settlement obligations for that
settlement period are computed. A multilateral netting procedure is adopted
to determine the net settlement obligations. In a rolling settlement, each
trading day is considered as a separate trading period and trades executed
during the day are netted to obtain the net obligations for the day. Trade-
for-trade deals and Limited Physical Market deals are settled on a trade
for trade basis and settlement obligations arise out of every deal.
Clearing & Settlement (Equities)
NSCCL carries out clearing and settlement functions as per the settlement
cycles of different sub-segments in the Equities segment. The clearing
function of the clearing corporation is designed to work out
(a) what counter parties owe
(b) what counter parties are due to receive on the settlement date.
Settlement
Settlement is a two way process which involves legal transfer of title to
funds and securities or other assets on the settlement date. NSCCL has also
devised mechanism to handle various exceptional situations like security
shortages, bad delivery, company objections, auction settlement etc.
NSCCL has empanelled 13 clearing banks to provide banking services to
trading members and has established connectivity with both the deposi-
tories for electronic settlement of securities.
Clearing
Clearing is the process of determination of obligations, after which the
obligations are discharged by settlement.
NSCCL has two categories of clearing members: trading members and
custodians.
Trading members can trade on a proprietary basis or trade for their clients.
All proprietary trades become the member’s obligation for settlement. Where
trading members’ trade on behalf of their clients they could trade for nor-
mal clients or for clients who would be settling through their custodians.
The whole trading process at NSE can be summarised in Fig 2.1.
NSE
8 9
DEPOSITORIES NSCCL CLEARING
BANK
6 7
10 5 2 3 4 11
CUSTODIANS CMs
Fig 2.1 : Trading process at NSE

1. Trade details are sent from the exchange to the NSCCL (real-time
and end-of-day trade file).
2. The NSCCL notifies the consummated trade details to clearing
members/custodians, who affirm back. Based on the affirmation,
the NSCCL applies multilateral netting and determines obligations.
37 Stock indices Para 2.3
3. Download of obligation and pay-in advice of funds/securities.

4. Instructions to clearing banks to make funds available by pay-in time.
5. Instructions to depositories to make securities available by pay-in-time.
6. Pay-in of securities (the NSCCL advises the depository to debit the
pool account of the custodians/CMs and credit its account, and the
depository does so).
7. Pay-in of funds (the NSCCL advises the clearing banks to debit the
account(s) of the custodians/CMs and credit its account, and the
clearing banks do so).
8. Pay-out of securities (the NSCCL advises the depository to credit the
pool account of the custodians/CMs and debit its account, and the
depository does so).
9. Pay-out of funds (the NSCCL advises the clearing banks to credit
the account(s) of the custodians/CMs and debit its account, and the
clearing banks do so).
10. Depository informs the custodians/CMs through DPs.
11. Clearing banks inform the custodians/CMs.
2.3 STOCK INDICES

An Index is used to give information about the price movements of prod-
ucts in the financial, commodities or any other markets. Financial indices
are constructed to measure price movements of stocks, bonds, T-bills and
other forms of investments.
Stock market indices are meant to capture the overall behaviour of equity
markets. A stock market index is created by selecting a group of stocks that
are representative of the whole market or a specified sector or segment
of the market. An Index is calculated with reference to a base period and
a base index value.
Stock market indices are useful for a variety of reasons - Some of them are:
u They provide a historical comparison of returns on money invested
in the stock market against other forms of investments such as gold
or debt.
u They can be used as a standard against which to compare the per-
formance of an equity fund.
u It is a lead indicator of the performance of the overall economy or
a sector of the economy.
u Stock indexes reflect highly up to date information.

u Modern financial applications such as Index Funds, Index Futures,
Index Options play an important role in financial investments and
risk management.
The two prominent Stock market indices in India are SENSEX and
NIFTY. Indices on BSE and NSE are classified into three categories:
i. Broad Market indices - These indices represent the broad mar-
ket and include companies from across a number of sectors.
ii. Sectoral Indices - Sector-based index are designed to provide
a single value for the aggregate performance of a number of
companies representing a group of related industries or within
a sector of the economy.
iii. Thematic Indices - Thematic indices are designed to provide
a single value for the aggregate performance of a number of
companies representing a theme such as green investing, ethical
investing, infrastructure etc.
Besides these three type of indices, we also have Strategy Indices on NSE
such as CNX 100 Equal Weight, CNX Alpha Index, CNX Defty, CNX Dividend
Opportunities Index, CNX High Beta Index, CNX Low Volatility Index,
CNX Nifty Dividend, NSE, NV20 Index Quality 30, NI15 Index, Nifty PR 1X
Inverse, Nifty PR 2X Leverage, Nifty TR 2X Leverage, Nifty TR 1X Inverse
Table 2.4 Indices on BSE and NSE
BSE NSE
Broad Market Indices Broad Market Indices
S&P BSE Sensex CNX Nifty
S&P BSE100 CNX Nifty Junior
S&P BSE 200 LIX 15
S&P BSE 500 LIX15 Midcap
S&P BSE Mid Cap CNX 100
S&P BSE Small Cap CNX 200
S&P BSE All Cap CNX 500
S&P BSE Large Cap Nifty Midcap 50
S&P BSE Large Mid Cap CNX Midcap
S&P BSE Mid small Cap CNX Smallcap Index
S&P BSE Mid cap select India VIX
Sectoral indices-
Sectoral indices- CNX Auto Index
39 Stock indices Para 2.3
BSE NSE
Broad Market Indices Broad Market Indices
S&P BSE Auto CNX Bank Index
S&P BSE Bankex CNX Energy Index
S&P BSE Consumer durables CNX Finance Index
S&P BSE Capital Goods CNX FMCG Index
S&P BSE Fast Moving Consume Goods CNX IT Index
S&P BSE Healthcare CNX Media Index
S&P BSE Information Technology CNX Metal Index
S&P BSE Metal CNX Pharma Index
S&P BSE Oil and Gas CNX PSU Bank Index
S&P BSE Power CNX Realty Index
S&P BSE Realty IISL CNX Industry Indices
S&P BSE Teck Thematic indices -
Thematic Indices- CNX Commodities Index
S&P BSE GREENEX CNX Consumption Index
S&P BSE CARBONEX CPSE Index
S&P BSE PSU CNX Infrastructure Index
S&P BSE India Infrastructure Index CNX MNC Index
S&P BSE CPSE CNX PSE Index
S&P BSE India Manufacturing Index CNX Service Sector Index
S&P BSE IPO CNX Shariah25
S&P BSE SME IPO CNX Nifty Shariah/CNX 500 Shariah
Index
Three prominent indices are explained below:
1. BSE SENSEX : Sensex, the oldest market index for equities, is a
free-float market-weighted stock market index of 30 largest, most
liquid and financially sound companies listed at BSE Ltd. The 30
companies represent various industrial sectors of the economy. It
was created in 1986 and provides time series data from April 1979
onward. The Free-float Methodology takes into consideration only
the free-float market capitalization of a company for the purpose of
index calculation and assigning weight to stocks in the Index. Free-
float market capitalization takes into consideration only those shares
issued by the company that are readily available for trading in the
market. It generally excludes promoters’ holding, government holding,
strategic holding and other locked-in shares that will not come to the
market for trading in the normal course. In other words, the market
capitalization of each company in a Free-float index is reduced to the
extent of its readily available shares in the market. Till date, Sensex
is considered as the pulse of the domestic stock markets in India.
2. CNX NIFTY : The CNX Nifty is a well diversified 50 stock index
accounting for 23 sectors of the economy. It is used for a variety of
purposes such as benchmarking fund portfolios, index based deriv-
atives and index funds. It was created in 1996.
CNX Nifty is owned and managed by India Index Services and Pro-
ducts Ltd. (IISL). IISL is India’s first specialised company focused
upon the index as a core product.
u The CNX Nifty Index represents about 66.17% of the free float
market capitalization of the stocks listed on NSE as on March
31, 2015.
u The total traded value for the last six months ending March
2015 of all index constituents is approximately 46.22% of the
traded value of all stocks on the NSE.
u Impact cost of the CNX Nifty for a portfolio size of Rs. 50 lakhs
is 0.06% for the month March 2015.
u CNX Nifty is professionally maintained and is ideal for derivatives
trading.
3. S&P BSE GREENEX
For promoting green investing in India, recently Bombay Stock
Exchange (BSE) has launched “BSE-GREENEX” on 22nd February,
2012. It is the 25th dynamic index hosted on the Bombay Stock
Exchange. “It is a first veritable step in creating an inclusive market
based mechanism for the promotion of energy efficient practices
amongst the largest business entities in India. It is a new index of
sustainability stocks that helps investors looking for green companies.
GREENEX comprises of 20 companies from the broader BSE 100
index that meet energy efficient norms, allowing investors to derive
benefit from the related cost savings. The index allows investors to
track companies that invest in energy efficient practices. It allows
asset managers to create products to help investors put their money
in green enterprises and make green investments. GREENEX is tar-
geted at retail as well as institutional investors such as pension funds
looking for investment in companies with strong long-term prospects
and develop green financial products” (The Hindu, February 23, 2012).
41 SOURCES OF FINANCIAL INFORMATION Para 2.4
2.4 SOURCES OF FINANCIAL INFORMATION

Information is said to be the most precious asset in today’s time. Right
kind information at the right time can help in taking a quick decision for
achieving a laid out objective. In context of stock market investment, in-
vestors have to take buy/sell decision for which they require complete and
accurate information about the various securities traded in the market.
2.4.1 Types of information

i. Economy level: Economic health of a nation and the returns provid-
ed by various investment avenues in a nation are highly correlated.
Investors reap higher returns during a flourishing economy, while
the returns would doom during a downward pressure on economic
growth and development. Stock markets are also said to perform
better when the GDP growth rates are high in a nation. Therefore,
investors would definitely want to analyse some economic information
like interest rates, inflation, GDP growth rates, unemployment levels,
exchange rates, etc. before taking any investment decision. HSBC
PMI is a popularly index which depicts the health of manufacturing
sector of economy.
ii. Industry level: An industry’s performance is a leading indicator of
future performance of companies in that industry. For e.g. IIP (Index
of Industrial production) is an indicator of manufacturing activity in
India. It is published by Ministry of commerce and industry. CMIE
publishes Industry outlook. Also, organisations like CII, FICCI, NASS-
COMM, etc. periodically release industry reviews.
iii. Company level: Mostly, investors are concerned about profitability
of a company, market price of its shares, PE ratio, dividend yield,
cash flows, volume turnover, etc. For a company, investors may need
following two types of data:
a. Accounting data
b. Market data regarding trading of shares or bonds of a company.
2.4.2 Sources of information

i. Annual reports
Financial statement of a company is the most fundamental source
of accounting and financial data pertaining to a company. It is pub-
lished annually as well as quarterly on company websites and lead-
ing national daily newspapers. The annual financial statements of a
company comprise of balance sheet, income statement, cash flow

statement, corporate governance reports, key financial ratios, etc.
ii. Stock exchanges
With the ICT revolution, the stock exchanges are also not far behind.
They are catching up faster on the technology front. Almost all the
leading stock exchanges like NSE, BSE, MCX, MSEI and USE have
well-maintained websites. Stock exchanges maintain all the trading
data like historical prices, volume, high/low prices, order level data,
etc. which can be used by researchers, investors, data analysts, etc.
However, some of the trading data is confidential and thus one has
to buy it from the exchange after signing an undertaking.
iii. News Websites
These days most of the information is available at the click of a
mouse. Popular business news groups like economic times, TV18,
etc. provide historical data for stocks, indices, mutual funds, etc. One
can also gather accounting data, annual reports, comparative data,
charts form these websites free of cost. Most prominently accessed
websites in India are:
a. Moneycontrol.com
b. Yahoofinance.com
c. Economictimes.com
iv. Database Software
a. Bloomberg: It is leading source of financial information re-
garding companies, stock markets, etc. It is an online data-
base providing current and historical quotes, business news,
research and statistics on over 52000 companies worldwide.
It is frequently used by data analysts. It can be accessed at
dedicated terminals in libraries or companies.
b. CMIE prowess: Centre for Monitoring Indian Economy (CMIE)
is a leading organisation which maintains economic and busi-
ness data about India. It was established in1976. Prowess is its
flagship database which provides financial information about
Indian companies. CMIE also keeps a reserve of economic data
pertaining to India and its states. It is subscribed (paid) source
of information for researchers.
v. Institutional Publications
a. RBI: RBI being the regulator of money market in India main-
tains a reserve of data concerning money market and foreign
43 SOURCES OF FINANCIAL INFORMATION Para 2.4
exchange market. It publishes reviews of monetary policy

quarterly, half yearly, annually. RBI website can be accessed
for data on money supply, interest rates, bank rates, repo,
reverse repo rate, foreign exchange rates, etc.
b. SEBI: Securities and Exchange Board of India is the regulator
of capital markets in India. It collects, maintains and publishes
significant information about stock exchanges, various mar-
ket segments, etc. in the form of market turnover, market
capitalisation, number of IPOs, number of companies listed.
It publishes monthly bulletins, annual reports, ISMR (Indian
Securities Market Review), etc.
c. OECD: OECD is the organisation for economic and cooper-
ation and development which was established in 1961. Apart
from policy making and advisory role, it also maintains an
extensive set of database for its member nations. It maintains
OECD Regional database which is a unique set of comparable
statistics and indicators on about 2000 regions in 34 coun-
tries. It has around 40 indicators on demography, economic
accounts, labour market, social themes, etc. It also has OECD
Metropolitan database which provides estimated indicators
on 281 OECD metropolitan area (urban areas)
2.4.3 Precautions while using financial information sources

1. It is important to access financial information from authentic sources
like company’s official website, lest there are chances of errors and
distortions in information.
2. Using only a single source is likely to give you incomplete information
about a product. So, always check more than one source and form
your own opinion about which investment suits you best.
3. Always use most recent information to take investment decisions.
Securities markets are very dynamic and outdated information will
not be fruitful in making investor strategies.
4. While using blogs, search engines such as Google or Yahoo, etc. one
shall verify every data with other sources too.
5. At times such information is fed with personal analyses or opinions
of individual investors, so, it is pertinent that one learns to identify
and segregate this from real financial information.
Para 2.4A Indian Securities Market 44
2.4A Regulation of Securities Market in India (SEBI)

The Securities and Exchange Board of India (SEBI) is the regulator of
capital market or securities market in India. It was established in the year
1988 as an administrative body and was given statutory powers on April
12, 1992 in accordance with the provisions of the Securities and Exchange
Board of India Act, 1992.
Management of the Board

The Board of SEBI consists of members, namely:-
(a) a Chairman
(b) two members from amongst the officials of the Central Government
dealing with Finance
(c) one member from amongst the officials of the Reserve Bank
(d) five other members of whom at least three shall be the whole-time
members to be appointed by the central Government.
Functions of SEBI
The Preamble of SEBI describes its basic functions. It reads as:
“...to protect the interests of investors in securities and to promote the
development of, and to regulate the securities market and for matters
connected therewith or incidental thereto”.
Section 11 of SEBI Act lays down that it shall be the duty of SEBI to protect
the interests of the investors in securities and to promote the development
of, and to regulate the securities markets by such measures as it thinks fit.
To achieve the aforementioned objectives, the Board may undertake the
following measures:
u regulating the business in stock exchanges and any other securities
markets;
u registering and regulating the working of stock brokers, sub-brokers,
share transfer agents, bankers to an issue, trustees of trust deeds,
registrars to an issue, merchant bankers, underwriters, portfolio
managers, investment advisers and such other intermediaries who
may be associated with securities markets in any manner;
u registering and regulating the working of the depositories, partici-
pants, custodians of securities, foreign institutional investors, credit
rating agencies and such other intermediaries as the Board may, by
notification, specify in this behalf;
45 Regulation of securities market in India Para 2.4A
u registering and regulating the working of venture capital funds and

collective investment schemes including mutual funds;
u promoting and regulating self-regulatory organisations;
u prohibiting fraudulent and unfair trade practices relating to securities
markets;
u promoting investors’ education and training of intermediaries of
securities markets;
u prohibiting insider trading in securities;
u regulating substantial acquisition of shares and take-over of compa-
nies;
u calling for information from, undertaking inspection, conducting
inquiries and audits of the stock exchanges, mutual funds, other
persons associated with the securities market intermediaries and
self-regulatory organizations in the securities market;
u performing such functions and exercising such powers under the
provisions of the Securities Contracts (Regulation) Act, 1956 (42 of
1956), as may be delegated to it by the Central Government;
u levying fees or other charges for carrying out the purposes of this
section;
u inspection of any book, or register, or other document or record of
any listed public company or a public company which intends to get
its securities listed on any recognised stock exchange;
u conducting research for the above purposes;
u performing such other functions as may be prescribed.
2.4A.1 Reforms introduced by SEBI

SEBI has come a long way since its inception as an institution regulating
the Indian Capital Markets. It has initiated a lot of reforms to make the
market safer for investors. The following are the major policy initiatives
taken by SEBI since its inception :
(a) Control over Issue of Capital : A major initiative of liberalisation was
the repeal of the Capital Issues (Control) Act, 1947 in May 1992. In the
interest of investors, SEBI issued Disclosure and Investor Protection
(DIP) guidelines. The guidelines allow issuers, complying with the
eligibility criteria, to issue securities at market determined rates. The
market moved from merit based to disclosure based regulation.
(b) Screen Based Trading : A major developmental initiative was a

nation-wide on-line fully-automated screen based trading system
(SBTS), where a member can punch into the computer quantities of
securities and the prices at which he likes to transact and the trans-
action is executed as soon as it finds a matching sale or buy order
from a counter party.
(c) Risk management : A number of measures were taken to manage
the risks in the market so that the participants are safe and market
integrity is protected. These include:
i. Trading Cycle : The trading cycle varied from 14 days for
specified securities to 30 days for others and settlement took
another fortnight. Often this cycle was not adhered to. Many
things could happen between entering into a trade and its
performance providing incentives for either of the parties to
go back on its promise. This had on several occasions led to
defaults and risks in settlement. In order to reduce large open
positions, the trading cycle was reduced over a period of time
to a week initially. Rolling settlement on T+1 basis was intro-
duced in phases. All scrips moved to rolling settlement from
December 2001.
ii. Dematerialisation : Trades used to be settled by physical
movement of paper. The process of physically moving the
securities from the seller to the ultimate buyer through the
seller’s broker and buyer’s broker took time with the risk of
delay somewhere along the chain. Moreover, the system of
transfer of ownership was grossly inefficient as every transfer
involved physical movement of paper securities to the issuer
for registration, with the change of ownership being evidenced
by an endorsement on the security certificate. Theft, forgery,
mutilation of certificates and other irregularities were rampant,
and in addition the issuer had the right to refuse the transfer
of a security. All this added to costs, and delays in settlement,
restricted liquidity and made investor grievance redressal time
consuming and at times intractable. To obviate these problems,
the Depositories Act, 1996 was passed to provide for the es-
tablishment of depositories in securities with the objective of
ensuring free transferability of securities with speed, accuracy
and security by
u making securities of public limited companies freely
transferable subject to certain exceptions;
u dematerialising the securities in the depository mode;

and
u providing for maintenance of ownership records in a
book entry form.
In order to streamline settlement process, the Act envisages
transfer of ownership of securities electronically by book entry
without making the securities move from person to person.
iii. Derivatives : To assist market participants to manage risks
better through hedging, speculation and arbitrage, Securities
Contracts (Regulation) Act (SCRA) was amended in 1995 to
lift the ban on options in securities. The SC(R)A was amended
further in December 1999 to expand the definition of securities
to include derivatives so that the whole regulatory framework
governing trading of securities could apply to trading of deriv-
atives also. A three-decade old ban on forward trading, better
known as BADLA, which had lost its relevance and was hindering
introduction of derivatives trading, was withdrawn. Derivative
trading took off in June 2000 on two exchanges BSE & NSE.
iv. Settlement Guarantee - A variety of measures were taken to
address the risk in the market. Clearing corporations emerged
to assume counter party risk. Trade and settlement guarantee
funds were set up to guarantee settlement of trades irrespec-
tive of default by brokers. These funds provide full novation
and work as central counter party. The Exchanges/clearing
corporations monitor the positions of the brokers on real time
basis. NSCCL was set up by NSE in 1996.
v. Securities Market Awareness - In January 2003, SEBI launched
a nation-wide Securities Market Awareness Campaign that
aims at educating investors about the risks associated with
the market as well as the rights and obligations of investors.
vi. Green Shoe Option - As a stabilization tool for post listing price
of newly issued shares, SEBI has introduced the green shoe
option facility in IPOs.
vii. Securities Lending and Borrowing - A clearing corporation/
clearing house, after registration with SEBI, under the SEBI
scheme for Securities Lending and Borrowing, as an approved
intermediary, may borrow securities for meeting shortfalls in
settlement, on behalf of the members.
viii. Corporate Governance - To improve the standards of corpo-

rate governance, SEBI amended Clause 49 of the Listing
Agreement. The major changes in the new Clause 49 include
amendments/additions to provisions relating to definition of
independent directors, strengthening the responsibilities of
audit committees, improving quality of financial disclosures,
including those pertaining to related party transactions and
proceeds from public/rights/preferential issues, requiring
Boards to adopt formal code of conduct, requiring CEO/CFO
certification of financial statements and improving disclosures
to shareholders. Certain non-mandatory clauses like whistle
blower policy and restriction of the term of independent
directors have also been included.
ix. Debt Listing Agreement - In order to further develop the cor-
porate debt market, SEBI prescribed a model debenture listing
agreement for all debenture securities issued by an issuer
irrespective of the mode of issuance.
x. Gold Exchange Traded Funds in India - SEBI appointed a
Committee for the introduction of Gold Exchange Traded
Fund (GETF) in India in 2005. Based on the recommendations
of the said Committee, the SEBI (Mutual Funds) Regulations,
1996 were amended and notification was issued on January
12, 2006 permitting mutual funds to introduce GETFs in India
subject to certain investment restrictions.
xi. Guidelines for Issue of Indian Depository Receipts (IDRs) -
SEBI issued Guidelines on disclosures and related requirements
for companies desirous of issuing IDRs in India. SEBI also
prescribed the listing agreement for entities issuing IDRs.
xii. Grading of Initial Public offerings (IPOs) - Grading of all IPOs
was made mandatory. The grading would be done by credit
rating agencies, registered with SEBI. It would be mandatory
to obtain grading from at least one credit rating agency. The
grading would be disclosed in the prospectus, abridged pro-
spectus and in every advertisement for IPOs.
xiii. Introduction of Fast Track Issuances - To enable compliant
listed companies to access Indian primary market in a time
effective manner through follow-on public offerings and rights
issues, SEBI introduced fast track issue mechanism. To make
the issuance process fast, the earlier requirement of filing draft
offer documents was amended and the need to file draft offer
documents with SEBI and the stock exchanges was done away
with.
xiv. Mandatory Requirement of Permanent Account Number (PAN)
for All Transactions in the Securities Market - SEBI stipulated
that PAN would be the sole identification number for all partic-
ipants in the securities market, irrespective of the amount of
transaction with effect from July 02, 2007. The objective was
to strengthen the ‘Know Your Client’ (KYC) norms through a
single identification number for all participants in the securities
market for facilitating sound audit trail.
xv. Corporate Debt Market - In order to develop a sound corporate
debt market in India, SEBI took a number of policy initiatives
with respect to the following areas:
i. setting up of reporting platforms for corporate bonds,
ii. setting up of trading platform for corporate bonds,
iii. issues pertaining to trading in corporate bonds,
iv. making amendments to the listing agreement for deben-
tures,
v. issuing securitised debt instruments regulations,
vi. evolving policy guidelines on debenture trustees,
vii. introducing Repos in corporate bonds,
viii. facilitating setting up of quote dissemination platforms,
ix. simplifying corporate bond issuance norms and
x. framing of draft issue and listing regulations for corpo-
rate bonds.
xvi. Setting up of SME Exchange - SEBI decided to put in place a
framework for setting up of new exchange or separate platform
of existing stock exchange having nationwide terminals for
SME. In order to operationalise the said framework, necessary
changes have been made to applicable regulations, circulars
etc. As per the framework, market making has been made
mandatory in respect of all scrips listed and traded on SME
exchange.
xvii. Application Supported by Blocked Amount (ASBA) - ASBA is
the acronym for Application Supported by Blocked Amount.
ASBA is an application containing an authorization to block
the application money in the bank account, for subscribing
to an issue. If an investor is applying through ASBA, his appli-
cation money shall be debited from the bank account only if

his/her application is selected for allotment after the basis of
allotment is finalized and only the proportional amount will
be debited. It is a supplementary process of applying in Initial
Public Offers (IPO) and Follow-On Public Offers (FPO) made
through Book Building route and co-exists with the current
process of using cheque as a mode of payment and submitting
applications. ASBA facility allows the investor to enjoy interest
on the blocked amount till the time of allotment. Hence his
opportunity cost would be lower if he applies for an IPO. ASBA
is stipulated by SEBI, and available from most of the banks
operating in India. This allows the investors money to remain
with the bank till the shares are allotted after the IPO. Only
then does the money transfers out of the investors account to
the company. This eliminates the need for refunds on shares
not being allotted.
SEBI made ASBA bid-cum application forms available for
download and printing, from websites of the Stock Exchanges
which provide electronic interface for ASBA facility i.e. Bombay
Stock Exchange (BSE) and National Stock Exchange (NSE).
The ASBA forms so downloaded should have a unique appli-
cation number and can be used for making ASBA applications
in public issues.
xviii. Securitized Debt Instruments - In order to develop the primary
market for securitized debt instruments in India, SEBI notified
the Securities and Exchange Board of India (Public Offer and
Listing of Securitised Debt Instruments) Regulations, 2008. The
regulations provide for a framework for issuance and listing
of securitized debt instruments by a Special Purpose Distinct
Entity (SPDE).
xix. SCORES - SEBI has commenced processing of investor griev-
ances against the intermediaries in a centralized web-based
complaints redressal system, ‘SCORES’ at http://scores.gov.
in/Admin.
xx. Facility of e-voting by shareholders has also been enabled in 2012.
xxi. Business Responsibility Reports - SEBI inserted Clause 55 in
the Equity Listing Agreement, mandating inclusion of Business
Responsibility Reports (“BR reports”) as part of the Annual
Reports for listed entities in line with the ‘National Voluntary
Guidelines on Social, Environmental and Economic Responsi-

bilities of Business’ issued by the Ministry of Corporate Affairs.
xxii. FPI Regulations - SEBI notified the SEBI (Foreign Portfolio
Investors) Regulations, 2014 on January 7, 2014 to simplify
compliance requirements and have uniform guidelines for
various categories of Foreign Portfolio Investors (FPIs) like
Foreign Institutional Investors (FIIs) including their sub-
accounts, if any, and Qualified Foreign Investors (QFIs).
xxiii. Revised clause 49 for listing argument - With the objectives to
align with the provisions of the Companies Act, 2013, to adopt
best practices on corporate governance and to make the cor-
porate governance framework more effective, SEBI revised
clause 49 of the listing agreement with effect from October
1, 2014. Details are provided in Chapter 12.
xxiv. Categorization and rationalization of Mutual Fund schemes -
In order to bring uniformity in the characteristics of similar
type of schemes launched by different Mutual Funds, in 2017,
vide circular SEBI/HO/IMD/DF3/CIR/P/2017/114; SEBI has
standardized the scheme categories and characteristics of each
category. This would ensure that an investor of Mutual Funds
is able to evaluate the different options available, before taking
an informed decision to invest in a scheme:
u Accordingly, mutual funds have been recategorized
into: Equity Schemes, Debt Schemes, Hybrid Schemes,
Solution Oriented Schemes and Other Schemes. Each of
these has been well defined by SEBI to avoid confusion
regarding nature of fund.
u Moreover, the mutual funds are instructed to rationalize
the number of schemes issued by them. Only one scheme
per category would be permitted, except:
n Index Funds/ETFs replicating/tracking different
indices;
n Fund of Funds having different underlying schemes;
and
n Sectoral/thematic funds investing in different sec-
tors/themes
u In case of Solution oriented schemes, there will be a
specified lock-in period.
xxv. Integration of broking activities of equity and commodity

markets - SEBI in its Board meeting on December 28, 2017
has approved the proposal of trading of commodity derivatives
and other segments of securities market on a single exchange
with effect from October 1, 2018.
2.5 LATEST DEVELOPMENTS

a. Merger of Forwards Market Commission with SEBI
Multiplicity of regulatory agencies has always been a challenge
in Indian securities markets. It not only results in delays in policy
administration but also ineffective and inefficient regulation at times.
Hence there is a move towards reducing the number of regulatory
organisation in India. An important step in this direction is the recent
merger of Forwards Market Commission with the SEBI. On 28th Sep-
tember 2015, Forwards market Commission, the market regulator
for commodity derivatives in India, merged with SEBI to provide
for effective and efficient regulation of all derivatives trading under
one regulatory regime.
b. DMA and Algorithmic Trading
Direct Market Access and Algorithmic trading was allowed in India
in April 2008. DMA opened up faster access to Indian markets for
financial institutions across the world. Now a significant movement
is going on all across the world, to consume the liquidity in a better
way, and increase capacities everywhere in the markets.
u Direct Market Access (DMA) - DMA is a facility which allows
brokers to offer clients direct access to the exchange trading
system through the broker’s infrastructure without manual
intervention by the broker. Some of the advantages offered by
DMA are direct control of clients over orders, faster execution
of client orders, reduced risk of errors associated with manual
order entry, greater transparency, increased liquidity, lower
impact costs for large orders, better audit trails and better
use of hedging and arbitrage opportunities through the use
of decision support tools/algorithms for trading.
u Algorithmic Trading - Any order that is generated using auto-
mated execution logic is known as algorithmic trading.
c. Straight through Processing (STP)
STP is generally understood to be a mechanism that automates the
end to end processing of transactions of financial instruments. It
53 LATEST DEVELOPMENTS Para 2.5
involves use of a system to process or control all elements of the

work flow of a financial transaction, what are commonly known as
the Front, Middle, Back office and General Ledger. In other words,
STP allows electronic capturing and processing of transactions in
one pass from the point of order origination to final settlement. STP
thus streamlines the process of trade execution and settlement and
avoids manual entry and re-entry of the details of the same trade
by different market intermediaries and participants. Usage of STP
enables orders to be processed, confirmed, settled in a shorter time
period and in a more cost effective manner with fewer errors. Apart
from compressing the clearing and settlement time, STP also provides
a flexible, cost effective infrastructure, which enables e-business
expansion through online processing and access to enterprise data.
It has been mandated that all the institutional trades executed on
the stock exchanges would be processed through the STP System.
d. International Stock exchanges in IFSC

An IFSC (International Financial Services Centre) caters to customers
outside the jurisdiction of the domestic economy. Such centres deal
with flows of finance, financial products and services across borders.
For e.g.: Gujarat International Finance Tec-City (GIFT City)’s Inter-
national Financial Services Centre (IFSC). GIFT-IFSC ranks 10th in
Global Financial Centre’s Index.
Stock exchanges operating in IFSC are meant to grow the financial
markets as well as bring capital into India. They are permitted to offer
trading in securities in any currency other than the Indian rupee. Top
bourses BSE and NSE have setup following two International stock
exchanges in GIFT IFSC:
i. India International exchange [India INX]

India International Exchange (IFSC) Limited (India INX) is
India’s first international exchange. It is a wholly owned sub-
sidiary of BSE Limited. The Exchange was inaugurated on Jan.
9, 2017 and commenced its operations from Jan. 16, 2017.
ii. NSE IFSC Limited [NSE International Exchange]

NSE IFSC was incorporated on November 29, 2016 as a fully
owned subsidiary company of National Stock Exchange of
India Limited (NSE). NSE IFSC Limited launched trading on
June 5th, 2017.
2.6 Other developments in Indian stock market since

1990
2.6.1 Screen based trading and Online (Internet based) trading

system:
In earlier times trading on a stock exchange used to happen in the trading
hall in an open outcry system. It is popularly known as ‘floor based trading
system’. It requires that the buyers and sellers assemble on the floor of the
trading hall and enter into transactions. This is quite inconvenient and at
times the transparency issues were also involved. Therefore all the stock
exchanges in India have adopted on-line screen-based electronic trading,
replacing the open outcry system. Of the two large stock exchanges, the
BSE provides a combination of order and quote driven trading system,
while NSE has only an order driven system.
In an order driven system, orders from all over India are entered into the
electronic system and matched directly on a continuous basis without the
involvement of a jobber or market maker. In a quote driven system, the
market makers offer two way quotes and are ready to buy and sell any
quantity. With the introduction of computerised trading, members could
enter their orders/quotes on work stations installed in their offices instead
of assembling in the trading ring.
Advantages of Online trading/internet trading
There are three main advantages of electronic trading over floor-based
trading as observed in India, viz.,
u Transparency :
In case of online trading all the transactions are entered in the com-
puter system and can be retrieved at any point of time. Hence screen
based trading has increased the transparency level of stock market
transactions. Transparency ensures that stock prices fully reflect
available information and lowers the trading costs by enabling the
investor to assess overall supply and demand.
u More efficient price discovery :
Owing to computer-based trading, the speed with which new
information gets reflected in prices has increased tremendously. The
quantity and quality of Information provided to market participants
during the trading process (pre-trading and post-trading) having sig-
nificant bearing on the price formation has also improved. Besides,
the screen-based trading has the advantage of integrating different
trading centres all over the country into a single trading platform. It
55 Indian Stock market since 1990 Para 2.6
may be noted that prior to screen-based trading, the very presence of

stock markets in different regions implied segmentation of markets
affecting the price discovery process. Investors in other locations were,
under such conditions, unable to participate in the price formation
process at the major stock exchange, namely the BSE. However, with
screen-based trading spread across various locations, the process of
price discovery has improved in the Indian stock markets.
u Reduction in transaction costs.
Screen-based trading has also led to significant reduction in the
transaction cost since it enabled the elimination of a chain of brokers
for execution of orders from various locations at BSE and NSE.
2.6.2 Depository system, dematerialisation and scrip less trading

In scrip based trading system, physical certificates and documents are
involved. When the securities are bought the investor gets physical
certificates representing the ownership of that security. When the security
holder sells his securities he has to deliver the physical certificates and
registration deed to the new buyer. This physical movement of papers
sufferers from major limitations or problems. These problems are :
u Bad deliveries due to loss of paper certificates
u Signature mismatch or other mistakes in transfer deeds
u Time consuming process
u Issues of fake certificates
u Stamp duty and related cost of physical transfer
u Tearing and mutilation of paper certificates
u Inconvenient handing of a number of certificates
u Postal delays and charges
u Fraudulent changes in the paper certificates.
Due to all these problems a need for scrip less trading or paper less trading
was felt. To overcome these difficulties, legislative changes were carried
out for maintaining ownership records in an electronic book-entry form.
Under this mode, securities are transferred in a speedy and safe manner
without interposition of issuers in the process.
A depository is an organisation, which assists in the allotment and transfer
of securities, and securities lending. The shares in a depository are held in
the form of electronic accounts, i.e., in dematerialised form and the deposi-
tory system revolves around the concept of paper-less or scrip-less trading.
Hence depositories and dematerialisation concepts go hand in hand. An
effective and fully developed securities depository system is essential for

maintaining and enhancing the market efficiency, which is one of the core
characteristics of a mature capital market.
The depository system provides a wide range of service, viz., primary market
services, secondary market services and ancillary services.
u In the case of primary market services, the depository through its
participants works as a link between issuers and prospective share-
holders.
u In the secondary market, the depository through participants works
as a link between the investor and dealing house of the exchange
to facilitate settlements of the security transactions through book-
keeping entries.
u Further, the depository can provide ancillary services like collecting
dividends and interests and reporting corporate information.
Constituents of Depository System - The depository system comprise of the
following - the depository, the depository participant, the issuing company
and the investors.
i. The depository - The depository is the main or apex organisation
which acts just like a bank. In the depository, securities are deposited
and withdrawn just like money. There are two depositories operating
in India viz NSDL (National Securities depository Ltd) and CSDL
(Central Securities Depository Limited) .But an investor cannot open
an account with the depository directly.
ii. Depository Participants - An investor cannot open an account directly
with the depository. He has to interact with depository participant
(DP.) The depository participant thus acts an intermediary between
the investor and depository. An investor open an account with the
depository through a depository participant(DP). As per the regula-
tions of SEBI, banks, financial institutions and other organisations
can become DP through the process of registration.
Procedure (working and operations) of depository system
1.
First of all the company whose securities are to be bought and sold
in electronic form must be registered with the depository.
2. The investor needs to open an account with a depository through a
depository participant. One account can serve the purpose of all the
demat transactions for a particular investor. The demat account of
the investor is opened with a depository participant but is linked to
the depository. The securities are deposited and withdrawn from the
depository.
3. in case of a buy transaction, the securities are credited in the account

of the investor. In case of a sell transaction, securities are debited.
Hence the account of the investor at any time shows the number of
outstanding securities.
4. In the depository system, the name of the shareholder or investor
is shown as the beneficiary’s name and his account as beneficiary
account.
Benefits of depository System
There are many advantages of the depository system and dematerialisation.
These benefits accrue to the issuing company, the investors and the stock
exchanges and regulators.
Benefits to the issuing company:
i. The issuing company saves a lot of efforts and paper work which
would have been required under physical certificates based trading.
It reduces substantially the cost of the issuing company.
ii. In case of physical transfer of shares the company had to maintain
a department which deals with the transfer of ownership from one
person to the other. It involved enormous work and cost. Demateri-
alisation makes transfer of ownership rights convenient and simple.
iii. The company saves a lot of postal cost in case of right issue, bonus
issue or stock splits. In case of depository system, such issues can be
dealt with in the form of electronic transfers only.
iv. A company which maintains its shares in demat form is perceived
as a company that takes care of the welfare of its shareholders.
Benefits to the Shareholders/Investors
The main beneficiary of a depository system is the investor or the share-
holder. Many of the problems related to scrip based trading were in case
of inefficient handling and bad delivery of paper certificates. The various
benefits of the depository system to the investors are discussed below
i. Convenient
Dematerialisation ensures that the securities of the investor are in
safe custody. The investor just has to maintain his demat book in
electronic form and is no longer required to deal with loads of paper
certificates. At times storage of paper certificates itself becomes a
tedious task. Hence handling of securities in demat from is convenient
for the investors.
ii. Elimination of certain risks

Transactions in demat mode completely eliminates the risk of bad
delivery, fraudulent signatures, fake certificates and problems of
delays.
iii. Cost reduction
There is no requirement of paper work and transfer deeds as well as
payment of stamp duty every time a transaction is made in securities.
This results in substantial reduction in the cost of investors.
iv. Increase in Liquidity
Dematerialisation makes the securities readily available for trans-
action. The investors need not locate the paper certificates so as to
make transactions. The demat account provides all the relevant details
to the investor at one place. Hence depository system increases the
liquidity of the securities.
v. Immediate transfer of securities
Depository system ensures immediate transfer of securities which
would have otherwise taken weeks or months to execute.
vi. One account for all transactions
The investor is required to open only one account with a depository
participant and all his holdings such as equity shares, bonds, mutual
funds etc. can be held in demat form in that account.
Depository system in India
In India the need for setting up a depository was realised after the large scale
irregularities in securities transactions of 1992 which is popularly known
as Harshad Mehta Scam . The need for depository system was also realised
for the healthy growth of primary market, which would reduce the time
between the allotment of shares and transfer of entitlements arising out of
each allotment. As India has a large number of listed company involving
a massive amount of paper work, there have been stolen shares, forged/
fake certificates, etc., which pose a threat to the security of investment. The
idea of setting up a depository and the introduction of scrip less trading
and settlement were thus conceived for improving the efficiency of the
markets and eliminating the various problems associated with dealing in
physical certificates. A depository system benefits the investing public, the
issuers of securities, the intermediates and the nation as a whole.
The move on depository system in India was initiated by the Stock Holding
Corporation of India Limited (SHCIL) in July 1992 when it prepared a con-
cept paper on “National Clearance and Depository System” in collaboration

with Price Waterhouse under a programme sponsored by the U.S. Agency
for International Development.
After an extensive discussion and realising the importance of demateri-
alisation and depository system, The Depositories Act was passed by the
Parliament in August 1996, which lays down the legislative framework for
facilitating the dematerialisation and book entry transfer of securities in
a depository.
The Depositories Act (1996) provides that a depository, which is required to
be a company under the Companies Act, 1956, and depository participants
(i.e. agents of the depository) need to be registered with SEBI. The depository
shall carry out the dematerialisation of securities and the transfer of bene-
ficial ownership through electronic book entry. Initially the investors, were
given the option to hold securities in physical or dematerialised form, or to
rematerialise securities previously held in dematerialised form. However
now dematerialisation is compulsory for all transactions in securities
market especially those related to equity shares. The National Securities
Depository Limited (NSDL), the first depository in India which has been
promoted by three premier institutions in India, viz., IDBI, UTI and NSE,
started operating from November 8, 1996. NSDL carries out its operations
through participants and the clearing corporation of the stock exchange,
with participants acting as market intermediaries through whom NSDL
interacts with the investors and the clearing members. The Depository
Act provides for multiple depository system. There is one more depository
operating in India i.e. Central Depositary Limited has been set up by BSE
in collaboration with Bank of India in the year 1998.
2.6.3 Book building

Book building is a concept related to primary market or new issue mar-
ket. It is a process related to IPO (Initial Public Offer) or FPO (Follow on
Public Offer). Book Building is basically a process used in Initial Public
Offer (IPO) or Follow on Public Offer (FPO) for efficient price discovery.
It is a mechanism where, during the period for which the IPO is open, bids
are collected from investors at various prices, which are above or equal
to the floor price. The offer price is determined after the bid closing date.
Book building is a systematic process of generating, capturing, and recording
investors demand for shares during an initial public offering (IPO), or FPO
(Follow on Public Offer). Usually, the issuer appoints a major investment
bank or merchant bank to act as a major securities underwriter or book
runner.
Difference between Book Building Issue and Fixed Price Issue

Before the starting of book building process in India, the issue price of a share
used to be ‘fixed price’ which is fixed by the issuing company. However such
a fixed issue price may not be as per the requirements of the prospective
investors as it generally ignored the prospective demand of the shares. If
the issue price which is fixed by the company happened to be lower than
the expected price of the prospective investors, the issue of the shares used
to be oversubscribed. On the other hand if the issue price happened to be
higher than the price which prospective investors are willing to pay, then
the issue of shares used to remain under subscribed. In both the cases the
company is not getting the benefit of optimum pricing. Hence there are
following difference between Book Building Issue and Fixed Price Issue :
u In Book Building securities are offered at prices above or equal to
the floor prices, whereas securities are offered at a fixed price in case
of a public issue.
u In case of Book Building, the demand can be known every day as
the book is built. But in case of the fixed price issue the demand is
known at the close of the issue.
u Book building process helps in discovery of efficient price, while fixed
price issue may not be so efficient.
Process of Book Building
When a company wants to raise money it plans on offering its stock to
the public. This typically takes place through either an IPO or an FPO (fol-
low-on public offers). The issue price of IPO or FPO is not fixed in advance.
The company provides a range of prices, lower limit and upper limit and
invites bids from prospective investors within a specified time period. The
maximum number of shares for which bids can be placed is also specified.
The prospective investors can offer their bids with respect to the number
of shares and the price at which they are willing to buy. These records are
maintained in a book by the investment banker. Later on these bids are
analysed and an issue price is arrived at in a manner so that the entire issue
gets subscribed. Hence book building price results in efficient discovery
of the issue price. The book building process helps determine the value of
the security.
As per SEBI guidelines, an issuer company can issue securities to the public
though prospectus in the following manner:
u 100% of the net offer to the public through book building process
u 75% of the net offer to the public through book building process and
25% at the price determined through book building. The Fixed Price
portion is conducted like a normal public issue after the Book Built
portion, during which the issue price is determined.
Greenshoe option is a special provision in an IPO prospectus, which allows
underwriters to sell investors more shares than originally planned by the
issuer. This would normally be done if the demand for a security issue
proves higher than expected. Legally referred to as an over-allotment option.
2.6.4 Derivatives
A derivative is a contract that derives its value from some other underlying
asset. Derivatives can be commodity derivatives or financial derivatives
depending upon whether the underlying asset is a physical asset or financial
asset. Financial derivatives were introduced in Indian stock market in June
2000 on the recommendation of Dr. L.C. Gupta committee on derivatives
which submitted its recommendations in 1998 for the phased introduction
of derivative products in India. At present following derivatives are avail-
able in futures and options segment of BSE and NSE. Detailed discussion
about derivatives have been provided in Chapter 11.
i. Stock index futures
ii. Stock index options
iii. Stock options
iv. Stock futures
2.6.5 Rolling settlement*

Rolling Settlement is a mechanism of settling trades done on a stock
exchange on T i.e. trade day plus “X” trading days, where “X” could be 1,
2, 3, 4 or 5 days. In other words, in T+5 environment, a trade done on T
day is settled on the 5th working day excluding the T day. In India, until
the year 2000, the settlement of majority of trades was done on Account
Period basis, where trades done in a trading cycle of 5 days were consol-
idated, scrip-wise netted and settlement of such netted trades took place
on a single day in the following week. Thus, it took anywhere between one
to two weeks for the investor, depending upon the day of his transaction,
to realize the money for shares sold or get delivery of shares purchased.
However, in the Rolling Settlements, trades done on each single day are
settled separately from the trades done on earlier or subsequent trading
days. The netting of trades is done only for the day and not for multiple
days. Initially, the trades in Rolling Settlements, to begin with, were settled
after 5 trading days from the day of trading. However, the trades in all
the scrips listed and traded on the exchange are now settled on T+2 basis.
*www.sebi.gov.in
Since the trades done during a day in a Rolling Settlement except those
in scrips in “Z” group are netted, one can square off the transaction on
that day only. The trades in “Z” group scrips are not allowed to be netted
and are settled on a trade-to-trade basis. As such, the squaring off should
be done before close of the market hours on that day. It may be clearly
understood that the trades during a day cannot be squared off or netted
with transactions on the earlier or subsequent days.
Trade to Trade in Rolling Settlement: SEBI has mandated that trading
and settlement in all listed securities would take place only in Compulsory
Rolling Settlement (CRS). Further, it had directed all companies to sign
agreements and establish connectivity with both the depositories latest
by September 30, 2001. SEBI had further mandated that the trading and
settlement in securities of those companies which have failed to make the
required demat arrangements by the above stipulated date, be shifted to
Trade-to-Trade basis. Once any scrip is shifted to Trade-to-Trade basis,
transactions in the scrip are not netted and all purchase and sale trans-
actions in the same scrip in single settlement are to be settled separately.
For example, the trading and settlement in securities of XYZ Ltd. have
been shifted to Trade-to-Trade. An investor has bought 100 shares of this
company in the morning on April 1, 2008 and he squares off purchase of
these 100 shares by selling the same in the trading hours on the same day.
In this case, his purchase and sale transactions would not be netted and
the investor would be required to give delivery of 100 shares against his
sale transaction and payment for the purchase transaction of 100 shares.
Advantage of Rolling settlement over weekly settlement
Internationally, the Rolling Settlements have been accepted as the best
method of settling trades. Therefore, Rolling Settlements represent the
best international practice.
Since in the Rolling Settlements, trades are settled earlier than in the
Account Period settlement, the settlement risk is lower. The reason for
this is that in weekly settlements, the cumulative position built up over
various days was consolidated, netted and settled on a single day. This
resulted in higher deliveries to be settled for the trades done during the
week. Since in Rolling Settlements, trades on a particular day are settled
separately from the trades done on any other day, the settlement risk is
considerably reduced. Moreover, the sellers and buyers get the monies
and securities for their sale and purchase transactions respectively earlier
than in Account Period settlements. This also achieves international best
practice for settling trades.
2.6.6 Securities lending scheme#

Before understanding securities lending scheme, one must understand why
there arise a need to lend and borrow securities. Such a need arises because
of short selling. Short Selling means selling of a stock that the seller does
not own at the time of trade. Short selling can be done by borrowing the
stock through Clearing Corporation/Clearing House of a stock exchange
which is registered as Approved Intermediaries (AIs). Short selling can be
done by retail as well as institutional investors. The Securities Lending and
Borrowing mechanism allows short sellers to borrow securities for making
delivery. Thus securities lending scheme has been introduced in India by
SEBI on 6th February, 1997 to allow brokers/traders to borrow securities
from a lending institution (AIs) for delivery to clients or other brokers to
avoid a failed delivery.
Securities Lending Scheme 1997
Securities Lending Scheme, 1997 is the scheme for lending of securities
through an approved intermediary to a borrower under an agreement for
a specified period with the condition that the borrower will return equiv-
alent securities of the same type or class at the end of the specified period
along with the corporate benefits accruing on the securities borrowed.
“Approved intermediary” means a person duly registered by SEBI under
the guidelines/scheme through whom the lender will deposit the securities
for lending and the borrower will borrow the securities;
Feature of Securities Lending Scheme 1997
Some of the important features of Securities Lending Scheme in India are :
(1) The lender shall enter into an agreement with the approved interme-
diary for depositing the securities for the purpose of lending through
approved intermediary as per the scheme and the borrower shall
enter into an agreement with the approved intermediary for the pur-
pose of borrowing of securities and as such there shall be no direct
agreement between the lender and the borrower for the lending or
borrowing of securities.
(2) The agreement between the lender and the approved intermediary
shall provide that when the lender has deposited the securities with
the approved intermediary under the scheme, the beneficial interest
shall continue to remain with the lender and all the corporate benefits
shall accrue to the lender.
(3) The lender shall be entitled to deposit only those securities registered
in his name or in the name of any other person duly authorised on his
behalf with the ‘approved intermediary’ for the purpose of lending.
#
www.sebi.gov.in/circulars/2004/cirsmd15a4.pdf.
(4) The lending of securities under the scheme through an approved

intermediary and the return of the equivalent securities of the same
type and class by the borrower shall not be treated as disposal of the
securities.
(5) The approved intermediary guarantees the return of the equivalent
securities of the same type and class to the lender along with the
corporate benefits accrued on them during the tenure of the borrow-
ing. Even in case of failure of the borrower to return the securities
or corporate benefits the approved intermediary shall be liable for
making good the loss caused to the lender.
(6) The approved intermediary may retain the securities deposited by
the lender in its custody as a trustee on behalf of the lender.
(7) The approved intermediary shall in accordance with the terms of
the agreement entered into with the lender, be entitled to lend the
securities deposited by the lender to the borrower from time to time.
(8) Under the scheme, the title of the securities lent to the borrower shall
vest with the borrower and the borrower shall be entitled to deal with
or dispose of the securities borrowed in any manner whatsoever.
(9) The agreement between the borrower and the approved intermediary
shall inter alia provide that the borrower shall have an obligation to
return, the equivalent number of securities of the same type and class
borrowed, to the approved intermediary within the time specified
in the agreement along with all the corporate benefits which have
accrued thereon during the period of borrowing.
(10) The agreement between the lender and the approved intermediary
and the borrower and the approved intermediary, shall also provide
for the following terms and conditions :-
(a) the period of depositing/lending of securities,
(b) charges or fees for depositing/lending and borrowing,
(c) collateral securities for borrowing,
(d) provisions for the return including premature return of the
securities deposited or lent; and
(e) mechanism for resolution of the disputes through arbitration.
(11) The borrower shall not be entitled to discharge his liabilities of
returning the equivalent securities through payment in cash or kind.
(12) The borrower shall deposit the collateral securities with the approved
intermediary in the form of cash, bank guarantee, Government secu-
rities or certificate of deposits or other securities as may be agreed
upon with the approved intermediary for the purpose of ensuring

the return of the securities.
(13) In the event of the failure of the borrower to return the securities
in terms of the agreement, the borrower shall become a defaulter
and the approved intermediary shall have the right to liquidate the
collateral deposited with it, in order to purchase from the market
the equivalent securities of the same class and type for purpose of
returning the equivalent securities to the lender. The approved inter-
mediary shall be entitled to take any action as deemed appropriate
against the defaulting borrower to make good its loss, if any.
2.6.7 Regulation regarding prohibition of Insider Trading
Most of the corporate frauds and scandals in the corporate world and capital
markets are not planned and executed by outsiders of the organization,
but by their insiders. This is the reason why regulators and legislatures
are increasingly paying attention to this area and are trying to make the
regulations and penal provisions regarding insider trading.
Insider trading refers to transaction in securities of a public listed company,
by any insider or any person connected with the company, based on any
material yet non-published information, which have the ability to impact
on said company's securities market price, for their personal advantage.
In the year 2013, SEBI set up a high level committee to review its two decade
old regulations under the chairmanship of N. K. Sodhi, former Chief Justice.
The committee has suggested fundamental changes to current regulations,
aimed at improving predictability, clarity and deterrence. In 2015, the said
proposed regulations replaced the existing one. They are explained below :
SECURITIES AND EXCHANGE BOARD OF INDIA (PROHIBITION
OF INSIDER TRADING) REGULATIONS, 2015
IMPORTANT DEFINITIONS
u “compliance officer” means any senior officer, who is financially
literate and is capable of appreciating requirements for legal and
regulatory compliance under these regulations and who shall be
responsible for compliance of policies, procedures, maintenance of
records etc.
u “connected person” means,—
(i) any person who is or has during the six months prior to the
concerned act been associated with a company, directly or
indirectly, in any capacity including,
n by reason of frequent communication with its officers

or
n being in any contractual, fiduciary or employment rela-
tionship or
n being a director, officer or an employee of the company
or
n holds any position including a professional or business
relationship between himself and the company. Such a
Position allows such person, directly or indirectly, access
to unpublished price sensitive information.
(ii) The persons falling within the following categories are deemed
to be connected persons unless the contrary is established,
(a) an immediate relative of connected persons specified in
clause (i); or
(b) a holding company or associate company or subsidiary
company; or
(c) an intermediary as specified in section 12 of the Act or
an employee or director thereof; or
(d) an investment company, trustee company, asset man-
agement company or an employee or director thereof;
or
(e) an official of a stock exchange or of clearing house or
corporation; or
(f) a member of board of trustees of a mutual fund or a
member of the board of directors of the asset man-
agement company of a mutual fund or is an employee
thereof; or
(g) a member of the board of directors or an employee, of
a public financial institution as defined in section 2(72)
of the Companies Act, 2013; or
(h) an official or an employee of a self-regulatory organiza-
tion recognised or authorized by the Board; or
(i) a banker of the company; or
(j) a concern, firm, trust, Hindu undivided family, company
or association of persons wherein a director of a company
or his immediate relative or banker of the company, has
more than ten per cent of the holding or interest;
u "generally available information" means information that is accessible

to the public on a non-discriminatory basis;
u "insider" means any person who is:
n a connected person; or
n in possession of or having access to unpublished price sensitive
information;
2.6.8 Regulation of Unpublished Price Sensitive Information

SEBI (Prohibition of Insider Trading) Regulations, 2015, primarily deal with
the regulation of unpublished price sensitive information. “Unpublished
price sensitive information” means any information, relating to a company
or its securities, directly or indirectly, that is not generally available and
which upon becoming generally available, is likely to materially affect the
price of the securities. It generally includes the information relating to the
following: –
(i) financial results;
(ii) dividends;
(iii) change in capital structure;
(iv) mergers, demergers, acquisitions, delistings, disposals and expansion
of business and such other transactions;
(v) changes in key managerial personnel; and
(vi) material events in accordance with the listing agreement.
Restrictions on communications and trading by corporate insiders
1. Communication or procurement of unpublished price sensitive
information.
Regulation 3 prohibits an insider from communicating, or providing
any unpublished price sensitive information, relating to a company
or securities, to any person including other insiders except where
such communication is in furtherance of legitimate purposes, perfor-
mance of duties or discharge of legal obligations. It further imposes a
prohibition on unlawfully procuring possession of unpublished price
sensitive information.
However, an unpublished price sensitive information may be com-
municated, in connection with a transaction that would:–
(i) entail an obligation to make an open offer under the takeover
regulations where the board of directors of the company is of
informed opinion that the proposed transaction is in the best
interests of the company;
(ii) not attract the obligation to make an open offer under the
takeover regulations but where the board of directors of the
company is of informed opinion that the proposed transaction
is in the best interests of the company and the information that
constitute unpublished price sensitive information is dissemi-
nated to be made generally available at least two trading days
prior to the proposed transaction being effected.
The regulation also instructs the board of directors to require the
parties to execute agreements to contract confidentiality and non-dis-
closure obligations on the part of such parties and such parties shall
keep information so received confidential.
2. Trading when in possession of unpublished price sensitive informa-
tion.
Regulation 4 prohibits the insiders to trade in securities that are listed
or proposed to be listed on a stock exchange when in possession of
unpublished price sensitive information.
Exemptions: –
the transaction is an off-market inter-se transfer between promot-
ers who were in possession of the same unpublished price sensitive
information;
in the case of non-individual insiders: –
(a) the individuals who were in possession of such unpub-
lished price sensitive information were different from
the individuals taking trading decisions
(b) appropriate and adequate arrangements were in place
to ensure that these regulations are not violated;
(iii) the trades were pursuant to a trading plan.
3. Trading Plans
Regulation 5 gives an option to the persons who may be in posses-
sion of unpublished price sensitive information and enabling them
to trade in securities in a compliant manner. This provision enables
the formulation of a trading plan by an insider to enable him to plan
for trades to be executed in future.
(1) An insider shall be entitled to formulate a trading plan and
present it to the compliance officer for approval and public
disclosure pursuant to which trades may be carried out on his
behalf in accordance with such plan.
(2) Such trading plan shall:–

(i) not entail commencement of trading on behalf of the
insider earlier than six months from the public disclosure
of the plan;
(ii) not entail trading for the period between the twentieth
trading day prior to the last day of any financial period
for which results are required to be announced by the
issuer of the securities and the second trading day after
the disclosure of such financial results;
(iii) entail trading for a period of not less than twelve months;
(iv) not entail overlap of any period for which another trading
plan is already in existence;
(v) set out either the value of trades to be effected or the
number of securities to be traded;
(vi) not entail trading in securities for market abuse.
(3) The trading plan once approved shall be irrevocable and the
insider shall mandatorily have to implement the plan.
(4) Upon approval of the trading plan, the compliance officer shall
notify the plan to the stock exchanges on which the securities
are listed.
Disclosures by trading insiders
Regulations 6 and 7 deal with disclosures of trading by insiders. Some of
the noteworthy points are as follows:
u The disclosures shall also include trading in derivatives of securities.
u Such disclosures shall be maintained by the company for a minimum
period of five years.
u Disclosures by certain persons are further classified as Initial Disclo-
sures and Continual Disclosures.
Type By Whom To Whom When
Initial Disclosures Every promoter, Company within thirty days
key managerial of these regulations
personnel and di- taking effect(These
rector Regulations are effec-
tive from 120th day of
the date of notification
i.e. on and from 15th
May, 2015)
Indian Securities Market 70
Type By Whom To Whom When

Every person on Company within seven days of
appointment as such appointment or
a key managerial becoming a promoter
personnel or a
director of the
company or upon
becoming a pro-
moter
Continual Every promoter, Company within two trading
Disclosures employee and di- days of such transac-
rector tion if the value of the
securities traded, over
any calendar quarter,
aggregate to a traded
value in excess of ten
lakh rupees.
Every company Stock exchange particulars of such
on which the se- trading within two
curities are listed trading days of receipt
of the disclosure or
from becoming aware
of such information.
Codes for fair disclosure and conduct
Regulation 8 requires every listed company to formulate and publish a
code of practices and procedures for fair disclosure of unpublished price
sensitive information, on its official website. The practices and amend-
ments thereto shall be promptly intimated to the stock exchanges where
the securities are listed.
Summary
u The Securities Market refers to the markets for those financial instruments,
claims or obligations that are commonly and readily transferable by sale.
u The securities market has three categories of participants-the issuer of secu-
rities, the investors in the securities and the intermediaries.
u The Securities Market has two segments - the new issues (primary) market
and the stock (secondary) market.
u The primary market provides the channel for creation and sale of new secu-
rities, while the secondary market deals in securities previously issued.
71 Summary
u Indian securities market has switched to screen based fully automated trading
system.
u A stock market index is created by selecting a group of stocks that are repre-
sentative of the whole market or a specified sector or segment of the market.
u There are broad based stock indices such as SENSEX and NIFTY as well
as sectoral indices (BANKEX, CNX IT etc.) and Thematic indices (such as
GREENEX).
u On NSE, strategy based indices are also available such as CNX Dividend
Opportunity Index.
u The Securities and Exchange Board of India is the regulator of capital market
in India.
u SEBI has undertaken a number of reforms in Indian securities markets such
as – screen based trading, dematerialisation, rolling settlement, book building
process, financial derivatives, securities lending scheme and prohibition of
insider trading.
u Any order that is generated using automated execution logic is known as
Algorithmic Trading.
u Direct Market Access (DMA) is a facility which allows brokers to offer clients
direct access to the exchange trading system through the broker’s infrastruc-
ture without manual intervention by the broker
u Depository system has many benefits and has completely eliminated the risk
of bad deliveries.
u Under book building process there is no fixed price of the new issue of shares
(IPO or FPO).
u Book building ensures efficient pricing of an IPO or RPO.
u Derivatives have been introduced in India since June 2000. At present stock
index futures, stock index options, stock options and stock futures are being
traded on NSE and BSE.
u Rolling settlement means that the trades on a particular day are necessarily
settled after a specified number of days and cannot be carried forward. At
present T+1 rolling settlement is prevalent on BSE and NSE which means
that trades on a particular day are settled after 1 day.
u Securities Lending Scheme, 1997 is the scheme for lending of securities
through an approved intermediary to a borrower under an agreement for a
specified period.
u Insider trading refers to transaction in securities of a public listed company,
by any insider based unpublished price sensitive information for his personal
advantage.
u SEBI (Prohibition of Insider Trading) Regulations, 2015 replaced the 1992
Regulations.
Test Yourself
True/False
i. The primary market is market for new securities.
ii. The secondary market deals in securities previously issued.
iii. Exchanges in India follow non-screen based and non-automated trading
system till date.
iv. Rolling settlement has increased the trading cycle.
v. Insider trading refers to use of financial statements information by company
officer.
vi. SEBI was given statutory powers in the year 1988.
vii. SEBI is the market regulator of Indian capital market.
viii. Trading plan allows insiders possessing unpublished price sensitive informa-
tion to trade in securities in a compliant manner.
ix. There are only broad based stock indices such as SENSEX and NIFTY avail-
able in Indian stock market.
x. CNX Dividend Opportunity Index is a strategy based Index.
xi. Depository system has many benefits and has completely eliminated the risk
of bad deliveries.
xii. Book building ensures efficient pricing of an IPO or FPO.
xiii. Only stock index options and futures are available in the derivatives market
in India.
xiv. Rolling settlement means that the trades on a particular day are necessarily
settled after a specified number of days and cannot be carried forward.
xv. Securities Lending Scheme, 1997 is the scheme for lending of securities
through an approved intermediary to a borrower under an agreement for a
specified period.
xvi. Insider trading is primarily concerned with the exploitation of unpublished
price sensitive information.
xvii. SEBI (Prohibition of Insider Trading) Regulations, 2015 replaced the 1992
Regulations.
xviii. Any order that is generated using automated execution logic is known as
Algorithmic Trading.
xix. Direct Market Access (DMA) facility is not available in India.
[Answers: (i) T (ii)T (iii) F (iv) F (v) F (vi) F (vii) T (viii) T (ix) F (x) T (xi) T (xii) T (xiii)
F (xiv) T (xv) T (xvi) T (xvii) T (xviii) T (xix) F]
73 Test yourself
Theory Questions
1. Differentiate between:
a. Primary Market and Secondary Market [Para 2.1]
b. BSE and NSE [Para 2.1]
c. SENSEX and NIFTY [Para 2.3]
2. How the trading in secondary market has evolved over the years? Explain
how clearing and settlement of equities take place at any recognised stock
exchange. [Para 2.2]
3. Write short notes on:
a. Direct Market Access [Para 2.5]
b. Internet Trading [Para 2.5]
c. Algorithmic Trading [Para 2.5]
d. SME Exchange [Para 2.4]
e. Dematerialisation (B.Com(H)DU 2013) [Para 2.6.4]
f. Book building process (B.Com(H)DU 2011) [Para 2.6.3]
g. Rolling settlement (B.Com(H)DU 2009) [Para 2.6.5]
h. SENSEX (B.Com(H)DU 2011) [Para 2.3]
i. NIFTY [Para 2.3]
j. GREENEX [Para 2.3
k. Role of SEBI [Para 2.4]
4. What do you mean by stock index? How are they useful? [Para 2.3]
5. How the board of SEBI is constituted? What are the major functions per-
formed by the board? [Para 2.4]
6. Write the procedure for transacting in depository system in brief and mention
its advantages to the company. (B.Com(H)DU 2011) [Para 2.6.2]
7. Discuss the developments and emerging trends in Indian Capital Market after
the constitution of SEBI in India. (B.Com(H)DU 2007) [Paras 2.4, 2.5, 2.6]
8. Briefly explain the procedure for trading in securities in India.
(B.Com(H)DU 2008) [Para 2.2]
9. Outline the reforms introduced by SEBI in primary and secondary markets
in India. (B.Com(H)DU 2010) [Paras 2.5 & 2.6]
10. “SEBI has initiated a lot of reforms to make the market safer and advanced
for investors”. Shed some light on those reforms. [Paras 2.5 & 2.6]
11. Stock exchanges play an important role in the Indian Securities Market.
Discuss the statement mentioning the role played by BSE and NSE in this
regard. [Para 2.2]
12. What do you mean by Insider Trading? Who is an insider as per SEBI Regu-
lations? [Para 2.6.7]
13. Define the terms ‘unpublished price sensitive information’ and ‘connected
person’ as per SEBI Regulations on Insider Trading? [Para 2.8]
14. What are the disclosure requirements as per SEBI Regulations on Insider
Trading? [Paras 2.6.7 & 2.6.8]
15. “Stock exchanges provide the linkage between the savings in the household
sector and the investments in the corporate sector” explain.
16. What is a stock exchange? What are its functions? How are securities traded
at the stock exchange? (B.Com.(H), GGSIPU, 2017)
17. Discuss the measures taken by SEBI to regulate the operations at stock ex-
changes. Explain the guidelines of SEBI pertaining to listing of securities.
3 ANALYSIS OF RETURN AND RISK
C H A P T E R
LEARNING OUTCOMES
After reading this chapter you will be able to:
 Understand the concept of return and risk of a security.
 Calculate return of a security and portfolio.
 Compare different investment alternatives in terms of expected
returns.
 Differentiate between systematic and unsystematic risk.
 Calculate beta of a security and explain its significance.
 Estimate total risk, systematic risk and unsystematic risk on a
security.
 Determine the effect of taxes on investment decision.
 Analyse the impact of inflation on investment return.
Investment refers to commitment of funds in expectation of future gains or

benefits. Every investment requires that current consumption is foregone
so that in future some benefits or returns are generated. A person may defer
his present consumption of buying a small car and invests the amount in
securities (such as equity shares, bond or debentures) expecting that his
investment would provide him revenue returns (in the form of interest
and dividends) at regular intervals and some capital appreciation, and he
will be able to buy a big car in future. A businessman invests in plants
and machinery in expectation of making profits (or returns). A person
puts the money in a fixed deposit account now so that he can get a higher
amount including interest incomes in future. An investor invests in a house
75
Analysis of return & Risk 76
property expecting that its price will go up in future. At that time he can sell
the property and make capital gain. Some people also invest in Gold and
other precious metals expecting a reward i.e. increase in the price of these
metals. Therefore the primary motivating or driving force of an investment
is the reward attached with it popularly known as RETURN. This return
has two parts – revenue return (i.e. interest or dividend) and Capital gain
(or loss) which arises due to change in the price of the investment. Some
investments may have only capital gain or loss due to price change as they
do not provide any revenue return to the investor. For example if an investor
invests in the shares of company which does not pay dividends, then his
return from the shares will comprise only the second part, i.e. change in
price leading to capital gain or loss.
However there is always a possibility that the actual return may not be same
as the expected or desired return. This may be due to a number of factors
such as changes in the economic environment, financial crisis, global
slowdown, poor performance of the company etc. Hence there is always a
RISK attached with investment that the actual return will be different from
the expected return. Risk is defined as the variability in expected returns.
It must be noted that no investment is risk free (except the hypothetical
risk free asset). Returns and risks move together. An investor can have
higher returns only when he is willing to undertake higher risk. However
the interesting fact is that investors like Return but they dislike Risk.
Therefore every investment decision requires careful analysis of Return
and Risk.
Two basic attributes of any investment are Return and Risk. Different
investment products have different levels of risk and return and hence
their estimation and analysis is an important aspect of investment decision
making. It must be noted that return and risk move in tandem i.e. one can
have higher return only at a higher level of risk and vice versa. An inves-
tor should make his investment decision depending upon his risk-return
preferences and analysis of risk-return features of the investment options.
For this we analyze every security in terms of its return and risk. This is
known as security analysis. However it is rare that an investor invests only
in one type of security or in just one security. Investors try to reduce their
exposure to risk by holding multiple securities or a large variety of securi-
ties. It is often said that “ Do not put all your eggs in one basket”. The same
is true in case in investments. A rational investor should hold a diversified
portfolio of assets. A portfolio is a combination of two or more securities.
Hence analysis of portfolio return and risk is essential to know the total
return and total risk exposure.
77 Return Para 3.1
This chapter provides a clear understanding of the Return and Risk in the
context of securities. A brief discussion of portfolio return is also provided
here. For detailed discussion on Portfolio Return and Risk please refer
Chapter 9.
RETURN
3.1 Return
Return may be defined as total income (or cash inflows including price
change) generated by investment expressed as a percentage of the cost
of investment. Income from an investment may be revenue income (such
as interest and dividends) and capital income (or capital gain or loss). The
first part i.e. revenue income is generated on regular basis say every year.
The second part i.e. capital gain or loss is the difference in the end price (or
selling price) and beginning price (or purchase price) of the investment. It
is generated only at the end of the investment period.
Return from a financial asset :
A financial asset which is purchased at “Purchase price”, held for a year,
provides some income at the end of the year and is sold at “Selling price”
will generate the following total return given in equation (3.1).
Return =Income from Asset + (Selling price- Purchase price) × 100.........(3.1)
Purchase Pr ice
Return on an Equity share
Return on an equity share held for one year, can be calculated as under:
D1 + (P1 − P0 )
Return on equity share = ……………………………………….(3.1A)
P0
Where
D1 = Dividend Received at the end of the year
P0 = Cost of Investment or Share Price in the beginning of the year
P1 = Share Price at the end of the year
Therefore there are two components of Return on an equity share - Dividend
yield and Capital appreciation. Dividend yield is that part of return which is
due to cash inflows in the form of dividend. Capital appreciation (popularly
known as capital gain) is that part of total return which arises due to change
in price. Hence it may be positive (capital gain) or negative (capital loss):
Div (P1 − P0 )
Return on equity share = +
P0 P0
= Div yield ± Capital gain yield (or Capital loss)
Para 3.1 Analysis of return & Risk 78
It may be noted that in most of the equity shares, dividend yield generally
forms a very small portion of the total return. Hence returns on an equity
share usually come primarily from price change or capital gains yield.
Illustration 3.1 : Mr. Misra purchased a share of RTL Ltd. at a price of
Rs. 950. He sold the share after receiving dividend income of Rs. 50 at the
end of one year, at a price of Rs. 1075. Calculate his total return from the
bond. How much is the dividend yield and how much is capital gain yield
on this share?
50 + (1075 − 950)
Solution: Return from share = × 100
950
= 18.42%
Div (P1 − P0 )
We know that Return on equity share = +
P0 P0
= Div yield ± Capital gain yield (or Capital loss)
50
= + (1075-950)
950 950
= 0.0526 + 0.1316
= 0.1842 or 18.42%
Hence dividend yield is 5.26% and capital gain yield is 13.16%.
Return on a bond:
Return on a bond held for one year, can be calculated as under:
I 1 + (P1 − P0 )
Return on bond = ……………………………………….(3.1B)
P0
Where
I1 = Interest Received at the end of the year
P0 = Cost of Investment or bond Price in the beginning of the year
P1 = Selling price or bond Price at the end of the year
Therefore there are two components of Return on a bond - Interest yield
and Capital appreciation. Interest yield is that part of return which is due to
cash inflows in the form of interest. Capital appreciation (popularly known
as capital gain) is that part of total return which arises due to change in
price. Hence it may be positive (capital gain) or negative (capital loss):
Int (P1 − P0 )
Return on bond = +
P0 P0
= Interest yield ± Capital gain yield (or Capital loss)
79 Return Para 3.1
Illustration 3.2 : Mr. Misra purchased a Rs. 1000, 10% bond maturing after
5 years at a price of Rs. 950. He sold the bond after receiving interest in-
come at the end of one year at a price of Rs. 975. Calculate his total return
from the bond.
Solution: Return from the bond = 100 + (975 − 950) × 100

950
= 13.16%
Illustration 3.3 : You are provided the following information about the year-
end values of a share and its dividends for the last 9 years. Calculate total
return for each year starting from 2008 in respect of a share assuming that
the year-end price of a year becomes the beginning price for the next year
i.e. year end price of 2007 is the beginning price for year 2008 and so on.
Year Year end share price (Rs.) Dividends (Rs.)
2015 260 2
2014 280 3
2013 200 5
2012 180 4
2011 190 3
2010 180 2
2009 170 2
2008 160 1
2007 150 1
Solution : We can solve this question using total return formula.
For the year 2008 Total return = 1 + (160 − 150) × 100 = 0.0733 or 7.33%
150
And so on. The following Table shows total return in each year
Year Total Return
2008 7.33%
2009 7.5%
2010 7.06%
2011 7.22%
2012 -3.16%
2013 13.88%
2014 41.5%
2015 -6.43%
3.2 Types of Returns and their Calculation

There are various types of returns based on the purpose and method of
calculation. These returns are explained below:
3.2.1 Average Return

In Illustration 3.3 we calculated yearly returns for a share over the last 8
years. These returns are annual returns for the respective years. These
returns vary widely over these 8 years. For example in 2014 the return is
highest 41.5% while in year 2012 it is lowest (highest loss) -31.58%. Looking
at these returns an investor may not decide whether the investment is a
good investment or not. Therefore an investor is more interested in know-
ing average return on a security. This average return may then be used to
make expectations about future returns on that security. In some of the
cases past average return is used as the expected return on that security.
We can calculate average return on the basis of historical returns of a
security. This average return is helpful in comparing investment alterna-
tives and building up expectations about the return on investment. Average
return can be calculated by taking the average of returns earned every year
over the assessment period. For this purpose we can use either arithmetic
average or geometric average.
(a) Average Return (Based on arithmetic mean)
Mostly average return is calculated using arithmetic mean or simple mean.
In this case average return is the simple average of annual returns earned
every year over the holding period or the assessment period.
R1 + R 2 ...R N N
A.R. =
N
= ∑R
i =1
i / N ……………………………………………(3.2)
Where
Ri = Return earned in year i
N = Number of years for which investment is held
Using Illustration 3.3 we can calculate average return as follows
7.33 + 7.5 + 7.06 + 7.22 – 3.16 + 13.88 + 41.5 -6.43
Average Return =
8
= 9.36%
Hence the average return on the share has been 9.36%.
Illustration 3.4: (When there are No dividends) Mr. X wants to calculate
average return of a share of RPL Ltd, currently available at a price of
Rs.160 as on 31st December, 2013. The share price at the end of years (31st
81 Types of returns and their calculation Para 3.2
Dec) 2008, 2009, 2010, 2011, 2012 and 2013 were Rs.100, 118, 130, 120, 140
and Rs. 160. The share did not pay any dividend over these years. Calculate
average return of RPL Ltd.’s shares. Also interpret the result.
Solution : Year Share Price (Rs.) Return (%)

2008 100 -
2009 118 18
i.e.  118 − 100 × 100
 100 
2010 130 10.17  130 − 118 
i.e.  × 100
 118 
2011 120 -7.69
i.e.  120 − 130 × 100
 130 
2012 140 16.67
i.e.  140 − 120 × 100
 120 
2013 160 14.27
i.e.  160 − 140 × 100
 140 
S = 51.42
51.42
Average Return =
5
(Based on Arithmetic Mean)
= 10.28%
Thus on the basis of historical data the average annual return on RPL Ltd
share has been 10.28%.
Interpretation:
The significance of this average return is that if Mr. X decides to buy the
share at the prevailing price, he may expect to generate an average annual
return, of 10.28% from this share, although there is no guarantee of this
to happen. This is because of the variable nature of returns from equity
shares. Please note that in year 2012 the share generated a return of 16.67%
while in 2011 it incurred a loss of 7.69%.
Illustration 3.5 : (When Dividends are also present) : In Illustration 3.4 what
will be average return if RPL Ltd. declared and paid the following dividends
over the past 5 years.
Year Dividend (Rs.)

2009 6
2010 5
2011 Nil
2012 10
2013 5
Solution : In this case annual return every year will have two components-
dividends as well as capital appreciation (or loss).
Year Stock Price Dividend Capital Gain (Loss) Return (%)
(Rs.) (Rs.) (Rs.)
2008 100 - -
2009 118 6 18 (6 + 18)/100 = 24
2010 130 5 12 (5 + 12)/118= 14.41
2011 120 Nil -10 (0 – 10)/130 = -7.69
2012 140 10 20 (10 + 20)/120 = 25
2013 160 5 20 (5 + 20)/140 = 17.85
Now Average Return (Based on A.M.)
24 + 14.41 − 7.69 + 25 + 17.85
=
5
73.57
= = 14.71%
5
Limitations of Arithmetic Mean based Average Return
Average Return based on A.M. suffers from the following limitations.
(1) It does not consider the effect of compounding because it is simple
average of a number of returns. This makes it less useful in investment
analysis because compounding is extremely important in investment.
(2) Average return based on A.M. may at times give misleading return.
This can be illustrated with the help of following illustration.
Illustration 3.6 : An investor buys a share of Rs. 20. At the end of year 1
its price becomes Rs. 25 but investor holds it. In the end of second year it
again becomes Rs. 20. Thus it gives 25% return in first year and 20% loss in
second year. Find out average return using arithmetic mean.
Solution :
25% + ( −20%)
Average Return (Based on A.M.) =
2
= 2.5%
However the value of share is Rs. 20 i.e. equal to purchase price and hence
actually investor has not made any return over two years period. It must be
noted that if we use average return (based on simple average or arithmetic
mean) in this case we will get an incorrect value of the return.
Hence it is better to calculate average return based on Geometric mean
as discussed below.
(b) Average Return (Based on Geometric Mean)
Average returns are often calculated using geometric average which con-
siders the effect of compounding. It must be noted that compounding is
extremely important in investment. Average return based on geometric
mean is actually average return compounded annually. It can be calculated
as given below :
1
Average Return (Based on G.M.) = ((1 + R )(1 + R ) (1 + R ) ... × (1 + R ))
1 2 3 N
N −1
…(3.3)
where R1 ,R 2 ,R3 ... are the returns generated in year 1, 2, 3, … respectively.

N is the total number of years.
Note :
(1) Geometric mean is the nth root of the product of n-values. Here we
add one in every return to ensure that no negative return appears in
the product term. Otherwise we will not be able to take its nth root.
Later on 1 is deducted from the entire term to offset its effect.
(2) Geometric mean based average return is generally lower than the
average return based on arithmetic mean because G.M. considers
compounding effect.
(3) If the time period is fairly long the difference between arithmetic
mean and geometric mean is negligible.
Illustration 3.7 : In Illustration 3.6 calculate average return based on G.M.
1
Average Return (Based on G.M.) = (1 + 0.25)(1 − 0.20) 2 − 1
 
1
= (1) 2 − 1
=0
Hence average return based on geometric mean is zero.
This is the accurate return because investor has not made any return after
two years. He bought the share at Rs. 20 and after two years its price is
Rs. 20 only.
Illustration 3.8 : Calculate average return using geometric mean from the
following data
Year 1 2 2 4
Return (%) 18 10.17 -7.69 16.67
Solution :
Average Return (Based on G.M.)
1
= (1 + R1 )(1 + R 2 ) (1 + R3 ) (1 + R 4 ) − 1

4
= (1 + 0.18)(1 + 0.1017 )(1 − 0.0769)(1 + 0.1667) 4 − 1
= 1.088 – 1
= 8.8% p.a.
Illustration 3.9 : Mr. Pandey invested Rs.100 in a mutual fund which earned
25% annually for 3 years. Unfortunately it lost 75% during the forth year
and earned 25% annually for next 4 years. Can we say that a total of 100%
return is earned by Mr. Pandey, over a period of 8 years which is 12.5% p.a.?
Solution : The value of mutual fund at the end of each year is given below :
Year Value of M.F. Description
Investment
0 100 i.e. Invested amount
1 125 i.e. a return of 25% in 1st year i.e. 100 (1 + 0.25)
2 156.25 i.e. 125 (1 + 0.25)
3 195.31 i.e. 156.25 (1 + 0.25)
4 48.83 i.e. 195.31 (1 – 0.75) a loss of 75%
5 61.04 i.e. 48.83 (1 + 0.25)
6 76.29 i.e. 61.04 (1 + 0.25)
7 95.37 i.e. 76.29 (1 + 0.25
8 119.21 i.e. 95.37 (1+0.25)
When we use arithmetic mean to calculate average annual return we get.
Average Return (Based on A.M.)
0.25 + 0.25 + 0.25 − 0.75 + 0.25 + 0.25 + 0.25 + 0.25
= 8
1
=
8
= 12.5%
However
If we use G.M. to calculate average return then we get the accurate answer :
Average return (Based on G.M.)
1
=(1 + 0.25)(1 + 0.25)(1 + 0.25)(1 − 0.75)(1 + 0.25)(1 + 0.25)(1 + 0.25) (1 + 0.25) 8 − 1
1
= 1.192 8 − 1 = 1.0222 – 1
( )
= 2.22%
This implies that actually the investor has earned a return of 2.22% p.a. &
not 12.5% p.a.
3.2.2 Expected Return (Based on probability distribution)

The investment environment is quite uncertain and therefore it is not always
wise to rely on a single estimate of return based on historical data. Hence
average return based on a series of historical returns may not be useful in
making future predictions about expected returns. Therefore an investor
may have a number of probable returns and assign probabilities to each
expected outcome. Security analysts can actually construct a probability
distribution of returns by assigning probabilities to the expected return
outcomes. Based on this probability distribution, they can then calculate
single expected return by using the following formula of statistics :
N
Expected Return = ∑PR
i =1
i i
.............................................................................(3.4)
where N = Total number of outcomes of returns

Pi = Probability of ith return
Ri = ith Return outcome
For example if we are given that the expected return from a share depends
upon the state of the economy (Good, Normal or Bad) and we are given
the following probability distribution
State of the Economy Return Probability
Good 18% 0.4
Normal 15% 0.3
Bad -5% 0.3
In such a case the Expected Return of the share will be calculated as
Expected Return = 18(0.4) + 15(0.3) -5 (0.3)
= 10.2%
However if all the three states of the economy are equally likely then we
will have equal probability for every return i.e. 1/3 or 0.33. In such case
the expected return will be
Expected return = 18(1/3) + 15(1/3) -5(1/3)
= 9.33%
Illustration 3.10: Calculate expected return of a security from the following
data :
Return Prob.
30% 0.40
-20% 0.40
50% 0.20
Solution : Return (Ri) Prob. (Pi) PiRi
30% or 0.30 0.40 0.12
-0.20 0.40 -0.08
0.50 0.20 0.10
SPiRi = 0.14 or 14%
n
Expected Return = ∑PRi =1
i i
= 0.14
or 14%
3.2.3 Return of a portfolio

Generally an investor invests in more than one asset or security i.e. he hold
a portfolio of securities. Therefore an investor may be more interested in
knowing the total return on his portfolio besides the total return on indi-
vidual securities.
The proportion of funds invested in a security is termed as its weight in the
portfolio. Therefore if an investor invests 40% of his funds in equity share
and 60% in bonds then his portfolio has a weight of 0.40 for equity share
and 0.60 for bond. If return on equity share is 15% and return on bond is
10% then his portfolio’s return will be equal to 0.4 (15) share) plus 0.6 (10)
i.e. 12%. Thus although equity share generated a return of 15% and bond a
return of 10%, the total return earned by the investor who invests 40% in
equity share and 60% in bonds will be 12%.
It must be noted that if weights change then the portfolio return will also
change. For example if there is another investor who invests 50% in equity
and 50% in bond then his portfolio return will be 12.5% { i.e. 0.5(15) +).5(10)}
Hence Portfolio return is the weighted average of the returns on individual
securities, weights being the proportion of funds invested in each security.
The statistical formula for the calculation of portfolio return is
N
Portfolio return = ∑WR
i =1
i i ……………………………………………………(3.4)
Where N = Number of securities in the portfolio

Wi = proportion of funds invested in security i
Ri = expected (or actual) return on security i
Illustration 3.11: Following information is available in respect of the rate
of return on two securities- equity share and bond
Condition Probability Rate of return on Rate of return on
Equity Bond
Recession 0.20 -0.20 0.10
Normal 0.50 0.25 0.12
Boom 0.30 0.35 0.15
Find out the expected returns on equity and bond. Suppose an investor has
Rs. 20000 to invest. He invests Rs. 14000 in equity share and the balance
in bond. What will be the expected return of his portfolio?
Solution: Expected return on Equity share = 0.20(-0.20) + 0.50(0.25) +
0.30(0.35)
= 0.19 or 19%
Expected return on bond = 0.20(0.10) + 0.50(0.12) + 0.30(0.15)
= 12.5%
Now weights of equity share and bond are calculated as under
14000
weight of equity share (WE) = = 0.70
20000
14000
weight of Bond (WB) = = 0.30
20000
Portfolio Return = WE RE + WB RB
= 0.70 × 0.19 + 0.30 × 0.125
= 0.1705
= 17.05%
3.2.4 Holding Period Return

Holding period return is the total return earned during the holding period
of investment. Holding period is also termed as investment horizon. If the
holding period is one year then the holding period return is same as the
total return calculated using equation (3.1). If an investor holds investment
for more than one year then we may calculate its holding period return as
the total income plus price change during the holding period expressed as
a percentage of purchase price.
Holding Period Return (HPR) is the total return earned during the holding
period of investment. It is not expressed in per annum form rather it is
the absolute return over a specified holding period such as 3-year return,
5-year return etc.
T.I. + (Pn − P0 )
H.P.R. = ……………………………………………………(3.5)
P0
Where
TI = Total Income (or dividends) received during the holding period
P0 = Purchase Price
Pn = Sale price at the end of holding period
n = No. of years for which shares are held (i.e. holding period in years)
Illustration 3.12 : An investor invests in a non-dividend paying share at a
cost of Rs.100 in the beginning of year 2004. At the end of year 2013, he sells
the share for a price of Rs.150. Calculate his holding period return on share.
Solution :
150 − 100
H.P.R. = = 50%
100
It must be noted here that holding period return of 50% is earned over a
period of 10 years (from 2004 to 2013). It is NOT 50% p.a. rather 50% over
10 years.
3.2.5 Limitations of HPR

There are certain limitations of holding period return which make it less useful
in the comparative analysis of investment options. These limitations are -
(1) It fails to consider how long it took to earn the return. If time period
is greater than one year the HPR over-states the true annual return
and vice versa.
(2) Holding period returns on two investment alternatives cannot be
compared if holding periods of the investments are different. It is
necessary to calculate effective annualized returns to make mean-
ingful comparisons in such a case.
3.2.5A Effective Annualized Return

Effective annualized return (EAR) is the equivalent per annum return
earned on an investment. Where the holding period is more or less than
one year it can be calculated as below:
1
EAR = (1 + R T ) T − 1 …………………………………………………………(3.6)
Where RT = Holding Period Return
T = Holding period in years
In above Illustration, the investor who earns 50% return over a period of
10 years has actually earned 4.13% p.a. as calculated below:
1
EAR = (1 + 0.50)10 − 1 = 1.0413 − 1
= .0413 or 4.13% p.a.
Illustration 3.13: An investor wants to invest in a Zero-coupon1 bond having
face value of Rs.100. Three different maturity period bonds are available
as given below :
Bond Time Horizon Price
A 6 Month 97
B 1 year 95
C 16 year 22
Calculate Holding period return (HPR) and effective annualized returns
(EAR) on each bond. Which is the best option for investment?
Solution : Holding Period return Calculation-
Bond HPR
A (100 – 97)/97 = 0.0309 or 3.09%
B (100 – 95)/95 = 0.0526 or 5.26%
C (100 – 22)/22 = 3.5454 or 354.54%
Effective Annualized Return (EAR) calculation-
EAR on bond A = (1 + 0.0309)2 – 1
= 1.0627 – 1 = .0627 or 6.27%
EAR on bond B = (1 + 0.0526)1 – 1 = 0.0526 or 5.26%
EAR on bond C = (1 + 3.5454)1/16 – 1
= 1.0624 – 1 = 0.0624 or 6.24%
1. A zero-coupon bond is available at discount, redeemable at par and does not pay any interest.
Therefore comparison of their effective annualized returns shows that

Bond A i.e. 6-month Zero coupon bond is the best, followed by Bond C i.e.
16-year bond and in the last Bond B i.e.1 year bond.
3.2.6 Absolute Return

So far we have discussed only about the return aspect of investment.
Therefore all the types of returns calculated so far are Absolute Returns.
Absolute return is the total return generated by an investment without
considering the risk of the investment. Hence absolute return is the return
generated on an investment without adjusting it for the underlying risk.
Absolute return is often quoted in magazines and newspaper advertise-
ments. Absolute return is not a good measure to compare investment
alternatives. This is because different investment have different risks. For
example two equity shares A and B provide absolute annual return of 15%
and 20% respectively. It does not mean that Share B is better as it provides
higher return. The reason is that quite possible that share B has very high
risk while risk on share A is low. Every investor is risk averse or tries to
avoid risk. All the investors like return but at the same time they dislike
risk. Hence while comparing investment alternatives a rational investor
must consider both Return as well as Risk. This can be done by calculating
Risk Adjusted Returns.
3.2.7 Risk-adjusted Return

Risk adjusted return is a relative measure of return because it is expressed
in terms of per unit of underlying risk. It is the return adjusted for under-
lying risk of the security. There are a variety of methods for calculating
risk adjusted returns such as Sharpe’s ratio, Treynor’s ratio etc. Detailed
discussion on Risk adjusted returns are provided in chapter 10. The most
popular risk adjusted return is calculated as Sharpe Ratio also known as
Return to Volatility ratio. It is return expressed in terms of per unit of the
underlying Standard deviation or total risk. The higher the Sharpe ratio,
the better is the security in terms of risk return relationship.
Average Return - Risk Free Return
Sharpe Ratio =
Total Risk
Risk
In the previous section we discussed about the concept, types and calcu-
lations of return from a security. However Return cannot be generated
without undertaking Risk. Hence, the second most important attribute of
any investment is Risk. This section discusses the concept, sources, types
and calculation of Risks associated with financial investment i.e. investment
in securities.
91 Risk Para 3.3
3.3 Risk
Risk arises because returns are not certain or fixed or cannot be predicted
in advance. It arises due to the fact that actual return may not be same as
the expected return. Risk is defined in terms of the variability in expected
return. It must be noted that all investments are subject to risks. However
the level of risk differs from security to security. Risk arises because the
investment may generate return different than the expected return.
Do You Know Risk and Uncertainty are Different?
Risk and Uncertainty are not same. Risk is defined as a situation where we
can assign some probabilities to the expected outcome of an event. In case of
uncertainty it is not possible to predict at all i.e. we cannot assign probabilities
to the expected outcomes of an event. In case of uncertainty we may not even
have expected set of outcomes of an event.
Risk and Uncertainty:
Risk and Uncertainty are not same. Risk is defined as a situation where
we can assign some probabilities to the expected outcome of an event. In
case of uncertainty it is not possible to predict at all i.e. we cannot assign
probabilities to the expected outcomes of an event. In case of uncertainty
we may not even have expected set of outcomes of an event.
However in practice, terms Risk and Uncertainty are often used inter-
changeably.
All rational investors like Return but at the same time they dislike Risk.
Hence all investors are risk-averse i.e. they want higher return for every
additional unit of risk and given a chance, they try to avoid risk. However,
there are various degrees of risk aversion. Some investors are more risk
averse (i.e. conservative investors) and others are less risk averse (aggres-
sive investors).
Risk aversion implies that for every additional unit of risk investors demand
more and more returns. The higher the degree of risk aversion the higher
will be the increase in required return from the investor.
Hence risk analysis is an important consideration in investment decision
making.
In order to avoid risk, some investors invest in a large number of securities.
The basic idea here is DO NOT PUT ALL YOUR EGGS IN ONE BASKET.
Investment in large number of securities may lead to risk reduction as
explained in the following discussion.
3.3.1 Causes (or Sources) and Types of Risk
Risk arises due to the variability of expected returns. Returns from a security
is affected by a host of factors both external and internal to the company
which issues that security. Thus Risk is caused by a host of External and
Internal Factors. These are also known as Sources of Risk. The external
factors are those economy wide as well as social and cultural factors such
as economic policies, taxation, political conditions cultural changes, social
changes etc., on which the company has no control. These external factors
influence the returns of all the securities in the market. The internal factors
on the other hand include factors such as management, labour conditions,
efficiency, governance etc which are well within the control of a specific
company. These internal factors influence the return of that specific security
only. It does not influence the return of all the securities across the board.
Total risk on a security can be classified into systematic risk and unsys-
tematic risk depending upon the factors causing it.
Depending upon the Causes of Risks or Sources of Risks, we can classify
Total Risk of a Security as Systematic Risk and Unsystematic Risk.
3.4 Systematic Risk

Systematic risk is that part of total risk which is caused by factors beyond
the control of a specific company or individual. Systematic risk is caused by
factors such as economic, political, socio, cultural etc. All the investments
or securities are subject to systematic risk and therefore it is non-diversi-
fiable risk. Systematic risk cannot be diversified away by holding a large
number of securities. This risk cannot be diversified away even by holding
an efficient portfolio of assets. Systematic risk primarily includes – market
risk, interest rate risk, purchasing power risk and exchange rate risk.
(a) Market Risk
Market risk is caused due to herd-mentality of investors i.e. the tendency
of investors to follow the direction of the market. Hence market risk is
the tendency of security prices to move together. If the market is falling
then even good performing companies’ shares fall in prices. Thus decline
in share price due to market factors is termed as market risk. Market risk
constitutes almost 2/3rd of total systematic risk. Therefore sometimes sys-
tematic risk is also referred to as market risk.
Market price changes is the most prominent source of risk in a security.
(b) Interest Rate Risk
Interest rate risk arises due to changes in market interest rate. This pri-
marily affects fixed income securities because bond prices are inversely
related to market interest rate. An increase in market interest rate causes
bond prices to fall and vice versa. In fact, interest rate risk has two opposite
components – Price Risk and Reinvestment risk. Both these risks work in
opposite directions. If price risk is negative (i.e. fall in price), reinvestment
93 Systematic Risk Para 3.4
risk would be positive (i.e. increase in earnings on reinvested money). Price

risk is the risk associated with changes in the price of a security due to
changes in interest rate. It must be noted that bond prices are inversely
related to interest rates as given :
coupon rate
Bond Price = × par value of bond
market Interest Rate
For example, A bond issued at par Rs.1000 has 5 year maturity and a
coupon rate of 10% p.a. Now, if the market interest rate increases to 12%,
we will not find any buyer for this bond at Rs.1000 because the bond will
provide interest income at 10% rate while the market interest rate is 12%.
Therefore this bond becomes attractive only at a price lower than Rs.1000.
The bond price will be :
Bond Price = 10 × 1000 = Rs.833.33

12
Hence an increase in interest rate makes bond price to fall and vice versa.
This is ‘Price Risk’ component of interest rate risk.
‘Reinvestment risk’ is the risk associated with reinvesting interest/dividend
income. It arises when market interest rate falls. In such a case, the investor
will be able to reinvest his interest/Dividend income at a lower rate which
implies lower future incomes. In the above example if the market interest
rate declines to 8% then the interest income of Rs.100 (i.e. 10% of 1000) will
be reinvested at this new 8% interest rate. Hence his future income from
Rs.100 (i.e. reinvested interest income) will be lower. It must be noted here
that when interest rate falls, bond price rises but reinvestment risk arises.
Therefore price risk and reinvestment risk work in opposite directions.
However, both these risks may not completely offset each other.
Interest rate changes is the main source of risk especially in case of fixed
income securities such as bonds and debentures.
(c) Purchasing Power Risk (or Inflation Risk)
Purchasing power risk arises due to inflation. Inflation is persistent and
sustained increase in general price level. Inflation erodes the purchasing
power of money i.e. the same amount of money can buy fewer goods and
services due to increase in prices. Therefore if investor’s income does not
increase in times of rising inflation, then the investor is actually getting
lower and lower income in real terms. Fixed income securities are sub-
ject to high level of purchasing power risk because income from such
securities is fixed in nominal terms.
For example : An investor invests in a 5-year 10% bond at par value of
Rs.1000. At the end of the year the inflation rate is 5%.
In this case
Interest income in nominal terms = Rs.100 (i.e. 10% of Rs.1000).
However,
Income in real terms = 100

= Rs. 95.23
1 + 0.05
i.e. at the end of the year Rs.100 will buy goods and securities worth Rs.
95.23 as available in the beginning of the year. This is due to inflation.
It is often said that equity shares are good hedge against inflation and
hence are subject to lower purchasing power risk. This is based on the as-
sumption that in times of inflation, dividend and/or share prices also rise
so as to compensate for the loss in the value of money due to rising prices.
(d) Exchange Rate Risk
In a globalised economy most of the companies have exposure to foreign
currency. Exchange rate risk is the uncertainty associated with changes in
the value of foreign currencies. Therefore this type of risk affects only the
securities of those companies which have foreign exchange transactions
or exposures such as export companies, MNCs or Companies which use
imported raw material or products. Given the global nature of business
in this modern times, a large section of companies have foreign exchange
exposure.
For example if rupee depreciates (say from Rs.50 per USD to Rs.60 per USD)
then the value of imported material will increase in terms of rupees even
though there is no change in the quantity of imported material. Therefore
the company importing this material will have to spend more rupees to
buy dollars for paying for the imported material.
3.5 Unsystematic Risk

Unsystematic risk is the risk caused by factors within the control of a
specific company such as issues related to management, assets, labour or
capital. Therefore unsystematic risk can be diversified away by holding
an efficient portfolio of securities which are least correlated (preferably
not correlated). Hence unsystematic risk is also called “diversifiable risk”.
There are two types (or sources) of unsystematic risk – Business risk and
financial risk.
(a) Business Risk
Business risk is associated with investment decision of company. It is also
termed as operating risk. It is the risk which arises due to the presence
of fixed operating costs in a company’s cost structure. It must be noted
that fixed operating costs are to be paid by the company irrespective of
95 Unsystematic Risk Para 3.5
the amount of its revenue. Therefore in times of declining sales, fixed op-
erating costs may result into net losses for the company. Business risk is
measured by the degree of operating leverage. Degree of operating leverage
measures the resultant change in operating income due to a change in its
sales revenue. When fixed operating costs are present in the cost structure
of a company then a given change in sales causes more than proportionate
change in operating income.
% change in operating income
Degree of Operating leverage (DOL) =
% change in sales
Operating risk arises when DOL > 1. The higher the degree of operating
risk the greater will be the business risk.
Other emerging sources of business risk include – labour unrest, inefficient
management and corporate governance issues.
(b) Financial Risk
Financial risk is associated with financing decision or capital structure of a
company. It arises due to the presence of fixed financial cost or debt capital
in a company. As a result a change in operating profit will have a more than
proportionate change in its earnings per share (EPS). It must be noted that
interest cost must be paid by the company irrespective of the amount of
its operating profit. Financial risk is measured by the degree of financial
leverage which is the ratio of change in EPS to change in operating profit
of a company.
% change in EPS
Degree of Financial Leverage (DFL) =
% change in operating profit or EBIT
Financial risk arises whenever DFL > 1. Therefore companies using exces-
sive debt capital are subject to high financial risk.
Illustration 3.14 : Specify whether the following events are the sources of
systematic risk or unsystematic risk.
(i) An increase in oil price by OECD
(ii) Labour unrest at Maruti Udyog Ltd.
(iii) Break up of Bharati Walmart Joint Venture
(iv) Increase in repo rate by RBI.
(v) Debt ridden Kingfisher airlines declares bankruptcy.
(vi) Decline in GDP growth rate.
(vii) A bad monsoon year.
(viii) Corporate mis-governance and management fraud at Satyam Ltd.
(ix) Global financial crisis.
(x) Depreciation of rupee.

(xi) Shut down of Singur plant of NANO following protests.
Solution. (i), (iv), (vi), (vii), (ix) and (x) are the sources of systematic risk,
while (ii), (iii),Fig 3.1 : Number of Securities and Risk
(v), (viii) and (ix) lead to unsystematic risk.
Number of Securities in a Portfolio and Risks
In order to diversify or reduce risk an investor should hold a well diversi-
fied portfolio of different and unrelated securities. By investing in a large
number of securities one can diversify away the unsystematic risk or
diversifiable risk of the portfolio. What remains then is the Systematic or
Non-Diversifiable Risk. In general the larger the number of securities the
greater is the diversification and hence the lower will be the unsystematic
risk. This is shown in Fig 3.1. However it must be noted that it is not just
the number of securities but the right type of securities which is important
for diversification. If an investor invests in 100 securities which are per-
fectly positively correlated then there is no benefit of diversification. This is
because all the securities are alike and hence there is no risk diversification.
On the other hand if an investor invests in only 20 unrelated securities
(i.e. where the correlation coefficient is less than +1) then the benefit of
diversification can be availed. Hence it is not the number of securities but
the right type of securities which is important for diversifying risk. More
about it is discussed in Chapter 9 on Portfolio Analysis.
Risk(%)
Total Risk
Unsystematic Risk
Systematic Risk
No. of Securities in Portfolio
Fig 3.1 : No. of Securities and Risks
In Fig 3.1 we can see that the systematic risk of the portfolio is same irre-
spective of the number of securities in the portfolio. However unsystematic
risk reduces as we increase the number of securities in the portfolio. It
must be noted that initially when number of securities is increased there is
substantial decline in unsystematic risk of the portfolio. Later on a further
increase in the number of securities reduces unsystematic risk but gradually.
Different types of investments have different amount of risks. Some securi-

ties such as Treasury bills and Govt. securities are often considered as risk
free due to negligible risk. On the other hand equity shares are considered
to be most risky security due to exposure to higher systematic risk. The
risk on bonds is lower than the risks on equity shares but higher than the
risks on T bills. Hence there is a need to quantify risk (or to measure risk)
and consider it in investment decision making.
One way of considering risk in investment decision making is to adjust the
expected return (or required return) to account for the underlying risk.
(you may recall the Risk Adjusted Discount Rate Concept under Capital
Budgeting). A security which has higher risk should have higher expected
return or higher required rate of return. On the other hand a security which
has low risk should have relatively lower expected return. Extending this
concept to a Risk Free Security or asset (such as Treasury bills) we may
say that the return on a risk free asset should not have any adjustment for
risk as there is no risk. But it does not mean that the return on a risk free
asset would be zero. There will be some return on a risk free asset as well.
Return on a Risk free asset is actually a compensation for time or simply
Time Value of Money. There is no compensation for the underlying risk
as there is no risk at all in case of a risk free asset. It implies that rate of
return on a Risk free asset is the base rate and every risky security must
have expected return which is higher than the risk free return. This addi-
tional return (i.e. over and above risk free return) is compensation for the
underlying risk. Hence it is termed as Risk Premium.
It must be noted that the higher the risk of a security the greater should
be Risk Premium.
Therefore Expected Return (or Required Return on a security) can be
expressed as :
Expected Return = Risk Free Rate of Return + Risk Premium
E(Ri) = Rf + Z…………………………………………(3.7)
Where E(Ri) = Expected rate of return
Rf = risk free rate of return
Z = Risk premium
Hence Risk premium is the difference between expected return of a secu-
rity and risk free return i.e.
Risk Premium = E(Ri) – Rf…………………………………………………..(3.7A)
Now the question arises how much risk premium should be justified for a
given security. It depends upon risk return preferences of the investor. It
must be noted here that different investors have different attitude about
risk. Depending upon the investor’s attitude about risk we can classify
investors as Risk Averse, Risk Neutral and Risk Lover. Risk Neutral and
Risk Lovers are not rational investors. Hence in stock market we have only
Risk Averse Investors.
3.6 Types of Investors

(i) Risk Averse Investors: These investors try to avoid risk. They
undertake risk only if additional risk is rewarded with commensurate
higher return. For every additional unit of risk they demand higher
and higher compensation in terms of higher returns. Investors also
differ in terms of their degree of risk aversion. Some investors are
more risk averse. These investors are termed as “Conservative inves-
tors”. Some investors are less risk averse. Less risk averse investors
are called “Aggressive investors”.
(ii) Risk Neutral : These investors make their investment decisions purely
on the basis of Return. They do not consider risk. Hence Risk does
not matter to them. They are risk neutral. A rational investor cannot
be risk neutral.
(iii) Risk Lover (or Risk Seeker) : A Risk Lover, as the name suggests,
likes risk. These investors engage in fair games as well as gambling
just for the sake of fun or excitement. They undertake more and
more risk even if it is not accompanied by higher returns. We do
not find Risk Lovers in stock market. They are found in casinos and
other similar places.
Do you know that even Speculators in stock market are NOT Risk Lover?
Even speculators are risk averse. However they are less risk averse. They under-
take very high risk in expectation of quick and very high commensurate return.
Hence it is a myth that speculators in stock market are Risk Lovers.
3.6.1 Risk Aversion, Utility Analysis and Indifference Curves

We have discussed so far that all the investors are risk averse i.e. they avoid
risk and they will choose less risky investments over more risky investments
other things being equal. They choose to have additional risk if it provides
commensurate higher return.
Investors make investments to derive some “Utility” or satisfaction. In eco-
nomics you must have studied the concept of diminishing marginal utility
of wealth i.e. the utility derived from every additional unit of wealth dimi-
nishes as wealth increases. Extending this concept to financial investment
in case of an investor, we can say that return increases utility while risk
decreases utility of an investment. A risk averse investor penalizes a more
risky investment. If returns are same then the investment having less risk
99 Types of Investors Para 3.6
will provide higher utility to an investor than the investment with more
risk. An investor with diminishing marginal utility is necessarily risk averse.
An indifference curve represents a set of risk and expected return com-
binations that provide an investor with the same amount of utility. The
investor is indifferent about the risk- expected return combinations on
the same indifference curve. Further the higher the indifference curve the
greaterFigwill be the utility
3.2 Indifference Map for a depicted by it. We can draw indifference curve
risk averse investor
for an investor using two parameters – Risk and Return.
Risk is shown on X axis and Return on Y axis. The indifference curve for
a risk averse investor will always be upward sloping and have increasing
slope (i.e. convex). The increasing slope implies that for every additional
unit of risk, this investor requires higher and higher additional return to
have same utility. The indifference map (or a set of indifference curves I1,
I2 and I3) for a risk averse investor is shown in Fig 3.2. It can be seen that
the higher the indifference curve the higher will be the utility i.e. I3 shows
highest utility among these three curves. But on the same indifference
curve, utility is same throughout. Utility derived from B & C are same.
E(RP) I3
I2
I1
D
C
B  A
σP
Fig: 3.2 : Indifference Map for a Risk Averse Investor
It must be noted that for every additional unit of risk, a more risk averse
investor will demand a higher additional return as compared to a less risk
averse investor. Hence the indifference curve of a more risk averse inves-
tor would be steeper (having higher slope than that of a less risk averse
investor) while the indifference curve for a less risk averse investor would
be relatively flatter. The indifference curve of a more risk averse investor
and a less risk averse investor are shown in Fig 3.3. It can be seen that for
the same additional unit of risk, a more risk averse investor demands a
higher additional return than a less risk averse investor.
IM
Return

More Risk Averse IL
Less Risk Averse
Risk
Fig: 3.3 : Indifference Curves for a More Risk
Averse and Less Risk averse Investor
Fig 3.4 Indifference curve of a Risk Neutral Investor

Return

Fig 3.5 Indifference curve of a Risk lover( Risk Seeker)
I ( Neutral)
Risk
Fig: 3.4 : Indifference Curve for a Risk Neutral Investor
Return
Risk Seeker(Lover)
Risk
Fig: 3.5 : Indifference Curve for a Risk Lover(Seeker)
The indifference curve in case of a risk neutral investor will be horizontal

straight line. This is because a risk neutral investor does not consider risk
101 Calculation of Total Risk Para 3.7
and uses only return to derive utility. Risk is immaterial for him and hence
we get a straight line as the indifference curve. This is shown in Fig 3.4.
In case of a risk lover, the indifference curve will be just the opposite of
the indifference curve of a risk averse investor. This is because a risk lover
likes risk whereas a risk averse dislikes it. Hence the indifference curve of
a risk lover or risk seeker would be downward sloping and have increasing
slope (i.e. concave). The indifference curve of a risk lover is shown in Fig 3.5.
Measurement of Risk
3.7 Calculation of Total Risk

In case of investment, it is not possible to predict the accurate return. At
best we can have some expected return. Different analysts and investors
may have different estimates or forecasts for expected return of a security.
The expected return is also based on a number of factors or conditions.
Risk is defined as the variability in expected returns. Therefore total risk on
a security can be measured by using statistical methods of measuring vari-
ability or dispersion such as Range, Standard Deviation (S.D) or Variance.
Range : Range is the difference between highest and lowest possible return
in case of an investment. The higher the Range the greater will be the dis-
persion and higher will be the risk.
This may not be a good measure of risk because it does not provide a single
estimate of Risk.
Variance or Standard Deviation :
Variance or standard deviation of expected returns is the most popular and
commonly used measure to calculate Total Risk of a security. It must be
noted that standard deviation is the square root of variance.
We can calculate standard deviation in two cases :
(i) In case only return series is given :
n
∑ (R )
2
−R
S.D. = i =1
i ……………………………………………………..(3.8)
n
where Ri = ith return n = number of observations
R = Mean return
(ii) In case a probability distribution of returns is given:
n
∑ p (R )
2
S.D. = i i −R ………………………………………………….(3.8A)
i =1
n
or Variance = ∑ p (R
i =1
i i −R )
2
Total risk can also be expressed in terms of total variance. The unit of
measurement of total variance of return is squared percentage. The unit
of measurement in case of standard deviation is in percentage.
Illustration 3.15 : Calculate total risk of the security for which past returns
are given below :
Year Ri(%)
1 10
2 12
3 8
4 5
5 10
6 13
7 7
8 5
9 8
10 12
Year Ri(%) (R i − R )
2
Solution :
1 10 1
2 12 9
3 8 1
4 5 16
5 10 1
6 13 16
7 7 4
8 5 16
9 8 1
10 12 9
SRi = 90 S = 74
90
R = Mean Return = = 9%
10
( )
2
S.D. = Σ Ri − R 74
= = 2.72%
n 10
103 Calculation of total risk Para 3.7
Hence the mean return on security is 9% with a total risk of 2.72% (or total
variance is 7.4 squared percentages).
Illustration 3.16: An investment analyst wants to analyse risk and return on
security A for which he has constructed the following return distribution.
Return (Ri) in % Prob (Pi)
20 0.1
15 0.2
-5 0.2
10 0.3
25 0.2
Calculate expected return and total risk.
( )
2
Solution Ri Pi RiPi Pi R i − R
20 0.1 2.0 6.4
15 0.2 3.0 1.8
-5 0.2 -1.0 57.8
10 0.3 3.0 1.2
25 0.2 5.0 33.8
ΣRiPi = 12.0 101.0
R = Expected Return = SRiPi = 12%
( )
2
Total Risk = S.D. = ΣPi R i − R = 101 = 10.05%
Hence security A has average return of 12% with a total risk of 10.05%.
This security has very high risk due to very large variability in return (i.e.
-5% to 25%).
3.7.1 Coefficient of Variation: A relative measure of Risk

The main limitation of standard deviation as a measure of total risk of a
security is that it is an absolute measure of risk. Therefore when expected
returns are same for two investments then their risks can be compared
using S.D. However when we want to compare two or more securities hav-
ing different average returns, we should not use S.D to conclude about the
riskiness of securities. In such case we should use coefficient of variation.
Coefficient of variation is a relative measure of risk. It can be calculated
as given below :
Standard deviation
Coefficient of Variation =
Mean Return
Illustration 3.17: A security analyst wants to analyse the following two

securities with respect to risk.
Security Expected Return (%) S.D. of Returns (%)
A 20 15
B 30 18
Can it be concluded that security B is more risky than security A.
Solution : In the question although S.D. of returns of security B is higher
than that of security A, it cannot be concluded that security B is more risky.
This is because return on security B is also higher. In this case we should
not assess riskiness of a security by S.D. which is an absolute measure of
risk. Rather we should use coefficient of variation (C.V.) which is a relative
measure of risk.
S.D.
Coefficient of variation =
Mean Return
15
Coefficient of variation of security A = = 0.75
20
18
Coefficient of variation of security B = = 0.60
30
Since C.V. of Security A is higher we can say that Security A is riskier than
security B.
3.8 Calculation of Systematic Risk

The above discussion shows the calculation of total risk of a security using
variance or standard deviation. Total risk of a security comprises of two
components – systematic risk and unsystematic risk.
As explained earlier systematic risk is that part of total risk which is caused
by factors beyond the control of a specific company, such as economic,
political and social factors. It can be captured by the sensitivity of a securi-
ty’s return with respect to market return. This sensitivity can be calculated
by b (beta) coefficient. b coefficient is calculated by regressing a security’s
return on market return. The estimated equation is given below :
Rs = a + bRM + e (This equation is called characteristic line)……….(3.9)
or
R̂ s = α + βR M
Rs is the return on a particular security while RM is market return. It can
be observed that b is the regression coefficient of Rs on RM. The intercept
term is a showing a security’s return independent of market return.
105 Calculation of systematic risk Para 3.8
The value of b can be calculated using the following formula:

ΣR s . ΣR M
ΣR s .R M −
β= n ………………………………………………..(3.10)
ΣR 2M −
(ΣR M )2
n
Here Rs is the return on security RM is the market return. You can see that
this formula is the same that is used to calculate regression coefficient of
Y on X, here Y is security Return and X is market return.
b of a security can also be calculated using equation (3.10A)
Cov(S, M)
β= ………………………………………………………..….……..(3.10A)
σm 2
Where Cov(S,M) = Covariance between returns of security S and Market
Return
σm2 = Variance of Market returns or simply Market Variance
Since b measures how sensitive is a security’s return with respect to market
return, b is an INDICATOR of systematic risk of a security.
Economic interpretation of b coefficient of a security
b measures the resultant change in Rs (i.e. a security’s return) for a unit
change in RM (i.e. market return). Hence it is an indicator of systematic risk
of a security. The higher the b the greater is the systematic risk.
If b = 1 then the security is as risky as market portfolio or market-index.
If b < 1 then the security is less sensitive risky than the market portfolio
and hence termed as ‘defensive’ stock.
If b > 1 then the security is more sensitive or risky than the market port-
folio and hence termed as ‘aggressive’ security.
For example if b = 0.80 then a 10% change in market return will result in
8% change in security return in the same direction. On the other hand if
b = 1.20 then a 10% change in market return will cause a 12% change in
security’s return in the same direction.
Can b be negative?
It must be noted that b can also be negative. If a security has negative b, it
implies that the security’s returns are moving in the opposite direction of
the market return. When market returns are increasing security’s returns
are decreasing and vice versa. This may be the case for certain stocks for
some periods. For example in times of rising oil prices the stocks of oil and
petroleum companies show decline in returns even though the market as
a whole is booming and providing increased returns. In such a case if we

calculate b of oil stocks we will get negative b.
Illustration 3.18: Calculate beta (b) of security P from the following infor-
mation. What can be said about security p ?
Security Return (%) Market Return (%)
10 8
12 10
15 12
30 25
6 4
4 5
Solution : Rs RM Rs.RM RM2
10 8 80 64
12 10 120 100
15 12 180 144
30 25 750 625
6 4 24 16
4 5 20 25
77 64 1174 974
ΣR s . ΣR M
ΣR s .R M −
β= n
ΣR 2M −
(ΣR M )2
n
1174 − 77 × 64 / 6 352.67
= = 1.21
=
974 −
(64) 2
291.33
6
Hence beta of security P is 1.21. Since b > 1 we can say that this security
is aggressive. A 1% increase in market return will result in 1.21% increase
in this security’s return.
Similarly a 1% decrease in market return will result in a 1.21% decrease in
this security’s return.
Calculation of the Magnitude of Systematic Risk
It must be noted that b is an indicator of systematic risk of a security. It is
a number independent of the unit of measurement. Hence it does not tell
us what is the quantity of systematic risk i.e. how much of the total risk
(say 10%) is systematic risk?
Systematic risk can be defined as that part of total risk which is explained
by market. Hence if security return is dependent variable (or S) and market
return is independent variable (or M) then systematic variance is the ex-
plained variance i.e. that part of total variance in S which is explained by M.
Explained Variance = Coefficient of determination x Security Variance
= rMS
2
.σ S2 ………………………………………………….(1)
σs
Now we know that rMS . σm = βSM
σm
Hence rms = β sm …………………………………………………….(2)
σs
Substituting the value of rsm from (2) in (1) we get
2
 σm  2
Explained Variance (Systematic Variance) =  βsm . σs  .σ s
2 2
= βsm .σ m
Systematic Risk = bsm………………………… ………………………(3.11A)
(in S. D.)
Systematic Risk (in the form of S.D.) is square root of systematic variance
and is expressed in % term.
For example if a security’s beta is 1.2 and market standard deviation is 10%
then the systematic risk (in terms of S.D.) will be 12%.
3.9 Unsystematic Risk

Unsystematic risk is that component of total risk which is not explained
by the market. This can be calculated by subtracting systematic variance
from the total variance of a security’s return.
Total Risk = Systematic Risk + Unsystematic Risk
\Total Variance = Systematic Variance + Unsystematic Variance
Therefore
Unsystematic Variance = Total Variance - Systematic Variance……(3.12)
σ ei2 = σ S2 − β2 σ 2m ……………………………………………………(3.12A)

Unsystematic Risk (sei) = σ 2s − β2 σ 2m ……………………………(3.12B)
The unsystematic risk in terms of standard deviation will be the square

root of the unsystematic variance.
Illustration 3.19: The total risk on a security (expressed in terms of S.D.)

is 10% and its beta is 1.2. Calculate systematic risk and unsystematic risk
of the security if market variance is 36% squared percentage (i.e. market
S.D. is 6%)?
sei2
Solution : Total Variance = σ 2 = (10)2 = 100 Sq%
Systematic Variance = β2 62m = (1.2) (36) = 51.84 Sq.%
2

Systematic risk in terms of S.D = 7.2%
Unsystematic Variance = 100 – 51.84
= 48.16 Squared.%
Unsystematic risk in terms of S.D.= 6.9%
Note : It must be noted that it is the risk expressed in terms of total vari-
ance which is to be decomposed into systematic variance and unsystematic
variance and not total standard deviation (S.D.). The reason is that S.D.
is square root of variance and two square root terms cannot be added
together. For example
5 + 4 ≠ 9 (in terms of S.D.)
But 5 + 4 = 9 (in terms of variance)
3.10 Expected Return (based on Capital Asset Pricing

Model)
Expected return on a security can also be calculated using Capital asset
pricing model (CAPM) the details of which are provided in Chapter 9. Here
we are providing the CAPM equation which is widely used to calculate
expected return by security analysts and investors. As per CAPM there is
a positive and linear relationship between expected return and systematic
risk as measured by beta.
E(Ri) = Rf + (E(RM)-Rf)βi………………………………………(3.13)
Where
E(Ri) = Expected return on a security i
Rf = Risk free return
E(Rm)= Expected market return
bi =Beta of the security
Beta of a security measures the sensitivity of a security’s return vis-a-vis
market return. This can be calculated by regressing a security’s returns
on market returns.
109 Impact of Taxes on Investment Return Para 3.11
It must be noted that (E(Rm)-Rf) is nothing but market risk premium i.e.
risk premium on the market portfolio.
(E(Rm)-Rf)βi is the risk premium of the security. Hence risk premium of a
security is calculated by multiplying market risk premium with the beta
of that security.
3.10.1 Abnormal Return

Abnormal return is the difference between actual return on a security and
its expected return. It shows whether the security has performed better
than what was expected of it or not. Generally in this case expected return
is based on standard Capital Asset Pricing Model.
Abnormal Return = Average(Actual) Return – Expected Return
Illustration 3.20 : The beta of a stock is 1.3 and standard deviation of its
return is 15%. The expected market return is 15%. Risk free rate is 6%.
Calculate
(i) Market risk premium
(ii) Expected return on the stock
(iii) Risk premium of the stock
(iv) Abnormal return of the stock (if any) if the actual average return on
this stock is 19%.
Solution :
(i) Market Risk Premium = 15-6 = 9%
(ii) Expected Return of the stock = 6 + (15-6)1.3 = 17.7%
(iii) Risk Premium of the stock = 17.7- 6% = 11.7
(iv) Abnormal Return = 19-17.7 = 1.3%
3.11 Impact of Taxes on Investment Return

Taxes play an important role in investment decision making. Personal taxes
are levied on individual’s income under the head salary, house property,
business and profession etc. Income from investment is also subject to
tax. However the rate of tax differs from investment to investment. Some
incomes from investments are also exempt from tax such as tax free bonds.
Besides, there are some investments which are deductible while calculating
taxable income and hence provide tax savings.
In order to compare alternative investments, one needs to take into con-
sideration the impact of taxes and compare the alternative investments
benefits either pre-tax or post-tax.
Post Tax rate = Pre tax Rate (1-Tax rate)

Or alternatively
Post Tax rate
Pre Tax rate =
(1-Tax rate)
Taxable Equivalent Yield : In case of Tax free investments (such as Tax
free bonds) no tax is to be paid on the annual interest income. The interest
income is exempt from tax in such a case. Here we can calculate taxable
equivalent yield to compare it with an investment the yield of which is tax-
able. Taxable equivalent yield is the equivalent pre tax yield of a tax free
investment. It can be calculated using the following formula :
Tax free rate
Taxable equivalent yield =
(1-Tax rate)
If tax free rate is 10% and the investor is in 30% tax bracket, then taxable
equivalent yield will be
0.10
Taxable equivalent yield = = 0.143 or 14.3%
(1 − 0.30)
Following illustration will clarify the impact of taxes on return from an
investment.
Illustration 3.21: Mr. X has two investment options – (i) invest in 10 year
tax-free REC bonds which provide annual interest-rate of 8.12% or (ii) in 10
year fixed deposit of bank at 10% p.a interest. Mr. X is in 30% tax bracket
and assume that there is no surcharge. Do you think Mr. X should invest
in fixed deposit because it provides higher interest income? Show relevant
calculations.
Solution : We know that interest on bank’s fixed deposit is taxable in hands
of recipient while REC bonds interest income is exempt from tax. Therefore
8.12% and 10% are not comparable because 8.12% is not subject to tax while
10% is subject to 30% tax.
Therefore post tax interest rate from fixed deposit = 10% (1 – 0.30) = 7%.
Since 8.12% > 7% Mr. X should opt for REC bonds.
Alternatively, we can also calculate pre -tax interest rate from REC bonds
(or taxable equivalent yield) and compare it with the interest rate on fixed
deposit.
Pre-tax (effective) interest rate (coupon rate) from
8.12%
REC bonds = = 11.6%
1 − 0.30
This can be compared with 10% which is pre-tax interest rate from fixed
deposit. Here also we find that REC bonds are better than fixed deposit.
111 Impact of Inflation on Return from Investment Para 3.12
Do You Know that Investment in Public Provident-Fund (PPF) is Exempt,

Exempt, Exempt (EEE) i.e. fully exempt from tax?
Amount invested in PPF is deductible u/s 80C from taxable income. Interest
on PPF is tax-free and no tax is charged on the amount received at the time
of maturity.
3.12 Impact of Inflation on Return from Investment

Inflation erodes the purchasing power of money. Therefore it is necessary
to consider prevailing inflation rate while making investment. Now-a-days
inflation is very high around 9 to 10%, and hence any investment alterna-
tive which generates less than this much of the return is actually making
a loss in real terms.
We can understand the impact of inflation on investment by calculating real
rate of return rather than nominal rate of return. Real rate of return is the
return adjusted for inflation i.e. it does not have any element of inflation
rate. Nominal rate of return is the prima facie rate of return earned on an
investment and contains the element of inflation rate. We can calculate
real rate of return as given below :
 1 + Nominal Rate of return 
Real Rate of Return = 
 1 + Inflation Rate  − 1 ………………….(3.14)
As an approximation
Real Rate of Return = Nominal Rate of Return - Inflation Rate………..(3.14A)
Hence if nominal rate of return an investment is 12% and inflation rate is
9% then real rate of return is
(1 + 0.12)
Real Rate of Return = − 1 = 0.0275 or 2.75%
(1 + 0.09)
It implies that in real terms the investment is generating only 2.75% return,
although it appears to a layman that the return is 12%. That is, the real net
worth of individual is increased only by approx. 2.75% return and not by 12%.
In times of higher inflation the amount of investment falls in an economy
because individuals prefer current consumption to future consumption
due to decline in the purchasing power of money.
In times of increasing inflation, a rational investor should search for
securities, the returns of which increase with increase in inflation. In such a
case the real rate of return may not decline. It must be noted that in times
of inflation bond or other fixed income securities are not so appropriate
because the return on fixed income securities is fixed in nominal terms
and does not increase with increase in inflation. Hence every year the real
rate of return declines as inflation increases.
Equity shares are generally considered to be good hedge against inflation

and hence an appropriate investment in times of increasing inflation. The
underlying reason is that return on equity shares (in the form of dividend
and capital gain) increases in times of inflation and hence real rate of return
is not affected much by inflation.
Illustration 3.22: Following information is available in respect of the rate
of return on a security .
Condition Probability Return on security
Bad 0.10 8%
Average 0.50 15%
Good 0.40 20%
Find out the expected return of the security. What will be inflation adjusted
return if inflation rate is expected to be 5%?
Solution :
Condition Probability Ri PiRi
(Pi)
Bad 0.10 8% 0.008
Average 0.50 15% 0.075
Good 0.40 20% 0.08
0.163
(i) R = Expected Return = SR P

i i
Therefore Expected return of Security = 0.163 or 16.3%

(ii) The expected return of 16.3% is nominal return. Hence inflation ad-
justed return will be calculated as follows :
(1 + 0.163)
Inflation adjusted Return = − 1 = 0.1076 or 10.76%
(1 + 0.05)
Solved Problems
Problem 3.1: Mr. Trivedi has purchased an equity share at a price of Rs.
220 in the beginning of year 2015. He sold the share at a price of Rs. 240
at the end of year 2015 after receiving a dividend of Rs. 2 from the share.
What is the holding period return on equity share? (ii) How much is divi-
dend yield and capital gains yield?
D1 + (P1 − P0 )
Solution: HPR on equity share =
P0
113 Solved problems
2 + (240 − 220 )
=
220
= 0.10 or 10%
Dl
Dividend yield =
Po
= 2/220 = 0.0091 or 0.91%
Capital gain yield = (P1-Po)/Po = (240-220)/220 = 0.0909 or 9.09%
Problem 3.2: Mr. A had purchased a bond at a price of Rs. 800 with a
coupon payment of Rs. 150 and sold it for Rs. 1000. (i) What is his Holding
Period Return? And (ii) if the bond is sold for Rs 750 after receiving coupon
payment, then what is his holding period return? (B.com (H) DU 2009)
I1 + (P1 − P0 )
Solution: HPR on bond =
P0
150 + (1000 − 800 )
=
800
= 0.4375 or 43.75%
150 + (750 − 800 )
HPR if sold for Rs. 750 = = 0.125 = 12.5%
800
Problem 3.3: An investor is considering the following two Zero coupon
bonds for the purpose of investment. The face value of the bond is Rs.100.
(i) 6-month zero coupon bond available at a price of Rs. 97
(ii) One year Zero coupon bond available at a price of Rs. 93.
(iii) Four years zero coupon bond available at an issue price of Rs. 88.
Advise the investor.
Solution : A zero coupon bond does not pay any interest and are issued at
discount. The return from a zero coupon bond is based on the difference
between redemption value (which is at face value) and issue price.
Here we can calculate Holding Period return (HPR) of the bonds-
Bond HPR
6 month bond (100 – 97)/97 = 0.0309 or 3.09%
One year Bond (100 – 93)/93 = 0.0753 or 7.53%
Four year bond (100 – 88)/88 = 0.1364 or 13.64%
However since the holding period is different, they cannot be compared
in terms of HPR. Hence we calculate effective annualized returns of the
three bonds.
Effective Annualized Return (EAR) calculation-

EAR of 6 month bond = (1 + 0.0309)2 – 1
= 1.0627 – 1 = .0627 or 6.27%
EAR of one year bond = (1 + 0.0753)1 – 1 = 0.753 or 7.53%
EAR of four year bond = (1 + 0.1364)1/4 – 1
= 1.0324 – 1 = 0.0324 = 3.24%
Therefore comparison of their effective annualized returns shows that
one year bond provides the highest annualized return and hence should
be selected by the investor.
Problem 3.4: Following information is available in respect of the rate of
return on a security T.
Condition Probability Rate of return on T
Bad 0.10 8%
Average 0.50 15%
Good 0.40 20%
Find out the expected return and risk of security T.
Solution :
Condition Probability Rate of PiRT
return on Pi(RT- R )2
(Pi) T (RT)
Bad 0.10 8% 0.008 0.1(0.08-0.163)2 = 0.000689
Average 0.50 15% 0.075 0.5(0.15-0.163)2= 0.0000845
Good 0.40 20% 0.08 0.4(0.20-0.163)2=0.000548
0.163 0.001321
(i) R = Expected Return = SRiPi
Therefore Expected return of T = 0.163 or 16.3%
(ii) Risk of a security can be measured by its S.D of returns.
( )
2
Total Risk = S.D. = ΣPi R i − R
Risk of security T = (0.001321)1/2 = 0.0363 or 3.63%
Problem 3.5: An investor purchases an equity share at a price of Rs. 100
now. Its expected year end price with relevant probabilities and expected
year end dividends are given below:
115 Solved problems
Probability Share price (Rs.) Dividend (Rs.)

0.20 125 5
0.40 120 3
0.30 115 2
0.10 105 Nil
Find out the expected return and variability of return of equity share.
Solution : Purchase Price (Po) = Rs.100
Probab- Share Dividend Dividend Purchase Total return (Div Pi*Ri
ility (Pi) price (Rs.) + Price price +Price change)/
(Rs.) change Purchase price (Ri)
0.20 125 5 30 100 30% 6
0.40 120 3 23 100 23% 9.2
0.30 115 2 17 100 17% 5.1
0.10 105 Nil 5 100 5% 0.5
(i) R = Expected Return = SR P

i i
Therefore Expected return of share = 6 + 9.2 +5.1+ 0.5 = 20.8%

(ii) Variability of the returns of a security can be measured by its S.D of
returns.
( )
2
Total variability = S.D. = ΣPi R i − R
= [ 0. 20(3 0 -20.8) 2 + 0.40( 23- 20. 8) 2 + 0.30(17-
20.8)2+0.10(5-20.8)2]1/2
= (48.16)1/2
= 6.94%
Problem 3.6: Following information is available in respect of the rate of
return on two securities - Q and S
Condition Probability Rate of return on Q Rate of return on S
Recession 0.30 -0.20 0.05
Normal 0.40 0.25 0.10
Boom 0.30 0.40 0.12
(i) Find out the expected returns and risk of security Q and S.
(ii) Which security is less risky? Why?
(iii) Suppose an investor has Rs. 10,000 to invest. He invests Rs. 5,500 in
security Q and the remaining Rs. 4,500 in Security S . What will be
the expected return of his portfolio?
Solution :
Condition Probability Rate of Rate of PiRQ PiRs P i ( R Q - Pi(Rs- R
(Pi) return return s)2
R Q)2
on Q on S (R
(RQ) (Rs)
Recession 0.30 -0.20 0.05 -0.06 0.015 0.03888 0.000504
Normal 0.40 0.25 0.10 0.10 0.04 0.00324 0.0000324
Boom 0.30 0.40 0.12 0.12 0.036 0.01728 0.000252
S 0.16 0.091 0.0594 0.000788

Therefore Expected return of Q = 0.16 or 16%
Expected return of S = 0.091 or 9.10%
( )
2
Risk of security Q = (0.0594)1/2 = 0.2437 or 24.37%

Risk of security S = (0.000788)1/2 = 0.028 or 2.8%
Hence security Q has average return of 16% with a total risk of 24.37%
while security S has average return of 9.1% with a total risk of 2.8%.
It is quite apparent that security Q is more risky than security S. This
can be verified by calculating a relative measure of risk i.e. Coefficient
of Variation
C.V of Security Q = 24.37/16 = 1.52
C.V of Security S = 2.8/9.1 = 0.31
Hence security S is less risky and security Q is more risky.
(iii) Here we are given that weight of Q = 5500/10000 = 0.55
weight of Q = 4500/10000 = 0.45
Hence portfolio return will be
Rp = 0.55(0.16) + 0.45(0.091)
= 0.1289 or 12.89%
Problem 3.7: Compute the Expected Return and risk of the following two
securities :
117 Solved problems
State Probability RA RB
Bear 0.30 -10% -20%
Normal 0.20 18% 10%
Bull 0.50 25% 20%
(B.com (H) DU 2013)
Solution :
State Prob. RA RB Pi x RA Pi XRB P i ( R A - R Pi(RB-
R
(Pi) A)2 B)2
Bear 0.3 -10% -20% -0.03 -0.06 0.0160 0.0203
Normal 0.2 18% 10% 0.036 0.02 0.0004 0.0003
Bull 0.5 25% 20% 0.125 0.1 0.0071 0.0098
Σ = 0.131 Σ = 0.06 Σ = 0.0235 Σ = 0.0304
(iv) R = Expected Return = SRiPi
Therefore Expected return of A = 13.1%
Expected return of B = 6%
(v) Risk of a security can be measured by its S.D of returns.
Total Risk = S.D. = ( ) ΣPi R i − R
2
Risk of security A = (0.0235)1/2 = 15.3%

Risk of security B= (0.0304)1/2 = 17.4%
Problem 3.8: The following two securities have been shortlisted by an
investor—
Probability Return on X Return on Y
0.40 10% 5%
0.40 5% 8%
0.20 -5% 2%
Which security should be selected and why? (B.com (H) DU 2011)
Solution :
Prob. (Pi) Rx Ry Pi X Rx Pi XRy Pi(Rx- R x)2 Pi(Ry- R y)2
0.40 10% 5% 4 2 10 0.144
0.40 5% 8% 2 302 0 2.300
0.20 -5% 2% -1 0.4 20 2.590
Total 5 5.6 30 5.034

Therefore Expected return of X = 5%
Expected return of Y = 5.6%
Expected return of security Y is higher.
( )
2
Risk of security X = (30)1/2 = 5.48%
Risk of security Y = (5.034)1/2 = 2.24%
Since returns are different we cannot compare these two securities
unless we use a relative measure of risk. For this we calculate coef-
ficient of variation (C.V)
C.V for X = 5.48/5 = 1.096
C.V for Y = 2.24/5.6 = 0.40
Using C.V we can say that security Y is less risky than security X.
Hence security Y should be selected as it provides higher return and
has lower risk.
Problem 3.9: Mr. Gupta makes an investment at Rs. 50. The year end price
of this investment under different market conditions with equal probabil-
ities are as follows:
Condition Year end price(Rs.)
Bullish 75
Normal 60
Bearish 45
(i) Find the expected value of return for one year period and risk .
(ii) Also calculate inflation adjusted return if rate of inflation during the
year is 8%.
(B.Com (H) DU 2010)
Solution:
Condition Prob. Year end Capital Return(%) Pi xRB Pi(RA- R
(Pi) price gain(loss) A)2
Bullish 1/3 75 25 50 16.67 300
Normal 1/3 60 10 20 6.67 0
Bearish 1/3 45 -5 -10 -3.34 300
Total 20 600
119 Solved problems

Therefore Expected return = 20%
( )
2
Risk of security = (600)1/2 = 24.5%
(iii) The rate of inflation is 8% and expected return (nominal return) is
20% as calculated above. Hence inflation adjusted return can be
calculated as follows. Please note that inflation adjusted return is
same as real rate of return.
(1 + 0.20)
Inflation adjusted return = −1
(1 + 0.08)
= 0.1111
= 11.11%
Problem 3.10: An investor has a portfolio of five securities whose expected
returns and amount invested are as follows:
Security 1 2 3 4 5
Amount (Rs.) 150000 250000 300000 100000 200000
Expected Return 12% 9% 15% 18% 14%
Find out the % expected return of the portfolio.
(B.Com (H) DU 2009)
Solution : Total amount invested = Rs. 1000000
Hence the weight of each security can be calculated as follows:
Amount invested in security i
Weight of security i =
Total amount invested
Security 1 2 3 4 5 Total
Weight (Wi) 0.15 0.25 0.30 0.10 0.20
Expected Return(Ri) 12% 9% 15% 18% 14%
Wi X Ri 1.8 2.25 4.5 1.8 2.8 13.15
Expected Return of the portfolio = 13.15%
Problem 3.11: In a portfolio of the company Rs. 200000 have been invest-
ed in asset X which has an expected return of 8.5%, Rs. 280000 in asset Y
which has an expected return of 10.2% and Rs. 320000 in asset Z which has
an expected return of 12%. What is the expected return for the portfolio?
(B.Com (H) DU 2010)

Asset X Y Z Total
Weight (Wi) 0.25 0.35 0.40 1.00
Expected Return in % (Ri) 8.5 10.2 12
Wi X Ri 2.125 3.57 4.8 10.495
Problem 3.12: The returns on two securities under four possible states of
nature are given below:
State of Nature Prob. (Pi) RA (%) RB(%)
1 0.2 7 4
2 0.4 9 10
3 0.3 14 18
4 0.1 18 28
Find :
(i) Expected return on security A and security B.
(ii) Risk (in terms of S.D.) on security A and B.
(iii) Covariance between returns on security A and B.
(iv) Coefficient of correlation between the returns on security A and B.
(B.Com (H) DU 2012)
Solution : Calculation of Expected Return and Risk
State Prob. (Pi) RA RB Pi X Pi XRB Pi(RA- R Pi(RB- R
RA A)2 B)2
1 0.2 7 4 1.4 0.8 3.2 16.2
2 0.4 9 10 3.6 4 1.6 3.6
3 0.3 14 18 4.2 5.4 2.7 7.5
4 0.1 18 28 1.8 2.8 4.9 22.5
TOTAL 11 13 12.4 49.8
Therefore Expected return of A = 11%
Expected return of security B is higher.
121 Solved problems
( )
2
Risk of security X = (12.4)1/2 = 3.52%
(iii) Covariance between returns of A and B can be calculated using the
following formula:
Covariance (A,B) = Σ Pi(RA- R A) (RB- R B)
State Prob. (Pi) RA RB (RA- R A) (RB- R B) Pi(RA- R A) (RB- R B)
1 0.2 7 4 -4 -9 7.2
2 0.4 9 10 -2 -3 2.4
3 0.3 14 18 3 5 4.5
4 0.1 18 28 7 15 10.5
Σ =24.60
Hence Covariance between A and B’s returns is 24.60 squared per-
centage.
Cov (AB)
(iv) Coefficient of Correlation (ρ) =
S.D. (A) S.D. (B)
24.50

=
3.52 × 7.06
3.52 × 7.06
= 0.989
Thus the two securities returns are highly positively correlated.
Problem 3.13: An investor is considering the following two investment
proposals. The returns from both the proposals are same but their
probabilities differ. Compute the Expected Return and risk of the following
two proposals and advise the investor.
Return(%) Prob. X Prob.Y
-10 0.05 0.20
15 0.15 0.20
20 0.30 0.25
25 0.25 0.25
30 0.25 0.10
Solution :
Ri(%) Prob. X Prob.Y PX(Ri) Py(Ri) Px (Ri- R )2 Py(Ri- R )2
-10 0.05 0.2 -0.5 -2 49.61 127.51
15 0.15 0.2 2.25 3 6.34 0.01
20 0.3 0.25 6 5 0.68 5.64
25 0.25 0.25 6.25 6.25 3.06 23.77
30 0.25 0.1 7.5 3 18.06 21.75
Total 21.5 15.25 77.75 178.68

Therefore Expected return of proposal X = 21.5%
Expected return of proposal Y = 15.25%
Total Risk = S.D. = (

ΣPi R i − R )2
Risk of proposal X = (77.75)1/2 = 8.81%
Risk of proposal Y = (178.68)1/2 = 13.36%
The investor should accept proposal X as it has higher return and
lower risk than proposal Y.
Problem 3.14: Mr. Dwivedi purchased a share at Rs. 100 five years ago. The
market price at the end of each year and dividend for the year are given
below. Calculate average rate of return and risk of the security.
Year 1 2 3 4 5
Dividend (Rs.) 5 6 6 4 3
Market Price (Rs.) 105 120 124 130 140
(B.Com (H) DU 2011)
Solution :
Year Market Dividend Capital Return(Rt) (Rt-
Price (Rs.) (Rs.) Gain (Rs.) avgR)2
1 105 5 5 (5+5)/100= 0.10 0.00016
2 120 6 15 (6+15)/105 = 0.20 0.00760
3 124 6 4 (6+4)/120= 0.083 0.00086
4 130 4 6 (4+6)/124 = 0.081 0.00103
5 140 3 10 (3+10)/130 = 0.10 0.00016
Total 0.564 0.009831
123 Solved problems
Average return: We can compute average return based on arithmetic mean

or geometric mean.
0.564
Average return (based on A.M) = = 0.1128 or 11.28%
5
Average return (Based on G.M.)
= [ (1+0.10)(1+0.20)(1+0.083)(1+0.081)
(1+0.10)]1/5 – 1
= (1.7)1/5 - 1
= 0.1120 or 11.20%
Risk can be calculated using the formula of S.D
( )
2
Σ Ri − R 0.00983
S.D. = = = 0.044 or 4.4%
N 5
Hence total risk of the security is 4.4%.
Problem 3.15: A security analyst wants to analyse the following two secu-
rities with respect to risk.
X 25 18
Y 30 20
Can it be concluded that security Y is more risky than security X.
Solution : In the question although S.D. of returns of security Y is higher
than that of security X, it cannot be concluded that security Y is more risky.
This is because return on security Y is also higher. In this case we should
not assess riskiness of a security by S.D. which is an absolute measure
of risk. Rather we should use coefficient of variation which is a relative
measure of risk.
S.D.
Coefficient of variation =
Mean Return
18
Coefficient of variation of security X = = 0.72
25
Coefficient of variation of security Y = 20 = 0.67

30
Since C.V. of Security X is higher we can say that Security X is riskier than
security Y.
Problem 3.16: Calculate beta (b) of security P from the following information :
Security Return (Rs) Market Return (Rm)
21 10
18 15
23 30
8 6
5 4
Solution : Rs RM Rs.RM RM2
21 10 210 100
18 15 270 225
23 30 690 900
8 6 48 36
5 4 20 16
Total 75 65 1238 1277
ΣR s . ΣR M
ΣR s .R M −
β= n
ΣR 2M −
( M )2
Σ R
n
1238 − 75 × 65 / 5 283
= = 0.61
=
1277 −
(65) 2
432
5
Hence beta of security is 0.61. Since b < 1 we can say that this security is
defensive. A 1% increase in market return will result in 0.61% increase in
Similarly a 1% decrease in market return will result in a 0.61% decrease in
Problem 3.17 : The total risk on a security (expressed in terms of S.D.) is
20% and its beta is 1.2. Calculate systematic risk and unsystematic risk of
the security if market variance is 36% squared percentage (i.e. market S.D.
is 6%)?
Solution : Total Variance = σ 2 = (20) = 400 Sq%
2
Systematic Variance = β2 62m = (1.2) (36) = 51.84 Sq.%

2
Systematic risk in terms of S.D = 7.2%

125 Solved problems
Unsystematic Variance = Total Variance – Systematic Variance

= 400 – 51.84
= 348.16 Squared.%
Unsystematic risk in terms of S.D.= 18.66%
Problem 3.18: The beta of a stock is 1.5 and standard deviation of its return
is 10%. The expected market return is 14%. Risk free rate is 4%. Calculate
(ii) Expected return on the stock using CAPM
this stock is 22%.
Solution :
(ii) Expected Return of the stock using CAPM = 4 + (14-4)1.5 = 19 %
(iii) Risk Premium of the stock = (14-4)1.5 = 15%
(iv) Abnormal Return = Actual return – expected return = 22-19 = 3%
Problem 3.19 : Mr. Y has two investment options – (i) invest in 10 year
tax-free PFC bonds which provide annual interest-rate of 7.92% or (ii) in
10 year fixed deposit of bank at 9% p.a interest. Mr. Y is in 30% tax bracket
and assume that there is no surcharge. Both the options will provide face
value at maturity. Do you think Mr. Y should invest in fixed deposit because
it provides higher interest income? Show relevant calculations.
Solution : We know that interest on bank’s fixed deposit is taxable in hands
of recipient while PFC bonds interest income is exempt from tax. Therefore
7.12% and 9% are not comparable because 7.92% is not subject to tax while
9% is subject to 30% tax.
Therefore post tax interest rate from fixed deposit = 9% (1 – 0.30) = 6.3%.
Since 7.92% > 6.3 % Mr. Y should opt for PFC bonds.
Alternatively, we can also calculate pre-tax interest rate from PFC bonds
(or taxable equivalent yield) and compare it with the interest rate on fixed
deposit.
Pre-tax (effective) interest rate (coupon rate) from PFC
7.92%
bonds = = 11.31%
1 − 0.30
This can be compared with 9% which is pre-tax interest rate from fixed
deposit. Here also we find that PFC bonds are better than fixed deposit.
Note : That here we have not considered maturity value while deciding
the investment between the two options because maturity value is same
in both the cases and hence becomes irrelevant. It should be considered
while calculating actual yield from the investment.
Problem 3.20: Mr. Tiwari invests Rs. 900 in a corporate bond (Face value-
Rs. 1000) selling for Rs. 900. In the coming year, the bond will pay interest
of Rs. 50. The price of the bond at year’s end will depend on the level of
interest rates prevailing at that time. The following scenario is expected:
Interest rates Probability Year end Bond Price
High 0.3 850
Unchanged 0.4 890
Low 0.3 950
T-bills provide a sure rate of return is 4%. Calculate HPR for each scenario,
the expected rate of return and the risk premium on Mr. Tiwari’s investment.
Solution : Mr. Tiwari buys a bond at a price of Rs. 900, hence Po = Rs 900
His Year end possible Holding period Returns are :
Int Rate Pi P1 Int Int + Price Return (Ri) PiRi
Change (HPR)
High 0.3 850 50 0 0/900 = 0 0
Unchanged 0.4 890 50 40 40/900 = 0.044 0.018
Low 0.3 950 50 100 100/900 = 0.111 0.033
0.0511
Hence the Expected Return is 5.11%
Risk Premium = Expected Return – Risk free rate
= 5.11- 4
= 1.1%
Summary
u Return may be defined as income (or cash inflows) generated by investment
expressed as a percentage of the cost of investment.
u Holding Period Return (HPR) is the total return earned during the holding
period of investment. It is not expressed in per annum form rather it is the
absolute return over a specified investment horizon period such as 3-year
return, 5-year return etc.
127 Test Yourself
u Holding period returns on two investment alternatives cannot be considered

if holding periods of the investments are different. It is necessary to calculate
effective annualized returns to make meaningful comparisons.
u Average return can be calculated by taking the average of returns earned
every year from the historical records. For this purpose we can use either
arithmetic average or geometric average. Average return based on geometric
mean is preferred because it considers the effect of compounding.
u Other types of returns generally used in security analysis are- expected return,
abnormal return, absolute return, risk adjusted return etc.
u Risk is defined in terms of the variability in expected return. It must be noted
that all investments are subject to risks. However the level of risk differs from
security to security.
u Total risk on a security can be classified into systematic risk and unsystematic
risk depending upon the factors causing it.
u Systematic risk is that part of total risk which is caused by factors beyond
the control of a specific company or individual. Systematic risk is caused by
factors such as economic, political, socio, cultural etc. Major types of sys-
tematic risks include- market risk, purchasing power risk, interest rate risk,
exchange risk, global risk etc.
u Unsystematic risk is the risk caused by factors within the control of a specific
company such as issues related to management, assets, labour or capital.
Therefore unsystematic risk can be diversified away by holding an efficient
portfolio of securities. It includes business risk and financial risk.
u b is an indicator of systematic risk.
Test Yourself
True/False
(i) Return is the reward for investment.
(ii) Risk may be ignored while making investments.
(iii) Holding period return can be used to compare two or more investment
options.
(iv) Average return can be calculated using arithmetic mean or geometric mean.
(v) Calculation of Expected return requires assignment of probabilities to the
expected outcomes.
(vi) There is no difference between risk and uncertainty
(vii) Beta is an indicator of unsystematic risk
(viii) Risk premium is zero in case of a risky asset.
(ix) Portfolio return is weighted average of individual returns of securities com-
prising that portfolio.
(x) Indifference curve of a risk averse investor is downward sloping and concave.
(xi) Investors are risk seekers.
(xii) A Risk Neutral Investor does not consider risk while making investment
decisions.
(xiii) The indifference curve of a more risk averse investor is steeper.
(xiv) Unsystematic risk is caused by factors within the control of a specific com-
pany.
(xv) All securities have same level of systematic risk.
(xvi) Systematic risk is also termed as diversifiable risk.
(xvii) Financial risk is a component of systematic risk.
(xviii) Inefficient management is a source of systematic risk.
(xix) Beta of a security can never be negative or zero.
(xx) In an efficiently diversified portfolio unsystematic risk is negligible.
Sol. (i) T (ii) F (iii) F (iv) T (v) T (vi) F (vii) F (viii) F (ix) T (x) F (xi) F (xii) T
(xiii) T (xiv) T (xv) F (xvi) F (xvii) (F) (xviii) F (xix) F (xx) T
Theory Questions
1. What do you understand by the term ‘Return’? Explain in the context of
investment in securities. [Para 3.1]
2. What is holding period return? How it measured and what are its
limitations? [Para 3.2.4]
3. What is effective annualized return? How is it calculated? What is the need
of calculating it? Explain. [Para 3.2.4]
4. How is average return calculated? Explain various methods of
calculating it. [Para 3.2.1]
5. Why is average return based on geometric mean considered superior to
arithmetic mean based average return? Justify. [Para 3.2.1]
6. Explain the following : [Para 3.2]
(i) Risk-adjusted Return
(ii) Absolute Return
(iii) Abnormal Return
7. What is expected return? How can it be calculated if a probability distribution
of returns is given? Illustrate with the help of a hypothetical example.
[Para 3.2.2]
8. Explain the term ‘Risk’ in the context of investment in securities. What are
different types of risks? Explain. [Para 3.3]
9. Define Risk. What are the various sources of risk in an investment? Explain
and elucidate. [B.Com (H)DU 2011] [Para 3.3]
129 Test Yourself
10. Discuss the following:

i. No investment is risk free [B.Com (H)DU 2007]
ii. Risk return Trade off [Para 3.5]
11. What is systematic risk? How is it different from unsystematic risk?
[B.Com (H)DU 2012] [Para 3.4]
12. What are the various types of systematic risks in a security? [Para 3.4]
(i) Business Risk
(ii) Financial Risk [Para 3.5]
14. What do you understood by Interest rate risk? Do you think that all securities
are subject to interest rate risk? [Para 3.4]
15. How can total risk on a security be calculated? Explain with the help of a
hypothetical example. [Para 3.7]
16. What is the indicator of systematic risk in a security? How can it be calcu-
lated? [Para 3.8]
17. “All securities are subject to systematic risk.” Do you agree? Justify. [Para 3.4]
18. “No investment is risk free”. In view of this statement, write a note on the
meaning and types of investment risk. [B.Com (H)DU 2014] [Para 3.3]
19. What are the various types of Investors? Explain in Detail : [Para 3.6]
20. What are unsystematic Risk ? How can it be calculated [Para 3.9]
21. Write notes on the following
(i) CAPM [Para 3.10]
(ii) Effect of taxes on investment [Para 3.11]
(iii) Effect of inflation on investment [Para 3.12]
22. Discuss the risk return trade-off with the help of examples.
23. Risk is defined as the unexpected variability or volatility or returns on an
investment. What are the main types of risks that you need to understand
and manage as an investment adviser? (B.Com.(H), GGSIPU, 2017)
Practical Problems
1. An investor wants to invest in a zero coupon bond with face value of Rs.1000.
Three different maturity period bonds are available as given below :
P 6 months 960
Q 1 year 900
R 20 years 320
Calculate Holding period return and effective annualized returns on each

bond. Which bond is a better option for investment?
Ans :

HPR P = 4.16% Q = 11.11% R = 212.5%
EAR P = 8.49%, Q = 11.11%, R = 5.86%, Q is better
2. Mr. Mehta wants to calculate average return of a share of Infy.com Ltd.
currently available at a price of Rs. 260 on 31st December, 2013. The share
price at the end of year 2007, 2008, 2009, 2010, 2011 and 2012 were Rs.100,
125, 118, 130, 120, and Rs.140. The share did not pay any dividend over these
years. Calculate average return on the shares of Infy.com Ltd.
(i) using arithmetic mean
(ii) using geometric mean.
(iii) what will be your answer in (i) and (ii) if the company paid a dividend
of Rs. 2 per share every year.
Ans. (i) 20.7% (ii) 17.26% (iii) 20.8%, 17.41%

3. You are given the following information about the share of WECHAT Ltd.
and market portfolio (CNX 500 equity index) over the past 10 years.
WECHAT Ltd. CNX 500 EQ Index
Year Ri(%) RM(%)
1 12 18
2 10 15
3 9 10
4 6 8
5 11 13
6 12 15
7 10 13
8 7 10
9 9 8
10 13 15
Calculate
(i) Average return of stock and market
(ii) Total risk of stock and market
(iii) Beta of the stock
(iv) Systematic risk and unsystematic risk of the stock
Ans. (i) 9.9% & 12.5% (ii) 2.12% & 3.2% (iii) 0.55 (iv) 3.09% & 1.4%
4. Mr. Devang, a security analyst wants to analyse the following three securities
with respect to risk and return.
131 Test Yourself

A 22 15
B 35 20
C 30 18
Can it be concluded that security B is the most risky and security A is the
least risky security. [Hint : compute coefficient of variation]
Ans. A is most risky & B is least risky
5. Mr. Sethi invested Rs. 200 in a mutual fund which earns 20% annually for 3
years. Unfortunately it loses 60% during the 4th year and earns 20% annually
for next 3 years. Can we say that a total of 60% return is earned over 7 years
which is 8.5% annually? Why or why not?
Ans. 2.57% p.a. (using G.M.)

6. The beta of a stock is 0.8 and standard deviation of its return is 40%. The S.D.
of the market portfolio is 25%. Break down the variance of the stock into
systematic and firm specific components.
Ans. Systematic Risk = 20% Systematic Var = 400 sq%

Firm specific Risk = 34.64% Firm specific Var = 1200 sq%
7. The beta of a stock is 1.2 and standard deviation of its return is 15%. The S.D.
of the market portfolio is 10% and expected market return is 12%. Risk free
rate is 5%. Calculate :
(ii) Risk premium of the stock
(iii) Expected return on the stock
this stock is 13%.
(v) Unsystematic risk of the stock.
Ans. (i) 7% (ii) 8.4% (iii) 13.4% (iv) – 0.4% (v) 9%
8. Twelve years ago, Anand paid Rs.12.25 a share for 100 shares of XYZ Ltd.
Today, the stock is worth Rs.19 a share. What is Anand’s holding period return
for the investment?
[Answer-55%]
9. What is the HPR for an investor who bought a stock a year ago at Rs.100 and
received Rs.15 in dividends over the year, if the stock is now trading at Rs.160?
[Answer-75%]
10. Which investment performed better? Stock X that was held for three years,
during which it appreciated from Rs. 200 to Rs. 250 and provided Rs. 30
in dividends, or Stock Y that went from Rs. 300 to Rs. 420 and generated
Rs. 40 in dividends over four years? [HPR- X:40%,Y:53.3%, Annualised yield-
X:11.87%,Y:11.22%, Stock X is better]
11. Mr. A invests Rs. 27,000 in a corporate bond (Face value-Rs. 1000) selling for
Rs. 900. In the coming year, the bond will pay interest of Rs.75. The price of
the bond at year’s end will depend on the level of interest rates prevailing at
that time. The following scenario is expected:
Interest rates Probability Year end Bond Price
High 0.3 850
Unchanged 0.5 910
Low 0.2 975
T-bills provide sure rate of return is 4%. Calculate HPR for each scenario, the
expected rate of return and the risk premium on Mr. A’s investment. What is
the expected return in Rupee terms of the investment?
[Answer:
HPR-2.78%, 9.4%, 16.7%,
Expected return 8.87%, Rupee terms - Rs. 2395 Risk Premium- 4.87%]
12. Compute the expected return and risk of the following X and Y securities?
State Probability Return on X Return on Y
Bear Market 0.3 -10% -20%
Normal Market 0.2 18% 15%
Bull Market 0.5 25% 20%
(B.Com (H), DU, 2013)
[Answer: Return on X-13.1%, return on Y-7%, risk on X-15.32%, risk on Y-17.78%]
13. Orange Cap Limited provides you with the following information with regard
to two stocks, A and B :
State Probability Return on A Return on B
Boom 0.10 10% 15%

Normal 0.40 8% 12%
Recession 0.50 5% 7%
Compute risk and return of stocks A and B. Which security would you rec-
ommend?(B.Com (H), DU, 2014)
[Answer: Return on A-6.7%, Return on B-9.8%, risk on A-1.79%, risk on B-2.92]
14. The current price of a company’s share is Rs. 65 per share. Due to the strong
performance of the company, the share price is expected to be Rs. 90 at the
end of Year 1. In the next year, the company is likely to declare Rs. 2.90 per
share as dividend. Find the expected return of an investor, who wants to hold
the share for one year from today. (B.Com(H), DU, 2014)[Answer - 42.92%]
15. Suppose you have invested your savings in the stock market for five years
If your returns each year were 90%, 10%, 20%, 30% and -90%, what would your
average return be during this period by using:
133 Project work
a. Arithmetic mean
b. Geometric mean
Which one gives you the actual return?
[Answer-A.M.:12%, GM: (-) 20.08%]
16. You invest Rs.100 in Mutual Fund which earns 25% annually for 3 years, loses
75% in fourth year, and earns 25% annually for next three years. What is your
actual average return?
[Answer- (-) 0.7%, calculated by G.M.]
17. An investor wants to invest in a zero coupon bond with face value of Rs. 1000.
Three different maturity period bonds are available in the market:

P 6 months 960
Q 1 year 900
R 20 years 320
Calculate Holding period return and effective annualised return on each bond.
Which is better option for investment?
[Answer-
HPR: P-4.16%, Q-11.11%, R-212.5%
EAR: P-8.49%, Q-11.11%, R-5.86%]
Project work
From the website of National stock exchange (www.nseindia.com) download
the closing adjusted index values of CNX NIFTY as on 31st March for the past 15
years. Assume that CNX NIFTY is the proxy for market portfolio as it represents
the majority of actively traded stocks on NSE. Also download the closing adjusted
share price data on the same dates for the following stocks-
u Infosys Ltd.
u SBI Ltd.
u Unilever Ltd.
u Biocon Ltd.
Make five series of the data that you collected and calculate yearly returns using
simple percentage formula i.e. Rt = Pt-P(t-1)/Pt-1
Now calculate the following and comment on the results :
(i) Average return and variance of CNX NIFTY as well as the above four stocks.
(ii) Beta of every stock. Why do beta of these companies differ?
(iii) Systematic risk and unsystematic risk of the above four stocks. Why do these
risks differ across the stocks?
4 FIXED INCOME SECURITIES-
VALUATION, YIELDS AND RISKS
C H A P T E R
leaRnInG outComes
 Understand bond fundamentals
 Classify various types of bonds and explain them
 Determine the intrinsic value of a bond, convertible debenture and
Deep discount bond
 Explain the interactions between bond value, interest rate and
time to maturity
 Explain various types of bond yields
 Explain and analyse various risks in bonds
 Explain Malkiel’s properties regarding bond pricing
 Explain and calculate bond duration
 Explain Credit rating and process of credit rating.
Fixed income securities, as the name suggests, provide a fixed amount of

revenue to the holder of the securities and hence the issuer has to bear
a fixed cost obligation. Fixed income securities are classified as ‘Debt’ in
the capital structure of an enterprise. Examples of fixed income securities
include – Bonds, Debentures, Government securities etc. For the sake of
simplicity we use the term bond in this chapter, to denote all fixed income
securities. Fixed income securities are a good investment option for the
investors who want to have a fixed and regular return over the investment
134
135 Bond fundamentals Para 4.1
period. The investors who do not want to undertake high risk should also
invest in bonds and debentures because risk in fixed income securities is
relatively lower than that in equity shares due to fixed return. However be-
fore investment, the investor must consider the valuation, yields and risks
of these fixed income securities to avoid erroneous investment decision.
Fixed income securities provide a fixed amount of revenue to the holder
of the securities and hence the issuer has to bear a fixed cost obligation.
In India, fixed income securities are the most preferred investment option
for retired people and conservative (or more risk averse) investors who
want to have a fixed source of income at low risk.
4.1 Bond Fundamentals
Bond
A bond is a security that is issued in connection with a borrowing arrange-
ment. The bond is IOU (I owe you) of the borrower. It implies that the issuer
of the bond, usually a company or government, has an obligation to pay
some periodic amount (say interest) as well as the borrowed amount (or
principal amount) to the holder of the bond.
A bond is a security that is issued in connection with a borrowing ar-
rangement
Is there any difference between debenture and bond?

Yes. A debenture is a debt security which is not secured by specific assets
of the issuer company. A Bond, on the other hand is a debt security which
is secured by the specified assets of the issuer company. Bonds are IOUs
between the borrower (issuing corporation) and lender (the bondholder).
However in India, both the terms are used interchangeably. Typically
bonds are issued by public sector enterprises and financial institutions.
Features of a Bond
Every bond has certain features which describe it. Some common features
of a bond are given below :
(1) Face Value or Par Value : Every bond has some basic denomination
(say Rs.1000 or Rs.100) on the basis of which interest (or coupon) is
paid. The issue price of the bond may be same as its face value or
different from its face value. When issue price is higher than face
value of the bond, it is said to be issued ‘at premium’. When issue
price of bond is lower than its face value then it is said to be issued
Para 4.1 Fixed income securities - Valuation Yields & Risks 136
‘at discount’. However interest (or coupon) on the bond is always

calculated on the par value of the bond irrespective of its issue price.
(2) Coupon Rate : Coupon rate is the rate of interest paid to the bondholder
on the face value of the bond. It is fixed in advance and is specified in
the bond agreement. Unless specified otherwise, the coupon rate of
a bond never changes throughout the life of the bond. The interest
payments are also referred as coupon payments. Coupon rate is just
like any other interest rate say 10% p.a. Thus coupon rate specifies
the fixed return which the bondholder will get at fixed intervals (say
every year) from the date of issue till maturity.
(3) Maturity Period : It is the time horizon for which bond is issued to
the bondholder. The issuer of the bond is required to pay interest on
bond during this period and redeem bonds at the end of this period.
Bonds can have long term maturity such as 10 years or 15 years or
short term maturity say 1 year or 3 years etc.
(4) Redemption Value : It is the value of the bond paid by the company
to the bondholder at the time of maturity. Redemption value can be
higher than, lower than or equal to the face value of bond. If redemp-
tion value is higher than bond face value it is termed as redemption
at premium. If redemption value is lower than the bond face value,
it is referred to as redemption at discount. When redemption value
is equal to the face value of the bond, it is termed as redemption at
par. The redemption value of the bond is also specified in the bond
agreement.
(5) Bond Indenture : It refers to all those terms and conditions agreed
upon by the issuer of the bond and bondholder. It is a contract bet-
ween the issuing corporation and the bondholder. It covers a number
of items specifying all the features of the bond such as - coupon
rate, mode and frequency of interest payments, redemption price,
maturity date, collateral, sinking fund, priority of payment in times
of liquidation etc. There are three parties to a bond indenture- the
issuing corporation, the bond trustee and bondholder.
(6) Collateral : Bonds may be secured by some asset or security. Collat-
eral is the asset or security against which bonds are issued. When a
company defaults in the payment of interest or repayment of bond
value, the bond trustee can dispose of this asset or security to recover
the amount for bondholders.
(7) No Voting Rights : Bondholders of a company do not have any formal
voting rights in normal circumstances. Bondholders are creditors of
137 Types of Bonds Para 4.2
a company and hence in special cases they may have some repre-
sentation on the board of management of the company.
(8) Priority in Payment in times of liquidation : Since bondholders are
creditors of the company they have prior claim over the assets of
the company in times of liquidation. The claims of bondholders are
settled first and then the claims of preference shareholders and equity
shareholders are settled.
4.2 Types of Bonds

‘Bond’ is a generic term which signifies a fixed income security. It must
be noted here that in India, bonds and debentures terms are used inter-
changeably. Depending upon different types of bond features, we can
classify bonds into various categories. Some commonly available bond
types are discussed below :
(1) Convertible and Non-Convertible Bonds (or debentures)
Convertible bonds (or debentures) may be Fully convertible bonds
or Partly convertible bonds.
Fully convertible bonds (debentures) are the bonds which are fully
converted into equity shares after a specified period. The bond-
holder gets fixed interest income till the time bond remains as bond
and after conversion these bonds become equity shares eligible for
equity dividend and other rights of equity shareholders. There is no
redemption value of the bonds as they are redeemed by converting
them into equity shares. For example, a company issues a convertible
10% bond having face value of Rs. 100. The bond and is fully con-
vertible into five shares of face value Rs. 20 each after five years. In
this case the bondholder will get interest income of Rs.10 every year
for five years. After five years the bond will be converted into five
equity shares of the company and the bondholder of the company
and enjoy all ownership rights. Whether the bondholder makes a
gain or loss depends upon the market price of the share at the time
of conversion. If market price of share at the time of conversion is
more than Rs. 20, say Rs. 25 the bondholder stands to gain because
then the market value of his five equity shares would be Rs. 125. On
the other hand if market price of the share at the time of conversion
happens to be Rs. 15 then the bondholders stand to lose as the market
value of five shares would be Rs. 75.
Partly convertible bonds (or debentures) are those bonds for which
a part of the face value of the bond is converted into equity shares
after a specified time and the balance remains as pure bonds to be
redeemed as per the terms and conditions of the bond agreement.

For example, a company issues a convertible 10% bond having face
value of Rs. 100. The bond is partly convertible into three shares of
face value Rs. 20 each after five years. The total tenure of the bond
is 10 years. This implies that 60% of the total face value (Rs. 60 out
of Rs. 100) of the bond will be converted into equity shares after five
years and the remaining 40% (Rs. 40 out of 100) will still remain as
10% bonds for another five years. In this case the bondholder will
get interest income of Rs.10 every year for first five years. After five
years the bond holder will get three equity shares and enjoy all own-
ership rights as well as dividends. Whether the bondholder make a
gain or loss depends upon the market price of the share at the time
of conversion. If market price of share at the time of conversion is
more than Rs. 20, say Rs. 25 the bondholder stands to gain because
then the market value of his three equity shares would be Rs. 75. On
the other hand if market price of the share at the time of conver-
sion happens to be Rs. 15 then the bondholders stand to lose as the
market value of three shares would be Rs. 45. The remaining Rs. 40
face value bond will remain as 10% bond with the bondholder and
provide him an interest of Rs. 4 (i.e. 10% of Rs. 40) for another five
years after which it will be redeemed as per the terms and conditions
specified in the bond agreement.
It must be noted that the convertible bonds may be compulsorily
convertible or convertible at the option of the bondholder/issuing
company. Some companies in India have also issued multi option
convertible debentures, where the debenture holder is given different
options regarding conversion type, mode and timing of conversion.
Non-convertible bonds (or debentures), are those bonds which have
no conversion clause i.e. they are not to be converted into equity
shares after specified period. These bonds are redeemed at maturity.
These bonds may be redeemed at par, at premium or at discount.
Secured Premium Note (SPN)

SPNs are a non convertible debentures which are issued with detach-
able warrants and are redeemable after a specified period. It can be
issued by the companies with the lock in period of say 4 to 7 years.
This implies that the investor can get his SPN redeemed only after
the lock in period. During the lock in period, even interest is not paid.
SPN is generally redeemed in instalments after the lock in period.
The instalment covers both interest and a part of principal amount.
The detachable warrants are convertible into equity shares within
a specified time period. For the conversion of warrants into equity
139 Types of bonds Para 4.2
shares, it necessary that the SPN is fully paid up. Therefore SPN is
sometimes referred to as hybrid debt instrument. The advantage
of SPN to the issuer company is that the company gets cash inflow
immediately and there is no burden of interest payments during
the lock in period. Hence during the lock in period there is no cash
outflow. After that it can be redeemed in instalments.
TISCO (Tata Iron and Steel Corporation Ltd.) issued SPNs in July
1992.
(2) Redeemable and Irredeemable Bonds
As the name suggests, redeemable bonds are the bonds which are to
be redeemed by the issuing company after the expiry of a specified
period known as maturity period. The redemption can be done at
premium, par or discount. Irredeemable bonds, on the other hand,
have infinite time horizon as no maturity period is specified in this
case. Such bonds are not redeemed by the company during its life.
The bondholder continues to get interest income on irredeemable
bonds throughout the life of the company or till the time company
decides to redeem the bonds. Irredeemable bonds are also referred
to as Perpetual Bonds. In real practice irredeemable bonds are a rare
phenomenon.
(3) Secured and Unsecured Bonds
Secured bonds are the bonds for which the issuer company provides
some asset (e.g. land, building etc.) as security or mortgage with
bond trustee. If the company fails to pay interest or repay the prin-
cipal amount, then the asset is sold to recover such amount. In case
of unsecured bonds no such asset is kept as security or mortgage.
Therefore unsecured bonds are riskier than secured bonds. In case
of liquidation, secured bonds get priority payments over unsecured
bonds. In India, some of the private sector companies have issued
unsecured bonds in the decades of 1990s.
(4) Callable and Putable Bonds
The peculiar feature of these bonds is that the bond indenture has
a ‘call option’ (in case of callable bond) or a ‘put option’ (in case of
putable bond). Call option is the right of the issuer company to call
off or redeem bonds after a specified period but before maturity.
Generally the company exercises its right to redeem or ‘call option’ if
the market interest rate declines and becomes less than coupon rate.
In that case it makes sense for the issuer company to redeem early
the high coupon rate bearing bonds and issue a new series of bonds
with lower coupon rate. Since these bonds are callable at the option
of the issuer company, the bondholders are exposed to an additional

source of risk i.e. call risk. Hence other things being equal a callable
bond is available at a lower price in the market than a normal bond.
ICICI Ltd. issued a series of Callable bonds in the year 2003 with a
call option after 3 years.
Puttable bonds, on the other hand, have a “put option”. Put option is
the right of the bondholder to ask for redemption after a specified
period but before maturity. The company is obliged to redeem the
bonds on which put option is exercised by the bondholders. Gen-
erally bondholders exercise their put option, when market interest
rate goes up and becomes significantly higher than the coupon rate.
In such a case it makes sense for the bondholder to get the existing
bond carrying lower coupon rate redeemed and instead buy a new
series of bonds having higher coupon rate. Since these bonds are
redeemable at the option of the bondholder, the bondholder has a
privileged position. Hence other things being equal a puttable bond
is available at a higher price in the market than a normal bond.
(5) Zero Coupon Bonds (or Zero Interest Fully Convertible Debentures-
ZIFCD)
As the name suggests, a zero coupon bonds does not carry any
coupon rate and hence no interest is paid/received on such bonds.
These bonds are issued at discount and redeemed at par. Therefore
the benefit to the bondholder is difference between the redemption
price and issue price. For example a Zero Coupon bond having face
value of Rs. 100 is issued at a price of Rs. 95. The redemption is due
after 5 years at face value. Hence the bondholder will pay Rs. 95
now to buy this bond but will not get any interest (or coupons) for
five years. At the end of fifth year the bondholder will receive Rs.
100. The net gain to the bondholder will be the difference between
the redemption value Rs. 100 and issue price i.e. Rs. 95. The holding
period return will be 5.26% i.e. (100-95)/95. The effective annualized
1
return will be 1.03% p.a. {(1+ 0.0526) 5 –1}
Zero Interest Fully Convertible Debentures (ZIFCD) are those zero
coupon debentures which are compulsorily fully convertible into
equity shares at the expiry of a specified period (not exceeding three
years) from the date of issue as per SEBI guidelines. These deben-
tures are also issued at discount and for the intervening period the
debenture holder does not receive any interest income. At maturity
these debentures are convertible into equity shares and hence the
net gain or loss to the debenture holder depends upon the market
141 Types of bonds Para 4.2
price of the share at the time of conversion/maturity. For example

a ZIFCD of a company having face value of Rs. 100 is issued at a
price of Rs. 95. After 3 years this debentures is compulsorily con-
verted into 10 equity shares of face value of Rs. 10 each. Hence the
debenture holder will pay Rs. 95 now to buy this bond but will not
get any interest (or coupons) for three years. At the end of third year
the debenture holder will receive ten equity shares of the company
and will become a shareholder enjoying all rights as to dividends
and voting. The net gain (or loss) to the debenture holder will be the
difference between the market value of share and issue price i.e. Rs.
95. Suppose the market price happens to be Rs. 120 per share, then
the holding period return on this ZIFCD will be 26.31% i.e. (120-95)/95.
The effective annualized return will be 8.09% p.a.(1+0.2631)1/3 – 1}.
On the other hand if the market of the share happens to be less than
Rs. 95 then the debenture holder may suffer a loss.
(6) Deep Discount Bonds (DDBs) :
A DDB is a non convertible zero coupon bond issued at a heavy dis-
count and redeemable at par after a specified period. The return on
a DDB is calculated as the difference between the redemption price
(or face value) and the discounted issue price. Normally the maturity
period of a DDB is longer than that of a zero coupon bond say 20 or
more years. In Jan 1994, Sardar Sarovar Narmada Nigam Limited
(SSNNL) issued secured DDB having face value of Rs. 110000 at a
price of Rs. 3600 maturing after 20 years at face value. Although the
investors had an option to get redemption at the end of 7th, 11th and
15th years at a price of Rs. 12500, 25000 and Rs. 50000 respectively.
If the bondholder holds this bond up to 20 years the holding period
return will be 296% i.e. (110000-3600)/3600 which means that the
annualized return will be 18.64% { i.e. (1+29.6)½ -1}.
The return of a zero coupon bond or DDB can also be calculated
using the following formula:
B = RV/ (1+k)n………………………………………………………..(4.1)
Where B = issue price of the bond (or present value)
RV= Redemption value (or future value)
n = Years to maturity
k = annualized return to be calculated.
For example
In the case of DDB issued by SSNNL above we have
3600 = 110000/(1+k)5
(1+k)5 = 110000/3600
K = (30.6)1/5 – 1
K = 18.64%
(7) Tax Free Bonds
Another popular type of bonds especially issued by infrastructure
companies in India, is tax free bonds. Interest income on tax free
bonds is exempt from income tax and hence such bonds become a
lucrative investment option for investors in higher tax bracket. Tax
free bonds are generally available for a maturity period of 10 years,
15 years and 20 years. Companies which have recently issued tax
free bonds in India include – Rural Electrification Corporation (REC),
Power Finance Corporation (PFC) etc. In September 2015, NTPC
issued Tax free bonds for a term of 10, 15 and 20 years.
(8) Junk Bonds
Junk bonds are the bonds which have high default risk. Due to high
risk these bonds have high coupon rate and trade at higher yields.
Junk bonds are the bonds of the companies having very low credit
rating and hence should be avoided by an investor. Due to high risk
and high yield these bonds are generally subscribed by speculators.
(9) Treasury Bonds and Corporate Bonds
Bonds issued by central government of a country are often referred
to as sovereign bonds or treasury bonds. Treasury bonds do not have
any call or put option. Most of the Treasury bonds are in the form of
Zero coupon bonds i.e. they do not have any explicit coupon rate. On
the other hand, bonds issued by a company are termed as corporate
bonds. They generally have a call option or put option.
(10) Municipal Bonds
Bonds issued by state and local government are termed as municipal
bonds. These bonds are not very popular in India due to high risk.
Further, not many local governments issue these bonds in India.
(11) Floating Rate Bonds
This is a new innovation in bond market. Floating rate bonds do not
have a fixed coupon rate. In this case coupon rate is linked to another
base interest rate such as Repo rate or MIBOR (Mumbai Inter Bank
Offer Rate). A change in Repo rate (or MIBOR) will cause a change in
coupon rate hence interest income from this bond will be fluctuating
rather than fixed and constant. For example if a company issues a
143 Bond Valuation Para 4.3
floating rate bond carrying a coupon rate as Repo rate + 3%, at a

time when Repo rate is 7.5%, then the initial coupon rate will be 10.5%.
However if Repo rate is increased to 8% in the next monetary policy
announcement by RBI then the coupon rate will become 11% and
the bondholder will gain. On the other hand if Repo rate is reduced
to 7% then the bondholder will get a lower coupon rate of 10% . Thus
a floating rate bond may not be advisable in times when the interest
rates are expected to decline in near future.
(12) Inverse Floaters Bonds:
Inverse floaters bonds are those floating rate bonds, the coupon rate
of which move in the opposite direction of the linked base rate. For
example in the above case if the coupon rate is linked to Repo rate as
Repo rate +3% - . If at present the Repo rate is 7.5% then the present
coupon rate will be 10.5%. If repo rate increases to 8% then coupon
rate will become 10% (i.e. decline by 0.5%) and if repo rate declines
to 7% then coupon rate will be 11% (i.e. up by 0.5%).
These bonds are good in times when the investor expects a decline
in base rate.
(13) International Bonds
There are two categories of international bonds- Foreign bonds and
Euro bonds. Foreign bonds are issued by a borrower from a country
other than the one in which bond is sold. These bonds are deno-
minated in the currency of the country in which it is marketed. E.g.
if a German firm sells dollar denominated bonds in US, the bond is
considered a foreign bond. These bonds are given colourful names
based on the countries in which they are marketed. Foreign bonds
in US- Yankeebonds, in Japan- Samurai bonds, in UK- Bulldog bonds
Euro bonds, on the other hand are issued in the currency of one
country but sold in other national markets. E.g. Eurodollar bonds are
dollar denominated bonds sold outside the US, Euro yen bonds are
yen denominated bonds selling outside Japan, Euro sterling bonds
are Pound sterling denominated bonds sold outside UK.
4.3 Bond Valuation (or Valuation of a fixed income

security)
In order to invest in bond market, one should understand how bonds are
valued. Let us first understand the concept of valuation.
How do we determine value of an asset?

The value of an asset shows its real worth and must be determined before
making investment in it. A rational investor should not buy an asset at a
price which is higher than its “true” value or real worth.
The process of valuation results in determination of the real value or
worth of an asset. The real worth of an asset depends upon its capacity to
generate returns or value for the acquirer or holder of that asset. Some of
the valuation concepts which we discuss are- book value, market value,
going concern value, liquidation value. The valuation concept in finance
primarily includes capitalized value or discounted cash flow (DCF) value.
Out of these the most realistic valuation concept in finance is DCF value.
In order to compute value of an asset, we must consider all future expected
benefits which the asset can generate. In case of real assets or physical as-
sets (under capital budgeting decision which you must have studied in the
paper on Financial Management), we compute Net Present Value (NPV)of
an asset or project by considering all future expected cash inflows from it.
Net Present Value = P.V. of Cash Inflows – P.V. of Cash Outflows
P.V. of cash outflows is nothing but the initial cost or purchase price of the
asset and P.V. of cash inflows is the sum total of the present value of all
expected future cash inflows from the asset or project. The present value
calculation requires an appropriate discount rate or minimum required
rate of return.
If NPV is positive, we say the asset or project is good as it adds some value
to the shareholders’ wealth. On the other hand if NPV is negative then the
asset or project should not be bought (or undertaken) as it erodes share-
holders wealth. The main idea is to invest in only those assets which have
positive NPV or for which the present value of cash inflows is higher than
the present value of cash outflows. Present value of cash outflows is the
“Cost” or “Purchase price” of the asset. While present value of the expected
cash inflows is nothing but the “true” or real value of the asset. So long as
the “ true” value exceeds the “cost” or “purchase price”, the asset is profit-
able and hence should be bought. If true value is lower than the purchase
price then the asset should not be purchased. This concept of determina-
tion of “true” value of an asset where we discount all future cash inflows
at an appropriate discount rate to calculate its present value is termed as
Discounted Cash Flow (DCF) Valuation.
Bond Valuation:
Bond is a financial asset. Extending the concept of DCF valuation as ex-
plained above in case of a real or physical asset, we can calculate the “true”
145 Bond valuation Para 4.3
or real worth of a financial asset as the present value of all future expected
cash flows from it. The present value calculation here also requires an
appropriate discount rate or minimum required rate of return.
The “ true” value or “real” worth of a financial asset is termed as its“ Intrinsic
value”.
Therefore, intrinsic value of a bond is the present value of all future ex-
pected cash inflows from it. Unlike equity shares, the expected cash flows
from a bond or debenture or any other fixed income security is not difficult
to determine.
The future expected cash inflows from a bond are in the form of interest
incomes and redemption value at maturity. Hence there are two parts
of the intrinsic value of a bond. First, the present value of all interest in-
comes throughout the life of the bond and second, the present value of
the redemption value at maturity. Since the amount of interest remains
same and is received periodically, the first part of the valuation formula
takes the form of an annuity. The second part is a lump sum amount to
be received at maturity.
Intrinsic value of a bond = P.V. of Interests + P.V. of Redemption value
The interest on a bond may be paid annually, semi annually or at any
other frequent intervals. Hence the valuation of a bond is discussed under
following cases.
Case 1 : Annual Interest

In case of annual interest payments, the intrinsic value of a bond is-
N
It RV
P0 = ∑
+ …………………………………..(4.2)
(1 + K ) (1 + K )
t N
t =1
d d
where P0 = Intrinsic value of the bond at present

It = Interest from bond in year t
N = Maturity period of bond in years
RV = Redemption value of bond
Kd = Appropriate discount rate (or minimum required rate of return
or prevailing market interest rate or required yield)
It must be noted that since interest incomes and redemption value occur in
different time periods, these need to be converted into their present value
before they can be added together. In order to calculate present value of a
future amount we need some appropriate discount rate. This appropriate
discount rate is the minimum required rate of return as desired by the
bondholder. Prevailing market interest rate is often taken as the discount

rate for present value calculations if minimum required rate of return is
not available or cannot be determined.
Since annual interest payments are in the form of an annuity, the formula
for bond valuation can also be expressed in the following form :
P0= I × PVFAK + RV × PVFKd N ……………………………(4.2A)

dN
where P0 = Intrinsic value of the bond

I = Annual interest amount
PVFAK N = Present value factor annuity at Kd discount rate
d
for N years
RV = Redemption value

PVF = Present value factor at Kd discount rate for N years.
Kd N
The values of PVFAK N i.e. Present value annuity factor and

d
PVFK N i.e. Present value factor can be found in the Tables given in
d
Appendix 1.
Investment Decision
The intrinsic value or true value of a bond is then compared with its actual
market price to decide whether to invest in a bond or not. The rule is -
Buy a bond if Intrinsic value > Current Market Price
Do Not Buy or Sell a bond, if Intrinsic value < Current Market Price
Indifferent, if Intrinsic value = Current Market Price
It must be noted that intrinsic value of a bond is “What the price should
be”. The actual market price of the bond may be different from this. If
market price is less than the intrinsic value then the bond is “underpriced”
and therefore is a good “buy”. Hence in such a case investor should invest
in the bond. This is because the actual price of the bond is less than its true
worth or intrinsic value. On the other hand if market price is higher than
the intrinsic value, then the bond is “overpriced” (or overvalued) and hence
a good “sell”. Therefore in this case bondholder should not buy the bond.
If the investor already holds a bond which has actual price higher than its
intrinsic value then he should immediately sell it. Further if intrinsic value
and market price are same then the bond is said to be “fairly priced” in the
market and hence an investor has an indifferent attitude. He may decide
to buy or sell at the prevailing price. If he decides to buy he will get a fair
return.
Case 2 : Semi-Annual Interest

Most of the bonds pay interest every six months. Therefore in a year there
are two compoundings rather than just one as in case of annual com-
pounding. In such a case the intrinsic value of the bond can be calculated
as given below-
2N
It / 2 RV

P0 = ∑ Kd 
2N
+
Kd 
2N
………………………………..(4.3)
t =1  
1 + 2  1 + 2 
OR
I   
P0 =  PVFAK  + RV  PVF K  …………………………..(4.3A)
2 2
d
, 2N   2
d
2N 
Case 3 : Quarterly Interest (or Quarterly compounding)

When interest is payable on quarterly basis (i.e. there is quarterly com-
pounding), we need to divide annual interest rate by 4 and multiply the
number of years by 4 to compute intrinsic value of a bond.
I
P0 = × PVFAKd + R.V. × PVFKd ………………………..(4.3 B)
4 4
,4N
4
4N
Case 4: Similarly in case of m times compoundings

I
P0 = × PVFAKd + R.V.PVFkd ……………………………(4.3C)
m m
,mN
m
,mN
Case 5: In case of perpetual bond

If the bond is perpetual, then there is no maturity period of the bond and
hence no redemption value. In such a case the interest incomes will be in
the form of a perpetuity i.e. the same amount will be received every year
for an infinite period of time. Hence the value of a perpetual bond will be
the capitalized value of its annual interests.
Annual Interest
Value of a Perpetual Bond = …………………….(4.3D)
Kd
Factors affecting value (or price) of a bond

From the above discussion we can conclude that there are various factors
affecting the intrinsic value as well as price of a bond.
1. Coupon rate - Coupon rate has a positive relationship with bond value.
The higher the coupon rate, the greater will be the value of the bond
other things being equal.
2. Redemption value - Redemption Value also has a positive relationship

with bond value. The higher the redemption value, the greater will be
the value of the bond other things being equal.
3. Required rate of return or market interest rate - Required rate of
return or market interest rate was a negative relationship with bond
value or price. The higher the required rate or market interest rate,
the lower will be the value of the bond other things being equal.
4. Years to maturity - Years to maturity has a positive relationship with
bond value or price. The longer the maturity the higher will be the
value of the bond other things being equal.
5. Frequency of interest payments - It has a negative relationship with
bond value or price. The higher the frequency of interest payments,
the more will be the number of compounding and hence the lower
shall be the intrinsic value of the bond other things being equal.
Various factors affecting bond’s value are summarised in Table 4.1.
Table 4.1
Factors affecting Bond Value
S. No. Factor Relationship with Bond Value or

Price
1 Coupon Rate Positive
2 Redemption Value Positive
3 Required rate of return Negative
4 Years to maturity Positive
5 Frequency of interest payment Negative
Illustration 4.1. A Rs.1000 par value bond carries coupon rate of 6% per
annum and is redeemable after 3 years at par. The required rate of return
is 12%, what is the value of the bond if :
(i) interest is payable annually
(ii) interest is payable semi-annually
(iii) interest is payable on quarterly basis
Should a prospective investor buy this bond if the market price is Rs. 855?
Solution : We are given that coupon rate is 6%. Therefore annual interest
on this bond is Rs. 60 (i.e. 6% of Rs.1000). Further N = 3 years, Kd = 12%
and RV = Rs.1000.
(i) When the interest is payable annually the valuation formula is
N
It RV
P0 =
∑ +
(1 + K ) (1 + K )
t N
t =1
d d
where P0 = Intrinsic value of the bond at present

It = Interest from bond in year t

N = Maturity period of bond in years
RV = Redemption value of bond
Kd = Appropriate discount rate (or minimum required rate of return
or prevailing market interest rate)
This can be written as –
P0 = I × PVFAK N + RV × PVFK
d dN
where P0 = Intrinsic value of the bond

PVFAK N = Present value factor annuity at Kd discount rate for N
d
years
PVFK
= Present value factor at Kd discount rate for N years.
dN
The values of PVFAK N i.e. Present value annuity factor and PVFK N i.e.
d d
Present value factor can be found in the Tables given in Appendix 1.

(i) When interest is payable annually
P0 = 60 × PVFA12% 3 years + 1000 × PVF12% 3 years
= 60 × 2.402 + 1000 × 0.712
= 144.12 + 712
= Rs. 856.12
If the market price of the bond is Rs. 855, then the investor should
buy it because intrinsic value is higher i.e. Rs. 856.12.
(ii) When the interest is payable semi-annually :
60
P = × PVFA6%6 + 1000 × PVF6%6
0
2
= 30 × 4.917 + 1000 × 0.705
= 147.51 + 705
= Rs. 852.51
If the market price of this bond is Rs. 855, then the investor should
not buy it because intrinsic value is lower i.e. Rs. 852.51.
(iii) When the interest is payable quarterly :
60
P
0
= × PVFA3%12 + 1000 × PVF3%12
4
= 15 × 9.954 + 1000 × 0.701
= 149.31 + 701
= Rs. 850.31
If the market price of this bond is Rs. 855, then the investor should not
buy it because intrinsic value is lower in case of semi annual and quarterly
compounding.
Hence the bond should be bought only in the case when it provides annual
interest payments.
It must be noted that in case of semi-annual compounding the value of the
bond is lower than that in case of annual compounding because the frequency
of interest payments is higher. Similarly in case of quarterly compounding
the value of the bond is lower than that in case of annual and semi annual
compounding. Thus the more frequently the interests are paid, the better it
is for the bondholder and hence the lower will be the true value of the bond.
4.4 Interactions between Bond Value, interest rate

(required rate of return) and time to maturity
(1) Relationship between Bond Value (or Price) and Interest Rate (or
required rate of return) : In the valuation formula, the value of a
bond is calculated as the discounted value or present value of all
future expected cash flows from the bond in the form of interests
andFig : 4.1 Bond Value and Interest Rate
redemption value. The present value is calculated at the required
rate of return (or market interest rate). The higher the required rate
of return (or market interest rate) the lower will be the value of the
bond. Hence, there is an inverse relationship between bond price and
market interest rate (or required rate of return). If market interest
rate rises, the required rate of return will also increase and therefore,
bond prices fall and bondholders suffer a capital loss. If interest rate
declines bond prices increase and hence bondholders gain. Interest
rate fluctuations represent the main source of risk in fixed income
securities. The inverse relationship between bond value and market
interest rate is shown in Fig 4.1
Bond
Value
Interest Rate
Fig 4.1 : Bond value and interest rate

151 Interactions between bond value, interest rate Para 4.4
(2) Interaction between Coupon rate, Required rate of return and bond
value: It must be noted that if required rate of return is same as the
coupon rate then the bond’s value will be equal to its face value. If
required rate of return (or market interest rate) is higher than the
coupon rate then the value of the bond will be lower than its face
value. Such a bond is termed as discount bond. On the other hand if
required rate of return is lower than the coupon rate then the value
of the bond will be higher than its face value. Such a bond is termed
as premium bond.
Illustration 4.2: In illustration 4.1, in case of annual compounding what will
be the value of the bond if (i) required rate of return (market interest rate
rises) to 14%. (ii) required rate of return(market interest rate) declines to 10%.
Solution :
(i) When required rate of return or market interest rate rises to 14%
then Kd = 14%. Therefore
P0 = 60 × PVFA14%3 + 1000 × PVF14%3
= 60 × 2.322 + 1000 × 0.675
= 139.32 + 675
= 814.32
Thus bond value declines from Rs. 856.12 (as calculated in Illustration
4.1) to Rs. 814.32
(ii) When required rate of return (market interest rate) declines to 10%
then Kd = 10%. Therefore
P0 = 60 × PVFA10%3 + 1000 × PVF10%3
= 60 × 2.487 + 1000 × 0.751
= Rs. 900.22
Thus bond value increases from Rs. 856.12 to Rs. 900.22, when market
interest rate declines from 12% to 10%.
Illustration 4.3: A bond of Rs. 1000 face value carrying a coupon rate of
14% is redeemable at par after 10 years. Interest is payable annually. Find
out the intrinsic value of the bond if required rate of return is (i) 12% (ii)
14% (iii) 16%.
Solution : Here I = 14% of 1000 i.e. Rs. 140, N= 10 years
(i) when required rate of return is 12%
Po = 140 × PVFA12%10 + 1000 × PVF12%10
= 140 × 5.65 + 1000 × 0.322
= Rs. 1113
You can see that the intrinsic value of the bond is higher than its face
value of Rs. 1000 because required rate of return is lower than the
coupon rate.
(ii) when required rate of return is 14%
Po = 140 × PVFA14%10 + 1000 × PVF14%10
= 140 × 5.216 + 1000 × 0.27
= Rs. 1000
You can see that the intrinsic value of the bond is same its face value
of Rs. 1000 because required rate of return is equal to the coupon
rate.
(iii) when required rate of return is 16%
Po = 140 × PVFA16%10 + 1000 × PVF16%10
= 140 × 4.833 + 1000 × 0.227
= Rs. 903.62
You can see that the intrinsic value of the bond is lower than its face
value of Rs. 1000 because required rate of return is higher than the
coupon rate.
Illustration 4.4 : A bond having face value of Rs. 1000 carrying a coupon
rate of 14% is redeemable after 10 years. Interest is payable annually. Find
out the intrinsic value of the bond if required rate of return is 16% and the
bond is redeemable at (i) Rs. 950 (ii) Rs. 1050.
Solution : Here I = 14% of 1000 i.e. Rs. 140, N= 10 years and required rate
of return Kd = 16%
(i) when redemption value is Rs. 950
Po = 140 × PVFA16%10 + 950 × PVF16%10
= 140 × 4.833 + 950 × 0.227
= Rs. 892.27
(ii) when redemption value is Rs. 1050
Po = 140 × PVFA16%10 + 1050 × PVF16%10
= 140 × 4.833 + 1050 × 0.227
= Rs. 914.97
Illustration 4.5 : A bond having face value of Rs. 1000 carrying a coupon
rate of 14% is redeemable at par at maturity. Interest is payable annually.
Find out the intrinsic value of the bond if required rate of return is 16%
and the bond is redeemable after (i) 10 years, (ii) 15 years (iii) the bond has
an original term of 10 years and had been issued 3 years ago.
Solution : Here I = 14% of 1000 i.e. Rs. 140, N= 10 years or 15 years and
required rate of return Kd = 16%
(i) when maturity is after 10 years
Po = 140 × PVFA16%10 + 1000 × PVF16%10
= 140 × 4.833 + 1000 × 0.227
= Rs. 903.62
(ii) when maturity is after 15 years
Po = 140 × PVFA16%15 + 1000 × PVF16%15
= 140 × 5.575 + 1000 × 0.108
= Rs. 888.50
(iii) when the bond has an original term of 10 years and had been issued 3
years ago then the remaining time to maturity will be 7 years. Hence
the intrinsic value of the bond should be calculated taking only 7
years expected cash flows. Thus
Po = 140 × PVFA16%7 + 1000 × PVF16%7
= 140 × 4.039 + 1000 × 0.354
= Rs. 919.46
Illustration 4.6 : A Rs 1000, 15% bond is available at a price of Rs. 900 in the
market. The bond is redeemable at par after 10 years. Interest is payable
annually. Should an investor buy this bond if his required rate of return
is16%?
Solution: Here we are given that Face value = Rs 1000, Coupon rate = 15%,
N = 10 years, R.V. = Rs. 1000 and current market price = Rs. 900.
Thus I = Rs 150 (i.e. 15% of Rs. 1000)
Therefore the intrinsic value (or true value) of the bond is,
Po = 150 × PVFA16%10 + 1000 × PVF16%10
= 150 × 4.833 + 1000 × 0.227
= Rs. 951.95
Now, the intrinsic value of the bond is higher than its market price of
Rs. 900 therefore the investor should BUY this bond. This bond is under-
valued and hence a good buy.
(3) Bond Value (or price) and Time (Convergence of Bond price to
redemption value at maturity)
Bond values/prices change with time and at maturity the market
price of the bond is equal to its redemption value. This is known as
convergence of bond price to its redemption value. It must be noted

that during the life of the bond, a bond can be priced at premium or
at discount. When market price is higher than redemption value the
bond price is trading at premium and vice versa. A rational investor
will not buy a bond at a heavy premium near maturity. Similarly a
rational seller will not sell a bond at heavy discount if its maturity is
quite near. Thus the price of a bond at maturity must be equal to its
redemption value. It is shown in Fig 4.2 when there are 10 years to
maturity, the bond price may be P1 or P2. However as the maturity
approaches, bond price approaches its redemption value and becomes
exactly equal to its redemption price at maturity.
E.g. A bond is redeemable at Rs.100 (its par value) after five years. Its
current price may be lower or higher than Rs. 100 depending upon
Fig 4.2 : Bond Price and Time to Maturity
the required rate of return (or market interest rate) and coupon
rate. But at maturity its price will be equal to Rs. 100 only, no matter
what the current price is. If its current price is Rs.105, it is a premium
bond and its price will decline with the passage of time, other things
being constant. If its current price is Rs. 95, it is a discount bond and
its price will increase with the passage of time, other things being
constant. At the time of maturity the price will be equal to Rs. 100
i.e. its redemption value.
Price
Price
P2
RV RV
P1
10 5 0
Time to maturity (Years)
Time to maturity(Years)
Fig 4.2 : Bond Price and Time to Maturity
Illustration 4.7 : A Rs 1000, 12% bond is redeemable at par after 10 years.

Interest is payable annually. Calculate the intrinsic value of the bond (or
fair price) if there are :
(i) 10 years to maturity (ii) 5 Years to maturity (iii) 2 years to maturity (iv)
1 year to maturity (v) calculate its value at maturity as well.
Assume that the required rate of return is (a) 14% (b) 10%?
Solution: Here we are given that Face value = Rs. 1000, Coupon rate =
12%, N = 10 years, 5 years, 2 years, 1 year and Zero years (i.e. at maturity),
R.V. = Rs. 1000.
Thus Interest = Rs. 120 (i.e. 12% of Rs. 1000). The value (or fair price) of
the bond can be computed under different cases as below-
(a) When required rate of return is 14%
(i) In case of 10 years to maturity:
Po = 120 × PVFA14%10 + 1000 × PVF14%10
= 120 × 5.216 + 1000 × 0.270
= Rs. 903.12
(ii) In case of 5 years to maturity:
Po = 120 × PVFA14% 5 + 1000 × PVF14%5
= 120 × 3.433 + 1000 × 0.519
= Rs. 930.96
(iii) In case of 2 years to maturity:
Po = 120 × PVFA14% 2 + 1000 × PVF14% 2
= 120 × 1.647 + 1000 × 0.769
= Rs. 966.64
(iv) In case of 1 year to maturity:
Po = 120 × PVFA14% 1 + 1000 × PVF14%1
= 120 × 0.877 + 1000 × 0.877
= Rs. 982.24
(v) In case of 0 year to maturity (i.e. at maturity) : In this case there
will be no interest to be received. The bond holder will get only
the redemption value and that too at present. So there will be
no need to calculate present value of the redemption price.
Po = 0 × PVFA14% 0 + 1000 × PVF14%0
= 1000
Thus you can see that as the time lapses, this bond’s price
increases and converges to its redemption value at maturity.
(b) When required rate of return is 10%
(i) In case of 10 years to maturity:
Po = 120 × PVFA10%10 + 1000 × PVF10%10
= 120 × 6.145 + 1000 × 0.386
= Rs. 1123.40
(ii) In case of 5 years to maturity:
Po = 120 × PVFA10% 5 + 1000 × PVF10%5
= 120 × 3.791 + 1000 × 0.621
= Rs. 1075.92
(iii) In case of 2 years to maturity:
Po = 120 × PVFA10% 2 + 1000 × PVF10% 2
= 120 × 1.736 + 1000 × 0.826
= Rs. 1034.32
(iv) In case of 1 year to maturity:
Po = 120 × PVFA10% 1 + 1000 × PVF10%1
= 120 × 0.909 + 1000 × 0.909
= Rs. 1018.08
(v) In case of 0 year to maturity (i.e. at maturity) : In this case there
will be no interest to be received. The bond holder will get only
the redemption value and that too at present. So there will be
no need to calculate present value of the redemption price.
Po = 0 × PVFA10% 0 + 1000 × PVF10%0
= 1000
Thus you can see that as the time lapses, this bond’s price declines and
converges to its redemption value at maturity.
Illustration 4.8 : A Rs. 1000, 12% bond is redeemable at par. Calculate its
value if the required rate of return is 10%, 11%, 12% 13% and 14% in each
of the following cases (i) the bond has 5 years to maturity (ii) the bond has
20 years to maturity (iii) the bond is perpetual.
Solution : The values of the bond under different required rates of return
and time to maturity can be calculated using the valuation formula given
in equations 4.2 and 4.3D.
Required rate 5 years to 20 years to Perpetual
of return maturity maturity bond
10% 1076 1171 1200
11% 1036 1080 1091
12% 1000 1000 1000
13% 965 930 923
14% 931 868 857
Fig 4.3 : Relationship between Bond Value, Required Rate of Return and Time to Maturity
157 Valuation of Convertible debentures Para 4.5
It can be seen that when required rate is equal to coupon rate then irre-
spective of maturity period, the value of the bond is equal to its face value.
When required rate of return is lower than the coupon rate then the longer
maturity bond will have higher variation in its value.
This can be shown graphically as below in Fig 4.3:
Bond Price
5 year bond
20 year bond
Perpetual bond
Required Rate of Return
Fig 4.3 : Relationship between Bond value, Required rate

of return and Time to maturity.
4.5 Valuation of Convertible debentures

Convertible debentures may be compulsorily convertible debentures or
convertible at the option of the debenture holders. Further such debentures
may be partially convertible or fully convertible.
(i) In Case of Compulsorily Convertible Debentures (CCD)
When the debentures are CCD then the debenture holders receive
interest (or coupons) at the specified coupon rate for a specified time
period. After which, the debentures are partially or fully convertible
into equity shares of the issuer company. If debentures are partly
convertible then after conversion, the debenture holder keeps on
receiving interest on the remaining portion till the time of maturity.
At maturity the remaining portion is redeemed at a specified price.
Thus in case of compulsorily convertible debentures (CCD) we have
the following stream of cash inflows –
u Interest received on the face value of debentures
u Expected market value of the portion of face value which is
converted into equity shares. This is calculated as the market
price multiplied by the number of shares.
u Redemption value of the remaining portion, if any.
The CCD can be valued using the following formula-
N
It mPr RV

P0 (CCD) = ∑ + + ………………(4.6)
(1 + K ) (1 + K ) (1 + K )
t r N
t =1
d e d
where P0 = Intrinsic value of the CCD at present

It = Interest from CCD in year t

N = Maturity period of CCD in years
m = number of shares received on conversion after r years
P = Market price of the share at the time of conversion
r = Time to conversion in years
Ke = required rate of return on equity shares
Kd = required rate of return on debentures
RV = Redemption value of CCD at the end of Nth year
It must be noted that in case of partly CCDs, the amount of annual
interest before conversion and after conversion will be different
because a part of the face value will be converted into shares at the
expiry of r years. In case of fully CCDs there will be no redemption
value and r will be same as N.
Illustration 4.9 : A company issues a compulsorily partly convertible 10%
debenture having face value of Rs.100. It is partially convertible (60% of
face value) into three shares of face value Rs.20 each after five years. The
total tenure of the bond is 10 years. The expected share price after 5 years
is Rs. 25. Calculate the value of this partially convertible debenture if re-
quired rate of return on equity is 15% and on debt 12%.
Solution : The information given in the question implies that 60% of the
total face value (Rs. 60 out of Rs. 100) of the debenture will be converted
into equity shares after five years and the remaining 40% (Rs. 40 out of 100)
will still remain as 10% debentures for another five years. In this case the
debenture holder will get interest income of Rs.10 every year for first five
years. After five years the debenture holder will get three equity shares (the
expected market price is Rs. 25 per share) and continue to receive interest
of Rs. 4 every year (i.e. 10% of Rs. 40) for another five years.
Therefore we have Interest 1 (for first 5 years) = Rs. 10 p.a., Interest 2 (for
next 5 years) = Rs. 4 p.a. RV = Rs. 40, m= 3 shares, P = Rs. 25 per share,
ke = 15%, kd= 12%, r = 5, n= 10
Po = 10 (PVFA 12% 5) + 4(PVFA12% 5)(PVF12% 4) + (3×25)(PVF15% 5) +
40(PVF12% 10)
=10 (3.605) + 4(3.605)(0.636) + 75(0.567) + 40(0.322)
= 36.05 + 9.17+42.52+12.88
= Rs. 100.62
159 Valuation of Deep Discount Bonds Para 4.6
Valuation of Optionally Convertible Debentures (OCD):

Optionally convertible debentures provides the debenture holder an option
(or right) to get them converted into equity shares after a specified period.
The debenture holder will opt for conversion only when the value of the
shares received after conversion is higher than the redemption value of
the debentures at that time. Therefore the right of conversion may or may
not be exercised by the debenture holder. If the debenture holder opts for
conversion then the issuer company has an obligation to convert these
debentures in shares as per specified terms and conditions. Since every right
has a price, the option given to the debenture holder in case of OCDs also
has a value which is termed as “option value or price”. Besides the value
of the option, the valuation of OCD will depend upon whether the option
is exercised or not as stated below. Such a value can be calculated only at
the time of conversion (or non conversion):
(i) If option is not exercised i.e. if the debenture holder continues as
such till maturity. In such a case the value of OCD can be calculated
using equation (4.2).
(ii) If option is exercised i.e. debentures are converted into shares then
we can use the same valuation formula as under CCD discussed
above. Thus equation (4.6) can be used here.
4.6 Valuation of Deep Discount Bonds (or zero cou-

pon bonds)
Deep discount bonds have been very popular in the decade of 1990s and
many financial institutions and PSUs such as IDBI, SIDBI, SSNNL etc.
issued DDB maturing after 10, 15, 20 and even 25 years. As explained earlier
a DDB does not carry any coupon rate and hence no interest is involved.
These bonds are issued at heavy discount and redeemed at par at maturity.
The valuation of DDB can be made using the same valuation method as is
applicable for a normal bond as given in equation (4.2) except that in case
of DDB we do not have any interest component and hence there will be
only one cash flow at maturity i.e. the redemption value of DDB.
Hence the valuation of DDB can be done using the redemption price (RV),
time to maturity (n) and the required rate of return (k). If required rate of
return is not specified then market interest rate should be used.
Po (DDB) = RV/ (1+k)n …………………………………………….(4.7)
Illustration 4.10 A Rs. 100000 face value DDB is redeemable at par after
25 years. The required rate of return is 9% p.a. Calculate the intrinsic value
of this DDB. Should an investor buy this bond if it is available at a price of
Rs. 12000 now? What should be the issue price of this bond if the company
wants to give a return of 15% to the bondholders?
Solution : (i) Here RV = Rs. 100000, k = 9% and n = 25 years
100000
Therefore Value of DDB =
(1 + 0.09)25
Value of DDB = 100000 (PVF9% 25)
= 100000(.116)
= 11600
Hence the intrinsic value of this DDB is Rs. 11600. If this bond is available
at a price of Rs. 12000 then the investor should not buy it.
(ii) In this case, RV = 100000, k = 15% and n = 25 years. We need to cal-
culate the issue price or the price at which it should be issued now so as
to provide a return of 15% p.a. to the bond holder. This is nothing but the
intrinsic value of the bond at 15% required rate of return. Hence
100000
Value of DDB (or issue price at k= 15%) =
(1 + 0.15)25
Value of DDB = 100000 (PVF15% 25)
= 100000(0 .030)
= 3000
Thus if the issue price of this bond is Rs. 3000, it will provide a required
return of 15% to the bond holder.
4.7 Bond Yields

So far we have discussed the valuation aspects of a bond. The valuation
of a bond requires an appropriate discount rate or required rate of return.
The most commonly used required rate of return is the prevailing market
interest rate.
However in the market, an investor may not always get his desired return.
A bond may provide an investor with a return which is different from the
market interest rate or the required rate return. Hence we need to calcu-
late the actual return from a bond to make a rational investment decision.
Return from a bond is generally expressed in the form of various types of
bond yields as explained below :
Types of Bond Yields

(i) Current Yield : Current yield on a bond is calculated by dividing
annual interest by the current market price of the bond
161 Bond yields Para 4.7
Annual Interest
Current yield =
Current Market Price
u It must be noted that with changes in current market price,

current yield on bond also changes.
u There is inverse relationship between current yield and current
market price. This establishes an inverse relationship between
bond price and yield. An increase in yield results in a decline
in bond price and vice versa.
u Current yield is different from coupon rate of the bond. If the
bond’s market price is same as its face value then the current
yield will be equal to coupon rate. For a premium bond, i.e.
the bond which has a market price greater than its par value,
current yield is lower than its coupon rate. For a discount bond,
i.e. the bond which has a market price lower than its par value,
current yield is higher than its coupon rate.
u Current yield provides a basic idea about the rate of return from
a bond. However it suffers from a limitation that it completely
ignores future cash flows associated with the bond. Hence
investment decision is generally not based on current yield.
(2) Yield to Maturity (YTM)
Yield to maturity, popularly known as YTM is the internal rate of
return generated by a bond. YTM is the discount rate which equates
the current market price of a bond (or the purchase price or the cost
of bond) with the present value of cash inflows associated with the
bond in the form of interest incomes and redemption price.
It is also termed as internal rate of return (IRR) on a bond which
equates present value of cash inflows and outflows associated with
the bond. Mathematically
N
It RV
P=∑
+ ………………………………..(4.8)
t =1 (1 + YTM )t
(1 + YTM )N
where P = Current market price of bond
It = Interest in year t
N = Maturity period in years
YTM = Yield to maturity
Please note that this formula is same as for the calculation of internal rate
of return (IRR) in case of capital budgeting. In the above formula all other
values except YTM are known.
Since annual interest is in the form of annuity we can use PVFA and PVF
tables to calculate equation (4.8)
P = Int(PVFAYTM, N) + RV (PVFYTM N)………………………(4.8A)
The table values for equation (4.8A) are given in Appendix 1.
In case interest payments are made semi annually then equations (4.8 and
4.8A) may be suitably adjusted. In that case interest will be halved, YTM
will be half and time periods will be doubled.
We can calculate YTM using either the trial and error approach or approx-
imation formula.
Approximation Formula :
The calculation of YTM using trial and error method is complex and time
consuming. As an approximation, the following formula may be used to
calculate YTM on a bond.
I + (RV - P ) / N
YTM =
……………………………………………(4.8B)
RV + P
2
where YTM = Approximate YTM
N = Number of years till maturity
P = Current market price
It can be seen that the approximation formula given in equation (4.8B)
assumes equal weights for redemption value and market price in its
denominator as we have (RV+P)/2 i.e. 0.50 RV + 0.50 P.
Some of the analysts and authors provide different weights to RV and P
and hence the formula may be different. Another popular formula for the
calculation of approximate YTM gives 0.40 weight to redemption value
and 0.60 weight to the current price. The argument is that redemption
value will be received in distant future and hence should be given less
weightage.
I + (RV − P ) / N
YTM = ………………………………………………(4.8C)
0.40RV + 0.60P
The approximation formulae given in equation (4.8B and 4.8C) provide
a rough idea about the actual YTM.
Trial and Error approach for calculation of YTM
Calculation of YTM requires the following steps in trial and error approach.
Step 1. Take approximate value for YTM as calculated by above formula

(4.8B). Please take only integer value i.e. without decimals. YTM and cal-
culate the sum total of present value of interest incomes and redemption
value. This is R.H.S. of the formula and denoted as V1.
Step 2. Now compare the value calculated in step 1 with current market
price i.e. P. If P < V1 then adjust the value of YTM upward say YTM2. So
that P > V2 at new YTM. However if P > V1 then adjust the value of YTM
downward so that P < V2 at new YTM2.
Step 3. Now YTM can be calculated using interpolation as given below :
VHigher − P
YTM = YTM lower +
VHigher − Vlower
(
× YTM Higher − YTM lower )
This is a trial and error approach because for the calculation of accurate
YTM we need two discount rates i.e. YTM1 & YTM2 of which one gives
present value higher than current market price and the other gives present
value lower than the current market price.
Investment Decision Making using YTM : YTM is the rate of return earned
on a bond if the bond is purchased at the current market price and held
till maturity. Therefore while deciding whether to buy or a bond or not, an
investor should compare YTM of the bond with his required or minimum
rate of return. A bond is a good buy if its YTM > Required rate of return.
In that case the bond provides a yield higher than the expected return of
the bond holder. On the other hand if YTM is lower than the required rate
of return then the bond should not be bought.
Buy a bond if YTM > Required rate
Do not buy if YTM < Required rate
Indifferent if YTM = Required rate
Important Points Regarding YTM
From the above discussion and the formulae given for the calculation of
YTM we can infer following important facts about YTM assuming the
redemption value is equal to par value of the bond.
u If market price is equal to par value of the bond then YTM will be
equal to coupon rate.
u If market price is greater than par value of the bond then YTM will
be less than coupon rate.
u If market price is less than par value of the bond then YTM will be
greater than coupon rate.
Illustration 4.11 A company has a Rs.1000 par value bond currently selling
at Rs.900. The coupon rate is 9% p.a. payable annually and maturity period
is 6 years. The bond is redeemable at par. Find YTM of the bond. Should
an investor buy this bond if his required rate of return is 12%?
Solution : We are given that
P = Rs. 900
I = 9% of Rs.1000 = Rs. 90
N = 6 years
RV = Rs.1000
(i) Calculation of Accurate YTM requires the following steps (using trial
and error method) :
Let us assume that YTM1 = 11%
Therefore the present value of all interest incomes and redemption
value will be calculated as given below :
V1 = 90 × PVIFA11%6 + 1000 × PVIF12%6
= 90 × 4.231 + 1000 × 0.535
= 915.79
This value is higher than the current price of Rs.900, therefore we
need to take a higher YTM say 12% as YTM2.
Therefore the present value of all interest incomes and redemption
value will be calculated as given below :
V = 90 × PVIFA12%6 + 1000 × PVIF12%6
1
= 90 × 4.111 + 1000 × .507

= 876.99
This value is lower than the current price of Rs.900, therefore ex-
act YTM will be somewhere between 11% and 12% as calculated
below :
915.79 − 900
YTM = 11% + × (12% − 11% )
915.79 − 876.99
= 11% + 0.406%
= 11.406%
Thus accurate YTM is 11.4%.
90 + (1000 − 9000 ) / 6
(ii) Approximate YTM = 1000 + 900
2
= 11.2%
You may see that the approximate YTM is 11.2% which is not sub-
stantially different from accurate YTM.
(iii) If the required rate of return is 12% then the investor should not buy
this bond as it has a lower YTM (11.4%).
Illustration 4.12 An investor wants to buy a bond currently selling at
Rs. 850. Its face value is Rs.1000 and coupon rate is 7.5% p.a. The bond will
be redeemed at par after 6 years. Advise whether the investor should buy
this bond if his required rate of return is 13%?
Solution : This question can be solved in either of the following two ways :
(1) We can calculate YTM of the bond and compare it with the required
rate of return.
75 + (1000 − 850 ) / 6
Approximate YTM = 1000 + 850
2
= 11%
Since YTM < 13% i.e. required rate of return the investor should not
buy this bond.
(2) Alternatively, we can calculate intrinsic value (or fair price) of the
bond and compare it with the market price. It must be noted that
here appropriate discount rate will be 13% i.e. Kd = 13%
We know that the intrinsic value of a bond is
P0 = I (PVFA13%6 ) + RV (PVF13%6 )
= 75 (3.998) + 1000 (0.480)
= Rs. 779.85
Since intrinsic value of bond is less than Rs. 850 i.e. the market price
of the bond, the bond is overvalued and hence investor should not
invest in this bond.
Limitation of Yield to Maturity (YTM): Reinvestment rate assumption
Although YTM is a popular concept to analyse a bond’s return, it suffers
from a serious limitation. It assumes that all intermediate cash inflows (i.e.
interest incomes) are reinvested at YTM only, which is quite an unrealis-
tic assumption. To overcome this limitation we calculate “Realised YTM”
wherein all intermediate cash inflows are assumed to be reinvested at some
specified rate of interest.
(3) Realised Yield to Maturity
Realised YTM does away with the limitation of YTM regarding re-
investment rate assumption. It assumes that all intermediate cash
flows are reinvested at certain predetermined rate and not at YTM
as in case of YTM. To calculate realised YTM (denoted by YTM*) we

follow 2 steps :
Step 1. Calculate future value of all cash inflows associated with the bond
in the form of interest incomes and redemption price at maturity
at the specified compound rate. This future value is denoted as FV.
Step 2. Now use the following formula to calculate realized YTM or YTM* :
FV
P=

(1 + YTM *)N
where P = Current market price
FV = Future value as calculated in step 1.
N = Number of years to maturity
Alternatively
P = FV (PVIFYTM*N )

If realised YTM > required rate of return, then the bond is a good
buy. Otherwise it should not be bought.
Illustration 4.13 A company has a Rs.1000 par value 8% bond currently
selling at Rs.900 and maturing after 6 years. Interest is payable annually
and bond is redeemable at par. Find realised YTM of the bond if interest
incomes can be reinvested at 8% p.a.
Solution : The following Table shows all expected cash flows from the bond
over its life of 6 years.
Year Cash Inflows CVF8% FV of Cash Inflows
1 80 1.469 117.52
2 80 1.360 108.8
3 80 1.260 100.8
4 80 1.166 93.28
5 80 1.08 86.4
6 80+1000 = 1080 1 1080
Total 1586.8
It must be noted that CVF for first year’s interest is applicable for 5 years
because we are calculating its future value at the end of 6th year. Similarly
6th year’s cash inflows do not need any compounding.
The total future value of Rs. 1586.8 can also be calculated using CVFA
(compound value factor annuity) table given in Appendix 1. In that case
FV = 80 (CVFA8%, 6) + 1000
= 80(7.33) + 1000
= 1586.8
Now P = FV (PVFYTM* N )
(
900 = 1586.8 PVFYTM* 6years )
900
PVFYTM*6 =
1586.8
PVFYTM*6 = 0.567
Now in present value factor table (PVF) we look at the cell value equal to
0.567 against 6 years. The corresponding interest rate will be realised YTM*.
In present value factor table we find that
PVF10%6years = 0.564
Therefore realised YTM is approximately 10%.
Illustration 4.14 The market price of a Rs.1000 par value bond carrying
coupon rate of 15% and maturing after 5 years is Rs.900. The reinvestment
rate is 16%, calculate realised YTM.
Solution: FV of Cash inflows = 150 (CVFA16%5) + 1000
= 150 × 6.877 + 1000
= Rs. 2032
Now 900 = 2032 (PVFYTM* 5)
PVFYTM*5 = 0.44
YTM* = 18%
We can use PVF table given in the Appendix to find out YTM*. Look for
the cell value of 0.44 in year 5 row. The corresponding interest rate would
be YTM*. We see that the value against 5 years and 18% is 0.437 which is
approx 0.44 . Hence Realised YTM will be 18%.
YTM in case of Zero Coupon Bonds (ZCBs) or Deep Discount Bonds (DDBs)
ZCBs and DDBs do not carry any coupon rate. They are issued at discount
and redeemed at par after a specified period. Therefore the yield of a ZCB
can be calculated as :
RV
P= = RV(PVF YTM n ) ……………………………….(4.8D)
(1 + YTM)n
Where P = price of the ZCB bond
YTM = Yield to maturity

n = years to maturity
Illustration 4.15 The market price of a Rs.100000 par value Zero Coupon
bond maturing after 15 years is Rs. 3000. Calculate YTM of the bond.
Solution: Here P= Rs. 3000, RV = Rs. 100000, n = 15 years.
Hence P = 100000 (PVF YTM, 15)
3000 = 100000 (PVF YTM, 15)
PVF YTM, 15 = 0.03
Look at the PVF table in the row of 15 years and find the value 0.03. The
corresponding interest rate is YTM.
YTM = 26% (approx.)
(4) Yield to Call (YTC)
In case of a bond with a provision of a call option we can compute
Yield to Call (YTC). YTC is the yield upto the time when call option
can be exercised by the issuer company. It must be noted that in case
of a callable bond the call price and time when call option can be
exercised is already specified in bond agreement. The calculation of
YTC is similar to that of YTM except that here we have call price in
place of redemption price and time to call in place of time to maturity.
Nc
It C
P = ∑ 1 + YTC + ……………………………….(4.9)
t =1 ( )
t
(1 + YTC )Nc
The calculation of YTC using equation (4.9) requires trial and error
approach as already discussed under YTM.
Approximate YTC can be computed using the following formula:
I + (C − P ) / N c
Approximate YTC = ……………………………(4.10)
C+P
2
where YTC = Yield to Call
I = Annual interest
C = Call price
P = Current Price
Nc = years to call
Illustration 4.16 An investor purchases a Rs.1000 par value bond carrying
coupon rate of 6.5% p.a. at Rs.750. The bond will mature after 5 years from
now at par. If the bond is callable after 3 years at Rs.1100, find approximate
Yield to call.
Solution : Here I = 65 (i.e., 6.5% of Rs. 1000)

P = 750
Call price C = Rs. 1100
Nc = 3 years
Therefore,
65 + (1100 − 750 ) / 3
Approx. YTC = 1100 + 750
2
= 19.64%
(5) Holding Period Return on a bond
The yield calculated as YTM (yield to maturity) of a bond provides return
on a bond if that bond is bought now and held till maturity. However an
investor may not be willing to hold the bond till maturity. His investment
horizon or holding period may be less than the time to maturity. You know
that bond prices are subject to change due to interest rate fluctuations.
Therefore the investor may wish to sell this bond, if the price of the bond
goes up say after a year or so. Since the investor is not holding the bond
till maturity, YTM (which is the return calculated on the assumption that
the bond will be held till maturity) will be of no use to such an investor.
He is interested in knowing the return that he will earn over his holding
period. Hence in such a case, the return on a bond is calculated in terms
of Holding Period Return (HPR). Holding period is the investment horizon
during which the asset or security is held by the investor. It starts when
the asset (or bond) is purchased and ends when it is sold.
Holding Period Return (HPR) is already explained in Chapter 2 (Return and
risk analysis). HPR is the total income earned on an asset including capital
gain or loss expressed as a percentage of the purchase price or cost of the
asset. Therefore HPR of a bond will be calculated as follows-
Total interest income + (Selling price-Purchase Price)

HPR (bond) = × 100
Purchase Pr ice
Important Note
u It must be noted that if holding period is for many years (say 2 years),
then in case of bonds we will receive interest incomes in the end of
first year as well as in the end of 2nd year. Now the total interest in-
come cannot be simply the sum total of these two interests because
they are received in different time periods. In such a case we need to
convert the interests into their future value (at the end of the holding
period) assuming that all intervening interest incomes are reinvested

at some specified rate. Then we can add all interest incomes so as to
calculate HPR. This is explained in Illustration 4.18 below:
u It must be noted that holding period return may also be less than one
year (say in months) or more than a year. HPR is always expressed
in terms of the total return earned over that period and hence HPR
of two bonds having different holding periods are not comparable.
HPR is not a suitable measure to compare the returns across bonds
or financial assets if they have different holding periods. In such a
case we convert HPR into effective annualized return (EAR) using
the formula
Effective Annualised Return= (1+HPR)1/T -1
EAR can be used to compare two or more bonds having different holding
periods.
coupon rate of 10% p.a. at Rs.750 in January 2014. The bond will mature
after 5 years from now at par. The investor keeps the bond for one year and
sells it at price of Rs. 800 after receiving interest of Rs. 100 in December
2014. Calculate his holding period return from the bond.
100 + (800 − 750)
Solution: HPR = × 100 = 20%
750
coupon rate of 10% p.a. at Rs.750 in January 2014. The bond will mature
after 5 years from now at par. The investor keeps the bond for two years
and sells it at price of Rs. 900 after receiving interest of Rs. 100 each in
December 2014 and December 2015. Calculate holding period return from
the bond. What is the effective annualized yield (or return) from the bond?
Assume that the interest income can be reinvested at an interest rate of 9%.
Solution: Here we have HPR = 2 years
Interest received in 1st year can be reinvested at 9% therefore Rs. 100
interest income of first year will become Rs. 109 (i.e. 100(1+0.09)) at the
end of 2nd year.
Interest received at the end of 2nd year = Rs. 100
Hence total interest income = 109 + 100 = 209
Purchase price = 750, Selling price = 900
209 + (900-750)
HPR = × 100 = 47.86%
750
It must be noted that 47.86% is earned over a period of two years.
171 RISKS IN BONDS Para 4.8
The effective annualize return will be

EAR = (1+ 0.4786)1/2-1
= 0.2159 or 21.59% p.a.
4.8 RISKS IN BONDS

It is often said that NO investment in Risk Free. Like investment in other
securities, investment in bonds is also subject to a variety of risks. However,
risks in bonds is less than the risks in equity shares because of the fixed
amount of income in the form of interests and repayment of the princi-
pal value at the time of maturity. Risks in bonds are – interest rate risk,
purchasing power risk, default risk, call risk and liquidity risk. These are
explained below :-
(1) Interest Rate Risk
The primary source of risk in bonds or any other fixed income
securities is interest rate risk i.e. the risk associated with interest rate
changes. A change in interest rate causes a change in bond price in
the opposite direction i.e. there is an inverse relationship between
bond price and interest rate. An increase in interest rate results in a
decline in bond price and vice versa. When interest rate rises (say from
8% to 10%), then the existing bond carrying a fixed coupon rate (say
8%) becomes unattractive because in the market new bonds would
be made available at the higher rate of 10%. Hence bond price falls.
On the other hand, when interest rate declines (say from 8% to 6%)
then the existing bond carrying a fixed coupon rate (say 8%) becomes
attractive as it provides higher interest incomes. Hence bond price
will rise. This would be more clear if we recall the bond valuation
formula as given below:
N
It RV
P =
∑ +
(1 + K ) (1 + K )
t N
t =1
d d
Here kd = required rate of return or market Interest rate

Therefore when market interest rate rises, K becomes higher and
d
P falls. The opposite happens when interest rate increases.

Price Risk and Reinvestment Rate Risk
As interest rates change, bond investors are actually subject to two
sources of offsetting risks, which work in opposite directions, viz -
price risk and reinvestment rate risk. Price risk means changes in
bond prices and reinvestment risk means changes in future incomes
from the reinvested coupons.
When interest rate rises, bond price falls (as shown above) and hence
price risk results in a loss to the bondholder. However at the same
time, the bondholder will get higher income on the reinvested cou-
pons because the interest amounts received in a year will be now
reinvested at a higher rate due to higher interest rate prevailing in
the market. Hence reinvestment risk results in some gain to the
bondholder. This gain may reduce the loss to the bondholder due to
price risk.
On the other hand, when interest rate declines, bond price increases (as
shown above) and hence price risk results in a gain to the bondholder.
However at the same time, the bondholder will get lower income on
the reinvested coupons because the interest amounts received in a
year will be now reinvested at a lower rate due to lower interest rate
prevailing in the market. Hence reinvestment risk results in some loss
to the bondholder. This loss may reduce the gain to the bondholder
due to price risk.
Thus price risk and reinvestment rate risk always work in the opposite
directions.
Important facts about interest rate risk
u The longer the maturity (N) the greater is this risk.
u The greater the coupon rate (It) the smaller in this risk.
Duration is a precise measure of interest rate sensitivity. The concept
of bond duration is explained in detail later in this chapter.
(2) Inflation Risk or Purchasing Power Risk
Inflation erodes the purchasing power of money. Inflation risk arises
due to changes in inflation rate.
The coupon rate on bonds is fixed and does not change with the
changes in market interest rate. A 10% bond having par value of
Rs. 1000 will provide Rs. 100 as interest incomes (or coupons) to the
bondholder, irrespective of the market interest rate. Suppose mar-
ket interest rate increases to 14% even then this bond will provide
an interest income of Rs. 100 every year till maturity. And if market
interest rate falls to 8% even then this bond will provide interest
income of Rs. 100 every year till maturity. Interest rates and hence
coupon rates are expressed in nominal terms. Hence the income of
Rs. 100 is nominal income and will remain same throughout the life
of the bond.
In times of inflation, i.e. sustained increase in general price level, the
purchasing power of money declines. Hence the real income from
173 Malkiel’s Properties regarding Bond Pricing Para 4.9
the bond will not be same as its nominal income. The real income
from a bond carrying fixed interest rate declines. Hence bonds or
fixed income securities are subject to inflation risk. The real interest
rate is calculated as below:
(1 + nominal Rate)
Real rate = −1
(1 + inflation rate)
A good approximation of real rate is nominal rate minus inflation
rate. If nominal interest rate is 11% and expected inflation rate is 5%
then real rate will be approximately 6%.
Impact of inflation rate is similar to that of a change in interest rate.
u The longer the maturity period the greater is the inflation risk.
(3) Default Risk
Default risk refers to the risk accruing from the fact that the borrower
may not pay interest and/or principal on time. It is also known as
‘credit risk’. Credit rating agencies assign ratings to debt instruments
of financial institutions and companies. Other things being equal, in
general,
u Bonds with higher default risk (low grade bonds) trade at a higher
YTM.

Junk Bonds are the bonds which have very high default risk. A con-
servative investor must not invest in junk bonds.
(4) Call Risk
A bond may have a call option, giving its issuer a right to callback/
redeem the bond prior to maturity. It is exercised when interest
rate has fallen. In such a situation, the investor or bondholder may
not find a comparable investment avenue. Hence in case of callable
bonds, call risk becomes an additional source of risk.
(5) Liquidity Risk
Except some of the popular Govt. securities which are traded actively,
most debt instruments do not have very liquid market in India. It is
primarily an Over The Counter (OTC) market. Thus lower liquidity
is another risk attached with bonds because of which bondholder
may not be able to sell his bonds when in need for money.
4.9 Malkiel’s Properties regarding Bond Pricing (Bond

Prices, interest rate (or yields) and Time to maturity)
The following are the important relationships between bond price, yield
and time to maturity.
1. There is an inverse relationship between bond price and yield.

2. An increase in yield causes a proportionately smaller price change
than a decrease in yield of the same magnitude. That is bond price-
yield curve is convex. This is also referred to as bond convexity.
3. Prices of long term bonds are more sensitive to interest rate changes
than prices of short-term bonds.
4. As maturity increases, interest rate risk increases but at a decreasing
rate.
5. Prices of low coupon bonds are more sensitive to interest rate changes
than prices of high coupon bonds.
6. Bond prices are more sensitive to yield changes when the bond is
initially selling at a lower yield.
The first five properties regarding bond price-yield-maturity rela-
tionship are given by Malkiel. Hence these are known as Malkiels
bond-pricing relationship, while property number 6 is given by Homer
and Liebowitz.
4.10 Bond Duration (Frederick Macaulay Duration)

Duration shows the effective maturity period of a bond. Duration of a bond
represents the length of time that elapses before the “average” amount of
P.V. from the bond is received. It must be noted that effective maturity of
a bond may not be same as its maturity period. In case of a zero coupon
bond having maturity after 10 years, all the cash flows occur at the end
of its maturity period i.e. at the end of 10th year. Hence, the effective ma-
turity of a zero coupon bond is equal to its maturity period. But in case of
a normal bond, the bondholder receives interest incomes every year i.e.
in the intervening years and then he receives the redemption value at the
end of the maturity period. The cash flows received in the form of interests
in the intervening years, makes the effective maturity period of a normal
bond less than its actual maturity period.
Duration of a bond is the weighted average maturity of its cash flow stream,
where weights are proportional to the P.V. of cash flows. It can be calculated
with the help of following formula (4.11).
n
D = ∑ w i t i …………………………………………………….(4.11)
i =1
175 Bond duration Para 4.10
where N = Years to maturity

ti = 1, 2, 3, 4, …, N
P.V. of CFi P.V. of CFi
wi = =
∑ P.V. of CF Price of bond i.e. its current price
For calculating P.V. of cash flows, YTM is used as the discount rate. When
we use YTM as the discount rate we get the current market price.
Illustration 4.19 A Rs.100 par value bond having coupon rate 10% p.a. and
5 years to maturity is currently selling at Rs. 86. Its yield to maturity is 14%.
Calculate the duration of the bond.
Solution
Year Cash Flows PVF14% P.V. of Cash Flows Wi Witi
1 10 0.877 8.7 0.10 0.10
2 10 0.769 7.7 0.09 0.18
3 10 0.675 6.7 0.08 0.24
4 10 0.592 5.9 0.07 0.28
5 110 0.519 57 0.66 3.30
86 Total 4.1 years
Hence the bond duration is 4.1 years.
Note that weights are calculated as under :
8.7
W1 = = 0.10
86
7.7
W2 = = 0.09
86
6.7
W3 = = 0.08
86
& so on
Importance of Duration
u It is a simple summary statistic of the effective average maturity of
bond.
u It is a measure of interest rate sensitivity of a portfolio.
u It is an essential tool in bond immunization i.e. immunizing portfolios
from interest rate risk.
Modified Duration
Duration is a precise measure of the effective maturity of a bond. It is
expressed in years (or in periods). However an investor may be interested
in knowing the resultant change in the bond price due to a given change
in yield. For this we calculate modified duration using equation (4.12).
D
D* = modified duration = – ................................. 4.12
1+ y
Where D* = Modified duration, D = Duration, y = yield.
It must be noted that since there is an inverse relationship between bond
price and yield we have added negative sign in modified duration.
If modified duration is -2.3 then it means that 1% change in yield will on an
average change the bond price by 2.3% in the opposite direction.
Bond Duration Theorems
1. The ‘Duration’ of a zero-coupon bond is equal to its maturity.
2. For a given maturity, a bond’s duration is higher when its coupon rate
is lower.
3. For a given coupon rate, a bond’s duration generally increases with
time to maturity. Therefore there is a positive relationship between
time to maturity and bond duration.
4. Other things being equal, the duration of a bond varies inversely with
its YTM.
Illustration 4.20 Consider a Zero coupon bond having
Face Value = Rs.100, Issue Price = Rs.95, Redemption Value = Rs.100,
Years to Maturity = 5 years. Calculate its Duration.
Solution : First we calculate YTM of the bond.
YTM
100
95 =
(1 + YTM )5
or
0+
(100 − 95)
5 = 0.01 = 1%
YTM =
100 + 95
2
Year CF P.V. @ 1% Wi Wi × t
1 0 -- -- --
2 0 -- -- --
177 CREDIT RATING Para 4.11
Year CF P.V. @ 1% Wi Wi × t
3 0 -- -- --
4 0 -- -- --
5 100 95 1.0 5
5 years
Illustration 4.21 Consider the following 2 Bonds:
A B
Years to maturity 5 years 5 years
Coupon rate 10% 15%
Face Value / R.C. 100 100
Current Price 86 85
YTM 14% 20%
Calculate Duration of bond A and bond B.
Solution : Bond A
Year (ti) Cash Flows P.V. @ 14% ∴of the bonds value (Wi) Witi
1 10 8.7 .10 .10
2 10 7.7 .09 .18
3 10 6.7 .08 .24
4 10 5.9 .07 .28
5 110 57.0 .66 3.3
86.0 1.00 D = 4.1 years
Bond B
Yr (ti) CF P.V. @ 20% Wi Witi
1 15 X .833 = 12.5 .15 .15
2 15 X .694 = 10.4 .12 .24
3 15 X .579 = 8.7 .11 .33
4 15 X . 482 = 7.2 .08 .32
5 115 X . 402 = 46.2 .54 2.7
85 D = 3.75 years
4.11 CREDIT RATING
Meaning & Basics

According to Ministry of Finance, Government of India (2009) “A credit
rating is technically an opinion on the relative degree of risk associated

with timely payment of interest and principal on a debt instrument”.
The Financial Times lexicon describes it as “an opinion expressed on an
alphanumeric scale on the relative ability and willingness of a debt issuer
to meet financial commitments.”
In other words, credit ratings refer to an evaluation of the creditworthi-
ness of an institutional debtor in terms of its ability to service the debt and
ascertain the risk of default, by taking into account a massive chunks of
quantitative and qualitative data available in public and non-public domains.
A poor credit rating reflects the rating agency’s opinion about the poor
credit quality of the issue, high risk of default on part of the issuer and
ultimately the low creditworthiness of the borrower and a good rating
reflects just the opposite.
Such evaluation is done by credit rating agencies. The assessment of a gov-
ernment’s ability and willingness to repay its public debt both in principal
and in interests on time is known as a sovereign rating.
Generally, alphabets or a combination of alphabets and numbers is used to
convey a credit rating. Most commonly rated instruments include: Bonds/
Debentures, Commercial paper, structured finance products, bank loans,
fixed deposits and bank certificate of deposits, mutual fund debt schemes
and IPOs.
For better understanding, we would like to stress upon three important
points related to Credit Rating Agencies (CRAs):
1. Ordinarily, it is the instrument and not the company which is rated
by the rating agency. However, the rating does also renders “strength
and credibility” to the issuer company, indirectly.
2. CRAs only comment on the “credit risk” relating to a security. Other
types of risks are not covered.
3. The word “opinion” is frequently emphasised upon while discussing
credit rating agencies to indicate the fact that the statements and
forecasts made by rating agencies with regard to the quality of a
particular issue are mere opinions and may or may not be true.
Role of CRAs
Haan and Antenbrink (2011) opine that CRAs essentially perform two func-
tions: First, they perform the “informational role” by offering an independent
evaluation of the ability of a credit instrument to fulfil its debt obligations,
which reduces information costs, increases the pool of potential borrow-
ers, and promotes market liquidity. Second, they perform the “monitoring
179 Credit rating Para 4.11
function” through which they influence issuers to take corrective actions

to avert downgrades via “watch” procedures.
Present Global Scenario
Presently, Fitch, Standard and Poor’s and Moody’s Investor Services are
the three major credit rating agencies operating globally. As of 2013 their
collective market share was “roughly 95 per cent” with Moody’s and Standard
& Poor’s having approximately 40% each, and Fitch around 15%.
Present Indian Scenario

In India, credit ratings started with the setting up of The Credit Rating
Information Services of India (now CRISIL Limited) in 1987. Presently,
there are six major credit rating agencies operating in India which have
been registered with SEBI. These are: CRISIL Ltd, Fitch Ratings India Pvt
Ltd, ICRA Ltd, Credit Analysis & Research Ltd (CARE), Brickworks Rating
India Private Limited and SME Rating Agency of India Limited (SMERA).
We will talk about each one of these in brief in the upcoming section.
4.11.1 Credit Rating Agencies in India

The concept of credit rating came to India much later (almost 70 years later
than US) in 1987 by setting up of CRISIL. The delay in the development
of credit rating in India could be partly attributed to the state of Indian
corporate bond markets at that time, which were still far from developed,
owing to fixed lending and borrowing rates which were not deregularised
by RBI. Therefore, when credit ratings did indeed begin in India in the late
80s, the idea was considered far ahead of the time. Nevertheless, the bond
markets started evolving with the setting up of SEBI in 1992 and NSE in
the mid-1990 and CRISIL began operating in a full-fledged manner.
(1) CRISIL Limited

Promoted by the likes of premier financial institutions like ICICI, HDFC,
UTI, SBI, LIC and Asian Development Bank in its initial years, CRISIL is
now an S&P company headquartered in Mumbai, India. CRISIL is India’s
leading rating agency and a global analytical company providing ratings,
research, and risk and policy advisory services. On its website, CRISIL has
divided its businesses into four categories, which include: Ratings, Research
& Analytics, Research and CRISIL Risk and Infrastructure Solutions. So
far, CRISIL has rated 47 million INR of Indian debt, holds more than 50%
of total bank loan ratings, and provides coverage across 86 industries.
CRISIL’s current market capitalisation stands at Rs. 12,909.68 crore.
(2) ICRA Limited

Formerly Investment Information and Credit Rating Agency of India Limited,
ICRA is India’s second largest credit rating agency in terms of customer
base. Established shortly after CRISIL in 1991 by a partnership between
some of India’s premier financial institution and world leader Moody’s, ICRA
operates as an Indian independent and professional investment information
and credit rating agency. ICRA has six subsidiaries in the form of ICRA
Indonesia, ICRA Sri Lanka, ICRA Nepal, ICRA Techno Analytics Limited,
ICRA Online Limited and IMaCs. The ICRA group provides a multitude
of services which include: Rating services, Grading services, Industry re-
search, Consulting services, Software Development, Analytics & Business
Intelligence and Engineering Services, Knowledge Process Outsourcing and
Online Software. ICRA presently has a market cap of Rs. 4,132.30 crore.
(3) CARE Limited

Credit Analysis and Research Limited (CARE) is the third oldest credit rating
agency of India. It commenced operations in 1993 and has since emerged
as leading agency for covering many diverse rating segments and rating a
volume of debt approximating to Rs. 70 crores. Like its counterparts, CARE
India provides ratings as well as consulting and research services for its
clients. Recently, CARE India joined hands with rating agencies of four
other nations to launch a global rating agency to provide an alternative to
the big three rating agencies operating globally at the moment.
(4) India Ratings and Research Limited - A Fitch Group Company

India Ratings & Research limited, popularly known as Ind-Ra is wholly owned
subsidiary of Fitch Group, one of the big three credit rating institutions
of the world. Presently, Ind-Ra ratings cover corporate issuers, financial
institutions, which includes banks and insurance companies, finance &
leasing companies and managed funds, Urban Local Bodies and Project
Finance companies.
(5) Brickwork Ratings India Private Limited

Brickwork ratings is a young, Bangalore based rating organisation incor-
porated in 2007. Brickwork states its mission is to “help Banks, Companies
and Investors make informed decisions...” and is actively engaged in rating
loans for small, medium and large companies to achieve this objective.
Brickwork is registered with SEBI, RBI & NSIC and has been successful in
expanding its presence to more than 50 cities within a short span of 8 years,
including the likes of Bengaluru, New Delhi, Mumbai, Chennai, Hyderabad,
Kolkata, Ahmedabad and Guwahati.
(6) SME Rating Agency of India Limited

SME Rating Agency of India Limited or SMERA as it is popularly known
is a one of its kind rating agency, catering specifically to the needs of
micro, small and medium enterprises. Founded in 2005 by Small Industries
Development Bank of India (SIDBI), Dun & Bradstreet Information Services
India Private Limited (D&B) and several leading Govt., Public, Private and
MNC banks in the country, SMERA has so far completed over 34,000 ratings
across sectors and geographies on a PAN – India basis.
4.11.2 Credit Rating Methodology

Although different credit rating agencies follow different methodologies
to evaluate the creditworthiness an associated with a particular security
and issuer, a general criteria for assessment includes evaluation on the
following parameters:
1. Business Risk
a. Economy risk
b. Industry risk
c. Issuer’s competitive position
d. New project risk
2. Financial Risk
a. Operating profitability
b. Gearing
c. Debt service coverage ration
d. Working capital intensity
e. Cash flow analysis
f. Foreign currency related risks
g. Tenure mismatches, and risks related interest rates and
refinancing
h. Accounting quality
i. Contingent liability/off balance sheet exposures
j. Financial flexibility
k. Financial ratios
3. Strength of promoters or management quality
a. Track record
b. Strategy
c. Organisation structure
d. Corporate governance
e. Control systems
f. Personnel policies
4.11.3 Advantages of Credit Rating Agencies

We have already discussed the role of CRAs in today’s globalized economy.
The major advantages of CRAs can be enunciated as follows:
1. Important informational tool for investors
CRAs perform the highly crucial task of collecting, assimilating and
presenting information in a form which can be easily understood by
investors to take important investment related decisions.
2. Important tool for Issuers to access investors
a. Getting a credit rating done from one of the credible CRAs
can enable investors to reach a wider investor base than they
otherwise could. In most countries, it is compulsory to get a
bond instrument credit rated before it can be floated in the
market. In India, RBI and SEBI have made it compulsory to
get certain debt instruments rated before their issue.
b. Further, CRAs also serve as an important guide for appropriate
pricing of debt issues. In financial markets, the price of debt is
determined primarily by the rating of the debt issue.
3. Add to Market efficiency
Credit ratings have the power to increase the efficiency of the market
by reducing information asymmetry and lowering costs for both bor-
rowers and lenders. CRAs can play a useful role in helping investors
and others sift through this information, and analyse the credit risks
they face when lending to a particular borrower or when purchasing
an issuer’s debt and debt like securities.
4. Means of checks & balances
The threat of downgrade acts as an important means to force issu-
ers into meeting their debt obligations in time and delivering on the
interest-related promises made. A downgrade in credit rating can
deter a firm’s debt raising capacity in the long term. This system of
checks and balances boosts investor confidence and restores investor
faith in the markets.
5. Utility of Sovereign ratings

In the light of increasing volatility in the global markets, sovereign
credit ratings give important indications about the financial health
of a nation.
4.11.4 Limitations of Credit Rating Agencies

CRAs have been criticise time to time because of their methodology, impact
and timing. The most prominent limitations of CRAs are as follows:
1. Respond with Time Lag
CRAs have been criticised several times for responding to changing
economic conditions with a considerable time lag. They fail to down-
grade or upgrade ratings promptly, leading to serious repercussions
for investors. The Lehman brother example is often quotes in this
context. For instance, the day before Lehman went bankrupt the
major CRAs gave the bank still investment grade ratings. To be sure,
at that time this issue had been long recognised. Similar cases of
time lag have been reported in several financial scandals including
ENRON and WorldCom.
2. Conflict of Interest
CRAs operate on a client-pays principle and their clients are usually
the issuers of bond securities. Since CRAs are essentially paid by
the issuers of financial products, they have a very strong incentive
to overstate the creditworthiness of a particular product in order
to build a good relationship with the issuer and increase their cash
flows thereby.
3. Severe impact of opinions
Criticism against CRAs has also been raised with respect to the
impact of the opinions which they express via ratings. Severe forms
of market volatility has been reported on account of reports released
by the credit rating agencies. Paying too much importance to CRA
activities can deter investor confidence in markets and financial
systems.
4. Lack of accuracy & predictive capabilities
The opinions expressed by CRAs lack foresight and predictive capa-
bilities. They have been highly condemned for their role in fuelling
the US sub-prime crisis and failure in predicting the Asian crisis. More
recently, in the context of the euro area crisis, the President of the
European Commission opined, “Ratings appear to be too cyclical, too
reliant on the general market mood rather than on fundamentals -
Fixed income securities - Valuation Yields & Risks 184
regardless of whether market mood is too optimistic or too pessimistic.”

This is further reflected in a related IMF statistic which revealed that
more than 3/4th of all private residential mortgage backed securities
which were issued in the United States from 2005-2007 that were
rated AAA by S&P are now rated below BBB.
5. Lack of proper disclosures
Credit rating agencies are often criticised because of their lack of
transparency, ambiguous methodologies and unclear assumptions.
For instance, S&P’s decision to downgrade US debt from AAA to
AA+ was severely condemned by many prominent economists on the
grounds that “math behind the downgrade made little sense” (Paul
Krugman).
Solved Problems
Problem 4.1 A Rs. 1000 bond carrying coupon rate of 12% matures in 20
years. The required rate of return is 14%. Calculate the value of the bond.
Solution : We have face value = Rs. 1000, Coupon rate = 12%, hence interest
= Rs. 120 p.a. N = 20 years and Kd = 14% (i.e. the required rate of return)
Assuming interest is payable annually.
The value of the bond is
Po = 120 (PVFA14% 20) + 1000 (PVF14% 20)
= 120(6.623) + 1000(0.073)
= 867.76
Hence the value of the bond is Rs. 867.76.
Problem 4.2 A Rs. 1000 bond carrying coupon rate of 12% matures in 20
years and currently sells at 85% . Is this bond a desirable investment for an
investor having required rate of return is 15% ?
= Rs. 120 p.a. N = 20 years and Kd = 15% (i.e. the required rate of return).
Current price = Rs. 850 (i.e. 85% of 1000)
The intrinsic value of the bond is
Po = 120 (PVFA 15% 20) + 1000 (PVF 15% 20)
= 120(6.259) + 1000(0.061)
= 812.08
185 Solved problems
Hence the intrinsic value of the bond is Rs. 812.08. This is lower than the
current price of Rs. 850. Hence this bond is not a desirable investment for
an investor having 15% as required rate of return.
Problem 4.3 A Rs. 1000 bond carrying coupon rate of 12% matures in
20 years and currently sells at a premium of 5% . Is this bond a desirable
investment for an investor having required rate of return is 11% ?
= Rs. 120 p.a. N = 20 years and Kd = 11% (i.e. the required rate of return).
Current price = Rs. 1050 (i.e. 105% of 1000)
The intrinsic value of the bond is
Po = 120 (PVFA11% 20) + 1000 (PVF11% 20)
= 120(7.963) + 1000(0.124)
= 1079.56
Hence the intrinsic value of the bond is Rs. 1079.56. This is higher than the
current price of Rs. 1050. Hence this bond is a desirable investment for an
investor having 11% as required rate of return.
Problem 4.4 Mr. Tiwari purchased a bond for Rs. 900 with a coupon payment
of Rs. 150 p.a. He sold the bond at a price of Rs. 1050 after one year. What
is the holding period return? Calculate HPR if the bond is sold for Rs. 800.
Solution: When selling price is Rs. 1050.
150 + (1050 − 900)
Holding period return = × 100
900
= 33.33%
When selling price is Rs 800
150 + (800 − 900)
Holding period return = × 100
900
= 5.56%
Problem 4.5 Mr. Sachin is being offered a scheme in which he has to
deposit Rs. 18250 now which will give him year-end return of Rs. 5000 each
year for the next 5 years. Should he accept the offer if his required rate of
return is (i) 10%, (ii) 12%.
(B.Com (H) DU 2010)
Solution : This problem can be solved using discounting technique.
(i) When required rate of return is 10%
P.V of all future cash inflows = 5000 PVFA10%, 5
= 5000(3.791)
= 18955
(ii) When required rate of return is 12%

P.V of all future cash inflows = 5000 PVFA12%, 5
= 5000(3.605)
= 18025
Investor should accept the offer only if his require rate of return is 10%.
Problem 4.6 V.K. Arora is considering investing in bond currently selling
at Rs. 8785.07. The bond has 4 years to maturity, Rs. 10000 face value and
8% coupon rate. The next annual interest payment is due one year from
today. The appropriate discount factor for investment of similar risk is 10%.
(i) Calculate the intrinsic value of the bond. Should Mr. Arora purchase
this bond?
(ii) Calculate YTM of the bond. (B.Com (H) DU 2010)
Solution: Here Face value = Rs. 10000, coupon rate = 8%, Maturity = 4 years
Assuming that the bond will be redeemed at par.
Hence Intrinsic value = 800 (PVFA 10% 4) + 10000 (PVF 10% 4)
= 800(3.169) + 10000(0.683)
= 9365.20
Mr. Arora should buy this bond as intrinsic value is higher than the current
price of Rs. 8785.07.
(iii) To calculate YTM we may use approximate YTM formula
800 + (10000 − 8785.07) / 4
Approx. YTM =
(10000 + 8785.07) / 2
= 11.75%
Now let us take discount rate as 12%.
The value of the bond at 12% is given below
Value at 12% = 800 (PVFA 12% 4) + 10000 (PVF 12% 4)
= 800(3.037) + 10000(0.636)
= 8789.60
Since this value is slightly higher than the current price of Rs. 8785.07,
hence the actual YTM of the bond is slightly higher than 12% say 12.10%.
Problem 4.7 : Piku textiles is considering to issue a Rs. 1000 debenture
having maturity after 6 years. The redemption is to be done at par. The
coupon rate is specified as follows:
Year 1-2 : 10%
187 Solved problems
Year 3-4 : 12%

Year 5-6 : 13%
The current market interest rate is 14%.
(i) At what price the debenture should be issued by the company?
(ii) Calculate the issue price of the debenture if the company proposes
to provide a compound yield of 15% p.a. to the investors.
(iii) What would be the effect on compound yield if issue price is higher
or lower than the one calculated in (ii) above?
Solution : (i) The market interest rate = 14%. Therefore issue price should
be the value of the bond at 14% rate of required return
P = 100 (PVF 14% 1) + 100 (PVF 14% 2) + 120 (PVF14% 3) + 120 (PVF 14% 4)
+ 130 (PVF 14% 5) + 1130 (PVF 14% 6)
= 100(.877) + 100(.769) + 120(.675) + 120(.592) + 130(.519) +
1130(.456)
= Rs. 899.39
(ii) The required rate of return is 15% (i.e. the compound yield). Hence the
issue price should be the value of this debenture at the required rate of
return of 15%. The cash inflow in six years will be Rs. 100, 100, 120, 120,
130 and 1130 respectively.
Bond’s value (or Issue Price in this case) = 100 (PVF15% 1) + 100 (PVF 15% 2)
+120 (PVF 15% 3) +120(PVF 15% 4) + 130(PVF 15% 5)+1130(PVF15% 6)
= 100(0.870) + 100(.756) + 120(.658) + 120(.572) + 130(.497) + 1130(.432)
= 87 + 75.6 + 78.96 + 68.64 + 64.61 + 488.16
= 862.97
Hence the company should issue the bond at a price of Rs. 862. 97 so as to
provide a compound yield of 15% p.a. to the investors.
(iii) If the issue price is less than Rs. 862.97 then the compound yield will
be higher than 15% p.a. and if the issue price is higher than Rs. 862.97 then
the compound yield will be lower than 15% p.a.
Problem 4.8 A company issued 12% bond with 3 years maturity. Bond
is redeemable at par at Rs. 1000. What would be the value of the bond
assuming interest is payable (i) annually (ii) semi annually. Required rate
of return of the investor is 14%.
(B.Com(H) 2013)
Solution: We have face value = Rs. 1000, Coupon rate = 12%, hence interest
= Rs. 120 p.a. N = 3 years and Kd = 14%
(i) When interest is payable annually
Po = 120 (PVFA 14% 3) + 1000 (PVF 14% 3)
= 120(2.322) + 1000(0.675)
= 953.64
(ii) When interest is payable semi annually
Po = 60 (PVFA 7% 6) + 1000 (PVF 7% 6)
= 60(4.767) + 1000(0.666)
= 952.02
Problem 4.9 : An investor is considering the purchase of the following bond:
Face value Rs 100
Coupon rate : 11%
Maturity : 3 years
(i) If he wants a yield of 13%, what is the maximum price he should be
ready to pay for?
(ii) If the bond is selling for Rs. 97.60, what would be his yield?
(B.Com (H) DU 2009)
= Rs. 11 p.a. N = 3 years and Kd = 13% (i.e. the required yield)
(i) The maximum price the investor would be willing to pay for would
be:
Po = 11 (PVFA13% 3) + 100 (PVF13% 3)
= 120(2.361) + 100(0.693)
= 95.27
(ii) If market price is Rs. 97.60 we can calculate yield using YTM formula
as given below:
P = I (PVFAYTM N) + RV (PVFYTM N)
To calculate accurate YTM we may first use approximate YTM for-
mula
11 + (100 − 97.60) / 3
Approx. YTM =
(100 + 97.60) / 2
= 11.94%
189 Solved problems

Value at 12% = 11 (PVFA 12% 3) + 100 (PVF 12% 3)
= 11(2.402) + 100(0.712)
= 97.62
Since this value is equal to current price of Rs. 97.60, hence the actual YTM
of the bond is 12%.
We can also calculate current yield as below
11
current yield = = 11.27%
97.60
Problem 4.10 : Following information is available in respect of a bond: Face
value Rs. 1000, Coupon rate : 8% Time to Maturity : 10 years, Market price
= Rs. 1140, Callable in 6 years at Rs. 1100.
Find out YTM and YTC of the bond. (B.Com (H) DU 2007)
Solution : To calculate accurate YTM we may first use approximate YTM
formula
80 + (1000 − 1140) /10
Approx. YTM =
(1000 + 1140) / 2
= 6.16 %
Value at 6% = 80 (PVFA 6% 10) + 1000 (PVF 6% 10)
= 80(7.36) + 1000(0.558)
= 1146.80
This value is slightly higher than the current price of Rs. 1140. Hence we
now take a higher discount rate say 7%.
Value at 7% = 80 (PVFA 7% 10) + 1000 (PVF 7% 10)
= 80(7.024) + 1000(0.508)
= 1069.92
Since this value is lower than the current price of Rs. 1140, we now use
interpolation to calculate accurate YTM:
1146.80 − 1140
Accurate YTM = 6% + × (7% − 6%)
1146.80 − 1069.92
= 6.09%
To calculate accurate YTC we may first use approximate YTC formula
80 + (1100 − 1140) /10

Approx. YTC =
(1100 + 1140) / 2
= 6.78 %
Value at 7% = 80 (PVFA 7% 6) + 1100 (PVF 7% 6)
= 80(4.767) + 1100(0.666)
= 1113.96
Since this value is lower than the current price of Rs. 1140, we now take a
lower discount rate say 6%.
Value at 6% = 80 (PVFA 6% 6) + 1100 (PVF 6% 6)
= 80(4.917) + 1100(0.705)
= 1168.86
1168.86 − 1140
Accurate YTC = 6% + × (7% − 6%)
1168.86 − 1113.96
= 6.53%
Hence accurate YTC is 6.53%
Problem 4.11 : The following information is available in respect of a bond:
Face value Rs. 10000, Coupon rate : 8% Time to Maturity : 4 years, Market
price = Rs. 8790, Investor’s Yield = 10%.
Find out YTM and Intrinsic value of the bond. Should an investor buy this
bond based on YTM and intrinsic value? (B.Com (H) DU 2008, 2009)
Solution : Note : Investor yield is nothing but the required rate of return.
To calculate accurate YTM we may first use approximate YTM formula
800 + (10000 − 8790) / 4
Approx. YTM =
(10000 + 8790) / 2
= 11.73 %
Value at 12% = 800 (PVFA 12% 4) + 10000 (PVF 12% 4)
= 800(3.037) + 10000(0.636)
= 8789.60 or approx 8790
191 Solved problems
This value is almost equal to the current price of Rs. 8790. Hence YTM of
the bond is 12%. Since YTM is greater than the investor’s yield of 10%, the
investor should buy this bond.
The intrinsic value of the bond can be calculated taking investor’s yield as
the required rate of return.
Po = 800 (PVFA 10% 4) + 10000 (PVF 10% 4)
= 800(3.170) + 10000(0.683)
= 9366
Since the intrinsic value of the bond is more than its market price, the inves-
tor should buy this bond. The bond is undervalued and hence a good buy.
Problem 4.12 : Leela Ltd. issues a 12%, 3 year bond with face value and
maturity value of Rs. 1000. What is the value of the bond if the required
rate of return is (i) 11% (ii) 12% or (iii) 13%. Why the values are different?
What is the relationship between bond’s value and required rate of return
or interest rate?
= Rs. 120 p.a. N = 3 years and Kd = 11%, 12% or 13%
(i) When required rate is 11%
Po = 120 (PVFA 11% 3) + 1000 (PVF 11% 3)
= 120(2.444) + 1000(0.731)
= 1024.28
(ii) When required rate is 12%
Po = 120 (PVFA 12% 3) + 1000 (PVF 12% 3)
= 120(2.402) + 1000(0.712)
= 1000
(iii) When required rate is 13%
Po = 120 (PVFA 13% 3) + 1000 (PVF 13% 3)
= 120(2.361) + 1000(0.693)
= 976.32
The values are different because of changes in the required rate of return.
There is an inverse relationship between bond’s value and required rate
of return. If required rate of return increases the bond’s value will decline
and vice versa. Further if required rate is equal to coupon rate then the
intrinsic value of the bond will be equal to its face value (assuming that
the bond is redeemable at par).
Problem 4.13 : Alpha Ltd. comes out with a scheme which specifies that
“Deposit Rs. 15000 now and receive Rs. 1000 p.a. at the end of every year
for next 5 years along with Rs. 15000 at the end of 5th year.” Should the
scheme be accepted by an investor if the required rate of return is 12%?
Solution : The present value of all future cash inflows can be calculated as
P.V of Future cash flows = 1000 (PVFA 12% 5) + 15000 (PVF 12% 5)
= 1000(3.605) + 15000(0.567)
= 12,110
Since this is less than the current cash outflow of Rs. 15000, the investor
should not accept this scheme.
Problem 4.14 : Rayon Ltd.’s 9%, bond with face value of Rs. 1000 is currently
available at a price of Rs. 850 and has 10 years to maturity. The redemption
value will be 90% of the face value. Calculate YTM of the bond.
Solution: Redemption value = 90% of 1000= Rs. 900
90 + (900 − 850) /10
Approx. YTM =
(900 + 850) / 2
= 10.85 %
Value at 11% = 90 (PVFA 11% 10) + 900 (PVF 11% 10)
= 90(5.889) + 900(0.352)
= 846.81
This value is lower than the current price of Rs. 850. Hence we now take
a lower discount rate say 10%.
Value at 10% = 90 (PVFA 10% 10) + 900 (PVF 10% 10)
= 90(6.145) + 900(0.386)
= 891.45
Since this value is higher than the current price of Rs. 850, we now use
891.45 − 850
Accurate YTM = 10% + × (11% − 10%)
891.45 − 846.81
= 10.92%
Problem 4.15 : ABC Ltd. is proposing to issue 8% bonds of face value of
Rs. 1000 redeemable in 5 annual instalments of Rs. 200 each every year
193 Solved problems
over 5 years period. If required rate of return is 7%, at what price the bonds
be offered to investors?
(B.Com (H) 2012)
Solution : In this case the redemption of the bond happens every year and
hence interest will be calculated on reducing balance of the bond. In the
first year the investor will get Rs. 280 (i.e. 8% of 1000 and Rs. 200), in 2nd
year Rs. 264 (i.e. 8% of 800 and Rs. 200), in 3rd year Rs 248 (i.e. 8% of 600
and Rs. 200), in 4th year Rs. 232 (i.e. 8% of 400 and Rs. 200) and in 5th year
Rs. 216 (i.e. 8% of 200 and Rs. 200).
Therefore the bond price should be = 280 (PVF7% 1) + 264 (PVF 7% 2) +
248(PVF 7% 3) + 232(PVF 7% 4) + 216(PVF 7% 5)
= 280(0.935) + 264 (0.873) + 248(0.816) + 232(0. 763) + 216 (0.713)
= 1025.66
The company should offer the bond at a price of Rs. 1025.66.
Problem 4.16 : An investor purchased a 12% bond at its par value of Rs. 1000
when time to maturity was 5 years. He sold the bond for Rs. 1300 after two
years. Out of the proceeds he immediately purchased a bond carrying cou-
pon rate of 10% which has 3 years to maturity and is redeemable at a price
of Rs. 1000 i.e. its face value. Find out YTM of the investor over the 5 years.
Solution : The investor has invested Rs. 1000 today and received Rs. 120 at
the end of 1st year, Rs. 120 at the end of 2nd year, Rs. 100 each at the end of
3rd year and 4th year and Rs. 1100 at the end of 5th year. The sales proceeds
of Rs. 1300 at the end of 2nd year is reinvested in a new bond and hence
there is no cash flow as such. We assume that 10% bond having face value
of Rs. 1000 is available at a price of Rs. 1300.
Let us assume that YTM over 5 years is 13%.
At 13% the value is = 120 (PVFA13% 2) + 100(PVF 13% 3) +100(PVF 13%
4) + 1100(PVF 13% 5)
= 120(1.668) + 100(.693) + 100(.613) + 1100(.543)
= 928.06
This value is lower than the current price of Rs. 1000. Hence we now take
a lower discount rate say 11%.
Value at 11% = 120 (PVFA11% 2) + 100(PVF 11% 3) +100(PVF 11% 4) +
1100(PVF 11% 5)
= 120(1.713) + 100(.731) + 100(.659) + 1100(.593)
= 996.86
This value is slightly lower than Rs. 1000. Hence YTM will be slightly higher
than 11%.
Problem 4.17 : Ruhi Ltd. had issued Rs. 1000 face value perpetual 15%
debentures 15 years ago at a price of Rs. 1000 each. Interest rates have
changed now and the debentures are now selling at a yield of 20%.
(i) Calculate the current expected market price of the debenture.
(ii) Should an investor buy the debenture at a price of Rs. 780?
(iii) What is the yield?
Solution : (i) Current expected market price of a perpetual
debenture = I/yield
= 150/0.20
= 750
If the debenture is available at Rs. 780 it should not be bought.
Yield at the price of Rs. 780 will be
780 = 150/yield
Yield = 19.23%
Problem 4.18 : Mr. Rawat bought a 12% bond with 10 years maturity,
having face value of Rs. 1000 at its issue price of Rs. 1000 six years ago.
The bond is redeemable at par. Its market price now is Rs. 1100. Should Mr.
Rawat sell this bond? Why? Assume that the required rate of return is 13%.
Solution : The bond has 4 years to maturity now (bought 6 years ago a 10
years bond). To answer the question we need to calculate intrinsic value
of the bond at the require rate of return of 13%.
Intrinsic value of bond now = 120 (PVFA 13% 4) + 1000(PVF 13% 4)
= 120 (2.974) + 1000(0.613)
= 969.88
The market price is Rs. 1100, which is greater than its intrinsic value. Hence
Mr. Rawat should sell this bond. It is overpriced.
Problem 4.19 : Mr. Awasthi bought a 18% bond with 20 years maturity,
having face value of Rs. 10000 at its issue price of Rs. 10050 one year ago.
The bond is redeemable at a premium of 10%. Its market price now is Rs.
10150. Should Mr. Awasthi sell this bond? Why? Assume that the required
rate of return is 15%. If Mr. Awasthi sells this bond at a price of Rs. 10150
what would be his Holding period return?
Solution : Now the bond has 19 years to maturity. Redemption value will
be Rs. 11000.
195 Solved problems
Intrinsic value of the bond = 1800(PVFA 15% 19) + 11000 (PVF 15% 19)
= 1800(6.198) + 11000 (.07)
= 11926.4
Since the intrinsic value is greater than the current market price of
Rs. 10150, Mr. Awasthi should not sell this bond now.
However if he sells it now at a price of Rs. 10150, then the holding period
return will be
1800 + (10150 − 10050)
HPR = × 100
10050
= 18.90%
Problem 4.20 : An investor is considering the purchase of the following bond:
Face value Rs. 5000
Coupon rate : 16%
Maturity : 5 years
(i) If he wants a yield of 17%, what is the maximum price he should be
ready to pay for?
(ii) If the bond is selling for Rs. 4541, what would be his yield if he buys
the bond and hold it till maturity?
Solution: We have face value = Rs. 5000, Coupon rate = 16%, hence interest
= Rs. 800 p.a. N = 5 years and Kd = 17% (i.e. the required yield)
(i) The maximum price the investor would be willing to pay for would
be:
Po = 800 (PVFA17% 5) + 5000 (PVF17% 5)
= 800(3.199) + 5000(0.456)
= 4839.2
The maximum price would be Rs. 4839.20
(ii) If market price is Rs. 4500, we can calculate yield using YTM formula
as given below:
P = I (PVFA YTM N) + RV (PVF YTM N)
To calculate accurate YTM we may first use approximate YTM for-
mula
800 + (5000 − 4541) / 5
Approx. YTM =
(5000 + 4541) / 2
= 18.69%

Value at 19% = 800 (PVFA 19% 5) + 5000 (PVF 19% 5)
= 800(3.058) + 5000(0.419)
= 4541
Since this value is equal to the current price of Rs. 4541, hence the actual
YTM of the bond is 19%.
Problem 4.21: A Rs.1000 par value bond having coupon rate 10% p.a. and 5
years to maturity is currently selling at Rs. 860. Its yield to maturity is 14%.
Calculate the Duration of the bond. Calculate modified duration. What will
be the effect of 1% increase in yield on bond price?
Solution
1 100 0.877 87 0.10 0.10
2 100 0.769 77 0.09 0.18
3 100 0.675 67 0.08 0.24
4 100 0.592 59 0.07 0.28
5 1100 0.519 570 0.66 3.30
860 Total 4.1 years
Modified duration = - D/ (1+y)
= - 4.1/(1+0.14) = -3.59
Hence a 1% increase in yield will result in a decline in bond price by 3.59%.
Problem 4.22 : A Rs.1000 par value bond having coupon rate 11% p.a. and 6
years to maturity is currently selling at YTM of 13%. The bond is redeemable
at a premium of 5%. Calculate the Duration of the bond. Calculate its modi-
fied duration. What will be the effect of 1% decrease in yield on bond price?
Solution : The cash flows from the bond are :
1 110 0.885 97.35 0.10 0.1
2 110 0.783 86.13 0.09 0.18
3 110 0.693 76.23 0.08 0.24
4 110 0.613 67.43 0.07 0.28
197 Solved problems

5 110 0.543 59.73 0.06 0.3
6 1160 (i.e. 110+ 1050) 0.48 556.8 0.59 3.54
943.67 Total 4.64 Years
Modified duration = - D/ (1+y)
= - 4.64/ (1+0.13) = -4.11
Hence a 1% decrease in yield will result in an increase in bond price by 4.11%.
Problem 4.23 : The market price of a Rs.1000 par value bond carrying
coupon rate of 18% and maturing after 5 years is Rs. 950. The reinvestment
rate is 16%. Calculate YTM and realised YTM of the bond. Should this bond
be bought if required rate of return is 18%?
Solution: (i) Calculation of YTM
180 + (1000 − 950) / 5
Approx. YTM =
(1000 + 950) / 2
= 18.97%
Value at 19% = 180 (PVFA 19% 5) + 1000 (PVF 19% 5)
= 180(3.058) + 1000(0.419)
= 969.44
Since this value is greater than the current price of 950, we use a higher
discount rate say 20%.
Value at 19% = 180 (PVFA 20% 5) + 1000 (PVF 20% 5)
= 180(2.991) + 1000(0.402)
= 940.38
969.44 − 950
Accurate YTM = 19% + × (20% − 19%)
969.44 − 940.38
= 19.67%
(ii) Calculation of Realised YTM: If reinvestment rate is 16%.

FV of Cash inflows = 180 (CVFA16%5) + 1000
= 180 × 6.877 + 1000
= Rs. 2237.86
Now 950 = 2237.86 (PVF YTM* 5)
PVF YTM* 5 = 0.42
YTM* = approx 19%
We can use PVF table given in the Appendix to find out YTM*. Look for
the cell value of 0.42 in year 5 row. The corresponding interest rate would
be YTM. We see that the value against 5 years and 19% is 0.419 which is
approx 0.42. Hence Realised YTM will be 19%.
This bond should be bought as realised YTM is greater than 18% i.e., the
required rate of return.
Summary
u Fixed income securities provide a fixed income at regular intervals till maturity
and a redemption value at maturity.
u The most common fixed income securities are bonds and debentures. Deben-
tures are unsecured while bonds are secured by specific assets of the issuer
company. However in India both the terms are used interchangeably.
u Bonds have certain common features such as par value, coupon rate, maturity
period, redemption value etc.
u Bond indenture is the bond contract specifying various terms and conditions
including collateral.
u Bonds can be classified as - secured and unsecured, redeemable and irre-
deemable, convertible and non-convertible, callable and puttable, tax free
bonds, zero coupon bonds, deep discount bonds etc.
u Intrinsic value of a bond is the present value of all future expected cash flows
from it in the form of stream of interests and redemption value.
u A bond should be bought if its intrinsic value is higher than its market price.
u There is an inverse relationship between bond value and interest rate (or
required rate of return).
u Depending upon the interest rate a bond may be priced at discount or at
premium in the market.
u Bond price converges to redemption value at maturity.
u There is an inverse relationship between bond price and yield.
u Current yield is annual interest as a percentage of current market price.
199 Test Yourself
u Yield to maturity is the discount rate that equates the present value of cash
outflow (or purchase price of the bond) with the present value of cash inflows
(i.e. interests and redemption value).
u Yield to call is the yield earned on a bond till the time it is called by the issuer
company.
u Interest rate risk is the main source of risk in bonds and other fixed income
securities.
u Other risks in bonds and other fixed income securities are- inflation risk, call
risk, default risk etc.
u Bond duration is the effective maturity of a bond. Duration is the weighted
average time weights being the proportion of present value of cash flows in
a particular period to total present value of the bond.
u Modified duration represents the % change in bond price due to a unit change
in its yield.
u Duration of a zero coupon bond is equal to its maturity period, while duration
of a normal bond is less than its maturity period.
u A credit rating is technically an opinion on the relative degree of risk associ-
ated with timely payment of interest and principal on a debt instrument.
Test Yourself
True False
i. A bond is an IOU of the borrower.
ii. There is no difference between bond and debenture
iii. If face value of a bond is Rs. 1000, coupon rate is 12%, and its market price
is Rs. 900 then the interest will be Rs. 108 for the investor who buys it at
Rs. 900.
iv. Bond value is sensitive to both the interest rates and required rate of return
of the investor.
v. Bond indenture is an agreement between the issuer company and the inves-
tors.
vi. YTM and HPR of a bond are same.
vii. The duration of a zero-coupon bond is equal to its maturity.
viii. Bond price is inversely related to interest rate.
ix. Duration of a bond can never exceed its maturity.
x. A bond with a callable feature will usually have a higher YTM than a similar
non-callable bond.
xi. The longer the maturity the smaller is the interest rate risk.
xii. In Deep discount bonds, issue price is always less than face value.
xiii. Bond price yield curve is upward sloping.

xiv. Modified duration is the resultant change in bond price due to a unit change
in yield.
xv. Time to maturity and Duration of a bond are same.
xvi. Credit rating is available for equity shares as well.
xvii. A company can have credit rating only from one agency.
[Answer - i. T, ii. F, iii. F, iv. T, v. T, vi. F, vii. T,viii. T, ix. T, x. T, xi. F, xii. T. xiii. F,
xiv. T, xv. F, xvi. F, xvii. F]
Theory Questions
1. What is a fixed income security? Give examples. [Introduction Para 4.1]
2. What are the merits and demerits of having fixed income securities in your
portfolio? [Introduction Para 4.1]
(B.Com(H), DU, 2013)
3. What is a bond? Is it same as a debenture? [Para 4.1]
4. What are common the features of a bond? [Para 4.1]
5. Write short notes on
i. Bond Indenture (B.Com(H), DU, 2007, 2009) [Para 4.1]
ii. Zero Interest Fully Convertible Bonds (B.Com(H), DU, 2009, 2014)
[Para 4.2]
iii. Deep Discount Bonds (B.Com(H), DU, 2007, 2014) [Para 4.2]
6. List out different types of bonds and explain them. [Para 4.2]
7. What is convertible bond? Why do investor prefer convertible bonds over
non-convertible bonds? (B.Com(H), DU, 2008)
8. Differentiate between: [Para 4.7]
a. YTC and YTM [Para 4.7]
b. Current yield and Holding Period Yield (or return) [Para 4.7]
c. Coupon Rate and Required rate of return [Para 4.1]
d. YTM and Required rate of return. [Para 4.7]
e. YTM and Realised YTM [Para 4.7]
f. Convertible and Non-convertible bonds [Para 4.2]
g. Callable and Puttable bonds (B.Com(H), DU, 2011) [Para 4.2]
h. Floating Rate bonds (B.Com(H), DU, 2014) [Para 4.2]
9. Examine the relationship between time to maturity and bond valuation, with
the help of a diagram. [Para 4.4]
(B.Com(H), DU, 2012, 2014)
201 Test yourself
10. Differentiate between YTM and HPR (Holding Period Return) on a bond
[Para 4.7]
11. Cite one major shortcoming for each of the following measures: [Para 4.7]
a. Current yield
b. Yield to Maturity
c. Realised compound yield
12. State various properties of bond value described by Malkiel. [Para 4.9]
(B.Com(H), DU, 2013)
13. Write a short note on callable bonds and junk bonds.
(B.Com(H), DU, 2014) [Para 4.2]
14. Write short notes on any two of the following:
a. Bond indenture
b. Deep discount bonds
c. Floating rate bonds (B.Com(H), DU, 2014) [Paras 4.1 & 4.2]
15. Explain the following:
a. Bond Duration [Para 4.10]
b. Bond price - yield relationship [Para 4.4]
16. What are the differences between duration and modified duration?
[Para 4.4]
17. Market interest rates and debenture prices are inversely related. Comment
(B.Com(H), DU, 2010) [Paras 4.1 & 4.4]
18. Examine the relationship between time to maturity and bond duration with
the help of a diagram. (B.Com(H), DU, 2012, 2014) [Para 4.10]
19. What do you mean by credit rating? How is credit rating relevant for inves-
tors? (B.Com(H), DU, 2009, 2012) [Para 4.11]
20. Explain the process of credit rating of debt instruments adopted by credit
rating agencies. (B.Com(H), DU, 2010) [Para 4.11.2]
21. What are the various risks is bonds? Explain [Para 4.8]
22. Write notes on
(i) Interest rate risk [Para 4.8]
(ii) Inflation risk [Para 4.8]
23. How can one determine the value of a DDB? Explain [Para 4.6]
24. How can you determine the value of a convertible bond? [Para 4.5]
25. “The market price of bonds is conversely related to the market interest rates”
comment. (B.Com.(H), GGSIPU, 2015)
26. What is meant by yield to maturity? (B.Com.(H), GGSIPU, 2016)
27. (a) What is the yield to maturity? How is it computed? Illustrate with the help
of an example. (B.Com.(H), GGSIPU, 2017)
(b) How does interest rates affect yield to maturity? Show clearly with the
help of an example. (B.Com.(H), GGSIPU, 2017)
Practical Problems
1. A Rs. 5000 face value bond is carrying a coupon rate of 14% and has maturity
after 8 years at par. Calculate the intrinsic value of the bond if required rate
of return is 16% and interest is payable (i) annually (ii) semi annually
[Answer-(i) 4566 (ii) 4557]
2. A Rs. 1000 12% bond has 10 years to maturity. It is currently available at a
price of Rs. 960. Should an investor buy this bond if his required rate of return
is 13%?
[Answer-No]
3. A Rs. 1000 bond having coupon rate as 12% and 7 years to maturity is available
at a price of Rs. 1040. The market interest rate is 11%. Is this bond a good
investment?
[Answer-Yes]
4. An investor has the following information for a bond:
a. Face value : 10,000
b. Coupon rate-10%
c. Market price-Rs. 10,500
Find the yield to maturity, yield to call if callable in 5 years at Rs. 10,800.
(B.Com (H), DU, 2011)
[Answer-8.65%, 9.99%]
5. A company is contemplating to issue bonds having face value of Rs. 1000
which will be redeemed over a period of 5 years in five equal instalments.
The bond carries a coupon interest rate of 8%. Find the value at which the
bonds shall be issued to the investors having expected rate of return at 7%.
[Answer-Rs.1,025.66]
6. The following information is given to you regarding the bond:
Face value Rs. 100

Coupon rate 10%
Maturity 4 years
Redemption value Rs. 120
Compute:
a. The value of the bond when the opportunity cost of capital is 15%?
b. What would be its yield to maturity if the current market price of the
bond is Rs. 94? (B.Com(H), DU, 2013)
[Answer-Rs. 97.16, 15.48%]
203 Test yourself
7. The bond with face value of Rs.100 is currently available at Rs. 96 in the
market. The coupon rate is 14% p.a. the maturity time is 5 years and interest
is paid annually. Compute the yield to maturity of this bond. What would be
your answer if the current selling price is Rs.105 instead of Rs. 96?
(B.Com(H), DU, 2013)
[Answer-15%,12.6%]
8. A 20 Years maturity 9% coupon bond is callable in 5 years at a call price of
Rs. 1050. The bond is currently selling at its YTM which is 8% and interest is
paid semi-annually. Calculate its yield to call?
[Answer-3.72%]
9. The bond with face value of Rs.100 is currently available at Rs. 97 in the
market. The coupon rate is 12% p.a. the maturity time is 5 years and interest
is paid semi-annually. Compute the semi-annual yield to maturity of this bond.
What would be your answer if the current selling price is Rs.110 instead of
Rs. 97? (B.Com(H), DU, 2014)
[Answer-6.05%, 4.66%]
10. A company contemplates to issue bonds having face value of 100 with 7 years
of life. The bond is to be redeemed at a 10% premium; the coupon rate is 12%
for first two years, 15% for next two years and 18% for rest of its life. Compute
the value of the bond when the desired rate of return by the bondholders is
15%.
[Answer-Rs.102.80]
11. The bond (of the face value of Rs.1000) is available in the market for Rs.780.
It has coupon rate of 6% and maturity period of 8 years. If the bond is re-
deemable at par, Compute:
a. Yield to maturity of the bond
b. If the required rate of return of an investor is 12%, should he purchase
the bond? (B.Com(H), DU, 2014)
[Answer- 10.15%, No]
12. A 5 years maturity Rs. 1000 face value 8% coupon bond is currently selling
at YTM of 14%. Interest is payable annually and bond is redeemable at par.
Calculate the current market price of the bond, duration of the bond and
modified duration of the bond. Also interpret the results.
[Answer-Rs. 794.015, 2.74 years, 2.88]
13. A 20 years maturity 9% coupon bond having Rs.1000 face value sells at initial
YTM of 9% and its price is Rs.1000. The modified duration of the bond is 10.5
and bond convexity is 205.6. What will be the expected decrease in bond price
if yield increases from 9% to 12%?
[Answer-22.25% decrease]
14. SIDBI issued Rs.1000 par value 12% coupon bonds paying annual interest pay-
ments and having 5 years to maturity at a price of Rs. 980. The reinvestment
rate is 10% p.a. calculate the realised YTM on this bond. Should the bond be
bought if the investor’s required rate of return is 13%?
[Answer-Realised YTM-12.07% No.]
15. A Rs.1000 par value 10% coupon bond issued by Aarogya Ltd. has 5 years until
maturity and is currently selling at YTM of 12%. Interest is payable annually
and bond is redeemable at par. Calculate:
a. The current market price of the bond
b. duration of the bond.
[Answer-a. Rs. 927.90, b. 2.77 years]
16. An investor purchases a Rs.1000 par value bond carrying coupon rate of 9%
p.a. at Rs. 950 in January 2014. The bond will mature after 5 years from now
at par. The investor keeps the bond for one year and sells it at price of Rs.
970 after receiving interest of Rs. 90 in December 2014. Calculate his holding
period return from the bond.
[Answer-11.58%]
17. The following information is available in respect of a bond: Face value
Rs. 5000, Coupon rate : 7% Time to Maturity : 4 years, Market price = Rs.
4790, Investor’s Yield = 10%
Find out YTM and Intrinsic value of the bond. Should an investor buy this
bond based on YTM and intrinsic value?
[Answer-8.15%, Rs. 4525, No]
18. Kaira Ltd. issues a 15%, 3 years bond with face value and maturity value of
Rs. 1000. What is the value of the bond if the required rate of return is (i)
11% (ii) 12% or (iii) 13%. Why are the values different? What is the relationship
between bond’s value and required rate of return or interest rate?
[Answer-1098, 1073, 1047, Negative]
19. Mack Ltd. comes out with a scheme which specifies that “ Deposit Rs. 16000
now and receive Rs. 1500 p.a. at the end of every year for next 5 years along
with Rs. 16000 at the end of 5th year.” Should the scheme be accepted by an
investor if the required rate of return is 13%?
[Answer-No]
20. Python Ltd.’s 12%, bond with face value of Rs. 1000 is currently available at
a price of Rs. 950 and has 8 years remaining to maturity . The redemption
value will be 90% of the face value. Calculate YTM of the bond.
[Answer-12.12%]
21. KBC Ltd. is proposing to issue 9% bonds of face value of Rs. 1000 redeemable
in 5 annual instalments of Rs. 200 each every year over 5 years period. If
required rate of return is 7%, at what price the bonds be offered to investors?
[Answer-Rs. 1051]
205 Test yourself
22. An investor purchased a 15% bond at its par value of Rs. 1000 when time to
maturity was 5 years. He sold the bond for Rs. 1300 after two years. Out of
the proceeds he immediately purchased a bond carrying coupon rate of 10%
which has 3 years to maturity and is redeemable at a price of Rs. 1000 i.e. its
face value. Find out YTM of the investor over the 5 years.
[Answer-12% approx]
23. Juhi Ltd. had issued Rs. 1000 face value perpetual 12% debentures 15 years
ago at a price of Rs. 1000 each. Interest rates have changed now and the
debentures are now selling at a yield of 18%.
(i) Calculate the current expected market price of the debenture.
(ii) Should an investor buy the debenture at a price of Rs. 780?
(iii) What is the yield?
[Answer-(i) Rs. 666.67 (ii) No (iii) 15.38%]
24. Mr. Tiwari bought a 9% bond with 10 years maturity, having face value of
Rs. 1000 at its issue price of Rs. 1000 six years ago. The bond is redeemable
at par. It’s market price now is Rs. 1100. Should Mr. Tiwari sell this bond?
Why? Assume that the required rate of return is 13%.
[Answer-Sell]
25. Mr. Kailash bought a 16% bond with 15 years maturity, having face value of
Rs. 10000 at its issue price of Rs. 9950 one year ago. The bond is redeemable
at a premium of 10%. It’s market price now is Rs. 10150. Should Mr. Kailash
sell this bond? Why? Assume that the required rate of return is 14%. If Mr.
Kailash sells this bond at a price of Rs. 11000, what would be his Holding
period return?
[Answer-Sell, 26.63%]
26. An investor is considering the purchase of the following bond:
Face value Rs. 1000
Coupon rate : 13%
Maturity : 8 years
i. If he wants a yield of 17%, what is the maximum price he should be
ready to pay for?
ii. If the bond is selling for Rs. 1241, what would be his yield if he buys the
bond and holds it till maturity?
[Answer-(i) 832 (ii) 8.58%]
27. A Rs.1000 par value bond having coupon rate 8% p.a. and 5 years to matu-
rity is currently selling at Rs. 885. Its yield to maturity is 14%. Calculate the
Duration of the bond. Calculate modified duration. What will be the effect
of 1% increase in yield on bond price?
[Answer-4.22 years, –3.7, price will decrease by 3.7%]
28. A Rs.1000 par value bond having coupon rate 8.5% p.a. and 6 years to maturity
is currently selling at YTM of 12%. The bond is redeemable at a premium of
5%. Calculate the Duration of the bond. Calculate its modified duration. What
will be the effect of 1% decrease in yield on bond price?
[Answer-4.88 years, –4.35, price will increase by 4.35%]
29. The market price of a Rs.1000 par value bond carrying coupon rate of 17%
and maturing after 5 years is Rs. 965. The reinvestment rate is 15%. Calculate
YTM and Realised YTM of the bond. Should this bond be bought if required
rate of return is 18%?
[Answer-18.02%, 17.34%, No]
Project Work
Go to the website www.moneycontrol.com and collect information about any bond
issued by a company in India in recent past. Search for the following (i) face value
(ii) Coupon rate (iii) time to maturity (iv) redemption price (v) Call option if any
and callable price and time to call (vi) Current market price.
Now assume that the required rate of return is 13%. Calculate whether the bond
is underpriced or overpriced in the market?
5 EQUITY ANALYSIS -
FUNDAMENTAL ANALYSIS
C H A P T E R
leArninG outcoMes
 Understand different approaches to security valuation- Fundamen-
tal analysis, Technical analysis and Efficient Market Hypothesis.
 Differentiate between top down approach and bottom up approach
of fundamental analysis
 Explain EIC framework.
 Highlight the importance of fundamental analysis
 Identify various economy wide factors and Perform Economic
analysis
 Identify various industry wide factors and Perform Industry
analysis
 Identify various company level factors and Perform company
analysis
 Explain the limitations of fundamental analysis
Investors invest in a wide range of securities as available in financial

markets. For the sake of simplicity these securities can be divided into two
broad categories like – fixed income securities i.e. bonds and debentures;
and variable income securities i.e. equity shares. In the previous chapter
we discussed about fixed income securities i.e. bonds and debentures and
provided valuation models for their pricing. The peculiar feature of bonds
and debentures is that the cash inflows from these securities can be very
well predicted in advance because they have a fixed rate of interest income.
207
Para 5.1 Equity analysis - fundamental analysis 208
Further they are also redeemable at maturity. Fixed income securities are
preferred by more risk averse investors who do not want to take high risk
and who prefer regular income rather than capital appreciation. Most of the
old age and retired people fall in this category. However bonds and deben-
tures may not interest to other investors who are less risk averse and prefer
capital appreciation rather than regular income. Most of the young people
and speculators fall in this category. For such investors equity shares are
ideal investment option. It must be noted that investors generally invest in
both bonds and equity shares as per their investment goals and investment
horizon. This chapter deals with equity shares.
Equity shares are fundamentally different from debt securities or bonds.
Equity shares represent ownership right in a company but return on equity
shares is not fixed. Income from equity shares varies depending upon the
amount of dividend declared by the company, which in turn, depends upon
company’s profits besides a number of other factors. Equity shareholders are
the owners of the company and not its creditors. Equity shares of publicly
held companies are mandatorily listed on stock exchanges, which in turn,
provides a platform for purchase and sale of equity shares. Hence equity
shares are more liquid than bonds. The market price of a share represents
shareholder’s wealth and hence the market value of a company. Share prices
move according to the information available in the market. Expectations also
play a major role in share price movement. A positive information or expec-
tation will increase market price of a share while a negative information or
expectation will dampen it. For example, market price of a company which
has shown higher growth in profitability increases while for a company,
which is in distress, the market price declines.
As discussed in chapter 1, security analysis is the process of analyzing avail-
able securities in terms of return, risk and other salient characteristics. It also
covers the aspect of security valuation wherein we calculate the theoretical
or fair price or intrinsic value of a security. Equity analysis is the analysis
of equity shares in terms of return and risk.
5.1 Approaches to Security Analysis

Behaviour of stock prices is an important area of research in finance. A
plethora of research studies have shown share price movements for devel-
oped as well as developing countries since the decade of 1960’s. The stock
market provides the market price of a share or “What the price is”. It is
the price at which a share can be bought or sold. However a prospective
investor as well as an existing shareholder is interested more in knowing
“What the price should be” or “What is the real worth of a share”, so that
a ‘buy’ or ‘sell’ decision can be made. In a bid to answer this question and
209 Approaches to security analysis Para 5.1
predict share price, the following three approaches to security valuation

have evolved over the years.
1. Fundamental Analysis : It is based on the premise that in the long run
true or fair value of an equity share is equal to its intrinsic value. The
intrinsic value of a share is the present value of all future expected cash
inflows from the share. If the intrinsic value is greater than current
price of the share, the share is underpriced and hence a good buy.
On the other hand, if intrinsic value is less than current price of the
share, it is over priced and hence a good ‘sell’. The future expected
cash inflows from a share depends upon a wide array of factors in-
cluding company’s performance and future prospects. Fundamental
analysis is used primarily to identify securities that are mispriced i.e.
that are undervalued or overvalued. However fundamental analyst
needs to be equipped with certain financial and statistical skills in
order to perform it. Fundamental analysis is dealt in detail later in
this chapter.
2. Technical Analysis : Technical analysis is based on the premise that
‘history repeats itself’. Hence future price movements can be well pre-
dicted on the basis of past price and volume data. Technical analysts
are therefore called “chartists” because they study various charts and
patterns to predict “What the price should be”. Technical analysis is
done on the basis of trend analysis of past prices. Technical analysis
is used primarily to time the market i.e. in identifying the right time
to buy or sell. It must be noted that technical analysis predicts future
prices over a short period of time and hence may not be useful for
a long term investor who just want to buy and hold the securities.
Technical analysis is dealt in detail in Chapter 6.
3. Efficient Market Hypothesis (EMH) : The proponents of EMH,
led by Eugene Fama in 1970, believe that share prices at any time
reflect their true intrinsic value and hence all available information
is already reflected in market price of a share. It is the flow of new
information which changes share price. However the extent to which
information is reflected in security prices and the speed of adjustment
determines what is called the level of market efficiency. Fama (1970)
has suggested three levels of market efficiency depending upon the
extent to which information is reflected in share prices.
(i) Weak form
(ii) Semi-strong form
(iii) Strong form
Details about Efficient Market Hypothesis are provided in Chapter 7.
5.2 FUNDAMENTAL ANALYSIS

Fundamental analysis is based on the premise that in the long run true
or fair value of an equity share is equal to its intrinsic value. The intrinsic
value of an asset is the present value of all expected future cash inflows (or
earnings) from that asset. In case of an equity share it will be equal to the
present value all expected future earnings (in the form of dividend, capi-
tal gain etc.) from that share because equity shares have infinite life. The
expected earnings from an equity share depend upon a variety of economy
wide, industry wide and company specific factors. Therefore fundamental
analysis involves in-depth analysis of all possible factors having a bearing
on company’s profitability and future prospects and hence on share price
(theoretical or fair price).
Fundamental analysts forecast, among other things, future level of the
economy’s GDP, future sales and earnings of a large number of industries
and earnings of a large number of companies. Eventually such forecasts
are converged to estimate the expected cash inflows from the shares of
these companies. There can be two approaches to fundamental analysis –
Top down approach and Bottom up approach.
Top down approach : With this approach the financial analysts are first
involved in making forecasts for the economy, then for the industries and
finally for the companies. The industry forecasts are based on the forecasts
of the economy. Further a company’s forecasts are based on the forecasts
of the economy as well as the concerned industry.
Bottom up approach: In case of bottom up approach, fundamental ana-
lysts forecast the prospects of the companies first, then for the industries
and in the last forecast for the economy. Such bottom up forecasting may
unknowingly involve inconsistent assumptions. Forecasts of the economy
is of no use if it is done after company forecasts because ultimately it is
the expected cash inflows from the company’s share that will be used in
finding out the intrinsic value of a share.
Hence in practice, Top down approach is widely used to perform
Fundamental analysis.
The various factors of interest in fundamental analysis can be broadly clas-
sified into three categories – economy wide factors, Industry wide factors
and Company wide factors. Hence we have
1. Economic Analysis
2. Industry Analysis
3. Company Analysis
211 EIC Framework Para 5.3
This top-down approach of fundamental analysis is also referred to as

E-I-C- framework, where E implies economy, I implies industry and C
implies company level analysis.
Investment Decision Making using Fundamental Analysis

Once we have forecasts about the profitability of a company and make an
estimate of the futures cash inflows from a security or share, we calculate
intrinsic value of the security or share and compare it with the market
price. If the intrinsic value is more than current market price of share then
the share is underpriced and hence an investor should buy it. On the other
hand if intrinsic value is less than current price, the share is over priced
and hence, the holder of the share should sell it and a prospective investor
should not buy it.
5.3 EIC Framework

As explained above EIC framework is the Top down approach of Fundamental
analysis wherein an analyst makes a forecast about the economy wide
factors first and then performs Industry analysis and finally Company level
analysis. This three level analysis covers a wide range of various economy
wide, industry wide and company- wide factors as discussed below:
5.3.1 Economic Analysis

Before performing industry level analysis and firm level analysis and
forecasting its dividends and earnings it is important to analyze the broad
economic environment in which it operates.
Economic analysis is the study of various economy wide factors influenc-
ing stock market viz. Gross Domestic Product (GDP) growth rate, inflation
rate, interest rate, exchange rate, balance of payment, fiscal deficit and
budgetary provisions, infrastructure etc. An important aspect of economic
analysis now a days is the political environment especially in an emerging
market like India. Political stability is a necessary requirement for stable
and growing financial market of that country. Further, issues such as
corruption, law and order, economic policies etc. are of pertinent use for
economic analysis.
Economic analysis is a useful tool to understand the general direction of
the economy and deciding about the right time to invest. This is particu-
larly done by large and institutional investors whose portfolio comprises of
securities from across a number of countries. Conducive macroeconomic
environment leads to bullish and/or stable stock market while negative
economic outlook affects stock prices adversely. Various economy wide
factors analysed in economic analysis are explained below :
(i) GDP Growth Rate : Gross domestic product (GDP) is the total val-
ue of goods and services produced in an economy during a given
period. Growth rate in GDP is an important indicator of the overall
state of the economy. Therefore fund managers and institutional
investors carefully examine GDP growth rates before deciding about
the countries where investment is intended. As per National Bureau
of Economic Research (NBER) of USA, two successive quarter de-
cline in GDP growth rate signals a recession in the economy. On the
other hand improvement in GDP growth rates indicates improving
economic conditions. Index of Industrial Production (IIP) is another
important source of manufacturing activity in an economy. Funda-
mental analysts are interested in understanding whether the overall
business and economic condition in the economy will be in terms
of boom or recession. If there is optimism and boom as shown by
GDP growth rate and IIP then that presents a right time to invest in
growing companies.
(ii) Inflation : Inflation erodes purchasing power of money and there-
fore in times of inflation nominal return does not reflect true or real
earnings from an asset. Mounting inflation in some of the developing
countries, including India, is one of the reasons for low level of in-
vestment. Increase in inflation rates also adversely affects product
demand and hence corporate profitability declines in general.
(iii) Interest Rates : Term structure of interest rate in an economy affects
capital investment and hence income level. Higher interest rate is
a symbol of tight monetary policy and increases cost of borrowing
which in turn lowers investment and business expansion. Thus interest
rates are negatively related with stock performance in an economy.
(iv) External Sector : Foreign trade sector or external sector of an econ-
omy is an important factor to analyse in this era of globalization.
External sector of an economy can be examined with the help of
balance of payment (BOP) account which is a statement of receipts
and payments of a given country for the transactions entered into
with the rest of the world. These transactions are further classified
into current account (for merchandise and services or invisibles) and
capital account. A widening current account deficit creates pressure
on exchange rate and leads to further deteriorating economic con-
dition.
(v) Infrastructure : An economy with sound infrastructure facilities
such as power, telecommunication, roads & transport etc. is always
preferred by institutional investors. Good infrastructure is necessary
for continuous and growing production level.
(vi) Budgetary Provisions & Fiscal Deficit : Fiscal health of an economy

is an indicator of how well the government manages its receipts and
expenditures. An increasingly high fiscal deficit is a cause of concern
in India and has adversely affected productive investment by the
government. Besides fiscal deficit, a number of budgetary provisions
such as tax structure, spending on infrastructure and education and
other social welfare schemes also affect stock market. A budget which
is conducive to industry (e.g. reduced taxes and tax holidays etc.) is
always welcome by the stock market in India.
(vii) Composition of GDP : It is not only GDP growth rate but also com-
position of GDP which is of interest to economic analysts. Here we
examine the contribution of agriculture, manufacturing and services
sector in overall GDP of the country. India is primarily an agrarian
economy but about 50-60% of its total GDP comes from services sector.
An year of bad monsoon adversely affects agricultural production,
reduces income level especially in rural areas which in turn reduces
demand for manufactured goods and services. This adversely affects
corporate profitability and depresses stock prices.
(viii) Employment : The unemployment rate is the percentage to total
labour force which is yet to find jobs. The unemployment rate mea-
sures the extent to which an economy is operating at full capacity.
High unemployment rate is a sign of contracting economy and hence
adversely affects stock performance.
(ix) Government’s Economic Policies : In order to understand the future
direction of economic activity, it is necessary to analyse government’s
economic policies such as fiscal policy, monetary policy, foreign trade
policy, etc. which directly affects an industry’s and hence a company’s
performance. Fiscal policy, especially, tax policy of the government
has a direct relationship with personal disposable income and cor-
porate profitability. Monetary policy especially changes in interest
rates can influence investment and savings especially in short term.
An increase in interest rate, increases cost of production and hence
may become counter-productive in an already contracting economy.
Besides above a number of other economic indicators help analyse the state
of an economy such as foreign exchange reserves, money supply, bond
yields, purchasing manager’s index (PMI) etc. Business cycles (Boom and
recession) also play an important role in economic analysis.
Economic Forecasting
Analysis of various economy wide factors can be performed using the simple
statistical techniques such as trend analysis or sophisticated econometric
modelling. Therefore economic forecasting can be done using the following

three approaches
i. Trend analysis of the basic economic indicators such as GDP growth
rate, inflation, interest rate, exchange rate etc.
ii. Probabilistic forecasting : Using probability distribution approach
the analyst may forecast several economic scenarios along with their
respective probability of occurrence.
iii. Econometric modelling : An econometric modelling is a statistical
model used to forecast the level of certain variables known as en-
dogenous variables. In order to make these forecasts the model uses
a number of exogenous or explanatory variables. For example the
level of next year’s GDP growth rate may be related to the rate of
investment and inflation rate.
5.3.2 Industry Analysis

The second stage in equity analysis using EIC framework is industry anal-
ysis, which implies study of peculiar features and performance of various
industries in an economy. Before deciding about the specific company
in which investment is to be done, an investor must get familiar with the
nature, performance and prospects of the industry to which that company
belongs. Industry analysis is performed on the basis of the analysis for the
entire economy. If the economy in general is expected to boom then the
overall scenario for all the industries is positive. However the performance
of all industries may not be same. Some industries may perform very well
and others may not catch up with expected boom in the economy. Different
industries have different return and risk profile.
Industry performance is an important determinant of expected earnings
and dividends of a company. Industry analysis covers a wide range of
factors such as the type of industry, nature of industry product, Industry
life cycle, Industry growth rate, govt. policy towards industry and so on.
These factors are discussed below:
1. Nature and Type of Industry :
Depending upon an industry’s response to business cycles, it can be
classified as a cyclical industry or defensive industry as explained
below :
i. Cyclical Industries : Industries which are more responsive or
sensitive to business cycles are termed as cyclical industries.
The performance of cyclical industries varies according to busi-
ness cycles. During expansion or boom period these industries
outperform other industries. Examples of cyclical industries are
consumer durables, automobiles, capital goods, construction

etc. Because purchases of these goods can be deferred during
a recession, sales are particularly sensitive to economic con-
ditions. Therefore sales of these industries decline faster than
other industries and thus they bear the brunt of a slow down.
ii. Defensive Industries : In contrast to cyclical industries, defen-
sive industries growth rates are less sensitive to business cycle.
These are the industries producing goods and services, sales of
which are least sensitive to the state of the economy. Examples
of defensive industries include pharmaceutical, food products,
education, public utilities etc. These industries outperform
other industries when recession starts in an economy.
Whether the industry is cyclical or defensive, it is important
to analyse certain features of the industry. These features are
crucial for proper assessment and forecasts related to earnings
and dividends at the company level.
2. Industry Life Cycle : Industries can also be classified on the basis
of their stage in industry life cycle viz. start up stage, growth stage,
maturity stage and declining growth stage.
(i) Start up Stage : This stage is usually characterized by the intro-
duction of a new product or technology such as smartphones.
At this stage it is difficult to predict which firm will emerge as
the market leader because every firm tries to capture largest
market share. At the firm level profit margins are relatively
low and demand is uncertain. However at the industry level.
This phase witnesses rapid and increasing growth because
of growing demand for new product. In India the market for
smartphones is growing more rapidly than that of T.V. or re-
frigerator. Industries in start up stage although promise higher
return but are also very risky in nature.
(ii) Growth Stage : This is also referred to as consolidation stage
due to stable growth in the industry. Due to stable growth
companies may enjoy higher profits and therefore companies in
growth stage industries promise higher return to the investors.
At the end of growth stage, the product becomes very much
commonly used and the growth rate starts declining although
positive. Industries in growth stage are lucrative investment
options. With consistently growing returns at relatively low
level of risk.
(iii) Maturity Stage : During maturity stage also the product de-
mand grows but at a decreasing rate. At the end of this stage
the industry reaches a saturation point when the demand for
the product reaches its maximum and stops growing. This stage
is also characterized by stable returns but investors prefer to
exit once an industry reaches to the maturity stage.
(iv) Declining Stage : Industries during this stage face decline
in product sales and hence negative growth rate. The profit-
ability of all companies, in general, decline once the industry
reaches this stage. Examples of industries in declining stage
in India at present include – conventional cell phones, color
T.Vs, two-wheelers etc. These products have been replaced by
their substitutes such as smart phones, LCD & LED TVs and
low cost cars.
3. Nature of Product of the Industry
The nature of the product of the industry has a bearing on its growth
and profitability. If the product is seasonal and agricultural e.g. sugar,
its growth rate will depend on monsoon in a particular year. Simi-
larly if the product is not an end-product rather used as material or
input in other industries then the growth rate of such an industry
depends upon the growth in industry where such a product is used.
For example growth and profitability of spare parts industry depends
upon automobile industry.
4. Nature of Competition
It is important to understand the nature of competition in an industry,
whether perfect competition, monopolistic, oligopoly or monopoly.
Companies in an industry with perfect competition have least profit-
ability as compared to a company in monopoly industry. For example
IT industry in India has monopolistic competition.
5. Industrial Policy of the Government
Government’s policy towards a particular industry also affects its
growth prospects and hence performance. Since 1991, Government
of India has followed liberalization and privatization policy allowing
private and foreign companies in a number of industries dominated
by public sectors such as banking, insurance and retail industries.
This led to stiff competition as well as improvement in efficiency of
good companies in these industries. Further, there are a few indus-
tries which enjoy tax exemptions and/or special subsidies such as
biotechnology, oil and gas etc. Government also protects small and
cottage industries by procuring their products and providing subsi-

dies. This leads to growth of micro and small enterprises in India.
6. Labour Conditions and Trade Union
In case of labour intensive industries such as agriculture, mining and
construction it is important to analyse labour conditions, availability
of cheap labour, and how strong is the trade union, if any. Industries
with organized labour or trade unions may face difficult times during
worker-management conflict. Especially in India trade unions are
very strong in banking and automobile industries, which at times
lead to disruption in production/operation when a nation-wide strike
is announced. For example Maruti Ltd. has to lock out its Manesar
plant following stiff protest by the trade union in year 2012.
7. Traditional vs. New Economy Industries
Industries may also be classified as being traditional (such as FMCG,
Construction, Capital goods etc.) and new economy industries (such
as IT, telecommunication, financial services etc.). Return from com-
panies in traditional industries is low but consistent while from new
economy industries return is relatively high but volatile.
In order to analyse risk-return aspects of various industries in India,
an investor may examine the performance of following sectoral in-
dices of BSE or NSE.
(i) Bankex – Banking Index
(ii) Petro index
(iii) Pharma-index
(iv) IT-index
5.3.3 Company Analysis

At the bottom of EIC framework analysis is company level analysis. Company
analysis is the study of various characteristics of a company regarding
its operating and financial performance and future prospects. Once an
investor decides to invest in a particular industry on the basis of economic
and industry analysis, it is important to select the company or companies
in which investment is to be made. For example, if an investor decides to
invest in IT industry, the next step is to decide in which company Infosys,
Wipro, HCL, TCS etc.
In fact the estimation of future dividends and earnings from a company
depends upon its past performance and managerial competence. Such an
estimate is made within the broad framework of economy wide and in-
dustry analysis. The outcome of the Company analysis is expected future
cash inflow from the share of that company which is used in determination
of the intrinsic value of the share of that company. The intrinsic value of
the share is then compared with the prevailing market price to find out
whether the share is undervalued or overvalued. If the share of a company
is available in the market at a price less than its true intrinsic value then it
is said that the share is undervalued. Hence a prospective investor should
purchase it. On the other hand if the share of a company is available in the
market at a price more than its true intrinsic value then it is said that the
share is overvalued. Hence a prospective investor should not purchase it.
Rather, if an investor already holds such a share, it should be sold.
The intrinsic value of a company depends upon the amount of dividends
and growth rate, which in turn depends upon the amount of earnings.
Hence analysis of earnings of the company is of utmost importance in case
of company analysis.
There are various sources for collecting necessary data for company analy-
sis. The company level data is primarily collected from the annual financial
statements of the company such as
- Balance sheet
- Income statement
- Cash flow statement
- Notes to financial statements
- Auditor’s report
- Social and sustainability reports, if any
- Corporate governance reports
Company analysis covers the following parameters of study- financial ratio
analysis especially earnings analysis, analysis of company management and
corporate governance, analysis of product differentiation and innovations.
(1) Financial Ratio Analysis
Financial ratio or accounting ratio is based on the historical perfor-
mance of the company. These ratios can be calculated using balance
sheet and income statement data. It covers analysis of profitability,
liquidity, solvency and efficiency level of a company.
(i) Earnings analysis or Profitability
Past profitability of a company is a good indicator of its
future prospects. Earnings analysis is an important component
of company analysis because future cash inflows from an
equity share depends to a great extent on the earnings of the
company. A company’s overall profitability may be analysed
using operating profit margin, return on capital employment

(ROCE), Return on Asset (ROA), Return on Investment (ROI),
net profit margin etc. In Indian companies announce quarterly
financial results and announcement regarding earnings or net
profits is the most sought after news in stock market. Some of
the important earnings measures are explained below:
a. Return on Equity (ROE) : Return on equity is that part
of total earnings of the company which belongs to equi-
ty shareholders. It is calculated by dividing profit after
tax and preference dividend by the amount of equity
shareholders’ funds or net worth.
PAT–Preference dividend
Return on Equity = × 100
Equity Shareholders funds
Return on equity = × 100
Net worth
Return on equity indicates whether equity shareholders
are getting adequate return on their funds or not. Return
on equity is higher than return on investment if the com-
pany is profitable and uses debt. Equity shareholders are
more interested in analyzing return on equity rather than
the overall profitability of the company because that is
what matters to them.
b. Earnings per share (EPS) : Earnings per share is cal-
culated by dividing the amount of profit after tax and
preference dividends by the total number of outstanding
equity shares of the company. Hence it shows how much
amount is earned per equity share of the company. It is
easy to understand than any other ratio and is widely
reported in news and media. An increasing EPS shows
the relative strength of the company.
Earning per share =
Number of equity shares
On the basis of the past trend analysis of EPS a fun-

damental analyst may very well forecast its future or
expected EPS which can be used in the valuation of
equity shares. The earnings multiplier approach of equity
valuation determines the fair price of an equity share as
the multiplication of Price earnings ratio and expected
EPS of the company.
c. Price Earnings Ratio (P/E) : Analysis of price earnings

ratio or P/E ratio, as we popularly call it, is an important
ingredient of company analysis. P/E ratio is calculated
by dividing market price per share by the EPS.
Market price per share
Price Earnings Ratio =
EPS
P/E ratio indicates the relative valuation of the share of
a company in stock market. A high P/E ratio implies that
the market is optimistic about the growth of the company
and hence is paying a premium or high price to buy the
share. However a very high P/E ratio of a company’s
share may also mean that the shares are overpriced in
the market. On the other hand low P/E ratio implies that
the market is pessimistic about the earnings potential of
the company and hence the shares of the company are
being traded at relatively low price. It may also mean
that the stocks are underpriced in the market. Hence
some investor prefer to buy stocks with low P/E ratio
as they believe that they are undervalued.
d. Book Equity to Market Equity Ratio (BE/ME) : A related
valuation ratio is Book equity to Market Equity ratio. It
is calculated by dividing the Book Value of Equity share
by the Market price.
Book value per share
BE/ME Ratio =
Market price per share
It must be noted that book value per share is Net asset

value per share. BE/ME ratio indicates the relative valu-
ation of the share of a company in stock market. A high
BE/ME ratio implies that the market is pessimistic about
the growth rates of the company and hence its shares are
being traded at a low price in the market. However a very
high P/E ratio of a company’s share may also mean that
the shares are underpriced in the market. Stocks with
high BE/ME ratio are considered as Value stocks. On
the other hand low BE/ME ratio implies that the market
is optimistic about the earnings potential and growth
of the company and hence the shares of the company
are being traded at relatively high price in the market.
It may also mean that the stocks are overpriced in the
market. Low BE/ME ratio stocks are called Glamour
Stocks or Growth stocks. Hence some investor prefer to
buy stocks with high BE/ME ratio as they believe that

they are undervalued. Fama French (1992) have shown
that high BE/ME ratio stocks outperform low BE/ME
ratio stocks in the market.
e. Growth rate in Earnings : Another important aspect of
company analysis is to forecast growth rate of the com-
pany. Growth rates can be calculated for assets, sales,
turnover as well as earnings. For equity valuation and
analysis, growth rate in earnings is of prime importance.
A forecast about the future growth rate of earnings of a
company can be made on the basis of trend analysis of
historical or past EPS or by using some regression anal-
ysis. For example if the earnings per share of a company
have grown from Rs. 10 to Rs. 20.11 over the period of
five years then it implies that the compound growth rate
in the earnings of the company is 15% p.a.
f. Dividend Policy of the company : Generally, the total
amount of earnings are not distributed as dividends.
A part of the earnings is distributed as dividends and a
part is retained in the company for further investment.
Once the earnings have been analysed it is important
to analyse the dividend policy of the company so as to
arrive at a fair valuation of equity shares. Dividend policy
of a company may also vary over time. Dividend policy
comprises of the following three important and related
measures-
i. Dividend per share
ii. Dividend payout ratio
iii. Growth rate in dividends

Dividend per share (DPS) is calculated by dividing total
amount of dividend by the number of equity shares.
Total profits distributed
DPS = Number of equity shares
The amount of dividend per share shows the actual cash

inflows from the equity shares. Hence it is an important
input in calculating intrinsic value of a share.

Dividend payout ratio is the ratio which shows how much
proportion (or %) of the total earnings is distributed as
dividends. It is calculated by dividing the Dividend per
share by Earnings per share. It can also be calculate by

dividing total amount of dividends by the total Earnings.
Dividend per share
Dividend Payout Ratio = Earnings per shares
Some companies have high payout ratio while others
have low payout ratio.

Growth rate in dividends is the rate at which dividends
have been growing or are expected to grow in future.
Growth rate is used to determine the amount of expected
future dividends from the share. If dividend payout ratio
is same then growth rate in earnings and growth rate in
dividends will be same.
(ii) Liquidity
An important factor affecting the payment of dividends is
liquidity of a company. Sufficient liquidity is a pre-condition
for dividend payment and hence liquidity analysis is important
in company analysis. Liquidity can be assessed using current
ratio or quick ratio (acid test ratio) of a company. Current
ratio is calculated by dividing the amount of current assets
by the amount of current liabilities. Ideal current ratio in a
manufacturing company is 2. For the calculation of quick ratio
we divide quick assets by current liabilities. Quick assets are
cash, marketable securities and accounts receivables. Ideal
quick ratio in a company is 1. At times companies are forced
to declare bankruptcy due to lack of liquidity.
Current Assets
Current ratio =
Current Liabilities
Cash + Marketable securities + Accounts Receivables

Quick ratio =
Current Liabilities
(iii) Long Term Solvency
Besides liquidity analysis, it is important to assess long term
solvency of a company. It can be done with the help of Debt-eq-
uity ratio or capital gearing ratio. A high level of debt-equity
ratio over the past years, makes a company more vulnerable
and increases the probability of financial distress. On the oth-
er hand a very low level of debt equity ratio implies that the
company is not using its debt capacity so as to increase return
on equity. Degree of Financial leverage indicates the extent of
financial risk in a company.
(iv) Operating Efficiency

The operating efficiency of a company can be assessed with
the help of various turnover ratios such as – Stock turnover
ratio, debtors turnover ratio, working capital turnover etc. An
increase in turnover ratios over the years is a sign of improved
operating efficiency in a company.
Assets Turnover Ratio = Net sales/Average Assets
Working Capital Turnover Ratio = Net sales/Average Working
Capital
(v) Operating and Financial Leverage (Business risk and Financial
Risk)
Before investing in a company it is important to analyse its
operating and financial leverage which results in operating
and financial risks respectively. Operating leverage arises due
to the presence of fixed operating costs (e.g. rent, depreciation
etc.) in the cost structure of a company. Higher amount of
operating costs increases the chance of not meeting fixed cost
obligations in bad times or when the sales decline. The degree
of operating leverage can be calculated as below :
% Change in EBIT
Degree of operating leverage =
% Change in Sales
The higher degree of operating leverage, the greater is the
operating risk of the company.
Financial leverage, on the other hand, measures the level of
financial risk in a company. It arises due to the presence of
fixed financial costs in costs structure of a company i.e. the
use of debt-capital. The degree of financial leverage can be
calculated as given below :
% Change in EPS
Degree of Financial leverage = .
% Change in EBIT
The higher degree of financial leverage, the greater will be
financial risk of the company. At times, when operating profits
of the company are declining, it leads to adverse impact on
earnings per share and hence shareholder’s return.
(2) Management and Corporate Governance
It is important to examine the managerial competence and corporate
governance in a company. A highly profitable company may not be
a good company to invest if its management is not competent and
corporate governance standards are not adequate. For example the
Equity analysis - fundamental analysis 224
share price of Satyam Ltd., which was one of the most profitable IT
companies in India till the year 2008, declined significantly after the
report of management fraud and bad corporate governance in January
2009. Investors must ensure that the companies in which they are
investing have competent, efficiency and professional management
which follow all corporate governance norms.
(3) Product Differentiation and Innovations
Two companies may sell same product (such as detergent) but the
company which differentiates its product from other products avail-
able in the market and engages itself in product innovations is a good
investment option. Further, creation of brand also helps a company
in reaping higher profits.
Besides above it is necessary to analyse production and marketing
strategies of a company and its future plans regarding expansion,
mergers and acquisitions etc. All these help in estimating company’s
earnings and hence dividends to the shareholders.
Summary
1. There are three approaches to security analysis and valuation – Fundamental
analysis, Technical analysis and Efficient Market Hypothesis.
2. Equity shares are different from bonds as they do not provide fixed income
and have infinite life.
3. As per Fundamental analysis, in the long term, the price of a security is equal
to its intrinsic value.
4. As per Technical analysis, past price and volume data can be plotted and on
the basis of charts and trends, future prices can be predicted.
5. Efficient market hypothesis states that the security prices fully reflect all
available information and hence the price of the security at any time is its
fair price.
6. Fundamental analysis is based on the analysis of various Economy, Industry
and company-wide factors.
7. There are two approaches to Fundamental analysis- Top down approach and
Bottom up approach.
8. In Top down approach, which is more popular, we first analyse Economy wide
factors, then industry analysis and finally company analysis. This is popularly
termed as EIC framework or analysis.
9. Economic analysis includes the analysis and forecast of various macro-
economic indicators such as GDP growth rate, interest rate, inflation rate,
exchange rate, economic policies, tax policy, fiscal policy, monetary policy,
foreign trade policy etc.
225 Test yourself
10. Industry analysis is concerned with the analysis of Nature of industry, industry
life cycle, growth rate in industry, completion etc.
11. Company analysis primarily includes analysing the earnings and dividend
policy of the company. Other factors which are analysed at company level
include- liquidity, solvency, operating efficiency, operating and financial risk,
management and corporate governance, product innovations etc.
Test yourself
True False
i. Cyclical industries are good investment options when the economy is recov-
ering from a recession.
ii. Defensive industries outperform other industries during economic boom.
iii. In India an year of bad monsoon can adversely affect stock market.
iv. Industries in the maturity stage are good to invest in.
v. Labour conditions are not important in equity analysis.
vi. When intrinsic value is less than current price, the security should be bought.
vii. Macroeconomic outlook does not affect stock market.
viii. Corporate governance is an important parameter of company analysis.
ix. New economy stock are less sensitive to business cycles.
x. A company with high operating and financial leverage is a good investment
option in times of declining sales and profitability.
Ans : (i) T (ii) F (iii) T (iv) F (v) F (vi) F (vii) F (viii) T (ix)
F (x) F
Theory Questions
1. What are the approaches to security valuation? Explain in brief. [Para 5.1]
2. What is fundamental analysis? How is it performed? [Para 5.2]
3. What do you mean by Fundamental Analysis? State the rationale and proce-
dure of this analysis. (B.Com (H) DU 2007) [Paras 5.2 & 5.3]
4. Explain EIC (Economy-Industry-Company) approach.
(B.Com (H) DU 2013) [Para 5.3]
5. What are the steps followed in Fundamental Analysis for analyzing securities
of a company? (B.Com (H) DU 2008) [Paras 5.2 & 5.3]
6. Why is it necessary to perform economic analysis? Explain various parameters
being analyzed in economic analysis. [Para 5.3.1]
7. What is top-down approach of equity analysis? Explain in brief. [Para 5.2]
Equity analysis - fundamental analysis 226
8. How is industry analysis performed? What is the significance of industry

analysis? [Para 5.3.2]
9. “Company analysis is the assessment of strength and weaknesses of a com-
pany”. Explain. What are the various aspects of company analysis?
[Para 5.3.3]
10. What is industry lifecycle? Explain its utility in equity analysis. [Para 5.3.2]
11. If you expect a depreciation of rupee in near future, will you invest in IT
companies in India? Why or why not. [Para 5.3.1]
12. Explain the following in brief :
(i) E-I-C framework [Para 5.3]
(ii) Technical analysis [Para 5.1]
13. On 29th October, 2015, Reserve Bank of India announced its credit and
monetary policy, in which repo rate was increased by 25 basis points. How
is it expected to affect stock market in India? [Para 5.3.1]
14. Elaborate the economic-industry-company analysis framework as used in
the fundamental analysis. (B.Com.(H), GGSIPU, 2015)
Project Work
Go to National stock exchange’s website www.Nseindia.com and download the data
for various sectoral indices such as banking index, petro index, pharma index, IT
index etc. for the period 2003-2013 on quarterly basis. Now go to Reserve Bank of
India website www.rbi.org and download quarterly GDP data for the same period.
Plot the data regarding a sector index and GDP in a diagram. What kind of rela-
tionship you find? Which of the sectors are more sensitive to GDP?
(Hint : Perform regression analysis by regressing sectoral index values on GDP
data. The slope of the regression equation gives the sensitivity of that sector to the
broader economy. The sector with highest slope is most sensitive to GDP).
6 TECHNICAL ANALYSIS
C H A P T E R
learninG ouTcomes
 Explain the meaning and basic tenets of Technical analysis
 Differentiate between fundamental analysis and technical analysis
 Understand various types of charts
 Draw line chart, bar chart, point and figure chart and candlestick
chart
 Explain Dow theory and Elliott Wave theory
 Understand and use various market indicators and stock specific
indicators to predict future price behaviour
 Use moving average analysis to identify buy and sell signals
 State the limitations of technical analysis
In Chapter 5 we discussed about Fundamental analysis. In case of funda-

mental analysis we perform EIC analysis to make a forecast about expected
earnings, dividends and growth rate of the company. On the basis of these
forecasts we determine the intrinsic value of a share (details about the
calculation of intrinsic value of an equity share are provided in Chapter
8 – Equity Valuation.) As per fundamental analysis, the true value or fair
price of a share is equal to its intrinsic value. Intrinsic value of a share is
the present value of all expected future cash inflows from it. Hence under
fundamental analysis we first calculate intrinsic value of a share and then
compare it with market price in order to decide whether to buy or sell.
Fundamental analysis is suitable for an investor who plans to invest in
227
Para 6.2 Technical analysis 228
shares for a fairly long period of time. However there are many investors,
especially speculators who do not want to invest for long. Their investment
horizon is short term and hence they want to predict stock prices in rela-
tively short term. This chapter deals with the second approach of security
valuation- Technical analysis.
6.1 Technical Analysis

Technical analysis is based on the premise that “history repeats itself” and
hence movement in stock prices follow an established trend which can be
gauged from past price and volume data. As per Technical Analysis future
price behaviour can be predicted on the basis of past price analysis. Technical
analysis involves the study of various charts, ratios and patterns to predict
future direction of stock prices. It helps in answering the questions like “Is it
the right time to buy a share?” or “Is it the right time to sell a share?” Hence
once it is decided to invest in the shares of a particular company, the right
timing of investment can be decided on the basis of technical analysis.
6.2 Difference between Fundamental Analysis and

Technical Analysis
Two approaches to security valuation – fundamental analysis and technical
analysis can be distinguished on the following basis :
(i) Meaning and basic philosophy : As per fundamental analysis, the
share price should be equal to its intrinsic value in long term. Intrinsic
value of a share is equal to the present value all future expected cash
inflows from the share. Technical analysis is based on the premise
that ‘history repeats itself’ and hence stock prices can be predicted
based on past price and volume data. The basic philosophy behind
fundamental analysis is that every security has a real worth. If its
price is less than its real worth then an investor can earn superior
returns by investing in it. On the other hand, the basic philosophy
of Technical analysis is that the share prices move in trends and
patterns which can be exploited by investors to predict near future
price movements.
(ii) Objectives : In case of fundamental analysis the main objective is to
determine the intrinsic value (or true worth) of a security. The main
objective of Technical analysis is to identify future trend in security
prices.
(iii) Source of information : Fundamental analysis is based on the infor-
mation related to Economy, industry and company fundamentals. EIC
framework is the backbone of fundamental analysis. The information
229 Difference between fundamental & technical analysis Para 6.2
regarding economy and industry is obtained from government reports

and database. Information regarding company analysis is obtained
from the annual financial statements of the company concerned. Here
we do not use stock price data to analyse a stock. Technical analysis
is based on the analysis of past stock prices and volume data so as to
predict future prices. Hence technical analysis requires information
which is easily available from the stock market i.e. prices and volume.
Therefore sometimes it is said that fundamental analysis is based
on external data while technical analysis is based on data which is
internal to stock market.
(iv) Types of information : Both fundamental analysis and technical
analysis are primarily based on secondary data. But in case of fun-
damental analysis the information required is extensive. Here the
fundamental analyst requires macroeconomic data such as GDP
growth rate, inflation rate, interest rate etc., industry data such as
nature of industry, competition, growth stage etc. as well as com-
pany specific data such as sales, profitability, liquidity etc. Technical
analysis, on the other hand, requires data related to securities only,
such as security prices, volume, benchmark index data and so on.
(v) Tools and Techniques for analysis : Fundamental analysis is based
on the assessment of economy, industry and company level data.
Hence a variety of accounting and statistical tools and techniques
such as ratio analysis, discounted cash flow analysis, regression
analysis, probability distribution method, sensitivity analysis (what if
analysis), and econometric modeling is used in case of fundamental
analysis. Technical analysis on the other hand is based primarily on
trend analysis and chart patterns.
(vi) Investment decision (Buy-Sell signals) : In fundamental analysis an
investor is advised to buy a stock if its market price is lower than the
intrinsic value. If market price is higher than the intrinsic value then
the ‘sell’ advice is given. In technical analysis, buy and sell signals are
based on the analysis of various chart patterns and market as well as
stock indicators. If stock prices are expected to rise in near future, a
buy signal is advised. If stock prices are expected to decline in near
future a sell signal is given.
(vii) Where to Invest vs. When to invest : Fundamental analysis answers
the question - Is this the right security to invest or Where to invest?
Hence using fundamental analysis, one can identify the securities
which are worth investing. Technical analysis is useful in timing the
market i.e. When to buy or sell? Hence fundamental and technical
analysis are not mutually exclusive. They are complementary and a
wise investment decision requires both - i.e. the right kind of securities
and right time of investment.
(viii) Time horizon : Fundamental analysis determines intrinsic value of
a share and hence the investment decisions based on fundamental
analysis is done for a relatively longer period. Technical analysis is
used to predict stock prices in near future. Hence technical analysis
is useful in short term investment making such as traders.
(ix) Emphasis : In case of fundamental analysis, the emphasis is on the
economic, industry and company fundamentals. It is not driven by
market forces or investor behaviour. Hence the intrinsic value of
a share will change only if there is a change in these fundamental
factors. Technical analysis, on the other hand, is based on market
movement of prices as determined by demand and supply forces.
Hence investors’ behaviour does affect technical analysis. In recent
times it has been shown that in stock market, investors do not behave
rationally. Investors are irrational and are subject to a number of
behavioural biases such as- overconfidence, regret avoidance, loss
aversion etc. Hence a new area of research in finance i.e. Behavioural
Finance has recently been developed.
(x) Who uses : Fundamental analysis is used primarily by long term
investors whereas technical analysis is used primarily by speculators
or short term traders in the market.
As explained above there are many points of differences between funda-
mental analysis and technical analysis. These two approaches of security
valuation are fundamentally different. But it does not mean that fundamental
and technical analysis are mutually exclusive. They are complementary as
a wise investment decision requires both - i.e. the right kind of securities
and right time of investment. Fundamental analysis helps in identification
of the right type of securities i.e. securities having higher real worth or
intrinsic value than the market price. Technical analysis supplements fun-
damental analysis in terms of timing the market. It can be used wisely to
decide about the right time to buy or sell.
6.3 Basic Tenets (Propositions) of Technical Analysis

Technical analysis is based on certain tenets, premises or propositions.
Technicians do not consider value in the sense in which fundamentalists use
it. The technicians believe that forces of demand and supply are reflected
in the patterns of price and volume trading. By examination of these pat-
terns they predict whether prices will move up or down. Thus technicians
231 tools of technical analysis Para 6.4
believe that price fluctuations reflect logical and emotional forces. The
basic tenets or premises of technical analysis are-
1. The price of a security is determined by the demand and supply
forces operating in a market.
2. Prices tend to move in trends over long term. This long term trend
sets the direction of market prices.
3. Price fluctuations reflect logical and emotional forces.
4. Price movements, whatever their cause, once in force persist for
some period of time and can be detected.
5. The trends in security prices may reverse due to shift in demand and
supply.
6. The changes in demand and supply can be predicted well in advance
with the help of charts and technical tools.
Hence the real task of a Technical analyst is to
i. Identify the trend and
ii. Recognize when one trend comes to an end and prices start
moving in the opposite direction.
For this, technical analyst uses a number of charts, patterns and technical
indicators which are discussed below. It must be noted that charts are the
basic tools for technical analysis.
6.4 Tools of Technical Analysis

Technical analysis can be performed both at the market level and at in-
dividual company level using various types of charts, ratios, patterns or
indicators. Here we will examine market indicators and individual stock
indicators separately.
6.4.1 Charts
Charts are the basic tools for performing technical analysis. It provides a
visual assistance to the technical analyst in detecting evolving and changing
patterns of price behaviour. Charts may be of various types such as Line
chart, Bar chart, Point and Figure Chart and Candlestick chart. It must be
noted that charts are useful both in the analysis of individual securities
as well as market movement analysis. On a particular day, the price of a
share varies many times. It is difficult to plot all the prices prevailing for a
particular stock on a particular day. Therefore generally the following four
prices are of interest to an investor- Open, High, Low and Close.
Open Price : Open price is the price at which the trading on a share starts
on a particular day.
High price : High price is the highest price at which the share has been
traded on a particular day.
Low price: Low price is the lowest price at which the share has been traded
on a particular day.
Close price: Close price is the price at which trading on a share closes on
a particular day.
There are various types of charts which are used in technical analysis.
i. Line chart
ii. Bar chart
iii. Bar chart of prices with volume
iv. Point and figure chart
v. Candlestick chart
These charts are explained below:
i. Line Chart : On a line chart X axis shows the time or number of
days/week. On Y axis stock prices are shown. On a line chart only
closing prices of a stock are shown. They are connected with each
other successively with straight lines as shown in Fig 6.1. The stock
prices on five days are Rs. 14,15,14,17 and 12.

Fig 6.1 – Line Chart
Although line chart is convenient to draw, it does not reveal anything about
the intraday volatility of the stock price. It shows only the closing prices
and not other prices such as high price, low price or open price.
233 Tools of technical analysis Para 6.4
ii. Bar Chart:

A ‘Bar chart’ shows high, low and closing prices of a stock every day.
Open price of a day is generally equal to the close price of the previous
day. Hence it is generally not shown on a bar chart. But if required
one can also show open price of the share in a bar chart. On a bar
chart X axis show time while Y axis shows stock prices. The length
of the bar shows the range of price i.e. the highest price minus lowest
price, in a particular day and hence if bar lengths increase overtime,
it may be regarded as a signal of increasing stock volatility. One bar
is placed every day and closing and opening prices may be depicted
with some signs such as – or X. In Fig 6.2 a bar chart is shown using
the stock price data given in the following table.
Day High Low Close
1 15 6 14
2 17 9 15
3 19 12 14
4 18 16 17
5 14 10 12
Fig 6.2 : Bar Chart
iii. Point and Figure Chart

It is a chart made up of X and O’s. X is placed for increase and O
for decrease in stock price. A buy signal is implied when X lines are
moving up after every O line. If O lines are going down after every
X line then a sell signal is triggered. In this chart the axis do not

Fig 6.3 : Point and Figure Chart


represent time or price level, rather they just show the directional
movement of prices irrespective of the quantity of change.

E.g. A stock’s price over the past 30 days is recorded as Rs. 20, 25,
28, 26, 25, 35, 37, 40, 42, 38, 35, 37, 39, 41, 34, 28, 25, 37, 40, 38, 36, 34,
36, 39, 41, 45, 43, 42, 40, 38.
The point and figure chart will appear as shown in Fig 6.3 :

Price
change

Fig 6.3 : Point and Figure Chart
It must be noted that whenever there is a change in price X or O are

placed. The columns are changed when there is a change in direc-
tion i.e. from increasing prices if the price starts declining then we
switched to second column and indicator O. After that the price starts
increasing therefore we shifted to third column and put X signs for
every increase.
The main advantage of such a chart pattern is that it can compress
large volumes of data in a small group which can be used in analysis.
iv. Candlesticks Charts
As the name suggests this chart type shows a candle for every day
price movements. It is a chart pattern which shows four prices – open,
close, high and low. If close price is lower than open price then the
box is filled with black colour otherwise left empty. An increasingly
dark candlesticks are bearish indicators. On X axis we measure time
and on Y axis we measure stock prices. This chart pattern provides
a bird’s eye view as to the movement of stock prices – both intraday
and inter day.
In Fig. 6.4, candlesticks are shown for the following 5 days.

Day Open High Low Close
1 16 20 6 14
2 12 17 9 15
3 16 19 12 14
4 20 23 16 17
5 11 14 10 12

Fig 6.4 : Candlesticks Chart pattern
v. Price and Volume Chart: Price –volume chart shows the high, low and
close price of a share along with its volume in the same chart. The
utility of this chart is that it provides information about the volume
of trading regarding that share besides showing the relevant prices.
Price and volume chart for the data given in the following table can
be depicted as shown in Fig 6.5.
Day Volume
(in 000) High Low Close
1 10000 20 6 14
2 11000 17 9 15
3 15000 19 12 14
4 14000 23 16 17
5 17000 14 10 12

Fig 6.5 : Price- Volume Chart
6.4.2 Technical Indicators and Technical Chart Patterns

A number of technical indicators and chart patterns are used by technical
analysts. Some important indicators and chart patterns are discussed blow:
Market indicators : Market indicators are charts, or trends which provide
the general direction of the market. It covers the following theories or
indicators.
Dow Theory : Charles Dow, the grandfather of technical analysis,
1.
propounded what is popularly known as Dow theory now. Dow theory
is based on the assumption that stock market does not move on ran-
dom basis rather there are set trends which can detect the direction
of market movement. According to this theory in any type of market;
whether bullish or bearish, three trends are simultaneously at work -
the primary trend, the intermediate trend and the minor trend.
i. Primary trend is the long term trend over a period lasting
for more than one year. This trend sets the overall direction
of the market. If primary trend is upward then bull market is
in operation whereas if primary trend is downward then the
market is bearish.
ii. Intermediate trend, on the other hand lasts for a few months
and operate in the opposite direction of primary trend. If
the primary trend is upward then intermediate trend will be
downward movement and vice versa. Therefore intermediate
trends are also known as “secondary corrections”.
iii. Tertiary or minor trends are day-to-day or intra-day fluctua-

tions in stock market which do not last for long. These trends
provide no meaningful conclusion regarding the overall market
movement and hence are given least importance.

Bull Market : As per Dow theory a bull market is in operation when
successive high points are higher than the previous high and succes-
sive low points are also higher than the previous low point. This can

be understood with the help of Fig. 6.6.
As shown in Fig. 6.6 one can easily make out that the primary trend
is upward moving. The intermediate trend is the period of decline

in this bull market. Therefore during bull market, it is good time to
buy during secondary corrections i.e. the periods of decline which
do not last for long. By doing so the investor would be able to buy at
low prices and in the long term he can expect increase in stock prices
due to bull market. Minor trends are day to day fluctuations in stock

market index and are of no use in deciding about the investment.

Primary Trend
Price
Secondary Trend
Time
Fig 6.6 : Bull Market (Dow Theory)
Bear Market : As per Dow theory a bull market is in operation when

successive high points are lower than the previous lows and suc-
cessive low points are also lower than the previous low point. This
can be understood with the help of Fig. 6.7. Here, primary trend is
downward sloping. The intermediate trend is the period of increase
Fig 6.7 : Bear Market ( Declining Trend)

in this bear market. Here also it is termed as Secondary correction.

Therefore in a bear market, the right time to sell is during the periods
of intermediate corrections.

Secondary
Price
Trend
Primary Trend
Time
Fig 6.7: Bear Market (Dow Theory)
2. Elliott Wave theory:

A related theory is Elliott wave theory, which is a variant of Dow
theory. As per Elliott wave theory stock prices can be described by
a set of wave patterns – long term, short term and minor waves.
Long term waves carry the entire market up or down while short
term wave move in the opposite direction. Minor waves are daily
fluctuations in the market and can be ignored by investors.
Elliott proposed that prices move in repetitive patterns, which he
termed as “waves”. According to him, these waves are caused by inves-
tors’ reaction to external factors or predominant market psychology
prevalent at the time. Moreover, prices move in sets of trends and
corrections. Based on unique characteristics of the wave patterns,
he identified:
1. Impulsive wave - A wave which goes with the main trend and
always shows five waves in its pattern. It shows the main di-
rection of prices.
2. Corrective wave - A wave which moves against the trend. It is
the sideways movement in the prices.
The Elliott Wave Theory categorizes the waves from largest to small-
est as follows:
Grand Supercycle, Supercycle, Cycle, Primary, Intermediate, Minor,
Minute, Minuette, Sub-Minuette.
Key Points

u Every action is followed by a reaction.
u Five waves move in the direction of the main trend, followed
by three corrective waves (a 5-3 move).
u A 5-3 move completes a cycle.
u This 5-3 move then becomes two sub-divisions of the next
higher 5-3 wave.
u The underlying 5-3 pattern remains constant, though the time
span of each may vary.
5
3 B
4 A
1
C
Fig 6.8 A 5-3 wave pattern in Bull Market (Elliott Wave Theory)
3. Moving Average Analysis

Moving average is a statistical technique to find out average of a
series on rolling basis. Moving average is an important indicator or
tool in technical analysis. Moving average can be used to analyse the
movement of the entire market as well as individual stock prices. 200
days or 53 weeks moving averages are most popular in the analysis
of overall market trend. The 200 days moving average is one of the
most reliable and easily understandable technical indicators available
to technical analysts and investors.
A 200 day moving average is calculated as follows – first of all the
stock prices are added for first 200 days and then divided by 200 so
as to calculate simple average of these 200 stock prices. This average
is kept at the middle i.e. 100.5th day. Next we drop first stock price
and take one more stock price from below and calculate average
stock price of these 200 observations. The average is then centered

at 101.5th day. Similarly we calculate average on moving basis and
put it in the centre. Next we take average of these averages by taking
two values at a time. Such averages are again centered. Hence first
moving average will be written against 101th day, second moving
average against 102th day and so on.
Calculation of moving average using odd number is easy, say 53
weeks moving average. In this case the average of first 53 weeks
stock prices is centered against 27th day which is the central most
day as 26 days are before this and 26 days are after this. Next we
drop first week and add one more week from the series bow. Then
we calculate average of these 53 weeks and center it at 28th day. This
goes on until we have the last 53 weeks observations. Beyond this
point it is not possible to calculate average of 53 data points.
Moving
average line is compared with index line (or stock price line)
to identify buy or sell signals (or market price line). Two basic rules

are-
Fig 6.8 : Moving Average Chart
i. When the market price line cuts the moving average line from

below it is a buy signal.
ii. If the market price line cuts the moving average line from
above, it implies that bearish trend will soon set in. Hence it is
regarded as a ‘Sell’ signal. This is shown in Fig 6.8
Stock
price MA Line

Sell
Buy
Stock price
line
Time
Fig 6.9 : Moving Average Chart
Illustration 6.1 : Following are the daily closing index values of CNX NIFTY
over the past 30 days. Calculate 7 Days moving average and 4 Days Moving
average and depict the moving average line and index line on a line chart.
Day Index value Day Index value

1 7000 16 8150
2 7200 17 8000
3 6900 18 7960
4 7100 19 7865
5 7400 20 7764
6 7500 21 7653
7 7700 22 7539
8 6900 23 7500
9 7300 24 7498
10 7600 25 7640
11 7700 26 7780
12 7800 27 7642
13 8000 28 7534
14 8120 29 7432
15 8200 30 7325
Solution : 7-Days and 4-Days moving averages are calculated below:
Day Index 7 Days 4 days Day Index 7 Days 4 Days
value MA MA value MA MA
1 7000 16 8150 8042.143 8097.5
2 7200 17 8000 8008.429 8035.625
3 6900 7100 18 7960 7941.714 7945.5
4 7100 7257.143 7187.5 19 7865 7847.286 7853.875
5 7400 7242.857 7325 20 7764 7754.429 7757.875
6 7500 7257.143 7400 21 7653 7682.714 7659.625
7 7700 7357.143 7362.5 22 7539 7637 7580.75
8 6900 7442.857 7362.5 23 7500 7624.857 7545.875
9 7300 7500 7375 24 7498 7607.429 7574.375
10 7600 7571.429 7487.5 25 7640 7590.429 7622.25
11 7700 7631.429 7687.5 26 7780 7575.143 7644.5
12 7800 7817.143 7840 27 7642 7550.143 7623
13 8000 7938.571 7967.5 28 7534 7540.125
14 8120 7995.714 8073.75 29 7432
15 8200 8032.857 8117.5 30 7325
Fig 6.9A : Moving average (MA)- 7 days Moving Average and Index
Fig 6.9B- 4 days Moving average
“Joseph E Granville* has listed the following 8 basic rules using 200
days moving average.
*Fisher and Jordan - Security analysis and Portfolio Management, PHI.

1. If the 200 days moving average line flattens out following a

previous decline, or is advancing, and the price of the stock
penetrates that average line on the upside, this comprises a
major buying signal.
2. If the price of the stock falls below the 200 days moving average
price while the average line is still rising, this is also considered
to be a buying opportunity.
3. If the stock price is above 200 days moving average line and
is declining towards that line, fails to go through and starts to
turn up again, this is a buying signal.
4. If the stock price falls too fast under the declining 200 days
moving average line, it is entitled to an advance back towards
the average line and the stock can be bought for this short
term technical rise.
5. If the 200 days moving average line flattens out following a pre-
vious rise, or is declining, and the price of the stock penetrates
that average line on the downside, this comprises a major sell
signal.
6. If the price of the stock rises above the 200 days moving average
price while the average line is still falling, this is also considered
to be a selling opportunity.
7. If the stock price is below 200 days moving average line and
is advancing towards that line, fails to go through and starts
to turn down again, this is a selling signal.
8. If the stock price rises too fast above the advancing 200 days
moving average line, it is entitled to a fall back towards the
average line and the stock can be sold for this short term
technical reaction.”
4. Market Breadth Analysis
Market breadth is the spread between the number of stocks that
advance and decline in price. For example if on a particular day
300 stocks advance in prices while 200 stocks decline in prices, then
market breadth will be 300 – 200 = 100. One can calculate cumu-
lative breadth and if it is increasing, it signals a bullish market and
vice versa. In Table 6.1 cumulative breadth is continuously rising
and hence it suggests the presence of Bullish market in future as
per Market breadth analysis.
Another way to analyse market breadth is calculating advance-decline

ratio. It is computed by dividing the number of advancing shares by the
number of declining shares. It compares the number of stocks that closed
higher against the number of stocks that closed lower than their previous
day’s closing prices.
No . of stocks advancing
Advance-Decline Ratio =
No . of stocks declining
Advance decline ratio greater than 1 (Positive market breadth) denotes
more stocks in the index have shown positive price movement whereas
advance decline ratio less than 1 (Negative market breadth) implies more
stocks had negative price movement in the index.
Table 6.1 : Market Breadth Analysis
Day Advances Declines Market Breadth Cumulative Breadth

1 300 200 100 100
2 350 220 130 230
3 300 50 250 480
4 320 170 150 630
5 270 160 110 740
5. Confidence Index
Confidence index as the name suggests, provides information as to
how confident are investors about the market performance. Barron’s
confidence index is calculated as the ratio of average yield on 10 top
rated corporate bonds divided by average yield on 10 intermediate
grade corporate bonds. Higher values of confidence index suggest
bullish nature of the market. This ratio will always be below 1 because
yield of top rated bonds cannot exceed those on low grade bonds.
Average Yield on Top 10 rated bonds
Confidence Index =
Average Yield on 10 intermediate rated bonds
6. Odd lot theory
Odd lot is trading in shares in smaller quantity than the market lot size.
Small investors buy and sell shares in odd lots. As per odd lot theory,
small investors are generally wrong especially before a change in the
direction of market. It implies that small investors buy heavily just
at the peak of the market and sell in huge quantities at the bottom
of the market. Therefore contrarian view is that one should trade
in the opposite direction of that of small investors. For this odd lot
ratio is calculated as below :
245 Specific stock indicators Para 6.5
Odd lot purchases

Odd lot ratio =
Odd lot sales
If the ratio is greater than 1 and continuously increasing then it im-
plies that market will turn bearish in near future.
6.5 Specific Stock Indicators

A number of indicators, chart patterns are used to identify buy and sell
signals on individual stocks. These are explained below :
(a) Support and Resistance Level
Support and resistance levels can be identified both for the market
index as well as individual stocks. Support level is that price, below
which the price is not expected to fall. Resistance level is that price,
above which the price does not go. For example assume that the
price of SBI share starts to decline whenever it reaches Rs. 3000
and it starts to rise whenever it approaches Rs 2000. The SBI share
price have been moving in the range of Rs. 2000 to Rs. 3000 for
long. Then Rs 2000 may be considered as its Support level (or sup-
port price) and Rs. 3000 as its Resistance level(or resistance price).
Hence if a stock’s price approaches its support level, it is a good buy
opportunity. If a stock’s price reaches its resistance level, it provides
a good opportunity to sell. For example if the support and resistance
price of SBI share is Rs. 2000 and Rs. 3000 respectively, then it is
expected that SBI share price will generally lie between Rs. 2000 and
Rs. 3000. If SBI share price reaches Rs. 2000, it is considered as a
good opportunity to buy. On the other hand if SBI share price reaches
Rs. 3000, it is considered to be a good opportunity to sell SBI share.
If stock price breaches its support level, it indicates a bearish trend
for the stock price. In that case, stock price is further expected to
decline. On the other hand is stock price breaches the Resistance
level, it indicates a bullish phase for the stock and stock price is ex-
pected to rise further. Fig 6.9 shows the formation of Support and
Resistance level.
Two important points about Support and Resistance Levels are
i. Support and Resistance levels indicate the Lower and Upper
limit respectively, within which stock prices are expected to
move. However these limits do not remain constant overtime.
They may change. In a bull market the support and resistance
levels may be revised upwards. In a bear market these levels
may be revised downward.
ii. Support and Resistance levels does not imply that stock price
cannot move beyond these levels. Stock price may breach
support and resistance levels. If the stock price goes beyond
Fig 6.9 : Support and Resistance Level
resistance level, it suggests a strong move in upward direction
and hence the future stock prices are predicted to be higher. It
provides a good opportunity to buy. On the other hand if the
stock price goes below support level, it suggests a strong move

in downward direction and hence the future stock prices are
predicted to be lower. It provides a good opportunity to sell.

Price

Resistance Level

Support
Level
Time
Fig 6.10 – Support and Resistance level
(b) Relative Strength

In relative strength analysis we compare a stock’s performance over a
recent period to the market performance or other stocks in the same
industry. Relative strength ratio is the stock price divided by market
index. If the ratio increases overtime it shows relative strength of the
stock and hence profitable investment opportunity.
(c) Chart Patterns or Formations
(i) Double Bottom and Double Top
Double bottom Chart Pattern looks like “W” shape while double top
looks like M ‘shape’. Two bottoms show the support level for the stock
and hence provides a buy opportunity at the bottom. Two tops show
the resistance level and an opportunity to sell. Fig 6.10 shows Double
Top and Fig 6.10A shows Double Bottom chart patterns.
Fig 6.10 : Double Top

Price
T1 T2
Resistance
Level

Fig 6.10A : Double Bottom
Time
Fig 6.11: Double Top

Price

B1 B2 Support Level
Time
Fig 6.11A: Double bottom
(ii) Higher Top, Higher Bottom

It is featured by a series of higher highs and higher lows. The stock con-
secutively reaches a high which higher than the previous high as so on.
It shows a continuous formation of higher top and higher bottom. Such
a stock is in uptrend. It is advisable to opt a ‘Buy on dip’ strategy because
there is optimism that the stock may rise further.
Price
Higher Top
Higher Bottom
Time
Fig 6.12: Higher Top Higher Bottom
(iii) Lower Top, Lower Bottom

It is featured by a series of lower highs & lower lows. The stock consecu-
tively reaches a high which lower than the previous high as so on. Whereas,
it touches a ‘low price’ which is further below the previous low. It shows
a continuous formation of lower top and lower bottom. The stock is in
downtrend. It is advisable to “Sell on bounces” as pessimism will take the
stock further lower.
Price
Lower Top
Lower Bottom
Time
Fig 6.12A: Lower Top Lower Bottom

(iv) Head and Shoulder

Head and shoulder chart pattern is the most popular among all chart
patterns. At the end of a long term trend (especially a bull run) we
may find head and shoulder configuration. This pattern has a high
Fig 6.12 : Inverted Head and Shoulder
top i.e. head and two small tops on its either side i.e. shoulders. One

can draw a neckline by joining the bottom of the shoulders. If stock
price
goes below the neckline, it indicates bearish phase in near
future
and hence a sell signal to the short term investor. Fig 6.11
shows
Head and Shoulder chart pattern.
H

Price S2

S1
Time
Fig 6.13: Head and shoulder
(v) Inverted Head and Shoulder

It is just the reverse of head and shoulder configuration. Inverted head
& shoulder pattern is shown in Fig 6.14. Inverted head and shoulder
chart pattern has an inverted head and two inverted shoulders. If
stock price rises above the neckline, it indicates bullish phase for the
stock in near future and hence provides a ‘buy signal’.
Fig 6.11: Head and Shoulder


Price

S2
S1
H
Time
Fig 6.14: inverted Head and Shoulder
(vi) Triangles
Triangle patterns can also be detected in stock price charts. Tri-
angle patterns can be of three types – symmetrical, ascending and
descending triangle. Symmetrical triangle suggests a range bound
market till it is complete. When ascending triangle breaks towards
above, it suggests bull run in near future and hence a buy signal. If
descending triangle breaks towards below, it implies price decline in
near future and hence suggests a ‘sell signal’. Triangles are shown in
Fig 6.15, 6.15A and 6.15B.
Fig 6.13 : Symmetrical Triangle


Price
Fig 6.13A : Ascending Triangle

Time
Fig. 6.15 : SYMMETRICAL TRIANGLE
Price
Time
Fig. 6.15A : ASCENDING TRIANGLE
Price
Time
Fig. 6.15B : DESCENDING TRIANGLE
(vii) Flags :
A flag chart pattern is detected when a bull rally or bear phase enters
into a consolidation pattern which appears as a rectangle or paral-
lelogram. The consolidation phase forms the ‘flag’ for a continuing
trend. It is predicted that after the consolidation phase is over, the
stock price will move in the same direction in which they were moving
before the formation of flag pattern.
Price
Time
Fig. 6.16 : Bullish Flag Pattern

253 Limitations of Technical analysis Para 6.6
(d) Volume Indicator

All the chart patterns and indicators discussed so far, used only past
price data for stocks. However stock’s past volume data also provides
useful insights into its short term price movement and hence can be
used in predicting stock prices. Researchers have observed that –
 Rising volume in bullish market is further bullish.
 Declining volume in bullish market suggests that market will
turn bearish in near future.
 Rising volume in bearish market farther strengthens the bearish
trend.
 Declining volume in bearish market suggests that market will
turn bullish in near future.
6.6 Limitations of Technical analysis

Technical analysis is an important approach of security valuation, as it
helps in identifying the timing of buy or sell decision. It is based on a variety
of tools, techniques and trend analysis. Technical analysis is based on the
analysis of past price and volume data. However it suffers from certain
limitations.
i. Requirement of Interpretational skills : Various charts and patterns
of technical analysis requires careful interpretation by skilled ana-
lysts. Hence technical tools and indicators may not be used widely
by common investors.
ii. Subjective analysis and Behavioural biases : Technical analysts, are
subject to many behavioural biases while interpreting various chart
patterns and predicting future stock prices based on the analysis of
past price data. Some of these behavioural biases are- over-confi-
dence, framing, regret avoidance and so on.
iii. Late response to a chart pattern : Once a chart pattern is detected,
it needs to be acted upon immediately. Hence the technical analyst
must be a quick identifier of a chart pattern to make gains out of it.
In practice, such a quickness or promptness is rarely observed.
iv. Short term perspective : The perspective of a chartist is short term
and hence long term predictions are generally not based on technical
tools and techniques. For long term analysis, fundamental analysis
is a better approach to find out the real worth of a share.
Technical analysis 254
Which is superior? - Technical analysis or Fundamental analysis

There has always been a debate between fundamental analysts and tech-
nical analysts to show their supremacy. It must be noted that Fundamental
analysis and Technical analysis are not mutually exclusive. They are comple-
mentary. Technical analysis complements fundamental analysis to identify
the right time to buy or sell the security which is suggested by fundamental
analysis. While fundamental analysis calculates the intrinsic value of a share
using EIC framework, technical analysis predicts future price movements
using past price and volume data. The perspective in case of Fundamental
analysis is long term while in case of Technical analysis, short term. Hence
Fundamental analysis is considered superior to Technical analysis when
an investor has a long term investment horizon. Technical analysis on the
other hand is preferred by short term traders and speculators.
Summary
1. Technical analysis is based on the premise that history repeats itself.
2. As per technical analysis, future prices can be predicted on the basis of past
price and volume data.
3. Technical analysis is primarily based on charts and hence technical analysts
are also termed as ‘chartists’.
4. Dow theory states that at any point of time three trends work in a market-
primary trend, secondary or intermediate trend and Minor trend.
5. Primary trend is the long term trend that takes the entire market up or down.
6. Secondary or intermediate trend works in the opposite direction. Hence in
an up market or bull market, it is the period of decline in prices.
7. Minor trends are day to day fluctuation and hence are not very useful in
predicting the direction of the market.
8. There are various types of charts such as Line chart, Bar chart, Point and
Figure chart, Candlestick Chart.
9. Technical analysis is based on a number of tools and techniques.
10. Moving average analysis is used to identify the direction of the market and
to identify buy and sell signals.
11. A number of chart patterns can be detected by using past prices such as
Head and Shoulder, Inverted head and shoulder, Double Top, Double Bottom,
Triangle, Flags etc.
12. Technical analysis is used primarily by short term traders and speculators in
stock market.
255 Test Yourself
Test Yourself
True/False
i. There is no difference between fundamental analysis and technical analysis.
ii. Technical analysis uses past price data to predict future prices.
iii. As per Dow theory bull market is in operation when successive highs and
lows are lower than previous highs and lows respectively.
iv. Intermediate trend is the long term trend in stock market.
v. Intermediate trend in a bear market is upward sloping.
vi. When the stock price crosses and goes down the neckline of a head and
shoulder pattern, a further decline in price is expected in near future.
vii. Moving average analysis is used to identify the direction and buy or sell signals.
viii. A dark candle shows that closing price was higher than the open price.
ix. Market breadth is the difference between number of stocks that increase in
prices and number of stocks that decline in prices.
x. When stock price approaches support price, it is a good opportunity to buy.
xi. Minor trends are very important in predicting market condition.
Ans. i. F ii. T iii. F iv. F v. T vi. T vii T viii F ix T x. T xi. F
Theory Questions
1. What is technical analysis? What are its basic tenets? [Para 6.1, 6.3]
2. What is the difference between fundamental analysis and technical analy-
sis? (B.Com (H) DU 2012) [Para 6.2]
3. Explain Technical analysis. How is it different from fundamental analysis?
(B.Com (H) DU 2009, 2010, 2013) [Para 6.1, 6.2]
4. Explain various types of charts used by technical analysts to predict future
price behaviour. (B.Com (H) DU 2014) [Para 6.4.1]
5. Explain Dow theory. Explain its relevance in analysis of securities.
(B.Com (H) DU 2008) [Para 6.4.2]
6. “A technical analyst is primarily a trend analysis”. Comment [Paras 6.1, 6.4.2]
7. Write short notes on the following
i. Point and Figure Chart (B.Com (H) DU 2013) [Para 6.4.1]
ii. Support and Resistance Level (B.Com (H) DU 2011, 2012, 2013)
[Para 6.4.2]
iii. Head and Shoulder chart pattern [Para 6.4.2]
iv. Double Top pattern [Para 6.4.2]
Technical analysis 256
v. Double Bottom Pattern [Para 6.4.2]

vi. Odd lot theory [Para 6.4.2]
8. Differentiate between the following
i. Support and Resistance level [Para 6.4.2]
ii. Bar chart and Candlestick Chart [Para 6.4.1]
iii. Primary trend and Secondary trend [Para 6.4.2]
iv. Market breadth and Moving Average [Para 6.4.2]
v. Bart chart and Point and Figure chart [Para 6.4.1]
vi. Double Top and Head and Shoulder chart pattern [Para 6.4.2]
9. Calculate 9 weeks Moving average from the following data about past prices
of a share. Show the share price line as well as moving average line in a graph.
Week Stock price Week Stock price

1 700 16 810
2 726 17 800
3 690 18 960
4 710 19 865
5 740 20 764
6 750 21 653
7 770 22 739
8 690 23 700
9 730 24 748
10 760 25 760
11 770 26 780
12 780 27 742
13 800 28 534
14 812 29 432
15 820 30 735
10. What do you understand by technical analysis? Explain various mathematical
techniques used in technical analysis. (B.Com.(H), GGSIPU, 2015)
11. Write short notes on: (B.Com.(H), GGSIPU, 2016)
a. Technical analysis
b. Charting techniques
12. Fundamental analysis and technical analysis are complementary approaches
in taking trading positions or making investment decisions. Explain the state-
ment with an example of how you will use the two to buy a script.
(B.Com.(H), GGSIPU, 2017)
257 Project work
Project work
Go to any financial website such as www.yahoofinance.com or www.nseindia.
com and download daily price data for a company of your choice for the past six
months. The price data should comprise of the following
i. Open price
ii. High price
iii. Low price
iv. Close price
Prepare:
a. A bar chart using the stock price data.
b. A candlestick chart using the price data
c. A line chart using closing prices of the share.
d. Which of the following chart patterns you can identify in your line chart
i. Head and shoulder ii. Inverted head and shoulder iii. Double top iv
Double bottom v. Triangle vi. Flags
e. Calculate 25 days moving average of the closing prices of the share. Plot
the moving average line and stock price line in a graph. Identify various
buy and sell signals.
f. Assume that you buy a share as per buy signal and sell as per sell signal.
Will you be able to earn profits. Show all calculations assuming that you
have Rs. 10000 to invest.
7 EFFICIENT MARKET HYPOTHESIS
C H A P T E R
leaRninG oUTcomes
 Understand the concept of Efficient Market Hypothesis(EMH)
 Understand the basic idea behind the notion of EMH
 Explain Random Walk Theory/hypothesis
 Specify different levels or forms of market efficiency
 Specify the implications of efficient market hypothesis
 Explain various tests for weak form of market efficiency
 Explain various tests for semi strong form of market efficiency
 Explain various tests for strong form of market efficiency
 Analyze the role of portfolio management in an efficient market.
There are three approaches to security valuation- Fundamental analysis,

Technical analysis and Efficient Market Hypothesis. Chapter 5 discussed
about Fundamental Analysis, while Technical analysis was the subject matter
of Chapter 6. This chapter explains the third approach to security valuation
i.e. Efficient Market Hypothesis popularly known as EMH.
The previous two approaches to security valuation viz. fundamental analysis
and technical analysis explain the process of calculating intrinsic value on
the basis of financial information or predict stock price movement on the
basis of past price and volume data. Both these approaches can be used to
advise a prospective investor as to which securities to buy and when to buy.
The third approach to security valuation viz. Efficient Market Hypothesis
258
259 Efficient Market Hypothesis Para 7.2
takes a different view. An efficient stock market is one in which the price
for any given stock effectively represents the true intrinsic value or fair price
of the stock. Hence any time is a good time to buy or sell.
Behaviour of stock prices has always been an interesting area of research
for analysts and academicians. Maurice Kendall (1953) studied stock price
behaviour overtime and found no predictable pattern in stock prices.
Prices seem to evolve randomly. Randomness in stock prices implies that
prices increase or decrease only in response to new information which is
unpredictable.
7.1 Random Walk Theory (RWT)

Random walk theory(or hypothesis) is based on the premise that stock
prices follow a random walk i.e. the successive price changes are random
and unpredictable. In other words it implies that successive price changes
are unrelated or independent of each other. Hence one cannot predict to-
morrow’s price on the basis of today’s or yesterday’s price or past prices.
However randomness in price changes does not imply market irrationality.
If prices are determined rationally then only the new information will cause
them to change. In fact a random walk would always be the natural result
of prices that always reflect full current information. Indeed, if stock prices
are predictable that shows market inefficiency and investors irrationality.
The random walk model can be given below :
Pt = Pt–1+ et
where Pt = Price in period t
Pt-1 = Price in period t-1
et = A random term which is unpredictable
\ Change in price
DP = et
7.2 Efficient Market Hypothesis

Random Walk Theory or Hypothesis presented above shows that stock prices
follow a random walk. Hence changes in stock prices cannot be predicted.
Efficient market hypothesis implies that security prices reflect all available
information and adjust rapidly to the inflow of new information. Hence
security prices will change only in case of inflow of ‘new’ information. Since
the inflow of ‘new’ information is unpredictable, security price changes
cannot be predicted. If new information happens to be good, then security
prices will adjust upward immediately and if the new information happens
to be bad then the security prices will adjust downward instantaneously.
Para 7.3 Efficient market hypothesis 260
Hence market efficiency is also concerned with the speed of adjustment of

security prices to new information. The notion that stock prices fully reflect
all available information is referred to as efficient market hypothesis. An
efficient market is one in which :
- Stock prices already reflect all available information and
- Stock prices adjust rapidly(instantly) to the infusion of new infor-
mation.
The basic idea behind EMH is that investors are rational and demand and
supply forces prevailing in the capital market are such that the prevailing
market price happens to be the true worth or intrinsic value or fair price
of the security. Hence at any given point of time, security prices reflect
all available information and a change will occur only if something ‘new’
happens. It must be noted that the concept of market efficiency here is
concerned with informational efficiency only. The other two types of market
efficiency are – operational efficiency and allocation efficiency. EMH is not
concerned with the operational or allocation efficiency of the market. Market
efficiency requires free flow of information to all the market participants
at the same point of time. If there is information asymmetry then security
prices will not adjust rapidly in case of new information.
7.3 Forms of Market Efficiency

Fama (1970) provided three levels or forms of market efficiency viz. weak
form, semi strong form and strong form. This classification is based on the
different meanings of the term “all available information”.
7.3.1 Weak Form Hypothesis

In weak form of market efficiency, security prices fully reflect all past pric-
es and volume information. This version of market efficiency implies that
trend analysis is useless – one cannot predict tomorrow’s price on the basis
of previous prices. Hence it is based on the premise that “stock prices have
no memory”. Further, successive price changes are statistically indepen-
dent and hence stock prices follow a random walk and are non-stationary.
A stationary time series implies mean reverting nature of the variable i.e.
the mean and variance of the series remains constant overtime. Random
Walk theory, as explained above, is another manifestation of weak form
of market efficiency. Let us take an example, if a technical analysts finds
that the price changes over the past many days are strongly positively
related, as the coefficient of correlation is high and positive, then he may
predict future price based on past price data. In this case, market is not
weak form efficient.
261 Forms of market efficiency Para 7.3
Implications of Weak form of Market Efficiency

(1) If the market is efficient in weak form then technical analysis becomes
a useless exercise. It is not possible to predict future price movements
on the basis of past price and volume data.
(2) Investors may still outperform the market and analyse stocks using
fundamental analysis. Therefore publicly available information such
as financial statements, company reports and announcements of
important events can be used to earn profits in stock market.
(3) Stock prices behave in a random way i.e. prices follow a random
walk.
7.3.2 Semi Strong Form

This is the second level or form of market efficiency. In semi strong form
of market efficiency, security prices reflect not only past prices and volume
information but also all publicly available information i.e. all financial and
operating information. This includes earnings announcements, announce-
ments of dividends, bonus issue, stock splits, mergers and acquisition and
any other information which is in public domain. Since security prices are
already adjusted for all publicly available information, one cannot outper-
form the market using such information. It implies that besides technical
analysis, even fundamental analysis becomes a fruitless exercise in semi-
strong efficient market. Let us take an example, A company announces
bonus issue on 1st January, 2015. The stock price behaviour of the company
around ± 10 days provide significantly higher abnormal returns for this
stock. It indicates that the market is not immediately adjusting for the new
information regarding bonus issue as 10 days is a long time for the adjust-
ment of security prices. Hence the market is not semi strong form efficient.
Implications of Semi-Strong form Market Efficiency
(1) If the market is efficient in semi-strong form then besides technical
analysis, fundamental analysis also becomes useless. The market price
of a security is always equal to its intrinsic value as can be calculated
using past prices as well as publicly available information.
(2) Only those investors or traders can outperform the market and earn
superior returns who have access to inside or private information.
(3) Any news, good or bad, once made public will have an immediate
effect on stock prices. Hence such a news cannot be used to earn
superior returns.
7.3.3 Strong Form of Market Efficiency

This is the highest level of market efficiency. In strong form of market
efficiency, security prices reflect all information be it public or private (i.e.
inside information). It means that no one, not even insiders can consistently
beat the market or earn superior returns. All information about the security
is already discounted and reflected in its price. It is only the inflow of ‘new’
information that can change security prices.
Strong form
Semi strong form
Weak Form
Fig 7.1 Forms/Levels of Market Efficiency
7.4 Implications of EMH

One of the important implications of efficient market hypothesis is that no
one can outperform the market on consistent basis over long term. This is
because security prices anytime reflect their true intrinsic value/fair price.
However short term fluctuations or adjustments may provide some gains to
some of the investors at times. Further, since there is random walk in stock
prices, technical analysis as well as fundamental analysis become useless.
Therefore one cannot yield superior returns on the basis of trend analysis
(or technical analysis) or fundamental analysis(Economy-Industry-Company
Analysis). Since security prices fully reflect all available information, anytime
is a good time to buy or sell. The best investment strategy in an efficient
market is ‘Passive Investment Strategy’ rather than ‘Active Management’.
Passive management implies investment in market portfolio or index funds
which does not require analysis of individual securities for selection in
263 Tests of Market efficiency Para 7.5
portfolio. The investor can invest in market index and earn market return
at market risk. Active management i.e. analyzing individual securities for
stock selection, building up optional portfolio and portfolio rebalancing
does not yield any superior gains in an efficient market.
It must be noted that Passive Management Strategy does not mean that
all investors have to assume same amount of risk and earn same return
i.e. market return. Investors can combine this Passive Portfolio i.e. market
portfolio with risk free asset to suit their risk-return preferences.
Role of Portfolio Management in Efficient Market

It must be noted that portfolio management does not become a redundant
exercise in efficient market. There is still a role for rational portfolio man-
agement even in efficient market. The specific roles of portfolio managers
in an efficient market include the following :
(i) Building up diversified portfolios : Portfolio managers need to
ensure efficient diversification to eliminate firm specific risks.
(ii) Tax considerations : Different types of securities are subject to differ-
ent tax rates and different investors also fall in different income tax
slabs. Therefore there is a need to build a portfolio which maximizes
tax benefits to the investor. Portfolio managers can bridge this gap
in efficient markets.
(iii) Building portfolio as per Investors’ Risk Profile : Different inves-
tors have different risk profiles. Some are more risk averse (such
as elderly and retired investors), while others are less risk averse
(such as young and salaried investors). There is a need to suggest
portfolio as per investors risk profile which suits the best considering
his risk-return preferences. For example an all equity portfolio may
not suit the requirements of a retired person who wants stability in
income.
7.5 Tests of Market efficiency

A plethora of studies have examined various forms of market efficiency
in different stock markets across the globe. Tests for market efficiency
depends upon which level/form of market efficiency one want to test for.
Therefore these tests have been presented in different heads as per weak
form, semi strong form and strong form of market efficiency.
1. Tests of weak form of market efficiency
A number of statistical tests and techniques are being used by the
researchers to test whether the market is weak form efficiency or
not. The basic idea here is to check whether the stock prices follow
a random walk i.e. whether successive price changes are unrelated
and independent.
(i) Serial Correlation test (or autocorrelation test)
This test checks for the presence of serial correlation or autocor-
relation in the stock return series. Serial correlation measures
the degree of association between returns in a given period
with those in the previous period. Positive serial correlation
means that positive returns tend to follow positive returns and
negative returns tend to follow negative returns. Jegadeesh
and Titman (1993)1 found a momentum effect in short run
over a period of 3 months to 12 months. They found good or
bad performance of particular stocks continues overtime. Past
winners tend to be future winners and past losers tend to be
future losers. Therefore a strategy in which investor selects to
buy past winners and sell past losers yield abnormal return in
stock market.
DeBondt and Thaler (1985)2 reported the evidence of negative
serial correlation in return series over long run (3 to 5 years).
Thus past winners tend to become future losers whereas past
losers turn into future winners. Therefore the investment
strategy that buys loser stocks and sells winner stocks can
yield abnormal returns over long run of 3 to 5 years. This re-
turn reversal is attributed to investors’ over-reaction in stock
market. Over-reaction effect implies that investors tend to
over-react to both good news (and hence good performing
stocks become over-priced) as well as bad news (and hence
bad performing stocks become under priced). Contrarians in-
vestment strategy works well in the long run. In India Tripathi
and Aggarwal (2010)3 documented to presence of asymmetric
over-reaction effect in Indian stock market. Indian investors
tend to over-react to good news but under react to bad news.
The presence of serial correlation or auto-correlation in return
series implies that the market is weak form inefficient.
(ii) Filter rules
Weak form of market efficiency requires that the investment
strategies based on past price or volume data (i.e. technical
1. Jegadeesh N & Titman S (1993), “Returns to Buying winners and Selling Losers : Implications
for stock market” Efficiency Journal of Finance 48(1), 65-91.
2. De Bondt W. & Thaler, R (1985) “Does stock Market overreact”? Journal of Finance, 40(3), 793-805
3. Tripathi V. & Aggarwal S. (2009) “over-reaction effect in Indian Stock Market” Asian Journal
of Business and Accounting vol.
265 Tests of market efficiency Para 7.5
analysis) cannot generate above normal returns over a long

term. Therefore filter rules test can be performed to check
whether market is weak form efficient or not. A filter rule is a
filter, usually a percentage which is used by the trader to initi-
ate a buy or sell decision. Normally the prices of stocks move
within a given range i.e. support and resistance level. On the
basis of this range the filter is decided. For example if a stock’s
price generally moves in the range of Rs. 20 to Rs. 40, then a
10% filter rule may be applied. It means that so long as the
price remains within ± 10% of the lower and upper price level,
no action would be initiated. But when the price goes beyond
this ± 10%, an action to buy or sell the stock is initiated. In this
case the trader will not do anything so long as the stock price
remains in the range of 20 to 22. Once it crosses 22, the trader
will buy the stock. On the other hand the trader will not do
anything if the stock price falls from 40 to 36.
But once it declines below 36, the trader should sell the stock.
This way a number of ‘Buy’ and ‘Sell’ signals are generated
using filter rules. If these filters provide the investor with above
normal returns, then it implies that the market is not weak
form efficient.
(iii) Runs Test
Runs test can be used to check whether successive price
changes are random or predictable. A run is an uninterrupted
sequence of price movements in the same direction. For ex-
ample the price series 20, 22, 23, 25 has only one run because
prices are moving only in the upward direction. On the other
hand price series 20, 22, 23, 21, 20 has two runs – one upto
23 and then decline upto 20. Similarly one can determine the
actual number of runs (R) in a given price series of a stock.
Then the actual number of runs can be compared with mean
( )
or expected number of runs R to check whether the two are
significantly different or not.
2. Tests of Semi-Strong Form of Market Efficiency
Tests of semi-strong form of market efficiency are based on Event
Study Methodology and tests of various market anomalies.
(i) Event Study Methodology : This can be used to check the
announcement effects of earnings, dividends, mergers, bonus
issue, stock splits etc. on stock prices and returns. The date
of such an announcement is regarded as the ‘event day’ and
returns are examined over a period prior to and after the

‘event day’. Normally a test window of ± 30 days is applied.
If significant abnormal returns are generated over the period
surrounding the event date, then the market is considered to
be semi-strong form efficient.
(ii) Tests for Market Anomalies : Over the past three decades a
number of researchers have reported the presence of various
CAPM anomalies such as size effect P/E effect, value effect,
neglected firm effect etc. Size effect implies that small sized
stocks out-perform large capitalization stocks in long term.
Sehgal and Tripathi (2005)4 reported the presence of a strong
size effect in Indian Stock market with a monthly size premium
of around 3.8%.
Value effect or book to market ratio effect is the tendency of
value stocks or stocks with high book value to market value
ratio to out-perform growth stocks (or Glamour stocks) or
stocks with lower book value to market value ratio. Researchers
have found strong evidence of both size and value effects in
U.S. and other developed markets. This motivated Fama and
French (1996)5 to suggest ‘Multifactor Asset Pricing Model’ in
place of single factor CAPM. However in emerging markets
including India, there is a weak and conditional value effect
(Sehgal and Tripathi 2007)6. Price Earnings Effect implies that
stocks with low P/E ratio tend to out-perform those with high
P/E ratio. Neglected firm effect is the tendency of neglected
stocks (i.e. the stocks which receive least media coverage, and
are ignored by security analysts) to out-perform the stocks
which are widely researched.
Besides above, a number of other anomalies such as seasonality
effect, turn of the year effect, turn of the month effect, holiday
effect, day of the week effect etc. have also been documented
for developed as well as developing markets.
The presence of these effects or market anomalies casts doubts
on semi-strong form of market efficiency in these markets
because investors can exploit these effects to earn superior
returns.
4. Sehgal S & Tripathi V (2005) “Size Effect in Indian Stock Market : Some Empirical Evidence”,
Vision-Journal of Business Perspective.
5. Fame E & French (1996) “Multi-factor Explanations of Asset Pricing Anomalies” Journal of
Finance 51(1), 55-84.
6. Sehgal S. & Tripathi V. (2007) “Value Effect in Indian Stock Market” Journal of Applied Finance,
13(1), 23-36.
267 Summary
It has been widely accepted that once an anomaly is detected,

it gets disappeared over a period as arbitrage opportunities
arise and everybody in the market wants to take advantage of
the anomaly. This behaviour restores equilibrium and wipes
out the anomaly.
3. Tests of Strong Form
Although the presence of strong form of market efficiency is a
rare phenomenon even in mature and developed markets, the
researchers do test for it. One way to test whether the market
is strong form efficient or not is to examine the return patterns
and trading behaviour of corporate management, insiders,
stock market specialists and mutual funds or large institutional
investors. All these investors are expected to have access to
superior amount of information and analysis skills which is not
generally available in public domain. If these sets of people are
able to generate significantly higher returns than the market
or general investors, one can conclude that the market is not
strong form efficient.
Summary
1. Random walk theory implies that stock prices follow a random walk. Suc-
cessive price changes are independent and unpredictable.
2. Efficient Market Hypothesis (EMH) implies that security prices reflect fully
all available information and adjust rapidly to the inflow of new information.
3. EMH is concerned with informational efficiency of the market.
4. There are three forms of market efficiency - weak form, semi strong form
and strong form.
5. In weak form of market efficiency security prices reflect all past price and
volume information.
6. Technical analysis is of no use in a weak form efficient market.
7. One can make superior profits by using fundamental analysis in a market
which is weak form efficient.
8. In semi strong form of market efficiency security prices reflect all past price
and volume information as well as all publicly available information.
9. Both fundamental analysis and technical analysis are of no use in case of
semi strong form efficient market.
10. In strong form of market efficiency security prices reflect all past price and
volume information, all publicly available information as well as all inside
information.
Efficient market hypothesis 268
11. In an efficient market it is not possible to earn consistently abnormal returns

or outperform the market.
12. Passive management is the best strategy in an efficient market.
13. Tests for weak form of efficiency include - serial correlation test, filter rules
and runs test.
14. Tests for semi strong form of market efficiency include event study methods
and detection of market anomalies.
15. Strong form of market efficiency can be tested by analyzing the return pat-
terns of mutual funds and corporate insiders.
Test Yourself
True/False
i. Random walk theory implies that stock prices are predictable.
ii. Efficient market hypothesis implies that security prices reflect fully all avail-
able information and adjust rapidly to the inflow of new information.
iii. EMH is concerned with informational efficiency as well as allocational effi-
ciency of the market.
iv. There are three forms of market efficiency - weak form, semi strong form
and strong form.
v. In weak form of market efficiency security prices reflect all past price and
volume information as well as all publicly available information.
vi. Fundamental analysis is of no use in a weak form efficient market.
vii. One can make superior profits by using fundamental analysis in a strong
form efficient market.
viii. In an efficient market it is possible to earn consistently abnormal returns or
outperform the market.
ix. Passive management is the best strategy in an efficient market.
x. Serial correlation test is a test for strong form of market efficiency.
Ans: i. F ii. T iii. F iv. T v. F vi. F vii. F viii. F ix. T x. F
Theory Questions
1. What do you mean by “Efficient Markets”? Explain. [Para 7.2]
2. What is Efficient Market Hypothesis (EMH)? What are the forms of market
efficiency? [Paras 7.2 & 7.3]
3. Explain the Efficient market hypothesis and three forms of market efficiency.
What is the basic idea behind the efficient market hypothesis?
(B.Com (H)DU 2010, 2012, 2014) [Paras 7.2 & 7.3]
4. What is Random Walk Theory? Explain. [Para 7.1]
269 Project work
4A. “Randomness in stock prices is an evidence of market irrationality”. Do you

agree? Elaborate. [Para 7.1]
5. Explain weak form of market efficiency. What are its implications?
[Para 7.3.1]
6. How can one test for weak form of market efficiency? Explain. [Para 7.3.1]
7. What is semi-strong form of market efficiency? What are its implications?
[Para 7.3.2]
8. What are the tests available for testing semi-strong form of market effi-
ciency? [Para 7.3.2]
9. Explain strong form of market efficiency. What are its implications? How can
it be tested? [Para 7.3.3]
10. “Portfolio Management becomes a redundant exercise in efficient markets”.
Do you agree? Justify your answer. [Para 7.4]
(i) Filter Rules [Para 7.3.1]
(ii) Size Effect [Para 7.3.2]
(iii) Runs Test [Para 7.3.1]
(iv) Serial correlation [Para 7.3.1]
(v) Overreaction Effect [Para 7.3.2]
12. A company announces bonus issue on 1st January, 2014. The stock price
behaviour of the company around ± 7 days provide significantly higher ab-
normal returns for this stock. What does it indicate towards the efficiency
of market? [Para 7.3.2]
13. The concept of a random walk in stock prices is bizarre and implies totally
irrational behaviour by the investing public. Nothing could be farther from
the truth than random walk. Prices are related to fundamental economic
worth. Comment. (B.Com.(H), GGSIPU, 2016)
14. What is efficient market hypothesis? What are its different forms? How do
we measure the efficiency of markets? (B.Com.(H), GGSIPU, 2017)
Project work
Market efficiency have been tested by many researchers around the globe since its
development by Fama (1970). Can you prepare a list –decade wise- about a few of
such research studies. What have been the prominent research studies in Indian
stock market in the context of market efficiency? Explain the outcome of any one
such research work.
8 VALUATION OF EQUITY SHARES
C H A P T E R
learninG outcoMes
 Explain peculiar features of an equity share
 Explain various models for equity valuation
 Determine intrinsic value of an equity share using dividend dis-
count model
 Calculate value of a share using Earnings multiplier Model
 Calculate required rate of return from an equity share using CAPM
Two broad categories of investments in financial assets or securities are –

Fixed income securities (primarily bonds) and Variable income securities
(primarily equity shares). Valuation of securities is an important aspect
of investment process. As discussed in Chapter 1 the Investment process
comprises of the following steps – analysis of securities in terms of risk and
return, constructing portfolios and managing and revising portfolios after
performance evaluation. Valuation of bonds or other fixed income securities
have been dealt in Chapter 4. The subject matter of the present Chapter is
valuation of variable income security i.e. equity shares.
Valuation of any asset provides its true value or worth. An investor is
always interested in knowing the intrinsic value or fair price of a security
before taking any investment decision. Therefore the valuation of securities
becomes an integral part of security analysis and portfolio management.
Valuation of a security can be based on accounting information (such as Book
Value or Liquidation Value) or on the basis of Discounted Cash Flow Value
(DCF). In finance, valuation of an asset is always based on the discounted
270
271 Peculiar features of Equity shares Para 8.1
value of all expected future cash flows from the asset. Such a valuation
concept very well considers time value of money and the underlying risk of
the security which is ignored by accounting based measures such as book
value or liquidation value (replacement value).
Valuation of fixed income securities is rather easy because of the certainty of
future cash inflows in the form of interests and redemption value. However
valuation of equity shares or common stocks requires sophisticated analysis
of related financial information so that reasonable forecasts about expected
future cash flows can be made. Because of variable and uncertain income
on equity shares, their valuation is not so straight-forward.
8.1 Peculiar features of Equity shares

Before proceeding further with the valuation of equity shares we must
understand the peculiar features of equity shares which make them dif-
ferent from fixed income securities:
Variability and uncertainty of income : The revenue income in case
1.
of bonds or debentures is fixed in terms of coupon rate. Irrespective
of the profitability of the company, these incomes are always received
by the bondholder. However revenue income in the form of dividend
on equity shares is not fixed in advance. Further there is no obligation
on the part of the company to pay dividends every year. It is purely
based on the dividend policy and profitability of the company. Hence
dividends on equity shares are variable and not fixed and may not
be regular as well. Therefore an investor needs to forecast dividends
using historical and expected data and information.
No time to Maturity : Equity shareholders are the owners of the
2.
company. There is no finite term for which equity shares are issued.
This is in contrast with the bonds which are redeemable after a
specified period.
No redemption price : In case of bonds the investor gets redemption
3.
price at the time of its maturity. However in case of equity shares there
is no such redemption value as equity shares are not to be redeemed
throughout the life of the company. Since business is considered to
be going concern entity, the life of an equity share is not finite but
infinite.
Related with growth and earnings of the company : valuation of
4.
bonds is not directly related with earnings of the company. This is
because irrespective of the earnings of the company, bond holders
will get a fixed interest income and redemption value at maturity.
They do not “ share” the profits or losses of the company. On the other
Para 8.2 Valuation of equity shares 272
hand, the market prices of equity shares are very much related with
the earnings of the company as equity shares represent ownership
claims over the assets of the company. High growth and earnings of
the company increase the amount of expected future cash inflows
in the form of dividends or higher prices. Hence market price of the
shares will increase. On the other hand, declining profitability and
low growth is associated with lower values for equity shares.
8.2 Valuation of Equity share

As explained earlier the intrinsic value of an asset is the present value of
future cash inflows from it. In the case of equity shares which are not sold
after a specified period, the future cash inflows are in the form of dividends
only. It may not always be easy to estimate such future cash inflows with
confidence and therefore a variety of methods have been evolved to address
to the issue of equity valuation. These methods can be classified as :
I. Discounted Cash Flow Models (DCF Models) or Dividend Discount
Models (DDM)
II. P/E Ratio Models.
III. Capital Asset Pricing Model
8.2.1 Discounted Cash Flow Models/Dividend Discount Models

As the name suggests, these models calculate the value of an equity share
as the total present value of all future expected cash inflows. The present
value is calculated using some appropriate discount rate or required rate
of return on equity (Ke). This is the minimum required rate of return from
the viewpoint of the prospective investor. The intrinsic value of the share
is also termed as its theoretical value of fair price. It must be noted that
the intrinsic value of the equity share implies “What the price should be”
and NOT “What the price actually is”. The actual market price may be
different from intrinsic value of the share giving rise to investible oppor-
tunities. If market price is lower than the intrinsic value of a share then
the share is undervalued or underpriced in the market. Such a share is a
good buy. Hence an investor should invest in a share for which intrinsic
value > market price.
On the other hand if market price is higher than the intrinsic value of a share
then the share is overvalued or overpriced in the market. Such a share is
a not a good buy. Hence an investor should not invest in a share for which
intrinsic value < market price. Rather if an investor already holds such a
share, it should be immediately sold.
273 Valuation of equity share Para 8.2
There can be two cases under DCF technique for valuation of an equity
share:
(a) When holding period is pre decided or finite
An investor may decide to hold the share for a specified period of
time and hence would be selling it at some price at the end of his
investment period. For the sake of simplicity here we can assume
that the expected dividends every year and selling price at the end
of holding period can be estimated in advance.
(i) One year holding period
When an investor wants to hold the share only for one year and
tries to determine its fair price, he needs to make an estimate
of the year-end dividend and selling price. Given these two,
the fair value can be calculated by using discounting rate (i.e.
required rate of return from equity shares).
The formula for equity valuation when we know the year end
dividend and selling price is :
D + P1

P0 = 1 ………………………………………………..(8.1)
1 + Ke
where P0 = Present value of share (fair price)
D1 = Expected year end dividend
P1 = Expected year end selling price
Ke = The required rate of return from equity investment
Illustration 8.1 : An investor wants to invest in the equity shares of XYZ
Ltd. for one year. The company is expected to declare a dividend of Rs. 2
per share at the year end. Further a leading security analyst has projected
the year end target price of this company’s shares as Rs.120. Do you think
the stock is a good buy at a price of Rs.100 now. Assume that the required
rate of return is 10%.
Solution : We are given D1 = Rs.2
P1 = Rs.120
Ke = 10%
D +P
\ P0 = 1 1
1 + Ke
2 + 120
=
1 + 0.10
122
= = rs.110.9 = rs.111
1.1
Therefore the fair price of this equity share is Rs.111. The investor should
buy it at the current price of Rs.100.
(ii) Multiple Years Holding Period
The above formula given in (8.1) can be extended to the case
of multiple years holding period. In such a case we need to
calculate the total of present value of all expected future div-
idends and at the end of the holding period expected selling
price. The formula is:
n
Dt Pn
P0 = ∑
+ ……………………………………….(8.2)
t =1 (1 + K ) ( )
t n
3 1 + K e
where P0 = Present value of share

Dt = Expected dividend in year t
Ke = The required rate of return from equity investment
Pn = Expected selling price at the end of year n.
n = holding period in years
If dividends are constant we can use present value annuity
factor. In such a case Equation (8.2) can be written as:
Po = D(PVFAKe n) + Pn (PVFKe n)………………………………(8.2A)
Illustration 8.2 : An investor wants to invest in the equity shares of XYZ
Ltd. for five years. The company is expected to declare a dividend of Rs. 2
per share at the end of every year for five years. Further a leading security
analyst has projected the expected price of this company’s shares after five
years would be Rs.150. Do you think the stock is a good buy at a price of
Rs.110 now. Assume that the required rate of return is 10%.
Solution : We are given D1= D2 = D3= D4 = D5 = Rs.2
P5 = Rs.150
Ke = 10%
\ P0 = 2 (PVFA10% 5) + 150 (PVF10% 5)
= 2(3.791) + 150(0.621)
= 7.582 + 93.150
= 100.73
Therefore the fair price of this equity share is Rs. 100.73. The investor
should not buy it at the current price of Rs.110.
(b) Dividend Capitalisation Model [also referred to as Dividend Discount

Model (DDM)]
In real life there is no definite holding period of common stocks (or
shares) and given the ‘going concern’ concept of a perpetual com-
pany we may assume that the life of equity shares is also infinite
or perpetual. Since holding period is not defined we do not make
an estimate of the expected selling price. Rather in such a case the
shares are valued on the basis of expected dividends throughout the
life of the company/equity shares. This makes the series of expected
dividends infinite. Hence the future cash inflows from equity shares
is nothing but an infinite stream of dividends. We need to calculate
their total present value to arrive at the intrinsic value or fair price of
the share. However dividends may or may not be same throughout,
due to various reasons such as, growth of company, market condi-
tions, investment requirements or change in dividend policy. It may
be expected that the dividends are constant as the company follows
a constant rupee dividend policy or they are growing at a constant
rate or they are fluctuating or having multiple growth rates.
Depending upon growth forecasts we may have four such cases:
(i) No growth in dividends (Constant Rupee Dividends)
When the company is expected to provide same amount of
rupee dividend year after year, it is said to have been follow-
ing a constant dividend policy. In such a case the investor will
receive same amount of dividend every year for an infinite
period. Hence this becomes a perpetuity. Therefore the present
value of dividends for such an infinite period will be calculated
as below :
D1 D2 D3
P0 = + + −−−∞
(1 + K ) (1 + K ) (1 + K )
1 2 3
e e e
Since D1 = D2 = D3 = D & so on
D1 D1 D1
P0 = 1 + K + + −−−∞
(1 + K e ) (1 + K e )
2 3
e
D1 /1 + K e D1
P0 = =
1 Ke
1−
1 + Ke
\ Intrinsic Value is P0 = D1 …………………………………………(8.3)

Ke
(ii) Constant growth rate in dividends

It is hard to assume in reality that the company will follow
constant rupee dividend policy throughout its life. In reality,
majority of the companies provide for growing dividends. If
we assume that dividends would grow at a constant rate (g)
forever, we would have the following stream of dividend
Year Dividend
1 D1
2 D1 (1 + g)
3 D1 (1 + g)2
4 D1 (1+g)3
: :
: :
a
a
This series will continue upto infinity. Now in order to calculate
intrinsic value, we need to calculate present values of all these
dividends. Therefore
D1 D (1 + g ) D1 (1 + g )

P0 = + 1 + −−−∞
1 + K e (1 + K e )2 (1 + K e )3
D1 /1 + K e

P0 =
1 − (1 + g ) /1 + K e
D1
Hence Intrinsic value is P0 = ……………………….(8.4)
Ke − g
where P0 = Intrinsic value or fair price or theoretical price
D1 = expected dividend at the end of year 1
g = Constant growth rate in dividend
Ke = Required rate of return on equity
If you recall equation (8.4) is same as the formula of Gordon’s
Model as given below :
e1 (1 − b)
Po = …………………………………………………..(8.4A)
Ke − g
Here E1 = Expected EPS
b = Retention ratio. Hence (1-b) is dividend payout ratio.
Therefore E1(1-b) = D1
g = Constant growth rate in dividend

Ke = Required rate of return on equity
Illustration 8.3 : An investor wants to invest in an equity share of PKN Ltd.
The company’s last EPS was Rs. 50 per share and dividend payout ratio is
40%. The required rate of return from equity investment is 20%. Calculate
the intrinsic value of equity share if :
(i) there is no growth in dividends
(ii) Dividends are expected to grow at a constant rate of 18% p.a.
Solution : We are given that EPS = Rs. 50
Dividend = 40%
Therefore the last dividend is D0 = 40% of 50
D0 = Rs.20
(i) When there is no growth in dividend then the last year’s dividend
will continue forever
\ D0 = D1 = Rs. 20
D1
\ P0 =
Ke
20
P0 =
0.20
P0 = Rs. 100
The intrinsic value of this share is Rs. 100 when there is no growth
in dividends
(ii) When there is constant growth rate in dividends:
g = 18%
Therefore D1 = D0 (1 + g)
D1 = 20 (1 + 0.18)
D1 = 23.6
D1
\ P0 =
Ke − g
23.6
P0 =
0.20 − 0.18
P0 = Rs. 1180
Here the intrinsic value of the share is Rs. 1180 when there is a con-
stant growth at the rate of 18% in dividends.
Note : The intrinsic value of a growth company’s share is more than

that of a no-growth company (Why?). To answer this just look at the
stream of dividends that will accrue to an equity shareholder in both
the cases. In case of no growth, the stream of dividends is constant,
hence the shareholder is receiving Rs. 20 every year. However in case
of growing dividends he is receiving a higher cash inflow every year.
Hence the valuation of a growing dividends share is more than that
of a no growth share.
(iii) Multi period growth rate model
A more realistic assumption about growth in dividends is that div-
idends grow at a higher rate during a few years before assuming a
normal growth rate for the rest of its life. We may have two-stage
growth model wherein dividends grow at a higher rate (g1) for first
few years before growing at the normal rate (g) beyond that period.
In such a case the intrinsic value will be calculated as below :

 D1 D2 D n  D n (1 + g ) D n (1 + g )2 ......a(8.5)
P0 =  + − − −  + +
1 + K e (1 + K e ) (1 + K e )n  (1 + K e )n +1 (1 + K e )n + 2
2
 D D2 Dn  Dn (1 + g ) 1
P0 =  1
+ + − − + × ......(8.5A)
+ ( ) ( ) − ( )
2 n n
1 K 1 + K 1 + K  K g 1 + K
 e e e  e e
Here D1 = D0 (1 + g1 ) , D2 = D0 (1 + g1 ) & so on
2
where P0 = Intrinsic value of share

Dt = Dividend in year t
n = Number of years of abnormal growth rate
g1 = Growth rate for first few years
g = Normal growth rate i.e. constant forever beyond first
few years
Ke = Required rate of return
Similarly we can have 3-stage or 4-stage models depending upon the
number of growth rate forecasts.
Illustration 8.4 : LM Ltd.’s earnings and dividends have been growing at a
rate of 18% p.a. This growth rate is expected to continue for next 4 years and
thereafter growth rate is expected to decline to 6% p.a. forever. Calculate
the intrinsic value of share if required rate of return is 15% and dividend
which has been just paid for last year is Rs. 2.
Solution: It must be noted that annual dividends are paid after the close
of the accounting year. Therefore dividends just paid are D0 i.e. in the be-
ginning of the current year.
Now D0 = Rs. 2
and g1 = 18% p.a. for first four years
\ D1 = 2 (1 + 0.18) = Rs. 2.36
Similarly D2, D3 and D4 can be calculated.
Dividends for first 4 years are :
Div. PVF 15% N P.V. of Div.
D1 = 2 (1 + 0.18) = 2.36 0.869 2.05
D2 = 2 (1 + 0.18) = 2.78
2
0.756 2.10
D3 = 2 (1 + 0.18) = 3.29
3
0.657 2.16
D4 = 2 (1 + 0.18) = 3.88
4
0.572 2.22
Total = 8.53
Now we are given that g = 6% from 5th year onwards.
So, D5 = 3.88 (1 + 0.06) = Rs. 4.11
Therefore beyond 4th year we can apply constant growth valuation model
to estimate intrinsic value. For this we need D5 i.e the expected dividend
at the end of 5th year. Using D5 we get P4 i.e. the intrinsic value or price at
the end of 4th year. (Please see that in order to get Po we used D1)
D5
P4 =
Ke − g
Once the intrinsic value at the end of 4th year is calculated, we can calcu-
late its present value by discounting this intrinsic value at the appropriate
discount rate for 4 years.
Therefore P.V. of stream of dividend beyond 4th year will be calculated as
under (this is nothing but the present value of the intrinsic value at the
end of 4th Year or in the beginning of 5th Year). P.V of P4 is nothing but the
present value of the dividend stream beyond 4th year.
D5 1
Present value of P4 = K − g ×
(1 + Ke )
4
e
D5
= × PVF15%4
Ke − g
4.11
= × 0.572
0.15 − 0.06
= 26.14
Finally we calculate the Intrinsic Value of the share at present :

Intrinsic value of the share (Po) = P.V of dividends in 4 years + P.V. of P4
= 8.53 + 26.14
= Rs. 34.67
How to determine ‘g’ i.e. growth rate in dividends?

In the above valuation models using DDM we have used growth rate. Now
the question arises as to how to determine this growth rate which can be
used in the valuation model to get the intrinsic value of the share.
There are a variety of methods which can be used to calculate growth rate
in dividends which is used in valuation process.
(i) Past trend Analysis
One can obtain an average growth rate based on past data on divi-
dends. For example if a company paid a dividend of Rs. 2 in the year
2003 and Rs. 3.50 in the year 2013 then the growth rate in dividend
(g) would be :
3.82 = 2 (1+g)10
FVF10 years g = 1.791
g = 6%
(ii) Using Retention ratio(b) and Return on equity (ROE)
If you recall Gordon’s Model in the context of Dividends in your
Financial Management course, you will know that there you calcu-
lated growth rate using Retention ratio and Rate of Return earned
by the company on its equity investments (not the require rate of
return which is used as discount rate).
If ‘b’ is the retention ratio and ‘ROE’ is the return on equity then a
reasonable estimate of growth rate in dividends is
g = b × ROE……………………………………………………….(8.6)
It is assumed that a company retains earnings when it is able to earn an
internal return (ROE) greater than the required rate return on equity.
Hence the company has adequate profitable opportunities. This means
the company’s dividends would grow at the rate of b x ROE. In Gordon’s
model in the analysis of relationship between dividend payout and market
price of a share, we calculate growth rate using b ROE.
For example if a company earns 13% on its equity capital and reinvests
55% of that then the book equity will increase by 0.55 x 0.13 = 0.072. If we
assume that ‘ROE’ and ‘b’ are constant over the years then both earnings
and dividends shall grow at the rate of 7.2% p.a.
Valuation of a share which does not pay Dividends

There are a number of companies especially in the initial years of their
operation, which do not pay dividends. These companies reinvest all of
their earnings. Hence dividend discount models which require D1 cannot
be used here. In such a case EPS1 is used as a proxy for D1
ePs1
\ P0 =
Ke
This is the reason why earnings yield i.e. EPS1/P0 is generally used as a
proxy for cost of equity.
Illustration 8.5 : A company’s earnings are expected to grow at the rate of
18% p.a. for first four years. For the next 4 years the growth rate is expected
to be 12% p.a. Thereafter the company is expected to grow at the rate of
6% p.a. forever. The most recent EPS announced by the company is Rs. 4
and dividend payout ratio is 50%. Calculate intrinsic value of the share of
required rate of return is 15%.
Solution : Please note that EPS0 = 4 and D/P = 50%
\ D0 = 50% of 4= Rs. 2
Here we have three growth rates. Growth rate of 18% is applicable for first
four years, growth rate of 12% is applicable from years 5 to 8 and from
year 9, growth rate of 6% will be applicable for an infinite period of time.
Therefore intrinsic value of the share can be calculated as the sum total
of the P.V. of dividends in initial 8 years plus P.V. of the infinite stream of
dividends from 9th year onwards i.e. P.V. of P8.
D1 = 2 (1 + 0.18) i.e. D0 (1 + g1)
= 2.36
D2 = 2 (1 + 0.18)2
= 2.78
D3 = 2 (1 + 0.18)3
= 3.28
D4 = 2 (1 + 0.18)4
= 3.88
D5 = D4 (1 + g2)
= 3.88 (1 + 0.12)
= 4.35
D6 = 4.35 (1 + 0.12)
= 4.87
D7 = 4.87 (1 + 0.12)
= 5.45
D8 = 5.45 (1 + 0.12)
= 6.10
Year Div. PVF15% n P.V. of Div.
1 2.36 0.869 2.05
2 2.78 0.756 2.10
3 3.29 0.657 2.16
4 3.88 0.572 2.22
5 4.35 0.497 2.16
6 4.87 0.432 2.10
7 5.45 0.376 2.05
8 6.10 0.327 1.99
Total 16.83
Here we have three growth rates g1 = 18%, g2 = 12% & g3 = 6%
Further D9 = D8 (1 + g3)
= 6.10 (1 + 0.06)
= 6.47
D9
P.V. of P8 = × PVF15%8
Ke − g
6.47
= × PVf15%8
0.15 − 0.06
6.47
= × 0.327
0.15 − 0.06
= 23.51
Therefore
Po = P.V of Dividends in initial 8 years + P.V. of P8
PO = 16.83 + 23.51
= Rs. 40.34
We can directly calculate Po as under
6.47
Po = 16.83 + × PVf15%8
0.15 − 0.06
= 16.83 + 23.51
= Rs. 40.34
Walter’s Model for share Valuation:

It can be observed that the DDM under constant growth rate for dividends
is same as Gordon’s Model of share valuation. There is another model for
valuation of share known as Walter’s Model. Walter’s model assumes that
the value of an equity share is the sum total of the following two amounts
i. Present value of infinite stream of dividends and
ii. Present value of infinite stream of capital gains i.e. returns from
retained earnings.
The valuation formula under Walter’s Model is given in equation (8.7)
D (r / Ke )(E − D )
P= + ……………………………………………….(8.7)
Ke Ke
Where D = expected dividend per share
E = expected EPS
Ke = Required rate of return or equity capitalization rate
R = rate of return on equity
The underlying assumption under Walter’s model is that the EPS and div-
idends are same throughout the perpetual life of the company. As per this
model the share price depends upon the relationship between r and Ke as
well as the dividend payout ratio of the company.
When r> Ke share value will be maximum when dividend payout is 0%.
When r< Ke share value will be maximum when dividend payout is 100%
When r= Ke share value will be same irrespective of dividend payout.
Illustration 8.6 : TK Ltd has an expected EPS (Constant) of Rs. 10 and
equity capitalization rate is 10%. Calculate the value of the share if return
on equity is 12% and dividend payout ratio is (i) 0% (ii) 40% (iii) 100%. What
will be your answer if return on equity is 9%.
Solution : Using Walter’s Model we can have the following share prices.
When r = 12%
(i) Dividend payout is 0%
(0.12 / 0.10)(10)
P =
0.10
= 120
(ii) Dividend payout is 40%
4 + (0.12 / 0.10)(6)
P =
0.10
= 112
(iii) Dividend payout is 100%

10 + (0.12 / 0.10)(0)
P =
0.10
= 100
When r = 9%
(i) Dividend payout is 0%
(0.09 / 0.10)(10)
P =
0.10
= 90
(ii) Dividend payout is 40%
4 + (0.09 / 0.10)(6)
P =
0.10
= 94
(iii) Dividend payout is 100%
10 + (0.0.09 / 0.10)(0)
P =
0.10
= 100
Hence the value of the share is highest when dividend payout is 100%.
8.2.2 Earnings Multiplier Approach or Price-Earnings Model (P/E

based model) for share valuation
DCF model requires an estimation of future cash flows as well the required
rate of return on equity shares. Determination of required rate of return
may not be easy.
Hence we have an alternative model for determining the theoretical price,
true price or fair price of a share.
Fair price or intrinsic value can also be calculated on the basis of P/E mul-
tiplier. It must be noted that the actual P/E ratio varies every time when
there is change in price. The reported P/E ratio is calculated as below :
Current Price Per share
Reported P/E =
the Most recent ePs
It must be noted that reported P/E ratio is based on the most recent EPS.
This reported or actual P/E ratio is of no use in calculating the fair price
of the share. We need to have some expected or appropriate PE ratio to
arrive at fair price of the share
Fair Price = Expected (or standard) P/E x Expected EPS
There are three approaches for determining the expected/normal/standard
P/E ratio for a company.
(i) Average P/E ratio

In this approach one may calculate average P/E ratio of the company
using historical P/E ratios. When historical P/E ratios are not highly
fluctuating then mean may be used to calculate average otherwise
median P/E ratio is a good estimate of the expected P/E ratio. One
may also calculate range (lower and upper) of historical P/E ratios
to estimate the expected price range.
(ii) Using Regression Analysis
We may also relate a firm’s historical P/E ratios to market P/E ra-
tios overtime using time series regression analysis. The estimated
relationship will be in the form of :
PEi = 1 + b PEM
where PEi = P/E ratio of firm i
PEM = P/E ratio of market index
b = Slope coefficient
a = Intercept
e.g. PEi = 1.67 + 1.21 (PEM)
Now on the basis of market P/E ratio forecast one may arrive at the
firm’s P/E ratio. Let us assume that the market P/E ratio is expected
to be 15. Therefore the firm’s expected P/E ratio would be 19.82.
PEi = 1.67 + 1.21 (15)
PEi = 19.82
Now if the expected EPS of the company is Rs.10 then the expected
price per share would be Rs.198.20 (i.e. 19.82 x 10).
(iii) Relate P/E ratio of a company to its broad determinants
A number of research studies have been conducted to determine
the factors affecting P/E ratio of a company. These determinants
are growth in earnings, risk, dividend policy etc. (Whitebeck Kisor
Model). As per Whitbeck Kisor (1963) model the following relationship
is obtained :
P/E = 8.2 + 1.5 (Earnings growth rate) + 0.067 (D/P ratio) – 0.20
(S.D. in growth rate)
As per this model, higher growth, higher dividend and lower risk
leads to higher P/E ratio.
Illustration 8.7 : The expected EPS of a company for the current year is
Rs. 6. In the industry the standard P/E ratio is 13 to 15. The company is
in high growth stage. What is the best estimate of company’s share price?
Should the share be purchased?
Solution : Since the company is in growth stage we can assume that the
appropriate P/E ratio is 15.
Therefore
Share price = 15 x 6
= Rs. 90
If the actual market price is lower than Rs. 90, then the share should be
purchased.
Illustration 8.8 : You are given the following information about a company.
The most recent EPS = Rs. 1.89
Annual growth rate in earnings which will remain forever = 6%
Dividend payout ratio = 50%
Required rate of return = 10%
After five years the expected P/E ratio is 12.5. Calculate
(i) The intrinsic value of share at present.
(ii) The expected selling price of the share at the end of 5th year
(iii) The maximum price at which an investor should buy this share.
Solution : (i) Here we calculate the intrinsic value of the share irrespective
of the given holding period using Constant growth model.
Given E0 = 1.89, g = 6%, Ke = 10%, dividend payout ratio = 0.50,
e1 (1 − b)
P0 =
Ke − g
P0 = (1.89)(1.06)(1 − 0.50)
0.10 − 0.06
P0 = 25.04
Therefore the intrinsic value is Rs. 25.04
(ii) The expected P/E ratio at the end of year 5 = 12.5
Expected Selling Price at the end of year 5 is calculated below:
P5 = (P/E) . EPS6
P5 = (12.5) . (1.89) (1 + 0.06)6
P5 = 33.45
Please note that in order to calculate P5 we need to consider earnings

at the end of 6th year because end of year 5 means beginning of year
6.
(iii) The maximum price an investor will be willing to pay would be the
intrinsic value of this share, i.e. Rs. 25.04.
This can be verified even if the holding period is 5 years.
Here we need to calculate present value of all expected cash inflows over
the investment period of 5 years as below:
Given that E0 1.89, Dividend payout = 50%
\ D0 = 50% of 1.89
= 0.945
D1 = D0 (1 + g)= 0.945 (1 + 0.06) = 1.00
D2 = D0 (1 + g)2 = 0.945 (1 + 0.06)2 = 1.06
D3 = D0 (1 + g)3 = 0.945 (1 + 0.06)3 = 1.12
D4 = D0 (1 + g)4 = 0.945 (1 + 0.06)4 = 1.19
D5 = D0 (1 + g)5 = 0.945 (1 + 0.06)5 = 1.26
Year Div PVF10% P.V. of Div.
1 1.00 0.909 0.909
2 1.06 0.826 0.876
3 1.12 0.751 0.844
4 1.19 0.683 0.813
5 1.26 0.621 0.783
Total 4.225
Expected Selling Price at the end of year 5 is calculated below:
P5 = (P/E) . EPS6
P5 = (12.5) . (1.89) (1 + 0.06)6
P5 = 33.45
33.45
P.V. of P5 =
(1 + 0.10)5
= 20.78
Therefore P0 = P.V. of Dividends for five years + P.V. of expected selling price
P0 = 4.225 + 20.78
P0 = 25.005
Therefore the fair price of the share is Rs. 25.005. This would be the max-
imum price at which an investor would buy this share.
8.2.3 Capital Asset Pricing Model (CAPM)

So far we used valuation methods assuming some pre-determined required
rate of return on equity. However it is not easy to make an estimate of the
required rate of return. Sharpe (1965) developed capital asset pricing model
(CAPM) to provide an estimate of the required return on a security based
on its systematic risk. Details about this model are provided in Chapter 9.
Here we will only discuss its application in equity valuation. The capital
asset pricing model provides that there is a linear and direct relationship
between return on a security and its systematic risk. This model can be used
to determine the required rate of return on a security. This required rate
of return can then be used in the valuation model discussed under DDM.
The capital asset pricing model is given below :
E(Ri) = Rf + (ERM) – Rf) bi……………………………………………………(8.8)
Where
E(Ri) = Expected return on security i
Rf = Risk free rate
E(Rm) = Expected return on market index
bi = Beta of security i
Expected Return = Risk Free Return + Risk Premium
Expected Return = Risk Free Return + [Market Risk Premium × Systematic
Risk Measure]
Using equation (8.8) an investor can calculate expected return on a security
or portfolio. This expected rate of return is nothing but the required rate
of return which is used as discount rate in the share valuation models.
Hence
Ke = Rf + (ERM) – Rf) bi …………………………………………(8.8A)
It must be noted that this approach assumes that markets are efficient
and in equilibrium.
It must be noted that if b is greater than 1, the security is termed as aggressive
security while when it is less than 1, the security is termed as a defensive
security. Aggressive stocks have higher risk and hence their required rate
of return will be higher than that of a defensive stocks.
289 Solved Problems
Illustration 8.9 : A company is expected to pay a dividend of Rs. 2 with

an expected growth rate of 6% p.a. The risk free rate is 4% and the return
on a broad market index is expected as 14%. Presently the company has
a beta of 1.2 but it is expected to increase to 1.5 due to some changes in
Govt. policies. Find out the present as well as the new value of share as
per CAPM model. Is the change in managerial policies beneficial for an
existing investor?
Solution : CAPM can be used to calculate expected return or Required rate
of return to be used in Valuation formula.
Ke = Rf + (ERM) – Rf) bi
When b = 1.2 (i.e. current beta)
Ke = 4 +(14-4)(1.2) = 16%
Value of share = D1/(Ke-g) = 2/(0.16-0.06) = Rs. 20
When b = 1.5 (i.e. new beta)
Ke = 4 +(14-4)(1.5) = 19%
Value of share = D1/(Ke-g) = 2/(0.19-0.06) = Rs. 15.38
Hence the change in Govt. policies has affected the value of the share
adversely.
Solved Problems
Problem 8.1 : A firm paid a dividend of Rs. 8 per share and the face value of
the share is Rs. 10. The dividend is expected to grow at 5% p.a. the company
belongs to a risk group for which equity capitalization is 12%.
(i) What is the intrinsic value of the share?
(ii) Would the value be different if risk class was 15%?
(B.Com (H) DU 2008)
Solution : (i) Here Do = Rs. 8, g = 5%, Ke = 12%
Therefore D1 = D0 (1 + g)
D1 = 8 (1 + 0.05)
D1 = 8.40
d1
\ P0 =
Ke − g
8.40
=
0.12 − 0.05
P0 = Rs. 120
Valuation of equity shares 290
The intrinsic value of the share is Rs. 120.

(ii) When Ke = 15%
D1
P0 =
Ke − g
8.40
=
0.15 − 0.05
P0 = Rs. 84
Yes the value will be different if risk class was 15%. The value becomes Rs. 84.
Problem 8.2 : Equity shares of Badarpur Gas Ltd. are currently selling at
Rs 60. The company is expected to pay a dividend of Rs. 3 after one year
with a growth rate of 8%. Find out the implied required rate of return for
equity investors. (B.Com (H) DU 2009)
Solution : Here P0 = Rs. 60, g = 8%, D1 = Rs. 3
As per constant growth model
D1
P0 =
Ke − g
Ke = D1/P0 + g
= 3/60 + 0.08
= 0.05 + 0.08 = 0.13 or 13%
Hence the implied required rate of return is 13%.
Problem 8.3 : A firm had paid a dividend at Rs. 2 per share last year. The
estimated growth of the dividends from the company is 5% p.a. Determine
the market price of the equity share given that the required rate of return
is 15.5%. What will be the estimated price if growth rate (i) rises to 8% (ii)
falls to 3%. (B.Com (H) DU 2009)
Solution : The present market price can be estimated using constant growth
model Ke = 15.5%, g = 5%, D0 = Rs. 2 hence D1 = 2(1.05) = 2.10
D1
P0 =
Ke − g
2.10
=
0.155 − 0.05
P0 = Rs. 20
Here the market price of the share is expected to be Rs.20.
(i) When g = 8% D1 = 2(1.08) = 2.16
D1
P0 =
Ke − g
291 Solved Problems
2.16
=
0.155 − 0.08
P0 = Rs. 28.80
(ii) When g = 3%, D1 = 2(1.03) = 2.06
d1
P0 =
Ke − g
2.06
=
0.155 − 0.03
Po = 16.48
Problem 8.4: The current market price of a share is Rs. 65 and it is expected
to be Rs. 90 after 1 year. Dividend expected after one year from now is
Rs. 2.90. Find out the equity capitalization rate.
(B.Com (H) DU 2014)
Solution : The equity capitalization rate is the discount rate or required
rate of return i.e. Ke.
We know that
d1 + P1
Po =
1 + Ke
2.90 + 90
65 =
1 + Ke
Solving for Ke we get that Ke = 0.429 or 42.9%.
Problem 8.5: A firm is currently paying a dividend of Rs. 2 per share. The
rate of dividend is expected to grow at 5% for first five years and 10%
thereafter. Find the value of the share if the required rate of return of the
investor is 15%.
(B.Com (H) DU 2011)
Solution : It must be noted that annual dividends are paid after the close
of the accounting year. Therefore dividends just paid are D0 i.e. in the
beginning of the current year.
Now D0 = Rs. 2
and g1 = 5% p.a. for first five years
\ D1 = 2 (1 + 0.05) = Rs. 2. 10
Similarly D2, D3 D4 C and D5 can be calculated.
Dividends for first 5 years are :
Div PVF (15% N) PV of Div

2.1 0.87 1.83
2.21 0.756 1.67
2.32 0.658 1.53
2.43 0.572 1.39
2.55 0.497 1.27
Total 7.69
Now we are given that g =10% from 6 year onwards.th
Therefore D6 = 2.55 (1 + 0.10) = Rs. 2.81

D6
Present value of P5 = K − g × PVF15%5
e
2.81
= × 0.497
0.15 − 0.10
= 27.88
= 7.69 + 27.88
= Rs. 35.57
Problem 8.6: Mr. Nanda wants to invest in a company that has just given a
current dividend of Rs. 3 per share. Dividends are expected to grow at 20%
for 10 years and at 8% thereafter perpetually. Find the value of the equity
share if the required rate of return of Mr. Nanda is 10%.
(B.Com (H) DU 2012)
Now D0 = Rs. 3
and g1 = 20% p.a. for 10 years
\ D1 = 3 (1 + 0.20) = Rs. 3.6
Similarly D2, D3 D4 etc. can be calculated.
Dividends for 10 years are :
3.6 0.909 3.27
4.32 0.826 3.57
293 Solved Problems

5.18 0.751 3.89
6.22 0.683 4.24
7.46 0.621 4.63
8.95 0.564 5.04
10.75 0.513 5.51
12.89 0.467 6.02
15.48 0.424 6.56
18.57 0.386 7.17
Total 49.90
Now we are given that g =8 % from 11th year onwards.
D11 = 18.57 (1 + 0.08) = Rs. 20.06
D11
Present value of P10 = × PVF10%10
Ke − g
20.06
= × 0.386
0.10 − 0.08
= 1003 × 0.386
= 387.16
= 49.9 +387.16
= Rs. 437.09
Problem 8.7 : Mr. Shukla wants to invest in a company that has just given
a current dividend of Rs. 5 per share. Dividends are expected to grow at
10% for 5 years, at 8% for next 3 years and at 5% thereafter perpetually.
Find the intrinsic value of the equity share if the required rate of return of
Mr. Shukla is 10%. What is intrinsic value of share at the end of 8th year? If
the actual market price is Rs. 100 should Mr. Shukla buy this share?
Now D0 = Rs. 5
and g1 = 10% p.a. for first 5 years, g2 = 8% for next 3 years and g = 5%
forever.
\ D1 = 5 (1 + 0.10) = Rs. 5.50
Similarly D2, D3 D4 etc. can be calculated for 8 years using appropriate

growth rate. Please note that D6 = D5(1+0.08) and so on.
Dividends for 8 years are :
5.5 0.909 5
6.05 0.826 5
6.65 0.751 5
7.32 0.683 5
8.05 0.621 5
8.70 0.564 4.90
9.39 0.513 4.81
10.14 0.467 4.74
Total 39.45
Now we are given that g =5 % from 9th year onwards.
D9 = 10.14 (1 + 0.05) = Rs. 10.65
D9
Now P8 =
Ke − g
10.65
=
0.10 − 0.05
= 212.94
Present value of P8 = P 8 × PVF10%8
= 212.94 × 0.467
= 99.44
= 39.45 +99.44
= Rs. 138.89
Intrinsic value of the share at the end of 8th year i.e. P8 = 212.94 as calcu-
lated above.
If the share is available at a price of Rs. 100 now, Mr. Shukla should buy
this share as its intrinsic value is higher Rs. 138.89.
Problem 8.8 : Mr. Tiwari wants to invest in the shares of PTL Ltd. having
current market price of Rs. 340. However Mr. Pandey, a good friend of
Mr. Tiwari, is suggesting him not to buy the shares now as he thinks that
295 Solved Problems
the shares are overvalued. You are given that the recently paid dividends
of PTL Ltd. are Rs. 10 per share. The expected growth rate in dividends is
7% p.a. forever. The required rate of return from a similar type of share is
10%. Do you think Mr. Pandey is correct? Should Mr. Tiwari buy this share?
Show all relevant calculations.
Solution : Here D1 = 10 (1 + 0.07) = Rs. 10.70
Now we are given that g =7%
D1
Now P0 =
Ke − g
10.70
=
0.10 − 0.07
= 356.67
Intrinsic value of the share is Rs. 356.67 and the current market price is
Rs. 340. Hence Mr. Pandey is incorrect. The share is actually underpriced
or undervalued. Hence Mr. Tiwari should buy it.
Problem 8.9: Mr. Sunil has required rate of return of 16%. He has made
investments in the shares of ABC Ltd. Using Gordon’s Model find the val-
ue of the share if EPS = Rs. 10, Return on Investment (ROI) = 20% and
retention ratio is (i) 0% (ii) 40% (iii) 60% (B.Com (H) DU 2011)
Solution : Using Gordon’s Model the share’s value can be calculated as
follows
E1 (1 − b )
P0 =
Ke − br
Here E1 = Rs. 10, r = 20% and Ke = 16% b = 0%, 40% and 60%
(i) When b = 0%
10(1 − 0)
Po =
0.16 − 0.20 × 0
= Rs. 62.50
(ii) When b= 40%
10(1 − 0.60)
Po =
0.16 − 0.20 × 0.40
= Rs. 75
(iii) When b = 60%
10(1 − 0.60)
Po =
0.16 − 0.20 × 0.60
= Rs. 100
Problem 8.10: DCL Ltd. is expected to declare a dividend of Rs. 5 at the

end of the current year. The earnings of the company are growing at 10%
p.a. Find out the intrinsic value of the share if required rate of return is
15%. If the current market price is equal to the intrinsic value then what is
the expected price after one year? If an investor buys the share now and
sells it after one year after receiving dividends what is his dividend yield
and Holding period return?
Solution : Here we are given D1 = 5, g =10% hence we can use constant
growth model to calculate intrinsic value (Po):
5
Po = = Rs. 100
0.15 − 0.10
Hence the intrinsic value of share is Rs. 100.
If Market price is same as intrinsic value of Rs. 100, then after one year
the price will be
D2
P1 =
Ke − g
Since D2 = D1(1+g) we can calculate P1 as below
P1 = Po (1+g)
= 100(1.10)
= 110
Now after one year the investor will get a dividend of Rs. 5 and would be
able to sell the share at Rs. 110.
Hence dividend yield = 5/100 = 5%
Capital gain yield = (110-100)/100 = 10%
Holding period Return = (5+ 10)/100 = 15%
Problem 8.11: A management consulting company is expecting to pay a
dividend of Rs 12 per share at the end of the year. The dividends have
been growing at 10% p.a. and this growth rate is expected to continue. The
equity capitalization rate applicable to the company is 12%. Assume that
the share is fairly priced in the market. Find out the implicit PE ratio if the
EPS of the company is Rs. 20.
Solution :
Share is fairly priced in the market implies that market price = intrinsic value
Hence intrinsic value = 12/(0.12- 0.10)
= Rs. 600
Hence the current market price of share is Rs. 600.
297 Solved Problems
Now P/E ratio = Market price/EPS

= 600/20 = 30.
Hence the implicit P/E ratio is 30.
Problem 8.12: The relevant details of a company are:
Annual Turnover = Rs. 5000000
Operating Profit = Rs. 20%
Eq share capital (FV RS 100) = Rs 20,00000
Capital Reserves = Rs 500000
12% preference share capital = Rs. 2000000
10% term loans = Rs. 1000000
12% debentures = Rs. 1000000
Tax rate = 30%
Div payout ratio = 50%
P/E Ratio = 30
Find out (i) EPS (ii) Div per share (iii) Market price (iv) Earning Yield and
(v) Dividend Yield
(B.Com (H) 2012, 2007)
Solution :
Sales = 5000000
Operating profit = 10,00,000
Less : interest on loan (100000)
Less: Interest on Debentures (120000)
Profit before Tax = 780000
Less : Tax @ 30% = (234000)
Profit after tax = 546000
Less : preference dividends = (240000)
Profit for equity shareholders = 306000
No. of equity shares = 20000
EPS = 306000/20000 = 15.30
DPS = 50% of 15.30 = 7.65
Market price = P/E ratio × EPS = 30 × 15.30 = 459
Earnings yield = EPS/market price = 15.30/459 = 3.33%
Dividend yield = DPS/Market price = 7.65/459 = 1.67
Problem 8.13: The shares of a company are currently available at a price of

Rs 30. The risk free rate is 5% and expected market returns 17%. The beta
of the company is 1.5. The year-end expected dividend from the share is
Rs. 4 and the company’s growth rate is 6% p.a. Calculate the intrinsic value
of the share. Should a prospective investor buy this share at the prevailing
market price?
Solution :
Here first of all we need to calculate required rate of return i.e. Ke. For
this we can use CAPM as given below:
Ke = Rf + (ERM) – Rf) bi
Ke = 5 + (17-5) 1.5 = 23%
Now
Po = 4/(0.23-0.06) = 23.53
Hence the intrinsic value of the share is Rs. 23.53
Since prevailing market price is higher than the intrinsic value the prospec-
tive investor should not buy this share at a price of Rs. 30.
Problem 8.14: The management of a company has just distributed a
dividend of Rs. 10 per share. The current growth rate of the company is
5%. Now the company wants to expand its operations overseas and de-
cides not to pay any dividend for the next 4 years. After that the company
expects to pay a dividend of Rs. 20 with a growth rate of 10% p.a. forever.
If company does not expand its operations then it will not discontinue its
dividends and will maintain its present growth rate of 5%. The firm’s cost
of equity is 15% and it will not be affected whether the company expands
or not. Calculate the value of the company’s share if (i) company expands
(ii) company does not expand.
Solution :
(i) If company expands then D1, D2,D3 and D4 will be zero. We will have
D5 = Rs. 20 and g = 10%, Ke = 15%
Using D5 we can calculate P4 i.e. Value of the share at the end of
Year 4 (or beginning of Year (5) using constant growth model.
P4 = 20/(0.15-0.10) = Rs. 400
To calculate Po i.e. value of the share now we need to discount P4
to find out its present value
Po = P4 (PVF 15% 4) = 400(0.572)
= Rs. 228.8
299 Solved Problems
(ii) If the company does not expand its operations overseas then D1 =
10 (1.05) = 10.50 and g =5%, Ke = 15%
Hence
Po = 10.50/(0.15-0.05)
= Rs. 105
Problem 8.15 : ABC Ltd. is currently paying dividend of Re. 1 per share
and is expected to grow at 7% infinitely. What is the value of the share if
(i) Equity capitalization rate is 15%
(ii) Equity capitalization rate is 16%
(iii) Growth rate is 8% instead of 7%
(iv) Equity capitalization rate is 16% and growth rate is 4%.
(B.Com (H) DU 2009)
Solution :
We use constant growth model of share valuation as given below:
D1
Po =
Ke − g
(i) Po = 1.07/(0.15-0.07) = Rs. 13.38
(ii) Po = 1.07/(0.16-0.07) = Rs. 11.89
(iii) Po = 1.08/(0.15 -0.08) = Rs. 15.43
(iv) Po = 1.04/(0.16-0.04) = Rs. 8.67
Problem 8.16 : From the following 3 shares select the best share for an
investor on the basis of fundamental analysis using (i) Price of share (ii)
Dividend Yield (iii) Capital Gains yield . Assume that the required rate of
return in each case is 20%.
Share X Y Z
Expected Dividend(Rs.) 4 4 4
Growth rate 5% 10% 15%
Solution :
We can compute Price of share using constant growth model
D1
Po =
Ke − g
Share X Y Z
Expected 4 4 4
Dividend(Rs.)
Growth rate 5% 10% 15%
(i) Price (Po) 4/(0.20-0.05)= 26.67 4/(0.20-0.10)= 40 4/(0.20-0.15)= 80
(ii) Div Yield= D1/ 4/26.67 = 15% 4/40 = 10% 4/80 = 5%
Po
(iii) P1 i.e. price 4.2/(0.20-0.05)= 28 4.4/(0.20-0.10)= 4.6/(0.20-0.15)=
after 1 year 44 92
Capital gain (P1-Po) 1.33 4 12
Capital gain yield = 5% 10% 15%
capital gain/Po
Hence the investor should select Share X if the selection criteria is price
or dividend yield. However on the basis of capital gain yield the investor
should select share Z.
Problem 8.17 : From the following information find Book Value per share
Item Co. X Co. Y
Face value per share (Rs.) 10 10
No. of equity shares 500000 800000
Equity share capital (Rs.) 5000000 8000000
Reserves(Rs.) 600000 6500000
(B.Com (H) 2008)
Solution :
Book value per share can be calculated as below:
Item Co. X Co. Y
Equity share capital (Rs.) 5000000 8000000
Reserves (Rs.) 600000 6500000
Total Book value = Eq share cap + Reserves 5600000 14500000
Book value per share = Total B.V/No. of shares 11.20 18.13
Problem 8.18 : PVR Ltd. expects an EPS of Rs. 20 per share for the current
year. The company earns a 15% return on equity and retains 40% of all its
earnings. The required rate of return on equity capital is 12%. Calculate
intrinsic value of the share. Should the share be bought if market price is
Rs. 180?
301 Solved Problems
Solution: Here EPS1 = 20

b = 0.40
\ D1 = 20 (1 – 0.40)
D1 = 12
Further ROE = 15%
\ g = b × ROE
g = 0.40 × 15%
g = 6%
Now the value of this company’s share is Po as calculated below:
d1
P0 =
Ke − g
12
P0 =
0.12 − 0.06
P0 = Rs. 200
This is the intrinsic value of the company’s share. If market price is
Rs. 180, it should be bought.
Problem 8.19 : Darwin Ltd. has the following details:
ROE =15%
Expected EPS = Rs. 5
Expected DPS = Rs. 2
Required Rate of Return = 10% Per Year
As a financial advisor, you are required to compute its expected
growth rate, its price, and its P/E ratio
Solution : We are given that EPS1 = Rs. 5 and DPS1 = Rs. 2 Hence b i.e.
retention ratio is 60% (i.e. 3/5)
Now r = 15%
Hence expected growth rate g = br = 0.60(0.15) = 0.09
Ke = 10%
Using Constant growth rate model its expected price is Po = Rs. 200 as
calculated below:
Po = 2/(0.10-0.09) = Rs. 200
Now its P/E ratio is calculated below:
P/E ratio = Price/EPS1 = 200/5 = 40.
Summary
1. Valuation of Equity shares is difficult due to the variability of future cash
inflows.
2. We can use Discounted cash flow technique to calculate intrinsic value of a
share.
3. Another popular method to calculate fair price of a share is Earnings Multi-
plier or P/E ratio model.
4. Using Dividends discount model, the intrinsic value of a share is the sum total
of all future expected cash inflows from it. Since the life of equity share is
infinite we get an infinite stream of dividends from the share.
5. Valuation models may assume No growth in dividends, a Constant growth
in dividend or Multiple growth rates.
6. The growth rate of a company’s dividends may be calculated using historical
data or by using the formula (retention ratio X Return on equity).
7. The intrinsic value per share is the capitalized value of all expected dividends.
8. The present value calculations are done using an appropriate discount rate
i.e. the required rate of return on equity or equity capitalization rate. It is also
termed as cost of equity from the view-point of the company.
9. Gordon’s Model and Walter’s Model can also be used to calculate share price.
10. The P/E ratio can be multiplied with expected EPS to find out Fair price or
Intrinsic value as per Earnings multiplier approach.
11. The Capital Asset Pricing Model (CAPM) can be used to determine the required
rate of return on equity. This required rate of return can be used to calculate
intrinsic value using DDM.
12. As per CAPM the required rate of return from a share depends on the system-
atic risk of the company measured by beta. The higher the beta the greater
will be the required rate of return.
13. An investor may choose to use various methods to calculate value of an equity
share.
Test Yourself
True False
i. Intrinsic value of a share is equal to its market price.
ii. If there is no growth in dividends then the intrinsic value of a share is the
capitalized value of its dividend perpetuity.
iii. If market price is lower than the intrinsic value then the share is over-priced
in the market.
iv. If intrinsic value is higher than market price, the share should be purchased.
303 Test Yourself
v. Higher ROE results in higher P/E ratio.

vi. Dividend discount model and P/E approach always results in same intrinsic
value of equity share.
vii. Equity shares and bonds follow the same valuation models.
viii. CAPM helps in determining required rate of return.
ix. Equity shares of no dividend paying company cannot be valued.
x. Gordon’s Model and Constant Growth model are same.
xi. Earnings are irrelevant in dividend discount models.
xii. Intrinsic value and market value of share are always equal.
xiii. In multi-period growth model, there are different growth rates for different
periods.
[Answer – i. F ii. T iii. F iv. T, v. T, vi. F, vii. F, viii. T, ix. F, x. T, xi.
F, xii. F, xiii. T]
Theory Questions
1. What are the peculiar features of equity shares? How valuation of equity
shares is different from valuation of bonds? [Para 8.1]
2. What problems an investor is expected to face while valuing the equity
shares? [Para 8.1]
3. What do you mean by constant growth in dividend? How does growth factor
affect the value of the share? [Para 8.2b]
4. What do you mean by intrinsic value? How is it determined? [Para 8.2]
5. Explain the different approaches to valuation of an equity share.
6. Examine the relevance of dividend in valuation of equity shares. How would
you value the shares of a company which does not pay dividend?
[Para 8.2b]
7. What is the constant growth model? What are its assumptions? [Para 8.2b]
8. Compare and contrast the two models - Gordon’s model and Walter’s
model. [Para 8.2]
9. What is the importance of Price – Earnings (P/E) ratio? What are its limita-
tions? [Para 8.2.2]
10. Explain the utility of CAPM in valuation of an equity share. [Para 8.2.3]
11. Why is the valuation of equity different from that of debentures or preference
shares? What is the purpose of equity valuation?
(B.Com.(H), GGSIPU, 2016)
12. Super Cement Industries has just paid a dividend for Rs. 4 per share. The
dividend is expected to grow at constant rate of 7% indefinitely. The beta of
the stock is one. The risk-free rate of return is 6% and market risk premium is
9%. Calculate the intrinsic value of the stock. What will be the intrinsic value
of the stock if its beta is 1.3, i.e. the stock is riskier?
(B.Com(H), GGSIPU, 2017)
Practical Problem
1. Mr. Sunil has required rate of return of 18%. He has made investments in the
shares of ABC Ltd. Using Gordon model, find the value of share if:
EPS= Rs. 10
Rate of return on Investment =22%
Retention ratio is:
a. 0%
b. 30%
c. 80%
[Answer : 55.55, 61.40, 250]
2. Mr. Shukla wishes to invest some of his funds in a company. His analysts have
advised him to buy shares of a company which has given a current dividend
of Rs. 12. Dividends are expected to grow at 20% for 10 years and thereafter
at 8% perpetually. Find out the value of the equity shares. The required rate
of return of Mr. Shukla is 10%.
[Answer : Rs. 1746]
3. The following information is available for PQR Ltd. for the year 2010-11:
Annual turnover 60,00,000

Operating profits 25%
Equity share capital(F.V. 100) 40,00,000
Capital Reserve 15,00,000
12% Pref. Share Capital 20,00,000
10% Long Term Loan 15,00,000
12% Debentures 10,00,000
Tax rate 30%
Dividend pay-out ratio 40%
Price earnings ratio 23
Find out:
a. EPS
b. DPS
c. Market Price per share
305 Test Yourself
d. Earning yield on equity share

e. Dividend yield on equity share
[Answer : 11.32, 4.53, 260.48, 4.35%, 1.74%]
4. A company pays a dividend of Rs. 1.5 with a growth rate at 7%. The risk free
rate is 10% and the market return is 15%. Presently, the company has a beta
factor of 1.50. However, it is expected to be increased by 0.25 if a new project
is undertaken. Find out the value of the share before and after the project.
[Answer- Rs. 15.29, Rs. 13.66]
5. XYZ Ltd. has paid a dividend of Rs. 3 per share and face value of share is
Rs. 10. The following information is given below:
Current market price per share- Rs. 70
Growth rate-10%
Beta of the share is 0.75
Market return-15%
Risk free rate-9%
Compute the intrinsic value of the share. (B.Com (H), DU, 2014)
[Answer Rs. 94.28]
6. Ambrose Ltd. has just paid a dividend of Rs. 2 per share. The growth rate of
the firm is 8% for three years and then it is expected to grow at 5% perpetually.
Compute the value of the share when the required rate of return is 12%.
(B.Com(H), DU, 2014)
[Answer-Rs. 32.48]
7. A company declared a dividend of Rs. 3 per share last year. The growth rate
is expected to be 10% for the next five years and thereafter the company will
grow at the constant rate of 7%. If the shareholder’s expected rate of return
is 16%, find out the intrinsic value of the share. (B.Com(H), DU, 2014)
[Answer Rs. 40.17]
8. Teakwood Ltd is growing @ 5% p.a. the company’s most recent earning per
share is Rs. 2.50 and dividend pay-out ratio is 60%. Mr Mehta wants to buy
and hold the share of Teakwood Ltd. for a period of 5 years .The P/E ratio of
the share after 5 years is expected to be Rs. 6. Required rate of return is 15%.
Calculate the fair price of the share at present. What is the expected selling
price of the share after 5 years?
[Answer: Present Price –Rs. 15.75, Price after 5 years-Rs. 20.10]
9. XYZ Ltd. has the following details:
Expected ROE -12%
Expected EPS – Rs 2
Expected DPS-Rs 1.5
Required Rate of Return – 10%

As a financial advisor, you are required to compute its expected growth rate,
its price, and its P/E ratio.
[Answer- 3%, Rs. 21.43, 10.71]
10. The management of ABC Ltd. insists on reinvesting 60% of its earnings in
projects which are expected to provide ROE of 10%. However, the required
rate of return for the firm is 15%. Its EPS is Rs. 5 while DPS is Rs. 2. Compute
the market price of its share and present value of growth opportunities?
[Answer : Rs. 22.22, Rs. 11.11]
11. XYZ Ltd. is growing @ 6% p.a. The company’s most recent earning per share
is Rs. 4.50 and dividend pay-out ratio is 50%. An investor wants to buy and
hold its share for a period of 5 years. The P/E ratio of the share after 5 years
is expected to be 12.5. Required rate of return is 10%. Calculate the fair price
of the share at present.
[Answer : Rs. 59.63]
12. The stock of a company is currently selling for Rs. 10 in the market. Its EPS
in the coming year is expected to be Rs. 2. The company has a policy of dis-
tributing 50% of its earnings and retained amount is invested in the projects
earning 20% ROE. Assuming the current market price reflects the intrinsic
value as computed by Constant Growth Model, what is the minimum rate of
return?
[Answer : 20%]
13. What will be the impact on the value of share [assuming growth rate is same
as calculate in Q.12] if the company in Question 12. above adopts policy of:
a. 100% pay-out
b. 25% pay-out
c. 10% pay-out
[Answer : Rs. 20, Rs. 5, Rs. 2]
14. STR Ltd. expects an EPS of Rs. 12 per share for the current year. The company
earns a 18% return on equity and retains 80% of all its earnings. The required
rate of return on equity capital is 14%. Calculate intrinsic value of share.
[Answer : Rs. 400]
15. From the following information find Book Value per share for company P
and Q.
Item Co. P Co. Q

Reserves(Rs.) 6000000 16500000
[Answer : Rs. 101.09, Rs. 109.67]
307 Project Work
16. ABC Ltd. is currently paying dividend of Rs. 3 per share and is expected to
grow at 11% infinitely. What is the value of the share if
(i) Equity capitalization rate is 15%
(ii) Equity capitalization rate is 13%
(iii) Growth rate is 8% instead of 11%
(iv) Equity capitalization rate is 12% and growth rate is 6%.
[Answer : (i) 83.25, (ii) 166.5, (iii) 46.29, (iv) 53)]
17. Mr. Misra wants to invest in a company that has just given a current divi-
dend of Rs. 15 per share. The face value per share is Rs. 100. Dividends are
expected to grow at 7% for 5 years, at 5% for next 3 years and at 3% thereafter
perpetually. Find the intrinsic value of the equity share if the required rate
of return of Mr. Misra is 10%. What is intrinsic value of share at the end of
5th year? If the actual market price is Rs. 100 now should Mr. Misra buy this
share?
[Answer : Rs. 272, Buy]
18. A company is expected to provide a dividend of Rs. 6 per share at the year
end. Dividends are expected to grow at 10% for next year and at 8% thereafter.
Find the intrinsic value of the equity share if the required rate of return of
investors is 13%. What is intrinsic value of share at the end of the first year?
What is the maximum price at which an investor should buy this share now.?
[Answer : Rs. 132]
19. Mr. Chaturvedi has just purchased a share having price Rs. 120, which is
expected to provide a dividend of Rs. 8 at the end of the year. Thereafter
the dividends will grow at a rate of 8% p.a. The equity capitalization rate of
a similar risk stock in the market is 16%. Has Mr. Chaturvedi made a right
investment decision? Why?
[Answer : Rs. 100.0, No]
20. A company’s last declared EPS is Rs 18. The growth rate of the company is
12% which is expected to maintain forever. Risk free rate in the market is 4%
and expected market return is 17%. The beta of the company is determined
as 0.85. What is the intrinsic value of company’s share if the company has a
policy of 70% dividend payout? Should this share be bought by a prospective
investor at the current market price of Rs. 195? Why ?
[Answer : Rs. 470.40, Buy]
Project Work
From the website of SEBI (www.sebiindia.com) collect the following details about
Reliance Industries Ltd. for the year 2014-15.
Annual Turnover
Operating Profit
Eq share capital
Capital Reserves
preference share capital if any
Term loans if any
debentures and bonds if any
Tax rate applicable
Div payout ratio
P/E Ratio, Average over past 5 years
Now calculate its expected market price using
(i) P/E ratio model
(ii) Using DDM assuming a constant growth rate of 7% p.a. and Required rate of
return of 11%
9 PORTFOLIO ANALYSIS AND
SELECTION
C H A P T E R
learning oUtcoMes
 Explain and calculate Portfolio Return
 Explain and calculate Portfolio Risk
 Construct a portfolio for a given expected return
 Determine Minimum Variance Portfolio
 Understand the concepts of Diversification and Hedging
 Understand portfolio theory of portfolio selection
 Derive efficient frontier and optimal portfolio
 Analyse Capital Market theory
 Calculate beta of a security
 Understand and use Capital Asset Pricing Model
 Derive Security Market Line
 Differentiate between CML and SML
introduction
Investors do not invest in a single asset. Rather they choose to invest in
large number of assets and a variety of assets. It is hard to find an investor
who invests all his savings in just one security (say equity shares of XYZ
Ltd.). Every investor makes investment in a variety of financial assets so as
to meet his investment goals. These investment goals or objectives are the
309
Para 9.1 Portfolio analysis and selection 310
guiding factors in investment decision making. The combination of assets

or securities in which the investor makes his investment is termed as
Portfolio. The underlying idea is Not to Put All the Eggs in One Basket, hence
investment is generally made in a wide variety of financial assets or securities.
9.1 Portfolio Management Process

A Portfolio is basically a collection of assets or securities which are so
collected together to reduce the risk. The basic idea behind a portfolio is
diversification.
Portfolio management is the process of construction, revision and evaluation
of a portfolio. The objective of portfolio management is to build a portfolio
which gives a return commensurate with the risk profile of the investor.
Process of Portfolio Management can be understood with the help of flow
chart depicted in Exhibit 9.1. It begins with the analysis of risk and return
of individual securities which will form part of the portfolio and hence
it is termed as Security analysis. Here we analyse all available securities
in terms of their return and risk features. Then we build up all possible
portfolios comprising these securities and calculate these portfolios’ risk
and returns. This is termed as Portfolio analysis. At the end of this step we
have a number of feasible and efficient portfolios to choose from. Next,
from these feasible and efficient portfolios we select the optimal portfo-
lio depending upon the risk profile of the individual investor. This step is
termed as Portfolio selection. Once the optimal portfolio is constructed we
need to revise this portfolio due to changes in investment environment or
changes in investment objectives. Hence Portfolio revision is the next step.
Finally, selection and revision of the portfolio is not the ultimate aim. We
also need to constantly monitor this portfolio in terms of its valuation and
evaluate the portfolio’s performance vis a vis some benchmark or other
similar portfolios. Hence portfolio management process ends at Portfolio
performance evaluation. If the portfolio is not performing well then the
investor needs to further revise his portfolio or construct a new optimal
portfolio to suit his risk return preferences. The portfolio management
process is explained below :
Step1 : Security Analysis: An investor has a large number of available securi-
ties which may be used in an infinite number of ways to construct portfolios.
These securities vary in terms of their features as well as risk and return
characteristics. Traditionally the available securities have been categorised
as Fixed income securities such as bonds and debentures and Variable
income securities, primarily equity shares. However, now a days a number
of innovations in financial markets are giving rise to new and innovative
financial instruments. For example now we have ADRs, GDRs, Floating rate
311 Portfolio Management process Para 9.1
bonds, Asset Linked Bonds, Financial derivatives etc. In security analysis

we analyse all available securities in terms of their risk return and related
features. There are three approaches to security analysis- Fundamental
analysis, Technical analysis and Efficient Market Hypothesis. These three
approaches have been dealt with in detail in Chapters 5, 6 and 7. As per
Fundamental Analysis the value of a security in long term will be equal to its
intrinsic value. Intrinsic value of a security is the present value of all future
expected cash inflows from the security. Hence we calculate intrinsic value
of a security using Economy, Industry and Company wide factors. Once
the intrinsic value is calculated, we compare it with the actual market price
to find out whether the security is underpriced, overpriced or fairly priced
in the market. Securities which are underpriced in the market are a good
investment option for a prospective investor. Fundamental analysis makes
use of EIC (Economy Industry and Company analysis) Framework to arrive
at a reasonable estimate of future cash inflows from a security. Fundamental
analysis helps in selecting the right securities. Technical Analysis on the
other hand is based on the premise that future prices can be predicted on
the basis of past trends in prices and volume data. It assumes that History
repeats itself. Hence a number of technical indicators and charts are used
to predict future direction of prices. Technical analysis helps in timing the
market. Efficient Market Hypothesis (EMH) implies that the current price
of the securities fully reflect all available information. Hence at any time in
the market, securities are fairly priced. Security prices change only in case
of inflow of new information and new information is completely random.
As per EMH, the given market price is the best price to buy or sell. Hence
anytime an investor can buy or sell.
Step 2 : Portfolio Analysis and Selection : After security analysis, the next
step is to analyse possible portfolios of various securities in terms of port-
folio returns and risks. It must be noted that a large number of securities
virtually give rise to an infinite number of feasible or possible portfolios.
However all portfolios may not be efficient. An efficient portfolio is one
which provides maximum return for a given level of risk or which has lowest
risk for a given level of return. We need to identify such efficient portfolios.
Step 3 : Portfolio Selection : After the identification of efficient portfolios,
an investor selects the optimal portfolio which optimises his utility given
his risk return preferences. This is known as portfolio selection. In order to
identify the optimal portfolio, the investor needs to consider his utility scores
(in terms of indifference curves) besides the return and risks of efficient
portfolios and select that portfolio as optimal portfolio which maximises
his utility. Markowitz Model and Capital Market Theory are the building
blocks of portfolio selection by a rational investor.
Step 4 : Portfolio Revision : It must be noted that portfolio management

is not a one time job, it’s a continuous process. This is due to the fact that
the financial environment in which investment decisions are made is not
static but dynamic or ever changing. Changes in investment environment
may render an optimal portfolio redundant or inefficient. Hence there
is a need to revise the optimal portfolio in the light of changes in capital
market, economic and industry wide factors. Further, it is quite possible
that with time, the investment objectives of the investor also change. This
requires for revision of his existing portfolio to accomplish new investment
goals or objectives. Hence portfolio revision is an integral part of portfolio
management process.
Step 5 : Portfolio Performance Evaluation : It is necessary to evaluate the
portfolio in order to ascertain whether it has performed as expected. The
evaluation of a portfolio is concerned with assessing the actual return
and risk of a portfolio over a specified period. This is important because if
portfolios are not evaluated periodically then the investor may not be able
to reap the expected returns at desired level of risk. There are a number
of methods which can be used to evaluate the performance of portfoli-
os. Popular risk adjusted measures of portfolio performance evaluation
are - Sharpe Ratio, Treynor’ s ratio, Jensen’s alpha, Fama’s decomposition
ratio etc. These are discussed in detail in Chapter 10. In order to assess
the performance of a portfolio it is necessary to evaluate a portfolio’s per-
formance by comparing it with some benchmark (or market portfolio).
Portfolios which out-perform the benchmark or market portfolio are held.
While those which under-perform are either revised or sold by the investor.
Security Analysis
Examines risk return characteristic of individual assets or securities
Portfolio Analysis
Identifying possible portfolios from combination of given assets or securities and the risk and return
Portfolio Selection
Selection of optimal portfolio from efficient portfolios
Portfolio Revision
Constant monitoring and revision or portfolio to be abreast with latest changes
Portfolio Evaluation
Assessing the performance of a portfolio over a given period
Exhibit 9.1: Process of Portfolio Management

313 Portfolio Analysis - Markowitz model Para 9.2
The first step i.e. security analysis is already dealt with in Chapter 4 to Chapter
8, wherein we analysed fixed income securities and equity shares in terms
of their valuation aspects (risk and returns). In this chapter we deal with
portfolios. Hence the discussion will begin with the analysis of portfolios
in terms of portfolio return and portfolio risk. After analysis of portfolios
in terms of return and risk we will discuss portfolio selection Models.
9.2 Portfolio Analysis - Markowitz Model

Harry Markowitz (1952) provided the foundation for portfolio analysis in
terms of return and risk. In fact Markowitz’s Portfolio Theory includes
portfolio analysis as well as portfolio selection. We will discuss portfolio
analysis first and then will resolve the problem of portfolio selection. The
underlying assumption in Markowitz model is that investors are risk averse.
9.2.1 Portfolio return

Portfolio return is the weighted average of the returns of the individ-
ual assets or securities comprising that portfolio. The weights are the
proportion of total funds invested in a particular asset or security. Let
us understand the concept with a simple case of two securities portfolio.
Suppose an investor can invest his money either in Security A or Security
B. The possible returns on these stocks under different market conditions
are given below:
Market condition Probability Security A (%) Security B (%)
Good 0.3 22 6
Neutral 0.5 14 10
Bad 0.2 7 11
As you already know the expected rate of return is the sum of the product
of possible returns and their respective probabilities. Thus, the expected
return on Security A and Security B shall be given by:
E (RA) = (0.3×22) + (0.5×14) + (0.2×7) = 15 %
E (RB) = (0.3×6) + (0.5×10) + (0.2×11) = 9 %
So, the expected return on an individual security X i.e. E (Rx) can be com-
puted with a generalised formula:
n
e(r x ) = ∑ ri Pi
i =1
Where,
Ri= return on security X, and
Pi= Probability of ith return.
Now suppose the investor decides to allocate his 50% funds in Security A
and 50% in Security B, then what shall be the expected return of portfolio
consisting of these two securities? In this case, we need to calculate expected
return by using weighted average.
The expected return of portfolio i.e. E (RP) is the weighted average of the
returns of the individual securities comprising that portfolio. It can be
calculated as :
e(r p ) = ∑ i=1 Wi × e(r i ) ...............................................................................(9.1)
n
Where,
E (RP) = Portfolio return
Wi= Proportion of total funds invested in a particular asset or security i.
Ri= Expected return of asset or security i, and
n= Number of assets or securities in the portfolio.
Let us compute the Portfolio return in our example using equation (9.1),
E (RP) = (15 ×0.5) + (9 ×0.5) = 12%
9.2.2 Portfolio risk

Portfolio risk is the combined risks of the securities comprising that port-
folio. It must be noted that every security in the portfolio has a variance
(or S.D.) measuring its risk. But we cannot just combine these variances (or
individual securities risks) so as to calculate portfolio risk. This is because
besides variances, securities in a portfolio also have co-variances i.e. inter-
active risk. A co-variance between security X and Y captures the tendency
of these two securities to move together. Hence portfolio risk is based on
not just variances of individual securities but also their covariances.
Portfolio Risk, as measured by standard deviation, is not simply the weight-
ed average of the standard deviation of the individual assets or securities.
Portfolio risk depends not just on individual risks but also interactive risk
(or co-variance) . Portfolio risk considers the standard deviation together
with the co-variance of returns on these assets or securities. Hence we use
variance co-variance matrix to calculate portfolio risk.
Portfolio Risk in a two security case:
For 2-security portfolio, the portfolio risk can be calculated using equation
(9.2)
σ p = W12σ 12 + W22σ 22 + 2W1W2Cov12 ...............................................(9.2)

Where
W1= Proportion of total funds invested security 1
W2= Proportion of total funds invested security 2
σ1= standard deviation of return of security 1,
σ2= standard deviation of return of security 2,
Cov12 = co-variance between security 1 and 2
Now we know that co-variance is equal to the product of coefficient of
correlation and standard deviation of security 1 and standard deviation
of security 2.
Cov(12) = ρ12σ1σ2
Hence equation (9.2) can be written in terms of Coefficient of correlation
as in equation (9.2A)
σp = W12 σ 12 + W22 σ 22 + 2W1W2ρ12 σ 1σ 2 .............................(9.2A)
It must be noted that in case of two securities we have one co-variance. As

the number of securities in the portfolio increases, the number of terms
on the right-hand side of the equation increases as well, because the num-
ber of co-variances also increases. For example in case of three securities
we have three co-variances while in case of 5 securities we have 10 co-
variances. As the number of securities increases we will have more and
more co-variance terms to be used in the calculation of portfolio risk.
Though the portfolio manager has no control over the risk of an individ-
ual security, but he does have control over the portfolio components. If
he selects two securities such that their returns are totally uncorrelated,
then the third term drops out completely and portfolio risk will be lower.
Portfolio risk in case of n securities can be calculated using equation (9.3):
∑ ∑ Wi Wjρ ij σ i σ j .................................................................(9.3)
n n
σp = i =1 j =1
Where,
Wi= Proportion of total funds invested in a particular security i
Wj= Proportion of total funds invested in a particular security j
σi= standard deviation of return of security i,
σj= standard deviation of return of security j,
ρij = coefficient of correlation between returns of security i and j
n= Number of securities in the portfolio.
The above discussion shows that portfolio risk depends on standard devi-
ation of individual securities as well as on covariances or on coefficient of
correlation between the two securities.
The return and risk of a portfolio depends on the following factors :
(i) Proportion of funds to be invested in each security comprising that
portfolio.
(ii) The returns of each security
(iii) The risk (or S.D.) of each security
(iv) The covariance between the returns of these securities. Since cova-
riance is equal to the coefficient of correlation multiplied with the
product of S.D. of each security, we may say that it depends upon
coefficient of correlation.
9.2.3 Limitation of Markowitz Model of Portfolio Analysis

As discussed above portfolio return is based on the returns of individual
securities while portfolio risk is based on variances as well as covariances.
The number of covariances increases manifold as we increase the number
of securities in the portfolio. For analysing 50 securities using Markowitz
model of Portfolio Analysis, we need 50 returns, 50 variances and 1225
covariance terms. (it must be noted that the number of covariances will be
N
C2). So a total of 1325 bits of data is required to proceed with the analysis
or portfolio return and risk.
Therefore the main limitation of Markowitz Model is that it requires sub-
stantial amount of input data so as to calculate portfolio return and risk. In
case of N securities The data requirement will be as follows: N= Expected
returns, N= Variances and N(N-1)/2 Covariances. When we add these we
get (3N+N2)/2 items.
Calculation of Portfolio Risk
Using the same example of two securities A and B, for which we have cal-
culated portfolio return above, we can now calculate portfolio risk.
We need risks of security A and B and also Covariance between the two.
We can calculate risk of Security A and B using Standard deviation.
n
∑ p (r )
2
Total Risk of a security = S.D. = i i −r
i =1
We get the following risks of Security A and B.

Market condition Probability Deviations Product
Pi RA-E(RA) RB-E(RB) Pi[RA-E(RA)]2 Pi[RB-E(RB)]2
Good 0.3 7 -3 14.7 2.7
Neutral 0.5 -1 1 0.5 0.5
Bad 0.2 -8 2 12.8 0.8
σ2
28 4
σ 5.3 2
Risk (σ) of Security A = 5.3%
Risk(σ) of Security B = 2%
To measure covariance we can use equation (9.4)
n
Cov AB = ∑
i =1
Pi [RA − E(RA )] [RB − E(RB )] .................................................(9.4)
Where,
CovAB = Covariance of returns on securities A and B
RA and RB= Returns on Securities A and B respectively
E (RA) and E (RB) = Expected Returns on Securities A and B respectively
Pi= Probability of returns or economic state
n = Number of different economic states
When we are not given probability distribution and only a series of returns
is provided for two securities then we can use equation (9.4A) to calculate
covariance
Cov AB = {∑ (RA − RA ) (RB − RB )} / n ...............................................(9.4A)
In our example the Expected Returns are:

Security A =15%
Security B = 9%
Calculation of Covariance
Market Probability Deviations Product
condition
Pi RA-E(RA) RB-E(RB) Pi[RA-E(RA)][ RB-E(RB)]
Good 0.3 7 -3 -6.3
Neutral 0.5 -1 1 -0.5
Bad 0.2 -8 -2 -3.2
Covariance -10.00
Hence the covariance between security A & B is –10.00 squared %.

Now, having understood the concept of covariance, we can infer that there
are 3 possibilities of relationship between Security A and Security B.
Positive Covariance - If A’s and B’s returns are above or below their
1.
average return during the same time period, the covariance is positive.
Zero Covariance - If returns on A and B do not follow any pattern,
2.
then there is no relationship and hence, no covariance.
Negative Covariance - If A’s returns are above its average returns
3.
while B’s returns are below its average returns, or vice versa, then
they are said to be having a negative covariance.
However covariance is expressed in terms of specified unit of measurement
(in squared percentages here) and hence is an absolute measure. It would
be difficult to compare covariances across securities. Hence we convert
it into a relative measure i.e. Coefficient of Correlation. It must be noted
that coefficient of correlation is independent of the unit of measurement.
Correlation coefficient measures the degree and direction of linear rela-
tionship between two variables (securities in our case). Its value ranges
between +1 and -1. It must be noted here that while covariance is expressed
in terms of unit of measurement, coefficient of correlation is independent
of the unit of measurement.
If coefficient of correlation is +1, it refers to perfect positive correlation and
if it is -1, it refers to perfect negative correlation. The correlation coefficient
(ρaB ) can be calculated using equation (9.5) .
Cov AB
ρ AB = .......................................................................(9.5)
σ Aσ B
Let us calculate correlation coefficient in our example. For that, we need
standard deviation of security A and Security B.
Coefficient of correlation of these two securities A and B is:
−10
ρaB = = −0.94
5.3 × 2
Securities A and B have a high degree of negative correlation i.e. -0.94. An
investor can reduce his risk by investing his funds in both the securities
instead of going for one only.
As we said earlier, Portfolio Risk, as measured by standard deviation, is not
simply the weighted average of the standard deviation of the individual
assets or securities. It considers interactive risk as well which is measured
by covariance.
Using equation (9.2A) the portfolio risk for our example, in which 50% of
the funds are invested in security A and 50% in security B, is:
σ p = (0.52 × 5.32 ) + (0.52 × 22 ) + 2 × 0.5 × 0.5 × ( −0.94) × 5.3 × 2 = 3

Hence
σ p = 1.73%
Thus in our example Portfolio return is 12% while risk is very low 1.73%.
It must be noted that if the portfolio changes (i.e. if weights of the securities
change) we get different portfolio return and portfolio risk. This is explained
with the help of Illustration 9.1.
Illustration 9.1 : You are given the following two securities. Calculate port-
folio return and risk if an investor invests
(i) 50% in A and 50% in B
(ii) 20% in A and 80% in B
(iii) 80% in A and 20% in B
Security A B
Expected Return 15% 9%
S.D 5.3% 2%
Coefficient of correlation between A and B = -0.94
Solution :
(i) When investor invests 50% in A and 50% in B we have
Portfolio Return = 12%
Portfolio Risk = 1.73%
(ii) When investor invests 20% in A and 80% in B
Portfolio Return = 0.20 × 15 + 0.80 × 9 = 10.20%
Portfolio Risk
σ 2p = (0.22 × 5.32 ) + (0.82 × 22 ) + 2 × 0.2 × 0.8 × ( −0.94) × 5.3 × 2 = 0.495

Hence
σ p = 0.7%
(iii) When investor invests 80% in A and 20% in B

Portfolio Risk
σ 2p = (0.82 × 5.32 ) + (0.22 × 22 ) + 2 × 0.2 × 0.8 × ( −0.94) × 5.3 × 2 = 14.95
Hence
σ p = 3.86%
Hence in case (ii) portfolio return as well as risk is lower while in case (iii)
portfolio return as well as risk is higher.
CONSTRUCTING A PORTFOLIO FOR A GIVEN EXPECTED RETURN:
We can construct a portfolio by using different weights of the securities
comprising it. Hence there are many possible portfolios that can be con-
structed using two securities. As the number of securities increases we can
construct still larger number of portfolios. This is explained in Illustration 9.2.
Illustration 9.2 : Construct a portfolio, using securities A and B, for an
investor who wants an expected return of 13% using the following data.
Expected return From Security A = 15%, Expected return from security
B = 9%. Calculate portfolio risk as well. If sA = 5.3% and sB = 2%. You are
also given that coefficient of correlation is – 0.94.
Solution : We want E (RP) = 13%, let us assume that the weight of security
A is W1 and therefore the weight of Security B (i.e.W2) will be (1-W1).
Hence
13 = (15 ×W1) + (9 ×(1-W1)
Solving for W1 we get W1 = 0.67 (appx)
Hence W2 = 1-0.67= 0.33
Thus the portfolio providing a return of 13% would be the one which invests
67% of the funds in security A and 33% in security B.
Portfolio risk of such a portfolio will be calculated as below:
σ 2p = (0.672 × 5.32 ) + (0.332 × 22 ) + 2 × 0.67 × 0.33 × ( −0.94) × 5.3 × 2 = 8.63
Hence
σ p = 2.94%
MINIMUM VARIANCE PORTFOLIO

Investors are risk averse. A risk averse investor will always like to reduce his
risk exposure and attain higher returns. So he may be interested in knowing
the combination of two securities such that portfolio variance is minimum.
It is interesting to note here that minimum variance portfolio is also the
optimal portfolio for an investor who wants to minimise exposure to risk.
In order to calculate minimum variance portfolio we use the following steps.
1. Differentiate portfolio variance w.r.t W1 i.e. the weight of the first
security.
2. Put it equal to zero.

3. Now simplify to find out W1.
4. Once W1 is determined W2 = 1-W1.
We can use the following formula for estimating the weights of two securi-
ties in a minimum variance portfolio. The weight for investment in security
A i.e. WminA is given by:
σ 2B − Cov AB
Wmin A = ..............................................(9.6)
σ + σ B2 − 2Cov AB
2
A
Or
σ 2B − ρ AB σ A σ B
Wmin A = .................................................(9.6A)
σ 2A + σ B2 − 2ρ AB σ A σ B
Calculation of minimum variance portfolio is explained in Illustration 9.3.

Illustration 9.3 : Construct a minimum variance portfolio of Securities A
and B from the following information. Calculate this portfolio’s return as
well as risk.
Security A B
Expected Return(%) 15 9
S.D. of returns(%) 5.3 2
Covariance between the returns of A and B = -10
Solution : The weight of security A in minimum variance portfolio is cal-
culated as:
(2)(2) − ( −10) 14
wmin A = = = 0.27
(5.3)(5.3) + (2)(2) − 2( −10) 52
wmin B = 1 − 0.27 = 0.73
Hence minimum variance portfolio is one which has 27% of security A and
73% of security B.
The portfolio risk of this portfolio will be 0.50% as calculated below :
σ 2p = (0.272 × 5.32 ) + (0.732 × 22 ) + 2 × 0.27 × 0.73 × ( −10) = 0.25
σ P = 0.50%
Thus the minimum variance portfolio comprises of 27% of security A and
73% of security B and the minimum portfolio risk is very low i.e. 0.50%. Any
other combination or portfolio of these two securities will give a portfolio

risk higher than 0.50%.
This minimum variance portfolio will have the following portfolio return:
E (RP) = (15 × 0.27) + (9 × 0.73) = 10.62%
Coefficient of Correlation and Risk of a portfolio :
As discussed above, portfolio risk is affected by the coefficient of correla-
tion between the returns of two securities. The value of the coefficient of
correlation ranges from -1 to +1. Other things being equal if coefficient
of correlation is higher, the portfolio risk will be higher and if it is lower
the portfolio risk will be lower. This can be understood with the help of
Illustration 9.4 given below.
Illustration 9.4 : From the following information about two securities
A and B. Calculate portfolio risk if coefficient of correlation is (i) + 0.80
(ii) +0.30 (iii) -0.30 (iv) -0.80
Security A B
S.D 5.3% 2%
Proportion of funds 0.50 0.50
Solution : We can use equation (9.2A) to solve it.
(i) When coefficient of correlation is +0.80
Portfolio Risk
σ 2p = (0.52 × 5.32 ) + (0.52 × 22 ) + 2 × 0.5 × 0.5 × (0.80) × 5.3 × 2 = 14.5
Hence
σ P = 3.80%
(ii) When coefficient of correlation is 0.30
σ 2p = (0.52 × 5.32 ) + (0.52 × 22 ) + 2 × 0.5 × 0.5 × (0.30) × 5.3 × 2 = 10.75
Hence
σ P = 3.20%
(iii) When coefficient of correlation is -0.30
σ 2p = (0.52 × 5.32 ) + (0.52 × 22 ) + 2 × 0.5 × 0.5 × ( −0.30) × 5.3 × 2 = 6.25

Hence
σ P = 2.50%
(iv) When coefficient of correlation is -0.80

σ 2p = (0.52 × 5.32 ) + (0.52 × 22 ) + 2 × 0.5 × 0.5 × ( −0.80) × 5.3 × 2 = 2.5
Hence
σ P = 1.58%
Hence Portfolio risk is lower when the coefficient of correlation is lower.
Coefficient of Correlation and Diversification:
“Don’t put all your eggs in the same basket.”
This is the basic idea behind diversification. Every investor would like to
invest his total funds in not just one type of security; rather he will like to
hold a combination of different securities. The reason being that diversifi-
cation helps to reduce the variability of returns and thereby reduces risk
of total investment. Diversification works because returns and prices of all
securities do not move together. In a Diversified portfolio securities are less
than perfectly positively correlated. It implies that when the coefficient of
correlation is less than 1,an investor can have the benefits of diversification.
For diversification the lower the coefficient of correlation the better it is.
Hence a portfolio of securities which has 0.30 as coefficient of correlation
will be more diversified than a portfolio of securities which has coefficient
of correlation as 0.70. In a diversified portfolio we can reduce diversifiable
risk. When the coefficient of correlation is negative, the security is termed
as Hedge Asset, because in that case we can further reduce portfolio risk
by combining a security whose returns are negatively correlated with the
returns of the existing security. Here besides diversification we can also
have the benefit of Hedging.
u When Coefficient of Correlation is +1: In such a case security returns
are perfectly positively correlated. It implies that an increase(decrease)
in one security return is accompanied by exactly same proportionate
increase(decrease) in another security. Hence the returns of the two
securities move in tandem. In other words, there is no difference in
the pattern of returns of these two securities. In such a case we do
not have any Diversification benefit. We only have Risk Averaging.
In such a case equation (9.2A) becomes
σp = W1σ1 + W2σ2

It can be seen that portfolio risk is nothing but the weighted average
of risk of individual securities in this case. This is termed as Naive
Diversification.
u When Coefficient of Correlation is less than 1 but greater than 0:
When coefficient of correlation is less than 1, then although the
returns of the securities move in the same direction but they are not
increasing or decreasing in the same proportion. Hence if we include
these securities in a portfolio we get the benefit of diversification. We
will be able to diversify away the unsystematic risk or diversifiable
risk. The corresponding portfolio risk will be lower.
u When Coefficient of Correlation is zero:
When coefficient of correlation is 0, the security returns are unrelated.
There is no relationship between the returns of the two securities.
This is even better for diversification. When we include securities
which are not related with each other, we get higher degree of di-
versification and hence lower portfolio risk.
u When Coefficient of Correlation is less than 0 but greater than -1
We can also have coefficient of correlation as negative. It implies that
the returns of the two securities are moving in opposite direction.
If there is an increase in the return of security A there is decrease
in the return of Security B. Such a case is even better than all the
previous cases. Here we term these securities as Hedge Asset. If we
construct a portfolio of securities which are negatively correlated, we
have more diversified portfolio and lower portfolio risk than when
the coefficient of correlation is positive.
u When Coefficient of Correlation is -1
Finally, we may also have coefficient of correlation equal to -1. This
is the case of perfectly negative coefficient of correlation. In such a
case it is possible to completely eliminate risk. Hence when coefficient
of correlation is -1, we can have a portfolio which has zero portfolio
risk.
u Zero Risk or Zero variance portfolio
We can have a portfolio having zero risk or zero variance if
(i) coefficient of correlation is –1 and
σ2
(ii) W1 = ..........................................(9.7)
σ1 + σ 2
For example, assume that two securities A and B have expected
returns of 12% and 18% and S.D. of returns as 20% and 30% respective-
ly. The coefficient of correlation between returns of securities A & B
is –1.
Since ρAB = –1, we can have a portfolio having no risk. We have
sA = 20% sB = 30%. Let us assume that the weights of securities A &
B are WA & WB.
30
wA = = 0.60
20 + 30
WB = 1 – 0.60 = 0.40
Hence the portfolio which invests 60% of total funds in security A and
40% in security B, will have zero risk. This can be verified as under
sp = (0.60)2 (20)2 + (0.40)2 (30)2 + 2(0.6)(0.4)(–1)(20)(30)
= 0
Table 9.1 shows the relationship between Coefficient of correlation,
Diversification and Portfolio Risk
Table 9.1
Relationship between Coefficient of correlation,
Diversification and Portfolio Risk
Coefficient of Correlation Diversification Portfolio Risk

+1 i.e. perfectly positive No Diversification. Only risk Not reduced. Portfolio risk
correlation averaging is weighted average of se-
curity risks.
Less than +1 but greater Diversification is possible Portfolio risk will be lower.
than 0 i.e. positive correla- Hence risk can be reduced
tion
0 i.e. no correlation Diversification is possible Portfolio risk will be lower.
Hence risk can be reduced
Less than 0 but greater than Diversification as well as Portfolio risk will be lower.
-1 i.e. negative correlation hedging is possible Hence risk can be reduced
-1 i.e. perfectly negative Diversification is possible. Portfolio risk will be even
correlation Perfect hedging is possible lower and can also be Zero.
Here portfolio risk can be
completely eliminated if
W1 = σ2/(σ1+ σ2)
The relationship between portfolio risk and coefficient of correlation in
case of two securities can be explained using Fig 9.1. If coefficient of cor-
relation is +1 we have portfolio opportunity set as straight line AB. Here
we do not have any diversification benefit as there is just risk averaging.
When coefficient of correlation is lower 0.30, we have portfolio opportunity
set as curve ACB. Here some benefit of diversification is available. As we
keep on reducing the coefficient of correlation, the benefit of diversifica-
tion would be higher and portfolio risk would be lower and lower. Finally
when coefficient of correlation is -1, we can have a portfolio which has
zero risk (i.e. portfolio Z).
Fig 9.1. Correlation coefficient and Portfolio Risk ( Portfolio Opportunity set) – Two Securities Case

E(RP)
B
r=‐1
C
r=0.33
Z r=1
r=‐1
A
0 σ
Fig 9.1 : Correlation coefficients and portfolio Risk

(Two securities Case)
Illustration 9.5 : A portfolio comprises of two securities X and Y having

following information:
Security Expected return Standard deviation
X 12% 10%
Y 20% 18%
The investor invests 50% each in X and Y. calculate the expected return
and risk of the portfolio if the coefficient of correlation is:
a. -1
b. -0.3
c. 0
d. 0.60
e. 1
Solution. The expected return of the portfolio is:
Security Expected Return Proportion Weighted Return
X 12% 0.5 6%
Y 20% 0.5 10%
RP=16%
The risk of the portfolio for different correlation coefficients is given below:
Case X Y Coefficient Portfolio

Weight Std. Dev. Weight Std. Dev. of Variance Std. Dev.
Correlation
a 0.5 10% 0.5 18% -1 .0016 .04 or 4%
b 0.5 10% 0.5 18% -0.3 .0079 .09 or 9%
c 0.5 10% 0.5 18% 0 .0106 .103 or
10.3%
d 0.5 10% 0.5 18% 0.6 .016 .13 or
13%
e 0.5 10% 0.5 18% 1 .0196 .14 or
14%
As it can be observed from the example, higher the coefficient of correlation,
the higher will be the portfolio risk. But one can take the benefit of diver-
sification if the coefficient of correlation is less than 1. When coefficient
of correlation is +1 we do not have the benefit of diversification. There is
only risk averaging as the portfolio risk would be weighted average of risks
on individual securities. Such a case is termed as Naive Diversification.
HEDGING:
Hedging implies investing in securities which are negatively correlated with
the existing securities. When coefficient of correlation is perfectly negative
i.e. -1 we have a PERFECT hedge asset. The inclusion of such an asset or
security can completely eliminate portfolio risk.
IS IT POSSIBLE TO COMPLETELY ELIMINATE RISK?
Yes. It is possible to completely eliminate the risk provided following two
conditions are satisfied:
1. ρ = –1
σ2
2. W1=
σ1 + σ 2
This is explained in Illustration 9.6 below.

Illustration 9.6 : You are given the following details about securities A and B.
A 12% 10%
B 20% 18%
The coefficient of correlation between the returns of A and B is -1. Is it
possible to have a portfolio comprising securities A and B which has zero
risk? Construct such a portfolio and calculate its portfolio return.
Solution : Here we have coefficient of Correlation =-1, A zero risk portfolio

can be constructed using A and B if
Weight of security A =18/(10+18) =18/28=0.64
And weight of security B= 1-0.64=0.36
Risk of portfolio
σp2= (0.64)2(10)2+ (0.36)2(18)2+ 2(0.64) (10) (0.36) (18) (-1)
= 40.96+41.99-82.95
=0
Portfolio Return :
Rp = O.64(12) + 0.36(20) = 14.88%
9.3 Portfolio Selection

Once we have analysed the portfolios in terms of their risk and returns,
the next step in portfolio management process is construction or selection
of optimal portfolio. Every investor in the market is risk averse. However
investors differ in terms of their attitude towards risk and return i.e. investors
have different risk return preferences. Some investors are less risk averse
or aggressive. Others are more risk averse or conservative investors. Even
in the category of aggressive and conservative investors we may have more
aggressive or less aggressive and so on. Depending upon the risk aversion
of a particular investor, the same security may provide different utilities or
satisfaction to different investors. The main criterion or guiding principle
while selecting the optimal portfolio is that it should be a portfolio which
provides maximum return for a given level of risk or which has minimum
risk for a given level of return. Further, every investor wants to maximise
his utility while selecting the optimal portfolio.
The problem of portfolio selection has been dealt in detail by Harry Markowitz
(1952) in his Portfolio Theory, which was later extended by Sharpe (1964) in
Capital Market Theory. Hence the two theories available to solve the prob-
lem of portfolio selection can be studied under the following two headings:
1. Portfolio Theory
2. Capital Market Theory
It must be noted that capital market theory is a major extension of the
Portfolio Theory of Markowitz. Portfolio theory is really a description of
how rational investors should build efficient portfolios and select the op-
timal portfolio which maximises their utility.
Capital Market theory simplifies the problem of portfolio selection by in-
troducing a risk free asset in the market. These theories are explained in
detail in the following sections.
329 Portfolio Selection Para 9.3
9.3.1 Portfolio Theory of Harry Markowitz (1952) or Mean Variance

Optimisation Model
The seminal work by Harry Markowitz published in a paper titled “ Portfolio
Selection” in Journal of Finance in 1952, sets the foundation for the selection
of optimal portfolio by a rational investor. The portfolio theory popularly
known as Markowitz Model provides the logical and analytical tool for the
selection of an optimal portfolio. This model is based on expected return (i.e.
mean) and risk (or variance) and hence it is also termed as Mean Variance
Optimisation Model. This model is based on certain assumptions such as
1. Investors are risk averse.
2. Portfolios can be analysed in terms of their risk and return. Portfolio
return is the weighted average of the return on individual securities.
Portfolio risk is calculated using variance covariance matrix as given
in equation 9.3.
3. The decision regarding selection of optimal portfolio by an investor
is based only on return and risk.
4. Investors are rational, they attempt to have maximum return for a
given risk and minimum risk for a given return.
5. Investors have different risk return preferences i.e. their indifference
curves are different.
Using above assumptions the Markowitz Model of portfolio selection can
be presented in following three steps.
Step 1: Setting the portfolio opportunity set (or investment opportunity set)
First of all we need to prepare a portfolio opportunity set. Portfolio oppor-
tunity set shows the risk and returns of all possible portfolios which can
be made from a set of available securities. In case of N securities we can
have an infinite number of possible portfolios in which an investor can in-
vest. For example in case of two securities A and B, we can combine these
two securities in a number of portfolios by just changing their weights or
proportion of funds invested in each. We can have 1% in A and 99% in B, 2%
in A and 98% in B and so on. The number of such portfolios will be many.
Every portfolio is then analysed in terms of its risk and return. The graph-
ical presentation of these portfolios is termed as Portfolio or Investment
Opportunity Set. When the number of securities is three say A, B and C
we can have even more possible portfolios because now we can have
portfolios of A+ B, B + C, A+ C as well as A+B+C and depending upon
their weights these portfolios will be many more in number. In real life we
have many securities, hence the portfolio opportunity set comprises of an
Para 9.3 Portfolio analysis and selection
Fig 9.2 : Portfolio Opportunity set in case of N securities
330
infinite number of feasible portfolios which can be constructed using the

available securities.
Fig 9.2 shows the Portfolio Opportunity Set in case of N securities. It can
be observed that there is a region of portfolio opportunity set in case of N
securities. Every point in this region belongs to a particular portfolio. There
are many feasible portfolios in which an investor can invest.
E(Rp) Efficient Frontier
 C K
 B
G’
σp
Fig 9.2 : Portfolio Opportunity Set in case of N securities
Step 2 : Determining the Efficient Set of portfolios (i.e. Efficient Frontier):

Once the region of all feasible portfolios has been identified, the next task
is to find out those portfolios which are efficient. All feasible portfolios are
not efficient. An efficient portfolio is one (i) which has maximum return
for a given level of risk or (i) which has minimum risk for a given level of
return. As investors are rational they will prefer more return to less return.
Further since the investors are risk- averse, they prefer less risk to more
risk. Hence given a choice among portfolios having same risk, investors
prefer to hold the portfolio with the highest return. On the other hand if
the choice is among the portfolios having same return, then the investors
will prefer that portfolio which has lowest risk. Here we apply the Rule
of Dominance. As per the Rule of Dominance a portfolio having highest
return dominates all other portfolios having same risk. Further a portfolio
having lowest risk dominates all other portfolios having same return. As
per the rule of dominance we can identify the set of efficient portfolios. In
Fig 9.2, it can be seen that portfolio A dominates portfolio B and all other
portfolios lying below A. This is because all other portfolios lying below
portfolio A provide lower return at the same level of Risk. Hence portfolio
A is an efficient portfolio. Similarly portfolio D dominates portfolio C and
all other portfolios lying to the right of portfolio D. This is because portfo-
lio C and all other portfolios lying to the right of portfolio D, have higher
risk than portfolio D but provide same return as provided by portfolio D.
Further the portfolios which lie below point G' say in the part G' C are also
inefficient because they are dominated by the portfolios in the upper part
of G'. We can identify all efficient portfolios in the similar manner. Finally
we get the set of efficient portfolios which lie on the curve G'ADK.
This set of efficient portfolios is popularly known as Efficient Frontier. Thus
Efficient frontier is the graphical presentation of all efficient portfolios out
of the feasible portfolios. It must be noted that all efficient portfolios are
feasible but all feasible portfolios are not efficient.
Step 3: Constructing Indifference curves of the investor
The Efficient frontier which we derive in step 2 shows all efficient portfolios
from which the investor will choose his optimal portfolio. There are many
efficient portfolios but optimal portfolio must be one from among these
portfolios. As you are aware that investors differ in terms of their risk return
preferences. Some investors are more risk averse and some are less risk
averse. The more risk averse investor should select an optimal portfolio
in the lower region of efficient frontier, while a less risk averse investor
should select a portfolio in the upper region of efficient frontier. But efficient
frontier alone cannot help an investor to select the optimal portfolio. The
basic criterion for the selection of optimal portfolio is that the satisfaction
or utility of the investor is maximised. For this we construct Indifference
Curves for the investors. As explained in Chapter 3, an indifference curve
shows all those combinations of risk and return which generate same utility
for an investor. Since all investors are risk averse, the indifference curves
of the investor will be upward sloping as shown in Fig 9.3. It must be noted
that a less risk averse investor will have rather flatter indifference curves
while a more risk averse investor will have steeper indifference curves.
But indifference curves for a particular investor cannot intersect. They
will be parallel. In Fig 9.3 we constructed three indifference curves for the
investor, I1, I2 and I3. The utility on I3 is highest and on I1 is lowest. Hence
portfolio D provides higher utility than portfolios A,B or C. However on
the same indifference curve, the utility derived is same. It implies that the
utility of portfolio B is same as that of C. Portfolio B and C provides higher
utility that portfolio A.
E(RP) I3
I2
I1
D
C
B  A
σP
Fig 9.3: Indifference Curves of a Risk Averse Investor
Step 4 : Selecting the optimal portfolio

The last step is the selection of optimal portfolio. Every investor wants to
select a portfolio which maximises his utility. Therefore for the selection of
optimal portfolio we superimpose Indifference Curves of the investor on the
Efficient Frontier. The indifference curves show the utility that an investor
derives using different combinations of risk and returns. The higher the
indifference curve the greater is the utility. On the same indifference curve
utility is same. Efficient frontier shows all efficient portfolios from which
the investor has to choose his Best or Optimal Portfolio. Hence selection
of the optimal or best portfolio must meet the following two conditions
i. The portfolio is efficient i.e. it must lie on efficient frontier and
ii. The utility of the investor is maximised i.e. it should lie on the highest
possible indifference curve.
Fig 9.4 shows this selection process. Here we have superimposed indiffer-
ence curves I1, I2 and I3, derived in step 3, on the efficient frontier which
we derived in step 2. The optimal portfolio is given by point E. i.e. the
point of tangency between the efficient frontier and the highest possible
indifference curve i.e. I2. It must be noted that only portfolio E meets the
conditions described above. No other portfolio is better than portfolio E.
Portfolio P1 and P2 are also efficient but they are on a lower indifference
curve and hence the utility derived from P1 and P2 will be lower than that
derived from E. Hence the investor will not select it as the best portfolio. On
the other hand portfolio P3 is desired by the investor as it provides higher
utility, but it is not attainable as it does not lie on Efficient frontier. Hence
the only optimal or Best portfolio is portfolio E. We can now generalise that
the optimal portfolio for an investor under Markowitz model is the point of
tangency between the efficient frontier and the highest possible indifference
curve. This also referred to as the point of equilibrium.
It must be noted here that since the indifference curves for different in-
vestors will be different, depending upon their degree of risk aversion, we
will have as many optimal portfolios of the risky securities as there are
number of investors. A more risk averse investor will have steeper indif-
ference curves and hence his optimal portfolio (i.e. point of tangency) will
be in the lower region of efficient frontier. A less risk averse investor will
Fig 9.4
have : Selecting
more flatthe Optimal Portfolio
indifference curves and hence his optimal portfolio (point
of tangency) will lie on the upper region of the efficient frontier.
In Fig 9.4A, the indifference curves for a more risk averse investor (Say Mr.
X) are I1, I2 and I3 while for a less risk averse investor (say Mr.Y) the indif-
ference curves are I5, I6 and I7. You can notice that the indifference curves
I1, I2 and I3 are steeper than the indifference curves I4, I5 and I6. The optimal
portfolio for Mr. X will be E1 and for Mr. Y it will be E2. Similarly every
investor will have a unique optimal portfolio which is defined by the point
of tangency between his highest possible indifference curve and efficient
frontier. There will be as many optimal portfolios as there are number of
investors in the market. This is the main limitation of Markowitz Model of
portfolio selection.
E(RP) I3
I2
I1
P3  Efficient Frontier
P2
E
P1
σP
Fig : 9.4 : Selecting the Optimal Portfolio

Fig 9.4A : Selecting the Optimal Portfolio

E(RP) I4
I5
I6
I1 I
2
I3 E2
E1
σP
Fig : 9.4A : Selecting the Optimal Portfolio
Limitations of Markowitz Model

Markowitz model explains in a logical way as to how the efficient portfolios
can be identified and finally how the optimal portfolio is selected. However
Harry Markowitz model suffers from the following limitations
1. Markowitz model is quite demanding in terms of data requirements.
In order to analyse N securities we need (3n+N2)/2 data inputs. It
becomes very cumbersome and complex to handle such a large
data set. For example in order to analyse 100 securities we need 100
returns, 100 variances and 4950 co variances i.e. a total of 5150 data
inputs. This is substantial.
2. As per Markowitz Model there are as many optimal portfolios as
there are number of investors. However this limitation is removed
when we introduce a risk free asset in the capital market.
9.3.2 Capital Market Theory

The development of Capital Market Theory can be traced to Sharpe when
he published a paper “ Capital Asset Prices: A Theory of Market Equilibrium
under Conditions of Risk” in Journal of Finance in 1964. Capital market
theory extends Markowitz model to a situation when a risk free asset is
introduced in the capital market. It must be noted that the optimal portfo-
lio of risky securities will be different for every investor under Markowitz
Portfolio Theory. There will be as many optimal portfolios of risky securities
as there are number of investors in the market. This is because every in-
vestor will have a different set of indifference curve and given the shape of
efficient frontier (a concave curve), we will have different points of tangency
defining optimal or equilibrium portfolio for an investor. This problem can
be resolved if we introduce a risk free asset in the market which allows
the investors to lend or borrow at risk free rate. Capital Market Theory
extends Markowitz’s Portfolio Theory by including risk free lending and
borrowings. It also assumes that all the investors are rational and mean
variance optimizers as assumed by Markowitz Portfolio Theory.
Capital Market theory is based on following assumptions:
i. Investors make decisions solely on the basis of risk and return as-
sessments. This implies that expected return and variance are the
only factors considered in investment decisions. Investors are mean
variance optimizers in Markowitz sense.
ii. Securities are infinitely divisible.
iii. There are no restrictions on short selling.
iv. There are many investors and buy or sell transaction of any investor
will not affect the price of the securities.
v. There are no transaction costs or taxes.
vi. There is a risk free asset in the market besides risky assets. Hence
investors can borrow or lend any amount at the same risk free rate.
vii. Investors have identical or homogeneous expectations about expected
returns, variances of expected returns and covariances of all pairs
of securities. This assumption is important so as to have a unique
efficient frontier. If the expectations of the investors differ in terms
of returns, variances and covariances then there would be a number
of efficient frontiers which would further complicate the problem.
Introduction of Risk Free Asset (or Risk Free Lending and Borrowing)
As per Portfolio Theory the shape of Efficient Frontier is a concave curve.
It can be seen in Fig 9.5 that the original efficient frontier as derived under
Portfolio Theory is curve AMB. When a risk free asset is introduced in the
capital market then the efficient frontier becomes a straight line which
originates from risk free return on Y axis and is tangent to the original
efficient frontier at point M. This line is RfMD. This new efficient frontier
which is a straight line is called Capital Market Line(CML). Thus Capital
Market Line is the line which starts from Rf and is tangent to the original
efficient frontier at point M. The CML shows a linear relationship between
portfolio return and Risk. Every point on CML shows an efficient portfolio
(which is actually a combination of the efficient portfolio M and risk free
asset). The intercept of CML is Rf i.e. risk free rate which shows that if
there is no risk, the return earned must be equal to Rf. It can be observed
that the slope of CML is [(E(RM)- Rf)]/σM which is market risk premium per
unit of market risk. Fig 9.5 shows Capital Market Line.
The Capital Market Line is given in equation (9.8)

[(e(r M ) – r f )]
e(r p ) = r f + .σ p ..................................................................................(9.8)
σM
Where : E(Rp) = Expected return of a portfolio
Rf = Risk free rate of interest
E(RM) = Expected Return on Market Portfolio
σM = Standard deviation (total risk) of Market portfolio

σp = Standard deviation (total risk) of the portfolio

Equation (9.8) can be written as
Expected Return = Reward for Time + (Reward per unit of total market
risk) X (Total portfolio Risk)
The Capital Market line shows that the return from a portfolio depends
upon risk free rate, reward per unit of market risk and total risk of the
portfolio. The higher the risk the greater will be the expected return.
The CML has the following features
u CML shows a linear and positive relationship between expected return
and risk of a portfolio.
u It originates from Rf i.e. risk free rate. Hence the intercept of CML
is Rf.
u The slope of CML is reward to variability ratio i.e. [(E(RM)- Rf)]/σM
u CML is tangent to original efficient frontier at point M, i.e. the Market
Portfolio or the optimal portfolio of risky assets.
u Only efficient portfolios consisting of risk free asset and portfolio M
Fig 9.5 : Capital Market Line
lie on CML.

u CML is upward sloping because price of risk must be positive since
investors are risk averse.

D
E(Rp) CML
M Efficient frontier
B
A
Rf
0 σp
Fig 9.5 : Capital Market Line

Fig 9.5A : Capital Market Line and Optimal Portfolio


E(RP) I4
Borrowing I5
I6

E2
I1
Lending I2 M
I3
E1
σP
Fig 9.5A : Capital Market Line and Optimal Portfolios
The portfolios that lie on CML are efficient portfolios. All the portfolios that
lie on CML are a combination of the following two.
i. Efficient portfolio M which is the optimal portfolio of risky assets;
and
ii. A risk free asset (either lending or borrowing).
Now the problem of portfolio selection is simplified. Every investor will
now have an optimal portfolio which is on CML. It must be noted that there
are many portfolios on CML but they all comprise of the same optimal
portfolio of risky asset i.e. portfolio M and a risk free asset. Hence every
investor will have the same optimal portfolio of risky assets i.e. portfolio
M and combine it with risk free lending or borrowing to suit his risk re-
turn preferences. Portfolios to the left of point M include risk free lending
and hence are relevant for a more risk averse or conservative investor.
These portfolios are termed as Lending Portfolios or Defensive Portfolios.
Portfolios to the right of point M include risk free borrowing and hence
are relevant for a less risk averse or aggressive investor. These portfolios
are termed as Borrowing Portfolios or Aggressive Portfolios. An investor
which does not want to have risk free asset (i.e. neither risk free lending
nor risk free borrowing) will choose portfolio M. This is shown in Fig 9.5A.
It can be seen that the conservative investor has his optimal portfolio as
E1 while an aggressive investor has his optimal portfolio as E2. Both E1
and E2 have the same optimal portfolio of risky assets i.e. portfolio M. But
conservative investor has risk free lending (or investing in risk free asset as
well) while aggressive investor is borrowing at risk free rate and investing
the entire funds in optimal risky portfolio M.
Similarly every investor has an optimal portfolio on CML. The common

feature of these optimal portfolios is that they have same portfolio of
risky assets i.e. portfolio M and differ only in terms of risk free lending or
borrowing.
Hence the problem of portfolio selection is simplified. Every investor should
hold the same optimal portfolio of risky assets i.e. portfolio M and combine
it with risk free lending or borrowing to meet his risk- return requirements.
Separation Theorem/Property
The selection of optimal portfolio is simplified as per Capital Market Theory
when we include a risk free asset in the market. We have explained that in
such a case, every investor holds the same optimal portfolio of risky assets
i.e. market portfolio M and has risk free lending or borrowing according
to his risk return preferences. This leads to Tobin’s separation Theorem
or Separation Property. As per separation theorem the investment and
financing decisions are separate. Investment decision is the decision to
invest in risky assets. Financing decision is the decision to lend or borrow.
In Capital market Theory, investment and financing decisions are separate
or independent. Investment decision is same for all the investors in the
market i.e. everyone is investing in the same Market portfolio, M i.e. the
optimal portfolio of risky assets. However Financing decision is different
for different investors- some investors prefer to lend while others prefer
to borrow.
Separation of Investment and Financing decision has important implications
for capital market. They are explained below:
(i) The only portfolio of risky assets that will exist in the market will
be portfolio M or Market portfolio. This is because every investor is
investing only in portfolio M. Hence any security or asset which is not
a part of portfolio M cannot survive or exist in the market, as there
will be no takers for it. Hence all the assets or securities which form
part of portfolio M only will survive or exist in the market. Hence
portfolio M is termed as Market Portfolio.
(ii) Every investor will invest in Market portfolio differing only in the
amount of investment. The weightage of each security will be exactly
same as it appears in the market portfolio. For example assume
that the market portfolio comprises of three securities A, B and C
in the proportion of 50%, 30% and 20%. There are two investors Mr.
X and Y. Mr. X has investible funds of Rs. 10000 and Mr. Y also has
Rs. 10000 to invest. Mr. X is conservative and hence he wants to
invest Rs. 8000 and lend Rs. 2000 at risk free rate. Therefore Mr.
X will invest Rs. 8000 in all three securities A, B and C in the ratio
of 50%, 30% and 20%. It implies that the portfolio of Mr. X will have
Rs. 4000 invested in security A, Rs. 2400 in B and Rs. 1600 in security
C along with Rs. 2000 in risk free asset. Let us assume that Mr. Y is
an aggressive investor and he wants to borrow Rs. 2000 at risk free
rate. Therefore Mr. Y will borrow Rs. 2000 and invest the entire Rs.
12000 (i.e. 10000+2000) in portfolio M i.e. in three securities A, B and
C in the ratio of 50%, 30% and 20%. It implies that the portfolio of
Mr. Y consists of Rs. 6000 invested in security A, Rs. 3600 invested in
security B and Rs. 2400 invested in security C along with a borrowing
of Rs. 2000 at risk free rate.
Illustration 9.7:
The details of three portfolios are provided to an investor :
Portfolio Expected Return Total Risk(S.D)
P 7% 3%
Q 19% 6%
R 20% 10%
It is further given that the risk free rate of interest is 4% and expected
market return is 12%. Risk (S.D.) of the market portfolio is 5%. Find out
whether these portfolios are efficient or not.
Solution:
We know that a portfolio is efficient if it lies on Capital Market Line. Hence
we need to calculate expected return of these portfolios as per CML. The
given expected returns are based on the probability distribution of returns
or some other analysis.
If expected return as per CML = given expected return then the portfolio
lies on CML and hence is efficient. Otherwise the portfolio is inefficient.
Expected return as per CML is calculated using the following equation.
[(e(r M )- rf)]σp
E(Rp) = e(rp) = rf +
σM
Portfolio Expected Expected return as per CML Efficient or Not

Return (given)
P 7% 4+(12-4)3/5 = 8.8% Not efficient
Q 19% 4+(12-4)6/5 =13.6% Not efficient
R 20% 4+(12-4)10/5 =20% Efficient
The above Table shows that only portfolio R is efficient portfolio because
in case of other portfolios the expected return as per CML does not match
with the given returns. Portfolio P has lower expected return (given as 7%)
and hence is inefficient portfolio. Portfolio Q has higher expected return

(19%) is also inefficient or more than efficient.
9.3.3 From Capital Market Theory to Capital Asset Pricing Model

(CAPM)
We have already stated that Capital Market Theory is an extension of
Portfolio theory and explains as to how an investor selects his optimal
portfolio in a capital market which has risky securities as well as risk free
asset. A risk averse investor selects an efficient optimal portfolio of risky
assets (which is market portfolio) and combines it with risk free lending
or borrowing as per his risk return preferences.
Capital Asset Pricing Model (CAPM) is an extension of Capital Market
Theory. Capital asset pricing model shows how risky assets are priced
in efficient capital market. CAPM has been developed by Sharpe (1964),
Lintner (1965) and Mossin (1966) in independent research papers. CAPM
helps in the prediction of expected return on a security or portfolio. The
expected return determined through CAPM can then be used to find out
whether a security is earning more or less than the expected return. From
investment point of view an investor should select securities which provide
higher return than the one expected by CAPM.
The Capital Market Line as derived under Capital Market Theory shows
all efficient portfolios consisting of the market portfolio and a risk free
asset. The market portfolio is efficiently diversified as it includes all avail-
able securities in the market. CML relates expected return on a portfolio
[E(Rp)] to its total risk (σp) and shows that there is a positive and linear
relationship between the two.
In Chapter 3 we discussed about the risk and return of a security. Total
risk of a security comprises of two components – Systematic Risk and
Unsystematic Risk.
u Systematic Risk or Non-Diversifiable Risk : Systematic risk is the risk
which is caused by factors beyond the control of a specific company
such as general factors in market, GDP, Inflation, Interest rates, Tax
policy, Govt. Policies etc. These factors affect all the companies and
cause variability in their returns. Systematic risk cannot be reduced
by holding an efficiently diversified portfolio. Therefore systematic
risk is that part of total risk which cannot be eliminated by diver-
sification. This part of risk arises because all the securities, on an
average, move in the direction of market return. Market risk is the
primary source of systematic risk of a security. Hence systematic
risk and market risk terms are used interchangeably. Changes in
market cause changes in a security’s return and hence no security
can escape systematic or market risk. Systematic risk of a security

is indicated by beta coefficient (β). β captures the sensitivity of a
security’s return with respect to market return.
Unsystematic Risk : Unsystematic risk is that part of total risk which is
diversifiable. Unsystematic risk is caused by factors which are within
the control of a specific company such as management, operational
efficiency, labour conditions, financial leverage etc. The sources of
unsystematic risks are business risk and financial risk. It is termed
as diversifiable risk because in an efficiently diversified portfolio
unsystematic risk can be completely eliminated. Diversification is
using a number of securities to reduce risk. Securities which are
less than perfectly positively correlated can be combined together
to diversify away unsystematic risk.
It can be observed that unsystematic risk reduces to zero in an effi-
ciently diversified portfolio and hence the only relevant risk in such
a portfolio is systematic risk. Market portfolio, M, is an efficiently
diversified portfolio and hence it must not contain any unsystematic
risk. Therefore as per capital market theory the only relevant risk
which is priced in capital market is systematic risk and not the total
risk.
β: An indicator of Systematic Risk
We have explained in the previous section that in an efficiently
diversified portfolio i.e. Market portfolio, there is no unsystematic risk.
All the unsystematic risk has been diversified away. Hence total risk
of the Market portfolio comprises of only systematic risk. It implies
that as per Capital Market theory, the only risk which is priced in the
market is systematic risk and not unsystematic risk.
β is an indicator of systematic risk of a security. It measures the
sensitivity of a secuirty’s returns with respect to market return. It is
an index or a number which shows whether a security is less sensi-
tive or more sensitive to the market return. The more sensitive (or
responsive) a security’s returns is to market return, the higher will
be the value of β.
u If a security has β <1 then it is less responsive to changes in market
returns.
u On the other hand if β > 1 then the security is more responsive to
changes in market return.
u A risk free asset is not responsive to changes in market returns and
hence the β of a risk free asset is always 0.
u The β of market portfolio is always 1. This is because here we are

relating market portfolio with itself and hence it must be one.
It must be noted that β of a security measures the resultant change in a
security’s return for a unit change in return of market portfolio. When β
is 0.80 then an increase in market return by 10% is likely to increase secu-
rity’s return by 8%. On the other hand a 10% decline in market return will
result into a decline of 8% in security’s return. When β is 1.5 then it implies
that a 10% increase in market return is expected to increase the security’s
return by 15% and similarly a 10% decrease in market return is expected
to decrease the security’s return by 15%.
The calculation of β is discussed in detail in Chapter 3. Here we are giving
only the relevant formulae:
b of a security can also be calculated as
cov(s, M) ........................................................................... (9.9)

β =
σ M2
Where Cov(S,M) = Covariance between returns of security S and Market
Return
σ M2 = Variance of Market returns or simply Market Variance
Now we know that Cov (SM) = σS × σM × Correl(SM)

Therefore
σ s × σ M × correl(sM)
β =
σM 2
σs σs
Hence β =
σM
× correl(sM) = ρsM ×
σM ................................................................(9.9A)
Where, σS = Standard Deviation of Returns on security S

σM = Standard Deviation of Returns on market portfolio M
Correl(SM) = Coefficient of Correlation between the returns of
security S and Market returns.
Illustration 9.8 explains the calculation of β in case of a security.
Total Risk (σ) and β
Both σ and β are measures of risk. But they are also different and capture
different amounts of risks. It is important to mention here that standard
deviation (σ) is a measure of total risk of a security or portfolio. β on the
other hand is an indicator of systematic risk.
Illustration 9.8 : Following information is available in respect of a security
G and the market portfolio M.
Probabilities Security G Market Portfolio M

0.3 10 12
0.4 12 15
0.3 14 18
Find out β of security G.
Solution :
Pi G M PiG PiM Pi(G-exp G)2 Pi(M-exp M)2 Pi(G-exp G)(M-exp M)
0.3 10 12 3 3.6 1.2 2.7 1.8
0.4 12 15 4.8 6 0 0 0
0.3 14 18 4.2 5.4 1.2 2.7 1.8
Σ =12 Σ =15 Σ =2.4 Σ =5.4 Σ =3.6
The above table shows that
Mean return of G = 12%, Mean market return = 15%, Variance of G = 2.4
sq % Variance of M = 5.4 sq %, Covariance = 3.6 sq %
β=Cov/Market Variance = 3.6/5.4 = 0.67
Hence beta of security G is 0.67.
Illustration 9.9 : Following information is available in respect of a security
A and the market portfolio M. Find out beta of the security A.
Security A Market Portfolio M
10 15
18 12
14 18
20 16
11 19
(B.Com (H) DU 2013)
Solution :
A M (A-Mean (M- Mean (G-Mean A)
A)2 M)2 X(M-Mean M)
10 15 21.16 1 4.6
18 12 11.56 16 -13.6
14 18 0.36 4 -1.2
20 16 29.16 0 0
11 19 12.96 9 -10.8
Mean A = 14.6 Mean M = 16 Σ =75.2 Σ =30 Σ =-21
Variance of M i.e. Market variance= 30/5 = 6

Covariance between A and M = -21/5= -4.20
Beta of A = Cov/Market variance= -4.2/6 = -0.7
Illustration 9.10 : Calculate beta factor of a security for which the follow-
ing details are available. Also specify whether the security is defensive or
aggressive.
Mean return from security = 10%
Mean return from Market portfolio = 13%
Standard Deviation of returns from Market portfolio = 15%
Standard Deviation of returns from security = 18%
Coefficient of correlation between the returns of security and market
portfolio = 0.80
Solution :
As per equation (9.9A)
coefficient of correlation × s.d of security returns
Beta of the security =
s.d of Market returns
= 0.80 × 0.18/0.15
= 0.96
Since beta of the security if less than 1, it is a defensive security. A 10%
change in the return of market portfolio will result in a 9.6% change in the
return of the security in the same direction.
9.4 Capital Asset Pricing Model

Capital asset pricing Model is an equilibrium model used to predict expected
return on a security or portfolio. Capital Asset pricing Model shows that there
is a positive and linear relationship between expected return and systematic
risk. As per this model, in the capital market, only systematic risk is priced.
Unsystematic risk, being a diversifiable risk, is not priced in capital market.
It implies that the investor gets a reward only for bearing systematic risk,
and not for unsystematic risk. CAPM is built on the premise that in market
portfolio there is no unsystematic risk because it is efficiently diversified
portfolio. Hence Capital Market Line which shows the relationship between
expected return and total risk should in fact show a relationship between
expected return and systematic risk indicated by β factor.
Assumptions of CAPM:
CAPM is based on several simplified assumptions which are given below.
All of the assumption of Capital Market Theory are used here.
345 Capital asset pricing model Para 9.4
i. All investors are risk averse.

ii. Investors make decisions solely on the basis of risk and return as-
sessments. This implies that expected return and variance are the
only factors considered in investment decisions. Investors are mean
variance optimizers in Markowitz sense.
iii. Securities are infinitely divisible. One can buy or sell securities even
in fractions.
iv. There are no restrictions on short selling.
v. There are many investors and buy or sell transaction of any investor
will not affect the price of the securities. There is perfect competition
in capital market.
vi. There are no transaction costs or taxes. The capital market is efficient
and frictionless.
vii. Investors can borrow or lend unlimited amount at the same risk free
rate.
viii. Investors have identical or homogeneous expectations about expected
returns, variances and covariances.
ix. All the investors hold efficiently diversified portfolios having no unsys-
tematic risk. The only relevant risk in estimating return is systematic
risk.
The CAPM Model
As per CAPM there is a linear and positive relationship between expected
return and systematic risk measured by β. CAPM is used to estimate expected
return from a security or portfolio. β measures the sensitivity of a security’s
returns to the returns of market portfolio. It must be noted that securities
differ in terms of their sensitivity to market portfolio. Some securities are
less sensitive while others are more sensitive. Hence β of different secu-
rities and portfolios are also different. Moreover, as discussed earlier the
unsystematic risk of a security can be diversified away and hence investor
will not receive any return or risk premium for bearing unsystematic risk.
The investor will receive risk premium only for the non diversifiable risk
i.e. systematic risk as indicated by β.
The CAPM is stated as below:
e(ri) = rf + [(e(rm) - rf] βi ................................................................................(9.10)
Where E(Ri) = Expected rate of return from a security or asset
Rf = Risk free rate of return
E(RM) = Expected Return on Market portfolio
β i= Beta coefficient or beta factor of security i, which is an indicator of

security’s systematic risk.
As per CAPM
Expected Return = Risk Free Rate + Market Risk Premium X Systematic
Risk
Expected Return = Risk free rate + Risk premium
Expected Return = Reward for Time + Reward for Risk
Risk free rate is rate of return on a security which does not have any risk.
Hence risk free rate is not a reward for bearing any risk. It is a compensa-
tion for time. It is therefore also termed as time value of money.
The market portfolio is the efficiently diversified portfolio which contains
all the securities available in the market. Market risk premium is the excess
of expected return on market over risk free return. Market risk premium
is the price (or reward) per unit of risk in capital market. It must be noted
here that we are concerned only with systematic risk here because in market
portfolio, which is efficiently diversified portfolio, unsystematic risk is nil.
Risk premium of a security is calculated as the product of Market risk
premium and systematic risk of the security as indicated by its β factor.
Thus we can say that the expected return from a security depends upon
the following three factors
1.
Risk free rate of return : This is the pure time value of money. This
is the compensation an investor must get just for time without any
assumption of risk.
2.
Market risk premium or the market price for risk : This is the reward
an investor must get for bearing one unit of market risk or systematic
risk.
Amount of systematic risk indicated by β : This is the relative amount
3.
of systematic risk in a security. The higher the systematic risk the
higher will be the expected return.
It must be noted that risk free rate of return and market risk premium will
be common for all the securities. Hence the only factor that causes differ-
ence in expected returns across various securities is, β factor or systematic
risk. The higher the systematic risk the greater will be the expected return
from that security.
For example if we are given that
Rf = 5%, E(RM) = 11% and β of a security T, is 1.5 then the expected return
of the security will be 14% as calculated below.
E(Ri) = Rf + [(E(RM) – Rf] βi

E(Ri) = 0.05 + (0.11-0.05) (1.5)
= 0.14 or 14%
If another security Z, has a β equal to 0.50 then its expected return will be
8% as calculated below:
E(Ri) = 0.05 + (0.11-0.05) (0.5)
= 0.08 or 8%
It must be noted that the security with high β has higher expected return.
Further there is a linear relationship between return and risk.
Whether a security is efficiently (or fairly) priced in the market?
In the above examples we have calculated the expected returns of two
securities as 14% for security T and 8% for security Z. These expected
returns are based on CAPM.
In Chapter 3 we calculated expected return from a security using proba-
bility distribution or historical returns. Such a return may be termed as
Actual return or the return which is expected on the subjective judgment
of the investor.
Now let us assume that the actual average return or expected return based
on probability distribution, of security T is also 14% then it means that the
security is efficiently priced in the market.
If actual return from security T is 13% then the security is over priced in
the market as its expected return based on CAPM is higher .
If actual return from security T is 15% then the security is under priced
in the market as its expected return based on CAPM is lower while it is
providing a higher actual return.
A prospective investor may be interested in finding out underpriced secu-
rities for which average return is greater than the expected return based
on CAPM.
Security Market Line (SML) :
The graphical presentation of Capital Asset Pricing Model is called Security
Market Line (SML). Security market line shows the relationship between
expected return and β factor indicating systematic risk. Hence it is drawn
in a return – β space. Fig 9.6 shows a Security Market Line (SML). Security
Market line is a straight line showing linear relationship between expected
return and β factor. It has an intercept as Rf i.e. it originates from Risk free
rate. It must be noted that when β is zero, the return an investor gets is equal
to risk free return. It passes through point M which shows market portfolio.
Since β of market portfolio is always 1, point M will be corresponding to 1
on X axis and E(RM) on Y axis.
SML is market risk premium or [(E(RM) – Rf].
The slope ofFig 9.6: Security Market Line
E(Ri) SML
M
E(RM)
Rf
βi
0 1
Fig 9.6A : Security Market Line
Fig 9.6 : Security Market Line
E(Ri)
A(underpriced) SML

E(RP)
 D
E(RM) M
C
E(RC)
 B (Overpriced)
RF
0 1 β
Fig 9.6A : Security Market Line

SML and pricing of securities:

u Itmust be noted that the securities which lie on SML are efficiently
priced in the market. For such securities actual return (or expected
return based on probability distribution) is equal to expected return
based on CAPM. In fig 9.6A, securities C and D are efficiently priced.
u Ifa security lies below SML then it is inefficiently priced, in fact
overpriced in the market. Such a security provides an actual return
which is lower than the expected return based on CAPM. In fig 9.6A
security B is overpriced in the market. A prospective investor should
not invest in such a security.
u If a security lies above SML then also it is inefficiently priced, but
it is underpriced in the market. Such a security provides an actual
return which is higher than the expected return based on CAPM.
In fig 9.6A, security A is underpriced in the market. A prospective
investor should invest in such a security.
Illustration 9.11 You are given the following information about two
securities P and Q.
Security P Q
Actual Return% 12 16
β 0.7 1.3
Risk free rate is 5% and Expected Return on market portfolio is 15%. Do
you think that securities A and B are efficiently priced in the market? Do
they lie on SML?
Solution: Here we need to calculate expected return as per CAPM
Expected return from A = 5+ (15-5)(0.7) = 12%
Expected return from B = 5+ (15-5)(1.3) = 18%
Since actual return of P is same as expected under CAPM, Security A is
efficiently priced and it will lie on SML.
The actual return of security Q is lower than the expected return under
CAPM, hence security B is inefficiently priced. It lies below SML. It is over-
priced in the market.
Illustration 9.12 The beta of a stock is 1.3 and standard deviation of its return
this stock is 19%.
Solution.
(ii) Expected Return of the stock = 6 + (15-6)1.3 = 17.7 %
(iii) Risk Premium of the stock = 17.7- 6% = 11.7%
(iv) Abnormal Return = 19-17.7 = 1.3%
It must be noted that abnormal return is the excess of actual return over
expected return as per CAPM.
Position and Slope of SML:
Security Market Line (SML) is an upward sloping straight line. The position
of SML depends upon Rf i.e. risk free rate and the slope of SML depends
upon Market risk premium. This is shown in Fig 9.6B and 9.6C. In Fig 9.6B
the original SML is S1 when risk free rate is Rf1. If there is an increase in
risk free rate to Rf2, then a new SML will be derived as S2. This SML is
parallel to S1 as there is no change in its slope.
In Fig 9.6C, Two SML lines are shown with different slopes. The higher the
market risk premium, the higher will be the slope of SML and the more
steeper will be
Fig 9.6B : thewith
SML SML. It can
different befree
risk seen that
rates the slope of the steeper SML,
S1 is higher. If there is a decline in market risk premium, other things being
equal, then the new SML, S2, will have a smaller slope.
E(Ri) S2
S1
Rf2
Rf1
0 βi

Fig 9.6B : SML with different risk free rates
351 SML & CML Para 9.5
Fig 9.6C : SML with different slopes
E(Ri) S1
S2
Rf
0 βi
Fig 9.6C : SML with different slopes
Simple Derivation of SML: We can derive SML using the following process.
We know that a straight line equation is
Yi = a +bXi …………………………(1)
In case of SML
Y = E(Ri) and X = βi
Therefore equation (1) becomes
E(Ri) = a + bβi…………………………(2)
We know that beta of a risk free assets is zero therefore if β = 0
Rf = a………………………………..(3)
Now beta of market portfolio is 1
Therefore E(RM) = a + b(1)
E(RM) = a + b
Since a = Rf
b= E(RM)- Rf……………………………(4)
Now we can substitute the values of “a” and “b” from (3) and (4) in the (2)
and we get
E(Ri)= Rf +{E(RM) –Rf } βi
This is SML or CAPM.
9.5 SML and CML

The SML looks similar to Capital Market Line since both are straight lines
and show risk return relationship. But there are many points of differences
between SML and CML.
Difference between SML and CML

1. SML shows the relationship between expected return and β factor
which is a measure of systematic risk. CML shows the relationship
between expected return and total risk as measured by σ of a port-
folio.
2. On SML we can show both individual securities as well as portfolios.
On CML only efficient portfolios are shown.
3. The slope of SML is Market Risk Premium. The slope of CML is the
Reward to Variability ratio.
4. SML can be used to determine expected return from a security or
portfolio. CML cannot be used to determine expected return of in-
dividual securities. CML is used to find out optimal portfolio for an
investor.
9.6 Uses of CAPM

CAPM is by far the most celebrated model in finance and widely used in
practice. It is used to determine the expected or required rate of return
from a security. Two important uses of CAPM are
1. In wealth management industry, CAPM is used to find out securities
which are underpriced or overpriced. So that a prospective investor
can make investment in underpriced security and an existing investor
can sell overpriced securities.
2. In Capital Budgeting decisions in Financial Management, we calculate
weighted average cost of capital (WACC) as the appropriate discount
rate. An important component of WACC is cost of equity. CAPM can
be used to determine the cost of equity which is nothing but required
rate of return from the investor.
9.7 Criticism/Limitations of CAPM

CAPM is a popular model for asset pricing or determination of expected
return. However it is criticised on the following grounds.
1. CAPM is based on many simplified and unrealistic assumptions which
may not hold true in real life. In real life securities are not infinitely
divisible, there are transaction costs and taxes, unlimited lending and
borrowing is not possible at the same risk free rate and so on.
2. The estimation of β factor is not a simple task. We may calculate β
using historical data. But past β values may not be valid in future.
Hence β is not constant overtime. Hence any estimation error in β
factor will result in an incorrect estimation of expected return.
353 Solved problems
Solved Problems
Problem 9.1 : An investor has 78% of his funds invested in the Security A
and 22% invested in the Security B. The risk and expected return data is
given below:
Security Risk (%) Expected return (%) Covariance(% squared)
A 16.32 9.82 0.43
B 32.86 14.97
What is the portfolio’s expected return and risk respectively?
Solution:
The expected return of the portfolio is:
Security Expected Return (Ri) Weight (Wi) WiRi
A 0.0982 0.78 7.66%
B 0.1497 0.22 3.29%
RP=10.95%
The risk of the portfolio is:
σ 2p = W12 σ12 + W22 σ 22 + 2W1W2ρ12 σ1σ 2
= (0.782 × 0.16322 ) + (0.222 × 0.32862 ) + 2 × 0.78 × 0.22 × 0.0043 = 0.0029

σP = .1513 or 15.13%
So, the return and risk of the portfolio are 10.95% and 15.13% respectively.
Problem 9.2: A portfolio is constructed by investing 70% of funds in Sharpe
Ltd. and 30% in William Ltd. Information regarding the two companies is
given below:
Sharpe 20% 15%
William 15% 8%
Compute the risk and return of the above stated portfolio assuming the
coefficient of correlation between two stocks is
a. +1
b. 0
c. -1 (B.Com (H) DU, 2013)
Solution. The expected return of the portfolio is:
Rp = W1(R1) + W2(R2) = 0.70 × 20 + 0.30 × 15 = 18.5%
Portfolio analysis and selection 354
Portfolio risk is calculated using the following formula

σ P = W12 σ 12 + W22 σ 22 + 2W1W2ρ12 σ 1σ 2
The risk of the portfolio for different correlation coefficients is given below:
X Y Coefficient Portfolio
Case Weight Std. Dev. Weight Std. Dev. of Variance Std. Dev.
Correlation
a. 0.7 15% 0.3 8% 1 166.41 12.9%
b. 0.7 15% 0.3 8% 0 116.01 10.77%
c. 0.7 15% 0.3 8% -1 65.61 8.1%
Problem 9.3: Mr. Small’s portfolio consists of two stocks: X and Y. The
standard deviation of returns is 0.25 for X and 0.14 for Y. The covariance
between the returns of the two stocks is 0.0045. Calculate the coefficient
of correlation between stock X and Y?
Solution:
covariance Xy 0.0045
ρXy = = = 0.1285
σXσy 0.25 × 0.14
Problem 9.4 What is the portfolio’s standard deviation if you invest 25% of
your money into stock A which has a standard deviation of returns of 15%
and the rest into stock B which has a standard deviation of returns of 10%?
The correlation coefficient between the returns of the two stocks is +.75.
Solution:
The standard deviation (risk) of the portfolio is:
σ 2P = W12 σ12 + W22 σ 22 + 2W1W2ρ12 σ1σ 2

= (0.252 × 0.152 ) + (0.752 × 0.102 ) + 2 × 0.25 × 0.75 × 0.75 × 0.15 × 0.10

= 0.0113
σ P = .1061

Thus, the standard deviation of the portfolio is 10.61%.
Problem 9.5 The correlation coefficient between assets D and E is +.50.
Asset D has a standard deviation of 40% and asset E has a standard deviation
of 60%. What is the standard deviation of the portfolio if 40% is invested
in asset D?
Solution: As 40% of funds are invested in asset D, then 60% must be invested
in asset E. The standard deviation (risk) of the portfolio is:
355 Solved problems
σ 2p = W12 σ12 + W22 σ 22 + 2W1W2ρ12 σ1σ 2
= (0.402 × 0.402 ) + (0.602 × 0.602 ) + 2 × 0.40 × 0.60 × 0.50 × 0.60 × 0.40

= 0.2128
σ p = .4613 or 46.13%
Problem 9.6 An investor invests 60% of his money into risk free T -Bills
that earn 5% and 40% into risky stocks which are expected to earn 10% and
have a standard deviation of 15%. Find out the expected return and the
standard deviation of the portfolio?
Solution:
The expected return of the portfolio is given by:
r p = 0.60 × 0.05 + 0.40 × .10 = 0.07 or 7%
Since the risk (standard deviation) of risk free rate of return is 0, the risk
of the portfolio is reduced to:
σ 2p = (0.402 × 0.152 ) = 0.0036
σ p = .06 or 6%
Note for students: The risk of the portfolio depends upon the risk of the
risky investments as there is no risk in case of a risk free asset or security.
Problem 9.7 The standard deviation of returns is 30% for Stock A and 20%
for Stock B. The covariance between the returns of A and B is 0.006. Find
out the correlation coefficient.
Solution:
Covariance Ab 0.006
ρAb = = = 0.10
σAσb 0.30 × 0.20
The correlation coefficient is 0.10.

Problem 9.8 Gliders and Co. has invested Rs. 5000 in a portfolio of shares.
It has invested 40% in shares of X Ltd. and balance in shares of Y Ltd. The
expected returns from these two companies are 10% and 8% respectively.
Find out the expected return of the portfolio in:
i. Absolute amount
ii. Percentage
Solution:
The expected return of the portfolio is:
Security Expected Return Proportion WiRi Amount Return

X Ltd. 0.10 0.40 0.04 2,000 200
Y Ltd. 0.08 0.60 0.048 3,000 240
RP=0.088 or 5000 440
8.8%
i. Absolute return = Rs. 440
ii. Percentage return = (440/5000) = 0.088 or 8.8%
Problem 9.9 The following are the expected return, R and risk, σ, of two
securities A and B:
R s
A 10% 20%
B 12% 25%
The correlation coefficient between the returns of A and B is 0.5. An inves-
tor is to decide about the portfolio of A and B as 75% + 25% or 25% + 75%.
Which one should he accept?
(B.Com (H) DU 2009)
Solution:
Option I: 75% + 25%
Expected return:
A 0.10 0.75 0.075
B 0.12 0.25 0.030
RP=0.1050 or 10.5%
Risk:
σ 2P = W12 σ12 + W22 σ 22 + 2W1W2ρ12 σ1σ 2
= (0.752 × 0.202 ) + (0.252 × 0.252 ) + 2 × 0.75 × 0.25 × 0.5 × 0.20 × 0.25
= 0.0358
σ P = .1892 or 18.92%
Option II: 25%+75%
Expected return:
A 0.10 0.25 0.025
B 0.12 0.75 0.090
RP=0.1150 or 11.5%
357 Solved problems
Risk:
σ 2p = W12 σ12 + W22 σ 22 + 2W1W2ρ12 σ1σ 2
2 2 2 2
= (0.25 × 0.20 ) + (0.75 × 0.25 ) + 2 × 0.25 × 0.75 × 0.5 × 0.20 × 0.25
= 0.047
σ P = 0.2169 or 21.69%
COMPARATIVE ANALYSIS
Option I Option II
Portfolio return 10.5% 11.5%
Portfolio risk 18.92% 21.69%
Portfolio Return per unit of risk=Return/Risk 0.55 0.53
Suggestion: As the return per unit of risk of Option I is higher, the investor
should go for option I i.e. 75% in A and 25% in B.
Problem 9.10 Calculate expected return and risk of the investments X and
Y. What will be the returns if total investment is allocated in the ratio of 2:3?
Market condition Probability Security A (%) Security B (%)
Dull 0.2 10 6
Stable 0.5 14 15
Growth 0.3 20 11
Also calculate the covariance and correlation coefficient.
Solution:
EXPECTED RETURNS AND RISK OF INDIVIDUAL INVESTMENT
Invest- Market P R E(R) R-E(R) [R-E(R)]2 P[R-E(R)]2

ment condition
A Dull 0.2 10 2 -5 25 5
Stable 0.5 14 7 -1 1 0.5
Growth 0.3 20 6 5 25 7.5
S=15% σ2 S=13
σ 3.6%
B Dull 0.2 6 1.2 -6 36 7.2
Stable 0.5 15 7.5 3 9 4.5
Growth 0.3 11 3.3 -1 1 0.3
S=12% σ 2
S=12
σ 3.46%
Ratio 2:3 implies 40% & 60% respectively.

Calculation of Portfolio Return
Rp = 0.40(15) + 0.60(12) = 13.2%
CALCULATION OF COVARIANCE
Market condition Probability Deviations Product

Pi RA-E(RA) RB-E(RB) Pi[RA-E(RA)][ RB-E(RB)]
Dull 0.2 -5 -6 6
Stable 0.5 -1 3 -1.5
Growth 0.3 5 -1 -1.5
Covariance 3
CALCULATION OF CORRELATION Coefficient
covariance aB 3
ρaB = = = 0.24
σaσB 3.6 × 3.46
Portfolio risk :
σ 2P = (0.42 × 3.62 ) + (0.62 × 3.462 ) + 2 × 0.4 × 0.6 × 3 = 7.81
Hence
σ P = 2.8%
Problem 9.11 You are given the following information about two stocks
A and B
Stock A B
E(R)% 15 12
Variance of returns (in Sq %) 13 12
Covariance between the stocks = 3 sq%
Calculate the optimal weights of individual investments such that variance
of portfolio is minimum.
Solution: The optimal weights can be computed as under:
σ 2B − Cov AB
WminA =
σ 2A + σ B2 − 2Cov AB
12 − 3 9
Wmina == = = 0.47
13 + 12 − 2 × 3 19
WminB = 1 − 0.47 = 0.53
The minimum variance portfolio is one which has 47% investment in A and
53% investment in B.
The portfolio variance and standard deviation (risk) at this combination
(47% in A and 53% in B) shall be:
359 Solved problems
σ 2p = (0.472 × 3.62 ) + (0.532 × 3.462 ) + 2 × 0.53 × 0.47 × 0.24 × 3.6 × 3.46 = 7.72
σ p = 2.78%
Problem 9.12 Under what conditions, the risk of portfolio will be eliminated
in Problem 9.11 above?
Solution: The following conditions need to be fulfilled to eliminate the risk
completely:
ρ= –1
1.
σB
2. WA=
σA + σB
σB 3.46
WA = = = 0.49
σ A + σ B 3.6 + 3.46
WB = 1 – 0.49 = 0.51
Verification:
σ 2p = (0.492 × 3.62 ) + (0.512 × 3.462 ) + 2 × 0.49 × 0.51 × ( −1) × 3.6 × 3.46 = 0
σp = 0
Problem 9.13
The details of three portfolios are provided to an investor :
X 11% 13%
Y 15% 16%
Z 25.67% 25%
You are further given that the risk free rate of interest is 5% and expected
whether these portfolios are efficient or not.
Solution:
Expected return as per CML is calculated using the following equation.
 (E (RM ) − Rf 
E(Rp) = Rf +   σp
 σM 

Return(given)
X 11% 5+(18-5)13/15 = 16.26% Not efficient
Y 15% 5+(18-5)16/15 =18.85% Not efficient
Z 25.67% 5+(18-5)25/15 = 26.65% Efficient
The table shows that only portfolio Z is efficient portfolio.
Problem 9.14 : Following information is available in respect of a security
A and the market portfolio M. Find out beta of the security A.
Security A Market Portfolio M
15 18
12 17
14 18
20 11
11 19
Solution :
A M (M- Mean M)2 (A-Mean A)X(M-Mean M)
15 18 1.96 0.84
12 17 0.16 -0.96
14 18 1.96 -0.56
20 11 31.36 -31.36
11 19 5.76 -8.16
Mean A = 14.4 Mean M = 16.6 Σ =41.2 Σ = - 40.2
Variance of M i.e. Market variance= 41.2/5 = 8.24
Covariance between A and M = -40.2/5= -8.04
Beta of A = Cov/Market variance= -8.04/8.24 = -0.97
Problem 9.15 : Calculate beta factor of a security for which the follow-
ing details are available. Also specify whether the security is defensive or
aggressive.
Mean return from security = 15%
Mean return from Market portfolio = 18%
Standard Deviation of returns from Market portfolio = 14%
Standard Deviation of returns from security = 23%
Coefficient of correlation between the returns of security and market
portfolio = 0.70
361 Solved problems
Solution :
Coefficient of correlation × S.d of Security returns
S.d of market returns
= 0.70 × 0.23/0.14
= 1.15
Since beta of the security is more than 1, it is an aggressive security. A 10%
change in the return of market portfolio will result in a 11.5% change in the
return of the security in the same direction.
Problem 9.16: Following information is available in respect of a security L
and the market portfolio M.
Probabilities Security L Market Portfolio M
0.2 6 12
0.5 10 15
0.3 16 18
Find out
(i) Mean return of security L and Market portfolio
(ii) Variance of Security L
(iii) Variance of Market returns
(iv) β of security L
Solution :
Pi(L- Pi(M-mean Pi(L-mean L)
Pi L M PiL PiM mean L)2 M)2 (M-mean M)
0.2 6 12 1.2 2.4 5 2.178 3.3
0.5 10 15 5 7.5 0.5 0.045 0.15
0.3 16 18 4.8 5.4 7.5 2.187 4.05
Σ =11 Σ =15.3 Σ =13 Σ =4.41 Σ =7.5
The above table shows that
Mean return of L = Σ piLi = 11%,
Mean market return = ΣpiMi= 15.3%,
Variance of L = Σ (Li-Mean L)2= 13 sq %
Variance of M = Σ (Mi-Mean M)2= 4.4 sq %,
Covariance = Σ pi(Li-Mean L)(Mi-Mean M) = 7.5 sq %
β=Covariance/Market Variance = 7.5/4.4 = 1.7
Hence beta of security L is 1.7
Problem 9.17 You are given the following information about two securities
P and Q.
Security P Q
Actual Return% 12 23
β 0.6 1.6
Risk free rate is 7% and Expected Return on market portfolio is 17%. Do
you think that securities A and B are efficiently priced in the market? Do
they lie on SML?
Solution: Here we need to calculate expected return as per CAPM
Expected return from P = 7+ (17-7)(0.7) = 14%
Expected return from Q = 7+ (17-7)(1.6) = 23%
Since actual return of Q is same as expected under CAPM, Security Q is
efficiently priced and it will lie on SML.
The actual return of security P is lower than the expected return under
CAPM, hence security P is inefficiently priced. It lies below SML. It is over-
priced in the market.
Problem: 9.18 Following information is available about two securities X
and Y.
Security X Y
Standard Deviation 3% 5%
Coefficient of correlation is 0.80.
Find out the expected return and risk of the following portfolios consisting
of these securities
(i) 50% of each security X and Y
(ii) 30% of X and 70% of Y
(iii) 70% of X and 30% of Y (B.Com (H) DU 2007)
Solution:
(i) When investor invests 50% in X and 50% in Y we have
Portfolio Risk
σ 2P = (0.52 × 32 ) + (0.52 × 52 ) + 2 × 0.5 × 0.5 × (0.80) × 3 × 5 = 14.50

σ P = 3.808%

363 Solved problems
(ii) When investor invests 30% in X and 70% in Y

Portfolio Risk
σ 2p = (0.32 × 32 ) + (0.72 × 52 ) + 2 × 0.3 × 0.7 × (0.80) × 3 × 5 = 18.10

σ p = 4.25%
(iii) When investor invests 70% in X and 30% in Y
Portfolio Risk
σ 2p = (0.72 × 32 ) + (0.32 × 52 ) + 2 × 0.7 × 0.3 × (0.80) × 3 × 5 = 11.70

σ p = 3.42%

Hence in case (iii) portfolio return as well as risk is lower while in case (ii)
portfolio return as well as risk is higher.
Problem 9.19 : Following information is available about two securities P
and Q.
Security P Q
If a portfolio of 30% of P and 70% of Q is formed, find out (i) expected return
(ii) Minimum Risk, and (iii) Maximum risk of the portfolio.
(B.Com (H) DU 2009)
Solution: When investor invests 30% in P and 70% in Q we have
Minimum Portfolio Risk will be when coefficient of correlation is -1
σ 2p = (0.32 × 42 ) + (0.72 × 72 ) + 2 × 0.3 × 0.7 × ( −1) × 4 × 7 = 13.7

σ p = 3.7%

Maximum Risk of the portfolio will be when coefficient of correlation is +1
σ 2p = (0.72 × 32 ) + (0.32 × 52 ) + 2 × 0.7 × 03 × (0.80) × 3 × 5 = 37.21
σ p = 6.1%

Problem: 9.20: Following information is available from Mr. Z in respect
of his portfolio.
Security Exp. Return S.D. Weight

A 20% 24% 0.50
B 12% 16% 0.50
(i) Find out the correlation between the returns if the standard deviation
of the portfolio is 18% or 15%.
(ii) Find out the standard deviation of the portfolio comprising A and B
in the ratio of 25% and 75% and when correlation coefficient is 1.
(B.Com (H) DU 2008)
Solution:
(i) We are given that s1 = 24%, s2 = 16% sp = 18%, W1 = 0.50, W2 = 0.50,
sp =
W12 σ12 + W2 2 σ 2 2 + 2W1W2 σ1σ 2 r12
(a) When sp = 18% we have
18 = (0.5)2 (24)2 + (0.5)2 (16)2 + 2 (0.5)(0.5)(24)(16) r12

324 = 144 + 64 + 192r12
12

r = 0.604
(b) When sp = 15% we have
15 = (0.5)2 (24)2 + (0.5)2 (16)2 + 2 (0.5)(0.5)(24)(16) r12

225 = 144 + 64 + 192r12
12

r = 0.09
(ii) When r12 = 1 and W1 = 25% & W2 = 75%
sp =
(0.25)2 (24)2 + (0.75)2 (16)2 + 2 (0.25)(0.75)(24)(16) (1)
sp = 18
sp = 18%
Problem 9.21: An investor has a portfolio of five securities whose expected
returns and amount invested are as follows:
Security 1 2 3 4 5
Amount (Rs.) 150000 250000 300000 100000 200000
Expected Return 12% 9% 15% 18% 14%
Find out the % expected return of the portfolio.
(B.Com (H) DU 2009)
365 Solved problems

Security 1 2 3 4 5 Total
Weight (Wi) 0.15 0.25 0.30 0.10 0.20 1.00
Expected Return(Ri) 12% 9% 15% 18% 14%
Wi X Ri 1.8 2.25 4.5 1.8 2.8 13.15
Problem 9.22: In a portfolio of the company Rs. 200000 have been invested
in asset X which has an expected return of 8.5%, Rs. 280000 in asset Y which
has an expected return of 10.2% and Rs. 320000 in asset Z which has an
expected return of 12%. What is the expected return for the portfolio?
(B.Com (H) DU 2010)
Asset X Y Z Total
Weight (Wi) 0.25 0.35 0.40 1.00
Expected Return in % (Ri) 8.5 10.2 12
Wi X Ri 2.125 3.57 4.8 10.495
Problem 9.23: The returns on two securities A & B under four possible
states of nature are given below:
1 0.2 7 4
2 0.4 9 10
3 0.3 14 18
4 0.1 18 28
Find
(i) Expected return on security A and security B.
(ii) Risk (in terms of S.D.) on security A and B.
(iii) Covariance between returns on security A and B.

(iv) Coefficient of correlation between the returns on security A and B.
(B.Com (H) DU 2012)
Solution : Calculation of Expected Return and Risk
State Prob. RA RB Pi X Pi Pi(RA- r A)2 Pi(RB- r
(Pi) RA XRB B)2
1 0.2 7 4 1.4 0.8 3.2 16.2
2 0.4 9 10 3.6 4 1.6 3.6
3 0.3 14 18 4.2 5.4 2.7 7.5
4 0.1 18 28 1.8 2.8 4.9 22.5
TOTAL 11 13 12.4 49.8
(i) r = Expected Return = SRiPi
Therefore Expected return of A = 11%
Expected return of security B is higher.
( )
2
Total Risk = S.D. = ΣPi Ri − R
Risk of security X = (12.4)1/2 = 3.52%
(iii) Covariance between returns of A and B can be calculated using the
following formula:
Covariance (A,B) = Σ Pi(RA- r A) (RB- r B)
State Prob.(Pi) RA RB (RA- r A) (RB- r B) Pi(RA- r A)
(RB- r B)
1 0.2 7 4 -4 -9 7.2
2 0.4 9 10 -2 -3 2.4
3 0.3 14 18 3 5 4.5
4 0.1 18 28 7 15 10.5
Σ =24.60
Hence Covariance between A and B’s returns is 24.60 squared per-
centage.
cov (aB)
(iv) Coefficient of Correlation (ρ) =
s.d (a) s.d (B)
367 Solved problems
24.60
=
3.52 × 7.06
= 0.989
Thus the two securities returns are highly correlated.
Problem 9.24: From the following portfolios identify efficient portfolios.
(Apply the rule of Dominance).
Portfolio A B C D E F G H I J
Exp. Ret(%) 20 20 22 10 24 6 10 26 20 10
Total Risk 19 8 11 7 13 13 19 22 24 24
Solution : As per the rule of dominance, a portfolio dominates another
portfolio if it provides (i) higher return at same risk or (ii) lower risk at
same return. Such a dominating portfolio is efficient portfolio to be used
in the construction of efficient frontier.
Hence efficient portfolios in the above Table are –B, C, D, E and H. Portfolio
B dominates A and I, Portfolio D dominates G and J. Portfolio E dominates
portfolio F.
Problem 9.25: If the risk free return is 10%, expected return on BSE Sensex
is 18% and risk measurement by standard deviation of BSE index is 5%, how
would you construct an efficient portfolio to produce an expected return
of 16% and what would be its risk.
(B.Com (H) DU 2012)
Solution : We have two things here. One is the market portfolio having
return of 18% and risk of 5%. The other is a risk free asset having return
as 10% and No risk.
Now we can construct an efficient portfolio combining Market portfolio
and risk free asset so that its return is 16%.
Let us assume that the weight of Market portfolio is W. So the weight of
risk free asset will be (1-W).
Portfolio Return = 16%
Hence 16 = W(18) + (1-W)10
W = 0.75
Hence the portfolio that invests 75% in Market Index i.e. Sensex and 25%
in risk free asset will generate an expected return of 16%.
Portfolio risk = WσM = 0.75 (5) = 3.75%
It must be noted that the risk (σ) of risk free asset is 0.
Problem 9.26 A security has a standard deviation of 5%. The correlation

coefficient of the security with the market is 0.70 and market standard
deviation is 4%. The return from govt. securities is 10% and from market
portfolio 15%. What is the required return on the security?
Solution :
correlation coeff × security s.d.
Market s.d
= 0.70(5/4) = 0.875
Now E(R) = Rf + [E(Rm)-Rf]β
Here Rf = 10% and β = 0.875 as calculated above, and E(Rm) = 15%
Hence E(R) = 10 + (15-10)(0.875) = 14.375%
The expected return from security is 14.375%.
Problem 9.27: The details of three portfolios are provided as under :
P 11.5% 5%
Q 14.4% 8%
R 26.5% 15%
It is further given that the risk free rate of interest is 5% and unlimited
lending and borrowing is possible at this rate. The return and risk of market
portfolio is 18% and 10%. Comment on the efficiency of these portfolios.
Solution:
Expected return as per CML is calculated using the following equation:
[(e(r M )- rf)]σ P
E(Rp) = r f +
σM

Return(given)
P 11.5% 5+(18-5)5/10 = 11.5% Efficient
Q 14.4% 5+(18-5)8/10 = 15.4% Not efficient
R 26.5% 5+(18-5)15/10 = 24.5% Not Efficient
369 Solved problems
The above Table shows that only portfolio P is efficient portfolio because
in case of other portfolios the expected return as per CML does not match
with the given returns.
In case of portfolio Q and R the expected return as per CML is higher or
lower than the given return and hence these portfolios are overpriced or
underpriced in the market. Only portfolio P is efficiently or correctly priced
in the market.
Problem 9.28 : The risk free rate of interest is 4% and return on market
portfolio is 10%. The risk of market portfolio is 3%. An investor has con-
structed a portfolio having risk of 2% and correlation with market portfolio
as 0.70. Find out the expected return to the investor.
Solution : Here we can find out expected return using two approaches
(i) Using CML, we can find out expected return of the portfolio as under:
[(e(r m )- rf)]σ p
E(Rp) = r f +
σm
Hence E(Rp) = 4 + (10-4) 2/3 = 8%
(ii) Using CAPM we can find out portfolio return by using beta factor.
Beta is calculated as below
σp
βp =
× Correl(p, m)
σm
bp = 0.7 X 2/3 = 0.467
Now expected return of the portfolio is
E(Rp) = Rf + [(E(RM)- Rf)] bp
E(Rp) = 4+ (10-4)(0.467) = 6.82%
Problem 9.29 : The risk free rate of interest is 6% and return on market
portfolio is 16%. The risk of market portfolio is 5%. An investor has con-
structed a portfolio having risk of 10%. Find out the expected return to the
investor as per CML.
Solution :
Using CML, we can find out expected return of the portfolio as under:
[(e(r m )- rf)]σ p
E(Rp) = r f +
σm
Hence E(Rp) = 6 + (16-6) 10/5 = 26%

Problem 9.30 : The risk free rate is 5%, market return is 17% and beta of
a security, H, is 1.5. Find out the expected return from the security. If the
expected return of a security G, is 18%, what must be its beta ?
Solution : Using CAPM

E(RH) = Rf + [(E(RM)- Rf)] bp
E(RH) = 5+ (17-5)(1.5) = 23 %
Hence expected return from security H is 23%.
Now for security G we have E(RG) = 18%
18 = 5+ (17-5)(b)
Solving for b we get
b = 1.08
Hence the beta of security G must be 1.08.
Problem 9.31 : The risk free rate is 4.5%, return on a broad market index is
17% and beta of a security, L, is 1.1. Find out the expected return from the
security. If the actual return provided by the security L is 20%, what does
it mean? If the expected return of a security S, is 22.5%, what must be its
beta if it is correctly priced in the market ?
E(RL) = Rf + [(E(RM)- Rf)] bp
E(RL) = 4.5+ (17-4.5)(1.1) = 18.25%
Hence expected return from security L is 18.25%. If the actual return is 20%,
the security L lies above SML and hence it is underpriced in the market.
Now for security S we have E(Rs) = 22.5%. If it is correctly priced we have
22.5 = 4. 5+ (17-4.5) (b)
Solving for b we get
b = 1.44
Hence the beta of security S must be 1.44 if it is correctly priced in the
market.
Problem 9.32 : The risk free rate is 6%, return on a broad market index is
18%. The actual return provided by the security is 20%. What must be its
beta if the security is
(i) Correctly priced in the market
(ii) Overpriced in the market
(iii) Underpriced in the market.
E(Ri) = Rf + [(E(RM)- Rf)] bi
371 Solved problems
(i) When security is correctly priced its actual return must be same as
its expected return as per CAPM.
Hence
20 = 6+ (18-6)(b)
b = 1.167

(ii) When security is overpriced it means that its expected return as per
CAPM is higher than the actual return. Hence b of the security must
be higher than 1.167 as calculated above.
(iii) When security is underpriced it means that its expected return as
per CAPM is lower than the actual return. Hence b of the security
must be lower than 1.167 as calculated above.
Problem 9.33: Find out the expected return of the following securities
if prevailing interest rate on Govt. Securities is 7% and rate of return on
market index is 10%.
Security I II III IV V
Beta factor 1.00 1.25 1.70 1.50 1.60
(B.Com (H) DU 2007)
Beta factor 1.00 1.25 1.70 1.50 1.60
E(Ri) = Rf + 7+(10-7)1 7+(10-7)1.25 7+(10-7)1.70 7+(10-7)1.50 7+(10-7)1.60
[(E(RM)- Rf)] bi
Expected return 10% 10.75% 12.10% 11.50% 11.80%
Problem 9.34: Returns on shares of K Ltd and S Ltd for two years are
given below:
Return of K Ltd Return of S Ltd
Year 1 15 10
Year 2 17 14
Calculate
(i) Expected return of each stock
(ii) Risk (standard deviation) of each stock
(iii) Covariance between K and S
(iv) Coefficient of correlation between K and S.
(v) Expected return and Risk of a portfolio made up of 30% of K and

70% of S.
(vi) Expected return and risk of a portfolio if investment in K and S is in
the ratio of 2:1.
Solution :
K S (K-16)2 (S-12)2 (K-16)(S-12)
15 14 1 4 -2
17 10 1 4 -2
Avg Ret = 32/2= Avg Return = Σ =2 Σ =8 Σ = -4
16% 24/2= 12%
(i) Expected return of K = 16%
Expected return of S = 12%
(ii) Risk (Standard deviation) of K = 2

= 1%
2
8
Risk (Standard deviation) of S = = 2%
2
(iii) Covariance between K and S = - 4/2 = - 2
Covariance −2
(iv) Coefficient of correlation = = = −1
σ1σ 2 1× 2
(v) Portfolio return when weights are 30% and 70%
Rp = 0.30 (16) + 0.70(12) = 13.2%
Portfolio Risk = σ P = W12 σ12 + W22 σ 22 + 2W1W2ρ12 σ1σ 2

σ 2P = (0.32 × 12 ) + (0.72 × 22 ) + 2 × 0.3 × 0.7 × 1 × 2 × ( −1) = 1.21

σ P = 1.1%
(vi) Portfolio return when weights are in 2:1 i.e. 2/3 and 1/3
Rp = 2/3 (16) + 1/3 (12) = 14.67%
Portfolio Risk = σ P = W12 σ12 + W22 σ 22 + 2W1W2ρ12 σ1σ 2
σ 2P = ((2 / 3)2 × 12 ) + (1/ 3)2 × 22 ) + 2 × (2 / 3) × (1/ 3) × 1 × 2 × ( −1) = 0

σP = 0

Problem 9.35 : The expected return on market portfolio is 15% and risk
(standard deviation) is 20%. Risk free rate is 5%. The details of three mutual
funds are provided as under :
373 Solved problems
Mutual Fund Total Risk(S.D) Actual Return

P 14% 12.8%
Q 17% 13.5%
R 15% 12.5%
Find out the slope of CML. Calculate the required rate of return from the
three mutual funds. Are these mutual funds efficient?
Solution:
CML is calculated using the following equation.
[(e(r m )- rf)]σ p
E(Rp) = r f +
σm
[(e(r m )- r f )]
The slope of CML = = (15-5)/20 = 0.50
σm
Now using CML equation the required rate of return (or expected return)
from three mutual funds are given in the Table
Mutual Fund Total Risk(S.D) Required return as per CML Actual Return
P 14% = 5 + (0.50)(14) = 12% 12.8%
Q 17% = 5 + (0.50)(17) = 13.5% 13.5%
R 15% = 5 + (0.50)(15) = 12.5% 12.5%
Mutual funds Q and R are efficient as their required return is same as their
actual return. Mutual fund P is underpriced as it provides higher actual
return than the required return.
Problem 9.36 : Two securities A and B have variance of 13 and 12 and
expected returns of 15% and 12% respectively. The covariance between
the returns is 3. Find out the return and risk of the following portfolios
comprising A and B in the given proportion.
Case A B
(i) 0.2 0.8
(ii) 0.7 0.3
(iii) 0.5 0.5
(B.Com (H) DU 2008)
Solution: Calculation of Expected return of portfolio when return of A =
15% and return of B = 12%
Case A B Expected return of portfolio

(i) 0.2 0.8 0.2(15) + 0.8(12) = 12.6%
(ii) 0.7 0.3 0.7(15) + 0.3(12)=14.1%
(iii) 0.5 0.5 0.5(15) + 0.5(12)=13.5%
Portfolio Risk
Case A B Portfolio variance Portfolio Risk in
Standard deviation
(i) 0.2 0.8 (0.2)213 + (0.80)212 + 2(0.2)(0.8) 3.03%
(3) = 9.16
(ii) 0.7 0.3 (0.7)213 + (0.30)212 + 2(0.7)(0.3) 2.95%
(3) =8.71
(iii) 0.5 0.5 (0.5)213 + (0.50)212 + 2(0.5)(0.5) 2.78%
(3) = 7.75
Problem 9.37 : An investor is holding two stocks Alpha and Omega, in his
portfolio. The ex-ante probability distribution of two stocks and market
index is given below.
Conditional Return in %
Economic condition Probability Alpha Omega Market
Good 0.3 21 23 22
Normal 0.2 12 17 18
Worse 0.5 -8 -10 -9
The risk free rate is 3%. Assume that the CAPM conditions hold true, should
an investor continue to hold the same stocks or not?
(B.Com (H) DU 2013)
Solution:
Calculation of expected returns using the given ex ante probability distri-
bution.
Investment Economic condition P R PiRi
Good 0.3 21 6.3
Normal 0.2 12 2.4
Alpha Worse 0.5 -8 -4.0
E(R) = 4.7%
375 Solved problems
Investment Economic condition P R PiRi

Good 0.3 23 6.90
Normal 0.2 17 3.40
Omega Worse 0.5 -10 -5.0
E(R) = 5.3%
Market Good 0.3 22 6.60

Normal 0.2 18 3.60
Worse 0.5 -9 -4.50
E(R) = 5.7%
Hence Market return is 5.7%, mean return of Alpha is 4.7% and of Omega
it is 5.3%.
In order to apply CAPM we need beta factor for each stock i.e. Alpha and
Omega
For this we need covariance of each stock with market and Market vari-
ance. These are calculated below:
Calculation of Market variance
Condition Probability
Pi pi[Rm-E(Rm)2]
Good 0.3 79.707
Normal 0.2 30.258
Worse 0.5 108.045
Σ = 218.01
Hence Market variance is 218.01 sq %
Calculation of Covariance of Alpha and Omega with Market
1 2 3
Condition Pi Ra-E(Ra) Ro-E(Ro) Rm-E(Rm) P [(1) x(3)] P[(2)x (3)]
Good 0.3 16.30 17.70 16.30 79.71 86.55
Normal 0.2 7.30 11.70 12.30 17.96 28.78
Worse 0.5 -12.70 -15.30 -14.70 93.35 112.46
Σ= 191.02 Σ= 227.79
Covariance between Alpha and Market = 191.02
Covariance between Omega and Market = 227.79
β of Alpha stock = Covariance/Market variance = 191.02/218.01 = 0.87
β of Omega stock = Covariance/Market variance = 227.79/218.01 = 1.045

Now using CAPM we can compute their Expected Returns as below
Expected Return as per CAPM for Alpha = 3 + (5.7-3)(0.87) = 5.349%
Expected Return as per CAPM for Omega = 3 + (5.7-3)(1.045) = 5.82%
Since stock Alpha’s expected return as per CAPM is higher than the expected
return using ex ante probability distribution, it is an overpriced stock. The
investor should not hold it. It must be sold now.
Since stock Omega’s expected return as per CAPM is lower than the ex-
pected return using ex ante probability distribution, it is an underpriced
stock. The investor should continue holding it as it is expected to provide
higher return than the one required under CAPM.
Problem 9.38 Mr. A, an investor is evaluating the prospects of investing in
two companies S Ltd. and G Ltd. The projections of returns for the stocks
of these companies with their probabilities are as follows:
Prob. Returns associated with
S Ltd. G Ltd.
0.2 15% 16%
0.25 16% 10%
0.30 -10% 28%
0.25 28% -2%
You are required to
(i) Calculate risk and return of investment in individual stocks
(ii) Calculate risk and return of the portfolio constituting these stocks
in equal proportions.
(iii) If ρ = -1, find out the proportion of each of the above two stocks to
construct a minimum risk portfolio.
(B.Com (H) DU 2014)
Solution :
Pi (Rs) (RG) Pi Rs PiRG Pi(Rs- Pi(RG- Pi [ (Rs- E(Rs))
E(Rs)2 E(RG)2 X (RG-E(RG)]
0.2 15 16 3 3.2 3.2 1.152 1.92
0.25 16 10 4 2.5 6.25 3.24 -4.5
0.30 -10 28 -3 8.4 132.3 62.208 -90.72
0.25 28 -2 7 -0.5 72.25 60.84 -66.3
Σ= 11 Σ=13.6 Σ=214 Σ=127.44 Σ=-159.6
377 Solved problems
(i) Hence Expected return of S = 11%

Expected Return of G = 13.6%
Risk of S = 214 = 14.63%
Risk of G = 127.44 = 11.29%
Covariance between returns of S and G = -159.6 square %
(ii) Portfolio risk and return of the portfolio having equal proportions
of S and G. Here weights are 0.50 and 0.50.
E(Rp) = 0.50(11) + 0.50(13.6) = 12.3%
Portfolio Risk is 2.36 % as calculated below:

σ 2p = (0.52 × 14.632 ) + (0.52 × 11.292 ) + 2 × 0.5 × 0.5 × ( −159.6) = 5.56
σ p = 2.36%

(iii) When ρ = -1, the proportion of minimum risk portfolio will be as
follows:
σG
Weight of Security S =
σS + σG
Weight of security S = 11.29/(14.63+11.29) = 0.4356 or 43.56%

Weight of Security G = 1- Weight of S = 1-0.4356 = 0. 5644 or 56.44%
Hence when coefficient of correlation is -1, the minimum risk port-
folio will be one that comprise of 43.56% of S and 55.44% of G. The
risks of such a portfolio will be zero.
Problem 9.39 The following data are available to you as a portfolio manager
Security Estimated Return(%) Beta Standard Deviation (%)
A 30 2 50
B 25 1.5 40
C 20 1.0 30
D 11.5 0.8 25
E 10 0.5 20
Market Index 15 1 18
Govt. Security 7 0 0
In terms of Security Market Line, find out the expected return of the
securities. Also state which of the securities are underpriced.
(B.Com (H) DU 2014)
Solution : As per SML, the expected return is calculated as-
Here E(RM) = 15% and Rf = 7% . Hence the following table shows Expected
return as per SML
Security Estimated Beta Expected Return as per SML Remarks
Return(%)
A 30 2 7+(15-7)2 = 23 Underpriced
B 25 1.5 7+(15-7)(1.5) = 19 Underpriced
C 20 1.0 7+(15-7)(1) = 15 Underpriced
D 11.5 0.8 7+(15-7)(0.8) = 13.4 Overpriced
E 10 0.5 7+(15-7)(0.5) = 11 Overpriced
A security is underpriced if its estimated return is higher than the expected
return as per SML. If estimated return is lower than the expected return
as per SML then it is overpriced.
Hence securities A, B and C are underpriced.
Problem 9.40 An investor is holding two stocks A and B, in his portfolio.
The ex-ante probability distribution of two stocks and market index is
given below.
Situation Probability Return of A(%) Return of B(%) Return of Market(%)
Recession 0.2 10 6 10
Average 0.4 12 15 16
Above 0.3 21 27 22
average
Boom 0.1 27 30 29
Calculate
(i) Covariance between security A and B
(ii) Beta of security A, B and Market
(B.Com (H) DU 2014)
Solution:
Calculation of Co variance between A and B as well as between A and
Market and Between B and Market
Pi RA RB RM PiRA PiRB PiRM Pi(RA-E(RA) Pi(R A-E(R A) Pi(R B-E(R B) Pi(RM-
(RB-E(RB) (RM-E(RM) (RM-E(RM) E(RM)2
0.2 10 6 10 2 1.2 2 14.268 9.164 19.434 12.482
0.4 12 15 16 4.8 6 6.4 5.016 2.888 2.508 1.444
0.3 21 27 22 6.3 8.1 6.6 13.572 6.396 10.701 5.043
0.1 27 30 29 2.7 3 2.9 13.104 12.432 12.987 12.321
Total
= 15.8 18.3 17.9 45.96 30.88 45.63 31.29
379 Solved problems
Covariance between A and B = 45.96 square %

Covariance between A and Market = 30.88 square %
Covariance between B and Market = 45.63 square %
Variance of Market = 31.29 square %
beta of security A = (Covariance between A and Market)/Market Variance
= 30.88/31.29 = 0.98
beta of security B = (Covariance between B and Market)/Market Variance
= 45.63/31.29 = 1.46
beta of Market is always 1.
Problem 9.41 The beta of a stock is 1.5 and standard deviation of its return
this stock is 19%.
(v) Is the stock a good buy?
Solution .
(ii) Expected Return of the stock = 6 + (15-6)1.5 = 19.5 %
(iii) Risk Premium of the stock = 19.5 - 6% = 13.5%
(iv) Abnormal Return = 19-19.5 = -0.5%
(v) No, the stock is not a good buy as it is overpriced having lower return
than the expected as per CAPM.
Problem 9.42 Following information is provided for two stocks F and G.
Find out the minimum variance portfolio. Calculate expected return of
this portfolio.
Stock F G
Exp. Return 10% 25%
S.D. (%) 20 35
Coefficient of correlation = –0.30
Solution:
The minimum variance portfolio is one where WF (i.e. weight of stock F)
is calculated as below :
σ 2 −r σ σ
WF = 2 G 2 FG F G
σ F + σG − 2rFG σ F σG
(35)2 − (−0.30)(20)(35)
WF = 2
(20) + (35)2 − 2 (−0.30)(20)(35)
= 0.70
Since WF = 0.70, WG = 1–0.70 = 0.30.
Hence minimum variance portfolio is one which has 70% of stock F
and 30% of stock G. The return of such a portfolio is
E(Rp) = 10(0.70) + 25(0.3)
= 14.50%
Summary
u A Portfolio is a collection of assets or securities which are so collected together
to reduce the risk.
u Portfolio return is the weighted average of the returns on individual securities.
u Portfolio risk is not the weighted average of the risks of individual securities.
Covariance and correlation also plays an important role.
u Diversification refers to holding a combination of different securities in order
to reduce risk of portfolio.
u When securities are perfectly positively correlated, there is no diversification
benefit. In that case there is just risk averaging.
u When securities are perfectly negatively correlated it is possible to completely
eliminate portfolio risk .
u Markowitz model of portfolio analysis is quite demanding in terms of data
requirement.
u The portfolio selection problem is studied under Markowitz Portfolio Theory
and Capital Market Theory.
u As per Portfolio Theory, the optimal portfolio for an investor is the point of
tangency between the efficient frontier and highest possible indifference
curve.
u Efficient frontier shows all efficient portfolios out of the feasible region of
portfolios.
u An efficient portfolio is one which provides maximum return for a given risk
or which has lowest risk for a given return.
u When a risk free asset is introduced in the market then the efficient frontier
becomes a straight line known as Capital Market Line.
381 Test Yourself
u As per Capital Market Theory every investor invests in the same optimal
portfolio of risky assets i.e. Market Portfolio and uses risk free lending or
borrowing to suit his risk return preferences.
u Capital Asset pricing model(CAPM) is a model for predicting expected return
of an asset.
u CAPM is a linear and positive relationship between expected return and sys-
tematic risk measure by β factor.
u The graphical presentation of CAPM is known as Security Market Line (SML).
Test Yourself
True/False
i. If two assets have the same risk, a risk averse investor will always choose the
asset with higher expected return.
ii. Covariance indicates variability in a particular stock’s returns.
iii. The portfolio variance is the weighted average of the variances of all the
assets held in the portfolio.
iv. When everything is held constant, lower correlation results in lower portfolio
variance.
v. The sum of investment weights must be equal to zero.
vi. Covariance plays a major role in determining the portfolio’s risk.
vii. Adding more securities to your portfolio will always make it more diversified.
viii. Diversification eliminates the risk completely.
ix. Correlation coefficient ranges between -1 to +1.
x. Minimum variance portfolio is also known as optimal portfolio.
xi. Portfolio risk is minimum when investments are done in equal proportions.
xii. Security market line is based on total risk.
xiii. Capital Market Line also shows individual securities besides efficient portfolios.
xiv. If a security lies below SML, it is underpriced.
xv. If a portfolio is below CML it is inefficient.
[Answers: (i) T (ii) F (iii) F (iv) T (v) F (vi) T (vii) F (viii) F (ix) T
(x) F (xi) F (xii) F (xiii) F (xiv) F (xv) T]
Theory Questions
1. What is a portfolio? How is the portfolio return and risk calculated for a
two-security portfolio? [Paras 9.1, 9.2]
2. What do you mean by diversification? Does it reduce the risk of an invest-
ment? Explain with an example. [Para 9.2]
3. Explain the role of correlation coefficient in the construction of a portfolio.

[Para 9.2]
4. How a minimum variance portfolio is constructed? Explain with an example.
[Para 9.2]
5. Is it possible to completely eliminate risk? If yes, specify the conditions.
[Para 9.2 ]
6. Write short notes on the following
i. Harry Markowitz Model [B.Com (H) DU 2010] [Paras 9.2 & 9.3]
ii. CAPM [B.Com (H) DU 2012] [Para 9.4]
iii. Systematic Risk [Para 9.3]
iv. Unsystematic risk [Para 9.3]
v. Portfolio Risk [Para 9.2]
vi. Capital market theory [Para 9.3.2]
7. What is Efficient portfolio in the context of Harry Markowitz Model. Explain
the role of investor’s preference in identifying optimal portfolio.
[B.Com (H) DU 2013] [Para 9.3]
8. Explain the following:
i. Feasible portfolios
ii. Efficient portfolios
iii. Optimal portfolio [Para 9.3]
9. Differentiate between Security Market Line and Capital Market Line.
[B.Com (H) DU 2012] [Para 9.5]
10. Examine critically Harry Markowitz Model giving its assumptions and lim-
itations.
[B.Com (H) DU 2012] [Para 9.3.1]
11. “All efficient portfolios are feasible but all feasible portfolios are not efficient”.
Do you agree? Explain in the context of Harry Markowitz Model.
[B.Com (H) DU 2011] [Para 9.3]
12. Explain the salient features of Security Market Line. [Para 9.4]
13. Is it possible to reduce portfolio risk by including a more risky security in the
portfolio? How? [Para 9.2]
Practical Problems
1. Suppose an investor has two assets whose standard deviation of returns
are 30% and 40%. The assets are perfectly negatively correlated. What asset
weights will eliminate all portfolio risk? [Answer- 57% and 43%]
383 Test Yourself
2. Stock A’s standard deviation of returns is 50% and Stock B’s standard devia-
tion of returns is 30%. Stock A and Stock B’s returns are perfectly positively
correlated. According to portfolio theory, how much should be invested in
each stock to minimize the portfolio’s standard deviation? [Answer-100% in
Stock B]
3. An investor puts 60% of his money into a risky asset offering a 10% return
with a standard deviation of returns of 8% and the balance in a risk- free
asset offering 5%. What is the expected return and standard deviation of this
portfolio? [Answer-8.0% and 4.8%]
4. Securities X and Y have standard deviations of 3% and 9%. Nishant is having
a surplus of Rs.20 Lakhs for investment in these two securities. How much
should he invest in each of these securities to minimize risk, if the correlation
co-efficient for X and Y is:
(a) -1
(b) -0.30
(c) 0
[Answer-
(a) 75% and 25%
(b) 84% and 16%
(c) 90% and 10%
5. A Ltd., and B Ltd., has the following risk and return estimates:
Return on A=20%
Return on B=22%
Standard deviation of A=18%
Standard deviation of A =15%
Correlation coefficient = –0.50
Calculate the proportion of investment in A Ltd., and B Ltd., to minimize the
risk of Portfolio. [Answer = – 56% and 44%]
6. Calculate expected return and standard deviation of the following two
investments “A” and “B” exclusively and also if total investment is divided one
half in each. The economic predictions are:
Economic climate Probability Return from A (%) Return from B (%)

Recession 0.2 12 10
Stable 0.5 15 16
Expansion 0.3 20 12
[Answer-Expected Return: A-15.90 B-13.60%; Risk: A-2.91%, B-2.5%; Portfolio
Return-14.75% and Portfolio Risk-1.89%]
7. The returns on two securities under four possible states of nature are given
below:

1 0.1 5 4
2 0.2 9 11
3 0.3 12 17
4 0.4 15 24
Find
i. Expected return on security A and security B.
ii. Risk (in terms of S.D.) on security A and B.
iii. Covariance between returns on security A and B.
iv. Coefficient of correlation between the returns on security A and B.
[Answer-
(i) 11.9%, 17.3%
(ii) 3.21%, 6.6%
(iii) 21.13%
(iv) 0.997
8. The details of three portfolios are provided to an investor :

X 16% 12%
Y 18% 18%
Z 25% 22%
You are further given that the risk free rate of interest is 5% and expected
whether these portfolios are efficient or not. [Ans: 14.6%, 19.4% 22.6%, No]
9. From the following portfolios identify efficient portfolios. (Apply the rule of
Dominance).
Portfolio A B C D E F G H I J
Exp. Ret(%) 20 20 21 10 24 6 10 21 20 10
Total Risk 5 8 11 7 13 13 19 12 24 24
[Ans : A, C, D, E]
10. If the risk free return is 7%, expected return on BSE Sensex is 16% and risk
measurement by standard deviation of BSE index is 8%, how would you
construct an efficient portfolio to produce an expected return of 12% and
what would be its risk? [Ans : 4.44%]
385 Test Yourself
11. The risk free rate of interest is 8% and return on market portfolio is 18%. The
risk of market portfolio is 5%. An investor has constructed a portfolio having
risk of 10% and correlation with market portfolio as 0.50. Find out the expected
return to the investor as per CML. [Ans : 28%]
12. The risk free rate is 5%, market return is 14% and beta of a security, H, is 1.5.
Find out the expected return from the security. If the expected return of a
security G, is 13%, what must be its beta ? [Ans : 18.5% 0.89]
13. The risk free rate is 5.5%, return on a broad market index is 17.25% and beta
of a security, L, is 1.15. Find out the expected return from the security. If
the actual return provide by the security L is 20%, what does it mean? If the
expected return of a security S, is 21.5%, what must be its beta if it is correctly
priced in the market ? [Ans : 19.01% underpriced, 1.36]
14. The risk free rate is 6%, return on a broad market index is 19%. The actual
return provided by the security is 20%. What must be its beta if the security
is
i. Correctly priced in the market
ii. Overpriced in the market
iii. Underpriced in the market. [Ans : (i) 1.08 (ii) >1.08 (iii) <1.08]
15. Find out the expected return of the following securities if prevailing interest
rate on Govt. Securities is 7% and rate of return on market index is 10%.
Beta factor 1.10 1.35 1.74 1.58 1.62
[Ans : 10.3%, 11.05%, 12.22%, 11.74%, 11.86%]
16. The following data are available to you as a portfolio manager
Security Estimated Return(%) Beta Standard Deviation (%)

A 31 2 50
B 14 1.4 40
C 18 1.2 40
D 12.5 0.7 23
E 12 0.5 21
Market Index 15 1 20
Govt. Security 7 0 0
In terms of Security Market Line, find out the expected return of the securi-
ties. Also state which of the securities are under priced.
[Ans : 23%, 18.2%, 16.6%, 12.6%, 11%, AC & E are underpriced]
Project Work
Select any two stocks from S&P BSE SENSEX (say SBI and Wockhardt) and
collect their closing adjusted prices on weekly basis for the period Jan 2015 to
Dec 2015 form the website of BSE i.e. www.bseindia.com. The stocks should be
from unrelated sectors. Now convert these prices into returns and make series of
stock returns for each stock. Calculate
1. Mean return on each stock
2. Standard deviation of returns of each stock
3. Covariance between the returns of stock 1 and stock 2 and interpret it.
4. Construct an equally weighted portfolio of these stocks (i.e. weights are 0.5
each) and calculate this portfolio’s return and risk.
5. Construct a portfolio for Mr. Mishra who wants an expected return of 12%.
What is the portfolio risk in this case?
6. Construct a portfolio for Mr. Tripathi who wants to have minimum possible
risk by combining the two stocks.
7. Is it possible to reduce portfolio risk to zero by combining these two stocks?
Why?
PORTFOLIO PERFORMANCE
10 EVALUATION AND MUTUAL
C H A P T E R FUNDS
learninG outcomeS
 Understand the need for portfolio performance evaluation
 Apply various risk adjusted measures/methods for performance
evaluation such as Sharpe ratio, Treynor’s Ratio and Jensen’s
Alpha
 Explain the concept, advantages and limitations of Mutual funds
 Describe Evolution of mutual funds in India
 Explain various types of mutual fund schemes
 Elaborate latest developments in Mutual funds in India
 Evaluate the performance of mutual funds
The previous chapter dealt with portfolio analysis and selection. The selection
of the optimal portfolio is based on Markowitz portfolio theory and Capital
market theory leading to the development of Capital Asset Pricing Model.
There are two types of portfolio management. One, is Passive Management
in which the investor invests in the broad market index and does not per-
form any security analysis or select individual securities. Hence analysis of
securities is not required if one is a passive investor. A passive investor sim-
ply invests in the index and holds it in order to earn commensurate return.
Second is Active Management, in which the investor is actively engaged in
the analysis and selection of securities so as to earn superior returns. The idea
here is to invest in undervalued stocks or assets so as to reap higher gains.
We have seen in the previous chapter that in an efficient market, Passive
387
Para 10.1 Portfolio performance evaluation & mutual funds 388
Management is the best strategy as no one can consistently outperform the

market. In an efficient market all the securities are fairly priced and hence
there are no underpriced assets. Therefore security analysis and selection
is of no use. One should simply invest in the market index. However in
real world the markets are not efficient as assumed under Capital Market
Theory and CAPM. Hence there is always a room for Active Management.
Now once an investor has selected his portfolio, the next step is to evaluate
the performance of the portfolio and, if needed, revise the portfolio according
to the changing circumstances and investment objectives. This chapter deals
with the methods of portfolio performance evaluation. Further we provide
discussion on Mutual Funds. A Mutual Fund scheme acts as a portfolio of
securities and hence a mutual fund may be regarded as a portfolio.
10.1 Portfolio Performance Evaluation

Once an investor selects a portfolio it is necessary that he evaluates its
portfolio periodically so as to achieve his financial goals. If there is no per-
formance evaluation, then it is not necessary that the portfolio is performing
as expected. This may be due to various reasons such as changes in the
investment environment or unexpected performance of the companies
whose securities are held etc. An investor may hold more than one port-
folios of assets such as equity portfolio comprising only shares and bond
portfolio comprising only bonds. The overall portfolio of an investor is the
combination of all these portfolios. Hence it is necessary for every investor
to evaluate the performance of various portfolios that he holds. In case of
performance evaluation it is necessary to have a benchmark portfolio against
which the performance of the portfolio will be evaluated. A benchmark is
the standard portfolio which provides minimum performance standards.
If the given portfolio performs better than the benchmark portfolio, then
the given portfolio is outperformer. On the other hand if the given portfo-
lio performs less than the benchmark portfolio, then the given portfolio is
underperformer. There are many methods or techniques for evaluating
the performance of portfolios. They are categorised as - Absolute return
measure and Risk Adjusted Measures or Methods.
i. Absolute return measure : In absolute return measure we compare
the absolute returns of various portfolios as well as benchmark
portfolio. There is no consideration of risk in case of performance
evaluation using this measure. Portfolio having highest return is
the top performer while the one giving least return is the poorest
performer. For example if the returns on two portfolios P and Q
are 24% and 17% respectively then portfolio P is a better performer
than portfolio Q as per Absolute Return Measure. However the
389 Risk adjusted or techniques evaluating of portfolios Para 10.2
serious limitation of this measure is that it does not consider risk at

all. It compares returns regardless of the underlying risks. It is not
acceptable as different portfolios may have differing degrees of risk.
For example if the risk of portfolio P is very high say 30% while the
risk of Portfolio Q is very low say 5%, then the two portfolios cannot
be compared just on the basis of returns. Hence we need some risk
adjusted measures to evaluate the performance of portfolios.
ii. Risk Adjusted Measures – Risk adjusted measures adjust the return
from a portfolio for the underlying risk. These measures are Sharpe
ratio (or index), Treynor’s Ratio (or index) and Jensen’s Alpha. They
are discussed below:
10.2 RISK ADJUSTED MEASURES OR TECHNIQUES FOR

EVALUATING PERFORMANCE OF PORTFOLIOS
1. Sharpe’s measure: (or Sharpe Ratio or Sharpe Index)
William Sharpe developed a composite measure to evaluate the
performance of mutual funds. It expresses risk premium (or excess
return) of the portfolio in terms of per unit of total risk. The excess
return or risk premium is the excess of actual return over the risk
free return. Total risk is measured by the standard deviation of the
returns from the portfolio. It is also termed as Reward to Volatility
ratio. It is calculated as under:
Return of portfolio-Return of risk free investment ................(10.1)

SP =
Standard deviation of Portfolio
Rp-Rf

SP = .................................................................................(10.1A)
σp
Thus Sharpe ratio converts risk premium into risk premium per unit
of risk. The higher the Sharpe’s ratio, the better it is.
Ranking of portfolios:
When we have to rank the portfolios we give first rank to the one
having highest Sharpe ratio and the last rank to the one having
lowest Sharpe ratio. Hence ranking of portfolios can be done in the
descending order of Sharpe Ratio.
Whether outperformed or Underperformed:
In order to find out whether the portfolio has outperformed or
underperformed we need some benchmark portfolio say the market
portfolio. If the Sharpe ratio of the given portfolio is higher than the
Sharpe ratio of Market portfolio (or any other benchmark portfolio)
then, we say that the given portfolio has outperformed the market
or is an outperformer. On the other hand if the Sharpe ratio of the
given portfolio is lower than the Sharpe ratio of Market portfolio (or
any other benchmark portfolio) then, we say that the given portfolio
has underperformed the market or is an underperformer.
2. Treynor’s measure (or Treynor’s ratio)
Another risk adjusted measure is Treynor’s ratio. Treynor’s measure
of portfolio performance, like Sharpe, measures portfolio’s risk pre-
mium return per unit of risk, but it uses systematic risk as indicated
by beta factor. Treynor’s ratio (Tp) is calculated as under:
Return of portfolio-Return of risk free investment ................(10.2)

Tp =
Beta of Portfolio
Rp-Rf

Tp = ..............................................................(10.2A)
βp
A portfolio with higher Treynor’s ratio is considered as a better per-

former than a portfolio with lesser Treynor’s ratio. Hence the higher
the Treynor’s ratio the better it is.
having highest Treynor’s ratio and the last rank to the one having
lowest Treynor’s ratio. Hence ranking of portfolios can be done in
the descending order of Treynor’s Ratio.
In order to find out whether the portfolio has outperformed or
underperformed we need some benchmark portfolio say the market
portfolio. If the Treynor’s ratio of the given portfolio is higher than the
Treynor’s ratio of Market portfolio (or any other benchmark portfolio)
then, we say that the given portfolio has outperformed the market
or is an outperformer. On the other hand if the Treynor’s ratio of the
given portfolio is lower than the Treynor’s of Market portfolio (or any
other benchmark portfolio) then, we say that the given portfolio has
underperformed the market or is an underperformer.
It must be noted that the Treynor’s ratio of Market portfolio is
always equal to its risk premium or excess return. This is because
the beta factor of the market portfolio is always one. Hence in the
denominator of the formula of Treynor’s ratio we have 1.

Can Sharpe Ratio and Treynor’s Ratio Give Contradictory Results?
It must be noted that Sharpe ratio uses total risk while Treynor’s
ratio uses Systematic risk in the denominator. Total risk comprises
of systematic as well as unsystematic risk. If there is no unsystematic
risk, especially in case of well and perfectly diversified portfolio, then
the total risk and systematic risk will be same and hence Sharpe ratio
and Treynor ratio will provide similar results.
However, it is quite possible that the total risk of a portfolio is not
equal to its systematic risk only. It may also comprise of unsystem-
atic risk. Especially in case of not so diversified portfolios we find
that there is presence of significant amount of unsystematic risk. In
such case Sharpe ratio and Treynor ratio may provide contradictory
results. This is explained in Illustration 10.1.
3. Jensen’s measure (or Jensen’s alpha)
Michael Jensen’s measure, denoted by α, is also a risk adjusted
measure. It is the actual return on the portfolio over and above the
CAPM predicted return. It is measured as follows:
aj = Actual return-Expected Return under CAPM.........................(10.3)

It must be noted that the expected return from CAPM is calculated
as under
E(Rp) = Rf + [RM-Rf]βp.............................................................(10.3A)
It can be observed that Jensen’s alpha measures “abnormal return”
of a portfolio. The higher the alpha, the better it is. The value of
alpha may be positive, zero or negative. When the portfolio provides
a return higher than the expected return as per CAPM, the value of
Jensen’s alpha is positive. When the portfolio provides a return ex-
actly same as expected under CAPM, the value of Jensen’s alpha is
zero. On the other hand, when the portfolio provides a return lower
than the expected return as per CAPM, the value of Jensen’s alpha
will be negative.
It must be noted that the Jensen’s alpha of the market portfolio is
always zero. This is because the beta factor of the market portfolio is
always 1. Therefore if we put beta of the portfolio as 1 in the equation
of CAPM above we get the market return only. Hence actual mar-
ket return is always same as expected market return and therefore
Jensen’s alpha of the market portfolio is always zero.
having highest Jensen’s alpha and the last rank to the one having
lowest Jensen’s alpha. Hence ranking of portfolios can be done in

the descending order of Jensen’s alpha.
Using Jensen’s alpha a portfolio outperforms if Jensen’s alpha is
positive.
On the other hand if Jensen’s alpha is negative the portfolio is said
to be an underperformer.
If Jensen’s alpha is zero, then the portfolio is performing as expected.
Treynor’s Ratio and Jensen’s Alpha
It must be noted that both the Treynor’s ratio and Jensen’s alpha uses
systematic risk factor i.e. beta factor to evaluate the performance of
the portfolio. Hence they always provide similar results in terms of
ranking.
Illustration 10.1 The following information is available about two portfolios
S and W, Market Index and Risk free asset.
Portfolio Actual Return(%) beta S.D of returns(%)
S 21 1.1 20
W 26 1.8 25
Risk free asset 7 0 0
Market index 19 1.00 16
i. Rank the portfolios S and W on the basis of Sharpe ratio and state
whether they have outperformed or underperformed the market
index.
ii. Rank the portfolios S and W on the basis of Treynor’s ratio and state
whether they have outperformed or underperformed the market
index
iii. Is there any difference in results stated in (i) and (ii) above? Why?
Solution : Sharpe ratio (Sp) and Treynor’s ratio (Tp) are calculated as follows:
Sp = [Rp-Rf]/σp
Tp= [Rp-Rf]/βp
Portfolio Rp σp Sharpe Rank
ratio(Sp)
S 21 20 [21-7]/20= 0.70 2 Underperformed as Sp <Sm
W 26 25 [26-7]/25 = 0.76 1 Outperformed as Sp> Sm
Market index 19 16 [19-7]/16 = 0.75
Portfolio Rp βp Treynor Rank

ratio(Tp)
S 21 1.1 [21-7]/1.1= 12.73 1 outperformed as Tp >Tm
W 26 1.8 [26-7]/1.8 = 10.55 2 Underperformed as Tp< Tm
Market index 19 1.0 [19-7]/1 = 12
ii. The rankings provided by Sharpe ratio and Treynor’s ratio is differ-
ent. As per Sharpe ratio portfolio W is better than portfolio S. As per
Treynor’s ratio, portfolio S is better than portfolio W. This is because
of the difference in the measure of risk. In case of sharpe ratio we
consider total risk while in case of Treynor’s ratio we consider only
systematic risk.
Illustration 10.2 The following information is available about three port-
folios P1, P2 and P3. The market index provided a return of 20% over the
same period while returns on Treasury bills were 6%.
Portfolio Actual Return(%) beta
P1 15 0.60
P2 30 1.80
P3 27 1.5
Calculate Jensen’s alpha for each portfolio and state whether they have
outperformed or underperformed the market index.
Solution : Jensen’s alpha is calculated as follows:
α = Actual Return – Expected return as per CAPM
Expected return as per CAPM is calculated as follows:
E(Rp) = Rf + [Rm-Rf]βp
Portfolio Actual Return(%) beta CAPM returns α
P1 15 0.60 6 + [20-6](0.6) = 14.4 15-14.40 = 0.60
P2 30 1.8 6 + [20-6](1.80) = 31.2 30-31.20 = -1.20
P3 27 1.5 6 + [20-6](1.5) = 27 27-27 = 0
Portfolio P1 has outperformed the market as its Jensen’s alpha is positive.
Portfolio P2 has underperformed the market as its Jensen’s alpha is negative.
Portfolio P3 is efficiently priced in the market and has neither outperformed
nor underperformed. Its actual performance is same as expected.
Illustration 10.3 Mr. Tiwari an investment analyst wants to evaluate the
performance of the following three portfolios A, B and C.
Portfolio Actual Return(%) Beta S.D of returns(%)

A 23 1.2 20
B 26 1.7 34
C 18 0.7 15
Market index 20 1.0 18
The return on 91 days Treasury bills over the period was 6%.
i. Calculate Sharpe ratio, Treynor’s ratio and Jensen’s alpha for each
portfolio and market index.
ii. Rank the portfolios A, B and C as per absolute return measure.
iii. Rank the portfolios A, B and C as per Sharpe ratio, Treynor ratio and
Jensen’s alpha.
iv. Which portfolio(s) have outperformed the market index?
Solution : i. We are given that Rf = 6%. The Sharpe ratio, Treynor’s Ratio
and Jensen’s alpha are calculated in the Table.
Portfolio Ri Beta S.D Sharpe Treynor E(Ri) Jensen’s Rank as Rank Rank Rank
ratio ratio using alpha per ab- as per as as per
(Sp) (Tp) CAPM solute Sp per Alpha
return Tp
A 23 1.2 20 0.85 14.17 22.8 0.2 2 1 2 2
B 26 1.7 34 0.58 11.76 29.8 -3.8 1 3 3 3
C 18 0.7 15 0.8 17.14 15.8 2.2 3 2 1 1
Market 20 1 18
index 0.78 14 20 0
ii. Ranking : As per absolute return portfolio B ranks first, portfolio A

is on second position and portfolio C on 3rd position.
iii. Ranking as per Sharpe ratio is A, C and B. Ranking as per Treynor’s
ratio is C, A and B. Ranking as per Jenesen’s alpha is C, A and B.
iv. In order to know which portfolio has outperformed we need to
compare these ratios with the ratio of market portfolio.
Using Sharpe ratio :
Sharpe index of Market portfolio is 0.78.
Sharpe index of Portfolio A is 0.85, hence it has outperformed the market
as per Sharpe ratio.
Sharpe index of Portfolio B is 0.58, hence it has underperformed the market
Sharpe index of Portfolio C is 0.8, hence it has outperformed the market
395 Mutual funds Para 10.3
Using Treynor’s ratio : Portfolios A and C have outperformed the market as

their Treynor’s ratio are greater than that of the market portfolio. Portfolio
B has underperformed the market.
Using Jensen’s alpha: Jensen’s alphas of portfolios A and C are positive and
hence these two portfolios have outperformed the market. Portfolio B has
underperformed as its alpha is negative.
10.3 Mutual Funds

Mutual fund is a financial intermediary that collects funds from individual
investors and invests those funds in a wide range of assets or securities. The
individual investor has a claim to the portfolio established by the mutual
fund in the proportion of the amount invested, thereby becoming a part
owner of the assets of mutual funds. The fund employs professional experts
and investment consultants who invest the money so collected in different
stocks, bonds or other securities so as to meet the objective of fund. The
net income earned on these investments together with the capital appre-
ciation, if any, are shared with the unit holders in the proportion of units
held by them. The mutual fund manager charges fee from the unit holders
for administering the fund and managing the portfolio of investment. In
India Mutual Funds are required to get registered with the Securities and
Exchange Board of India (SEBI). Fig 10.1 shows the working of mutual fund.
Investors pool
their money
Return are Fund Manager in-

distributed to vests pooled
unitholders money in securities
Income and
dividends are
generated
Figure 10.1: Working of Mutual Funds

Mutual Funds Are An Indirect Mode of Investment:

Mutual funds as explained above pools the money from investors and
invest it across a wide range of securities. Hence from an investor’s point
of view, mutual funds is an indirect mode of investment in financial and
other assets and securities. Direct mode of investment is one in which an
investor invests directly in securities or assets by himself purchasing them.
In case of mutual funds, the investor invests in a particular scheme of a
mutual fund and hence buys or invests in the units of mutual funds. The
mutual fund in turn invests the amount given by the investor, in assets and
securities and creates a portfolio. The value of this portfolio represents the
value of the units sold by the mutual funds. To be precise, the net asset value
(NAV) of the portfolio reflects the value of the unit held by the investor.
For example, Mr. X wants to invest Rs 10000 in equity shares. He can do
so using two modes in investment. (i) Direct investment – in this case Mr.
X will first of all decide about the equity shares in which investment is to
be made, then he will allocate Rs 10000 among these equity shares and
finally buy equity shares. He has to manage this portfolio of equity shares
on his own and revise it periodically. (ii) Indirect Mode of Investment- in
this case, Mr. X will buy the units of an Equity mutual fund scheme which
invests in a diversified portfolio of equity shares. By buying the units of
mutual fund, Mr X supplies his Rs 10000 to the mutual fund which in turn
invests it in equity shares. The task of shares selection, portfolio construction
and revision is not done by Mr. X now. It is done by the fund manager, for
which the mutual fund charges some nominal fee.
Hence Indirect mode of investment i.e. mutual funds represent a convenient
mode of investment for a small investor who has small savings and does
not possess requisite skills for investment.
10.4 EVOLUTION OF MUTUAL FUNDS IN INDIA

The mutual fund industry in India began in 1963 with the formation of Unit
Trust of India, at the initiative of the Government of India and Reserve
Bank of India. It can mainly be divided into four phases:-
First Phase - 1964-1987

Unit Trust of India (UTI) was established in 1963. UTI launched its first
scheme named as Unit Scheme 1964. For a quite long period of time UTI
was the only mutual fund operating India. UTI enjoyed monopoly till the
year 1987.
397 Evolution of mutual funds in india Para 10.4
Second Phase - 1987-1993

During this phase the Government allowed entry of public sector banks, Life
Insurance Corporation of India (LIC) and General Insurance Corporation
of India (GIC) into the mutual fund industry. SBI Mutual Fund established
India’s first non-UTI Mutual Fund in 1987. The same year witnessed the
entry of Canbank Mutual Fund. Other banks following the suit were Punjab
National Bank Mutual Fund (1989), Indian Bank Mutual Fund (1989), Bank
of India (1990), and Bank of Baroda Mutual Fund (1992). LIC and GIC es-
tablished their mutual funds in 1989 and 1990 respectively.
Third Phase - 1993-2003

This phase marked the entry of private sector into mutual fund industry
in India. Moreover, the phase witnessed the first Mutual Fund Regulations
(1993), according to which all mutual funds, except UTI were needed to
be registered. The first private sector mutual fund registered in 1993 was
Kothari Pioneer which has now merged with Franklin Templeton. In the
year 1996, market regulator SEBI came up with SEBI (Mutual Fund)
Regulations 1996 replacing the old regulations of 1993. This phase had been
a prosperous phase where number of mutual fund houses set up in India
was on rise, with many foreign mutual funds setting up funds in India and
also several mergers and acquisitions were witnessed by industry. In the
year 1994 the first foreign mutual fund Morgan Stanley entered Indian
Mutual fund industry.
Fourth Phase - Since February 2003

In this phase, UTI was divided into two separate entities. First is the
Specified Undertaking of the UTI which functions under an administrator
and the rules framed by Government of India and does not come under
the purview of the Mutual Fund Regulations. Second is UTI Mutual Fund,
sponsored by SBI, PNB, BOB and LIC, registered with SEBI and functions
under the Mutual Fund Regulations. With tremendous growth potential as
evident by mergers taking place among different private sector funds, the
mutual fund industry can be said to have entered into its current phase of
consolidation and growth.
Presently there are around 45 mutual fund organizations in India handling
assets worth nearly Rs. 10 lakh crore. Today, the Indian mutual fund industry
has opened up many exciting investment opportunities for investors. As a
result, we have started witnessing the phenomenon of savings now being
entrusted to the funds rather than in banks alone. Mutual Funds are now
perhaps one of the most sought-after investment options for most investor.
ESTABLISHMENT OF MUTUAL FUNDS

SEBI (Mutual Fund) Regulations,1996 defines mutual fund as under:
“mutual fund” means a fund established in the form of a trust to raise mon-
ies through the sale of units to the public or a section of the public under
one or more schemes for investing in securities including money market
instruments or gold or gold related instruments or real estate assets. Thus,
a mutual fund is set up in the form of a trust and this trust has following
major constituents:
Sponsor : Sponsor means any person who, acting alone or in com-
1.
bination with another body corporate, establishes a mutual fund.
Sponsor is similar to promoter of a company.
Board of trustees : The board of trustees of the mutual fund hold its
2.
property for the benefit of the unitholders. The board is vested with
the general power of superintendence and direction over Asset Man-
agement Company. They are required to monitor the performance of
mutual fund and ensure compliance of SEBI Regulations by them.
SEBI regulations require that at least two thirds of the directors of
trustee company or board of trustees must be independent i.e. they
should not be associated with the sponsors.
Asset Management Company (AMC) : AMC is a Company established
3.
under Companies Act, 2013 and it is required to take approval of SEBI
to be AMC of a mutual fund. It manages the funds of the mutual
fund scheme by making investments in various types of securities.
SEBI regulations require that 50% of the directors of AMC must be
independent.
Custodian : Custodian is required to be registered with SEBI. Custo-
4.
dian is appointed to keep custody of the securities or gold and gold
related instrument or other assets of the mutual fund and provide
such other custodial services as may be authorised by the board of
trustees.
ADVANTAGES OF INVESTING IN MUTUAL FUNDS

Mutual funds offer a number of benefits or advantages to the investors.
The basic idea behind mutual funds is diversification and risk reduction.
A small investor may not have such a large amount of savings to buy a
diversified portfolio. Hence mutual funds provide an option to such a small
investor so as to reap the gains of diversification. The advantages of mutual
funds are discussed below:
399 Evolution of mutual funds in india Para 10.4
(i) Professional Management:

The services of highly experienced and skilled professionals are
availed under mutual funds. These professionals are backed up by
a dedicated investment research team which first analyses the per-
formance and prospects of companies and then invest accordingly.
(ii) Diversification:
MFs invest in a wide range of companies of different industries and
sectors. Thus, investors enjoy the benefit of diversification with less
money and less risk. However it must be noted that sectoral funds
such as IT funds, Pharma funds etc. may not provide the benefit of
diversification as all the stocks in the portfolio of sectoral schemes
belong to a particular sector.
(iii) Convenient Administration:
Investing in a Mutual Fund reduces a huge amount of paper work.
Further, it helps investors to avoid many problems like bad deliver-
ies, delayed payments and unnecessary follow up with brokers and
companies.
(iv) Return Potential:
Mutual Funds may provide higher returns in medium to long term as
they invest in wide range of securities which is not possible to attain
by a small investor.
(v) Low Costs:
Mutual Funds are less expensive way of investing in comparison with
direct investing. Indirect investing via mutual funds offers the ben-
efits of scale in brokerage, custodial & other fees. All these benefits
translate into lower costs for investors.
(vi) Liquidity:
In open ended schemes, investors can get their money back instantly
at the prevailing NAV. Also in close-ended schemes, investors can sell
their units on a stock exchange at the prevailing market price, or can
go for direct repurchase at NAV related prices.
(vii) Transparency:
Investors get regular information about the value of their investment.
The disclosure on the investments made by the particular scheme
along with the proportion invested in each class of assets and details
regarding future investment strategy are also provided.
LIMITATIONS OF INVESTING IN MUTUAL FUND

Although mutual funds offer a number of advantages as discussed above,
they are also subject to certain limitations. These limitations are provided
below:
No direct Choice of Securities:
1.
Mutual funds is an indirect mode of investment. Hence Investors
do not have a say in the securities selection. They cannot choose
securities in which they want to invest in. The portfolio of mutual
fund scheme is built by the fund manager and unit holders cannot
ask for any alteration or modification.
Relying on Mutual Fund Manager’s Performance:
2.
Investors have to rely on the fund manager for receiving any earning
made by the fund. Further, if manager’s pay is linked with the fund’s
performance, then in the zest of earning more, he may go for short
term goals ignoring the long term. There is always a possibility that
the mutual fund deviates from its investment objective and serves
the interest of its management.
High Management Fee and other expenses:
3.
All mutual funds may not run efficiently. Mutual funds at times may
charge high management fee so as to pay higher compensation to the
fund managers. The management fees, related expenses and loads
charged by the fund reduce the return available to the investors.
Lock-In Period:
4.
Many Mutual Funds schemes especially tax savings schemes have
strict lock in period. The mutual fund units cannot be redeemed
during the lock in period. Hence during lock in period the units of
mutual funds become illiquid.
10.5 MUTUAL FUND SCHEMES

Mutual funds offer various schemes to attract the investors and to meet
up their investment objectives. These schemes are of different types as
the fund invests in a wide range of securities keeping in mind their inves-
tor’s preference and the fund goals. Some schemes offer a steady flow of
income while others offer tax advantage. These schemes can be classified
in a number of ways as explained under:
401 Mutual fund schemes Para 10.5
Open-ended
schemes
close-ended
Structure
schemes
interval
schemes
income
schemes
growth
Investments schemes
Mutual funds
objectives
balanced
schemes
money market
schemes
tax saving
schemes
sector
others schemes
index
schemes
Figure 10.2: Schemes of Mutual Fund
The following paragraphs discuss these schemes in detail:

1. Open-ended, Close-ended and Interval funds:
An open-ended scheme allows the investor to make entry and exit
at any point in time. The capital of the fund is unlimited and there is
no fixed maturity date. An investor can buy or sell the units under
open ended fund at anytime. On the other hand, close-ended scheme
has a fixed maturity period and investors can invest only during the
initial launch period known as the IPO period. The investor can make
an exit from the scheme by selling his units in the secondary market
or at the end of maturity period or during repurchase period. The
points of distinction between open-ended and close-ended schemes
are tabulated as under:
Basis Open-ended Scheme Close-ended Scheme
Initial Available for subscription Available for subscription
Subscription throughout the year during a specified period only
Maturity No fixed maturity period Stipulated maturity period
Subsequent Investors can buy or sell Investors can buy or sell
Transactions units at net asset value (NAV) units at stock exchange
declared by the fund where the fund is listed. The
units may trade at a premi-
um or discount to the NAV.
Basis Open-ended Scheme Close-ended Scheme

The demand and supply of
fund units and other market
factors also affect their price.
Number of Increases when the fund The number does not change
outstanding house sells more units in the as a result of trading on the
units market and decreases when stock exchange.
the fund house repurchases
the existing units
Size of fund The fund expands in size No change in fund size as no
when the fund house sells sudden redemption of units
more units than it repur- takes place.
chases and the fund’s size
reduces when the fund house
repurchases more units than
it sells.
Interval funds are hybrid funds and combine the features of
open-ended and close ended schemes. These schemes are open for
purchase and redemption during pre-specified intervals (monthly,
quarterly, annually, etc.) at NAV related prices.
2. Load funds and No Load Funds:
“Load” in the context of mutual funds means “charges” or “fee”. A load
fund charges a percentage of NAV as entry or exit fees. The charge
ranges from 4% to 8% of the amount invested or it could also be a
flat fee. For example, if you invested Rs. 1,000 into a 5% load fund,
you would actually be investing only Rs. 950 with the remaining Rs.
50 going to the company as a charge. Mutual fund can charge load
in the following manner:
u Entry Load: This is charged at the time of purchasing units of
the scheme (added to the prevailing NAV thereby allotting less
units)
u Exit Load: This is charged at the time of redeeming units of
the scheme (deducted from the prevailing NAV while making
payment)
On the other hand, a no-load fund does not charge any fees
for entry or exit. In case of no-load funds, all transactions of
purchase and sale are made at NAV only.
3. Domestic Funds and Off-Shore funds :

Domestic mutual funds are open for investment by the investors
within the country where the fund is registered. Most of the mutual
403 Mutual fund schemes Para 10.5
funds in India are domestic funds. Off shore mutual funds are open
for subscription by foreign investors only. These funds channelize
foreign investment in mutual funds in a country. At present a number
of off shore funds have been launched by mutual funds in India.
4. Growth funds, Income funds and Balanced funds:
A growth fund scheme is one which offers capital appreciation and
dividend opportunity to the investor. Such schemes invest majority
of their funds in equities. The main idea behind a growth scheme is to
provide capital gains rather than regular income to the unit holders.
Capital appreciation is in the form of increased NAVs over long period.
This is ideal for investors who are in their prime earning stage and
are looking for long term investment. A growth fund invests about
90% or more in equity shares. As growth schemes invest primarily
in equity shares they are exposed to high risk.
On the other hand, income funds promise a regular income to its
investors. Majority of funds are channelized towards fixed income
securities such as debentures, government securities, and other debt
instruments. Although capital appreciation is low as compared to
the growth funds, this is a relatively low risk-low return investment
avenue. This scheme is ideal for investors seeking capital stability
and regular income. Income funds invest about 90% of their total
funds into fixed income securities so as to provide regular income
to the unit holders.

A balanced fund is a combination of growth fund and income fund. A
balanced fund invests about 50:50 in equity shares and bonds. They
invest in shares for growth and invest in bonds for regular income.
These are ideal for investors who are looking for a regular income
source and moderate growth over a period of time.
5. Equity Fund schemes:
They are same as Growth schemes. Under equity fund schemes,
the funds are invested primarily in equity shares. Hence the return
from these schemes is primarily in the form of change in prices or
NAVs rather than regular dividend. Equity fund schemes are growth
schemes. There are a variety of equity schemes available which
include- Sector specific schemes, Equity Linked Savings Schemes,
Diversified equity schemes etc.
6. Debt fund schemes :
These schemes are similar to income funds. In case of debt funds
the collected funds are invested in debt securities such as bonds,
debentures, govt. Securities etc. These schemes offer low return at

low risk as compared to Equity schemes. Debt schemes are ideal for
investors who are not willing to undertake high risk and want regular
income.
7. Gilt Funds :
Gilt funds are those funds which invest exclusively in government
securities. Therefore, these funds provide low return at a very low
risk. They are preferred by risk averse and conservative investors
who wish to invest in the shadow of secure government bonds. Since
gilt funds invest only in government bonds, investors are protected
from credit risk. Almost every mutual fund operating in India has
launched a Gilt fund. SBI Magnum Gilt is a Gilt fund operating in
India.
8. Money market funds:
Money market funds provide the opportunity of easy liquidity and
moderate income. These schemes invest in short-term debt, i.e. mon-
ey market instruments and seek to provide reasonable returns for
the investors. The funds collected are exclusively invested in money
market instruments such as Treasury Bills, Certificates of Deposit,
Commercial Paper and Inter-Bank Call Money. The income from these
funds is generally determined by short-term interest rates. These
schemes are mainly used by corporate and institutional investors
who wish to invest their surplus funds for short period of time.
9. Tax saving schemes [or Equity Linked Savings Scheme (ELSS)]
As the name suggests, these schemes offer tax benefits to its investors
under specific provisions (Section 80C) of Indian Income Tax Act,
1969. These funds (also called Equity Linked Savings Schemes) invest
in equities, thus offer long-term growth opportunities. Investment
in these schemes is deductible from total income under section 80C
within the limit of Rs. 150000. This helps the investor in reducing tax
liability. However these schemes have a 3-year lock-in period. These
schemes are ideal for persons who seek to reduce their tax liability.
10. Index Schemes:
Index Funds or Index Schemes attempt to replicate the performance
of a benchmark market index such as the BSE SENSEX or the NSE
NIFTY. The collected funds are allocated on the basis of proportion-
ate weight of different securities as stated on the benchmark index
and earn the same returns as earned by the market. A number of
index schemes have been launched in India. Index funds are ideal
405 Latest developments regarding mutual funds Para 10.6
for Passive management. An investor may invest in an index fund

and can earn return at commensurate risk.
11. Sectoral Funds:
These funds invest exclusively in the stocks of companies belonging
to a specified sector or industry. The idea is to reap the benefit of the
sector or industry cycles. If an industry is going through good times,
these schemes offer good returns to the investors. However, the in-
vestor can’t limit his risk exposure as available in case of diversified
funds.
12. Ethical funds:
A more recent development in mutual funds is Ethical funds. As the
name suggests ethical funds make investment on the basis of certain
ethics or values, especially Shariah values. These funds use a screening
criteria to decide about the companies or stocks which are suitable
for investment. There are only two ethical funds operating in India.
They are – Tata Ethical Fund and Tauras Ethical fund. Tata ethical
fund was launched in 1996. Taurus Ethical Fund launched in 2007
from Taurus Mutual Fund is an actively managed Equity Oriented
Shariah Compliant Diversified Fund. The investments in this fund are
based on the fundamentals of Shariah or Shariat, which are guided
by the Islamic investment philosophy which invests in companies
based on certain screening norms. The funds of an ethical fund are
invested in the companies other than the following—
u Companies providing financial services on interest basis like
conventional banks, insurance companies
u Companies involved in some other business not approved by
Shariah, such as companies manufacturing, selling or offering
liquors, or involved in gambling, night club activities, pornog-
raphy etc.
10.6 LATEST DEVELOPMENTS REGARDING MUTUAL FUNDS

1. EXCHANGE TRADED FUNDS
ETFs are baskets of securities that are traded on an exchange like
individual stocks. They track an index and money is invested in se-
curities of the index in same proportion, thus has a similarity with
index mutual funds. However, unlike the mutual funds, ETFs can be
bought and sold throughout the trading day like any stock. These funds
charge lower expenses than index mutual funds but an investor has
to pay a brokerage to buy and sell ETF units. Originally, ETFs were
first introduced in USA in 1993. The first ETF in India, “Nifty BeEs
(Nifty Benchmark Exchange Traded Scheme)” based on S&P CNX
Nifty, was launched in January 2002 by Benchmark Mutual Fund.
These funds rely on an arbitrage mechanism to keep the prices at
which they trade in line with the NAV of their underlying portfolios.
Thus, potential arbitrageurs need to have full and timely knowledge
of a fund’s holdings. The structure of ETFs is explained in the Fig
10.3:

Fig 10.3: Structure of Exchange Traded Funds
(Source : www.nse-india.com)
Advantages of ETFs
ETFs provide exposure to an index or a basket of securities that
trade on the exchange like a single stock. They offer a number of
advantages over traditional open-ended index funds as follows:
u While redemptions of Index fund units takes place at a fixed
NAV price (usually end of day), ETFs offer the convenience of
intra-day purchase and sale on the Exchange, to take advantage
of the prevailing price, which is close to the actual NAV of the

scheme at any point in time.
They provide investors a fund that closely tracks the perfor-
mance of an index throughout the day with the ability to buy/
sell at any time, whereby trading opportunities that arise during
a day may be better utilized.
u They are low cost investment options than traditional funds.
u Unlike listed closed-ended funds, which trade at substantial
discounts to NAV, ETFs are structured in a manner which al-
lows Authorized Participants and Large Institutions to create
new units and redeem outstanding units directly with the fund,
thereby ensuring that ETFs trade close to their actual NAVs.
u Since an ETF is listed on an Exchange, costs of distribution are
much lower and the reach is wider. These savings in cost are
passed on to the investors in the form of lower costs. Further,
the structure helps reduce collection, disbursement and other
processing charges.
u ETFs protect long-term investors from inflows and outflows of
short-term investors. This is because the fund does not incur
extra transaction cost for buying/selling the index shares due
to frequent subscriptions and redemptions.
u Tracking error, which is divergence between the NAV of the
ETF and the underlying Index, is generally observed to be low
as compared to a normal index fund.
u ETFs are highly flexible and can be used as a tool for gaining
instant exposure to the equity markets, equitizing cash or for
arbitraging between the cash and futures market.
2. FUND OF FUNDS
A fund of funds scheme means a scheme which invests in other mu-
tual fund schemes. In other words, a scheme where the subscription
proceeds are invested in other Mutual Funds, instead of investing
in Equity or Debt Instruments. Since these funds invest in other
mutual funds, they offer and achieve a greater diversification than
traditional mutual funds. On the down side, expense/fees on such
funds are higher than those on regular funds as they need to pay
expenses and fees charged by the underlying funds as well.
3. SYSTEMATIC INVESTMENT PLANS
A Systematic Investment Plan or SIP is a smart mode for investing
money in mutual funds. SIP allows an investor to invest a certain
pre-determined amount at a regular interval (weekly, monthly, quar-

terly, etc.). A SIP is a planned approach towards investments and helps
to inculcate the habit of saving and building wealth for the future.
SIPs are ideal for retail investors who do not have the resources to
pursue active investments.
Let us take the example of Mr. X who is a SIP investor. His money
is auto-debited from his bank account on 10th of every month and
invested into a specific mutual fund scheme which allocates him a
certain number of units based on the prevailing NAV for the day.
So each time he invests money, additional units of the scheme are
purchased at the prevailing NAV for that day and added to his ac-
count. Hence, units are bought at different rates and Mr. X benefits
from SIP in the following ways:
u Rupee - Cost averaging - An investor invests a fixed amount
irrespective of NAV. So he gets fewer units when NAV is higher
and more units when NAV is lower. This smoothens out the
market’s ups and downs thereby reducing the risk of invest-
ment when markets are volatile. Thus, SIP allows its investors
to achieve lower average cost per unit.
u Power of Compounding - Albert Einstein once said, “Compound
interest is the eighth wonder of the world. He who understands
it, earns it... he who doesn’t... pays it.” The rule is simple- “the
sooner you start investing, the more time your money has to
grow”. Let us say Mr. A start investing Rs. 10000 per month on
his 30th birthday. In a period of 20 years, he would have put
aside Rs. 24 lakhs. If that investment grew by an average of 7%
a year, it would be worth Rs. 52.4 lakhs when he reaches 50.
However, if he started investing 10 years earlier i.e. on his 20th
birthday, his Rs. 10000 each month would add up to Rs. 36 lakh
over 30 years. Assuming the same average annual growth of
7%, he would have Rs. 1.22 Crore on his 50th birthday.
u Disciplined Saving - When investment is made through SIP,
investor commits to himself to save regularly. This leads to
discipline in savings and investment.
u Flexibility - While it is preferred to invest in SIP for long-term,
there is no compulsion. Investors can discontinue the plan
at any time. Moreover, one can also increase/decrease the
investment amount.
u Long-Term Gains - Due to rupee-cost averaging and the power

of compounding SIPs have the potential to deliver attractive
returns over a long investment horizon.
u Convenience - SIP is a hassle-free mode of investment. One can
issue a standing instruction to his bank to facilitate auto-debits
from his bank account.
4. SYSTEMATIC WITHDRAWAL PLANS
Systematic Withdrawal Plan or SWP permits the investor to make
an investment at one go and systematically withdraw at periodic
intervals, at the same time permitting the balance amount to remain
invested. Withdrawal can be done either on a monthly basis or on a
quarterly basis, based on needs and investment goals of the investor.
It is ideal for investors who are looking for regular income. SWP
includes convenient pay out options and has several tax advantages.
Under SWP, neither tax is deducted nor is dividend distribution tax
applicable. Moreover, there are no entry or exit loads in SWP.
5. SYSTEMATIC TRANSFER PLANS

STP (Systematic Transfer Plan) is a variant of SIP, in which an in-
vestor can transfer his investment from one asset or asset type into
another asset or asset type. The fund from which the transfer takes
place is called the ‘source fund’ and the fund into which funds are
transferred is called the ‘target fund’.
So, STP allows investors to invest an amount upfront in the source
fund, out of which a stipulated amount will be systematically trans-
ferred into the target fund at a suggested frequency (weekly, monthly,
quarterly) on a pre-specified date.
Investors can use Systematic Transfer Plan (STP) as a defensive
strategy in volatile market. For example: If you have invested
Rs. 5,00,000 in an equity mutual fund but now, you expect the eq-
uity markets to fall sharply. In order to minimize you risk, you can
use an STP to transfer some amount (say, Rs. 2,00,000) from equity
mutual fund to a debt mutual fund which will yield stable return
even when markets fall.
Importance
1. Saves the time and effort involved in giving multiple instructions to
the mutual fund to redeem from one scheme and invest in another.
2. Provides an opportunity to earn a better return as compared to re-
turns on the ‘source fund’.
Types of STPs
Fixed STP - A fixed amount is regularly transferred from the source
1.
fund to the target fund.
Capital appreciation STP, where investors take the profit part out of
2.
one fund and invest in the other. Only profits in excess of a predefined
amount are transferred to the target fund.
Most investors prefer fixed STP which is easier and more convenient.
10.7 EVALUATING PERFORMANCE OF MUTUAL FUNDS

A mutual fund may be considered as a portfolio of securities. Hence the
performance of mutual funds can be evaluated in terms of absolute returns
as well as various risk adjusted returns such as Sharpe ratio, Treynor’s ratio
and Jensen’s alpha as discussed under portfolio performance evaluation in
Section 10.2. However calculation of return from a mutual fund requires
some explanations. Every mutual fund in India is required to disclose Net
Asset Value (NAV) on daily basis. In order to calculate return from a mu-
tual fund we need to understand calculation of NAV and costs of mutual
funds first.
1. Net Asset Value (NAV)
Net Asset Value refers to the amount which a unit holder would
receive per unit if the scheme is wound up. As the name implies, it
is the value of the net assets of the fund. The term net assets mean
assets less liabilities. In balance sheet of the fund, the investors’ sub-
scription is treated as the capital and the investments on their behalf
are treated as assets.
Net Asset Value of the Fund
NAV Per unit =
No. of Units Outstanding
Where Net Assets = Market Value of Investments + Receivables +

Accrued Income + Other Assets - Accrued Expenses - Payables - Other
Liabilities
2. Costs incurred by mutual fund
“In the mutual fund field, costs assume a tremendous importance
for the long-term investor. Other things held equal, lower costs mean
higher returns.” -John Bogle
Cost of mutual fund has two components:
1. Initial expenses attributable to establishing scheme
411 Evaluating performance of mutual funds Para 10.7
2. On-going recurring expenses (management expense) which is

made up of
a. Cost of employing expert investment analyst
b. Cost of administration
c. Cost of advertisement
Management expense ratio may be expressed as a percentage of
average assets under management during the relevant period. It
relates to the extent of assets used to run a mutual fund. It includes
administrative expenses and advisory expenses and excludes bro-
kerage fees. It is computed as below:
Expenses
Expenses Ratio =
Average assets under management
3. Return from mutual fund

The return from a mutual fund may be of three types:
1. Dividends
2. Capital gains disbursement
3. Change in NAV over the period.
Return from a mutual fund may be computed as follows:
Div1 + CG1 + [ NAV1 -NAV0 ]
Return = × 100
NAV0
Where
Div1 = dividends for the period
CG1 = Capital gains realised
NAV1 = NAV at the end of the year
NAV0 = NAV in the beginning of the year
4. Performance Evaluation of Mutual Funds:
Once the return from a mutual fund is calculated, we can also de-
termine its total risk by calculating standard deviation of returns.
Further beta of a mutual fund can also be determined to capture
the sensitivity of a mutual fund scheme to market portfolio returns.
Once we have actual return, risk and beta factor of the mutual fund,
we can apply the following measures for performance evaluation of
a mutual fund
i. Absolute return
ii. Risk adjusted Measures : this include
a. Sharpe ratio
b. Treynor’s ratio
c. Jensen’s alpha
Details about these measures have already been provided in sections 10.1
& 10.2
Illustration 10.4 Find out NAV per unit from the following information:
Size of the scheme Rs. 10,00,000
Face value of shares Rs. 10
Number of outstanding share Rs. 1,00,000
Market value of fund’s investment Rs. 18,00,000
Bills receivable Rs. 20,000
Liabilities Rs. 10,000
Solution:
Total Assets=Market Value of Investment + Bills Receivable=Rs. 18,00,000
+ Rs. 20,000 = Rs. 18,20,000 Liabilities= 10,000
total assets-liabilities rs. 18,20,000-rs. 10,000
NAV per unit = = =
no. of shares 1,00,000
= Rs. 18.1 per share
Illustration 10.5: Information about three mutual fund schemes X, Y and
Z are available.
Mutual Fund Actual Return(%) beta S.D.(%)
X 14 0.70 21
Y 26 1.20 30
Z 24 1.15 29
The return on market index is 22% and standard deviation of returns on
market index is 25%. The risk free rate is 5%.
i. Calculate Sharpe ratio for all the funds and market index and rank
them.
ii. Calculate Treynor’s ratio for all the funds and market index rank
them.
iii. Calculate Jenesen’s alpha for all the funds and market index rank
them.
413 Evaluating performance of mutual funds Para 10.7
Solution :
i. Sharpe ratio
Sp = [Rp-Rf]/σp
Mutual Rp σp Sharpe ratio(Sp) Rank Remarks
Fund (including
market index)
X 14 21 [14-5]/21= 0.43 4 Underperformed
the market
Y 26 30 [26-5]/30 = 0.70 1 Outperformed
the market
Z 24 29 [24-5]/29= 0.65 3 Underperformed
the market
Market 22 25 [22-5]/25 = 0.68 2
index
ii. Treynor’s ratio
Tp= [Rp-Rf]/βp
Mutual Actual beta Treynor ratio(Tp) Rank Remarks
Fund Return(%)
X 14 0.70 [14-5]/0.7= 12.85 4 Underperformed
the market
Y 26 1.20 [26-5]/1.2 = 17.5 1 Outperformed the
market
Z 24 1.15 [24-5]/1.15= 16.52 3 Underperformed
the market
Market 22 1.0* [22-5]/1 = 17 2
index
*beta factor of market portfolio is always one.
iii. Jensen’s alpha is calculated as follows:
α = Actual Return – Expected return as per CAPM

Expected return as per CAPM is calculated as follows:
E(Rp) = Rf + [Rm-Rf]βp
Mutual Actual beta CAPM re- α Rank (includ- Remarks

Fund Return(%) turns ing market
index)
X 14 0.70 5 + [22-5] 14-16.90 4 Underper-
(0.7) = 16.9 = -2.90 formed the
market
Portfolio performance evaluation & mutual funds 414
Mutual Actual beta CAPM re- α Rank (includ- Remarks

Fund Return(%) turns ing market
index)
Y 26 1.20 5 + [22-5] 2 6 - 2 5 . 4 1 Outperfo-
(1.2) = 25.4 = +0.60 rmed the
market
Z 24 1.15 5 + [22-5] 24-24.55 3 Underper-
(1.15) = =-0.55 formed the
24.55 market
Market 22 1 5 + [22-5] 22-22 = 2
Index (1) = 22 0**
** it must be noted that Jensen’s alpha for market index is always
zero.
Solved problems
Problem 10.1 A Mutual Fund made an issue of 10,00,000 units of Rs. 10 each
on 01.01.2014. No entry load was charged. It made the following investments:
50,000 Equity Shares of Rs. 100 each @ 160 Rs. 80,00,000
7% Government Securities Rs. 8,00,000
9% Debentures (Unlisted) Rs. 5,00,000
10% Debentures (Listed) Rs. 5,00,000
Total Rs. 98,00,000
During the year, dividends of Rs. 12,00,000 were received on equity shares.
Interest on all types of debt securities was received as and when due. At
the end of the year equity shares and 10% debentures are quoted at 175%
and 90% respectively. Other investments are quoted at par. Find out the Net
Asset Value (NAV) per unit given that the operating expenses during the
year amounted to Rs. 5,00,000. Also find out the NAV, if the Mutual Fund
had distributed a dividend of Re. 0.80 per unit during the year to the unit
holders. (B.Com (H) DU 2012)
Solution:
I. Cash balance at the end of the period
Opening balance (Rs.100 lakhs-98 lakhs) Rs. 2,00,000
Dividends received 12,00,000
Interest income:
u 7% Government Securities 56,000
u 9% Debentures (Unlisted) 45,000
415 Solved problems
u 10% Debentures (Listed) 50,000

Total 15,51,000
Less: operating expenses 5,00,000
Closing cash balance 10,51,000
II. Calculation of NAV
Closing cash balance Rs.10,51,000
50,000 Equity Shares of Rs. 100 each @ 175% or Rs. 175 87,50,000
each
7% Government Securities 8,00,000
9% Debentures (Unlisted) at cost 5,00,000
10% Debentures (Listed) at 90% 4,50,000
Total assets (before dividend) 1,15,51,000
Dividend distribution @ Re. 0.80 per unit 8,00,000
Total assets (after dividend) =11551000-800000 1,07,51,000
No. of units 10,00,000
NAV per unit (before dividend) 11.55
NAV per unit (after dividend) 10.75
Problem 10.2 In case of an open ended Mutual Fund scheme the market
price (ex-dividend) was Rs. 75. A dividend of Rs. 15 has just been paid and
ex-divided price now is Rs. 95. What return has been earned over the past
year?
Solution:
div1 + CG1 + NAv1 -NAv0 15 + (95 − 75)
return = = = 46.67%
NAv0 75
Problem 10.3 A mutual fund had a Net Asset Value (NAV) of Rs. 65 at the
beginning of the year. During the year a sum of Rs. 8 was distributed as
dividend besides Rs. 5 as capital gains distribution. At the end of the year
NAV was Rs. 73. Calculate total return for the year.
Solution:
div1 + CG1 + NAv1 -NAv0 8 + 5 + (73 − 65)
return = = = 32.31%
NAv0 65
Problem 10.4 A mutual fund had a Net Asset Value (NAV) of Rs. 73 at the
beginning of the year. At the end of the year it gives a dividend of Rs. 5
and no capital gains distribution and NAV at the end of the year is Rs. 68.
What is the return from the fund ?
Solution:
div1 + cG1 + nav1 -nav0 5 + 0 + (68 − 73)
return = = = 0%
nav0 73
Problem 10.5 Ram invested in a Mutual Fund when the Net Asset Value
was Rs. 12.65. Thirty days later the Asset Value per unit of the fund was
Rs. 12.25. In the meantime, Ram had received a cash dividend of Re. 0.50
and a Capital Gain distribution of Re. 0.30. Compute the monthly return.
Solution:
div1 + cG1 + nav1 -nav0 0.50 + 0.30 + (12.25 − 12.65)
return = = = 3.16%
nav0 12.65
Problem 10.6 A mutual fund has an NAV of Rs. 26 in the beginning of the
period and Rs. 30 at the end of the same period. During the period, it in-
curred expenses at the rate of Rs. 0.80 per unit. Find out the expense ratio.
Solution:
expenses 0.80 0.8
expense ratio = × 100 = × 100 = × 100
average assets under management (26 + 30) / 2 28
=2.86%
Problem 10.7 A mutual fund has an NAV of Rs. 50 in the beginning of
the period and Rs. 70 at the end of the same period. During the period, it
incurred expenses at the rate of Rs. 5 per unit. Find out the expense ratio.
(B.Com(H) DU 2013)
Solution:
expenses
expense ratio = × 100
average assets under management
5
= × 100 = 8.33%
(50 + 70) / 2
Problem 10.8 The following particulars relating to a mutual fund are given
to you:
Management Advisory Fees Rs. 275 lakhs
Administration Expenses (including Fund Manager Remuneration) Rs. 350 lakhs
Publicity and Documentation Rs. 80 lakhs
Opening NAV Rs. 108 crore
Closing NAV Rs. 170 crore
417 Solved problems
Ascertain the Expense ratio.

Solution: Total expenses= Management Advisory Fees+ Administration
Expenses+ Publicity and Documentation=Rs. 275 lakhs + Rs. 350 lakhs +
Rs. 80 lakhs=Rs. 705 lakhs or 7.05 crores
Average assets = (Opening NAV+ Closing NAV)/2 = (Rs. 108 crore + Rs.
170 crore)/2 =Rs. 139 crore
expenses 7.05 Crore
expense ratio = × 100 = × 100 = 5.07%
Average assets under management 139 Crore
Problem 10.9 : A mutual fund has launched a new scheme in which the
initial expenses are 4% and annual recurring expenses are 1%. The required
rate of return in the market is 12%. What should be the annual return earned
by mutual fund so as to satisfy investors expectations.
Solution : Let us assume that the Face value of the unit is Rs 100. Initial
expense of 4% means investible funds are only Rs. 96 (i.e. 100- 4% of 100).
Now recurring expenses are charged on the funds actually invested. Hence
recurring expenses is 1% of Rs. 96 i.e. Re. 0.96 per unit.
Now the return expected by the unit holder is 12% i.e. Rs. 12.
Plus : Recurring expenses = 0.96
Total amount of return required = Rs. 12.96
Amount invested = Rs. 96
Return in % = 12.96/96 =0.135 or 13.5%
Thus in order to provide a return of 12% to the investors, the mutual fund
must earn a return of 13.5% annually.
Problem 10.10 Mr. K expects a return of 15% by investing on his own in
the equity shares. He is considering a mutual fund scheme which has the
issue expenses of 5.5% and is expected to earn 17%. How much should be
the recurring expenses of mutual fund to provide a return of 15% to Mr. K.
(B.Com(H)DU 2014)
Solution : Let us assume that the Face value of the unit is Rs. 100. Initial
expense of 5.5% means investible funds are only Rs. 94.5 (i.e. 100- 5.5% of 100).
Let us assume that recurring expenses are Rs. y.
Hence
0.17 = (15+y)/94.5
y = 1.065
Recurring Expenses in % are 1.065/94.5 = 1.12%
Hence the recurring expenses must be 1.12% to provide a return of 15%

to Mr. K.
Problem 10.11 Following information is available regarding four mutual
funds:
Mutual Fund Return (%) Risk(σ) (%) Beta(β)
A 13 16 0.9
B 17 23 0.86
C 23 39 1.2
D 15 25 1.38
Market 14.5 20
Evaluate performance of these mutual funds using Sharpe Ratio and
Treynor’s Ratio if risk free return is 10%. Comment on the evaluation after
ranking the funds.
Solution:
I. SHARPE’S RATIO
return of portfolio - return of risk free investment
s=
standard deviation of Portfolio
MUTUAL FUND SHARPE’S RATIO RANKING PERFORMANCE

A (13-10)/16 = 0.19 5 Underperform
B (17-10)/23 = 0.30 2 Outperform
C (23-10)/39 = 0.33 1 Outperform
D (15-10)/25 = 0.20 4 Underperform
Market (14.5-10)/20 = 0.225 3
II. TREYNOR’S RATIO
return of portfolio- return of risk free investment
t=
Beta of Portfolio
MUTUAL FUND TREYNOR’S RATIO RANKING PERFORMANCE

A (13-10)/0.90 = 3.33 5 Underperform
B (17-10)/0.86 = 8.14 2 Outperform
C (23-10)/1.20 = 10.83 1 Outperform
D (15-10)/1.38 = 3.63 4 Underperform
Market (14.5-10)/1 = 4.50 3
Since ranking based on Sharpe’s ratio and Treynor’s ratio is same, we can
infer that all funds are well diversified.
419 Solved problems
Problem 10.12 The following particulars are furnished about three Mutual
Fund Schemes P, Q and R
Particulars P Q R
Dividend distributed 2 - 1.5
Capital Appreciation 3 4 2
Opening NAV 30 27 25
Beta 1.5 1.1 1.4
Ascertain the Alpha of the three schemes and evaluate their performance,
if Government of India Bonds carry an interest rate of 6% and the Sensex
has increased by 12%.
Solution:
S. No. Particulars P Q R
A. Dividend distributed 2 - 1.5
B. Capital Appreciation 3 4 2
C. Total Return(A+B) 5 4 3.5
D. Opening NAV 30 27 25
E. Actual Return(C/D) 16.67% 14.81% 14%
F. Risk free return 6 6 6
G. Market return 12 12 12
H. Beta 1.5 1.1 1.4
I. Expected return as per CAPM[(RF + βP × (RM 15% 12.6% 14.4%
– RF)]
F+H(G-F)
J. Jensen’s alpha(E-I) 1.67% 2.21% -0.4%
Ranking 2 1 3
Evaluation: Schemes Q and P outperformed the Sensex while R has un-
derperformed in comparison with Sensex.
Problem 10.13 The following information is available in respect of a mutual
fund. Find out the NAV per unit.
Cash and bank balance Rs. 550000
Bonds and debentures (unlisted) 700000
Equities (current market value) 1250000
Quoted govt. Securities 1005000
Expenses incurred 75000
No. of units outstanding 200000
(B.Com (H) 2008)
Solution : Calculation of NAV

+Bonds and debentures (unlisted) 700000
+Equities (current market value) 1250000
+Quoted govt. Securities 1005000
Total assets 3505000
Less : Expenses incurred (75000)
Net assets 3430000
Units 200000
NAV = Net assets/No. of units 17.15
Summary
u Mutual fund is a financial intermediary that collects funds from individual
investors and invests those funds in a wide range of assets or securities.
u Mutual Funds are required to get registered with the Securities and Exchange
Board of India (SEBI).
u Mutual funds offer different schemes to attract the investors and to meet up
their investment objectives.
u Mutual funds are managed by professionals and are expected to give higher
returns at less risk.
u ETFs are baskets of securities that are traded on an exchange like individual
stocks.
u A Systematic Investment Plan allows an investor to invest a certain pre-de-
termined amount at a regular interval.
u Systematic Withdrawal Plan permits the investors to make an investment at
one time and go for systematically withdraw at periodic intervals.
u Net Asset Value refers to the amount which a unitholder would receive per
unit if the scheme is wound up.
u The performance of mutual fund can be measured with the help of Sharpe’s
Ratio, Treynor’s Ratio and Jensen’s Alpha.
Test Yourself
True/False
i. For an open-end fund, the number of units outstanding can change daily.
ii. The market value of closed-end fund’s shares is usually not equal to the fund’s
NAV.
421 Test yourself
iii. Benefits that investment companies provide include economies of scale in

managing and diversifying financial assets and liabilities.
iv. No-load mutual funds do not add any sales commission to the NAV.
v. ETFs and Index Funds are same.
vi. Mutual funds are an indirect investment vehicle.
vii. All mutual funds schemes have entry and exit load.
viii. Exchange Traded funds are launched by Stock Exchanges only.
ix. All close-ended schemes have limited time span.
x. Close-ended schemes automatically get converted into open-ended schemes
after few years.
[Answers: (i) T (ii) T (iii) T (iv) T (v) F (vi) T (vii) F (viii) F (ix) T (x) F]
Theory Questions
1. What do you mean by mutual fund? How does it work? [Para 10.3]
2. “Mutual funds is an indirect investment”. Examine it in the light of features
and advantages of mutual funds. (B.Com(H)DU 2009, 2014) [Para 10.3]
3. What are the types of mutual fund schemes available in India? Give details.
(B.Com(H)DU 2011) [Para 10.5]
4. Write short notes on the following :
i. Net asset value [Para 10.7]
ii. Balanced funds [Para 10.5]
iii. Load and No load Funds (B.Com(H)DU 2013) [Para 10.5]
iv. Open ended and Closed ended funds (B.Com(H)DU 2011) [Para 10.5]
v. Features of a mutual fund (B.Com(H)DU 2011) [Para 10.3]
5. What do you mean by NAV? How is it calculated? Explain with example.
[Para 10.7]
6. Explain various types of equity schemes of mutual funds.
(B.Com(H)DU 2007, 2013) [Para 10.5]
7. What are the advantages of investing in mutual funds? [Para 10.3]
8. Distinguish between:
(a) Open-ended and close-ended funds [Para 10.5]
(b) Income and growth funds [Para 10.5]
(c) Systematic Investment Plan (SIP) and Systematic Withdrawal Plan
(SWP) [Para 10.6]
(a) Systematic investment plan [Para 10.5]
(b) Exchange traded funds [Para 10.6]
(c) Advantages of SIP [Para 10.5]
10. What is ETF? How is it different from conventional mutual funds?

[Para 10.6]
11. “Mutual funds have seen its share of ups and downs in India”. Discuss the
statement in the light of its evolution and present status. [Paras 10.3 & 10.4]
Practical Problems
1. A Mutual Fund made an issue of 70,000 units of Rs. 100 each on 01.01.2015.
No entry load was charged. It made the following investments:
25,000 Equity Shares of Rs. 100 each @ 200 Rs. 50,00,000

5% Government Securities Rs. 4,00,000
10% Debentures (Unlisted) Rs. 7,00,000
12% Debentures (Listed) Rs. 7,00,000
Total Rs. 68,00,000
During the year, dividends of Rs. 5,00,000 were received on equity shares.
Interest on all types of debt securities was received as and when due. At
the end of the year equity shares and 10% debentures are quoted at 125%
and 80% respectively. Other investments are quoted at par. Find out the Net
Asset Value (NAV) per unit given that the operating expenses during the year
amounted to Rs. 2,50,000. [Ans. : Rs. 77.27]
2. Four friends Tarun, Barun, Arun, and Varun have invested equivalent amount
of money in four different funds in tune with their attitude to risk, Tarun
prefers to play aggressive and is keen on equity-funds, Barun is moderately
aggressive with a desire to invest upto 50% of his funds in Equity, whereas
Arun does not invest anything beyond 20% in Equity. Varun, however, relies
more on movement of market, and prefers any fund which replicates the
market portfolio. Their investment particulars, returns and Beta of the fund
are given below —
Fund Invested Return for Beta Factor

the year
Money Multiplier Fund (100% Equity) 23.50% 1.80
Balanced Growth Fund (50% Equity - 50% Debt) 16.50% 1.25
Safe Money Fund (20% Equity and 80% Debt 12.50% 0.60
Funds)
If the Market Return was 16% and the Risk Free Return is measured at 7%,
which of the four friends were rewarded better per unit of risk taken?
[Answer –Tarun and Arun]
423 Test yourself
3. The following are the data on Five mutual funds—
Mutual Fund Return Risk(σ) Beta(β)

A 16 8 1.5
B 12 6 0.98
C 14 5 1.4
D 18 10 0.75
E 15 7 1.25
Evaluate performance of these mutual funds using Sharp Ratio and Treynor’s
Ratio if risk free return is 6%. Comment on the evaluation after ranking the
funds.
Answer-
Mutual Fund Sharpe ratio Treynor ratio

A 3 3
B 5 4
C 1 5
D 4 1
E 2 2
4. A mutual fund had a Net Asset Value (NAV) of Rs. 75 at the beginning of the
year. During the year a sum of Rs. 8 was distributed as dividend besides Rs.5
as capital gains distribution. At the end of the year NAV was Rs. 83. Calculate
total return for the year. [Ans. : 28%]
5. A mutual fund had a Net Asset Value (NAV) of Rs. 48 at the beginning of the
year. At the end of the year it gives a dividend of Rs. 5 and no capital gains
distribution and NAV at the end of the year is Rs. 43. What is the return for
the second year? [Ans. : 0%]
6. Ram invested in a Mutual Fund when the Net Asset Value was Rs. 13.65. Sixty
days later the Asset Value per unit of the fund was Rs. 13.25. In the meantime,
Ram had received a cash dividend of Re. 0.50 and a Capital Gain distribution
of Re. 0.30. Compute the annualised and monthly return. [Ans. : 1.48% p.m.]
7. A mutual fund has an NAV of Rs. 62 in the beginning of the period and Rs.
72 at the end of the same period. During the period, it incurred expenses at
the rate of Rs. 0.90 per unit. Find out the expense ratio. [Ans. : 1.34%]
8. A mutual fund has an NAV of Rs. 56 in the beginning of the period and Rs.
70 at the end of the same period. During the period, it incurred expenses at
the rate of Rs. 3 per unit. Find out the expense ratio. [Ans. : 4.76%]
9. The following particulars relating to a mutual fund are given to you:
Management Advisory Fees Rs. 235 lakhs

Administration Expenses (including Fund Manager Rs. 320 lakhs
Remuneration)
Publicity and Documentation Rs. 88 lakhs
Opening NAV Rs. 118 crore
Closing NAV Rs. 190 crore
Ascertain the Expense ratio. [Ans. : 4.17%]
10. A mutual fund has launched a new scheme in which the initial expenses are
4.5% and annual recurring expenses are 1.3%. The required rate of return in
the market is 14%. What should be the annual return earned by mutual fund
so as to satisfy investors expectations. [Ans. : 15.96%]
11. Mr. J expects a return of 13% by investing on his own in the equity shares. He
is considering a mutual fund scheme which has the issue expenses of 5.5%
and expected to earn 16%. How much should be the recurring expenses of
mutual fund to provide a return of 13% to Mr. J. [Ans. : 2.24%]
12. Following information is available regarding four mutual funds:
Mutual Fund Return Risk(σ) Beta(β)

A 14 17 0.95
B 19 25 0.85
C 23 39 1.25
D 15 25 1.30
Evaluate performance of these mutual funds using Sharpe Ratio and Treynor’s
Ratio if risk free return is 10% . Comment on the evaluation after ranking the
funds. [Ans. : Ranking is same]
13. The following particulars are furnished about three Mutual Fund Schemes,
P, Q and R
Particulars P Q R
Dividend distributed 5 - 2.5
Capital Appreciation 2 3 2
Opening NAV 33 29 27
Beta 1.3 1.1 1.2
Ascertain the Alpha of the three schemes and evaluate their performance,
if Government of India Bonds carries an interest rate of 5% and the Sensex
has increased by 15%. [Ans. : 3.21%, -5.65%, -0.33%, P outperforms]
14. The following information is available in respect of a mutual fund. Find out
the NAV per unit.
425 Test yourself

Bonds and debentures (unlisted) 750000
Equities (current market value) 1650000
Quoted govt. Securities 1005000
Expenses incurred 72000
No. of units outstanding 250000
[Ans. : Rs. 15.932 p.u.]
FINANCIAL DERIVATIVES -
11 FORWARDS, FUTURES AND
C H A P T E R OPTIONS
learninG oUtCoMes
 Know the meaning of derivatives and various types of derivatives.
 Understand participants in derivative markets.
 Differentiate forward and futures contracts.
 Know salient features of futures contracts
 Determine forward and futures price using Cost of Carry Model.
 Define an options contract and explain its various types
 Distinguish between futures and options
 Determine payoffs from various positions on Call and Put options.
 Use options for hedging
 Analyse various types of derivatives available in Indian markets.
11.1 introDUCtion to Derivatives

Derivatives are financial instruments whose value depend upon or is derived
from some underlying assets. the underlying assets can be real assets such
as commodities, gold etc. or financial assets such as index, interest rate etc.
a derivative does not have its own physical existence. it emerges out of
the contract between the buyer and seller of the derivative instrument. its
value depends upon the value of the underlying asset. Hence returns from
derivative instruments are linked to the returns from underlying assets.
the most common underlying assets include stocks, bonds, commodities,
426
427 Classification of Derivatives Para 11.2
currencies, interest rates and market indexes. Stock futures are derivative
contracts based on individual stocks in the securities market. Stock index
futures are derivative contracts where the underlying asset is an index. In
case of wheat futures, the underlying asset is wheat. In case of gold futures
the underlying asset is gold. Similarly we have derivatives based on various
real as well as financial assets. Now a days we also find derivatives which
are based on other derivatives. The derivative itself is merely a contract
between two or more parties.
Securities Contracts (Regulation) Act, 1956 defines derivative as under:
“Derivative” includes—
(A) a security derived from a debt instrument, share, loan, whether se-
cured or unsecured, risk instrument or contract for differences or
any other form of security,
(B) a contract which derives its value from the prices, or index of prices,
of underlying securities.
11.2 Classification of Derivatives

Derivatives can be classified into broad categories depending upon the
type of underlying asset, the nature of derivative contract or the trading
of derivative contract.
1. Commodity derivatives and Financial derivatives
Derivatives can be classified into Commodity derivatives and Finan-
cial derivatives on the basis of the type of underlying asset. In case
of Commodity derivatives the underlying asset is a physical or real
asset such as wheat, rice, jute, pulses, or even metals such as gold,
silver, copper, aluminium, oil etc. In case of financial derivatives the
underlying asset is a financial asset such as equity shares, bonds,
debentures, interest rate, stock index, current, exchange rate etc.
Financial derivatives are more popular the world over. Commodity
derivatives are traded on Multi Commodity Exchange (MCX) and
National Commodities and Derivatives Exchange (NCDEX) in India.
Commodity derivatives based on agricultural commodities are more
popular than those based on metals. It must be noted that the deriv-
atives were developed to hedge the price risk in case of agricultural
commodities. Hence initially commodity derivatives were developed.
Financial derivatives were developed later in the decade of 1980s.
Financial derivatives are traded on BSE, NSE, United stock exchange
(USE) and MCX-SX in India.
Para 11.3 Financial derivatives - Forwards, futures & options 428
2. Elementary derivatives and Complex derivatives

Elementary or basic derivatives are those derivatives which are
simple and easily understandable. Such derivatives are futures and
options. Complex derivatives have complex provisions and features
which make them difficult to understand by an investor. Complex
derivatives include exotic options, synthetic futures and options and
so on.
3. Exchange traded derivatives and Over The Counter (OTC) derivatives
Derivatives may be traded on an exchange or they may be privately
traded over the counter (OTC). Exchange traded derivatives are
standardised derivative product traded as per the rules and regula-
tions of the exchange. For example Stock index futures, stock index
options and Stock futures and options in India are exchange traded
derivatives. OTC derivatives are private bilateral contracts between
two parties and are non standardised. These derivatives are specific
to the needs of the parties involved. For example forward contracts
in foreign exchange market are OTC derivatives.
11.3 Participants (or Traders) in Derivatives Market

Different types of parties participate in derivatives market and make it a
liquid and smooth market. Derivatives were initially developed to provide
hedging against price risk. However now a days these instruments are also
widely used for the purpose of speculation. Further, if there is any mis-
pricing then arbitrage opportunities arise which can be exploited to restore
equilibrium. Three categories of traders in derivative market are- Hedgers,
Speculators and Arbitrageurs.
Hedgers : Investors having long position in assets are exposed to
1.
price risk i.e. the risk that asset prices will go down. On the other
hand investors having short position in assets are also exposed to
price risk i.e. the price of the asset may go up. Hence they want to
hedge their position to be immune to price risk. Hedgers use financial
derivatives to reduce or eliminate the risk associated with price of an
asset. Futures contracts enable both the parties (having long or short
position) to hedge or eliminate their risk. In case of hedging, risk is
actually transferred from the hedger to the speculator. Options are
widely used by hedgers to reduce their risk exposure.
Speculators use derivatives to get extra leverage and earn quick and
2.
large potential gains on the basis of future movements in the price
of an asset. They can increase both the potential gains and potential
losses by usage of derivatives in a speculative venture. Speculators
429 FORWARDS Para 11.4
take position on the basis of their assessment of future price move-

ments. Futures are widely used by speculators. If a speculator expects
that the stock price will go up, he buys futures and vice versa.
3. Arbitrageurs are those traders who take advantage of any discrep-
ancy in pricing and exploit it to bring in equilibrium. Arbitrageurs
are in business to take advantage of a discrepancy between prices in
two different markets. Arbitrage is possible over space as well over
time. Derivatives allow arbitrageurs to exploit arbitrage opportunities
over time as well. If, for example, they see the futures price of an
asset getting out of line with the cash price, they will take offsetting
positions in the two markets (overtime) to lock in a profit.
Types of Financial derivatives

The subject matter of this chapter is financial derivatives. Financial de-
rivatives are those derivatives where the underlying asset is the financial
asset or instrument such as index, stocks, bonds, currency, interest rates
etc. Financial Derivatives are generally classified as Forwards, Futures,
Options and Swaps depending upon their nature and features. In this
book we focus only on the first three categories i.e. Forwards, Futures and
Options. They are explained below:
11.4 FORWARDS
A forward contract is a private bilateral agreement between two parties to
buy and sell a specified asset at a specified price on a specified future date.
Consider a farmer in Punjab, Mr. Singh, plans to grow 5000 Kgs of wheat
this year. He can sell his wheat for whatever the price is when he harvests
it, or he could lock in a price now by selling a forward contract that obli-
gates him to sell 5000 kgs of wheat to Pillsbury after the harvest for a fixed
or specified price. By locking in the price now, he can actually eliminate
the risk of falling wheat prices. On the down side, if prices rise later, he is
foreclosing the opportunity of super profits. But then, he must have played
safe and insured himself against the possibility of prices falling down
eventually. The transaction that Mr. Singh has entered into is known as
Forward transaction and the contract covering such transaction is known
as Forward Contract.
Hence a forward is a contract between two parties to buy or sell a specified
asset at a pre-determined price on a specified future date.
A financial forward contract is that forward contract where the underlying
is a financial asset such as currency. For example assume that an Indian
company XYZ Ltd. has to pay its import bills in 20000 US dollars after three
months. However the company faces the risk of rupee depreciation, i.e. the
price of the US dollar may go up. To guard against this exchange rate risk,
the company may enter into a forward agreement with some other com-
pany to buy 20000 US dollars at a specified price after 3 months. This way
it has hedged its position. If after three months the exchange rate is higher,
the company `stands to gain. If on the other hand the rupee appreciates
and US dollars are available at a lower price, the company stands to lose.
In any case the company’s position is certain in the sense that it will get
20000 US dollars at the pre specified price after 3 months.
Features-
Forward contract has following features:
u Customised - Each contract is custom designed and parties may agree
upon the contract size, expiration date, the asset type, quality, etc.
u Underlying asset - The underlying asset can be a stock, bond, com-
modity, foreign currency, interest rate or any combination thereof.
u Symmetrical rights and obligations - Both the parties to a forward
contract have equal rights and obligations. The buyer is obliged to
buy and the seller is obliged to sell at maturity. They can also enforce
each other to perform the contract.
u Non-regulated market - Forward contracts are private and are largely
non-regulated, consisting of banks, government, corporations and
investment banks. It is not regulated by any exchange.
u Counter-party Risk or default risk - This is a risk of non-performance
of obligation by either party as regards to payment (buyer) or deliv-
ery (seller). Being a private contract, there are chances of default or
counter party risk.
u Held till maturity - The contracts are generally held till maturity. A
forward contract cannot be squared up at the wish of one party. It
can be cancelled only with the consent of the other party.
u Liquidity - Liquidation is low, as contracts are customised catering
to the needs of parties involved. They are not traded on an exchange.
u Settlement of Contract - Settlement of a derivative contract can be
in two ways - through delivery or through cash settlement. Most of
the forward contracts are settled through delivery. In this case the
buyer pays the price and seller gives the delivery of the specified as-
set at maturity. Some of the forward contracts are also cash settled.
In case of cash settlement, the parties only pay/receive the price
431 FUTURES Para 11.5
differential so as to settle the contract. No physical delivery of asset

takes place and hence no full payment is made for the contract.
11.5 FUTURES
A Futures contract is a refined or modified forward contract. A futures
contract is a contract to buy or sell a specified asset (physical or financial
asset) at a specified price on a specified future date. It is traded on an
exchange and is a standardised contract. A financial futures contract is
a contract wherein two parties agree to buy or sell a specified financial
asset at a specified price on a specified future date. Futures contracts are
generally traded on an exchange which sets the basic standardized rules
for trading in the futures contracts.
Features:
u Standardised Contract - Terms and conditions of future contracts
are standardized. They are specified by the exchange where they are
traded.
u Exchange based Trading - Trading takes place on a formal exchange
which provides a place to engage in these transactions and sets a
mechanism for the parties to trade these contracts.
u No default risk - Futures contract has virtually no default risk be-
cause the exchange acts as a counterparty and guarantees delivery
and payment with the help of a clearing house.
u Clearing house - The clearing house protects the parties from default
by requiring the parties to deposit margin and settle gains and losses
(or mark to market their positions) on a daily basis.
u Liquidity - Futures contracts are highly liquid contracts as they are
continuously traded on the exchange. Any party can square up his
position any time.
u Before maturity settlement possible - An investor can offset his future
position by engaging in an opposite transaction before the stipulated
maturity of the contract.
u Margin requirement - All futures contracts have margin requirements.
Margin money is required to be deposited with the exchange by both
the buyer as well as seller at the time of entering into the contract.
Margin is important to safeguard the interest of the other party. There
are two types of margins – initial margin and maintenance margin.
Initial margin is the margin amount to be deposited initially with the
exchange. If contract value is Rs. 100000, initial margin requirement
is 5% and maintenance margin is 2%, then the buyer of the contract

has to deposit Rs. 5000 with the exchange in his margin account.
Now margin account is settled on daily basis i.e. mark to market
settlement. If margin amount in the account on any day falls below
the maintenance margin of Rs. 2000, then a variable call is made to
replenish the margin amount to the level of initial margin.
u Settlement mechanism - Settlement of a derivative contract can be
in two ways- through delivery or through cash settlement. Very few
of the futures contracts are settled through delivery. In this case the
buyer pays the price and seller gives the delivery of the specified asset
at maturity. Most of the futures contracts are cash settled. In case of
cash settlement, the parties only pay/receive the price differential
so as to settle the contract. No physical delivery of asset takes place
and hence no full payment is made for the contract. In case of Index
futures the settlement is done only through cash as an Index cannot
be delivered.
11.5.1 Futures Contract Terminology

u Spot price - The price at which an underlying asset trades in the spot
market.
u Futures price - The price that is agreed upon at the time of the futures
contract for the delivery of an asset at a specific future date.
u Contract cycle - It is the period over which a contract trades on the
exchange. Every month on Friday following the last Thursday; a new
contract having a three-month expiry is introduced for trading, on
NSE and BSE.
u Expiry date - Is the date on which the final settlement of the contract
takes place. Last Thursday of every month is expiry date for futures
contracts. If that happens to be a trading holiday then previous
working day.
u Contract Size or Lot size - The quantity of the underlying asset that
has to be delivered under one contract.
u Price steps - The minimum difference between two price quotes. The
price step in respect of CNX Nifty futures contracts is Re. 0.05.
u Price bands - The minimum and maximum price change allowed in a
day is termed as price bands. It is generally +- 10%. There are no day
minimum/maximum price ranges applicable for CNX Nifty futures
contracts. However, in order to prevent erroneous order entry by
trading members, operating ranges are kept at +/- 10%.
433 futures Para 11.5
11.5.2 Comparison between Forwards and Futures

Though both forwards and futures share common characteristics, they
differ on the following grounds:
BASIS FORWARDS FUTURES
Standardisation Forward contracts are private Futures contracts are ex-
of contract agreements between two parties change traded and stan-
and are non-standardised. dardised contracts as terms
and conditions are set in
advance.
Trading & Forwards are not traded on stock Futures are traded on stock
Regulation exchange. They are not regulated. exchange and are regulated.
Counter party There is always a possibility that Clearing houses guarantee
default risk a party may default. the transaction, thus mini-
mising the default risk.
Liquidity Liquidity is low, as contracts Liquidity is high, as con-
are tailor-made contracts ca- tracts are standardised
tering to the needs of parties exchange-traded contracts.
involved. Further, they are not
easily accessible to other market
participants.
Price Discovery Price discovery is not efficient, Price discovery is efficient,
as markets are scattered. as markets are centralised.
Settlement Settlement of the Forward con- Futures contracts are mar-
tract occurs at the end of the ked-to market on daily basis
contract, i.e. Settlement date which means that they are
only. settled day by day until the
end of the contract.
Hedging/specu- Forward contracts are popular Futures are popular among
lation among hedgers. speculators.
Margin There is no requirement for Both the buyer and seller
Requirements depositing margin money by have to deposit margin mon-
either party. ey with the exchange.
Examples Foreign Currency market in Commodities futures, Index
India futures and Individual Stock
futures in India.
11.5.3 Types of Financial Futures Contracts

Financial futures contracts can be - index futures, stock futures, currency
futures, interest rate futures depending upon the underlying asset. In case of
index futures, the underlying asset is an Index. In this chapter we deal with
only two types of financial futures viz - Index futures and Stock Futures.
a. INDEX FUTURES
In case of Index futures the underlying asset is a stock index say NIFTY
or SENSEX. A stock index is constructed by selecting a number of
stocks and is used to measure changes in the prices of that group of
stocks over a period of time. Futures contracts are also available on
these indices. This helps investors make money on the performance
of the index.
u Contract size : Index futures contracts are dealt in lots. The
stock indices points – the value of the index – are converted
into rupees.
For example, suppose the BSE Sensex value was 6000 points.
The exchange stipulates that each point is equivalent to Rs. 1,
Further each contract has a lot size of 100. Then the value of
one contract will be 100 times the index value – Rs. 6,00,000
i.e. 1×6,000×100.
u Expiry : An open position in index futures can be settled by
conducting an opposing transaction on or before the day of
expiry.
u Duration: Index futures have three contract series open for
trading at any point in time - the near-month (1 month), mid-
dle-month (2 months) and far-month (3 months) index futures
contracts.
Example : If the index stands at 3550 points in the cash market today
and an investor decide to purchase one Nifty 50 July future, he would
have to purchase it at the price prevailing in the futures market.
The price of one July futures contract could be anywhere above,
below or at Rs. 3.55 lakh (i.e., 3550×100), depending on the prevail-
ing market conditions. Investors and traders try to profit from the
opportunity arising from this difference in prices.
b. STOCK FUTURES
Stock futures are futures contracts where the underlying is an in-
dividual stock. For example SBI stock futures have SBI stock as the
underlying asset.
u Lot/Contract size : In the financial derivatives market, the
contracts are not traded for a single share. Instead, every stock
futures contract consists of a fixed lot of the underlying share.
The size of this lot is determined by the exchange and it differs

from stock to stock. For instance, a Reliance Industries Ltd.
(RIL) futures contract has a lot of 250 RIL shares, i.e., when you
buy one futures contract of RIL, you are actually trading 250
shares of RIL. Similarly, the lot size for Infosys is 125 shares.
u Duration : Stock Futures contracts are also available in du-
rations of 1 month, 2 months and 3 months. These are called
near month, middle month and far month, respectively. The
month in which it expires is called the contract month and new
future contracts are issued on the day after expiry of the last
contract.
u Expiry : All three maturities contracts are traded simultaneously
on the exchange and expire on the last Thursday of their respective
contract months. If the last Thursday of the month is a holiday,
they expire on the previous business day. In this system, as near-
month contracts expire, the middle-month (2 month) contracts
become near-month (1 month) contracts and the far-month (3
month) contracts become middle-month contracts.
Example: If an investor purchased a single June futures contract of
XYZ Ltd., he has to buy at price at which the June futures contracts
are currently available in the derivatives market. Let’s say these
futures are trading at Rs. 1,000 per share. This implies, the investor
agrees to buy/sell at a fixed price of Rs. 1,000 per share on the last
Thursday in June. However, it is not necessary that the price of the
stock in the cash market (or spot market) on last Thursday has to be
Rs. 1,000. It could be Rs. 992 or Rs. 1,005 or anything else, depending
on the prevailing market conditions. This difference in prices lead to
profit or loss.
11.5.4 Pricing (Or Valuation) of Futures Contract (Or a Forward

Contract)
When an investor enters a futures contract, he agrees either to buy or to
sell the asset underlying the futures contract on a fixed date in future at
a specified price. Pricing of futures contract means determination of the
specified price at which contract will be executed. The theoretical or fair
price of a futures contract can be determined through Cost of Carry Model.
The actual price of a futures contract is however determined through the
forces of demand and supply in futures market.
Cost of Carry Model:

The fair value or theoretical price of a futures contract must be equal to the
current value of the underlying shares or index, plus an amount referred

to as the ‘cost of carry’. The cost of carry reflects the cost of holding the
underlying asset or shares over the life of the futures contract reduced
by the amount the shareholder would receive in dividends or incomes on
those assets or shares during that time.
Based upon the payment and non-payment of dividend, the following
situations may arise:
Situation Applicable Pricing Model
When the underlying asset provides F = Se rt
no income (or dividend)
When the underlying asset provides F = ( S − I )e rt
known income (or dividend)
When the underlying asset provides F = Se ( r − q )t
known income yield (or dividend yield)
Where
F = Futures Price
S = Spot Price of the underlying asset
e = 2.71828 (base of natural logarithm)
r = Continuously compounding rate of interest p.a.
t = Time duration of futures in years
I = Present value of income or dividend at r
q = Income yield (or Dividend yield)
Note :
u The above futures price needs to be multiplied with the lot size or
contract size in order to determine the value of a futures contract.
u The Cost of Carry model provides the theoretical or fair price of
the futures contract. The actual price is determined in the market
according to demand and supply forces.
u Investment decision : If fair or theoretical price of a futures contract
is higher than its actual market price then a prospective investor
should buy it. In such a case the futures contract is underpriced. On
the other hand if fair or theoretical price of a futures contract is lower
than its actual market price then a prospective investor should not
buy it. If the investor holds such a futures contract then he should
immediately sell it. In this case futures contract is overpriced.
If fair or theoretical price of a futures contract is equal to its actual
market price then the contract is efficiently and correctly priced in
the market.
Illustration 11.1 Consider a stock futures contract on a non-dividend paying

share which is currently trading at Rs. 70 in the spot market. The futures
contract mature in 3 months and the continuously compounded risk free
rate is 8% per annum. Calculate the price of one stock futures contract
having lot size of 100. (e0.02= 1.0202).
Solution:
F = Sert = 70e(0.08)3/12 = 70e0.02 = Rs. 71.41
Lot size = 100, Hence the price of one futures contract = 100 × 71.41 =
Rs. 7141
Illustration 11.2 Consider a 3-month stock index futures contract NIFTY
Index. The current value of the index is 520 and continuously compound-
ed dividend yield expected on the underlying shares is 4% per annum and
continuously compounded risk free rate is 10% per annum. Calculate the
price of one futures contract if lot size is 100. (e0.015= 1.015)
Solution:
F = Se(r-q)t = 100 × 520 e(0.10-0.04)3/12 = 100 × 520e0.015 = Rs. 52,785
Illustration 11.3 Consider a 12-month stock index futures contract on
NIFTY Index. The current value of the index is 5200 and continuously
compounded risk free rate is 10% per annum. The stock index is expected
to provide a dividend of Rs. 120 at the end of the year. Calculate the price
of one futures contract if lot size is 100. (e0.10= 1.105)
Solution: The present value of Rs. 120 dividend to be received at the end
of the years will be calculated as follows: (r =10%)
P.V of Dividend = I = 120 e–(0.10) = 108.58
F = (S - I)ert = 100 × (5200 - 108.58)e(0.10)) = Rs. 562689
Illustration 11.4 The price of shares of XYZ Ltd. is Rs. 50 in the spot mar-
ket. The risk free rate is 12% per annum with continuous compounding.
An investor wants to enter into a 6 months forward contract. Calculate the
forward price. (e0.06= 1.062)
Solution:
F = Sert = 50e(0.12)6/12 = 50e0.06 = Rs. 53.09
Illustration 11.5 The shares of PQR Ltd. are currently selling at Rs. 900 per
share. The 4 months futures contract on this share is available at Rs. 915.
Should the investor buy this future if the risk free rate of interest is 12%.
Solution:
F = Sert = 900e(0.12)4/12 = 900e0.04 = Rs. 936.73
As the futures are available at Rs. 915 only, the investor should buy the
futures.
Illustration 11.6 An investor buys Sensex futures at a price of 5500 in the
market lot size of 400. On the settlement date, the Sensex is 5700. Find out
his profit or loss for one futures contract.
Solution:
Profit = (5700-5500) × 400 = Rs. 80000
Illustration 11.7 A share is currently selling at Rs. 900 in the spot market.
Dividend of Rs. 20 is expected after 6 months and after 12 months. The risk
free rate is 18% per annum with continuous compounding. What is price
of a 12 months futures contract?
Solution : Here we have dividend income of Rs. 20 at the end of 6 months
and Rs. 20 at the end of 12 months.
Hence the present value of dividend incomes = I = 20e-(0.18)6/12 + 20e-(0.18)12/12
= 20e-0.09 + 20e-(0.18) = 20(0.913) + 20(0.835) = 18.27 + 16.70 = Rs. 34.98
Futures Price = (900 - 34.98)e(0.18)12/12
= (865.02)(1.197)
= Rs. 1035.6
11.6 OPTIONS
An options is a contract that gives its buyer (holder) a right (but not obli-
gation) to buy or sell a specified asset at a specified price (exercise price)
on or before a specified future date. An options is a contract sold by one
party (option-writer) to another party (option holder). The holder of the
options can exercise the option at specified price or may allow it to lapse.
The specified price is also termed as strike price or exercise price.
The options contract gives a right to the buyer. The seller has the obliga-
tion but no right. If the option holder exercises the option, then the writer
or seller of the option will be obliged to perform. Hence when the option
holder has a right to buy, the option writer has the obligation to sell. When
option holder has a right to sell, then the option writer has the obligation
to buy. Hence in case of options, the buyer and sellers are not on equal
footing. The buyer has a privileged position. Since the buyer has a right
but no obligation, he has to pay some price, known as options premium
to the seller (or writer) of the option. NO RIGHT COMES FREE OF COST.
Hence the buyer pays options premium to the seller to buy the right to
buy or sell. The seller receives this options premium as a compensation for
the obligation he undertakes. Hence options contracts are asymmetrical
439 options Para 11.6
w.r.t. rights and obligations. The buyer of the options contract has a right
but no obligation. The seller or writer of the options has an obligation but
no right. Since the holder of the option has a right, he may not exercise
his right if the conditions are unfavourable. Hence it is possible that the
options contract is not exercised at all.
This clearly differentiate options contract from futures contract discussed
above. In case of futures contracts, both the buyer as well as seller has
equal rights and obligations. They can enforce each other to perform the
contract. At the same time they are obliged to perform the contract.
COMPARISON BETWEEN FUTURES AND OPTIONS
BASIS FUTURES OPTIONS

Rights Both the parties have right to Only the buyer (or holder) of the
ask for the performance of the options has the right to buy or sell.
contract. Seller does not have any right.
Obligations Both the parties are obliged to Only the seller is obliged to per-
perform the contract. form the contract.
Premium No premium is paid by either The buyer pays the options pre-
payment party. mium to seller.
Margin re- Both the parties have to deposit Only the option writer has to
quirement some initial margin as per the deposit initial margin with the
requirements of the exchange. exchange as only the seller is
exposed to price risk. No margin
is to be deposited by the option
holder, as he has a right but no
obligation.
Profit and The buyer as well as the seller of The option holder’s loss is limited
loss poten- the futures contract are exposed (to the extent of premium paid),
tial to all the downside risk and has but has potential for all upside
potential for all upside profits. profits. The seller’s gain is limited
The gain to the buyer is loss to to the amount of options premi-
the seller and the loss to the buyer um but he is exposed to all the
is gain to the seller. There is un- downside risk (i.e. potential loss
limited gain and loss possibility is unlimited).
for both the parties.
Realisation Profit or loss on futures are The gain on option can be realized
of profits/ ‘marked to market’ daily, mean- in the following ways:
losses ing the change in the value of the a. Exercising the option at
positions is attributed to the ac- expiry
counts of the parties at the end of
every trading day - but a futures
holder can realize profits/losses
BASIS FUTURES OPTIONS

by going to the market and taking b. Going to the market and
the opposite position. taking the opposite position,
or
c. Waiting until expiry and
collecting the difference
between the asset price and
the strike price.
Execution Futures contract are settled Buyer may or may not exercise
of contract through cash or delivery but they the option and therefore the
are always executed. option contract may lapse with-
out being exercised or become
a waste.
Purpose Futures are used to hedge and Usually used as a hedge instru-
speculate. ment. Options are a better hedg-
ing instrument than futures. This
is because here the hedger keeps
all the potential for upside gain
but his loss is limited.
Types of Options:
a. Call options - An options contract that gives its holder the ‘right to
buy’ a specified asset at a specified price on or before a specified future
date, is termed as call option. The seller has the obligation to sell. A
call option is bought when the buyer of the call option fears a rise
in underlying asset’s price. A call option is exercised when the stock
price is greater than the exercise price. In such a case the holder of
the call options can buy the stock or asset at the exercise price which
is lower than the prevailing market price.
For example: Let us assume that the current price of SBI shares is
Rs. 119. Mr. A expects that the price of SBI share will go up, hence
he buys a call option on SBI shares at the exercise price of Rs. 120.
The expiration date is after 1 month. Further assume that the option
can be exercised only on the expiry date and not before that. Now if
on the expiry date, the prevailing market price of SBI share is more
than 120, say Rs. 125, then Mr. A will exercise the option. He will buy
a share of SBI by exercising his call option at the price of Rs. 120. He
can sell it at the market price of 125 in spot market and make a gain
of Rs. 5. If on the other hand the market price is Rs. 115 on the date
of expiry, then Mr. A will not exercise this call option. His loss in this
case will be the amount of option premium that he must have paid
at the time of buying this call option.
b. Put option - A put option provides a right to sell. An option contract

that gives its holder the ‘right to sell’ a specified asset at a specified
price on or before a specified future date, is termed as put option.
The seller has the obligation to buy. A put option is bought when the
buyer of the put option fears a decline in underlying asset’s price. A
put option is exercised when the stock price (or the underlying asset’s
price) is lower than the exercise price. In such a case the holder of
the put option can sell the stock (or asset) at the exercise price which
is higher than the prevailing market price.
For example: Let us assume that the current price of SBI shares is
Rs. 119. Mr. A expects that the price of SBI share will go down, hence
he buys a put option on SBI shares at the exercise price of Rs. 120.
The expiration date is after 1 month. Further assume that the option
can be exercised only on the expiry date and not before that. Now
if on the expiry date, the prevailing market price of SBI share is less
than 120, say Rs. 116, then Mr. A will exercise the option. He will sell
a share of SBI by exercising his put option at the price of Rs. 120, and
make a gain of Rs. 4. If on the other hand the market price is Rs. 123
on the date of expiry, then Mr. A will not exercise this put option. His
loss in this case will be the amount of option premium that he must
have paid at the time of buying this put option.
Styles of Options:
a. European options - A European style options contract can be exercised
only on the expiration date. In the above examples the call options
as well as put options were of European style as it is given that they
can be exercised only on the expiration date and not before that.
b. American options - An American style options contract can be exercised
at any time before the expiration or on the expiration date. American
options provide more flexibility to the holder of the options, as he may
exercise the options anytime till maturity. Therefore, American style
of options have higher options premium than the European style of
options.
Covered Options and Naked options

There are two ways to write options – Covered option writing and Naked
option writing.
a. Covered option – Covered option means an option for which the
seller owns the underlying securities. When the option writer has the
underlying stock and writes (or sells) the option to buy that stock (i.e.
writes the call option), then such a call option is known as Covered
Option. If the option is exercised then the writer supplies the stock
that he holds or has previously purchased. In this case the option
is covered with the stock that the option writer is holding. Covered
option writing is a less risky strategy.
b. Naked option – Naked option means an option for which the seller
does not own the underlying security. When the option writer does
not have the underlying stock but writes (or sells) the option to buy
that stock (i.e. writes the call option), then such a call option is known
as Naked option. If the price of the stock rises and the call option is
exercised, the option writer must buy the stock at the higher mar-
ket price in order to supply it to the buyer. With naked option the
potential for loss is considerably greater than with covered option.
Index, stock, currency and interest rate options:

Options can be classified on the basis of the underlying assets as well. Here
we have – index options, stock options, currency options and interest rate
options.
a. Index options : In case of Index options, the underlying security is a
stock index such as NIFTY or SENSEX. Hence the value of an index
option is derived from the value of the underlying index. In India
Options are available on NIFTY and SENSEX.
b. Stock options : In case of stock options, the underlying security is a
stock such as TCS ICICI BANK etc. Hence the value of a stock option
is derived from the value of the underlying stock. In India Options
are available on more than 100 stocks listed on NSE and BSE.
c. Currency options : In case of currency options, the underlying security
is a foreign currency such as US Dollar, EURO etc. Hence the value
of a currency option is derived from the value of the underlying
foreign currency.
d. Interest Rate options : In case of interest rate options, the underlying
security is a particular interest rate such as Repo rate or MIBOR.
Hence the value of an interest rate option is derived from the value
of the underlying interest rate.
BASIC TERMINOLOGY used in case of options

u Exercise price (or strike price) - It is the specified price at which an
option can be exercised. It is also known as strike price. The exercise
price for a call option is the price at which the security can be bought
(on or before the expiration date) and the exercise price for a put
option is the price at which the security can be sold (on or before
the expiration date).
u Expiration date - The date, on or before which, the option may be
exercised is termed as expiration date. Beyond this date the right of
the options holder ceases to exist. On or before the expiration date,
the option may be exercised if conditions are favourable to the buyer.
If conditions are not favourable then the option is not exercised and
is left to lapse.
u Option premium - In options contract, the option holder (or the buyer
of the options) has to pay some amount known as options premium
to the option writer (or seller of the options) for availing the right. It
is required because the buyer of the options has a right while seller of
the options has obligation to buy or sell at the specified price. Hence
there is a transfer of risk from the holder to the writer of the options.
Hence the holder of the options must pay some amount to the writer
to buy the options. The amount of option premium depends upon
strike price, time to expiry, risk free rate of return and volatility of
the underlying asset.
PAYOFFS FROM BASIC OPTION POSITIONS

1. CALL OPTION
As you already know by now, a Call option gives the option holder a right
to purchase a security at the exercise price. In stock market a long position
means buying and a short position means selling.
1(a) Long Call (Buying a call option)
Let us suppose an investor buys a call option of ABC Ltd. share with exercise
price (or strike price) of Rs. 250 at a premium of Rs. 10. The option holder
will exercise his option to buy the share when the actual market price of the
share on the expiration date is more than Rs. 250. In that case the holder
of the call option can buy the stock at exercise price of Rs. 250 and can
immediately sell it at a higher market price in the market. At price below
Rs. 250, the option holder shall choose not to exercise the call option. He
can buy the share from the market at a lower price if he so desires. Hence,
payoff of a call option at expiration will be as under. It is also termed as
the value of the call option at expiry.
Payoff of a Long Call (i.e. call option = S1 – X if S1 > X
buyer or call option holder) =0 if S1 ≤ X
Where S1= Stock Price at expiration and X = Exercise Price.
One of the noteworthy points about option is that payoffs to the buyer or
holder cannot be negative. This is because, the option is exercised only if
S1> X. If S1 < X, option holder won’t exercise the call option and the call
option expires with zero value. The loss to the option holder shall be limited
to the premium paid by him originally. Profit to the option holder is the
value of the option at expiration minus the premium paid.
It must be noted that the option holder must pay an amount called Option
premium to the option writer so as to buy the call option. If the amount of
call option premium is C, the Net payoff (or profit and loss) of a Long Call
(i.e. of a buyer of a call option) is determined as under
= S1 – X - C if S1 > X
Net Payoff (profit or loss) to Long call (call holder)
= 0-C = - C if S1 ≤ X
The investor would break-even if market price is equal to exercise price
plus the option premium already paid. When market price is higher than
this break-even point then the call option holder makes profits. On the
other hand if market price is lower than the break-even point then the call
option holder incurs a loss, maximum of the amount of option premium.
In our example the buyer of a call option would break-even if the market
price is Rs. 260. The net payoff of the call with the exercise price Rs. 250
can be given as under for different stock prices at expiration.
Share price on exercise date (S1) 240 250 260 270 280
Exercise price (E) 250 250 250 250 250
Exercise option No No Yes Yes Yes
Buyer’s Inflow 0 0 260 270 280
Buyer’s outflow 0 0` -250 -250 -250
Premium Paid -10 -10 -10 -10 -10
Net Payoff Or Loss/Profit -10 -10 0 10 20
Limited Loss area Break-even Price

Unlimited
Profit area
Pay-off
Exercise Price
250 260 Share Price

-10
Premium
Figure 11.1: Net Pay-off to buyer of call option (Long Call)

In the Fig 11.1 above, it could be observed that if the share price is less than
the exercise price, the loss of the option holder is constant and is limited
to the option premium paid. However, as the share price increases beyond
the exercise price, his loss reduces and breaks even when the share price
equals exercise price plus premium. When the share price is beyond this
break-even point then the option holder makes profit or gains. The potential
for the gains is unlimited. The higher the share price the greater is the gain.
Hence the loss to a long call (or call option holder) is limited to the amount
of option premium paid, but gains are unlimited.
1(b) Selling a call option (Short Call or call option writer)
The position of a call option writer is exactly opposite of call option holder.
The seller of a call option receives option premium for writing the call option
but bears all the downside risk. A short call (i.e. seller of call option) incurs
losses if the share price is higher than the exercise price. In that case, the
option holder will exercise the call option and the writer or seller has to
fulfil his obligation deliver the share worth S1 (stock price at expiration)
for only X (exercise price) amount:
= –(S1 –X) if S1 > X
Payoff of a Short call (or call option writer)
=0 if S1 ≤ X
Where S1= Stock Price at expiration and X = Exercise Price.
Since the seller of the call options receives a premium of C irrespective of
the outcome of the call option, the net payoff (or profit and loss) to a short
call (or to call option seller) is given below:
= –(S1 – X)+C if S1 > X
Net Payoff (profit or loss) to Short call(or call writer)
= 0+C = C if S1 ≤ X
Where C = call option premium amount.
It must be noted that the net gain to a short call is limited to C while his po-
tential loss is unlimited. The higher the stock price at expiration the greater
will be the loss to a short call. Please note that the net payoff of a seller of
a call option is exactly the opposite of the net payoff of the holder of a call
option. Hence gains to the option holder is loss to the option seller and loss
of the option holder is the gain to the option seller. The break-even point
of call option seller is same as the break-even point of call option holder.
The call writer is exposed to losses if the share price increases: In our
example the net payoff to a seller of the call option will be as under for
different stock prices.
Share price at expiration (S1) 240 250 260 270 280
Exercise price 250 250 250 250 250
Whether option is Exercised by the holder No No Yes Yes Yes

Seller’s Inflow 0 0` 250 250 250
Seller’s Outflow 0 0 -260 -270 -280
Premium received 10 10 10 10 10
Net payoff (Loss/Profit) 10 10 0 -10 -20
The position of call option seller or option writer can be depicted in Fig
11.2 as follows:
It can be observed that Fig 11.2 is just the reverse of Fig 11.1. This is because
net payoff to a short call is exactly opposite of the net payoff to a long call.
In Fig 11.2, the option seller makes the profit when the share price is less
than the exercise price plus premium. However, the profit reduces when
the share price increases beyond 250. So the profit potential of a call seller
is limited to 10 only i.e. the premium received. But chances of losses are
unlimited and are dependent upon the market price of share. The higher
the market price the greater will be the potential loss.
Profit area Break-even Price
Premium
10
Pay-off
250 260 Share Price

Unlimited Loss
Exercise Price area
Fig 11.2 : Net Payoff of a short call (or Call option writer/seller)
2. PUT OPTION :
A Put option provides the holder of the option, the right to sell, a security
at the exercise price .
2(a) Long Put (i.e. Buying a Put option or Put option holder)
Let us suppose an investor buys a put option of ABC Ltd. share with exercise
price (or strike price) of Rs. 250 at a premium of Rs. 10. The option holder
will exercise his put option to sell the share when the actual market price
of the share on the expiration date is less than Rs. 250. In that case the
holder of the put option can buy the share at a lower price from market
and sell the share at exercise price of Rs. 250 by exercising his put option.
At share price equal to or above Rs. 250, the option holder will choose not
to exercise the put option. He can sell the share in the market at a higher
price if he so desires.
To generalise, a put option is exercised by the holder only when the stock
price at expiration (S1) is lower than the exercise price (X). In such a case
the put option holder will sell his stock at exercise price to the seller of the
option rather than selling it in the market where he will get a lower price
for his stock. The option holder will not exercise his option if the stock
price at expiration is equal to or higher than the exercise price. Hence the
payoff from a put option is given below. It is also termed as the value of a
put option at expiry.
Pay-off to a Long Put (Put option buyer or Put =0 if S1 ≥ X

option holder) = X-S1 if S1 < X
It must be noted that the option holder must pay an amount called put
Option premium to the option writer so as to buy the put option. If the
amount of option premium is P, the Net payoff of a Long Put (i.e. of a buyer
of a put option) is determined as under
Net Payoff to Long Put (Put option buyer or Put = 0-P = -P if S1 ≥ X

option holder) = X-S1 -P if S1 < X
The investor would break-even if stock price is equal to exercise price
minus the option premium already paid. When stock price is lower than
this break-even point then the put option holder makes profits. On the
other hand if stock price is higher than the break-even point then the put
option holder incurs a loss, maximum to the amount of option premium.
Continuing our example, the position of a put option buyer or holder could
be summarised as follows:
Share price at expiration 220 230 240 250 260 270
Exercise option Yes Yes Yes No No No
Buyer’s cash inflow 250 250 250 0 0 0
Buyer’s cost or cash outflow 220 230 240 0 0 0
Premium Paid -10 -10 -10 -10 -10 -10
Net Payoff (Loss/Profit) 20 10 0 -10 -10 -10
The Net Payoff diagram of a Long Put or buyer of a put option is provided
in Fig 11.3.
240
Break-even Price
Profit area
Pay-off
-10 240 250 Share Price

Premium Loss area
Fig 11.3 : Net Pay off of a Put Option holder (Buyer)
As it could be observed, the option holder of a put option exercises his option
as long as the stock price is lower than the exercise price. But he will not
make profit unless the difference between exercise price and stock price is
more than the amount of put option premium already paid by the option
holder. His profit is equal to the exercise price less the sum of stock price
and premium. Further, the option holder would like his option to lapse in
case the stock price is more than the exercise price. In that case the loss to
the option holder is equal to the amount of option premium already paid.
The option holder’s maximum loss is limited to the amount of premium paid
i.e. Rs. 10. The maximum gain to the put option holder will be when stock
price is zero (which is a hypothetical condition). In such a case the gain to
the put option holder will be equal to exercise price minus the amount of
premium paid. In our example it would be Rs 250-10 = Rs 240.
2(b) Short Put (or Selling a Put Option or Put Option writer)
The position of a put option writer is exactly opposite of the put option holder.
As seen above, the option holder will not exercise his option unless the stock
price is lower than the exercise price. Hence when stock price is higher than
the exercise price, the put option will lapse and its value will be zero. But
if stock price is lower than the exercise price then put option is exercised
and the loss to the put option seller will be equal to the difference between
exercise price and stock price. The payoff from a short put option or for a
seller of a put option is given below:
=0 if S1 ≥ X
Payoff to Short Put (or Put option Writer)
= -(X-S1) if S1 < X
Since the seller of the put option receives a premium of P irrespective of

the outcome of the put option, the net payoff to a short put (or to option
seller) is given below:
=0+P=P if S1 ≥ X
Net Payoff to Short Put (or Put option Writer)
= -(X-S1) + P if S1 < X
It must be noted that the net gain to a put option writer is limited to P while
his potential loss is unlimited. The lower the stock price at expiration the
greater will be the loss to a short put (or put writer). Please note that the
net payoff of a seller of a put option is exactly the opposite of the net payoff
of the holder of a put option. Hence gains to the option holder is loss to the
option seller and loss of the option holder is the gain to the option seller.
The break-even point of put option seller is same as the break-even point
of put option holder.
The put option writer is exposed to losses if the stock price decreases. In
our example the net payoff to a seller of the put option will be as under.
Share price 220 230 240 250 260 270
Whether put option is exercised by its Yes Yes Yes No No No
holder
Seller’s cost or cash outflow -250 -250 -250 0 0 0
Seller’s benefit or cash outflow 220 230 240 - - -
Premium Received 10 10 10 10 10 10
Net Payoff (Loss/Profit) -20 -10 0 10 10 10
The Net payoff matrix for writer of a put option looks like the Fig 11.4:
Break-even Price
Loss area
Premium
10
Limited Profit
Pay-off
240 250 Share Price
240
Fig 11.4: Net Payoff of a Short Put (i.e. Put Option Writer)
The net payoff for the put option writer is negative if stock price is less
than (X–P). His loss potential is substantial and dependent upon the share
price. The lower the share price the greater will be the loss. However as
the share price cannot fall below zero, the maximum loss will be equal
to exercise price less premium. Hence in our example the maximum loss
to a put option writer will be Rs. 240 (i.e. 250-10). Please note that in our
example the maximum gain to a put option holder was Rs. 240. Further,
the profit to a put option writer is limited to the option premium received.
Break even position of Option parties

The above discussion shows net payoffs to a call option holder, call option
writer, put option holder and put option writer. In the discussion we have
also specified the break-even level or position in each case. It must be noted
that the buyer and seller of options (whether call or put) have completely
opposite net payoffs. Hence their break-even level is also same. No gain or
loss to buyer also means no gain or loss to the seller.
In case of a call option, it will be exercised when stock price at expiration
(S1) is higher than the exercise price (X). But the buyer of a call option will
be break even, having no gain or loss, only when the stock price at expira-
tion(S1) is equal to exercise price (X) plus call option premium (C). This is
because the call option premium is also a cost which is already incurred by
the call option holder. Hence the break-even point for a call option holder
is when stock price is equal to X+C. The same is the break even position
for the writer of a call option.
In case of a put option, it will be exercised when stock price at expiration
(S1) is lower than the exercise price (X). But the buyer of a put option will
be break even, having no gain or loss, only when the stock price at expira-
tion (S1) is equal to exercise price (X) minus put option premium (P). This
is because the put option premium is also a cost which is already incurred
by the put option holder. Hence the break-even point for a Long put (buyer
of a put option) is when stock price is equal to X–P. The same is the break
even position for a Short put or the writer of a put option.
The table below shows a summary of the break-even position of the var-
ious parties.
Type of option Break-even level/position
Call option (Buyer as well as seller) S1 = X + C
Put Option (Buyer as well as seller) S1= X-P
Where S1 = stock price at expiry, X = Exercise price, C = call option pre-

mium, P = Put option premium
MONEYNESS OF OPTIONS
The moneyness of options is based upon the relationship between stock
price at the time of entering into the options contract (So) and exercise
price (X). Here we have to assess whether an option contract is beneficial
to the option holder initially i.e. in the beginning itself or not. If the option
contract is beneficial or favourable to the option buyer initially, then it is
termed as In the Money option. If it is not beneficial or is unfavourable
initially, it is termed as Out of Money option. If the option contract is nei-
ther favourable nor unfavourable then it is termed as At the Money option.
In other words ‘In the money’ implies the option holder can make mon-
ey(profit) by immediately exercising his right. ‘At the money’ implies there
is no chance of making money(no profit, no loss). ‘Out of money’ implies
that it is better not to exercise the option and let it lapse.
Call option
With respect to a call option, if the exercise price (X) is lower than the stock
price at the time of entering into contract (SO), then the option contract is
beneficial or favourable to the buyer of the call option and he can exercise
it immediately. Such a call option where, X<So, is termed as In the Money
Call option. When the exercise price is less than the stock price at the time
of entering the contract then the contact is neither beneficial nor unfa-
vourable to the buyer of the call option. Such a call option where, X=So,
is termed as At the Money Call option. On the other hand, if the exercise
price is higher than the stock price at the time of entering into contract,
then the option contract is unfavourable to the buyer of the call option
and he will incur a loss if he exercises it immediately. Such a call option
where, X>So, is termed as Out of the Money Call option.
Put option
With respect to a put option, if the exercise price (X) is higher than the stock
price at the time of entering into contract (SO), then the option contract is
beneficial or favourable to the buyer of the put option as he can exercise
it immediately and have profits. Such a put option where, X>So, is termed
as In the Money Put option. When the exercise price is less than the stock
price at the time of entering the contract then the contact is neither bene-
ficial nor unfavourable to the buyer of the put option. Such a put option
where, X=So, is termed as At the Money put option. On the other hand, if
the exercise price is lower than the stock price at the time of entering into
contract, then the option contract is unfavourable to the buyer of the put
option and he will incur a loss if he exercises it immediately. Such a put
option where, X<So, is termed as Out of the Money put option.
RELATIONSHIP CALL OPTION PUT OPTION
So>X In the money Out of money
So=X At the money At the money
So<X Out of money In the money
Illustration 11.8 An investor buys a call option on the stock of RTL Ltd.
at an exercise price of Rs. 200 for a premium of Rs. 15. The option can be
exercised on the expiration date after 3 months. The current market price
of the stock is Rs 195. Find out the profit/loss to the call option holder if
stock price on expiration date is (i) 175 (ii) 185 (iii) 195 (iv) 200 (v) 205 (vi)
215 (vii) 225 (viii) 235. Also specify moneyness of the call option. What will
be his maximum loss and maximum gain?
Solution : The current stock price is 195 and exercise price is 200. Hence
the call option is “Out of Money” call option.
The net profit/loss to the call option holder is calculated as under
S1 (Stock price at expiry) 175 185 195 200 205 215 225 235
Whether option is exercised No No No No Yes Yes Yes Yes
Cash outflow 0 0 0 0 -200 -200 -200 -200
Cash inflow 0 0 0 0 205 215 225 235
Premium paid -15 -15 -15 -15 -15 -15 -15 -15
Profit/loss (Rs.) -15 -15 -15 -15 -10 0 10 20
The maximum loss will be limited to Rs. 15, i.e. the option premium paid.
The maximum gain potential is unlimited. The higher the stock price at
expiry the higher will be the gain.
Illustration 11.9 An investor buys a put option on the stock of XTL Ltd.
at an exercise price of Rs. 170 for a premium of Rs. 10. The option can be
exercised on the expiration date after 3 months. The current market price
of the stock is Rs 165. Find out the profit/loss to the put option holder if
stock price on expiration date is (i) 140 (ii) 150 (iii) 160 (iv) 170 (v) 180 (vi)
190 (vii) 200 (viii) 210. Also specify moneyness of the put option. What will
be his maximum loss and maximum gain?
Solution : The current stock price is 165 and exercise price is 170. Hence
the put option is “In the Money” put option.
The net profit/loss to the put option holder is calculated as under :

S1 (Stock price at expiry) 140 150 160 170 180 190 200 210
Whether option is exercised Yes Yes Yes No No No No No
A. Cash inflow 170 170 170 0 0 0 0 0
B. Cash outflow -140 -150 -160 0 0 0 0 0
C. Premium paid -10 -10 -10 -10 -10 -10 -10 -10
Profit/loss (Rs.) (A-B-C) 20 10 0 -10 -10 -10 -10 -10
The maximum loss will be limited to Rs. 10, i.e. the option premium paid.
The maximum gain will be when the stock price is zero. In that case his
profit will be Rs 160. The lower the stock price at expiry the higher will be
the gain.
Illustration 11.10 : Identify which of the options will be exercised by the
buyer of the option and (ii) whether the option is In the money, At the
money, or Out of Money for the buyer of the option.
S. No. Strike price (Rs.) Nature of option Market price (Rs.)
1 200 Call 220
2 280 Put 260
3 235 Put 220
4 240 Call 240
5 252 Call 245
6 260 Put 285
7 215 Put 210
(B.Com (H) DU 2014)
Solution : A call option is exercised when market price at expiration > strike
price. A put option is exercised when market price at expiration < strike
price. Further a call option is In the money when at the time of entering
into contract the market price is > strike price. A put option is Out of mon-
ey in that case. At the money options are those for which market price at
the time of entering into contract is same as the strike price. Here in the
question we are given only one price i.e. market price. So we assume that
the same market price prevails at the time of entering the contract and at
expiration. The solution is as under.
S. Strike Nature of Market Whether exercised Moneyness
No. price (Rs.) option price (Rs.)
1 200 Call 220 Yes In the money
2 280 Put 260 Yes In the money
S. Strike Nature of Market Whether exercised Moneyness

No. price (Rs.) option price (Rs.)
4 240 Call 240 Indifferent Yes/No At the money
5 252 Call 245 No Out of money
6 260 Put 285 No Out of money
OPTIONS STRATEGIES
The earlier section discussed about the payoff positions of different options.
These positions are referred to as uncovered positions. The options can be
combined with other actions to develop option strategies. These would be
known as covered positions. Different options can be combined together
to develop trading strategies. Some of the strategies are discussed below:
Protective Put (combination of share and put) - A protective put strat-
1.
egy is generally employed when the options holder is bullish on a
stock he already owns but is concerned about the uncertainties in
the future. In this strategy, an investor holding a stock will buy the
put option on the same stock. The buying of put option protects
the investor against the loss in price of shares. The strategy offers
opportunity to earn unlimited profit with limited risk. The strategy
is best for conservative but optimistic investors.
Covered Calls (combination of share and call) - A covered calls
2.
strategy is one where an investor holds a long position in a share
and writes (sells) call options on that share. The position is covered
because the investor holds share and can deliver the same, if the
call option (which he sold) is exercised by the option holder. This
strategy offers the opportunity to earn a premium by writing calls
while at the same time appreciate all benefits of stock ownership,
such as dividends and voting rights unless he is asked to deliver the
stock. On the downside, the profit potential of covered call writing
is limited .
Straddle (combination of call and put) - A straddle strategy involves
3.
holding a call option and a put option with the same strike price and
expiration dates. This strategy is used when the investor expects
substantial price movements but is not sure about its direction. That
is, when the investor expects that either the stock price will decline
substantially or will increase significantly.
Butterfly Spread - Butterfly spread uses four option contracts with
4.
the same expiration date but three different strike prices to create a
range of prices the strategy can profit from. The trader sells two call
options at the middle strike price and buys one call option at a lower
strike price and one call option contract at a higher strike price.
The butterfly strategy is to :
i. Buy one call option with a lower strike price,
ii. Sell two calls option with a middle strike price,
iii. Buy one call option with a higher strike price.
Illustration 11.11 Equity shares of PK Ltd. are currently available at a price
of Rs. 25 per share. Both the call option and put options are available at
a strike price of Rs. 27 per share for a premium of Rs. 2 and Rs. 3 respec-
tively. An investor creates a straddle strategy. Explain how he can do that.
What would be his net profit/loss if on the expiration date the stock price
is Rs. 18 or Rs. 35?
Solution : As explained above a Straddle strategy means buying a Call
option and a put option at the same strike price.
So the investor should buy a Call option and a Put option on the share at a
Strike price of Rs. 27 per share and will pay Rs. 2 +3 i.e. Rs. 5 as premium
amount.
Now if on expiry stock price = 18, the call option will not be exercised, but
Put option will be exercised. In that Case
Payoff from Call = 0
Payoff from Put = 27-18 = 9
Less : Premium paid = (5)
Net profit = Rs. 4
Further if on the expiry date stock price happens to be Rs. 35, then Call
option will be exercised but Put option will not be exercised. In that Case
Payoff from Call = (35-27) = 8
Payoff from Put = 0
Net profit = Rs. 3
Hence in both the situations, the investor will make a gain.
Illustration 11.12 Equity shares of KK Ltd. are currently available at a
price of Rs. 22 per share. Three call options are available at different strike
prices. The strike prices are Rs. 20, 25 and 30 per share for a premium of
Rs. 5, 4 and Rs. 2 respectively. An investor creates a Butterfly spread
strategy. Explain how he can do that. What would be his net profit/loss if
on the expiration date the stock price is Rs. 15, Rs. 23, 28 or Rs. 35.
Solution : As explained above a Butterfly strategy means buying a Call
option at a lower strike price, buy another call option at higher strike price
and sell two call options at middle strike price.
So the investor will create a butterfly spread by
u Buying a call option at Rs. 20 and pay premium Rs. 5
u Buying a call option at Rs. 30 and pay premium of Rs. 2
u Sell two call options at Rs. 25 and receive premium of Rs. 6 i.e.
(2× 3)
So the net outflow of the investor is -1 (i.e. 6-5-2).
Now
i. if on expiry, stock price = Rs. 15, None of the call options will not be
exercised, hence his net loss will be Re. -1 only.
ii. if on expiry, stock price = Rs. 23, then he will exercise the call option
with the strike price of Rs. 20. His payoff from call will be Rs. 3 i.e.
(23-20). His profit will be Rs 2 i.e. (3-1) . The other two calls will not
be exercised.
iii. if on expiry, stock price = 28, then he will exercise call option with
the strike price of Rs. 20. The two calls which he has sold at strike
price of Rs. 25 will also be exercised by the holders of these options.
In this case his
payoff from Long Call = Rs. 8 i.e. (28-20),
Payoff from two Short Calls = -6 i.e. [ i.e. 2 × (25-28)]
Net payoff or profit = 8-6-1 = 1
iv. if on expiry stock price = 35, then all the four calls will be exercised.
Now his payoffs are;
payoff from Long Call at strike price Rs. 20 = Rs. 15 i.e. (35-20),
Payoff from two Short Calls = -20 [ i.e. 2 × (25-35)]
payoff from Long Call at strike price Rs. 30 = Rs. 5 (35-30)
Net payoff or profit = 20-20-1 = -1
Pricing or valuation of options:
The value of an option is the price or premium that the buyer of the option
has to pay to get the option (or the right to buy or sell). Every option has a
price. In the money options will have higher price than out of money options.
FACTORS AFFECTING OPTION PRICE OR OPTION PREMIUM

The buyer of the option has to pay some premium to buy the option. This is
the cost that he has to incur to get the right (to buy or sell a specified asset
at a specified price on a specified date). The option writer gets this option
premium as he is selling the right to the option buyer. This is also known as
the option price or Value of the option. It depends upon a number of factors
such as current price of the asset, exercise price, volatility of asset returns,
risk free rate, time to expiration, dividends or any income from the asset.
The value of an option depends on the following factors:
a. Current Price (or spot price) of the underlying share(asset)
b. Exercise Price
c. Volatility of returns on share
d. Time to expiration
e. Interest rates
f. Dividends
a. Current Price of the underlying asset - The value of call and put
options depend upon the price movement of the underlying share.
When the share price goes up, call options value increases while that
of put option declines. Conversely, put option value increases and
call option value drops when the share price goes down. Other things
being equal, if the current price is high, call option premium will be
high and if the current price is low then the call option premium will
be low. The opposite is true in case of put options. Hence there is a
positive relationship between current price of the underlying asset
and call option value, while there is a negative relationship between
current price of the underlying asset and put option value.
b. Exercise Price : The option value also depends upon the exercise price.
This is the price at which a call holder may buy the underlying share
and the put holder may sell the same. The lower the exercise price,
the better it is for the call option buyer. Hence call options become
more expensive as the exercise price decreases. On the other hand,
put options become more expensive in value as the exercise price
increases. Hence there is a negative relationship between exercise
price and call option value, while there is a positive relationship
between exercise price and put option value.
c. Volatility of asset prices changes - Volatility refers to the degree to
which price moves, regardless of direction. It is a measure of the
speed and magnitude of the underlying asset’s share price changes.
Shares that are volatile go through more frequent changes in their

prices than the non-volatile ones. Highly volatile stocks pose a higher
risk to the writer of an option. Thus, we can say that an option on a
more volatile share is much more expensive than one on a less vol-
atile share. There is a positive relationship between stock volatility
and call option value. At the same time there is positive relationship
between stock volatility and put option value.
d. Time to expiration - The present value of the exercise price depends
upon the time to expiration. It will be less if time to expiration is
longer, and therefore, the value of the option will be higher. Hence
there is a positive relationship between time to expiry and option
price, whether call option price or put option price. The longer the
maturity the more will be the call as well as put option price other
things being equal.
e. Risk free Interest rates - The option holder does not pay the exercise
price when he buys the option, rather he pays it at the time he exercises
the option. Thus, the present value of the exercise price will depend
upon the risk free interest rate as well. The higher the interest rates,
the present value of exercise price shall be less and consequently,
the value of a call option rises. The effect shall be reversed for put
option. The higher the risk free interest rate, the higher will be the
call option premium and vice versa. Further the higher the risk free
interest rate, the lower will be the put option premium and vice versa
f. Income from the underlying asset (or Dividends) - Dividends can
also affect option prices. Generally, the share’s price drops by the
amount of any cash dividend on the ex-dividend date. Thus, if the
share’s dividend increases, call prices will decrease and put prices
will increase. Conversely, if the share’s dividend decreases, call prices
will increase and put prices will decrease.
The effects of the above factors can be summarised in the table below:
Factor (If Increases) Call Option Value Put Option Value
Price of the Underlying Asset + -
Exercise Price - +
Time to expiration + +
Volatility of Stock Prices + +
Interest rates + -
Dividends - +
COMPONENTS OF OPTION PRICE (OPTION PREMIUM)

There are two components of an option price:
a. Intrinsic Value
b. Time Value
a. Intrinsic Value - The intrinsic value is the difference between the
underlying asset’s price and the exercise price. For a call option, the
intrinsic value is equal to the underlying asset price minus the exer-
cise price or zero whichever is higher. For a put option, the intrinsic
value is equal to the exercise price minus the underlying asset price
of zero whichever is higher. It is non-negative, i.e. it is either zero
or positive. This implies that the options that have positive intrinsic
value are those that are “in the money” options.
Intrinsic Value(Call) = Max [(Market Price -Exercise Price), 0]
Intrinsic Value(Put) = Max[(Exercise Price-Market Price), 0]
b. Time Value - This is the amount by which the option price exceeds
the intrinsic value. As already discussed, the longer the time to expi-
ration, the greater the value of the option.
Time Value = Option Price - Intrinsic Value
An option price, thus, is equal to its intrinsic value plus its time value.
Option Price = Intrinsic Value + Time Value
Illustration 11.13 : A call option is available for a strike price of Rs. 274, at
a premium of Rs. 10 for a share having current price of Rs. 276. Find out
the intrinsic value and time value components of the option value. What
will be the answer for a put option with the same features.
Solution : In case of call option, option premium = Rs. 10, Current price =
276, Strike price or Exercise price = 274. It is an In the money call option.
Hence it will have an intrinsic value equal to the difference between current
price and strike price.
Intrinsic value = Max [ (276-274), 0] = Max [2,0] = Rs. 2
Time value = option price – Intrinsic value = 10-2 = Rs. 8
In case of put option, option premium = Rs. 10, Current price = 276, Strike
price or Exercise price = 274. It is an Out of money put option. Hence it
will have an intrinsic value equal to zero.
Intrinsic value = Max [ (274-276), 0] = Max [-2,0] = 0 or Nil
Time value = option price – Intrinsic value = 10-0 = Rs. 10
Hence in case of put option the entire Option premium is Time value
component.
OPTION VALUATION MODELS

1. BLACK AND SCHOLES MODEL
The Black-Scholes model was introduced in 1973 in a paper enti-
tled, “The Pricing of Options and Corporate Liabilities” published in
the Journal of Political Economy. The formula, developed by three
economists – Fischer Black, Myron Scholes and Robert Merton – is
perhaps the world’s most well-known options pricing model. The
model is used to calculate a theoretical price (ignoring dividends
paid during the life of the option) of a call option. The model uses
the five key determinants of an option’s price: stock price, exercise
price, volatility, time to expiration, and risk free interest rate.
The model makes following assumptions:
u The options are European and can only be exercised at expi-
ration.
u No dividends are paid out during the life of the option.
u Efficient markets (i.e., market movements cannot be predicted).
u No commissions & taxes.

u The risk-free rate and volatility of the underlying are known
and constant.
u Stock prices follow a log normal distribution; that is, log returns
on the underlying asset or stock are normally distributed.
The formula for calculating the option price is as follows:
C = SN(d1) – Xe-rt N(d2)...............................................................(11.1)
Where:
 s  σ2 
In  + t r +
 x   2  ................................................................(11.1A)
d1 =
σ t
d2 = d1 − σ t ..................................................................................(11.1B)

The variables are:

S= Current Stock Price
X= Exercise Price
t= time remaining till expiry in years
r= continuously compounded risk-free interest rate
In = natural logarithm
N(d1) = Normal area to the left of d1

N(d2) = Normal area to the left of d2
However, the model has one major limitation: it cannot be used to
accurately price options with an American-style exercise as it only
calculates the option price at one point in time, i.e. at expiration. It
does not consider the steps along the way where there could be the
possibility of early exercise of an American option. The numerical
questions on B&S model are beyond the scope of this book.
2. BINOMIAL MODEL
The binomial model is a variation of the original Black-Scholes op-
tion pricing model. It was proposed in 1979 by financial economists/
engineers John Carrington Cox, Stephen Ross and Mark Edward
Rubenstein. The model is popular because it considers the underlying
instrument over a period of time. The model is especially useful for
analysing American Options. The model makes certain assumptions:
u a perfectly efficient market
u at each time node, the underlying price can only take an up or
a down move and never both simultaneously.
The model breaks down the time to expiration into potentially a
very large number of time intervals, or steps. A tree of stock prices
is initially produced working forward from the present to expiration.
At each step it is assumed that the stock price will move up or down
by an amount calculated using volatility and time to expiration. This
produces a binomial distribution of underlying stock prices. The
tree represents all the possible paths that the stock price could take
during the life of the option.
At the end of the tree, i.e. at expiration of the option - all the terminal
option prices for each of the final possible stock prices are known as
they are equal to their intrinsic values.
Next the option prices at each step of the tree are calculated working
back from expiration to the present. The option prices at each step
are used to derive the option prices at the next step of the tree using
risk neutral valuation based on the probabilities of the stock prices
moving up or down, the risk free rate and the time interval of each
step. Any adjustments to stock prices (at an ex-dividend date) or
option prices (as a result of early exercise of American options) are
worked into the calculations at the required point in time. At the top
of the tree we are left with one option price.
In very basic terms, the model involves three steps:

1. The creation of the binomial price tree
2. Option value calculated at each final node
3. Option value calculated at each preceding node
The big advantage the binomial model is that it can be used to ac-
curately price American options. This is because with the binomial
model it’s possible to check at every point in an option’s life (i.e. at
every step of the binomial tree) for the possibility of early exercise.
Where an early exercise point is found it is assumed that the option
holder would elect to exercise, and the option price can be adjusted
to be equal to the intrinsic value at that point. This then flows into
the calculations higher up the tree and so on.
11.7 FINANCIAL DERIVATIVES MARKET IN INDIA

In the year 1993 after Harshad Mehta Scam in Indian stock market, SEBI
banned forward trading and carry forward or badla system. The Indian
stock market did not have any instrument for hedging since then. The in-
flow of institutional investors and participation of foreign investors requires
that some instrument of hedging must be provided so as to enhance the
liquidity of the market. Derivatives were the obvious choice as many coun-
tries have been introducing derivative products for hedging in their stock
market around that time. By providing investors and issuers with a wider
array of tools for managing risks and raising capital, derivatives improve
the allocation of credit and the sharing of risk in the global economy, low-
ering the cost of capital formation and stimulating economic growth. Now
that world markets for trade and finance have become more integrated,
derivatives have strengthened these important linkages between global
markets, increasing market liquidity and efficiency, and have facilitated
the flow of trade and finance.
SEBI formed a Committee on Derivatives (popularly known as L.C. Gupta
Committee on derivatives) under the chairmanship of Dr. L.C. Gupta in
1997. The mandate of this committee was to examine the feasibility of
introducing financial derivative products in Indian stock market. The
Committee came out with its recommendations in the year 1998. The
committee recommended introduction of following derivative products in
Indian stock market – (i) Index Futures (ii) Index Options (iii) Stock options
(iv) Stock futures.
In December 1999, the Securities Contracts (Regulation) Act, 1956 was
amended to include derivatives within the definition of Securities under
section 2(h). Regulatory framework for the introduction of derivatives
products was also introduced by SEBI.
463 Financial derivatives market in india Para 11.7
India’s tryst with derivatives began in 2000 when both the NSE and the BSE
commenced trading in equity derivatives. On 9th June, 2000, BSE launched
index futures on S&P BSE SENSEX. On 12th June, 2000 NSE introduced
Index futures on CNX NIFTY. Hence index futures became the first type
of derivatives instruments to be launched in the Indian markets, followed
by index options in June 2001, stock options in July 2001, and stock futures
in November 2001. Since then, equity derivatives have come a long way.
New products, an expanding list of eligible investors, rising volumes, and
the best risk management framework for exchange-traded derivatives
have been the hallmark of the journey of equity derivatives in India so far.
India’s experience with the equity derivatives market has been extremely
positive. India is one of the most successful developing countries in terms
of a vibrant market for exchange-traded derivatives. This reiterates the
strengths of the modern development in India’s securities markets, which
are based on nationwide market access, anonymous electronic trading,
and a predominantly retail market. There is an increasing sense that the
equity derivatives market plays a major role in shaping price discovery.
The NSE currently provides trading in Futures and Options contracts on 9
major indices (including indices in Indian market as well in Global markets)
and more than 100 securities.
The indices on which futures and options are being traded on NSE are-
u CNX NIFTY Index
u CNX IT Index
u BANK NIFTY Index
u NIFTY Midcap 50 Index
u CNX Infrastructure Index
u CNX PSE Index
GLOBAL INDICES
u S&P 500
u DJIA
u FTSE100
BSE has also expanded its derivatives segment by introducing new deriv-
ative products since the year 2001. In addition to BSE SENSEX, futures
and options are available on the following five sectoral indices.
u BSE TECK
u BSE FMCG
u BSE Metal
u BSE Bankex
u BSE Oil & Gas
Long Dated Options : BSE has also introduced ‘Long Dated Options’ on its
flagship index - Sensex -on February 29, 2008, whereby the Members can
trade in Sensex Options contracts with an expiry of up to 3 years.
Currency Derivative : October 1, 2008 BSE launched its currency deriv-
atives segment in dollar-rupee currency futures as the exchange traded
currency futures contracts to facilitate easy access, increased transparency,
efficient price discovery, better counterparty credit risk management, wider
participation and reduced transaction costs.
It must be noted that the settlement of all index and stock futures and options
in India is through cash and settlement through delivery is not permitted.
NATIONAL SECURITIES CLEARING CORPORATION LTD.
NSCCL, a wholly owned subsidiary of NSE, was incorporated in August
1995. It was the first clearing corporation to be established in the country
and also the first clearing corporation in the country to introduce settle-
ment guarantee.
It was set up with the following objectives:
u to bring and sustain confidence in clearing and settlement of secu-
rities;
u to promote and maintain, short and consistent settlement cycles;
u to provide counter-party risk guarantee, and
u to operate a tight risk containment system.
NSCCL commenced clearing operations in April 1996. The main functions
of NSCCL are discussed below–
Clearing and settlement : NSCCL carries out the clearing and settle-
1.
ment of the trades executed in the equities and derivatives segments.
It operates a well-defined settlement cycle and there are no deviations
or deferments from this cycle. It aggregates trades over a trading
period, nets the positions to determine the liabilities of members and
ensures movement of funds and securities to meet respective liabil-
ities. NSCCL has empanelled 13 clearing banks to provide banking
services to trading members and has established connectivity with
both the depositories for electronic settlement of securities.
Guarantee : NSCCL assumes the counter-party risk of each member
2.
and guarantees settlement through a fine-tuned risk management
system and an innovative method of on-line position monitoring.
A large Settlement Guarantee Fund provides the cushion for any
465 Solved Problems
residual risk. It operates like a self-insurance mechanism where

members contribute to the Fund. In the event of failure of a trading
member to meet settlement obligations or committing default, the
Fund is utilised to the extent required for successful completion of the
settlement. This has eliminated counter-party risk of trading on the
Exchange. As a consequence, credit risk no longer poses any threat
in the market place. The market has full confidence that settlement
shall take place in time and shall be completed irrespective of default
by isolated trading members. A separate Settlement Guarantee Fund
is maintained for the Futures & Options segment.
Risk management : A sound risk management system is integral to
3.
an efficient clearing and settlement system. NSE introduced for the
first time in India, risk containment measures that were common
internationally but were absent from the Indian securities markets.
NSCCL has put in place a comprehensive risk management system,
which is constantly upgraded to pre-empt market failures. The
Clearing Corporation ensures that trading member obligations are
commensurate with their net worth. Risk containment measures
include capital adequacy requirements of members, monitoring of
member performance and track record, stringent margin require-
ments, position limits based on capital, online monitoring of member
positions and automatic disablement from trading when limits are
breached, etc.
NSCCL has successfully brought about an up-gradation of the clearing
and settlement procedures and has brought Indian financial markets in
line with international markets.
NSCCL became the First Indian Clearing Corporation to get rated. CRISIL
has assigned its highest corporate credit rating of ‘AAA’ to the National
Securities Clearing Corporation Ltd. (NSCCL). ‘AAA’ rating indicates highest
degree of strength with regard to honouring debt obligations. NSCCL is
the first Indian Clearing Corporation to get this rating. The rating reflects
NSCCL’s status as Clearing Corporation for NSE, India’s largest stock
exchange. The rating also factors in NSCCL’s rigorous risk management
controls and adequate settlement guarantee cover.
Solved Problems
Problem 11.1 Consider a 3-month index future contract on 100 shares. The
current value of the index is 1520 and continuously compounded dividend
yield expected on the underlying shares is 4% per annum and continuously
Financial derivatives - Forwards, futures & options 466
compounded risk free rate is 10% per annum. Calculate the price of one
future contract. (e0.015= 1.015)
Solution:
F = Se(r-q)t = 100 × 1520 e(0.10-0.04)3/12 = 100 × 1520e0.015 = Rs. 154,280
Problem 11.2 Consider a stock future contract on a non-dividend paying
share which is currently trading at Rs. 35. The futures contract mature in 3
months and the continuously compounded risk free rate is 8% per annum.
Calculate the price of one future contract. (e0.02= 1.0202).
Solution:
F = Sert = 35 e(0.08)3/12 = 35e0.02 = Rs. 35.71
Problem 11.3 The price of equity share of a company is Rs. 250. The risk
free rate is 8% per annum with continuous compounding. An investor wants
to enter into a 3 months futures contract. Calculate the futures price.
(B.Com (H) DU 2013)
Solution:
F = Sert = 250 e(0.08)3/12 = 250e0.02 = Rs. 255.05
Problem 11.4 The price of shares of XYZ Ltd. is Rs. 150. The risk free rate is
12% per annum with continuous compounding. An investor wants to enter
into a 6 months forward contract. Calculate the forward price. (e0.06= 1.062)
Solution:
F = Sert = 150 e(0.12)6/12 = 150e0.06 = Rs. 159.3
Problem 11.5 The stock index is currently valued at Rs. 400 and the risk
free rate is 6%. Find out the futures price for a 4 months contract if the
dividend yield is 3%.(.(e0.01= 1.01)
Solution:
F = Se(r-q)t = 400 e(0.06-0.03)4/12 = 400e0.01 = Rs. 404.02
Problem 11.6 The shares of PQR Ltd. are currently selling at Rs. 450 per
share. The 4 months futures contract on this share is available at Rs. 500.
Should the investor buy this futures contract if the risk free rate of interest
is 12%?
Solution:
F = Sert = 450 e(0.12)4/12 = 450e0.04 = Rs. 468.36
As the futures are available at Rs. 500, the investor should not buy the
futures contract.
467 Solved problems
Problem 11.7 An investor buys Sensex futures at 25500 in the market lot
of 400 futures. On the settlement date, the Sensex is 25700. Find out his
profit or loss for one lot of futures.
Solution:
Profit = (25700 - 25500) × 400 = Rs. 80000
Problem 11.8 An investor buys 600 shares of ABC Ltd. @ Rs. 300 per share
in the cash market. In order to hedge, he sells 400 futures of ABC Ltd @
Rs. 200 each. The share price and the future price decline by 8% and 4%
the very next day. He closes his position by counter transactions. Find out
his profit or loss.
Solution:
600 Shares of ABC Ltd. Buying Cost 600× 300 Rs. 180000
Selling Value 600× (300-8%) Rs. 165600
Loss Rs. 14400
400 Futures of ABC Ltd. Selling Value 400 × 200 Rs. 80000
Buying Value 400× (200-4%) Rs. 76800
Profit Rs. 3200
NET LOSS 14400-3200 Rs. 11200
Problem 11.9 An investor buys 500 shares of ABC Ltd. @ Rs. 210 per share
in the cash market. In order to hedge, he sells 300 futures of ABC Ltd @
Rs. 195 each. The share price and the future price decline by 5% and 3%
respectively the very next day. He closes his position by counter transac-
tions. Find out his profit or loss.
(B.Com (H) DU 2008, 2012)
Solution:
500 Shares of ABC Ltd. Buying Cost 500× 210 Rs. 105,000
Selling Value 500× (210-5%) Rs. 99750
Loss Rs. 5250
400 Futures of ABC Ltd. Selling Value 300 × 195 Rs. 58500
Buying Value 300× (195-3%) Rs. 56745
Profit Rs. 1755
NET LOSS 5250-1755 Rs. 3495
Problem 11.10 An investor buys NIFTY Futures contract for Rs. 300000(lot
size 200). On the settlement date, the NIFTY closes at 1470. Find out his
profit or loss, if he pays Rs. 1000 as brokerage. What would be position, if
he has sold the futures contract?
Solution: NIFTY Futures on the date of transaction is 1500(300000/200).

NIFTY Futures on the date of settlement is 1470. Thus, it has reduced by
30 points. The loss to the investor is
Loss = (1500 - 1470) × 200 + Rs. 1000 = Rs. 6000 + Rs. 1000 = Rs. 7000
In case, the investor has sold the futures, his profit would have been:
Profit = (1500 - 1470) × 200 - Rs. 1000 = Rs. 6000 - Rs. 1000 = Rs. 5000
Problem 11.11 The market price of equity shares of a company is Rs. 50
and the company is expected to declare a dividend of Rs. 10 after 1 month.
What should be the futures price of three months futures contract if con-
tinuously compounded risk free rate is 12%. [e0.03 = 1.03, e0.01 = 1.01]
Solution : The dividend of Rs. 10 will be received after one month. The
duration of futures contact is 3 months. Hence present value of dividend
will be calculated as follows :
Hence present value of Dividend = 10e(–0.12)(1/12) = 10 e–0.01 = 9.9
Futures price = [50 –9.9]e0.12 × 3/12
= (40.1)(1.03)
= 41.303
Problem 11.12 The market price of the equity share of TRK Ltd. is Rs. 65
in the spot market. It has not been paying any dividend. The continuously
compounding risk free rate is 6% p.a. The three month futures price for the
share is Rs. 68. Should the investor enter into 3 month futures contract?
Solution: Theoretical or fair price of Three month futures is calculated below:
F = Sert = 65 e(0.06)3/12 = 65e0.015 = Rs. 65.98
Since the fair price of futures is Rs. 65.98 which is lower than the actual
price of Rs. 68, the investor should sell this futures contract. This is an ar-
bitrage opportunity. He can borrow Rs. 65 now at risk free rate of 6% p.a.
and sell the share in futures market at Rs. 68. By doing this he can make
a profit of Rs. 2.02 (i.e. 68-65.98) in just three months.
Problem 11.13 An investor buys SBI futures at Rs. 2800 in the market lot
of 100 futures. On the settlement date the market price of SBI share in
spot market is Rs. 2950. Find out his profit or loss for one lot of futures.
Solution: In this case the investor will get one lot of futures at Rs. 280000
(2800 × 100). Since the spot price is Rs. 2950, the investor can sell these
100 shares at Rs. 2950 per share and make gain. It must be noted that on
settlement date the price of futures contract converges to the prevailing
market price.
Total gain = (295000-280000) = Rs. 15000
469 Solved problems
Problem 11.14 An investor buys a SENSEX futures contract for Rs. 15,00,000
(lot size 50 futures). On the settlement date SENSEX closes at 29500. Find
out his profit or loss if he has paid a brokerage of Rs. 1000. What would
have been his gain if he had sold futures?
Solution : The investor has bought SENSEX futures at 30000 in lot size of
50 (i.e. value of one contract is 30000 × 50) and the value of SENSEX has
declined. Hence he would incur loss on his futures position. Assuming that
the brokerage is paid at the time of settlement, his total loss would be :
Loss = (30000-29500) × 50 + 1000 = Rs. 26000
If the investor has sold SENSEX futures at 30000 in lot size of 50 (i.e. value
of one contract is 30000 × 50) and the value of SENSEX has declined. Then
he would make gain on his futures position. Assuming that the brokerage
is paid at the time of settlement, his total gain would be :
Gain = (30000-29500) × 50 - 1000 = Rs. 24000
Problem 11.15 The market lot size is 100 and the futures price is Rs. 1700.
An investor takes a long position in futures market and buys 10 lots. On
the settlement date the market price of the share is Rs. 1710. Find out the
profit or loss to the investor.
Solution : The purchase price of 10 lots of futures = 1700 ×100 ×10 =
Rs. 1700000
The selling price = 1710 × 100 × 10 = Rs. 1710000
Hence profit = Rs. 10000
Problem 11.16 A three month call option premium is Rs. 5 and 3 month
put option premium is Rs. 7. Assume that the exercise price for both the
cases is Rs. 100, find out the net pay-off of call option holder, call option
writer, put option holder and put option writer if the spot price of the share
on the expiry day is
i. Rs. 95
ii. Rs. 100
iii. Rs. 103
iv. Rs. 105
v. Rs. 107
vi. Rs. 110
Solution:
NET PAY OFF FOR CALL OPTION HOLDER
Share Price on Exercise Day 95 100 103 105 107 110

Option exercise No No Yes Yes Yes Yes
Outflow(strike price) 100 100 100 100

Outflow (premium paid) 5 5 5 5 5 5
Total outflow 5 5 105 105 105 105
Less: inflow(sale proceed) - - 103 105 107 110
Net pay-off -5 -5 -2 0 2 5
NET PAYOFF From call option writer
Share Price at expiry 95 100 103 105 107 110

Option exercise No No Yes Yes Yes Yes
Inflow (Strike Price) - - 100 100 100 100
Inflow (Premium) 5 5 5 5 5 5
Total Inflow 5 5 105 105 105 105
Outflow (Share Price) - - 103 105 107 110
Net Payoff (Rs.) 5 5 2 0 -2 -5
NET PAYOFF FOR PUT OPTION HOLDER

Option exercise Yes No No No No No
Outflow(Purchase price) 95 - - - - -
Outflow (premium paid) 7 7 7 7 7 7
Total outflow 102 7 7 7 7 7
Inflow(Strike Price) 100 - - - - -
Net pay-off -2 -7 -7 -7 -7 -7
NET PAYOFF For put option writer
Share Price at expiry 95 100 103 105 107 110

Option exercise Yes No No No No No
Inflow (Purchase Price) 95 - - - - -
Inflow (Premium) 7 7 7 7 7 7
Total Inflow 102 7 7 7 7 7
Outflow (Strike Price) 100 - - - - -
Net Payoff 2 7 7 7 7 7
Problem 11.17 The shares of FPL Ltd. are being traded at a price of Rs. 234
in the spot market. An investor buys a 3 month put option at a premium of
Rs. 12 and strike price of Rs. 232. Under which situation the investor will
be able to make profit assuming that the option is of European style and
can be exercised only on maturity. When would he exercise the option?
471 Solved problems
Solution : Put option is the right to sell. The investor will exercise this put
option when the market price on expiration date is less than Rs. 232 i.e. the
strike price. However he would start making profit only when the market
price falls below 220 (i.e. 232 - 12) because he has already incurred a cost
of Rs. 12 in buying this put option.
Problem 11.18 The shares of KPL Ltd are being traded at a price of Rs.
234 in the spot market. Mr. X writes a call option at a strike price of Rs. 236
for a premium of Rs 7. Under which situation Mr. X will be able to make
profit assuming that the option is of European style and can be exercised
only on maturity. What would be the amount of his profit. When will he
incur a loss?
Solution : Call option is the right to Buy. Mr. X is the call option writer or
seller of the call option. Hence he will receive option premium of Rs. 7 but
is exposed to all the downside risk. A call option is not exercised when the
market price at expiry date is lower than or equal to the strike price. Hence
in that case the call option writer i.e. Mr X will make profit to the extent of
Rs. 7 i.e. premium already received. Thus Mr. X will make a profit of Rs. 7
when the market price at expiry is lower than or equal to Rs. 236.
However when the market price is more than Rs. 236, then the call option
will be exercised by its holder. In that case Mr. X will have some profit only
up to the price of Rs 243 (i.e. 236+7). If price is higher than Rs. 243 then
Mr. X will incur a loss.
Problem 11.19 Mr. B purchased 3 months call option of 100 shares of
Barati Airtel at a strike price of Rs. 300 per share and paid a premium of
Rs. 30 per share. Find out his expected gain or loss if the actual price on
expiration date is (i) Rs. 250 (ii) Rs. 350. Also find his break even point with
the help of payoff diagram.
(B.Com(H) DU 2012)
Limited Loss area Break-even Price

Unlimited
Profit area
Pay-off
Exercise Price
300 330 Share Price

-30
Premium
Solution : Lot size = 100. Premium on call = Rs. 30 per share, Strike price
= 300 per share.
i. When actual price is Rs. 250, then the call option will not be exercised.
Hence there will be loss to Mr. B to the extent of Rs. 30 per share
which he has already paid as premium.
Hence net loss = 30 × 100 = 3000.
ii. When actual price is Rs. 350. Call option will be exercised. In that
case payoff from call option will be Rs. 50 per share (i.e. 350 – 300).
But he has already incurred a cost of Rs. 30 per share as premium.
Hence his net profit will be
Payoff from call option = 50 × 100 = 5000
Less: premium already paid = (3000)
Net profit = Rs. 2000.
iii. Mr. B will have break-even point when actual price is equal to
Rs. 330 per share (i.e. 300 + 30) . Beyond this price he will have profits.
Below this price he will incur loss.
This is shown in terms of per share in the given diagram as above.
Problem 11.20 Three months call option premium is Rs. 2 and 3 months
put option premium is Rs. 3. Assume that the exercise price for both the
cases is Rs. 50, find out the net payoff of the call option buyer, call option
writer, put option buyer as well as put option writer when spot price of
the share on the exercise price day is Rs. 47, Rs. 49, Rs. 50, Rs. 52, Rs. 53,
Rs. 55 and Rs. 60.
(B.Com(H) DU 2013)
Solution : Premium on call = Rs. 2 per share, Premium on Put = Rs. 3 per share.
Strike price = Rs. 50 . The call option is exercised when stock price at expiry is
higher than Rs. 50 and a put option is exercised when it is lower than Rs. 50.
Spot price on Expiration date 47 49 50 52 53 55 60
Call option buyer
Payoff from call 0 0 0 2 3 5 10
Premium paid -2 -2 -2 -2 -2 -2 -2
Net payoff -2 -2 -2 0 1 3 8
Call option writer
Payoff from call 0 0 0 -2 -3 -5 -10
Premium received 2 2 2 2 2 2 2
Net payoff 2 2 2 0 -1 -3 -8
473 Solved problems
Spot price on Expiration date 47 49 50 52 53 55 60

Put option buyer
Payoff from put 3 1 0 0 0 0 0
Premium paid -3 -3 -3 -3 -3 -3 -3
Net payoff 0 -2 -3 -3 -3 -3 -3
Put option writer
Payoff from Put -3 -1 0 0 0 0 0
Premium received 3 3 3 3 3 3 3
Net payoff 0 2 3 3 3 3 3
Problem 11.21 Sanjay has bought a call and put options. Each contract is
of 100 shares. (i) He has purchased 3 months call with a strike price of 52
and paid Rs. 2 as premium. (ii) He has paid Re. 1 per share premium for
buying a three months put with a strike price of Rs 50. Find out
a. What would be Sanjay’s position if the stock price moves upto
Rs. 53 in three months?
b. What would be his position if the stock price falls to Rs. 46 in 3
months?
(B.Com(H) DU 2012)
Solution : Lot size = 100. Premium on call = Rs. 2 per share, Premium on
Put = Re. 1 per share. Strike price = 52 for call option, 50 for put option
Total Premium paid by Sanjay in buying a call and a put option =100 ×
(2 +1) = Rs. 300.
(a) When market price is Rs. 53. Sanjay will exercise call option but will
not exercise put option. His payoff from call option will be Re. 1 (i.e.
53-52) per share.
Hence
Payoff from call = 100 × 1 = 100
Less : Premiums already paid = (300)
Net Loss = (200).
So, in this case Mr Sanjay will have net loss of Rs. 200.
(b) When market price is Rs. 46. Sanjay will exercise put option but will
not exercise call option. His payoff from put option will be Rs. 4 (i.e.
50-46) per share.
Hence
Payoff from put option = 100 × 4 = 400
Less : Premiums already paid = (300)

Net Profit = 100
So, in this case Mr. Sanjay will have net profit of Rs. 100.
Problem 11.22 Mr. Verma has bought a call and put options. (i) He has
purchased 3 months call with a strike price of 32 and Rs. 1.50 as premium.
(ii) He has paid Re. 1 per share premium for buying a three months. Put
option with a strike price of Rs. 34. Find out his net profit or loss if the stock
price on the expiration date is Rs. 35.
Solution : Premium on call = Rs. 1.50, Premium on Put = Re. 1. Strike price
= Rs. 32 for call option, Rs. 34 for put option
Total Premium paid by Mr. Varma in buying a call and a put option =(1.50
+1) = Rs. 2.50.
When market price at expiration is Rs. 35, call option will be exercised while
put option will not be exercised.
Hence
Payoff from call = (35-32) = Rs. 3
Payoff from Put = 0
Less : Premiums already paid = (2.50)
Net Profit = Re. 0.50 per share.
So, in this case Mr. Verma will have net profit of Re. 0.50 per share.
Problem 11.23 Equity shares of TKY Ltd. are currently available at a price
of Rs. 65 per share. Both the call option and put options are available at
a strike price of Rs. 67 per share for a premium of Rs. 3 and Rs. 4 respec-
tively. An investor creates a straddle strategy. Explain how he can do that.
What would be his net profit/loss if on the expiration date the stock price
is Rs. 52 or 78?
Solution : As explained above a Straddle strategy means buying a Call
option and a put option at the same strike price.
So the investor should buy a Call option and a put option on the share at a
Strike price of Rs. 67 per share and will pay Rs. 3 + 4 i.e. Rs. 7 as premium
amount.
Now if on expiry stock price = 52, the call option will not be exercised, but
Put option will be exercised. In that case
Payoff from Call = 0
Payoff from Put = 67-52 = 15
475 Solved problems
Net profit = Rs. 8

Further if on the expiry date stock price happens to be Rs. 78, then Call
option will be exercised but Put option will not be exercised. In that Case
Payoff from Call = (78-67) = 11
Payoff from Put = 0
Net profit = Rs. 4
Hence in both the situations, the investor will make a gain.
Problem 11.24 Equity shares of RSV Ltd. are currently available at a
price of Rs. 32 per share. Three call options are available at different strike
prices. The strike prices are Rs. 30, 35 and 40 per share for a premium of
Rs. 5, 4 and Rs. 2 respectively. An investor creates a Butterfly spread strat-
egy. Explain how he can do that. What would be his net profit/loss if on
the expiration date the stock price is Rs. 23, Rs. 33, 39 or Rs. 47?
Solution : A Butterfly strategy means buying a Call option at a lower strike
price, buy another call option at higher strike price and sell two call options
at middle strike price.
So the investor will create a butterfly spread by
u Buying a call option at Rs. 30 and pay premium Rs. 5
u Buying a call option at Rs. 40 and pay premium of Rs. 2
u Sell two call options at Rs. 35 and receive premium of Rs. 6 i.e.
(2 × 3)
So the net outflow of the investor is -1 (i.e. 6-5-2).
Now
(i) if on expiry stock price = 23, None of the call options will not be
exercised, hence his net loss will be -1 only.
(ii) if on expiry stock price = 33, then he will exercise the call option with
the strike price of Rs. 30. His payoff from call will be Rs. 3 (33-30). His
profit will be Rs. 2 (3-1) . The other two calls will not be exercised.
(iii) if on expiry stock price = 39, then he will exercise call option with
the strike price of Rs. 30. The two calls which he has sold at strike
price of Rs. 35 will be exercised by the holders of these options. In
this case his
payoff from Long Call = Rs. 9 (39-30),
Payoff from two Short Calls = -8 [ i.e. 2 × (35-39)]
Net payoff or profit = 9-8-1 = 0
(iv) if on expiry stock price = 47, then all the four calls will be exercised.
Now his payoffs:
Payoff from Long Call at strike price Rs. 30 = Rs. 17 (47-30),
Payoff from two Short Calls at strike price of Rs. 35 = -24 [ i.e. 2 ×
(35-47)]
Payoff from Long Call at strike price Rs. 40 = Rs. (47-40) = 7
Net payoff or profit = 17+7-24 -1 = Re. -1
Summary
u Derivatives are financial instruments whose value depend upon or derived
from one or more underlying assets.
u The most common underlying assets include stocks, bonds, commodities,
currencies, interest rates and market indexes.
u A forward is a private contract between two parties to buy or sell a specified
asset at a pre-determined price.
u A futures contract is a contract wherein two parties agree to buy or sell a
specified financial instrument or physical commodity for future delivery at a
pre-agreed price. Futures contracts are traded on an exchange and are well
regulated.
u For pricing a futures contract we use Cost of Carry Model.
u Futures contract can be used for the purpose of hedging as well as for specu-
lation.
u A long position in stocks can be hedged by selling futures.
u A short position in stocks can be hedged by buying futures.
u An option is a contract sold by one party (option-writer) to another party
(option holder). The option contract gives its holder the right, but not the
obligation, to buy (call) or sell (put) a security or other financial asset at a
specified price on or before the expiration date.
u A call option gives its holder a right to buy while a Put option gives its holder
a right to sell.
u An American style option can be exercised at any time before the expiration
or on the expiration date while a European style option can only be exercised
on the expiration date.
u Different factors like Share price, exercise price, volatility of the share return,
interest rate and time to expiration, affect the value of a share option.
u Models like Black-Scholes Model and Binomial Model are used to value a call
option.
477 Test Yourself
Test Yourself
True/False
a. Derivatives are same as shares and debentures.
b. Forwards and Futures are same.
c. Futures have a theoretical price.
d. Options give unlimited profit potential to seller always.
e. Futures and options are available on the shares in India.
f. Expiry date of option contract is mutually decided by the parties.
g. Loss of call option holder and put option holder is always limited.
h. Intrinsic value of option is positive or zero.
i. American options can be exercised at expiry only.
j. Put and call options are inverse of each other.
k. Futures and options are used only for hedging.
[Answer-(a) F (b) F (c) T (d) F (e) T (f) F (g) T (h) T (i) F (j) F (k) F]
Theory Questions
1. What are Financial Derivatives? Who all are the major participants in the
derivative market? How would you distinguish between futures and options?
(B.Com (H) DU 2007)(Paras 11.2, 11.3, 11.5)
2. What do you mean by forwards? What are their features? (Para 11.4)
3. What are futures contracts? How futures are different from forwards?
(B.Com (H) DU 2009, 2011)(Para 11.5)
4. How the futures contracts can be priced under different situations?
(Para 11.5)
5. Differentiate between forwards and futures.
(B.Com (H) DU 2014)(Para 11.5)
6. What is an option? What is the difference between a put option and call
option? (Para 11.6)
7. Differentiate between options and futures. (Paras 11.5 & 11.6)
8. Show the payoff diagrams of an investor who is:
a. a buyer of a call option
b. a seller of call option
c. a buyer of put option
d. a seller of put option (Para 11.6)
9. Explain when a call option and a put option are in the money, at the money
and out of the money? (Para 11.6)
10. Differentiate between

i. Call option and Put option
ii. American Option and European option (B.Com (H) DU 2014)
iii. Futures and Forwards
iv. Futures and Options (B.Com (H) DU 2014)
v. In the Money and Out of Money options (Paras 11.6, 11.5)
11. How a call option is different from a Put option? What do you mean by ex-
ercising an option? (B.Com (H) DU 2008) (Para 11.6)
12. What are the assumptions of Black – Scholes approach for option pricing?
What are the attributes of the model? (Para 11.6)
13. What do you mean by option strategies? Explain Straddle strategy with ex-
ample. (Para 11.6)
14. Explain Butterfly spread strategy using options. When is it used?
(Para 11.6)
15. Elaborate the development of financial derivatives market in India.
(Para 11.7)
16. Write a detailed note on National Securities Clearing Corporation of India
Ltd. (NSCCL). (Para 11.7)
Practical Problems
1. A share of the company is available at Rs. 2500. If the risk free rate of return
is 7% per annum compounded continuously and dividend yield is 5% p.a. What
will be the futures price of share after 3 months?
[Answer-Rs. 2512.53]
2. The market price of the share is Rs. 250 at present. The risk free rate is 8%.
Find out the price of futures contract when the time period of futures contract
is 3 months.
[Answer- Rs. 255.05]
3. An investor buys 300 shares of ABC Ltd. @ Rs. 210 per share in the cash
market. In order to hedge, he sells 200 futures of ABC Ltd @ Rs. 195 each.
The share price and the future price decline by 5% and 3% the very next day.
He closes his position by counter transactions. Find out his profit or loss.
[Answer - Net Loss - Rs. 1980]
4. The current price of share is Rs. 700. Risk-free cost of financing is 15% and
the future period is one month. Find out the price of the futures contract.
[Answer - Rs. 708.80]
5. Risk-free interest rate in the market is 8% and the market price of the share
is Rs. 355. What is the price of a futures contract for 3 months period if the
dividend yield is 4% p.a.?
479 Test Yourself
6. Consider a 4-month index futures contract on 100 shares lot size. The cur-
rent value of the index is 1620 and continuously compounded dividend yield
expected on the underlying shares is 5% per annum and continuously com-
pounded risk free rate is 12% per annum. Calculate the price of one future
contract.
[Answer- Rs. 1658.24]
7. Consider a stock future contract on a non-dividend paying share which is
currently trading at Rs. 75. The futures contract mature in 3 months and the
continuously compounded risk free rate is 7% per annum. Calculate the price
of one future contract.
[Answer- Rs. 76.32]
8. The price of equity share of a company is Rs. 270. The risk free rate is 7% per
annum with continuous compounding. An investor wants to enter into a 2
months futures contract. Calculate the futures price. If this futures contract
is available at Rs. 260, should an investor buy it?
[Answer- Rs. 273.17, Buy]
9. The price of shares of XYZ Ltd. is Rs. 135. The risk free rate is 12% per annum
with continuous compounding. An investor wants to enter into a 6 months
forward contract. Calculate the forward price.
10. The stock index is currently valued at Rs. 4000 and the risk free rate is 9%.
Find out the futures price for a 4 month contract if the dividend yield is 3%.
[Answer- Rs. 4080.80]
11. The shares of RSY Ltd. are currently selling at Rs. 340 per share. The 4 months
futures contract on this share is available at Rs. 350. Should the investor buy
this futures contract if the risk free rate of interest is 12%?
[Answer- Rs. 353.88, Buy]
12. An investor buys Sensex futures at 24550 in the market lot of 200 futures. On
the settlement date, the Sensex is 24700. Find out his profit or loss for one lot
of futures.
[Answer- Profit Rs. 30000]
13. An investor buys 300 shares of ABC Ltd. @ Rs. 280 per share in the cash market.
In order to hedge his position, he sells 200 futures of ABC Ltd @ Rs. 270 each.
The share price and the future price decline by 5% and 4% the very next day.
He closes his position by counter transactions. Find out his profit or loss.
[Answer- Net loss Rs. 2040]
14. An investor buys NIFTY Futures contract for Rs. 300000 (lot size 200). On
the settlement date, the NIFTY closes at 1570. Find out his profit or loss, if
he pays Rs. 1500 as brokerage. What would be his position, if he has sold the
futures contract?
[Answer- Profit Rs. 12500 : Loss Rs. 15500]
15. The market price of equity shares of a company is Rs. 145 and the company
is expected to declare a dividend of Rs. 10 after 1 month. What should be the
futures price of three months futures contract if continuously compounded
risk free rate is 12%?
16. The market price of the equity share of KTR Ltd. is Rs. 55 in the spot market.
It has not been paying any dividend. The continuously compounding risk free
rate is 6% p.a. The three month futures price for the share is Rs 58. Should
the investor enter into 3-month futures contract?
[Answer- Rs. 55.83, Sell]
17. An investor buys ICICI Bank’s futures at Rs. 280 in the market lot of 100 fu-
tures. On the settlement date the market price of ICICI Bank’s share in spot
market is Rs. 295. Find out his profit or loss for one lot of futures.
[Answer- Profit Rs. 48.800]
18. An investor buys a SENSEX futures contract for Rs. 25,00,000 (lot size 100
futures). On the settlement date SENSEX closes at 25500. Find out his profit
or loss if he has paid a brokerage of Rs. 1200.
[Answer- Loss Rs. 10000]
19. The market lot size is 100 and the futures price is Rs. 1720. An investor takes
a long position in futures market and buys 10 lots. On the settlement date
the market price of the share is Rs. 1710. Find out the profit or loss to the
investor.
[Answer- Loss Rs. 10000]
20. Identify which of the following options will be exercised by the buyer of
option:
S. No. Strike price (Rs.) Nature of option Market price (Rs.)
1 200 Call 220
2 280 Put 260
3 235 Put 220
4 240 Call 240
5 252 Call 245
6 260 Put 285
7 215 Put 210
[Answer – 1 Yes 2 Yes 3 Yes 4 No 5 No 6 No 7 No]
21. A three month call option premium is Rs. 6 and 3-month put option premium
is Rs. 5. Assume that the exercise price for both the cases is Rs. 220, find out
the net pay-off of call option holder, call option writer, put option holder and
put option writer if the price of the share on the exercise day is
i. Rs. 200
ii. Rs. 210
481 Test Yourself
iii. Rs. 220

iv. Rs. 230
v. Rs. 240
[Answer- Call option holder : Rs. –6, –6, –6, 4, 14
Call option writer : Rs. 6, 6, 6, –4, –14
Put option holder : Rs. 15, 5, –5, –5, –5
Put option writer : Rs. 15, 5, –5, –5, –5]
22. Mr A purchased 3 months call option of 100 shares of Reliance Power at a
strike price of Rs. 200 per share and paid a premium of Rs. 30 per share. Find
his expected gain or loss if the actual price on expiration date is
i. Rs. 150
ii. Rs. 250
Also find out his break-even point.
[Answer- i. Loss Rs. 3000, ii. Profit Rs. 2000 Break even = Rs. 230.]
12 INVESTOR PROTECTION
C H A P T E R
LEARNING OuTCOMES
 Analyse role of SEBI and Stock Exchange in investor protection
 Understand Investor’s grievances and their redressal system
 Know SCORES, SEBI’s centralised web based system for inves-
tors’ complaints
 Explain Securities Ombudsman scheme
 Examine reforms of SEBI in Investor protection
 Know amendments in Listing agreement
 Understand Prohibition of Insider trading
 Explain Regulation of unpublished price sensitive information
 Know Investors’ awareness programmes of SEBI, NSE and BSE
 Know role of BSE in Investor protection
 Know role of NSE in Investor protection
 Explain Investors’ Activism in India
INTRODuCTION
Investor protection is one of the crucial elements of a growing securities
market. Investor protection focuses on making sure that investors are fully
informed about their purchases, transactions and the corporate affairs
and updates. Investor protection is a buzz word among the parties of the
482
483 ROLE OF SEBI IN INVESTOR PROTECTION Para 12.1
capital market, be it stock exchanges like BSE/NSE, market regulators like

SEBI, MCA, RBI, or Investors Association, or the companies themselves.
Various procedures, guidelines, rules and regulations have been issued in
the legislations to protect the ‘Investors’ right and repose their confidence.
Keeping the above in view, this chapter will help to understand the concept
and need for investor protection and education, rights and responsibilities
of investors, legal framework for investor protection in India, measures
taken for financial literacy in India and SEBI initiatives, etc.
12.1 ROLE OF SEBI IN INVESTOR PROTECTION

The Securities and Exchange Board of India is the regulator of capital
market in India. It was established in the year 1988 and was given statutory
powers on April 12, 1992 in accordance with the provisions of the Securities
and Exchange Board of India Act, 1992. The Preamble of SEBI describes
its basic functions. It reads as: “...to protect the interests of investors in
securities and to promote the development of, and to regulate the secu-
rities market and for matters connected therewith or incidental thereto”.
Thus, as it can be seen, the primary function of SEBI is the protection of
the investors’ interest.
The two broad objectives of SEBI are given below:
i. Conducive environment : SEBI aims at creating a proper and con-
ducive environment for raising money from capital market through
the rules, regulations, trade practices and guidelines. SEBI regulates
stock exchanges and other intermediaries in securities market such
as brokers, sub-brokers, marchant bankers, venture funds, mutual
funds, FII etc.
ii. Investor Protection and Education : SEBI aims at protecting investors
from fraudulent practices and educating investors so as to make
them aware of their rights as well as duties.
Measures taken by SEBI for Investor Protection

In order to protect the investors’ interest, SEBI has taken a number of
measures over the years in this regard. These measures are broadly clas-
sified as – (i) Issue of regulations and Guidelines, (ii) Investor education
and Public interest advertisements (iii) Grievance redressal system (iv)
disclosure requirements and (v) other measures.
(i) Issue of Regulations and guidelines
SEBI issues regulations and guidelines to companies, mutual funds,
portfolio managers, merchant bankers, underwriters, lead managers,
etc. These guidelines ensure transparency in their operations and
Para 12.2 Investor protection 484
avoid exploitation of investors by one way or the other. SEBI has

issued revised guidelines for Listing agreement. These guidelines are
provided later in the Chapter. SEBI has also issued Securities Om-
budsman Scheme Governed by SEBI (Ombudsman) Regulations,
2003. The details are provided later in this chapter.
(ii) Investor Education and Public interest advertisements
SEBI encourages the formation of investor associations that dissem-
inate information through newsletters. As on July 02, 2015, 18 Inves-
tor Associations are recognised by SEBI. Moreover, SEBI’s monthly
publications- Market Review and Newsletter informs and educates
the investors at large. SEBI issues public interest advertisements to
enlighten investors on the basic features of various instruments and
minimum precautions they should take before choosing an invest-
ment. All these efforts are made to create awareness among investors
about their rights and about remedies if problem arise. SEBI has also
established Investor’ Protection and Education Fund.
(iii) Grievance redressal system (Dealing with complaints of investors)
The investors can make complaints to SEBI in case they face any
problems relating to industrial securities and financial assets’ in-
vestment. The complaints generally relate to non-receipt of refund
orders, allotment letters, non-receipt of dividend or interest and
delays in the transfer of shares and debentures. SEBI is committed
to redress these complaints. SEBI Complaints Redressal System
(SCORES) facilitate investors to lodge their complaints online with
SEBI and view its status.
(iv) Disclosure requirements by companies
SEBI requires disclosure on various financial aspects of companies.
These provisions relating to disclosures are for the information and
protection of small and retail investors.
(v) Other measures
SEBI conducts inspection, inquiries and audits of stock exchanges,
intermediaries and self-regulating organisations and takes suitable
remedial measures wherever necessary. Further, it penalizes those
who undertake fraudulent and unfair trade practices.
12.2 INVESTOR’S GRIEVANCES AND REDRESSAL SYSTEM of

SEBI*
*(Source: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1340957586933.pdf)
485 Investor’s & redressal of SEBI Para 12.2
Investor Grievances
An investor may have a complaint against, a listed company or an inter-
mediary registered with SEBI. In the event of such complaint, the investor
should first approach the concerned company/intermediary against whom
there is a complaint.
Investors who are not satisfied with the response to their grievances received
from the brokers/Depository Participants/listed companies, can lodge
their grievances with the Stock Exchanges or Depositories. The grievance
can be lodged at any of the offices of the BSE/NSE located at Chennai,
Mumbai, Kolkata and New Delhi. In case of unsatisfactory redressal, BSE/
NSE has designated Investor Grievance Redressal Committees (IGRCs), or
Regional Investor Complaints Resolution Committees (RICRC). This forum
acts as a mediator to resolve the claims, disputes and differences between
entities and complainants. Stock Exchanges provide a standard format to
the complainant for referring the matter to IGRC/RICRC. The committee
calls for the parties and acts as a nodal point to resolve the grievances.
If the grievance is still not resolved, an investor can file arbitration under
the Rules, Bye laws and Regulations of the respective Stock Exchange/
Depository.
Handling of investor complaints in SEBI

SEBI has a dedicated department viz., Office of Investor Assistance and
Education (OIAE) to receive investor grievances and to provide assistance
to investors by way of education. Investors who are not satisfied with the re-
sponse to their grievances received from the Stock Exchanges/Depositories
can lodge their grievances with SEBI. Grievances pertaining to stock brokers
and depository participants are taken up with respective stock exchange
and depository for redressal and monitored by SEBI through periodic re-
ports obtained from them. Grievances pertaining to other intermediaries
are taken up with them directly for redressal and are continuously mon-
itored by SEBI. Grievances against listed company are taken up with the
respective listed company and are continuously monitored. The company
is required to respond in prescribed format in the form of Action Taken
Report (ATR). Upon the receipt of ATR, the status of grievances is updated.
Where the response of the company is insufficient/inadequate, follow up
action is initiated. If the progress of redressal of investor grievances by an
entity is not satisfactory, appropriate enforcement actions (adjudication,
direction, prosecution etc.) are initiated against such entity.
Types of complaints handled by SEBI

Complaints arising out of activities that are covered under SEBI Act, 1992;
Securities Contracts (Regulation) Act, 1956; Depositories Act, 1996 and
Rules and Regulations made thereunder and provisions that are covered
under Companies Act, 2013 are handled by SEBI. Various entities against
which complaints are handled by SEBI include the following :
u Listed companies
u Stock Brokers/Sub-brokers
u Stock Exchanges
u Depository
u Depository Participants
u Registrars to an Issue/Share Transfer Agent
u Mutual Funds
u Portfolio Managers
u Bankers to an Issue
u Collective Investment Schemes
u Credit Rating Agencies
u Custodians of Securities
u Debenture Trustees
u Merchant Bankers
u Underwriters
SEBI also has a separate department to look into market irregularities. If

any irregularities are found in trading in shares or manipulation in price or
violation of Insider trading regulations, the same can be reported to SEBI.
An important initiative recently taken by SEBI is the launch of a web portal
for lodging complaints. This is known as SCORES.
12.3 SCORES (SEBI Complaints Redress System)

SCORES is a web based centralized grievance redress system of SEBI. In
May 2012, The Securities and Exchange Board of India (SEBI) has initi-
ated SCORES, a centralised Web-based system for lodging and tracking
complaints (its website address is http://scores.gov.in). A complaint can be
filed on SCORES against listed companies and intermediaries registered
with SEBI, such as R&T agents, portfolio managers, depositories and its
participants, debenture trustees, credit rating agencies, custodians, stock
487 Scores Para 12.3
exchanges, asset management companies, collective investment schemes,

bankers to an issue, and brokers.
SCORES enables investors to lodge and follow up their complaints and
track the status of redressal of such complaints online from the above
website from anywhere. This enables the market intermediaries and listed
companies to receive the complaints online from investors, redress such
complaints and report redressal online. All the activities starting from lodg-
ing of a complaint till its closure by SEBI would be online in an automated
environment and the complainant can view the status of his complaint
online. An investor, who is not familiar with SCORES or does not have
access to SCORES, can lodge complaints in physical form at any of the
offices of SEBI. Such complaints would be scanned and also uploaded in
SCORES for processing.
The salient features of SCORES are:

u SCORES is web enabled and provides online access 24 × 7;
u Complaints and reminders thereon can be lodged online at any time
from any where;
u An email is generated instantaneously acknowledging the receipt of
complaint and allotting a unique complaint registration number to
the complainant for future reference and tracking;
u The complaint is forwarded online to the entity concerned for its
redressal;
u The entity concerned uploads an Action Taken Report (ATR) on the
complaint; SEBI peruses the ATR and closes the complaint if it is
satisfied that the complaint has been redressed adequately;
u The concerned investor can view the status of the complaint online
from the above website by logging in the unique complaint registra-
tion number;
u The entity concerned and the concerned investor can seek and pro-
vide clarification on the complaint online to each other;
u Every complaint has an audit trail; and
u All the complaints are saved in a central database which generates
relevant MIS reports to enable SEBI to take appropriate policy de-
cisions and or remedial actions, if any.
12.4 Securities Ombudsman

In order to ensure effective and transparent system of investors’ grievance
redressal, the scheme of Ombudsman has been provided under the SEBI
(Ombudsman) Regulations, 2003 and under Sec 11(1) of SEBI Act, 1992.
Important Definitions under Ombudsman scheme:
“Ombudsman” means any person appointed under regulation 3 of these
regulations and, includes Stipendiary Ombudsman;
“securities” means Securities as defined in clause (h) of section 2 of the
Securities Contracts (Regulation) Act, 1956.
“Stipendiary Ombudsman” means a person appointed under regulation 9
for the purpose of acting as ombudsman in respect of a specific matter.
Qualifications of an Ombudsman
In order to be appointed as an Ombudsman a person shall be -
i. a citizen of India;
ii. of high moral integrity ;
iii. not below the age of forty five years of age; and
iv. either
a. a retired District Judge or qualified to be appointed a District
Judge or
b. having at least ten years experience of service in any regulatory
body or
c. having special knowledge and experience in law, finance, cor-
porate matters, economics, management or administration for
a period not less than ten years, or
d. an office bearer of investors’ association recognised by the
Board having experience in dealing with matters relating to
investor protection for a period not less than 10 years.
Powers and Functions of Ombudsman:

The Ombudsman shall have the following powers and functions in general :-
(a) to receive complaints specified in regulation 13 against any interme-
diary or a listed company or both;
(b) to consider such complaints and facilitate resolution thereof by
amicable settlement;
489 Securities ombudsman Para 12.4
(c) to approve a friendly or amicable settlement of the dispute between

the parties;
(d) to adjudicate such complaints in the event of failure of settlement
thereof by friendly or amicable settlement.
For the purpose of carrying out his duties under these regulations, an
Ombudsman may require the listed company or any other party to provide
any information or document relating to the complaint.
12.4.1 Grounds of complaints:

A person may lodge a complaint on any one or more of the following
grounds either to the SEBI or to the Ombudsman concerned :-
i. Non-receipt of refund orders, allotment letters in respect of a public
issue of securities of companies or units of mutual funds or collective
investments schemes;
ii. Non-receipt of share certificates, unit certificates, debenture certifi-
cates, bonus shares;
iii. Non-receipt of dividend by shareholders or unit-holders;
iv. Non-receipt of interest on debentures, redemption amount of deben-
tures or interest on delayed payment of interest on debentures ;
v. Non-receipt of interest on delayed refund of application monies;
vi. Non-receipt of annual reports or statements pertaining to the port-
folios;
vii. Non-receipt of redemption amount from a mutual fund or returns
from collective investment scheme;
viii. Non-transfer of securities by an issuer company, mutual fund, Col-
lective Investment Management Company or depository within the
stipulated time;
ix. Non-receipt of letter of offer or consideration in takeover or buy-
back offer or delisting;
x. Non-receipt of statement of holding corporate benefits or any griev-
ances in respect of corporate benefits, etc;
xi. Any grievance in respect of public, rights or bonus issue of a listed
company ;
xii. Any of the matters covered under section 55A of the Companies Act,
1956;
xiii. Any grievance in respect of issue or dealing in securities against an

intermediary or a listed company.
Settlement by mutual agreement

As soon as it may be practicable so to do, the Ombudsman shall endeavour
to promote a settlement of the complaint by agreement or mediation be-
tween the complainant and the listed company or intermediary named in
the complaint. If any amicable settlement or friendly agreement is arrived
at between the parties, the Ombudsman shall pass an award in terms of
such settlement or agreement within one month from the date thereof and
direct the parties to perform their obligations. For the purpose of promoting
a settlement of the complaint, the Ombudsman may follow such procedure
and take such actions as he may consider appropriate.
Award on Adjudication
In the event the matter is not resolved by mutually acceptable agreement
within a period of one month of the receipt of the complaint the ombuds-
man, shall, based upon the material placed before him and after giving
opportunity of being heard to the parties, give his award in writing or pass
any other directions or orders as he may consider appropriate.
The award on adjudication shall be made by Ombudsman within a period of
three months from the date of the filing of the complaint. The Ombudsman
shall send his award to the parties to the adjudication to perform their
obligations under the award.
12.5 Other Regulators/Authorities to approach for

complaints other than those dealt by SEBI
An investor may also have complaint against other participants and inter-
mediaries in financial market such as banks, primary dealers, corporate
governance issues, insurance products etc.
Grievances pertaining to Regulator
Banks deposits and banking Reserve Bank of India (RBI)
Fixed Deposits with Non-Banking/Financial http://www.rbi.org.in
Companies (NBFCs) and other matters pertaining
to NBFCs
Primary Dealers
491 REFORMS BROUGHT UP BY SEBI Para 12.6
Fixed Deposits with manufacturing companies Ministry of Corporate Affairs

Unlisted companies (MCA) http://www.mca.
gov.in/
Mismanagement of companies, financial perfor-
mance of the company, Annual General Meeting,
Annual Report, minority shareholders interest,
non-receipt of preferential allotment shares, etc.
and corporate actions as per the court order such as
mergers, amalgamation, reduction of share capital/
par value, etc.
Nidhi Companies
Insurance Companies/Brokers/Agents/products Insurance Regulatory and
and Service Development Authority of
India (IRDA) .http://www.
irdaindia.org/
Commodities Now handled by SEBI after
the merger of Forwards
Market Commission with
SEBI on 28th Sept, 2015.
Pension fund Pension Fund Regulatory
and Development Authority
(PFRDA)
http://www.pfrda.org.in/
Monopoly and anti-competitive practices Competition Commission
of India (CCI) http://www.
cci.gov.in/
Chit Funds Registrars of Chit Funds of
the concerned state.
Housing Finance Companies National Housing Bank
(NHB) www.nhb.org.in
12.6 REFORMS BROUGHT UP BY SEBI

In a recent study by World Bank-“Doing Business 2015”, India has been
ranked 7th in the world in terms of ‘protecting minority investors’ –much
ahead of developed countries like the US, Japan, France and Germany. The
ranking improved due to the reforms brought up by the new Companies
Act and the SEBI amendments thereafter.
12.6.1 Amendments in Listing Agreement

In order to ensure transparency and better investor protection, during the
year 2014, a series of amendments were made to Clause 49 of the Listing
Agreement with the purpose of aligning it with the Companies Act, 2013.
Applicability:
The Clause 49 of the Listing Agreement shall be applicable to all listed
companies except:
a. Companies having paid up equity share capital not exceeding Rs. 10
crore and Net Worth not exceeding Rs. 25 crore, as on the last day
of the previous financial year;
b. Companies whose equity share capital is listed exclusively on the
SME Platforms.
Key provisions of listing agreement
(Adapted from NSE, Source: http://www.nseindia.com/content/us/ismr2014_C.pdf)
I. Board of Directors
u The Board of Directors of the company shall have an optimum
combination of executive and non-executive directors with at least
one woman director (applicable w.e.f. April 1, 2015) and not less than
fifty per cent of the Board of Directors comprising non-executive
directors.
u Where the Chairman of the Board is a non-executive director, at least
one-third of the Board should comprise independent directors and in
case the company does not have a regular non-executive Chairman,
at least half of the Board should comprise independent directors.
u A person shall not serve as an independent director in more than
seven listed companies. Further, any person who is serving as a whole
time director in any listed company shall serve as an independent
director in not more than three listed companies.
u The maximum tenure of independent directors shall be in accordance
with the Companies Act, 2013 and clarifications/circulars issued by
the Ministry of Corporate Affairs in this regard, from time to time.
[As per the Companies Act, 2013, an independent director shall hold
office for a term up to five consecutive years on the Board of a com-
pany, but shall be eligible for reappointment on passing of a special
resolution by the company. No independent director shall hold office
for more than two consecutive terms.]
u The company shall establish a vigil mechanism for directors and
employees to report concerns about unethical behaviour, actual or
suspected fraud or violation of the company’s code of conduct or
ethics policy.
493 Reforms brought up by SEBI Para 12.6
II. Audit Committee

u The Audit Committee shall have minimum three directors as members.
Two-thirds of the members of Audit Committee shall be independent
directors.
u The Chairman of the Audit Committee shall be an independent di-
rector.
u All members of Audit Committee shall be financially literate and at
least one member shall have accounting or related financial man-
agement expertise.
u The Audit Committee should meet at least four times in a year and
not more than four months shall elapse between two meetings.
u The role of the Audit Committee shall include:
i. Oversight of the company’s financial reporting process and
the disclosure of its financial information to ensure that the
financial statement is correct, sufficient and credible;
ii. Review and monitor the auditor’s independence and perfor-
mance, and effectiveness of audit process.
III. Nomination and Remuneration Committee
u The company through its Board of Directors shall constitute the
Nomination and Remuneration Committee which shall comprise at
least three directors. Chairman of the Committee shall be an inde-
pendent director.
u The chairperson of the company (whether executive or non-executive)
may be appointed as a member of the Nomination and Remuneration
Committee but shall not chair such Committee.
u The role of the Nomination and Remuneration Committee shall
include:
i. Formulation of the criteria for determining qualifications,
positive attributes and independence of a director; and rec-
ommend to the Board a policy relating to the remuneration of
the directors, key managerial personnel and other employees;
ii. Formulation of criteria for evaluation of Independent Directors
and the Board;
iii. Devising a policy on Board diversity
IV. Risk Management
u The Board shall be responsible for framing, implementing and mon-
itoring the risk management plan for the company.
u The company through its Board of Directors shall constitute a

Risk Management Committee. The Board shall define the roles and
responsibilities of the Risk Management Committee and may
delegate monitoring and reviewing of the risk management plan to
the committee and such other functions as it may deem fit.
u The majority of Committee shall consist of members of the Board
of Directors. Senior executives of the company may be members of
the said Committee but the Chairman of the Committee shall be a
member of the Board of Directors.
V. Related Party Transactions
u A Related Party Transaction (RPT) is a transfer of resources, services
or obligations between a company and a related party, regardless of
whether a price is charged.
u The company shall formulate a policy on materiality of Related Party
Transactions and also on dealing with Related Party Transactions.
u A transaction with a related party shall be considered material if
the transaction/transactions to be entered into individually or taken
together with previous transactions during a financial year, exceeds
10% of the annual consolidated turnover of the company as per the
last audited financial statements of the company.
u All Related Party Transactions shall require prior approval of the
Audit Committee. However, the Audit Committee may grant ‘omnibus
approval’ for Related Party Transactions proposed to be entered into
by the company subject certain conditions.
u All material Related Party Transactions shall require approval of the
shareholders through special resolution and the related parties shall
abstain from voting on such resolutions.
VI. Disclosures
u Details of all material RPTs shall be disclosed quarterly along with
the compliance report on corporate governance.
u As part of the directors’ report or as an addition thereto, a Manage-
ment Discussion and Analysis Report should form part of the Annual
Report to the shareholders.
u In case of the appointment of a new director or re-appointment of a
director, the shareholders must be provided with the detailed infor-
mation
VII. Report on Corporate Governance

u There shall be a separate section on Corporate Governance in the
Annual Reports of company, with a detailed compliance report on
Corporate Governance. Non-compliance of any mandatory require-
ment of this clause with reasons thereof and the extent to which the
non-mandatory requirements have been adopted should be specifically
highlighted.
u The companies shall submit a quarterly compliance report to the
stock exchanges within 15 days from the close of quarter as per the
prescribed format.
In order to conform to the SEBI circular regarding the mandatory appoint-
ment of one woman director within the given deadlines, Stock Exchanges,
BSE and NSE, has also penalised the non-compliant companies. As per
reports dated July 13, 2015, BSE has till date slapped fines on 530 listed
companies for failing to meet the deadline to appoint a women director and
boost gender diversity in their boardrooms. NSE had also sent out letters
informing 260 listed firms of its intention to levy fines. It must be noted.
There are 5,711 companies listed on BSE and 1,733 on NSE.
12.6.2 Regulation regarding prohibition of Insider Trading
Most of the corporate frauds and scandals in the corporate world and capital
markets are not planned and executed by outsiders of the organization,
but by their insiders. This is the reason why regulators and legislatures
are increasingly paying attention to this area and are trying to make the
regulations and penal provisions regarding insider trading.
Insider trading refers to transaction in securities of a public listed company,
by any insider or any person connected with the company, based on any
material yet non-published information, which have the ability to impact
on said company’s securities market price, for their personal advantage.
In the year 2013, SEBI set up a high level committee to review its two de-
cade old regulations under the chairmanship of N. K. Sodhi, former Chief
Justice. The committee has suggested fundamental changes to current reg-
ulations, aimed at improving predictability, clarity and deterrence. In 2015,
the said proposed regulations replaced the existing one. They are explained
below :
SECURITIES AND EXCHANGE BOARD OF INDIA (PROHIBITION
OF INSIDER TRADING) REGULATIONS, 2015
IMPORTANT DEFINITIONS
u “compliance officer” means any senior officer, who is financially
literate and is capable of appreciating requirements for legal and
regulatory compliance under these regulations and who shall be

responsible for compliance of policies, procedures, maintenance of
records etc.
u “connected person” means,-
(i) any person who is or has during the six months prior to the
concerned act been associated with a company, directly or
indirectly, in any capacity including
n by reason of frequent communication with its officers
or
n being in any contractual, fiduciary or employment rela-
tionship or
n being a director, officer or an employee of the company
or
n holds any position including a professional or business
relationship between himself and the company. Such a
portion allows such person, directly or indirectly, access
to unpublished price sensitive information.
(ii) The persons falling within the following categories are deemed
to be connected persons unless the contrary is established,
(a) an immediate relative of connected persons specified in
clause (i); or
(b) a holding company or associate company or subsidiary
company; or
(c) an intermediary as specified in section 12 of the Act or
an employee or director thereof; or
(d) an investment company, trustee company, asset man-
agement company or an employee or director thereof;
or
(e) an official of a stock exchange or of clearing house or
corporation; or
(f) a member of board of trustees of a mutual fund or a
member of the board of directors of the asset man-
agement company of a mutual fund or is an employee
thereof; or
(g) a member of the board of directors or an employee, of
a public financial institution as defined in section 2(72)
of the Companies Act, 2013; or
(h) an official or an employee of a self-regulatory organiza-

tion recognised or authorized by the Board; or
(i) a banker of the company; or
(j) a concern, firm, trust, Hindu undivided family, company
or association of persons wherein a director of a company
or his immediate relative or banker of the company, has
more than ten per cent of the holding or interest;
u “generally available information” means information that is accessible
to the public on a non-discriminatory basis;
u “insider” means any person who is:
n a connected person; or
n in possession of or having access to unpublished price sensitive
information.
12.6.3 Regulation of Unpublished Price Sensitive Information

SEBI (Prohibition of Insider Trading) Regulations, 2015, primarily deal with
the regulation of unpublished price sensitive information. “Unpublished
price sensitive information” means any information, relating to a company
or its securities, directly or indirectly, that is not generally available and
which upon becoming generally available, is likely to materially affect the
price of the securities. It generally includes the information relating to the
following: –
(i) financial results;
(ii) dividends;
(iii) change in capital structure;
(iv) mergers, demergers, acquisitions, delistings, disposals and expansion
of business and such other transactions;
(v) changes in key managerial personnel; and
(vi) material events in accordance with the listing agreement.
Restrictions on communications and trading by corporate insiders
1. Communication or procurement of unpublished price sensitive
information.
Regulation 3 prohibits an insider from communicating, or providing
any unpublished price sensitive information, relating to a company
or securities, to any person including other insiders except where
such communication is in furtherance of legitimate purposes, perfor-
mance of duties or discharge of legal obligations. It further imposes a
prohibition on unlawfully procuring possession of unpublished price

sensitive information.
However, an unpublished price sensitive information may be com-
municated, in connection with a transaction that would:–
(i) entail an obligation to make an open offer under the takeover
regulations where the board of directors of the company is of
informed opinion that the proposed transaction is in the best
interests of the company;
(ii) not attract the obligation to make an open offer under the
takeover regulations but where the board of directors of the
company is of informed opinion that the proposed transaction
is in the best interests of the company and the information that
constitute unpublished price sensitive information is dissemi-
nated to be made generally available at least two trading days
prior to the proposed transaction being effected.
The regulation also instructs the board of directors to require the
parties to execute agreements to contract confidentiality and non-dis-
closure obligations on the part of such parties and such parties shall
keep information so received confidential.
2. Trading when in possession of unpublished price sensitive informa-
tion.
Regulation 4 prohibits the insiders to trade in securities that are listed
or proposed to be listed on a stock exchange when in possession of
unpublished price sensitive information.
Exemptions: –
the transaction is an off-market inter-se transfer between promot-
ers who were in possession of the same unpublished price sensitive
information;
in the case of non-individual insiders: –
(a) the individuals who were in possession of such unpublished
price sensitive information were different from the individuals
taking trading decisions
(b) appropriate and adequate arrangements were in place to ensure
that these regulations are not violated;
(iii) the trades were pursuant to a trading plan.
3. Trading Plans
Regulation 5 gives an option to the persons who may be in posses-
sion of unpublished price sensitive information and enabling them
to trade in securities in a compliant manner. This provision enables

the formulation of a trading plan by an insider to enable him to plan
for trades to be executed in future.
(1) An insider shall be entitled to formulate a trading plan and
present it to the compliance officer for approval and public
disclosure pursuant to which trades may be carried out on his
behalf in accordance with such plan.
(2) Such trading plan shall:–
(i) not entail commencement of trading on behalf of the
insider earlier than six months from the public disclosure
of the plan;
(ii) not entail trading for the period between the twentieth
trading day prior to the last day of any financial period
for which results are required to be announced by the
issuer of the securities and the second trading day after
the disclosure of such financial results;
(iii) entail trading for a period of not less than twelve months;
(iv) not entail overlap of any period for which another trading
plan is already in existence;
(v) set out either the value of trades to be effected or the
number of securities to be traded along with the nature
of the trade and the intervals at, or dates on which such
trades shall be effected; and
(vi) not entail trading in securities for market abuse.
(3) The trading plan once approved shall be irrevocable and the
insider shall mandatorily have to implement the plan.
(4) Upon approval of the trading plan, the compliance officer shall
notify the plan to the stock exchanges on which the securities
are listed.
Disclosures by trading insiders
Regulations 6 and 7 deal with disclosures of trading by insiders. Some of
the noteworthy points are as follows:
u The disclosures shall also include trading in derivatives of securities.
u Such disclosures shall be maintained by the company for a minimum
period of five years.
u Disclosures by certain persons are further classified as Initial Disclo-
sures and Continual Disclosures.
TYPE BY WHOM TO WHOM WHEN

Initial Disclosures Every promoter, Company within thirty days
key managerial of these regulations
personnel and di- taking effect(These
rector Regulations are effec-
tive from 120th day of
the date of notification
i.e. on and from 15th
May, 2015)
Every person on Company within seven days of
appointment as such appointment or
a key managerial becoming a promoter
personnel or a
director of the
company or upon
becoming a pro-
moter
Continual Every promoter, Company within two trading
Disclosures employee and di- days of such transac-
rector tion if the value of the
securities traded, over
any calendar quarter,
aggregate to a traded
value in excess of ten
lakh rupees.
Every company Stock exchange particulars of such
on which the se- trading within two
curities are listed trading days of receipt
of the disclosure or
from becoming aware
of such information
Codes for fair disclosure and conduct
Regulation 8 requires every listed company to formulate and publish a
code of practices and procedures for fair disclosure of unpublished price
sensitive information, on its official website. The practices and amend-
ments thereto shall be promptly intimated to the stock exchanges where
the securities are listed.
12.7 INVESTORS’ AWARENESS

With the advent of technologically advanced financial markets and in the
light of corporate scandals and frauds, it is imperative on the part of in-
vestors to be aware about the general market conditions and environment
501 Investors’ Awareness Para 12.7
before investing. An aware investor will make a right choice and will not
come into trap of dubious and Ponzi schemes. Various institutions, market
regulator and stock exchanges have taken the initiative to conduct inves-
tors’ awareness programmes some of the key initiatives are given below :
1. SEBI
u SEBI is using platforms like TV, radio and print newspapers for
investor education and awareness programmes. It has carried
out campaigns in 13 languages including English, Hindi and
regional languages spoken across India.
u Moreover, SEBI has also decided to tap social media and other
popular internet and mobile platforms to make investors aware
about their rights and to safeguard them against possible frauds.
u In addition, SEBI also conducts investors awareness pro-
grammes through Resource Persons, Investor Associations,
Exchanges, Depositories and various trade bodies.
2. NSDL
u NSDL considers it necessary to create awareness about the
depository processes and reassure the investors about the safety
and benefits of depository system through multiple channels
of communication with investors. Investor Depository Meets
(IDMs) is an important communication channel used for this
purpose.
u It also conducts various Investor awareness programmes.
3. Stock Exchanges
u BSE and NSE, both try to educate the investors by their efforts
like guide to investors, specifying do’s and don’ts, sending in-
vestment alerts, etc.
u In an interesting move by NSE, the stock exchange tied up
with the railways and metro trains to reach out to passengers
expected to travel on these trains as part of their investor
education campaign. The campaign to spread awareness on
crucial do’s and don’ts with respect to online transactions and
NSE traded products — with the motto ‘Soch Kar, Samajh Kar,
Invest Kar’.
4. Ministry of Corporate Affairs
u The Ministry of Corporate Affairs (MCA) organises Investor
Awareness Programmes (IAPs) with the objectives of creating
awareness amongst the investors about fraudulent schemes
and facilitating informed investment decisions. The IAPs are

organized in association with the three Professional Institutes,
namely, Institute of Chartered Accountants of India, Institute
of Company Secretaries of India and Institute of Cost Accoun-
tants of India.
u MCA also hosts website http:/www.iepf.gov.in for providing
simple and user friendly educational and awareness content to
all the investors. This website provides information on various
aspects such as role of capital market, IPO investing, Mutual
Fund Investing, Stock Investing, Stock Trading, Depository
Account, Debt Market, Derivatives, Indices, Indices (comic
strip), Index Fund, Investor Grievances & Arbitration (Stock
Exchanges), Investor Rights & Obligations, Do’s and Don’ts etc.
u MCA publishes a comprehensive guide in English and two small-
er booklets in English, Hindi and 11 vernacular languages for
use of investors. The same are distributed to all the investors
participating in the investor awareness programmes.
u It has created facility on the MCA21 website for lodging investor
complaints and for tracking their status.
12.7.1 SEBI Investor Protection and Education Fund

SEBI has established an Investor Protection and Education Fund in exercise
of the powers conferred by section 30 of SEBI Act, 1992. SEBI made the
SEBI (Investor Protection and Education Fund) Regulations, 2009 for the
regulation of such a fund. Important provisions of the fund are explained
below.
Contribution to the fund

Regulation 4 provides for the amounts to be credited to the Fund. The
following amounts shall be credited to the Fund:
(a) Contribution as may be made by SEBI to the Fund;
(b) Grants and donations given to the Fund by the Central Government,
State Government or any other entity approved by SEBI for this
purpose;
(c) Security deposits, if any, held by stock exchanges in respect of public
issues and rights issues, in the event of de-recognition of such stock
exchanges;
503 Investors’ awareness Para 12.7
(d) Amounts in the Investor Protection Fund and Investor Services Fund
of a stock exchange, in the event of de-recognition of such stock ex-
change;
(e) Amounts forfeited for non-fulfilment of obligations specified in reg-
ulation 15B of the SEBI (Buy-back of Securities) Regulations, 1998;
(f) Amounts disgorged under section 11B of the Act or section 12A of
the Securities Contracts (Regulation) Act, 1956 or section 19 of the
Depositories Act, 1996
(g) Interest or other income received out of any investments made from
the Fund;
(h) Such other amount as SEBI may specify in the interest of investors
Utilisation of Fund.
Utilisation of fund
The Fund shall be utilised for the purpose of protection of investors and
promotion of investor education and awareness. The Fund may be used
for the following purposes, namely:-
(a) Educational activities including seminars, training, research and
publications, aimed at investors;
(b) Awareness programmes including through media - print, electronic,
aimed at investors;
(c) Funding investor education and awareness activities of Investors’
Associations recognized by the Board;
(d) Aiding investors’ associations recognized by the Board to undertake
legal proceedings in the interest of investors in securities that are
listed or proposed to be listed;
(e) Refund of the security deposits which are held by stock exchanges
and transferred to the Fund consequent on derecognition of the
stock exchange as mentioned in clause (d) of regulation 4, in case
the concerned companies apply to the Board and fulfil the conditions
for release of the deposit;
(f) Expenses on travel of members of the Committee, who are not officials
of the Board, and special invitees to the meetings of the Committee,
in connection with the work of the Committee;
(g) Salary, allowances and other expenses of office of Ombudsman; and
(h) Such other purposes as may be specified by the SEBI.
12.8 ROLE OF STOCK EXCHANGES IN INVESTOR PROTECTION

Most of the trading in the Indian stock market takes place on its two leading
stock exchanges: the Bombay Stock Exchange (BSE) and the National Stock
Exchange (NSE). BSE is the oldest stock exchange in existence. It started
its operations in the year 1875. On the other hand, the NSE was founded
in 1992 and started trading in 1994. However, both exchanges follow the
same trading mechanism, trading hours, settlement process, etc.
12.8.1 BSE initiatives for Investor Protection

The following paragraphs explain some important initiatives on the part
of BSE for protecting investors’ interest.
1. Department of Investor Services
To protect the interest of investors, BSE set up a Department of
Investor Services in the year 1986. The department redresses the
grievances of investors against listed companies and BSE Trading
Members. Moreover, it assists in the arbitration process both, between
Trading Members inter-se and between Trading Members and non
- Trading Members. Since its establishment, the DIS has played an
important role in enhancing and maintaining investors’ faith and
confidence. The services offered by DIS are as follows:
(a) Investors’ Grievances against Listed Companies
u Investors’ complaints against listed companies are for-
warded by BSE to the concerned companies, with a copy
sent to the complainant.
u The investors are advised to inform BSE if the complaints
are not resolved within 30 days.
u If a company fails to redress the complaint within 30
days, BSE sends a reminder to the company.
u BSE follows-up with the companies and/or their Registrar
& Transfer Agents, to resolve such complaints.
u If the total number of pending complaints against a com-
pany exceeds 25 and remain unresolved by the company
for more than 45 days, then steps are initiated by BSE
to suspend trading in the securities of such company till
the complaints are resolved. BSE may also transfer such
scrips to, “Z” Group.
u A “Z” category company indicates that it has not complied
with various provisions of the listing agreement includ-
505 Role of stock exchanges in investor protection Para 12.8
ing non-resolution of investors’ complaints. Through

creation of “Z” category, BSE cautions investors to be
more careful in their investments in such companies.
u Investors are expected to submit their complaints in
the prescribed complaint form to the nearest Regional
Investor Service Centre of BSE on the basis of an inves-
tor’s address.
(b) Investors’ Grievances against BSE’s Trading Members
u The complaints of investors against BSE’s Trading
Members are forwarded to the concerned Trading
Members for resolution.
u Trading Members to reply the same within 3 working
days from receipt of the complaint from BSE.
u In case no reply is received from the Trading Member
or the reply received from the Trading Member does
not satisfy the complainant, the same is placed before
Investors’ Grievances Redressal Committee (IGRC).
u BSE provides services of IGRC which, in its meetings,
mediates and counsels the disputing parties for finding
amicable solution, for which the Exchange sends Notice
to both parties to remain present before the said IGRC.
u In cases, where an amicable solution cannot be reached,
IGRC suggests the complainant to opt for an arbitration if
they so desire. It records the final outcome in the matter
in the form of minutes, a copy of which is handed over
to the parties or mailed to an absent party.
u The Exchange levies penalties on the Trading Member for
not replying within the specified period to the complaints
forwarded or not attending the IGRC meetings. Further,
in case the Trading member fails to implement what is
agreed before IGRC as recorded in the said minutes
of the IGRC, the Exchange places the same before the
Disciplinary Action Committee levies the penalties.
u The complaints amounting to less than Rs. 25,00,000 is
heard by the IGRC comprising of one member’ and those
amounting to more than Rs. 25,00,000 are heard by the
IGRC comprising of three members.
u The Exchange has formed separate IGRCs, for each
Regional Investor Service Centre to deal with the cases.
It will be in the interest of investors to ascertain the con-

cerned Regional Investor Service Centre for filing his/
her complaint, since the period consumed in redressal
of complaint through IGRC will not be considered while
measuring period of ‘limitation’ in filing arbitration ap-
plication.
(2) Visit of Registrar & Transfer Agents to BSE
BSE regularly organizes visits of Registrars & Transfer Agents (RTAs)
at its Registered Office to allow Trading Members and investors to
have direct interface with them for redressal of complaints against
companies listed on BSE.
(3) Investor Protection Fund
BSE set up an Investor Protection Fund (IPF) on July 10, 1986 to
compensate the clients who suffer financial loss due to their member
being declared as defaulter, in accordance with the Guidelines issued
by the Ministry of Finance, Government of India. IPF is managed by
the Trustees appointed by BSE.
(4) Compensation Policy
At present the Exchange compensate to the maximum extent of
Rs. 15,00,000 to the client of a defaulter from its Investors Protection
Fund (IPF). The amount is paid to the extent of award amount or Rs.
15,00,000, whichever is lower. The revised amount of Rs. 15,00,000/-
is applicable to the clients of the Trading Member of the Exchange,
who are declared Defaulter after 5th December, 2009.
(5) Defaulters Committee
The arbitration Award obtained by investors against defaulters are
scrutinized by the Defaulters Committee, a Standing Committee
constituted by BSE, which may recommend to the Trustees of the
Fund for release the payment as per the applicable limits to the cli-
ents of Trading Members which have been declared Defaulter. After
the approval of the Trustees of the Fund, the amount is disbursed
to the investors from the Fund. Those claims which are permissible
for payment from IPF as per the Trust Deed are considered by the
Defaulters’ Committee for recommending payment from the fund.
(6) Investor Awareness Program
Investor Awareness Programs are being regularly conducted by
BSE at various places in the country to educate the investors and to
create awareness among the investors regarding the capital market
and in particular the working of the stock exchanges. The Investor
507 Role of stock exchanges in investor protection Para 12.8
Awareness Programs cover topics like Do’s and Don’ts for investors,
Instruments of Investment, Portfolio approach, Mutual funds, Trading,
Clearing and Settlement, Rolling Settlement, Investors’ Protection
Fund, Trade Guarantee Fund, Dematerialisation of Shares, Debt
Market, Investors’ Grievance Redressal system available with SEBI,
BSE & Company Law Board, information on S&P BSE Sensex and
other Indices, Derivatives etc.
(7) Investor Education Programs
BSE Training Institute (BTI) which organises investor education
programs periodically on various subjects like Capital Markets, Fun-
damental Analysis, Technical Analysis, Derivatives, Index Futures and
Options, Debt Market etc. For the Derivatives market, BTI conducts
BCDE i.e. BSE’s certification on Derivative Exchange, a certification
test recognized by the SEBI.
12.8.2 NSE initiatives for Investors’ Protection

NSE has taken following initiatives for investors’ protection:
(1) NSE Investor Services Cell
u To cater to the needs of investors, NSE has established its
Investor Services Cell at Mumbai, Chennai, Kolkata, New Delhi,
Ahmedabad, Hyderabad, Indore, Kanpur, Pune, Bangalore,
Jaipur, Vadodara, Patna and Lucknow.
u The Investor Services Cell facilitates resolution of complaints
of investors against the listed corporate entities and NSE mem-
bers.
u NSE has accorded high priority for resolution of investor
complaints and therefore the activities of Investors Services
Cell are supervised by a Board Sub-Committee exclusively
constituted for the purpose.
u The Investor Services Cell also renders administrative assistance
to arbitration proceedings in respect of arbitration cases that
are admitted for Arbitration under the Exchange’s Arbitration
Framework.
Types of complaints taken up by Investors’ grievance cell (IGC)
The IGC takes up complaints for redressal in respect of:
u Trades executed on the NSE through its NEAT terminal
and routed through the NSE trading member or SEBI
registered sub-broker of NSE trading member.
u Trades pertaining to Companies traded on the NSE.
(2) NSE investor protection fund

u NSE has established an Investor Protection Fund with the objec-
tive of compensating investors in the event of defaulters’ assets
not being sufficient to meet the admitted claims of investors,
promoting investor education, awareness and research.
u The Investor Protection Fund is administered by way of reg-
istered Trust created for the purpose. The Investor Protection
Fund Trust is managed by Trustees comprising of Public repre-
sentative, investor association representative, Board Members
and Senior officials of the Exchange.
u The Investor Protection Fund Trust, based on the recommenda-
tions of the Defaulters’ Committee, compensates the investors
to the extent of funds found insufficient in Defaulters’ account
to meet the admitted value of claim, subject to a maximum
limit of ` 15 lakhs per investor per defaulter/expelled member.
(3) Complaints management at NSE
Complaints against trading members/registered sub-brokers
u Complaints received from the investor are forwarded to the
respective trading member/registered sub-broker asking them
to provide their comments or for resolving the case.
u The trading members are expected to file their replies within
15 days. In case of the trading member/registered sub-broker
disputes the claim of the investor, the response of the trading
member is forwarded to the investor.
u If required both the parties are called for a joint meeting. Most
of the complaints are resolved in this manner. In cases where
the disputes remain unresolved in IGC, the parties may refer
the matter for arbitration if they so desire.
Complaints against Companies
u Complaints received from the investors are forwarded to the
respective Companies/Share Transfer Agents for necessary
action at their end.
u In case no response is received from the Company/Share
Transfer Agents within 21 days, a follow up by way of letters,
telephone calls and personal meeting is undertaken to expedite
their replies.
509 INVESTORS’ ACTIVISM Para 12.9
12.9 INVESTORS’ ACTIVISM

A new term in the context of investor education and awareness is Investors’
activism. Investors’ activism is a way in which investors can influence a
corporation’s behaviour, either through its management or otherwise, by
exercising their rights. The issue of investor activism has been a prominent
one in the western part of world for many years. However, in India, the
topic has come to the fore only in the last couple of years. Recent develop-
ments in the Indian corporate world have laid the foundation of investors’
activism in India. One key form of such activism is the availability of class
action suits for securities law violations by companies, their promoters or
managers. The Companies Act, 2013 together with revised SEBI regulations
is paving the way for investors’ empowerment.
Companies Act SEBI Regulations
Institutional
Participation
Class Action
(Sec 245)
Electronic Voting
Related Party (Sec 108) (Clause 49 – Listing Agreement)
Transactions (Sec 188) u Minority Shareholder Approval
u Independent directors
Small Shareholder
Director (Sec 151)
Figure 12.1: Companies Act and SEBI regulations: Empowering Investors
(Source: http://www.blog.sanasecurities.com/shareholder-activism-india/)
Class Action Suit - Section 245 of Companies Act, 2013 introduces a
1.
new concept of class action suits which can be initiated by sharehold-
ers and depositors against the company, its directors and auditors.
Small Shareholder Director - Small shareholder means a shareholder
2.
holding shares of nominal value of not more than twenty thousand
rupees or such other sum as may be prescribed. Section 151 of the
Act requires listed companies to appoint at least one director elected
by small shareholders.
Related Party Transaction - Section 188 of the Act has widened the
3.
scope of restricted transactions, including various kinds of transac-
tions which require consent of the board of directors.
Electronic voting - Section 108 provide for electronic voting on
4.
shareholder resolutions, allowing minority stakeholders to have their
say, without coming from distant locations or relying upon postal
ballots. Further, SEBI has amended the listing agreement requiring
large companies to provide electronic voting facilities in respect of

matters requiring postal ballot.
Clause 49 of Listing Agreement - SEBI has amended the provisions
5.
of Clause 49 in order to align with the new Act. More thrust has been
given on appointments of independent and woman director. These
changes have already been discussed in the chapter.
Institutional Investors - Continuous efforts are being made by both
6.
SEBI and the Government to encourage participation of mutual
funds and other leading institutions in corporate decision making.
12.9.1 Investors’ Activism in India

The following table shows important instances of investors’ activism in India
Target Activist When What happened?
Company
Digital Minority June 2003 Investors were concerned about the
Globalsoft Shareholders price being paid by Digital GlobalSoft
for HP’s software business (HPISO)
and also the deal was not beneficial
for the public shareholders of the
company.
Satyam Minority December Institutional investors forced Satyam
Computers Shareholders 2008 Computer Services to call off its
(now ac- $1.6bn twin deals to acquire Maytas
quired Properties and Maytas Infra, con-
by Tech trolled by the sons of the company’s
Mahindra) Chairman.
Coal India The August TCI filed a case against Coal India
Childrens’ 2012 (CIL) and the Government of India to
Investment prevent CIL from signing Fuel Supply
Fund (TCI) Agreements (FSA) guaranteeing lower
than market prices to private firms.
TCI eventually started selling CIL
stock in 2013 and doesn’t hold CIL
stock now.
Maruti Minority Jan-Feb Domestic mutual funds opposed the
Suzuki Shareholders 2014 plan of Suzuki Motor, which owns
56% of Maruti, to invest USD 488m
in the Gujarat plant and to sell cars
for the plant to Maruti, going back on
an earlier plan that would have seen
Maruti set up the factory itself.
511 Investors’ activism Para 12.9
Target Activist When What happened?

Company
Holcim, Minority Jul-13 Holcim approached shareholders to
Ambuja Shareholders increase its royalty payments from
Cements subsidiary Ambuja Cements. 88.6%
of the minority shareholders voted
against it. However, the proposal was
passed with the promoter sharehold-
ing (> 50%).
Alstom Minority Feb-14 Alstom Transport India, a wholly
India, Shareholders owned subsidiary of French engineer-
Alstom ing major Alstom, bought the trans-
Transport portation division of Alstom India,
India another arm of Alstom for INR1.77b,
a figure lower than the division’s
sales for the previous 12 months. 94%
of the institutions voted against the
resolution but it still went through
as the promoter holding of 68.5%
outweighed institutional holding.
Cadbury Minority July 2014 Shareholders of the company felt that
India Ltd. Shareholders they deserve a higher price for their
shares in the company and have chal-
lenged the buyback price. The Bombay
high court directed the company to
pay Rs. 2,014.50 per share to buy back
its share. This was 50% more than its
original offer of Rs. 1,340 made in 2009.
Tata Motors Minority July 2014 Minority shareholders rejected pro-
Shareholders posed executive compensation pack-
age for several of the company’s
directors, after the company reported
a net loss for the year.
Siemens Minority July 2014 Siemens was forced to raise its offer
Shareholders price to buy out the metal technologies
business of its listed Indian subsidiary,
after shareholders rejected the initial
offer.
United Minority November Diageo had to change certain plans
Spirits of Shareholders 2014 when minority shareholders of United
Diageo Spirits, its Indian subsidiary, rejected
a proposal to make, sell and distribute
spirits with some of the brands of its
UK-based parent company.
(Source: BNP Paribas Asia Strategy Report and other Media Reports)
Investor protection 512
Summary
u Investor protection focuses on making sure that investors are fully informed
about their purchases, transactions and the corporate affairs and updates.
u The primary function of SEBI is the protection of the investors’ interest.
u SCORES is a web based centralized grievance redress system of SEBI.
u Insider trading refers to transaction in securities of a public listed company, by
any insider or any connected person, based on any material yet non-published
information, which have the ability to impact on said company’s securities
market price, for their personal advantage.
u SEBI (Prohibition of Insider Trading) Regulations, 2015 replaced the 1992
Regulations.
u Various institutions, market regulator and stock exchanges have taken the
initiative to conduct investors’ awareness programmes.
u Investors’ activism is a way in which investors can influence a corporation’s
behaviour, either through its management or otherwise, by exercising their
rights.
Test Yourself
True/False
i. Investors’ protection is about how to handle investors’ complaints.
ii. SEBI is the market regulator of Indian capital market.
iii. Stock exchanges have not taken any initiative for investors’ education and
awareness.
iv. Investors’ grievances are not redressed by the companies themselves.
v. Insider trading refers to use of financial statements information by company
officer.
vi. Regulation of stock market is a pre-requisite to investors’ protection.
vii. SEBI aims to provide for redressal of investors’ grievances.
viii. Trading plan allows insiders possessing unpublished price sensitive informa-
tion to trade in securities in a compliant manner.
[Answers: (i) F (ii) T (iii) F (iv) F (v) F (vi) T (vii) T (viii) T]
Theory Questions
1. What do you mean by Investor Protection? Explain the role of SEBI in this
regard. [Para 12.1]
2. Write a lucid note on the role of SEBI in investors’ protection. What are the
objectives of the constitution of SEBI? (B. Com(H)DU 2011), [Para 12.1]
513 Test Yourself
3. List out some of the grievances of Investors. How can they be addressed?
[Para 12.4]
4. What is SCORES? Explain the procedure to lodge complaint under
SCORES. [Para 12.3]
5. Stock exchanges play an important role in safeguarding investors. Discuss
the statement mentioning the measures adopted by BSE and NSE in this
regard. [Para 12.8]
6. What are the important amendments made by SEBI and Companies Act,
2013 in listing agreement? Explain in brief. [Para 12.6.1]
7. What are the types of investors’ grievances dealt by SEBI?
(B. Com (H)DU 2008) [Para 12.2]
a. Investor Protection (B. Com (H)DU 2012, 2013) [Para 12.1]
b. SCORES [Para 12.3]
c. Investor Education and Protection Fund [Para 12.7.1]
d. Insider Trading (B. Com (H) DU 2012, 2013) [Para 12.5.2]
e. Investors’ activism [Para 12.9]
f. Unpublished price sensitive information [Para 12.6.3]
g. Uses for SEBI Investor Protection and Education Fund [Para 12.7.1]
h. Securities Ombudsman Scheme [Para 12.4]
9. “Investors’ activism keeps companies in check”. Shed some light on the above
statement by referring to some Indian corporate examples. [Para 12.9]
10. What do you mean by Securities Ombudsman? Under what circumstances
an investor can lodge a complaint with Securities Ombudsman?
(B. Com(H)DU 2010) [Para 12.4]
11. What do you mean by Insider Trading? Who is an insider as per SEBI Guide-
lines?
(B. Com(H)DU 2009) [Para 12.6.2]
12. “An investor should be aware about his rights and responsibilities before
investing”. Do you agree? Elaborate. [Paras 12.1, 12.2]
13. Define the terms ‘unpublished price sensitive information’ and ‘connected
person’ as per SEBI Regulations on Insider Trading ? [Para 12.6.3]
14. What are the disclosure requirements as per SEBI Regulations on Insider
Trading? [Para 12.6.3]
B.Com. (Hons.) 2015
PAPER : FUNDAMENTALS OF INVESTMENT
(Admissions of 2006 and onwards)

Time allowed: 3 hours Maximum marks: 75
Attempt All questions.
All questions carry equal marks.
Q. 1. (a) Define investment. Discuss briefly the steps involved in the
investment decision process. 6
Ans. Chapter 1 [Paras 1.1, 1.7]
(b) An investor has choice to invest in one of the following two securi-
ties: 9
State of Economy Probability Return on A (%) Return on B (%)
Good 40% 16 20
Fair 40% 12 13
Bad 20% 3 -5
Which of the following two securities is good for investment?
(i) In terms of return
(ii) In terms of risk. 9
Sol.
State of Probability Return Expected RA – RA (RA – RA)2 P ×(RA – RA)2
Economy (P) on A (%) Return (RA)
(RA) (P × RA)
Good 0.40 16 6.4 4.2 17.64 7.056
Fair 0.40 12 4.8 0.2 0.04 0.016
Bad 0.20 3 0.6 -8.8 77.44 15.488
RA = 11.8 22.56
515
B.Com. (Hons.) 2015 Paper : FUNDAMENTALS OF INVESTMENT 516
Return, RA=11.8%
Standard deviation of A = ∑ P (r a − r a )2 = 22.56 = 4.75%
Coefficient of Variation = standard Deviation of a

ra
4.75
= = 0.4025 = 40.25%
11.8
State of Probability Return Expected (RB – RB) (RB – RB)2 P ×(RB – RB)2
Economy (P) on B (%) Return (RB)
(RB) (P × RB)
Good 0.40 20 8 7.8 60.84 24.336

Fair 0.40 13 5.2 0.8 0.64 0.256
Bad 0.20 –5 –1 – 17.2 295.84 59.168
RB = 12.2 83.76
Return, RB= 12.2%
Standard deviation of B = ∑ P (r B − r B )2 = 83.76 = 9.15%
standard Deviation of B 9.15

Coefficient of Variation = = = 0.75 = 75%
rB 12.2
(i) In terms of return, Security B yields more return than security A,
therefore Security B will be preferred.
(ii) But, risk measured by SD is more in case of Security B, therefore
Security A is preferable for investment in terms of risk.
Or
(a) Differentiate between:
(i) Forward and Future Chapter 11 [Para 11.5.3]
(ii) Money market and Capital market. Chapter 2 [Introduction] 6
Ans. (i) Forward and Future.
(ii) Money market and Capital market.
(b) An investor is considering investment in securities X and Y, whose
details are given below: 10
X Y
Risk (in terms of standard deviation) 4% 7%
517 B.Com. (Hons.) 2015 Paper : FUNDAMENTALS OF INVESTMENT
If a portfolio of 30% of X and 70% of Y is formed, find the:

(i) Expected return of portfolio
(ii) Risk of portfolio when correlation is -1.
(iii) Risk of portfolio when correlation is +1. 9
Sol. Chapter 9 Problem [9.19]
Q. 2. (a) What is meant by efficient market hypothesis? What are its various
forms? Explain with the help of a suitable diagram. 7
Ans. Chapter 7 [Para 7.3]
(b) A company is planning to issue debentures carrying a coupon rate of
6% p.a. (face value: ` 1,000) which will be redeemed after 3 years at its par
value. If the investors’ required rate of return is 10%, what should be the
value of the debentures if:
(i) Interest is payable annually
(ii) Interest is payable semi-annually. 8
Sol. Face value (FV) = ` 1,000 Number of years (n) = 3 years
Coupon Rate (Interest Rate) = 6% Redemption value (RV) = ` 1,000
Required rate of return (r) = 10% Interest Amount = ` 1,000 × 6% = ` 60
(i) Value of Debenture (D) = Interest (PVAFr,n) + RV (PVFr,n)
= ` 60 (PVAF10%,3) + ` 1,000 (PVF10%,3)
= ` 60 (2.487) + ` 1,000(0.751)
= ` (149.22 + 751) = ` 900.22
(ii) Value of Debenture (D) = Interest (PVAFr,n) + RV(PVFr,n)
= ` 60(PVAF5%,6) + ` 1,000(PVF5%,6)
= ` 60(5.076) + ` 1,000(0.746)
= ` (304.56 + 746) = ` 1050.56
Or
(a) Differentiate between fundamental analysis and technical analysis. 5
Ans : Chapter 6 [Para 6.2]
(b) ABC Ltd. declared dividend of ` 2 per share last year. The company
expects to maintain growth rate as per schedule given below:
Year 1 to 2 3 4 5th onwards
Growth rate (%) 10% 8% 10% 8%
The shareholders’ expected rate of return is 16%. Advise whether the share
is worth buying at ` 30. 10
Sol.
Year Expected Dividend (Rs.) (A) PVF16%,n (ke) Present value of Dividend
1 2(1.10) = 2.20 0.862 1.90
2 2.2(1.10) = 2.42 0.743 1.80
3 2.42(1.08) = 2.61 0.641 1.67
4 2.61 (1.10) = 2.87 0.552 1.58
Total 6.95
Price of share at the end of year fourth year:
D5 = 2.87(1 + 0.08) = ` 3.0996 ...where ke = Expected rate of
return or cost of
D5
P4 = equity
(
ke − g ) g = Growth rate
` 3.0996
P 4 = 0.16 − 0.08 = ` 38.745
Intrinsic Value of Share = PV of P4 +PV of Dividends
P0 (Present value) = ` 38.745 × PVR(16%,4) + ` 6.95
= ` 38.745 × 0.552 + ` 6.95 = ` 28.34
The share should not be purchased because the intrinsic value of share is
less than the market price of ` 30.
Q. 3. (a) Discuss various kinds of risks involved in bond investment. 5
(b) The bonds of XYZ Ltd. are currently available at a price of ` 750 (Face
value = ` 1,000). It has coupon rate of 6.5% and maturity period of 5 years.
Find the yield to maturity of the bond. If the bond is callable at ` 1,100 at
the end of 3 years from now, find the yield to call of the bond. 10
Sol. Approximate Yield to Maturity (YTM)
rV − P
1+
= n
rV + P
2
1, 000 − 750
`65 +
= 5

1, 000 + 750
2
` 65 +` 50 ` 115
= =
`875 ` 875 = 0.1314 or 13.14%
So, the discount rate must be taken as 13% and 14%.

Value of Bond (V) = Interest × PVAF(r,n) × RV × PVF(r,n)
At 13% Interest rate (Discount rate).
= ` 65 × PVAF(13%,5) + ` 1,000 × PVF(13%,5)
= ` 65 × 3.517 + ` 1,000 × 0.543
= ` (228.605 + 543) = ` 771.605
At 14% Interest rate (Discount rate)
= ` 65 × PVAF(14%,5) + ` 1,000 × PVF(14%,5)
= ` 65 × 3.433 + ` 1,000 × 0.519
= ` (223.145 + 519) = ` 742.145
YTM = Lower Discount rate +

(Higher value − market value) × Difference in rates
(Higher value − Lower value)
771.605 − 750 21.605

= 13 + ×1 ⇒ 13 +
771.605 − 742.145 29.46

= 13 + 0.73 = 13.73%
CV − P
I+
Approximation of Yield to Call (YTC) = c
CV + P
2
1,100 - 750
` 65 +
= 3
1,100 + 750
2
` 65 + 116.67 181.67
= = = 0.1964 = 19.64%
925 925
So, the discount rate must be taken as 20% & 21%.

Value of Bond (V) = Interest × PVAF(r,n) + CV × PVF(r,n)
At, 20% Interest rate (Discount Rate)
P0 = ` 65 × PVAF(20%,3) + ` 1,100 × PVF(20%,3)
= ` 65 × 2.106 + ` 1,100 × 0.579
= ` (136.89 + 636.9) = ` 773.79
At 21% Interest rate (Discount rate)
PO = ` 65 × PVAF(21%,3) + ` 1,100 × PVF(21%,3)

= ` 65 × 2.074 + ` 1,100 × 0.564
` 134.81 + 620.4 = ` 755.21
Since this is very close to the given price of ` 750, the accurate YTC will
be slightly higher than 21%.
Or
(a) The stock of ABC Ltd. currently sells for ` 20 per share. The stock
just paid dividend of ` 1 per share. The dividend is expected to grow at a
constant rate of 10% per year. What stock price is expected one year from
now? What is the required rate of return on the company’s stock? 5
Sol. Current Market Price (P0) = ` 20
Growth rate (g) = 0.10 Current Dividend (D0) = ` 1
Price after 1 year (P1) = ? Required Rate of Return (ke) = ?
Expected dividend after 1 year (D1) = D0(l + g) = ` 1 (1 + 0.10) = ` 1.1
D1
We know that P0 = ,
ke − g
` 1.1
So, ke = - D1 + g = + 0.10 ⇒ 0.055 + 0.10 = 0.155 or 15.5%.
P0 ` 20
Thus the required rate of return is 15.5%.
The expected stock price one year from now = P0(1+g) = 20(1+0.10) = E22.
(b) The shares of PQR Ltd. are currently trading at ` 150. It declared div-
idend per share of ` 8 last year. The dividend is expected to grow at the
rate of 9% p.a. forever. Investors A, B and C have expected rate of return
of 15%, 18% and 12% respectively. Find whether the current price offers
them proper opportunity for investment in the shares of the company. 10
Sol. D1 = D0(l + g) = ` 8 (1 + 0.09) = ` 8.72
We know that
D1
P0 =
ke − g
Intrinsic values according to expected rate of returns are :-
` 8.72
For a ⇒ P 0 = = ` 145.33
0.15 − 0.09
` 8.72
For B ⇒ P 0 = = ` 96.88
0.18 − 0.09
` 8.72
For C ⇒ P 0 = = ` 290.67
0.12 − 0.09
The current price of ` 150 offers good opportunity for investment to only
C. A & B cannot get the expected returns as the intrinsic value is lower
than ` 150.
Q. 4. (a) Mr. A has ` 1,00,000 for investment on which he wants to earn
return of 16%. He has two sources available for investment debentures
offering return of 15% and equity shares offering return of 20%. Find the
amount invested in each security to achieve the target rate of return. 5
Sol. Let the fund invested in debentures be w per cent & (1-w) per cent
equity shares
So, w × 0.15 + (1-w) 0.20=0.16 ⇒ 0.15w + 0.20 - 0.20w = 0.16
0.04
⇒ 0.05x = 0.20 - 0.16 = 0.04 ⇒w= = 0.8 or 80%
0.05
Mr. A should invest 80% of ` 1,00,000, i.e., ` 80,000 in debentures and 20%
of ` 1,00,000, i.e. ` 20,000 in equity shares to earn a total return of 16%.
(b) If the risk free return is 5% and return on Sensex is 15% with a risk of
8%, find the proportion of funds to be invested in each of the above two
alternatives so as to have a portfolio with a return of 13%. Also find the
risk of the portfolio so formed. 10
Sol. Let w be the amount invested in risk-free asset and rest (1-w) amount
in Market Index.
⇒ w × 0.05 + (1 -w)0.15 = 0.13 ⇒ 0.05w + 0.15 - 0.15w = 0.13
⇒ - 0.10w = -0.02
0.02
⇒w= = 0.2 or 20%
0.10
∴ 20% of the funds should be invested in risk-free asset and 80% in market
index.
Risk of the Port Folio (sp)
For this we use capital market ...where Rp = Return of Portfolio
line (CML) Rf = Risk of Return
σp Rm = Return on Sensex (market index)
Rp = Rf + (Rm - Rf) ×
σm σm = Risk of market
σp = Risk of portfolio
σp
⇒ 0.13 = 0.05 + (0.15 - 0.05) ×
0.08
σp
⇒ 0.13 - 0.05 = 0.10 × ⇒ 0.08 × 0.08 = 0.10 × σp
0.08
0.0064
⇒ σ p = = 0.064 or 6.4%
0.10
Thus the risk of the portfolio is 6.4%.

Or
(a) Briefly explain the structure of mutual funds.
(b) The return on four securities under different situations are given below:
Probability Security A Security B Security C Security D
0.25 3 2 5 4
0.35 4 4 3 3
0.40 2 5 2 1
Find the expected return on all the securities and portfolio made by equal
component of all the securities. 5
Sol.
Probability RA RB RC RD (P × RA) (P × RB) (P × RC) (P × RD)
(P)
0.25 3 2 5 4 0.75 0.50 1.25 1
0.35 4 4 3 3 1.40 1.40 1.05 1.05
0.40 2 5 2 1 0.80 2 0.80 0.40
Total RA = 2.95 RB = 3.90 RC= 3.10 RD= 2.45
Hence the expected return of the securities A, B, C & D are 2.95%, 3.90%,
3.10% and 2.45% respectively
Portfolio return if weight are equal is calculated as under :
WA = WB = WC = WD = 0.25 (i.e. 25% in each security)
Hence E (RP) = Wa r a + WB r B + WC rC + WD rD
= 0.25 (2.95) + 0.25 (3.90) + 0.25 (3.10) + 0.25 (2.45)
= 3.10%
(c) A mutual fund has NAV of ` 18 per unit in the beginning of the period
and ` 22 per unit at the end of the period. It has incurred expense at the
rate of ` 0.80 per unit. Find the expense ratio. 5
naV at the beginning + naV at the end
Sol. Average of NAV =
2
` (18 + 22) ` 40
= = = ` 20
2 2
expenses
Expense Ratio = × 100
average of naV
0.80
Therefore, Expense Ratio = × 100 = 4%
` 20
Q. 5. Write short notes on any three of the following: 15
(i) Insider trading
Ans : Chapter 2 [Para 2.6.7]
(ii) Factors affecting investment
(iii) Participants of securities market
(iv) Risk-return trade off.
Ans : Chapter 1 [Para 1.5]
Or
(a) The following information is given in respect of a security:
Beta of security 0.8
Return on risk free asset 5%
Return on market index 18%
(i) Find out the expected return of the security.
(ii) If the other security has an expected return of 22%, what must be its
beta.
Sol. (i) using CAPM Ri = Rf + β ...where Ri = Return on Security
(Rm - Rf)
Rf = Return of Risk free asset i.e., 5%
Ri - 0.05 + 0.8(0.18 - 0.05)
Rm = Return on Market Index i.e., 18%
= 0.05 + 0.8(0.13)
β = Coefficient of Risk of security i.e., 0.8
= 0.05 + 0.104
= 0.154 or 15.4%
(ii) Expected Return, Ri = 0.22

0.22 = 0.05 + β (0.18 - 0.05)
0.22 - 0.05 - β (0.13)
0.17 = β (0.13)
0.17
β= = 1.307
0.13
(b) (i) An investor purchased a bond at a price of ` 900 with ` 100 as cou-
pon payment and sold it at ` 1,000. What is his holding period return? 5
(ii) If the bond is sold for ` 750 after receiving ` 100 as coupon payment,
then what is the holding period return.
100 + (1000 − 900)
Sol. (i) HPR =
900
= 0.2222 or 22.22%
100 (750 − 900)
(ii) HPR =
900
= 0.0555 or – 5.55%
B.Com (TYUP) 2016
PAPER : SECURITY ANALYSIS &
PORTFOLIO MANAGEMENT
Time Allowed : 3 Hours Maximum Marks : 75

Q1. (a) How is “Investment” different from “Speculation” ? How do In-
flation and Taxes affect return on investment ? 6
Ans. (a) See paras 1.4 & 1.11
(b) A financial analyst is analyzing two investment alternatives Y and Z.
Their rates of returns under different probabilities are as follows :
Probability Rate of Return
Y Z
0.20 22% 5%
0.60 14% 15%
0.20 - 4% 25%
(i) For Y and Z, determine expected rate of return, variance and standard
deviation.
(ii) Is Y comparatively less risky investment ? Explain.
(iii) If the financial analyst wishes to invest equal amounts Y and Z,
would it reduce risk ? Explain. 9
Solution :
(b)
Prob RY (%) RZ (%) PiRyi PiRzi P (R - Ry )2 Pi(Rzi- Rz )2
i yi Pi(Ry- Ry )(R ẑ - Rz )
0.20 22 5 4.4 1.0 20 20 -20.0
0.60 14 15 8.4 9.0 2.4 0 0
0.20 -4 25 -0.8 5.0 51.2 20 -32.0
Σ 12.0 15.0 73.6 40 -52.0
525
B.Com. (tyup) 2016 Paper : Security analysis & PORTFOLIO MANAGEMENT 526
(i) Expected Return on y = 12%

Expected Return on z = 15%
S.D. of Y = 73.6
= 8.58 %
S.D. of Z = 40
= 6.32 %
Variance of y = 73.6 Sq %
Variance of z = 40 Sq %
8.58
(ii) Coefficient of Variation of y = = 0.715
12
6.32
Coefficient of Variation of z = = 0.421
15
No. z is comparatively less risky
(iii) If financial analyst invests equal amounts in y & z then weights of
y and z would be 0.5 each.
Cov (y, z) = –52
Portfolio Risk = (0.5)2 (73.6) + (0.5)2 (40) + 2(.5)(.5)( −52)
= 18.4 + 10 − 26
= 2.4
= 1.55 %
Hence risk will be reduced if the financial analyst invests equal amounts in
y and z. This is because the covariance and hence coefficient of correlation
between them is negative.
Or
(a) Write short notes on any two of the following :
(i) Callable and Putable bonds.
(ii) Current Yield and Holding Period Rate of Return (HPRR).
(iii) Deep discount bonds. 6
Ans.
(a) (i) See para 4.2
(ii) See para 4.7
(iii) See para 4.2
527 B.Com. (tyup) 2016 Paper : Security analysis & PORTFOLIO MANAGEMENT
(b) Based on the following information, determine which of the securities

are overpriced and which underpriced in terms of Security Market
Line (SML) : 9
Security Actual return b σ
A 0.33 1.7 0.50
B 0.13 1.4 0.35
C 0.26 1.1 0.40
D 0.12 0.95 0.24
E 0.21 1.05 0.28
F 0.14 0.70 0.18
Nifty Index 0.13 1.00 0.20
T Bills 0.09 0 0.0
Solution :
(b) SML = Rf + [Rm – Rf]b
In the question
Rf = 9 %
RM = 13 %
Security Actual Return b Expected Return as per SML
A 0.33 1.7 .09+(0.13-0.09)1.7 = 0.158 Underpriced
B 0.13 1.4 .09+(0.13-0.09)1.4 = 0.146 Overpriced
C 0.26 1.1 .09+(0.13-0.09)1.1 = 0.134 Underpriced
D 0.12 0.95 0.09+(0.13-0.09)(0.95) = 0.128 Overpriced
E 0.21 1.05 .08+(0.13-0.09)(1.05) = 0.132 Underpriced
F 0.14 0.70 0.09+(0.13-0.09)0.70 = 0.118 Underpriced
Please note:
A security is underpriced if Actual Return is greater than expected return
as per SML.
A security is overpriced if Actual Return is less than the expected return
as per SML.
Q2. (a) What is Interest Rate Risk ? Does it affect bond prices only or
does it influence equities also ? 6
Ans. See para 4.8
(b) (i) Determine the price of ` 1,000 Zero Coupon Bond with yield
to maturity (YTM) of 18 per cent and 10 years to maturity.
(ii) What is YTM of this bond if its price is ` 220 ? 9

Solution :
(i) Zero coupon Bond Face Value = ` 1,000
YTM = 18%
Time to Maturity = 10 years
Price of Bond = 1000 (PVF 18% 10)
= 1000 (0.191)
= ` 191
(ii) if we take YTM as 18% then the price of the bond is ` 191.
This is higher than ` 220 so we reduce YTM to 16%
At 16% YTM, the bond price will be
= 1000 (PVF 16 % 10)
= 1000 (0.227)
= ` 227
This is approximately same as ` 220 so YTM of the bond will be 16%
Or
(a) What are the different sources of Risk ? Which of these risks can be
diversified away ? 6
Ans. See para 3.3
(b) Saba is considering purchase of a bond currently selling at ` 878.50.
The bond has four years to maturity, face value of ` 1,000 and Cou-
pon Rate of 8 per cent. The next annual interest payment is due after
one year. The required rate of return is 10 per cent.
(i) Calculate the Intrinsic Value (Present Value) of the bond.
Should Saba buy the bond ?
(ii) Calculate the Yield To Maturity of the bond. 9
Solution :
(b)(i) Current price = ` 878.50
N = 4 years
Coupon rate = 8 %
Face Value = ` 1000
Required rate of Return = 10%
Intrinsic Value of Bond = 80 (PVFA 10% 4) + 1000 (PVF 10% 4)

= 80 (3.17) + 1000 (0.683)
= ` 936.6
Since current price is less than the intrinsic value of the bond, Saba should
buy it.
(ii) The approximate YTM of the bond is calculated below:
80 + (1000 − 878.50) / 4
Approx YTM = (1000 + 878.50) / 2
80 + 30.375
= 939.25
= 0.1175 or 11.75%
Let us take YTM as 12% then the bond price is
= 80(PVFA 12% 4) + 1000 (PVF 12% 4)
= 80 (3.037) + 1000 (.636)
= 719.037
This is lower than the current price of ` 878.50
So,
Accurate YTM will be between 10% & 12%
(936.6 − 878.5)
Accurate YTM = 10% + × 2%
(936.6 − 719.037)
58.1
= 10% + × 2%
217.563
= 10.53%
Q3. (a) “Nifty is an index number of the National Stock Exchange (NSE)
for gauging the sentiment of the stock market.” Do you agree with the
statement ? 6
Ans. See para 2.3
(b) The growth rate of ABC Company at present is 21 per cent. Assume
this to continue for the next five years and thereafter a growth rate of 10
per cent indefinitely. The dividend paid for the current year is ` 3.20. The
required Rate of Return is 20 per cent and the present market price of the
share is ` 57. What is the fair price of this Stock should the investors buy
this stock ? 9
Solution :
(b) We are given that g = 21 % for 5 years thereafter 10% indefinitely
D0 = ` 3.20
Required rate of Return (Ke) = 20%
Present market price = ` 57
We need to calculate fair price of the Share
Dividend in year 1 = D0 (1+g)
= 3.20 (1+0.21)
= 3.872
Similarly we can calculate D2, D3, D4, & D5
Year Div PVF20% N P.V. of Div
1. 3.872 0.833 3.22
2 4.685 0.694 3.25
3 5.668 0.579 3.28
4 6.859 0.482 3.31
5 8.299 0.402 3.34
Total 16.4
D6 = 8.299 (1 + 0.10)
= 9.129
 9.129 
Fair price of Share = 16.4 +  × 0.402 
 0.20 − 0.10 
= 16.4 + (91.29 × 0.402)
= 53.1
So the fair price of the share is ` 53.10
Since current market price is higher, the investors should not buy this stock.
Or
(a) Differentiate between Fundamental Analysis and Technical Analy-
sis. 6
Ans. See para 6.2
(b) PQR Ltd. has the following details :
Return On Equity (ROE) = 15%
Expected Earning Per Share (EPS) = ` 5
Expected Dividend Per Share (DPS) = ` 2
Required Rate of Return = 10% per year.

As a financial advisor, you are required to compute its expected growth
rate, price and P/E ratio. 9
Solution :
(b) ROE = 15% EPS = ` 5, DPS = ` 2 K e = 10%
growth rate = g = b × ROE
b = Retention ratio
2
Dividend payout ratio = × 100 = 40%
5
So, Retention ratio = 1 – 0.40 = 0.60 or 60%

Hence g = 0.60 × 0.15
= 0.09
= 9%
D1
Price of share =
Ke − g
2
=
0.10 − 0.09
= ` 200
200
So, P/E ratio = = 40
5
Q4. (a) What are financial derivatives ? Who are the major participants
in the derivatives market ? 6
Ans. See paras 11.3 and 11.4
(b) Consider the three Portfolios given in the table below :
Portfolio Average Annual Standard Correlation Coefficient
Return (%) Deviation (%) of Market & Portfolio
A 18 27 0.8
B 14 18 0.6
C 15 8 0.9
Market 13 12 –
If the risk-free rate of interest is 9%.
(i) Rank these portfolios using Sharpe’s and Treynor’s methods.
(ii) Compare both the indices. 9
Solution :
(b)
Portfolio AR(%) S.D(%) Correlation Sharpe Ranking Treynor Ranking
Cogg of mkt. β Index as per index as per
& portfolio sharp Treynor
A 18 27 0.8 1.8 0.333 2 5 3
B 14 18 0.6 0.9 0.277 3 5.55 2
C 15 8 0.9 0.6 0.750 1 10 1
Market return = 15% Market S.D = 12% r f = 9%
We know that
S.D of Security
β = Correlation Coefficient ×
S.D of market
So 27
βa = 0.8 × = 1.8
12
18
βB = 0.6 × = 0.9
12
8
βC = 0.9 × = 0.6
12
ar − r f
Sharpe Index =
σp
ar − r f
Treynor Index = βp
These two indices give different results regarding ranking because Sharpe
index uses total risk while Treynor’s index considers only systematic risk.
Or
(a) Differentiate between Futures and Options. 6
Ans. See para 11.6
(b) (i) John paid a premium of ` 5 per share for a 6-month Call
Option contract (i.e. total premium of ` 500 for 100 shares)
of Mohana Corporation. At the time of purchase. Mohana’s
share price was ` 57 per share and the Exercise Price of the
Call Option was ` 56.
(1) Determine John’s profit or loss if, when the Option is
exercised. Mohana’s share price is ` 53.
(2) What is John’s profit or loss if, when the Option is ex-
ercised, Mohana’s share price is ` 63 ?
(ii) Kirthi is bearish on the stock of Vinay Corporation. Therefore,

he purchases five Put Option contracts on Vinay’s shares at a
premium of ` 3. The Exercise Price is ` 41 and maturity period
is three (3) months. The current market price of the stock is
` 40. The market lot is 100. If Kirthi’s prediction turns out
to be correct and Vinay’s stock price falls to ` 30, how much
profit will Kirthi earn over a three-month period ? 9
Solution :
(b) (i)
Premium paid = `5 per share or ` 500 for 100 shares
So = ` 57 E = ` 56
(1) When Share price is ` 53, then this call option will not be exercised.
Hence total loss to John will be ` 500 (i.e. premium already paid).
(2) When Share price is ` 63, this call option will be exercised at ` 56.
Net Profit = (63 - 56) 100 - 500
= 700 - 500
= ` 200
(ii) Put option premium paid = 5 × 100 × 3 = ` 1500
Exercise price = ` 41 per share
Maturity period = 3 months
So = `40
Market lot size = 100
When Stock price falls to ` 30
then
Net profit = 5 × 100(41 – 30) – 5 × 100 × 3
= 5500 - 1500
= ` 4,000
Q5. (a) What are the different measures of Portfolio Performance ? Which
of these, in your opinion, is a more appropriate measure of performance ?
Why ? 6
Ans. See paras 10.1 and 10.2
(b) Neeru is considering investment in securities P and Q, whose details
are given below :
P Q
Risk in terms of Standard Deviation 4% 7%
If a portfolio with 30% of P and 70% of Q is formed, find the :
(i) Expected return of the portfolio
(ii) Minimum risk of the portfolio
(iii) Maximum risk of the portfolio
Solution :
(b)
(i) e ( r p ) = 0.3 × 13 + 0.70 × 16
= 3.9 + 11.2
= 15.1%
(ii) Minimum Risk of Portfolio is when r = -1
Min. σ p = (0.3)2 (4)2 + (.7)2 + (7)2 + 2 (.3) (.7)(−1)(4)(7)

= 1.44 + 24.01 − 11.76
= 13.69
= 3.7%
(iii) Maximum risk of the portfolio is when r = 1
Max. σ p = (.3)2 (4)2 + (.7)2 + (7)2 + 2 (.3) (.7)(1)(4)(7)
= 1.44 + 24.01 + 11.76

= 6.1%
Or
(a) Compare Gordon’s and Walter’s models of share price valua-
tion. 6
Ans. See para 8.2.1
(b) Consider the following data in respect of three portfolios A, B
and C :
Portfolio Return % Portfolio Risk in terms
of Standard Deviation
A 26 30%
Portfolio Return % Portfolio Risk in terms

of Standard Deviation
B 29 18%
C 19 16%
The return on market index (Rm) is 18% and the risk on market index σm
is 10%. The risk free rate of return is 7% and unlimited lending and bor-
rowing is possible at this rate. Using Capital Market Line, comment on the
efficiency of the above portfolios. 9
Solution :
(b)
Port- Actual S.D.(%) Exp Return Remarks
folio R(%) as per CML
A 26 30 40% inefficiently priced (overpriced)
B 29 18 26.8% inefficiently priced (underpriced)
C 19 16 24.6% inefficiently priced (overpriced)
r m = 18% σ m = 10% r f = 7%
σp
CML = r f + r m − r f 
σm
30
Exp. Return of Portfolio A as per CML = 7 + 18 − 7
10
= 40%
Similarly expected returns are calculated for B & C. An efficiently priced
portfolio has Actual return same as expected return as per CML.
Hence all the portfolios A, B & C are inefficiently priced. While A & C are
overpriced, B is underpriced in the market.
B.Com. (Hons.) 2017
PAPER : FUNDAMENTALS OF INVESTMENT
SEMESTER : VI
Duration : 3 Hours Maximum Marks : 75
1. (a) define Investment. What factors should an investor consider while
making an investment decision ? 5
Ans. See Paras 1.1 & 1.3
(b) mr. vinayak purchased the share of on-line ltd. for ` 50 five years ago.
during the last five years, the share exhibited the following average price
and the company declared for the following dividend : 10
Year Price Dividend
(in `) (in `)
1 70 5
2 76 6
3 80 6
4 104 7
5 120 8
Find average return and risk of the investor using the data given above.
Or
(c) distinguish between (any two) : 5
(i) expected return and realized return
(ii) Beta and standard deviation
(iii) senseX and nIFtY.
(d) mr. abhinav makes an investment at ` 100. the year-end price of this
investment under different market conditions and their probabilities are
given below : 10
536
537 B.Com. (Hons.) 2017 Paper : Fundamentals of Investment
Conditions Year-end price Probabilities

Bullish ` 160 0.30
Normal ` 120 0.30
Bearish ` 80 0.40
(i) Find out the expected return and risk for one year period.
(ii) Also calculate inflation adjusted return if, the rate of inflation during
the year is 6%.
2. (a) Differentiate between (any two) : 5
(i) Systematic risk and Unsystematic risk
Ans. See Paras 3.4 & 3.5
(ii) Yield to Maturity (YTM) and Yield to Call (YTC)
Ans. See Para 4.7
(iii) Secured Premium Note (SPN) and Deep Discount Bond (DDB).
(b) The following information is available in respect of a bond :
Face Value : ` 1,000
Market Price : ` 879
Coupon rate : 8%
Investor yield : 10%
Time to maturity : 4 years
Find out the Yield to Maturity (YTM) and Instrinsic Value of the bond.
Should the investor buy this bond based on YTM and intrinsic value ?
10
Or
(c) Examine the relationship between Time to Maturity and Bond Valuation.
5
Ans. See Para 4.9
(d) Mr. Ashutosh is considering investing in one of the following bonds :
Bond A Bond B
Face Value ` 1,000 ` 1,000
Coupon rate 12% 10%
Time to maturity 10 years 7 years
Current market price ` 700 ` 600
If Mr. Ashutosh’s income is taxed @ 30% and capital gain is taxed @ 10%,
find the post-tax Yield to Maturity from these bonds using approximation
method. Which bond should be selected by Mr. Ashutosh ? 10
3. (a) Define credit rating. Do you think that high credit rating is a
recommendation to buy the bond ? 5
Ans. See Para 4.11
(b) The following information is available for S Ltd. for the year 2014-15 :
10
Annual turnover ` 1,00,00,000
Profit 30%
Equity Share Capital (FV = ` 10) ` 10,00,000
Capital Reserve ` 5,00,000
12% Preference Share Capital ` 15,00,000
13% Long-term Loan ` 12,00,000
12% Debentures ` 10,00,000
Tax Rate 30%
Dividend payout ratio 50%
Price Earning (PE) ratio 15
Find Earning Per Share (EPS), Dividend Per Share (DPS), Market Price,
Earning Yield and Dividend Yield.
Or
(c) Explain how Point and Figure Chart (PFC) and Candlestick Chart are
used by technical analysts to predict future behaviour of prices. 5
Ans. See Para 6.4
(d) Rajan Ltd. has just paid a dividend of ` 2 per share. In view of the rapid
growth of the company, the dividend is expected to grow at 20% p.a. for
the next three years. Subsequently, the earnings are expected to grow at
only 7% p.a. infinitely. With the expected rate of return at 22%, find out the
price an investor should be ready to pay for the share. 10
4. (a) “Capital Market Line shows all the combinations of risk-free investment
and the Market Portfolio.” Explain in the light of this statement meaning
and features of Capital Market Line (CML). 5
Ans. See Para 9.3
(b) From the data given below, find which of the following securities is
overpriced/underpriced/correctly priced using SML equation or CAPM :
10
Security b Actual Return

A 1.2 20
B 1.0 15
C 1.6 22
D 2.0 24
E 0.5 8
The return on the market index is 15% and risk-free return is 6%.
Or
(c) What is Mutual Fund ? Explain the difference between Open Ended
Mutual Fund and Close Ended Mutual Fund. 5
(d) Two securities A and B have variance of 13 and 15 and expected returns
of 15% and 18% respectively. The covariance between the returns is 3. Find
out the return and risk of the portfolio if the ratio of investment in two
securities is 70% and 30%. 5
(e) The shares of Blue Diamond Ltd. are quoted at ` 25. Mr. Grover writes
a call option at a strike price of ` 29 and a premium of ` 3. Calculate his
net payoff if the market price on the expiration date is ` 24 or ` 26 or `
32 or ` 35. At what market price Mr. Grover will be in no profit no loss
situation ? 5
5. (a) Explain the role of correlation coefficient in the construction of a
portfolio.5
(b) What do you mean by futures? How are they different from For-
wards ? 5
(c) An investor buys a NIFTY futures contract for ` 2,80,000 (lot size 50
futures). On the settlement date the NIFTY closes at 5512. Find the profit/
loss if he pays ` 1,000 as brokerage. What would be the position if he has
sold the future contract ? 5
Or
(d) Discuss : 5
(i) Book building
(ii) Rolling settlement.
(e) Explain Efficient Market Hypothesis and the three forms of Market
Efficiency. What is the level of efficiency of the Indian Capital Market ? 5
(f) Calculate the NAV from the following information for the year ending
31st March, 2016 : 5
Cash and Bank balance ` 7,50,000

Bonds and Debentures ` 8,00,000
Equity (Current market value) ` 16,50,000
Quoted Govt. Securities ` 12,05,000
Expenses ` 9,50,000
No. of units 2,00,000
If the NAV on 1st April, 2015 was ` 20 per unit, calculate the expense ratio.
Ans. 1(b)
Calculation of Average Return
Year Price Dividend Capital Gain/loss Return
1 70 5 20 (5 + 20)/50 = 0.5
2 76 6 6 (6 + 6)/70 = 0.17
3 80 6 4 (6 + 4)/76 = 0.13
4 104 7 24 (7 + 24)/80 = 0.39
5 120 8 16 (8 + 16)/104 = 0.23
Total Return = 1.42
Avg. Return =
∑r ⇒ Average Return (based on AM) =
1.42
n 5
= 0.284 or 28.4%
d1 + (P1 − P0 )
Note 1 Return =
P0
D1 = Dividend received at end of the year

P0 = Cost of Investment
P1 = Share price at end of year
Note 2 at year 0, Price of share = ` 50
Calculation of Risk
∑ (r )
2
−r
s = i
Year Return (Ri) (Ri - 0.284)2

1 0.50 0.0466
2 0.17 0.0129
3 0.13 0.0237
Year Return (Ri) (Ri - 0.284)2

4 0.39 0.0112
5 0.23 0.0029
Total 0.0973
0.0973
s=
5
s = 0.14 or 14%
(in term S.D)
Ans. 1(d)
Condition Year End price Probabilities Purchase (Ri) Return PiRi
Price
Bullish 160 0.30 100 160 - 100/100 0.18
= 0.60
Normal 120 0.30 100 120 - 100/100 0.06
= 0.20
Bearish 80 0.40 100 80 - 100/100 -0.08
= - 0.20
Expected Return = SPiRi
0.18 + 0.06 - 0.08
16%
Calculation of Risk
∑ P (r )
2
s= i i −r
Condition pi (Ri - r )2 pi(Ri - r )2
Bullish 0.30 (0.60 - 0.16)2 0.30(0.44)2 = 0.05808

Normal 0.30 (0.20 - 0.16) 2
0.3(0.04)2
= 0.00048
Bearish 0.40 (-0.20 - 0.16) 2
0.4(-0.36) 2
= 0.05184
Total 0.1104
s = 0.3324
i.e. 33.24%
(ii) If Rate of Inflation = 6%
Nominal Rate of Return = 16%
1 + nominal rate of return

Inflation Adjusted Return = −1
1 + Inflation rate
1 + 0.16
= -1
1 + 0.06
1.16
-1 ⇒ 9.43%
1.06

Ans. 2(b)
Face Value = ` 1000, Market Price = ` 879
Coupon Rate = 8%, Investor Yield = 10%
Time to Maturity = 4 years
I+
(rv − P)
n
YTM =
(rv + P)
z
Annual Interest Amount (I) = ` 80
Rv = 1000 P = ` 879, N = 4
80 +
(1000 − 879)
4
YTM =
(1000 + 879)
2
80 + 30.25
YTM =
939.5
110.25
YTM = ⇒ 11.73%
939.5
Investment Decision on the basis of YTM
YTM > Required Rate of Return
11.73 > 10%
Investor must buy this Bond
Intrinsic Value of Bond
I× PVAF (Rd, N) + RV + PVF (Rd, N)
80×PVAF(10%, 4) + 1000 × PVF(10%, 4)
80(3.170) + 1000(0.683)
253.6 + 683
Intrinsic Value ` 936.6

Investment Decision (based on Intrinsic Value)
Intrinsic Value > Current Market price
` 936.6 > ` 879
Thus Investor must buy.
Ans. 2(d)
Bond A Bond B
Face Value ` 1000 ` 1000
Coupon Rate 12% 10%
Time to Maturity 10 years 7 years
Current Market Price ` 700 ` 600
Annual Interest Income ` 120 ` 100
Taxable Annual Interest Income ` 84 ` 70
RV-P ` 300 ` 400
Taxable Income @ 10% ` 270 ` 360
I+
(rv − P)
n
YTM =
(rv + P)
z
84 +
(270) 70 +
(360)
10 7
YTM1 = YTM2 =
270 360
2 2
111 121.5
YTM1 = YTM2 =
135 180
YTM1 = 82.2% YTM2 = 67.5%
Select Bond A
Ans. 3(b)
Sales 10,00,000
Operating Profit (EBIT) 30% of sales
EBIT = 30,00,000
Less Interest on 13% Loan (1,56,000)
Less Interest on 12% Debenture (1,20,000)

EBT 27,24,000
Less Tax @ 30% 8,17,200
EAT 19,06,800
Less Preference Dividend (1,80,000)
Profit for Equity shareholders (A) 17,26,800
Numbers of equity shares (B) 1,00,000
EPS(A/B) ` 17.268
DPS 50% of EPS ` 8.634
Market price = P/E Ratio × EPS 15 × 17.268
` 259.02
Earning Yield = EPS/Market price 17.268/259.02 = 6.74%
Dividend Yield = DPS/Market price 8.634/259.02 = 3.33%
Ans. (d)
D0 = ` 2 g = 20% p.a. for 3 years & 7% infinitely
(ke) Expected Rate of Return = 22%
d1
P0 =
re − g
Year Expected Dividend Income PVF(22%, n) P.V of Dividend

Income
1 2(1.20) = 2.4 0.820 1.968
2 2(1.20) = 2.88
2
0.672 1.93536
3 2(1.20)3 = 3.456 0.551 1.904256
P.v. of Dividend Income 5.80
d4
P3 = r − g
e
3.456 (1.07)
P3 = 0.22 − 0.07
3.6915
P3 = ⇒ P3 = 24.61
0.15
P.v. of P3 = P3 × PVF (22%, 3)
24.61 × 0.551
` 13.56 2
Add 1 & 2
Price of share 19.36
CAPM = RF + (RM - RF)b
Ans. 5(b)
Security b Actual Return Expected Return Underprice/
CAPM[E(Ri)] Overprice
A 1.2 20 6 + (15 - 6) 1.2 = 16.8 Underpriced
B 1 15 6 + (15 - 6) 1 = 15 Correctly priced
C 1.6 22 6 + (15 - 6) 1.6 = 20.4 Underpriced
D 2.0 24 6 + (15 - 6) 2 = 24 Correctly priced
E 0.5 8 6 + (15 - 6) 0.5 = 10.5 Overpriced
In case of overprice, Security lie below SML line
In case of underprice, Security lies above SML
In case of correctly price, it lies on SML line
Underpriced SML
E(Ri) A C
D
B
E (overpriced)
RF
Ans. 5(d)
A B
Variance s2 13 15
Covariance = 3
W1 = 0.70, W2 = 0.30
Ri(%) Wi WiRi
15 0.70 10.5
18 0.30 5.4
Portfolio Return 15.9
RP = SWiRi
Calculation of Portfolio Risk
2 2 2 2
sP = W1 σ1 + W2 σ 2 + 2W1W2 Cov.12
sP = (0.70)2 (13) + (0.30)2 (15) + 2 (0.70)(0.30)(3)

sP = 6.37 + 1.35 + 1.26
sP = 3
Ans. (e)
Share price on expiry day 24 26 32 35
Option Exercise No No Yes Yes
Inflow (Strike price) - - 29 29
Inflow (Premium) 3 3 3 3
Total inflow 3 3 32 32
Outflow (Share price) - - 32 35
Net pay off (`) 3 3 Nil -3
At Market price of ` 32, Net pay off will be Nil
Ans. 5(c)
NIFTY future on date of transaction = 2,80,000/50
5600
Thus, it decreases by 5600 - 5512 = 88 points Loss
(5600 - 5512) × 50 + 1000 = ` 5400
In case, investor sold the future, his profit would be:
Profit = 88 × 50 - 1000 = ` 3400
Ans. (f)
NAV Calculation
net asset value of Fund
= no. of units
Cash & Bank Balance 7,50,000

Bond & Debentures 8,00,000
Equity 16,50,000
Govt. Securities 12,05,000
Net Asset Value of Fund 44,05,000
(÷) No. of units 2,00,000
NAV per unit ` 22.025 per unit
Expense Ratio = Expense
Avg. Asset under Management
nav at beg. + nav at end
Avg. Asset under Mgt. =
2
20 + 22.025
=
2
21.0125
9,50,000
Expense Ratio =
2,00,000
21.0125
22.60%
B.Com. (H)/III/NS 2017
PAPER XX : FUNDAMENTALS OF
INVESTMENT (C-305)
ELECTIVE GROUP : EA-FINANCE-I

Time : 3 hours Maximum Marks : 75
1. (a) How does ‘Investment Decision Process’ help investors in making
sound investment decisions? 5
Ans. See Para 1.7
(b) a portfolio is constructed by investing 40% of the funds in Bharat
Ltd. and 60% in India Ltd. The following information regarding the two
companies is given below:
Bharat Ltd. India Ltd.
expected return 14% 22%
Compute risk and return of the above stated portfolio assuming:
(i) Correlation between two stocks is +1
(ii) Correlation between two stocks is +0
(iii) Correlation between two stocks is -1. 10
Or
(a) explain the important features of National Stock exchange of
India. 5
Ans. See Para 2.1
(b) Compute the expected return and risk of the following X and
Y securities:
State Probability Rx Ry
Bearish 0.30 -10% -20%
Normal 0.30 15% 18%
Bullish 0.40 22% 25%
10
548
549 B.Com. (H)/III/NS 2017 Paper XX : FUNDAMENTALS OF INVESTMENT (C-305)
2. (a) What do you mean by credit rating? How is credit rating relevant for
investors? 5
Ans. See Para 4.11
(b) The following information is given regarding a bond SRM Ltd.:
Face Value Rs. 1,000
Coupon Rate 12%
Maturity 5 years
Redemption Value Rs. 1,100
Compute:
(i) The value of the bond when the opportunity cost of capital is 14%.
5
(ii) What would be its yield to maturity if the current market price of
this bond is Rs. 97? 5
Or
(a) What is bond yield? Explain the factors affecting bond yield.
5
Ans. See Para 4.7
(b) One of your friends holds bonds having face value of Rs. 1,000 which
will be redeemed over a period of 5 years in five equal annual instal-
ments. The bond carries a coupon interest rate of 10%. Find the value
at which you would like to buy the bonds if your expected rate of
return is 12%. 10
3. (a) What is Economy-Industry-Company (EIC) Approach? Explain the
key factors in Industry Analysis. 6
Ans. See Para 5.3
(b) Vipra Ltd. has paid a dividend of Rs. 3 per share on the face value of
Rs. 10. The following information is given below:
Current market price per share 170
Growth rate 12%
Beta coefficient of the share 1.8
Market return 17%
Risk free rate of return 12%
Compute the value of the share based on CAPM. 9
Or
(a) Explain ‘Elliott Wave Theory’. 6
B.Com. (H)/III/NS 2017 Paper XX : FUNDAMENTALS OF INVESTMENT (C-305) 550
(b) The following information is available in respect of FOI Ltd. for the
year 2014-15:
Annual Turnover ` 60,00,000
Operating Profits 20%
Equity Share Capital (Rs. 10 each) ` 25,00,000
Capital Reserve ` 6,00,000
12% Preference Share Capital ` 20,00,000
10% Long Term Loan ` 8,00,000
12% Debentures ` 12,00,000
Tax Rate 30%
Dividend Payout Ratio 60%
Price-Earning Ratio 27
Find out:
(i) Earning per equity share
(ii) Dividend per equity share
(iii) Market price of the equity share
(iv) Dividend yield on equity share. 9
4. (a) What do you mean by options? Distinguish between American
Options and European Options. 5
Ans. See Para 11.6
(b) Mr. Zahir has selected 2 securities, X and Y, for his portfolio. The
following information is provided by him:
Security Expected Return Standard Deviation
X 12% 5%
Y 18% 7%
If he invested 40% of his fund in X and 60% in Y, find the return of portfolio.
Also, find the maximum and minimum risk of such a portfolio. 10
Or
(a) “Mutual fund is an indirect investment.” Examine it in the light of
features of mutual funds. 5
Ans. See Para 10.4
(b) A three months call option premium of SMS Ltd. is Rs. 2.50 and 3
months put option premium is Rs. 4. Assume that the exercise price
for both the cases is Rs. 60.
Find out the net payoff of call option buyer, call option writer, put option
buyer as well as put option writer along with the graph when spot price of
the share on the exercise day is 56, 58, 60, 63 and 65. 10
5. Answer any three of the following:
(a) Write a short note on ‘Role of Stock Exchanges in Investor Protection’.
Ans. See Para 12.2
(b) Write a short note on ‘Depository System’.
Ans. See Para 2.6.2
(c) Explain ‘Bar Chart’ and ‘Candlestick Chart’.
Ans. See Para 6.4
(d) Explain the structure of a mutual fund.
Ans. See Para 10.3
(e) Explain various forms of Efficient Market Hypothesis. 5×3
Ans. See Para 7.3
Ans. 2(b)
Bharat Ltd. India Ltd
W1 = 0.40 W2 = 0.60
Ri Wi RiWi
Bharat Ltd. 14 0.40 5.6
India Ltd. 22 0.60 13.2
Portfolio Return SWiRi = 18.8%
I Calculation of Portfolio Risk if r = +1
2 2 2 2
sP = W1 σ1 + W2 σ 2 + 2W1W2 r12 σ1σ 2
sP = (0.4)2 (7)2 + (0.6)2 (10)2 + 2 (0.4)(0.6)(1)(7)(10)

sP = 7.84 + 36 + 33.6
s = 8.8
P
II if r = 0
sP = (0.4)2 (7)2 + (0.6)2 (10)2 + 2 (0.4)(0.6)(0)(7)(10)

sP = 7.84 + 36
s = 6.62%
P
III If r = -1
sP = (0.40)2 (7)2 + (0.60)2 (10)2 + 2 (0.4)(0.6)( −1)(7)(10)

sP = 7.84 + 36 − 33.6
s = 3.2
P
Implication lower the coefficient of correlation, more will be benefit

of diversification & lower will be portfolio risk.
Ans. (b)
State pi Rx(in %) Ry(in %) PiRx PiRy
Bearish 0.30 -10 -20 -3 -6
Normal 0.30 15 18 4.5 5.4
Bullish 0.40 22 25 8.8 10
Portfolio Return SpiRi rx = 10.3 ry = 9.4
(Risk)
Calculation of Standard Deviation of X & Y
State pi Rx pi(Rx - 10.3)2 Ry pi(Ry - 9.4)2
Bearish 0.3 -10 0.3(-20.3)2 = 123.63 -20 0.3(-29.4)2 = 259.3
Normal 0.3 15 0.3(4.7)2
= 6.620 18 0.3(8.6) 2
= 22.2
Bullish 0.4 22 0.4(11.7) 2
= 54.75 25 0.4(15.6) 2
= 97.34
Var x 185 Var y = 378.84
sx = 13.60 sy 19.46
Ans. 2(b)
Face Value = ` 1,000
Coupon Rate = 12%
(N) Maturity = 5 years
Redemption Value = ` 1100
I × PVAF(Rd, N) + RV × PVF(Rd, N)
120 × PVAF(14%, 5) + 1100 × PVF(14%, 5)
120(3.433) + 1100(0.519)
412 + 570
Intrinsic Value ` 982
I+
(rV − P)
(ii) YTM = N
(rV + P)
2
120 +
(1100 − 97)
YTM = 5
(1100 + 97)
2
120 + 200.6
YTM =
598.5
YTM = 53.56 > cost of Capital of 14%
Investor must buy this bond.
Or
Ans. (b)
Face Value = ` 1000
Maturity = 5 years
Redeem in 5 equal instalments
Coupon Rate = 10%
expected Rate of Return = 12%
Year Coupon Payment + Redemption in 5 equal PVF(12%, n) PV
instalments
1 100 + 200 = 300 0.893 268
2 80 + 200 = 280 0.797 223
3 60 + 200 = 260 0.712 185
4 40 + 200 = 240 0.636 152
5 20 + 200 = 220 0.567 125
Intrinsic Value of Bond = 953
Ans. 3(b)
D0 = ` 3, Face Value = ` 10
Current Market price = 170 g = 12%
b = 1.8 Market Return (RM) = 17%
RF = 12%
ke (CAPM) = RF + (RM - RF)b
= 12 + (17 - 12)(1.8)
= 12 + 9
ke = 21%
D1 D (1 + 9)
P0 = = P0 = 0
ke − g Ke − 9
3 (1 + 0.12)
P0 =
0.21 − 0.12
3.36
P0 =
0.09
P0 = 37.3 < Current Market Price
Investor must not buy this bond
Or
Ans. (b)
Annual Turnover or Sales 60,00,000
Operating profit (20% of Sales) 12,00,000
Less(-) Interest on Long Term Loan (80,000)
Less(-) Interest on Debentures (1,44,000)
EBT 9,76,000
Less (-) Tax 30% 2,92,800
EAT 6,83,200
Less Preference Dividend (2,40,000)
Earning to equity 4,43,200
No. of equity shares 2,50,000
EPS 1.773
DPS = .60 (EPS) = 1.063
Market price of equity = PE Ratio × EPS
= 27 × 1.77
M.P. = 47.8
Dividend Yield = DPS/Market price
1.063
=
47.8
= 0.022
Ans. 4(b)
Security Ri Wi RiWi
X 12 0.4 4.8
Y 18 0.6 10.8
RP SWiRi = 15.6
sx = 5
sy = 7
Calculation of Portfolio Risk if r = + 1 [Max Risk]
2 2 2 2
sP = W1 σ1 + W2 σ 2 + 2W1W2 r12 σ1σ 2
sP = (0.4)2 (5)2 + (0.6)2 (7)2 + 2 (0.4)(0.6)( + 1)(5)(7)

sP = 4 + 17.64 + 16.8
sP = 38.44
sP = 6.2
If r = -1 [Minimum Risk]
sP = (0.4)2 (5)2 + (0.6)2 (7)2 + 2 (0.4)(0.6)( − 1)(5)(7)

= 4 + 17.64 + ( − 16.8)
sP = 2.2
Ans. (b)
Net payoff for call Option Holder
Share price on Exercise Day 56 58 60 63 65
Option Exercise No No No Yes Yes
Outflow (Strike price) - - - 60 60
Premium paid 2.50 2.50 2.50 2.50 2.50
Total Outflow - - - - 62.50 - 62.50
Less Inflow - - - 63 65
Net pay off -2.50 -2.50 -2.50 0.50 2.50
Net payoff from call option writer
Share price at Expiry 56 58 60 63 65
Option Exercise No No No Yes Yes
Inflow (Strike price) - - - 60 60

Option Premium 2.50 2.50 2.50 2.50 2.50
Total Inflow 2.50 2.50 2.50 62.50 62.50
Outflow - - - -63 -65
Net payoff 2.50 2.50 2.50 -0.50 -2.5
Net payoff for put Option holder
Share price on Exercise Day 56 58 60 63 65
Option Exercise Yes Yes No No No
Outflow (purchase price) 60 60 - - -
Option premium 4 4 4 4 4
Total outflow -64 -64 -4 -4 -4
Inflow (Strike price) 56 58 - - -
Net payoff -8 -6 -4 -4 -4
Net payoff for put option Writer
Share price at expiry 56 58 60 63 65
Option Exercise Yes Yes No No No
Inflow (Strike price) 60 60 - - -
Option Premium 4 4 4 4 4
Total Inflow 64 64 4 4 4
Outflow 56 58 - - -
Net payoff 8 6 4 4 4
B.Com (Hons.) 2018
SEM. VI :
Duration: 3 Hours Maximum Marks : 75
1. (a) What do you mean by Insider Trading? Who is an insider as per SEBI
Regulations? (4)
Ans. See para 2.6.7
(b) An investor has to choose from two securities. They have different rates
of return but the probability is same. Suggest in which security he should
invest. (11)
Probability Return (X) Return (Y)
0.1 -10 12
0.2 10 14
0.3 20 18
0.4 25 20
Or
(a) What do you mean by unfair trade practice? When is a trade practice
considered as fraudulent? (4)
(b) An investor purchases an equity share at a price of ` 100. Its expected
year end price and dividend with relevant probabilities are given below:
(11)
Probability Share Price Dividend
0.1 135 8
0.2 125 5
0.4 110 3
557
B.COM (HON.) 2018 SEM. VI : FUNDAMENTALS OF INVESTMENT 558

0.2 105 2
0.1 95 Nil
Find out the expected return and variability of the equity share.
2. (a) Differentiate between SENSEX and NIFTY. (4)
Ans. See para 2.3
(b) A company is contemplating to issue bonds having face value of `
5000 which will be redeemed over a period of 5 years in five equal annual
instalments. The bond carries a coupon interest rate of 8%. Find the price
at which the bonds should be issued to the investor having expected rate
of return of 10%. (11)
Or
(a) Define the term investment. How is it different from speculation? (4)
Ans. See para 1.3.1
(b) A bond having face value of ` 1000 is currently sold at ` 1078. The cou-
pon rate (payable annually) is 12%. It will be maturing after 8 years. What
is the yield expected on this bond by the investor? If this bond is callable
after 5 years at ` 1050, what will be the yield? (11)
3. (a) Briefly explain DOW Theory with the help of a diagram. (4)
Ans. See para 6.4.2
(b) ABC Co. has just paid a dividend of ` 2 share. In view of the rapid growth
of the company, the dividend is expected to grow at 10% p.a. for next 3
years. After that the growth process will slow down and the dividend is
expected to grow only at 8% p.a. infinitely. In view of the risk involved in
the investment, a return of 20% is considered appropriate. What is the price
an investor should be ready to pay for this share? (11)
Or
(a) Explain Economic-Industry-Company (EIC) Approach. (4)
Ans. See para 5.3
(b) XYZ Company’s current share price is ` 72 and its last dividend paid
was ` 4.80. If dividends are expected to grow at a constant rate g and if
required rate of return (Ke) is 12%, what is XYZ’S expected share price 3
years from now? (11)
4. (a) Explain the procedure involved in credit rating of debt instruments.
(4)
Ans. See para 4.11
(b) The following information is available with respect to two securities in
the portfolio of Mr. Mohinder: (11)
559 B.COM (HON.) 2018 SEM. VI : FUNDAMENTALS OF INVESTMENT
Security Weight Return Standard deviation

A 40% 15% 20%
B 60% 18% 14%
i. Find out the correlation coefficient between the two securities if the
standard deviation of the portfolio is 14%.
ii. Find out the expected return and standard deviation of the portfolio
comprising of A and B in the ratio of 30% & 70% respectively and
correlation coefficient of 1.
Or
(a) Differentiate between systematic risk and unsystematic risk. (4)
Ans. See paras 3.4 & 3.5
(b) From the following data given below find which of the following secu-
rities are overpriced or underpriced using SML equation: (11)
Security P Q R S T
Beta 1.4 0.8 1.1 2.5 2.0
Return 12 11 17 22 16
The return on market index is 11% and the return on risk free asset is 5%.
5. (a) The following particulars are given relating to a mutual fund: (4)
Opening NAV per unit ` 22
Closing NAV per unit ` 28
Administrative expenses including fund manager remuneration ` 134 lakhs
Management advisory fees ` 85 lakhs
Publicity and documentation ` 51 lakhs
Total units issued by the fund 200 lakhs
Ascertain the expense ratio.
(b) Mr. Sunil has bought call and put options both. Each contract is of 1000
shares. He has purchased one 3-months call with a strike price of ` 154 and
` 15 as premium. He has purchased a 3-months put option with a strike
price of ` 150 and ` 13 as premium. Find out his position and total profit
or loss if the stock price on expiration date is (i) ` 120, (ii) ` 180. (11)
Or
(a) What do you mean by futures? How is future contract different from
forward contract? (4)
Ans. See paras 11.5, 11.5.2
(b) Mr. A is holding shares of X Ltd. in his portfolio. Probability distribution

of expected return from this stock and market index is given below: (11)
Situation Probability Return of A (%) Return of Market (%)
Recession 0.2 6 10
Average 0.4 15 16
Good 0.3 27 22
Boom 0.1 30 29
The risk free rate is 7%. Assuming that CAPM conditions hold true, should
Mr. A continue to hold this stock in his portfolio?
Ans. 1(b)
Pi RX RY PiRX PiRY Pi(Rx - Rx)2 Pi(Ry - Ry)2
0.1 -10 12 -1 1.2 72.9 2.916

0.2 10 14 2 2.8 9.8 2.312
0.3 20 18 6 5.4 2.7 0.108
0.4 25 20 10 8 25.6 2.704
17 17.4 111 8.04
Expected Return
E(RX) = ∑P R
i X
= 17%
E(RY) = ∑P Ri Y = 17.4%
Risk
σ X = ∑Pi (RX − R X )2 = 111 = 10.54%
σY = ∑Pi (RY − RY )2 = 8.04 = 2.84%
Since the expected return of the two securities is not equal, we cannot use
standard deviation to compare their risk. We, would rather use a relative
measure of risk, i.e., Coefficient of Variation to draw meaningful comparisons.
Coefficient of Variation
10.54
C .V .X = = 0.62
17
2.84
C .V .Y = = 0.16
17.4
Hence Security Y is preferred as it has lower Coefficient of variation than
security X. It has lower risk per unit of return generated.
Or
Ans. 1(b) Purchase Price = ` 100
Total Return (Ri)(%) = (Div + Cap Gain)/Purchase Price*100
Prob Share Divi- Capital (Ri) (%) Pi* Ri Pi*(Ri - Ri)2
(Pi) Price dend Gain
0.1 135 8 35 43 4.3 70.756
0.2 125 5 25 30 6 36.992
0.4 110 3 10 13 5.2 4.624
0.2 105 2 5 7 1.4 17.672
0.1 95 Nil -5 -5 -0.5 45.796
Return = ∑P R
i i = 16.4%
Risk = σ i = ∑Pi (Ri − Ri ) = 175.84 = 13.26%

2
Ans. 2(b) Bond Price = PV of future cash inflows

Year (n) Interest Redemption Total PVF10%,n PV of Inflows
Inflows Inflows
1 400 1000 1400 0.909 1272.6
2 320 1000 1320 0.826 1090.32
3 240 1000 1240 0.751 931.24
4 160 1000 1160 0.683 792.28
5 80 1000 1080 0.621 670.68
Bond Price ` 4757.12
Or
I + (RV − P) / n 120 + (1000 − 1078) / 8
Ans. 2(b) YTM (approx.) = = = 10.61%
(RV + P) / 2 (1000 + 1078) / 2
At 10%, PV = 120 * PVAF10%,8 + 1000 * PVF10%,8
= 120*5.335 +1000*0.467 = ` 1107.2
At 11%, PV = 120 * PVAF11%,8 + 1000 * PVF11%,8
= 120*5.146+1000*0.434 = ` 1051.52
1107.2 − 1078
By interpolation, YTM = 10 + × (11 − 10) = 10.52%
1107.2 − 1051.52
I + (RVc − P ) / n 120 + (1050 − 1078) / 5

YTC (approx.) = = = 10.75%
(RVc + P ) / 2 (1050 + 1078) / 2
At 10%, PV = 120 * PVAF10%,5 + 1050 * PVF10%,5

= 120*3.791 +1000*0.621= ` 1075.92
At 11%, PV = 120 * PVAF11%,5 + 1050 * PVF11%,5
= 120*3.696 +1000*0.593= ` 1036.52
At YTC = 9%, PV = 120 * PVAF9%,5 + 1050 * PVF9%,5
= 120*3.890 +1000*0.650 = ` 1116.8
1116.8 − 1078
1116.8 − 1075.52
Ans. 3(b) D0 = ` 2 g1=10% g2= 8% Ke= 20%
Year (n) Dividend PVF20%,n PV of Dividend

1 D1 = 2*(1+0.10) = 2.2 0.833 1.83
2 D2 = 2.2*(1+0.10) = 2.42 0.694 1.68
3 D3 = 2.42*(1.10) = 2.662 0.578 1.54
TOTAL 5.05
D4 2.662* (1 + 0.08) 2.87

P3 = = = = ` 23.92
Ke − g 0.20 − 0.08 0.12
P0 = PV of first three years’ dividend + PV of P3
= 5.05 + 23.92*0.578 = ` 18.88
Or
Ans. 3(b) D0 = ` 4.8 P0 = ` 72 Ke=12%
D1
P0 =
ke − g
4.8*(1 + g)
72 =
0.12 − g
g = 5%
D4 4.8*(1 + 0.05)4
P3 = = = ` 83.67
Ke − g 0.12 − 0.05
Ans. 4(b) (i) σp = σ2A * w A2 + σ2B * w B2 + 2* σA σ B * w Aw A * r
14 = 202 * 0.42 + 142 * 0.62 + 2* 20* 14* 0.4* 0.6* r

(14)2= 64+70.56+134.4r
r = 0.46
(ii) Return (Rp) = ∑PW i i = 0.3*15+0.7*18 = 17.1%
σp = σ2A * w A2 + σ2B * w B2 + 2* σA σ B * w Aw A * r
= 202 * 0.32 + 142 * 0.72 + 2* 20* 14* 0.3* 0.7* 1
= 36 + 96.04 + 117.6 = 15.8%

Or
Ans. 4(b) SML equation is Ri= Rf + (Rm- Rf)* β
Security P Q R S T
Expected =5+(11-5)*1.4 =5+(11-5)*0.8 =5+(11-5)*1.1 =5+(11-5)*2.5 =5+(11-5)*2.0
return As =13.4% =9.8% =11.6% =20% =17%
per SML
Actual 12% 11% 17% 22% 16%
Return
Remark Overpriced Underpriced Underpriced Underpriced Overpriced
Ans. 5(a) Expenses = 134+85+51 = ` 270 lakhs

Expenses per unit = 270/200 = ` 1.35
Average AUM = (22+28)/2 =25
Expenses 1.35
Expense Ratio = Average AUM × 100 = × 100 = 5.4%
25
Ans. 5(b)(i)
Particulars Call option Put option
Strike price 154 150
Premium 15 13
Spot price on expiry date 120 120
Position Out of money In the money
Exercise the option NO YES
Profit or loss =15*1000 =[1000*(150-120)]-13*1000
= ` 15000 loss =` 17000 profit
Net Profit or loss = 17000-15000 =
` 2000 profit
(ii)
Strike price 154 150
Premium 15 13

Position In the money Out of money
Decision YES NO
Profit or loss =1000*(180-154)- =13*1000
15*1000 = ` 13000 loss
=` 11000 profit
Net Profit or loss = 11000-13000 = ` (2000) loss
Or
Ans. 5(b)
Pi * [(Rm-
Situation (Pi) RA (%) Rm (%) Pi * RA Pi * Rm
E(Rm)]2
Recession 0.2 6 10 1.2 2 13.778
Average 0.4 15 16 6 6.4 2.116
Good 0.3 27 22 8.1 6.6 4.107
Boom 0.1 30 29 3 2.9 11.449
Total 18.3 17.9 31.45
E(RA) = 18.3%
E(Rm) = 17.9%
Market Variance = 31.45 sq. %
Covariance of Market and Share A
Situation (Pi) RA-E(RA) Rm-E(Rm) Pi*[RA-E(RA)* Rm-E(Rm)]

Recession 0.2 -12.3 -7.9 19.434
Average 0.4 -3.3 -1.9 2.508
Good 0.3 8.7 4.1 10.701
Boom 0.1 11.7 11.1 12.987
Covariance 45.63
For CAPM, we need beta factor of the share.
Covariance
Beta (β) = = 45.63/31.45 = 1.45
Market Variance
CAPM Return, E(RA) = 7+(17.9-7)*1.45 = 22.81%

CAPM return > Estimated Return, so, it is overpriced. Mr A should sell it.
B.Com 2018
SEM. VI :

1. (a) define Investment. How does it differ from Speculation? (5)
Ans. : See paras 1.1, 1.4
(b) mr. mehta is considering two investment proposals. the probability
distribution of returns on these two stocks in different market conditions
is as follows: (10)
Economic Probability of Rate of return (%)

conditions occurrence X Ltd. Y Ltd.
1 0.2 -10 5
2 0.4 25 30
3 0.3 20 20
4 0.1 10 10
Based on this information, calculate expected risk and return on both the
proposals. also suggest to mr. mehta, which investment proposal is better.
Or
(a) distinguish between systematic risk and unsystematic risk. (5)
(b) an investor is considering investment in Securities a and B with the
following data: (10)
Security A B
Expected return 14% 18%
Risk (standard deviation) 3% 6%
If a portfolio with 60% of a and 40% of B is formed, find:
565
B.Com 2018 SEM. VI : fundamentals of investment 566
i. Expected return of the portfolio

ii. Risk of the portfolio if the correlation coefficient is +1.0
iii. Risk of the portfolio if the correlation coefficient is -1.0
2. (a) Distinguish between any two of the following: (5)
i. Fully Convertible Debentures (FCD) and Non-Convertible Debentures
(NCD)
ii. IPO and FPO
iii. Double Bottom and Double Top
iv. Business risk and Financial risk
Ans. : See paras 4.2, 6.5(c), 3.5
(b) X Ltd. has a 10% debenture with a face value of ` 1000 that will mature
at par in 15 years. The debenture is callable in 5 years at ` 1100. It is cur-
rently trading in the market at ` 1050. Calculate: (10)
i. Yield to maturity of the bond
ii. Yield to call of the bond
Or
(a) Define mutual fund. Explain advantages of investing through Systematic
Investment Plan (SIP). (5)
Ans. : See paras 10.3, 10.6(3)
(b) The following information is available about a bond: (10)
Face Value ` 1000
Market price ` 1200
Expected life 5 years
Coupon rate 8%
Investor’s expected rate of return 10%
Find intrinsic value of the bond if the interest is payable:
i. Annually
ii. Semi-annually
Is it a worthwhile investment at the prevailing market price?
3. (a) “Technical analysis is the study of historical prices and volume.” Do
you agree? Explain. (5)
(b) The following information is available about Sumeet Electronics for
the year 2015-16: (10)
567 B.Com 2018 SEM. VI : fundamentals of investment
Annual turnover 5000000

Equity share capital (FV = ` 100) 4000000
Reserves 2000000
8% Preference share capital 2000000
10% Long term loan 1000000
10% Debentures 1000000
Tax rate 30%
Find out:
i. Earnings per share
ii. Dividend per share
iii. Book value per share
iv. Market price per share
Or
(a) Explain the important factors of fundamental analysis. (5)
Ans. : See para 5.2
(b) The equity share of Omega Ltd. is currently trading at ` 70. The company
declared a dividend of ` 4 per share last year. It is expected that earnings
and dividends will grow at the rate of 10% p.a. for the next 5 years and
thereafter at a constant rate of 7% p.a. forever. If the shareholders’ expected
rate of return is 12%, find the intrinsic value of the share. Would you advice
buying of this share at the current market price? (10)
4. (a) What is Efficient Frontier in the context of Harry Markowitz model?
How is an optimum portfolio selected from efficient portfolios? (5)
Ans. : See para 9.3.1
(b) Find out fair price of the following securities using CAPM (Capital Asset
Pricing Model) if the prevailing interest rate on Government securities is
7% and the rate of return on market index is 10%. Also mention which of
these securities is overpriced or underpriced or fairly priced. The beta and
estimated returns on these securities are as follows: (10)
Security A B C D E
Beta 1.00 1.25 1.70 1.50 1.60
Estimated returns (%) 11 10 12 11.5 12
Or
(a) “Futures are improves versions of forward contracts.” Explain the state-
ment, clearly distinguishing between forwards and futures contracts. (5)
Ans. : See paras 11.5, 11.5.2
(b) A 3 months call option is available at a premium of ` 2 per share. Find
out the net pay-off of the option holder as well as the option writer if:
(10)
i. The exercise price is ` 50
ii. The spot price of the share on the exercise day is ` 46, ` 50, ` 52,
` 54, ` 58
5. (a) “In every investment decision, there is an inherent risk-return trade-
off.” Explain. (5)
Ans. : See para 1.5
(b) The earnings of Relaxo Ltd. are expected to grow at the rate of 6% p.a.
The dividend expected on Relaxo’s share a year hence is ` 2. The dividends
are expected to grow at 6% forever. At what price should this share be sold
to an investor having a required rate of return 14%? (5)
(c) A company has Zero COUPON Bond for ` 520 to be redeemed at ` 1000
after 5 years. Is it a worthwhile investment for an investor having a required
rate of return of 16%? (5)
Or
(a) Write short notes on any two: (5,5)
i. Insider trading
ii. SENSEX
iii. Random Walk Theory
iv. SEBI
Ans. : See paras 2.6.7, 2.3, 7.1, 2.4
(b) Calculate NAV per unit of a mutual fund scheme when the following
information is provided: (5)
Cash balance 400000
Bank balance 200000
10% debentures 1000000
Equity shares (FV = ` 100) 1000000
Accrued expenses 100000
Number of units outstanding 200000
10% Debentures and Equity shares are currently trading in the market at
90% and 120% respectively.
Ans. : 1(b)
Pi RX RY PiRX PiRY Pi(Rx - Rx)2 Pi(Ry - Ry)2
0.2 -10 5 -2 1 125 45

0.4 25 30 10 12 40 40
0.3 20 20 6 6 7.5 0
0.1 10 10 1 1 2.5 10
15 20 175 95
Expected Return
E(RX) = ∑P R
i X= 15%
E(RY) = ∑P Ri Y = 20%
Risk
σ X = ∑ P i (RX − R X )2 = 175 = 13.23%
σY = ∑ Pi (RY − RY )2 = 95 = 9.75%
13.23
C .V .X = = 0.88
15
9.75
C .V .Y = = 0.49
20
Or
Ans. : 1(b)(i) Return (Rp) = ∑PW i i = 0.6*0.14+0.4*0.18 = 0.156 or 15.6%
(ii) σp = σ A2 * w A2 + σ B2 * w B2 + 2 * σ Aσ B * w Aw A * r
= 32 * 0.62 + 62 * 0.42 + 2 * 3* 6 * 0.6 * 0.4 *1
= 3.24 + 5.76 + 8.64 = 4.2%

(iii) σp = σ A2 * w A2 + σ B2 * w B2 + 2 * σ Aσ B * w Aw A * r
= 32 * 0.62 + 62 * 0.42 + 2 * 3* 6 * 0.6 * 0.4 * ( −1)
= 3.24 + 5.76 − 8.64 = 0.6%
I + (RV − P ) / n 100 + (1000 − 1050) /15

Ans.: 2(b) YTM (approx.) = = = 9.43%
(RV + P ) / 2 (1000 + 1050) / 2
At 9%, PV= 100 * PVAF9%,15 + 1000 * PVF9%,15
= 100*8.061 + 1000*0.275 = ` 1081.1
At 10%, PV= 1000 * PVAFK%,n + 1000 * PVFK%,n
= 100*7.606 + 1000*0.239 = ` 999.6
1081.1 − 1050
1081.1 − 999.6
I + (RVc − P ) / n 100 + (1100 − 1050) / 5

YTC (approx.) = = = 10.23%
(RVc + P ) / 2 (1100 + 1050) / 2
At 10%, PV = 100 * PVAF10%,5 + 1100 * PVF10%,5
= 100*3.791 + 1000*0.621 = ` 1000.1
At 11%, PV = 100 * PVAF11%,5 + 1100 * PVF11%,5
= 100*3.696 + 1000*0.593 = ` 962.6
At 9%, PV = 100 * PVAF9%,5 + 1100 * PVF9%,5
= 100*3.89 + 1000*0.65 = ` 1039
At 8%, PV = 100 * PVAF8%,5 + 1100 * PVF8%,5
= 100*3.993 + 1000*0.681 = ` 1080.3
1080.3 − 1050
1080.3 − 1039
Or
Ans.: 2(b)(i) P0 = Int * PVAFK%,n + RV * PVFK%,n
= 80 * PVAF10%,5 + 1000 * PVF10%,5
= 80*3.791 + 1000*0.621 = ` 924.28
Since MP (1200) > Intrinsic Value (924.28), so it is a underpriced bond.
Investor should buy it.
(ii) P0 = Int * PVAFK/2%,2n + RV * PVFK/2%,2n

= 40 * PVAF5%,10 + 1000 * PVF5%,10
= 40*7.722 + 1000*0.614 = ` 922.88
Ans. 3(b) PAT = (20%*5000000 − 100000 − 100000)*(1 − 0.3)
= ` 560000
Profits for equity shareholders = PAT – Preference Dividend
= 560000 − 8%*2000000
= ` 400000
400000
EPS = ` 10 per share
40000
DPS = EPS*Dividend Payout Ratio = 10*40% = ` 4 per share
4000000 + 2000000 + 400000
Book value per share = = ` 160 per share
40000
MP per share = PE ratio * EPS
= 20*10 = ` 200
Or
Ans. : 3(b) D0 = ` 4 g1=10% g2=7% Ke=12%
Year Dividend PVF PV of Dividend

1 D1 = 4*(1+0.10) = 4.4 0.893 3.93
2 D2 = 4.4*(1+0.10) = 4.84 0.797 3.86
3 D3 = 4.84*(1+0.10) = 5.324 0.711 3.78
4 D4 = 5.324*(1+0.10) = 5.856 0.636 3.72
5 D5 = 5.856*(1+0.10) = 6.442 0.567 3.65
18.94
d6 *(1 + g) 6.442*(1 + 0.07) 6.893

P5 = = = = ` 137.86
Ke − g 0.12 − 0.07 0.05
P0 = PV of first five years’ dividend + PV of P5
= 18.94 + 137.86*0.567 = ` 97.11
Since the share is trading above its intrinsic value, one should not buy it
as it is overpriced.
Ans. : 4(b)
Security Beta CAPM Return Estimated Remarks
returns
A 1.00 = 0.07+(0.10-0.07)*1 = 10% 11% Underpriced
B 1.25 = 0.07+(0.10-0.07)*1.25 = 10.75% 10% Overpriced
C 1.70 = 0.07+(0.10-0.07)*1.7 = 12.1% 12% Overpriced
D 1.50 = 0.07+(0.10-0.07)*1.5 = 11.5% 11.5% Fairly priced
E 1.60 = 0.07+(0.10-0.07)*1.6 = 11.8% 12% Underpriced
Or
Ans.: 4(b) Pay-off of Call Option Writer
Share price 46 50 52 54 58
Option exercise No No Yes Yes Yes
Inflow (strike price) - - 50 50 50
Inflow (premium) 2 2 2 2 2
Total inflow 2 2 52 54 58
Outflows (share price) - - 52 54 58
Net pay-off 2 2 0 -2 -6
Pay-off of Call Option Holder
Share price 46 50 52 54 58
Outflow (strike price) - - 50 50 50
Outflow (premium) 2 2 2 2 2
Total Outflow 2 2 52 54 58
Inflows (share price) - - 52 54 58
Net pay-off -2 -2 0 2 6
Ans. : 5(b) D1 = ` 2 g = 6 % Ke = 14%
d1 2
P0 = = = ` 25 per share
Ke − g 0.14 − 0.06
RV
Ans.: 5(c) P0 =
(1 + K d )
n
1000
Intrinsic Value = = ` 476.11
(1 + 0.16 )
5
Market Price > Intrinsic Value, it is an overpriced bond. It is not profitable

to buy.
Or
400000 + 200000 + 900000 + 1200000 − 100000
Ans. : 5(b) naV = = ` 13 per unit
200000
B.COM (HON.) 2019
SEM. VI :

Q.1. (a) What do you mean by investor’s education? What are the right
and responsibilities of an investor? (4)
Ans. : See para 12.8
(b) an investor wants to invest in one of the two securities with equal
returns but different probabilities. Compare the expected return and risk
of both the securities. Which security should the investor buy? (11)
Return Probability (X) Probability (Y)
-5 0.2 0.1
10 0.3 0.1
12 0.2 0.3
15 0.2 0.2
18 0.1 0.3
OR
(a) What is SEBI? What are its objectives? (4)
Ans. : See para 2.4
(b) an investor purchases an equity share at a price of Rs. 50. Its expected
year end price and dividend with relevant probabilities are given below:
0.20 70 6
0.15 65 5
0.25 55 4
574
575 B.COM (HON.) 2019 SEM. VI : fundamentals of investment

0.15 50 3
0.25 42 Nil
Find out the expected return and variability of the equity share. (11)
Q.2. (a) What is primary market? How is it different from secondary mar-
ket? (4)
Ans. : See para 1.6
(b) Mr. X is considering buying a bond having face value of Rs. 2000 which
will be redeemed over a period of 5 years in five equal annual instalments.
The bond carries a coupon interest rate of 8%. Find the value at which
Mr. X would like to buy the bond if his expected rate of return is 10%. (11)
OR
(a) Define the term investment. What factors should an investor consider
while making investment decision? (4)
Ans. : See paras 1.1, 1.3.1
(b) A 12% bond of Rs. 100 is available in the market at Rs. 95. The interest
is payable semi-annually. It will be maturing 5 years from now. Compute
the YTM of this bond. What will be the value of the bond if the required
rate of return of an investor is 14%? Should he buy the bond? (11)
Q.3. (a) Differentiate between Bar Chart and Candlestick Chart (4)
(b) ABC Co. is expected to grow at 10% p.a. for next 4 years and then grow
only at 7% p.a. infinitely. The required rate of return on the equity shares
is 12%. The company paid a dividend of Rs. 2 share last year. Determine
the market price of the share today. (11)
OR
(a) What is Market Efficiency? What are its three forms? (4)
(b) A company’s share is currently selling at Rs. 144. The last dividend paid
was Rs 9.60. If dividends are expected to grow at a constant rate g and if
required rate of return (Ke) is 12%, what is XYZ’s expected share price 2
years from now? (11)
Q.4. (a) What do you mean by Credit Rating? Explain its importance in
investment decision. (4)
Ans. : See paras 4.11, 4.11.3
(b) The following information is available on two securities A & B (11)
B.COM (HON.) 2019 SEM. VI : fundamentals of investment 576
Security Return Standard deviation

A 12% 16%
B 15% 20%
The correlation coefficient between the returns of A & B is 0.8. An investor
wants to put 40% of his investment in A and 60% in B or 60% in A and 40%
in B. Which portfolio is better?
OR
(a) What is a deep discount bond? How is the value of such bond calculated?
(4)
Ans. : See paras 4.2 & 4.6
(b) From the data given below find which of the following securities are
over priced or under priced using SML equation: (11)
Security P Q R S T
Beta 1.6 0.5 1.2 3.0 1.9
Return 15 10 18 25 15
The return on market index is 12% and the return on risk free asset is 8%.
Q.5. (a) The following particulars are given relating to a mutual fund: (4)
Opening NAV per unit Rs. 104 crores
Closing NAV per unit Rs. 162 crores
Administrative expenses including fund manager remu- Rs. 253 lakhs
neration
Management advisory fees Rs. 132 lakhs
Publicity and documentation Rs. 70 lakhs
Ascertain the expense ratio.
(b) Mr. X is holding shares of A Ltd. in his portfolio. Probability distribution
of expected return from this stock and market index is given below: (11)
Situation Probability Return of A (%) Return of Market (%)
Recession 0.2 10 10
Average 0.4 12 16
Good 0.3 21 22
Boom 0.1 27 29
The risk free rate is 6%. Assuming that CAPM conditions hold true, should
Mr. A continue to hold this stock in his portfolio?
OR
(a) What do you mean by Systematic Investment Plan? What are its ben-
efits? (4)
Ans.: See para 10.6
(b) Mr. A has bought call and put options both. Each contract is of 100
shares. He has purchased one 3-months call with a strike price of Rs. 54
and Rs. 2 as premium. He has purchased a 3-months put option with a
strike price of Rs. 50 and Rs. 1 as premium. Find out his position and total
profit or loss if the stock price on expiration date is (i) Rs. 48, (ii) Rs 58.
(11)
Ans.: 1 (b)
Ri PX PY PiRX PiRY Pi (RX − RX )2 Pi (RY − RY )2
-5 0.2 0.1 -1 -0.5 40.328 30.625

10 0.3 0.1 3 1 0.192 0.625
12 0.2 0.3 2.4 3.6 1.568 0.075
15 0.2 0.2 3 3 5.8 1.25
18 0.1 0.3 1.8 5.4 7.744 9.075
9.2 12.5 55.632 41.65
Expected Return
E (RX) = ∑PiRX = 9.2%
E (RY) = ∑PiRY = 12.5%
Risk
σX = ∑Pi (RX − RX )2 = 55.632 = 7.46%
σY = ∑Pi (RY − RY )2 = 41.65 = 6.45%
7.46
C .V .X = = 0.81
9.2
6.45
C .V .Y = = 0.52
12.5
OR
Ans. : 1 (b) Purchase Price = Rs. 50

Total Return (Ri)(%) = (Div + Cap Gain)/Purchase Price*100
Prob Share Divi- Capital (Ri) (%) Pi* Ri Pi * (Ri − Ri )2
(Pi) Price dend Gain
0.20 70 6 20 52 10.4 233.928
0.15 65 5 15 40 6 73.926
0.25 55 4 5 18 4.5 0.01
0.15 50 3 0 6 0.9 20.886
0.25 42 Nil -8 -16 -4 285.61
Return = ∑PiRi = 17.8%
Risk = σi = ∑Pi (Ri − Ri )2 = 614.36 = 24.79%
Ans.:2 (b) Bond Price = PV of future cash inflows

Year Interest Redemption Total Inflows PVF10%,n PV of In-
(n) Inflows flows
1 160 400 560 0.909 509.04
2 128 400 528 0.826 436.128
3 96 400 496 0.751 372.496
4 64 400 464 0.683 316.912
5 32 400 432 0.621 268.272
Bond Price Rs.1902.848
OR
I + (RV − P) / n 6 + (100 − 95) /10
Ans. : 2 (b) YTM (approx.) = = = 6.67%
(RV + P) / 2 (100 + 95) / 2
At 10%, PV= 6 × PVAF6%, 10 + 100 × PVF6%, 10

= 6×7.36 + 100 × 0.558 = Rs. 99.96
At 11%, PV= 6 × PVAF7%, 10 + 100 × PVF7%,10
= 6×7.024 + 100 × 0.508 = Rs. 92.944
99.96 − 95
99.96 − 92.944
Present Value of bond
At 14%, PV= 6 × PVAF7%, 10 + 100 × PVF7%, 10
= 6×7.024 + 100 × 0.508 = Rs. 92.944

Since the bond is available at a price (Rs. 95) above its fair value (Rs. 92.944),
he should not buy the bond.
Ans.: 3 (b) D0 = Rs. 2 g1=10% g2=7% Ke = 12%
Year (n) Dividend PVF12%,n PV of Dividend
1 D1 = 2×(1 + 0.10) = 2.2 0.893 1.9646
2 D2 = 2.2×(1 + 0.10) = 2.42 0.797 1.9287
3 D3 = 2.42×(1.10) = 2.662 0.712 1.8953
4 D4 = 2.662×(1.10) = 2.9282 0.636 1.8623
TOTAL 7.6509
D5 2.9282 × (1 + 0.07) 3.1332
P4 = = Rs. 62.66
Ke − g
= 0.12 − 0.07 = 0.05
P0 = PV of first four years’ dividend + PV of P4
= 7.65 + 62.66×0.636 = Rs. 47.50
OR
Ans. :3 (b) D0 = Rs 9.6 P0 = Rs 144 Ke=12%
d1
P0 =
ke − g
9.6×(1 + g)
144 =
0.12 − g
g = 5%
d3 9.6*(1 + 0.05)3
P2 = = Rs. 158.76
Ke − g
= 0.12 − 0.05
Ans.: 4 (b) (i) A - 40%, B - 60%
Return (Rp) = ∑PiWi = 0.4×12+0.6×15 = 13.8%
σp = σ 2A ×w A2 + σ 2B ×w B2 + 2×σ A σ B ×w Aw A ×r
= 162 ×0.42 + 202 ×0.62 + 2×16×20×0.4×0.6×0.8
40.96 + 144 + 122.88 = 17.55%

C.V = 17.55/13.8 = 1.272
(ii) A-60%, B-40%
Return (Rp)= ∑PiWi = 0.6×12+0.4×15 = 13.2%
2 2 2 2
σp = σ A ×w A + σ B ×w B + 2×σ A σ B ×w Aw A ×r
2 2 2 2
= 16 ×0.6 + 20 ×0.4 + 2×16×20×0.6×0.4×0.8
= 92.16 + 64 + 122.88 = 16.70%

C.V. = 16.70/13.2 = 1.265
Therefore, portfolio (ii) is better because it has lower coefficient of variation.
OR
Ans. : 4 (b) SML equation is Ri= Rf + (Rm- Rf )× β
Security P Q R S T
Expected =8 + (12 =8+ = 8 + (12 - = 8 + (12 - = 8 + (12 -
return As - 8) × 1.6 (12 - 8) × 1.2 = 8) × 3.0 = 8) × 1.9 =
per SML =14.4% 8)×0.5 12.8% 20% 15.6%
=10%
Actual 15% 10% 18% 25% 15%
Return
Remark Under Fairly Under Under Over
priced priced priced priced priced
Ans.: 5 (a) Expenses = 253 + 132 + 70 = Rs. 455 lakhs
Average AUM = (104 + 162)/2 = Rs. 133 crores = Rs. 13300 lakhs
Expenses 455
Expense Ratio = × 100 × 100 = 3.42%
average auM 13300
=
Ans. : 5 (b)
Situation (Pi) RA (%) Rm (%) Pi × RA Pi × Rm Pi × [(Rm-E(Rm)]2
Recession 0.2 10 10 2 2 12.482
Average 0.4 12 16 4.8 6.4 1.444
Good 0.3 21 22 6.3 6.6 5.043
Boom 0.1 27 29 2.7 2.9 12.321
Total 15.8 17.9 31.29
E (RA) = 15.8% E(Rm) = 17.9%
Market Variance = 31.29 sq. %
Covariance of Market and Share A
Situation (Pi) RA-E(RA) Rm-E(Rm) Pi×[RA-E(RA)× Rm-E(Rm)]
Recession 0.2 -5.8 -7.9 9.164
Average 0.4 -3.8 -1.9 2.888
Situation (Pi) RA-E(RA) Rm-E(Rm) Pi×[RA-E(RA)× Rm-E(Rm)]

Good 0.3 5.2 4.1 6.396
Boom 0.1 11.2 11.1 12.432
Covariance 30.88
For CAPM, we need beta factor of the share.
Covariance
Beta (β) = = 30.88/31.29 = 0.987
Market Variance
CAPM Return, E(RA) = 6+(17.9-6)×0.987 = 17.74%
CAPM return > Estimated Return, so, it is overpriced. Mr. A should sell it.
OR
Ans.: 5(b)(i)
Strike price 54 50
Premium 2 1
Position Out of money In the money
Exercise the option NO YES
Profit or loss = 2 × 100 = Rs 200 loss = [100 × (50 - 48)] - 1
× 100 = Rs. 100 profit
Net Profit or loss = 200-100 = Rs. 100
LOSS
(ii)
Strike price 54 50
Premium 2 1
Spot price on expiry 58 58
date
Position In the money Out of money
Decision YES NO
Profit or loss = 100×(58 - 54) - 2 × 100 = Rs. = 1× 100 = Rs. 100
200 profit loss
Net Profit or loss = 200-100 = Rs. 100 PROFIT
B.COM 2019
SEM. VI :

Q.1. (a) define Investment. distinguish it from speculation and Gam-
bling. (5)
(b) Mr. Raman is considering two investment proposals. the probability
distribution of returns on these two stocks in different market conditions
is as follows: (10)
Rate of return (%)
economic conditions Probability of occurrence
X ltd. Y ltd.
1 0.2 -10 5
2 0.3 25 30
3 0.3 20 20
4 0.2 10 10
Based on this information, calculate expected risk and return on both the
proposals. also suggest to Mr. Raman, which investment proposal is better.
OR
(a) define Risk. distinguish it from uncertainty. explain briefly main sources
of risk in investment. (5)
Ans. : See paras 3.3, 3.4, 3.5
(b) an investor is considering investment in securities a and B with the
following data: (10)
security a B
expected return 14% 19%
Risk (standard deviation) 3% 6%
582
583 B.COM 2019 : sem. VI : Fundamentals of Investment
If a portfolio with 60% of A and 40% of B is formed, find:

i. Expected return of the portfolio
ii. Risk of the portfolio if the correlation coefficient is 0.5
iii. Minimum risk of the portfolio
Q.2. (a) Distinguish between any two of the following: (5)
i. Deep Discount Bond (DDB) and Zero Interest Fully Convertible
Debentures (ZFCD)
ii. Primary market and Secondary market
iii. Support level and Resistance level
Ans. : See paras 4.2, 2.1.2, 6.5 (a)
(b) X Ltd. has a 14% debenture with a face value of Rs. 1000 that will
mature at par in 15 years. The debenture is callable in 5 years at Rs. 1140.
It is currently trading in the market at Rs. 1050. Calculate: (10)
i. Yield to maturity of the bond
ii. Yield to call of the bond
OR
(a) What are the advantages of investing through a mutual fund? (5)
(b) The following information is available about a bond: (10)
Face Value Rs. 1000
Market price Rs. 1050
Expected life 5 years
Coupon rate 8%
Investor’s expected rate of return 10%
Find intrinsic value of the bond if the interest is payable:
i. Annually
ii. Semi-annually
Is it a worthwhile investment at the prevailing market price?
Q.3. (a) Are Fundamental Analysis and Technical Analysis mutually exclu-
sive? (5)
Ans. : See para 6.2
(b) The following information is available about Amit Electronics for the
year 2015-16: (10)
B.COM 2019 : sem. VI : Fundamentals of Investment 584
Annual turnover 6000000

Equity share capital (FV=Rs. 100) 4000000
Reserves 1500000
12% Preference share capital 2000000
10% Long term loan 1500000
12% Debentures 1000000
Tax rate 30%
Find out:
i. Earnings per share
ii. Dividend per share
iii. Book value per share
iv. Market price per share
OR
(a) Explain the DOW Theory of Technical Analysis with the help of dia-
grams. (5)
(b) The equity share of Zenith Ltd. is currently trading at Rs. 50. The com-
pany declared a dividend of Rs. 3 per share last year. It is expected that
earnings and dividends will grow at the rate of 10% p.a. for the next 5 years
and thereafter at a constant rate of 7% p.a. forever. If the shareholders’
expected rate of return is 16%, find the intrinsic value of the share. Would
you advice buying of this share at the current market price? (10)
Q.4. (a) What is Efficient Frontier? How is an optimum portfolio selected
from efficient portfolios? (5)
(b) Find out fair price of the following securities using CAPM (Capital Asset
Pricing Model) if the prevailing interest rate on Government securities is
7% and the rate of return on market index is 10%. Also mention which of
these securities is overpriced or underpriced or fairly priced. The beta and
estimated returns on these securities are as follows: (10)
Security A B C D E
Beta 1.00 1.25 1.70 1.50 1.60
Estimated returns (%) 11 10 12 11.5 12
OR
(a) How do stock options differ from stock futures? Explain. (5)
(b) A 3-months call option is available at a premium of Rs. 2 per share. Find
out the net pay-off of the option holder as well as the option writer if: (10)
i. The exercise price is Rs. 50
ii. The spot price of the share on the exercise day is Rs. 36, Rs. 50, Rs.
52, Rs. 54, Rs. 68
Q.5. (a) “In every investment decision, there is an inherent risk-return
trade-off.” Explain. (5)
Ans. : See para 1.5
(b) The earnings of RE Ltd. are expected to grow at the rate of 6% p.a. The
dividend expected on RE’s share a year hence is Rs. 2. The dividends are
expected to grow at 6% forever. At what price should this share be sold to
an investor having a required rate of return 14%? (5)
(c) A company has Zero COUPON Bond for Rs. 520 to be redeemed at Rs.
1000 after 5 years. Is it a worthwhile investment for an investor having a
required rate of return of 16%? (5)
OR
(a) Write short notes on any two: (5,5)
i. Stop loss order
ii. NIFTY
iii. Efficient Market Hypothesis (EMH)
iv. SEBI’s initiatives on investor protection
Ans. : (i) A stop loss order is basically designed to limit the amount of potential
loss on buy/sell position. Stop loss is an order placed to buy or sell security
once a certain price is reached. It is an order to buy (or sell) a security once
the price of the security rises above (or falls below) a specified stop price.
(ii) See para 2.3
(iii) See para 7.2
(iv) See para 12.6
(b) Calculate NAV per unit of a mutual fund scheme when the following
information is provided: (5)
Cash balance 400000
Bank balance 200000
10% debentures 1000000
Equity shares (FV=Rs. 100) 1000000
Accrued expenses 100000
Number of units outstanding 200000
10% Debentures and Equity shares are currently trading in the market at
90% and 120% respectively.
Ans.: 1 (b)
Pi RX RY PiRX PiRY
Pi (RX − RX )2 Pi (RY − RY )2
0.2 -10 5 -2 1 110.45 33.8
0.3 25 30 7.5 9 39.675 43.2
0.3 20 20 6 6 12.675 1.2
0.2 10 10 2 2 2.45 12.8
13.5 18 165.25 91
Expected Return
E(RX)= ∑P R i X= 13.5%
E(RY)= ∑P R i Y = 18%
Risk
4
σ X = ∑Pi (R X − R X ) 2 = 2 165.25 = 12.85%
1
4
σ Y = ∑Pi (RY − R Y ) 2 = 2 91 = 9.54%
1
12.85
C.V. X = = 0.95
13.5
9.54
C.V.Y = = 0.53
18
OR
Ans.: 1 (b) (i) Return (Rp)= ∑P Wi i = 0.6 × 0.14 + 0.4 × 0.19 = 0.16 or 16%
(ii) σp = σ 2A ×w A2 + σ 2B ×w B2 + 2×σ A σ B ×w Aw A ×r
= 3 2 ×0.6 2 + 6 2 ×0.4 2 + 2×3×6×0.6×0.4×0.5
= 3.24 + 5.76 + 4.32 = 3.65 %
(iii) σp = σ 2A ×w A2 + σ 2B ×w B2 + 2×σ A σ B ×w Aw A ×r
= 3 2 ×0.6 2 + 6 2 ×0.4 2 + 2×3×6×0.6×0.4×(−1)
= 3.24 + 5.76 − 8.64 = 0.6%

I + (RV − P ) / n 140 + (1000 − 1050) /15
Ans.: 2 (b) YTM (approx.) = = = 13.33%
(RV + P ) / 2 (1000 + 1050) / 2
At 14%, PV= 140 × PVAF14%,15 + 1000 × PVF14%,15

= 140×6.142 + 1000×0.140 = Rs. 999.88
At 13%, PV= 140 × PVAF13%,15 + 1000 × PVF13%,15
= 140 × 6.462+ 1000 × 0.160 = Rs. 1064.68
1064.68 − 1050
1064.68 − 999.88
I + (RVc − P ) / n 140 + (1140 − 1050) / 5
YTC (approx.) = = = 14.43%
(RVc + P ) / 2 (1140 + 1050) / 2
At 15%, PV= 140 × PVAF15%,5 + 1140 × PVF15%,5

= 140×3.352+ 1140×0.497 = Rs. 1035.86
At 14%, PV= 140 × PVAF14%,5 + 1140 × PVF14%,5
= 140×3.433 + 1140×0.519 = Rs. 1072.28
1072.28 − 1050
1072.28 − 1035.86
OR
Ans.: 2 (b) (i) P0 = Int × PVAFK%,n + RV × PVFK%,n
= 80 × PVAF10%,5 + 1000 × PVF10%,5

= 80×3.791 + 1000×0.621 = Rs. 924.28
(ii) P0 = Int × PVAFK/2%, 2n + RV × PVFK/2%, 2n
= 40 × PVAF5%,10 + 1000 × PVF5%,10
= 40×7.722 + 1000×0.614 = Rs. 922.88
Ans.: 3 (b) PAT = (25% × 6000000 - 120000 - 150000 × (1 - 0.3))
= Rs. 861000
Profits for equity shareholders = PAT - Preference Dividend
= 861000 - 12% × 2000000
= Rs. 621000
621000
ePs = = Rs. 15.525 per share
40000
DPS = EPS × Dividend Payout Ratio = 15.525 × 40% = Rs. per share
4000000 + 1500000 + 2000000
Book value per share= = Rs. 187.5 per share
40000
MP per share = PE ratio × EPS
= 23×15.525 = Rs 357.075
OR
Ans.:3 (b) D0 = Rs. 3 g1=10% g2 = 7% Ke=16%
Year Dividend PVF PV of Dividend
1 D1 = 3×(1 + 0.10) = 3.3 0.862 2.8446
2 D2 = 3.3×(1 + 0.10) = 3.63 0.743 2.6971
3 D3 = 3.63×(1 + 0.10) = 3.993 0.641 2.5595
4 D4=3.993×(1 + 0.10) = 4.3923 0.552 2.4245
5 D5=4.3923×(1 + 0.10) = 4.8315 0.476 2.2998
12.82
d 6 ×(1 + g) 4.8315×(1 + 0.07) 5.1697
P5 = = = = Rs. 57.44
Ke − g 0.16 − 0.07 0.09
P0 = PV of first five years’ dividend + PV of P5
= 12.82 + 57.44+×0.476 = Rs. 40.16

Since the share is trading above its intrinsic value, one should not buy it
as it is overpriced.
Ans.: 4 (b)
Secu- Estimated
Beta CAPM Return Remarks
rity returns
Under-
A 1.00 =0.07+(0.10-0.07)×1= 10% 11%
priced
=0.07+(0.10-0.07)×1.25=
B 1.25 10% Overpriced
10.75%
C 1.70 =0.07+(0.10-0.07)×1.7= 12.1% 12% Overpriced
Fairly
D 1.50 =0.07+(0.10-0.07)×1.5= 11.5% 11.5%
priced
Under-
E 1.60 =0.07+(0.10-0.07)×1.6= 11.8% 12%
priced
OR
Ans.: 4 (b) Pay-off of Call Option Writer
Share price 36 50 52 54 68
Inflow (strike price) - - 50 50 50
Inflow (premium) 2 2 2 2 2
Total inflow 2 2 52 52 52
Outflows (share price) - - 52 54 68
Net payoff 2 2 0 -2 -16
Pay-off of Call Option Holder
Share price 36 50 52 54 68
Outflow (strike price) - - 50 50 50
Outflow (premium) 2 2 2 2 2
Total Outflow 2 2 52 52 52
Inflows (share price) - - 52 54 58
Net payoff -2 -2 0 2 16
Ans.: 5 (b) D1 = Rs. 2 g = 6% Ke = 14%
d1 2
P0 = = = Rs. 25 per share
Ke − g 0.14 − 0.06
RV
Ans.: 5 (c) P0 =
(1 + K )
n
d
1000
Intrinsic Value = = Rs. 476.11
( 0.16) 5
1 +
Market Price > Intrinsic Value, it is an overpriced bond. It is not profitable

to buy.
OR
400000 + 200000 + 900000 + 1200000 − 100000
Ans.: 5 (b) naV =
200000

= Rs. 13 per unit

Mathematical Tables
Table A1 : Present Value Factor for a lump sum amount {PVF (r%, n)}
Period
n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893 0.885 0.877 0.870
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 0.812 0.797 0.783 0.769 0.756
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 0.731 0.712 0.693 0.675 0.658
4 0.961 0.924 0.889 0.855 0.823 0.792 0.763 0.735 0.708 0.683 0.659 0.636 0.613 0.592 0.572
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 0.593 0.567 0.543 0.519 0.497
6 0.942 0.888 0.838 0.790 0.746 0.705 0.666 0.630 0.596 0.564 0.535 0.507 0.480 0.456 0.432
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 0.482 0.452 0.425 0.400 0.376
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 0.434 0.404 0.376 0.351 0.327
591
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 0.391 0.361 0.333 0.308 0.284
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 0.352 0.322 0.295 0.270 0.247
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 0.317 0.287 0.261 0.237 0.215
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 0.286 0.257 0.231 0.208 0.187
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 0.258 0.229 0.204 0.182 0.163
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 0.232 0.205 0.181 0.160 0.141
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 0.209 0.183 0.160 0.140 0.123
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 0.188 0.163 0.141 0.123 0.107
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 0.170 0.146 0.125 0.108 0.093
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 0.153 0.130 0.111 0.095 0.081
19 0.828 0.686 0.570 0.475 0.396 0.331 0.276 0.232 0.194 0.164 0.138 0.116 0.098 0.083 0.070
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149 0.124 0.104 0.087 0.073 0.061
25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092 0.074 0.059 0.047 0.038 0.030
30 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057 0.044 0.033 0.026 0.020 0.015

Table A1 : Present Value Factor for a lump sum amount {PVF (r%, n)}
Period
n 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
1 0.862 0.855 0.847 0.840 0.833 0.826 0.820 0.813 0.806 0.800 0.794 0.787 0.781 0.775 0.769
2 0.743 0.731 0.718 0.706 0.694 0.683 0.672 0.661 0.650 0.640 0.630 0.620 0.610 0.601 0.592
3 0.641 0.624 0.609 0.593 0.579 0.564 0.551 0.537 0.524 0.512 0.500 0.488 0.477 0.466 0.455
4 0.552 0.534 0.516 0.499 0.482 0.466 0.451 0.437 0.423 0.410 0.397 0.384 0.373 0.361 0.350
5 0.476 0.456 0.437 0.419 0.402 0.386 0.370 0.355 0.341 0.328 0.315 0.303 0.291 0.280 0.269
6 0.410 0.390 0.370 0.352 0.335 0.319 0.303 0.289 0.275 0.262 0.250 0.238 0.227 0.217 0.207
7 0.354 0.333 0.314 0.296 0.279 0.263 0.249 0.235 0.222 0.210 0.198 0.188 0.178 0.168 0.159
8 0.305 0.285 0.266 0.249 0.233 0.218 0.204 0.191 0.179 0.168 0.157 0.148 0.139 0.130 0.123
9 0.263 0.243 0.226 0.209 0.194 0.180 0.167 0.155 0.144 0.134 0.125 0.116 0.108 0.101 0.094
10 0.227 0.208 0.191 0.176 0.162 0.149 0.137 0.126 0.116 0.107 0.099 0.092 0.085 0.078 0.073
11 0.195 0.178 0.162 0.148 0.135 0.123 0.112 0.103 0.094 0.086 0.079 0.072 0.066 0.061 0.056
12 0.168 0.152 0.137 0.124 0.112 0.102 0.092 0.083 0.076 0.069 0.062 0.057 0.052 0.047 0.043
13 0.145 0.130 0.116 0.104 0.093 0.084 0.075 0.068 0.061 0.055 0.050 0.045 0.040 0.037 0.033
14 0.125 0.111 0.099 0.088 0.078 0.069 0.062 0.055 0.049 0.044 0.039 0.035 0.032 0.028 0.025
Mathematical Tables
15 0.108 0.095 0.084 0.074 0.065 0.057 0.051 0.045 0.040 0.035 0.031 0.028 0.025 0.022 0.020
16 0.093 0.081 0.071 0.062 0.054 0.047 0.042 0.036 0.032 0.028 0.025 0.022 0.019 0.017 0.015
17 0.080 0.069 0.060 0.052 0.045 0.039 0.034 0.030 0.026 0.023 0.020 0.017 0.015 0.013 0.012
18 0.069 0.059 0.051 0.044 0.038 0.032 0.028 0.024 0.021 0.018 0.016 0.014 0.012 0.010 0.009
19 0.060 0.051 0.043 0.037 0.031 0.027 0.023 0.020 0.017 0.014 0.012 0.011 0.009 0.008 0.007
20 0.051 0.043 0.037 0.031 0.026 0.022 0.019 0.016 0.014 0.012 0.010 0.008 0.007 0.006 0.005
25 0.024 0.020 0.016 0.013 0.010 0.009 0.007 0.006 0.005 0.004 0.003 0.003 0.002 0.002 0.001
30 0.012 0.009 0.007 0.005 0.004 0.003 0.003 0.002 0.002 0.001 0.001 0.001 0.001 0.000 0.000
592
Table A2 : Present Value Factor for an Annuity {PVFA (r%, n)}
593
Period
n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.901 0.893 0.885 0.877 0.870
2 1.970 1.942 1.913 1.886 1.859 1.833 1.783 1.783 1.759 1.736 1.713 1.690 1.668 1.647 1.626
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 2.444 2.402 2.361 2.322 2.283
4 3.902 3.808 3.717 3.630 3.546 3.465 3.312 3.312 3.240 3.170 3.102 3.037 2.974 2.914 2.855
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 3.696 3.605 3.517 3.433 3.352
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 4.231 4.111 3.998 3.889 3.784
7 6.728 6.472 6.230 6.002 5.789 5.582 5.389 5.206 5.033 4.868 4.712 4.564 4.423 4.288 4.160
8 7.652 7.326 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 5.146 4.968 4.799 4.639 4.487
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 5.537 5.328 5.132 4.946 4.772
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 5.889 5.650 5.426 5.216 5.019
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 6.207 5.938 5.687 5.453 5.234
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 6.492 6.194 5.918 5.660 5.421
13 12.134 11.348 10.635 9.986 9.394 8.858 8.358 7.904 7.487 7.103 6.750 6.424 6.122 5.842 5.583
14 13.004 12.106 11.296 10.563 9.899 9.295 8.746 8.244 7.786 7.367 6.982 6.628 6.303 6.002 5.724
Mathematical Tables
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.560 8.061 7.606 7.191 6.811 6.462 6.142 5.847
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 7.379 6.974 6.604 6.265 5.954
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.002 7.549 7.120 6.729 6.373 6.047
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 7.702 7.250 6.840 6.467 6.128
19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 7.893 7.366 6.938 6.50 6.198
20 18.046 16.352 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514 7.963 7.469 7.025 6.623 6.259
25 22.023 19.524 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077 8.422 7.843 7.330 6.873 6.464
30 25.808 22.397 19.601 17.292 15.373 13.765 12.409 11.258 10.274 9.427 8.694 8.005 7.496 7.003 6.566

Table A2 : Present Value Factor for an Annuity {PVFA (r%, n)}
Period
n 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
1 0.862 0.855 0.847 0.850 0.833 0.826 0.820 0.813 0.806 0.800 0.794 0.787 0.781 0.775 0.769
2 1.605 1.585 1.566 1.547 1.528 1.509 1.492 1.474 1.457 1.440 1.424 1.407 1.392 1.376 1.361
3 2.246 2.210 2.174 2.140 2.106 2.074 2.042 2.011 1.981 1.952 1.923 1.896 1.868 1.842 1.816
4 2.798 2.743 2.690 2.639 2.589 2.540 2.494 2.448 2.404 2.362 2.320 2.280 2.241 2.203 2.166
5 3.274 3.199 3.127 3.058 2.991 2.926 2.864 2.803 2.745 2.689 2.635 2.583 2.532 2.483 2.436
6 3.685 3.589 3.498 3.410 3.326 3.245 3.167 3.092 3.020 2.951 2.885 2.821 2.759 2.700 2.643
7 4.039 3.922 3.812 3.706 3.605 3.508 3.416 3.327 3.242 3.161 3.083 3.009 2.937 2.868 2.802
8 4.344 4.207 4.078 3.954 3.837 3.726 3.619 3.518 3.421 3.329 3.241 3.156 3.076 2.999 2.925
9 4.607 4.451 4.303 4.163 4.031 3.905 3.786 3.673 3.566 3.463 3.366 3.273 3.184 3.100 3.019
10 4.833 4.659 4.494 4.339 4.192 4.054 3.923 3.799 3.682 3.570 3.465 3.364 3.269 3.178 3.092
11 5.029 4.836 4.656 4.487 4.327 4.177 4.035 3.902 3.776 3.656 3.544 3.437 3.335 3.239 3.147
12 5.197 4.988 4.793 4.611 4.439 4.278 4.127 3.985 3.851 3.725 3.606 3.493 3.387 3.286 3.190
13 5.342 5.118 4.910 4.715 4.533 4.362 4.203 4.053 3.912 3.780 3.656 3.538 3.427 3.322 3.223
14 5.468 5.229 5.008 4.802 4.611 4.432 4.265 4.108 3.962 3.824 3.695 3.573 3.459 3.351 3.249
Mathematical Tables
15 5.575 5.324 5.092 4.876 4.675 4.489 4.315 4.153 4.001 3.859 3.726 3.601 3.483 3.373 3.268
16 5.669 5.405 5.162 4.938 4.730 4.536 4.357 4.189 4.033 3.887 3.751 3.623 3.503 3.390 3.283
17 5.749 5.475 5.222 4.990 4.775 4.576 4.391 4.219 4.059 3.910 3.771 3.640 3.518 3.403 3.295
18 5.818 5.534 5.273 5.033 4.812 4.608 4.419 4.243 4.080 3.928 3.786 3.654 3.529 3.413 3.311
19 5.877 5.585 5.316 5.070 4.843 4.635 4.442 4.263 4.097 3.942 3.799 3.664 3.539 3.421 3.311
20 5.929 5.628 5.353 5.101 4.870 4.657 4.460 4.279 4.110 3.954 3.808 3.673 3.546 3.427 3.316
25 6.097 5.766 5.467 5.195 4.948 4.721 4.514 4.323 4.147 3.985 3.834 3.694 3.564 3.442 3.329
30 6.177 5.829 5.517 5.235 4.979 4.746 4.534 4.339 4.160 3.995 3.842 3.701 3.569 3.447 3.332
594
Table A3 : Compound Value Factor for a lump sum amount {CVF (r%, n)}
595
Period
n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090 1.100 1.110 1.120 1.130 1.140 1.150
2 1.020 1.040 1.061 1.082 1.102 1.124 1.145 1.166 1.188 1.210 1.232 1.254 1.277 1.300 1.322
3 1.030 1.061 1.093 1.125 1.158 1.191 1.225 1.260 1.295 1.331 1.368 1.405 1.443 1.482 1.521
4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 1.412 1.464 1.518 1.574 1.630 1.689 1.749
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539 1.611 1.685 1.762 1.842 1.925 2.011
6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677 1.772 1.870 1.974 2.082 2.195 2.313
7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949 2.076 2.211 2.353 2.502 2.660
8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993 2.144 2.305 2.476 2.658 2.853 3.059
9 1.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172 2.358 2.558 2.773 3.004 3.252 3.518
10 1.105 1.219 1.344 1.480 1.629 1.791 1.967 2.159 2.367 2.594 2.839 3.106 3.395 3.707 4.046
11 1.116 1.243 1.384 1.539 1.710 1.898 2.105 2.332 2.580 2.853 3.152 3.479 3.836 4.226 4.652
12 1.127 1.268 1.426 1.601 1.796 2.012 2.252 2.518 2.813 3.138 3.498 3.896 4.335 4.818 5.350
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.056 3.452 3.883 4.363 4.898 5.492 6.153
14 1.149 1.319 1.513 1.732 1.930 2.261 2.579 2.937 3.342 3.797 4.310 4.887 5.535 6.261 7.076
Mathematical Tables
15 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 4.177 4.785 5.474 6.254 7.138 8.137
16 1.173 1.373 1.605 1.873 2.183 2.540 2.952 3.426 3.970 4.595 5.311 6.130 7.067 8.137 9.358
17 1.184 1.400 1.653 1.948 2.292 2.693 3.159 3.700 4.328 5.054 5.895 6.866 7.986 9.276 10.761
18 1.196 1.428 1.702 2.026 2.407 2.854 3.380 3.996 4.717 5.560 6.544 7.690 9.024 10.575 12.375
19 1.208 1.457 1.754 2.107 2.527 3.026 3.617 4.316 5.142 6.116 7.263 8.613 10.197 12.056 14.232
20 1.220 1.486 1.806 2.191 2.653 3.207 3.870 4.661 5.604 6.728 8.062 9.646 11.523 13.743 16.367
25 1.282 1.641 2.094 2.666 3.386 4.292 5.427 6.848 8.623 10.835 13.585 17.000 21.231 26.462 32.919
30 1.348 1.811 2.427 3.243 4.322 5.743 7.612 10.063 13.268 17.449 22.892 29.960 39.116 50.950 66.212

Table A3 : Compound Value Factor for a lump sum amount {CVF (r%, n)}
Period
n 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
1 1.160 1.170 1.180 1.190 1.200 1.210 1.220 1.230 1.240 1.250 1.260 1.270 1.280 1.290 1.300
2 1.346 1.369 1.392 1.416 1.440 1.464 1.488 1.513 1.538 1.562 1.588 1.613 1.638 1.664 1.690
3 1.561 1.602 1.643 1.685 1.728 1.772 1.816 1.861 1.907 1.953 2.000 2.048 2.097 2.147 2.197
4 1.811 1.874 1.939 2.005 2.074 2.144 2.215 2.289 2.364 2.441 2.520 2.601 2.684 2.769 2.856
5 2.100 2.192 2.288 2.386 2.488 2.594 2.703 2.815 2.392 3.052 3.176 3.304 3.436 3.572 3.713
6 2.436 2.565 2.700 2.840 2.986 3.138 3.297 3.463 3.635 3.815 4.001 4.196 4.398 4.608 4.827
7 2.826 3.001 3.185 3.379 3.583 3.797 4.023 4.259 4.508 4.768 5.042 5.329 5.629 5.945 6.275
8 3.278 3.511 3.759 4.021 4.300 4.595 4.908 5.239 5.590 5.960 6.353 6.767 7.206 7.669 8.157
9 3.803 4.108 4.435 4.785 5.160 5.560 5.987 6.444 6.931 7.451 8.004 8.595 9.223 9.893 10.604
10 4.411 4.807 5.234 5.695 6.192 6.727 7.305 7.926 8.549 9.313 10.086 10.915 11.806 12.761 13.786
11 5.117 5.624 6.176 6.777 7.430 8.140 8.912 9.749 10.657 11.642 12.708 13.862 15.112 16.462 17.921
12 5.936 6.580 7.288 8.064 8.916 9.850 10.872 11.991 13.215 14.552 16:012 17.605 19.343 21.236 23.298
13 6.886 7.699 8.599 9.596 10.699 11.918 13.264 14.749 16.386 18.190 20.175 22.359 24.759 27.395 30.287
14 7.988 9.007 10.147 11.420 12.839 14.421 16.182 18.141 20.319 22.737 25.420 28.395 31.961 35.339 39.373
Mathematical Tables
15 9.266 10.539 11.974 13.590 15.407 17.449 19.742 22.314 25.196 28.422 32.030 36.062 40.565 45.587 51.185
16 10.748 12.330 14.129 16.172 18.488 21.113 24.084 27.446 31.243 35.527 40.357 45.799 51.923 58.808 66.541
17 12.468 14.426 16.672 19.244 22.186 25.547 29.384 33.758 38.741 44.409 50.850 58.165 66.461 75.862 86.503
18 14.463 16.879 19.673 22.901 26.623 30.912 35.848 41.523 48.039 55.511 64.071 73.869 85.071 97.862 112.454
19 16.777 19.748 23.214 27.252 31.948 37.404 43.735 51.073 59.568 69.389 80.730 93.813 108.890 126.242 146.190
20 19.461 23.106 27.393 32.429 38.338 45.258 53.357 62.820 73.864 86.736 101.720 119.143 139.380 162.852 190.047
25 40.874 50.658 32.669 77.388 95.396 117.388 144.207 176.857 216.542 264.698 323.040 393.628 478.905 581.756 705.627
30 85.850 111.065 143.371 184.675 237.376 304.471 389.748 497.904 634.820 807.793 1025.904 1300.477 1645.504 2078.208 2619.937
596
Table A4 : Compound Value Factor for an Annuity {CVFA (r%, n)}
597
Period
n 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
1 1.000 1.000 1.000 1.000 1.000 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 2.110 2.120 2.130 2.140 2.150
3 3.030 3.060 3.091 3.122 3.152 3.184 3.215 3.246 3.278 3.310 3.342 3.374 3.407 3.440 3.473
4 4.060 4.122 4.184 4.246 4.310 4.375 4.440 4.506 4.573 4.641 4.710 4.779 4.850 4.921 4.993
5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105 6.228 6.353 6.480 6.610 6.742
6 6.152 6.308 6.468 6.633 6.802 6.975 7.153 7.336 7.523 7.716 7.913 8.115 8.323 8.536 8.754
7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8.923 9.200 9.487 9.783 10.089 10.405 10.730 11.067
8 8.286 8.583 8.892 9.214 9.549 9.897 10.260 10.637 11.028 11.436 11.589 12.300 12.757 13.233 13.727
9 9.369 9.755 10.159 10.583 11.027 11.491 11.978 12.448 13.021 13.579 14.164 14.776 15.416 16.085 16.786
10 10.462 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937 16.722 17.549 18.420 19.337 20.304
11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.531 19.561 20.655 21.814 23.004 24.349
12 12.683 13.412 14.192 15.026 15.917 16.870 17.888 18.977 20.141 21.384 22.713 24.133 25.650 27.271 29.002
13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523 26.212 28.029 29.985 32.089 34.352
14 14.947 15.974 17.086 18.292 19.599 21.015 22.550 24.215 26.019 27.975 30.095 32.393 34.883 37.581 40.505
Mathematical Tables
15 16.097 17.293 18.599 20.024 21.579 23.276 25.129 27.152 29.361 31.772 34.405 37.280 40.417 43.842 47.580
16 17.258 18.639 20.157 21.825 23.657 25.673 27.888 30.324 33.003 35.950 39.190 42.753 46.672 50.980 55.717
17 18.430 20.012 21.762 23.698 25.840 28.213 30.840 33.750 36.974 40.545 44.501 48.884 53.739 59.118 65.075
18 19.615 21.412 23.414 25.645 28.132 30.906 33.999 37.450 41.301 45.599 50.396 55.750 61.725 68.394 75.836
19 20.811 22.841 25.117 27.671 30.539 33.760 37.379 41.446 46.018 51.159 56.939 63.440 70.749 78.969 88.212
20 22.019 24.297 26.870 29.778 33.066 36.786 40.995 45.762 51.160 57.275 64.203 72.052 80.947 91.025 102.44
25 28.243 32.030 36.459 41.646 47.727 54.865 63.249 73.106 84.701 98.347 114.413 133.334 155.620 181.871 212.793
30 34.785 40.568 47.575 56.805 66.439 79.058 94.461 113.283 136.308 164.494 199.021 241.333 293.199 356.787 434.745

Table A4 : Compound Value Factor for an Annuity {CVFA (r%, n)}
Period
n 16% 17% 18% 19% 20% 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 1.000 1.000 1.000 1.000 1.000
2 2.160 2.170 2.180 2.190 2.200 2.210 2.220 2.230 2.240 2.250 2.260 2.270 2.280 2.290 2.300
3 3.506 3.539 3.572 3.606 3.640 3.674 3.708 3.743 3.778 3.813 3.843 3.883 3.918 3.954 3.990
4 5.066 5.141 5.215 5.291 5.368 5.446 5.524 5.604 5.684 5.766 5.848 5.931 6.016 6.101 6.187
5 6.877 7.014 7.154 7.297 7.442 7.589 7.740 7.893 8.048 8.207 8.368 8.533 8.700 8.870 9.043
6 8.977 9.207 9.442 9.683 9.930 10.183 10.442 10.708 10.980 11.259 11.544 11.837 12.136 12.442 12.756
7 11.414 11.772 12.142 12.523 12.916 13.321 13.740 14.171 14.615 15.073 15.546 16.032 16.534 17.051 17.583
8 14.240 14.773 15.327 15.902 16.499 17.119 17.762 18.430 19.123 19.842 20.588 21.361 22.163 22.995 23.858
9 17.518 18.285 19.086 19.923 20.799 21.714 22.670 23.669 24.712 25.802 26.940 28.129 29.369 30.664 32.015
10 21.321 22.393 23.521 24.709 25.959 27.274 28.657 30.113 31.643 33.253 34.945 36.723 38.592 40.556 42.619
11 25.733 27.200 28.755 30.404 32.150 34.001 35.962 38.039 40.238 42.566 45.030 47.639 50.399 53.318 56.405
12 30.850 32.824 34.931 37.180 39.580 42.141 44.873 47.787 50.985 54.208 57.738 61.501 65.510 69.780 74.326
13 36.786 39.404 42.219 45.244 48.497 51.991 55.745 59.778 64.110 68.760 73.750 79.106 84.853 91.016 97.624
14 43.672 47.103 50.818 54.841 59.196 63.909 69.009 74.528 80.496 86.949 93.925 101.465 109.612 118.411 127.912
Mathematical Tables
15 51.660 56.110 60.965 66.261 72.035 78.330 85.191 92.669 100.815 109.687 119.346 129.860 141.303 153.750 167.285
16 60.925 66.649 72.939 79.850 87.442 95.779 104.933 114.983 126.011 138.109 151.375 165.922 181.868 199.337 218.470
17 71.673 78.979 87.068 96.022 105.931 116.892 129.019 142.428 157.253 173.636 191.733 211.721 233.791 258.145 285.011
18 84.141 93.406 103.740 115.266 128.117 142.439 158.403 176.187 195.994 218.045 242.583 269.885 300.252 334.006 371.514
19 98.603 110.285 123.414 138.166 154.740 173.351 194.251 217.710 244.033 273.556 306.654 343.754 385.323 431.868 483.968
20 115.380 130.033 146.628 165.418 186.688 210.755 237.986 268.783 303.601 342.945 387.384 437.568 494.213 558.110 630.157
25 249.214 292.105 342.603 402.042 471.981 554.230 650.944 764.596 898.092 1054.791 1238.617 1454.180 1706.803 2002.608 2348.765
30 530.321 647.439 790.748 966.712 1181.882 1445.111 1767.044 2160.459 2640.916 3227.172 3941.953 4812.891 5873.231 7162.785 8729.805
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Dedicated to my parents

Late Shri N.P. Tripathi

5. Test Yourself - Every chapter provides a variety of assignments to test

Prof. Vanita Tripathi

Prof. Vanita Tripathi

Objective: To familiarize the students with different investment alternatives,

Objective: To familiarize the students with different investment alternatives,

Objective : To familiarize students with different investment alternatives,

Preface to Fourth Edition I-5

B.Com. (Hons.) 2017 Paper : Fundamentals of Investment 536

Preface to Fourth Edition I-5

Investment is the backbone of any economy. Savings of an economy must

1.2 Financial Investment vs. Real Investment

important part of individual investor’s portfolio. Real estate is investment

1.3 objectives of Investment

An investor’s investment objectives depend upon his risk tolerance, which

1.3.1 Features (or Factors affecting Investment)

Different investment instruments have different returns depending on their

price continuity and liquidity. However excessive speculation is bad as it takes

Speculation vs. Investment

1.5 Risk Return Trade off

The return from an investment has two components:

1.6 Investment Environment

a. Equity shares : Equity shares are also known as ‘Common

d. Other securities : Besides above, a number of new securities

Capital Market Money Market

Sl. Basis Primary Market Secondary market

1.7 Investment Decision Process

4. Constructing portfolios, analyzing portfolios and selecting the optimal

using some appropriate discount rate and then compares it with

of bonds. On the other hand for a retired, old aged investor

1.8 Direct Investing and Indirect Investing

Therefore direct investing requires investing skills and expertise. Moreover

Direct Investing Indirect investing

1.9 Approaches to Investing - Active Investing

1.10 Diversification, Hedging and Arbitrage

1.11 Impact of Taxes on Investment

1.12 Impact of Inflation Investment

7. State investment decision process. What factors should an investor consider

25. Distinguish between financial and economic meaning of investment.

Securities market is a component of the wider financial market where

2.1 Structure of Indian Securities Market

2.1.1 Market Participants

Market Intermediaries 2014- 2015- 2016- 2017- Apr-

Market Intermediaries 2014- 2015- 2016- 2017- Apr-

Market Intermediaries 2014- 2015- 2016- 2017- Apr-

2.1.2 Market Segments

purposes from investors to entrepreneurs. The latter use the funds

Public 70 12,453 95 48,928 121 58,433 207 88,740 72 31,953

Rights 18 6,750 13 9,239 12 3,415 21 21,400 4 1,127

Total 88 19,202 108 58,167 133 61,848 228 1,10,140 76 33,080

Listed 42 15,892 34 43,351 28 32,753 29 26,366 11 22,176

IPO 46 3,311 74 14,815 105 29,095 199 83,774 65 10,904

Total 88 19,202 108 58,167 133 61,848 228 1,10,140 76 33,080

ensures free marketability, negotiability and price discharge.

(the BSE Institute Ltd.). BSE also provides depository services

iii. SME Exchange

Particulars 2014-15 2015-16 2016-17 2017-18 Apr-Aug 2018

2.2 TRADING MECHANISM ON EXCHANGES

electronically matched on price-time priority and hence cut down on time

2.2.1 National Securities Clearing Corporation Limited (NSCCL)

Fig 2.1 : Trading process at NSE

3. Download of obligation and pay-in advice of funds/securities.

2.3 STOCK INDICES

25. Distinguish between financial and economic meaning of investment.