Chapter 2

An Introduction to Security Analysis

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 To discuss basic elements of security analysis i.e.,
I. Concepts and types of return and risk, Risk
return trade off
II. The methods of valuation of bonds, preference
shares, common stocks and convertible securities

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 RISK: the Chance that the expected or
prospective advantage, gain or return may not
materialise

 Actual ROI < Expected ROI

 The greater the variability or dispersion in the

possible outcome return than the expected
return, the greater the risk

 In Inflationary condition there is no asset with

certainty of real return or risk–free asset

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 Default Risk  Interest rate Risk
 Financial Risk • Price Risk
 Liquidity Risk • Reinvestment Risk
 Maturity Risk
 Call Risk  Market Risk
 Inflation Risk • Unsystematic Risk
 Business Risk • Systematic Risk

 Total Risk
 Country Risk
 Exchange rate or Currency Risk

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 Beta (β) indicates the extent to
which the risk of a given asset is non-
diversifiable

It is the covariance of a security’s

return with that of the market for a
security class

A measure of relative risk of a

security

It is the slope of the regression line

relating to the security
return with the market
return

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 Total Return on an investment
= Income (Periodic Cash Flow) Plus/minus Price
Appreciation/Depreciation

 Internal Rate of Return is the rate of discount which

makes the present value of all the future cash flows
equal to the total cost of that Investment

 Realised and Expected Return

 Nominal and Real Return
 Required Rate of Return
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  Holding Period Yield/Return (HPY) measures the total
return from an investment during a given time period of
investment

HPY =
Any cash payment received + Price Changes over the holding Period
Price at which the asset is purchased (Beginning Price)

Holding Period Return = HPY + 1

 Basic Yield
 Current Yield
 Redemption Yield
 Dividend Yield
 Earnings Yield
 Gross and Net Yield 7
 Minimum Expected Rate of Return
 The reward or price to forgo present consumption in
favour of Future consumption plus a premium for expected
inflation
 Required Rate of Return(RRR) and market interest rates
are positively related

RRR = Pure Time Value of Money + Inflation Premium + Risk

Premium
= Risk free rate of Return + Risk Premium

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Return-Risk Trade Off

 Return potential and risk

involved in financial asset:
Positive linear relation ship
(AB Line)

CML a special case of SML

Market portfolio has beta = 1.0

SML estimates the return of

a single security relative to its
exposure to systematic risk

SML :To find out that whether the

expected return on the securities is
better than the risk which he is
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taking
 To determine appropriate required rate of return of an
asset, if that asset is to be added to an already well-
diversified portfolio, given that asset's non-diversifiable
risk i.e market risk

 Unique risks can be diversified and Investors expect

compensation for market risk
 Investors need to be compensated in two ways: time
value of money and risk

 The model takes into account the asset's sensitivity to

non-diversifiable risk i.e beta (β)
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 CAPM is based on certain assumptions as follows:

 All investors aim to maximise utilities

 All investors are rational risk-averse
 All the investors are price takers i.e. they can not
influence prices
 They can lend and borrow unlimited under the risk free
rate of interest
 Securities are all highly divisible into small parcels There
are no transaction or taxation costs incurred.

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The CAPM in equation:

E(Ri) = Rf + β (Rm – Rf)

= Risk Free Rate + Systematic risk x Market Risk Premium
Where,

E(R i ) = Expected return of individual security

R f = Risk free rate of return
R m = Market return
β = Market risk of individual
Security or Systematic risk
 Alternative to the capital asset pricing model (CAPM)

 Arbitrage Pricing Model (APT)

 An asset's returns can be predicted using the relationship
between that same asset and many common risk factors
 There are multiple factors representing systematic risk

 Fama and French Three Factor Model

 Expands CAPM by adding size and value factors in
addition to the market risk factor

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 Valuation of Bonds
 Valuation of Preference Shares
 Valuation of Convertible Securities
 Valuation of Common Stock

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Broad Approaches:

 The Efficient Market Hypothesis

 Technical Analysis Approach

 Fundamental Analysis Approach

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 The Efficient Market Hypothesis
 Weak-Form Efficient Market Hypothesis
 Semi-Strong Form Efficient Market Hypothesis
 Strong Form Efficient Market Hypothesis

 Technical Analysis Approach

 Strength of the Current Trend
 Maturity or Stage of the Current Trend
 Reward to Risk Ratio of new Position
 Potential Entry Level for New- Long Positions

 Fundamental Analysis Approach

 Top Down Approach
 Bottom-Up Approach
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 Top Down Approach
 Economic Analysis
 Industry Analysis
[Business Cycles, Monetary & Fiscal Policy, Economic
Indicators ]
 Analysis of Individual Firm
i. Earnings Multiple
ii. Dividend Capitalisation Model
iii. Relative Valuation Model
iv. Fundamentals Vs. Comparables
v. Cross Sectional Versus Time Series
 Bottom-Up Approach - Stock Pickers & not foolproof if
a company is more vulnerable to upheavals than the investor
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believed