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SAPM -Security Analysis and Portfolio
Management
Overview Lecture No.1
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Meaning of Security
A document that gives its owner a specific claim of ownership of a particular
financial asset
Securities are financial instruments which are bought and sold in the financial
market for investment
Important financial instruments are Shares, fixed deposits, insurance policiesbonds etc.
There are various financial instruments which leads to giving Investment
alternatives
Class Exercise
Please list all the alternative investment avenues that you are aware of
2
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3
Investment
Avenues
Various types of Deposits
Bank Deposits
Post office Deposits
Company Deposits Provident Fund Deposits
Bonds:
Government Securities
Government Agency Securities
PSU Bonds Debentures of Private Sector
Companies
Preference Shares
Other Investments
Life Insurance
Mutual funds
Real estate
Precious objects
Shares and derivatives
Equities
Various financial derivatives
e.g. Futures, options etc.
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Comparison of Investment Avenues and investment
Objectives
Return on Investment Period of Investment
Safety of the Instrument/ market standing of the issuing
agency
Risk in investment
Loan facility
Tax benefits
Age of the person investing
Future marketability of the investment
4
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Investment and Speculation
Investment and speculation are two terms that are closely related.
Both involve the purchase of assets like shares and securities.
Traditionally investment is distinguished from speculation with respect to
three factors, viz.
Risk
Capital gain Time period
Risk:
It refers to the possibility of incurring a loss in a financial transaction. It
arises from the possibility of variation in returns from an investment. Risk isinvariably related to return. Higher return is associated with higher risk.
No investment is completely risk free. An investorgenerally commits his
funds to low risk investment, whereas a speculator commits his fund to
higher risk investments. A speculator is prepared to take higher risk in
order to receive higher returns.5
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Question
When money is put in Shares is it
Investment or is it Speculation
6
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Investment and Speculation. (Contd)
Capital Gains:
The speculators motive is to achieve profits through price
changes, i.e. he is interested in capital gains rather than the
income from the investment. if purchase of securities is
preceded with proper investigation and analysis to receive
stable returns and capital appreciation over a period oftime, it is investment. Thus speculation is related with buying
low and selling high with the hope of making high capital
gains.
A speculator consequently engages in frequent buying
and selling transactions
7
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Question
Is buying a house investment orspeculation?
8
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Time period:
Investment is long term in nature (Why?), whereas
speculation is only short-term.
An investor commits his funds for a longer period and waits for
his return. But a speculator is interested in short-term gainsthrough buying and selling of investment instruments.
9
Investment and Speculation. (Contd)
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Financial Eco-System
FinancialEco-System
FinancialInstitutions
FinancialMarkets
FinancialInstruments
FinancialServices
Banks
InsuranceCompanies
Mutual fund
companies
Stock
exchanges
( BSE andNSE)
Commodity
Exchanges
Money
Market
Stocks (Primary
and Secondary)
BondsInsurance
policies
Fixed Deposits
Loans etc.
Intermediaries
and mainlinecompanies
which offer
these financial
instruments
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Portfolio Management
Meaning of Portfolio
An investor considering investment in securities is faced with
the problem of choosing from among a large number of
securities such as Shares, Debentures, bonds, mutual funds
etc. This set of securities that he holds is called Portfolio
Characteristics of a Portfolio
They have different risk return characteristic
Different periods of maturity
Different yields/ return
Objective of a portfolio
To reduce risk by diversification and to maximise gains
11
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Portfolio Management
Portfolio management comprises all the processes
involved in the creation and maintenance of an
investment portfolio.
It deals specifically with Security analysis,
Portfolio analysis,
Portfolio selection,
Portfolio revision and
Portfolio evaluation
12
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OBJECTIVES OF PORTFOLIO MANAGEMENT
Security/Safety of Principal: Security not only involves keeping the principal sum intact but
also keeping intact its purchasing power.
Stability of Income: Stability of income so as to facilitate planning more accurately andsystematically the reinvestment or consumption of income.
Capital Growth: Capital growth which can be attained by reinvesting in growth securities or
through purchase of growth securities.
Marketability: The case with which a security can be bought or sold. This is essential for
providing flexibility to investment portfolio.
Liquidity: Liquidity i.e. nearness to money. It is desirable for the investor so as to take
advantage of attractive opportunities upcoming in the market.
Diversification: The basic objective of building a portfolio is to reduce the risk of loss of
capital and income by investing in various types of securities and over a wide range of
industries.
Favourable Tax Status: The effective yield an investor gets from his investment depends on
tax to which it is subject. By minimizing the tax burden, yield can be effectively improved.13
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Basic Principles of Portfolio Management
There are two basic principles for effective Portfolio Management:
1) Effective investment planning for the investment in securities by considering thefollowing factors:
Fiscal, financial and monetary policies of the Government of India and the
Reserve Bank of India.
Industrial and Economic environment and its impact on industry prospects in
terms of prospective technological changes, competition in the market, capacity
utilization with industry and demand prospects etc.
14
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2) Constant review of investment: Portfolio managers are required to review their
investment in securities and continue selling and purchasing their investment inmore profitable avenues. For this purpose they will have to carry the following
analysis:
Assessment of quality of management of the companies in which investment
has already been made or is proposed to be made.
Financial and Trend analysis of companies, Balance Sheet/Profit and Loss
accounts to identify sound companies with optimum capital structure and betterperformance and to disinvest the holding of those companies whose
performance is found to be slackening.
The analysis of securities market and its trend is to be done on a continuous
basis.
15
Basic Principles of Portfolio Management
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Construction of a Portfolio
Portfolio construction means determining the actual composition of portfolio. It is a
critical stage because asset mix is the single most determinant of portfolioperformance.
The components of portfolio construction are
a) Asset allocation means setting the asset mix
b) Security selection involving choosing the approporiate security to meet the
portfolio targets
c) Portfolio structure involving setting the amount of each security to be included
in the portfolio
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Approach to Portfolio Allocation
Interior Decorating Approach It is a approach which is tailor made to the
investment objectives and constraints of each investor Protective Investments
Tax oriented investments
Fixed income investments
Emotional investments
Speculative investments Growth investments
With the help of these variety of investments, an attempt can be made to develop
a matrix for matching the individual characteristics of specific investments so that
multiple portfolio can be developed
17
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Approach to Portfolio Allocation - Markowitz Approach
A Markowitz Efficient Portfolio is one where no added diversification can
lower the portfolio's risk for a given return expectation (alternately, no additionalexpected return can be gained without increasing the risk of the portfolio). The
Markowitz Efficient Frontier is the set of all portfolios that will give the highest
expected return for each given level of risk. These concepts of efficiency were
essential to the development of the Capital Asset Pricing Model
18
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Process of Portfolio Composition
Collecting the Basic Data of the person
a) Satisfying the basic needs Food, clothing, housing and transportation
Education, Medical and other needs
Long term needs, Saving for emergency
b) Investments done Shares, Bonds, Life insurance, pension plan etc.
c) Future earning capability, number of years etc.
Formulating the Portfolio Objectives
a)Need for current income to meet the expenses
b)Need for constant income to face inflation
c)Ability to liquidate the investment in short notice
d)Need for tax exemptione)Need to get returns commensurate with the risk taken
Weighing Constraints When and how much can be invested
Selecting the Securities Based on above to select securities19
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Risk and Return
Lecture No.3
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Risk and Return
Risk and return will be very central terms in our analysis and it isessential that we clearly understand the meaning of each term and howassets with different payout structures can be compared.
General utility theory suggests that the average investor is risk averse.Given the same expected return of two assets with different risks, hewould prefer the one with less risk. (This assumption may not beperfectly true for all individuals in all situations, but for the investor community as a whole it is probably true).
For an asset with uncertain cash flows and payoffs, which are normallydistributed, the mean of the distribution will be the expected return whilethe standard deviation forms some kind ofrisk.
Choosing the less risky asset therefore comes down to choosing theasset with the lowest standard deviation in its payout distribution.
An investor could also approach the problem from the other direction,choosing among assets with the same risk and then choose the assetwith the highest expected return.
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1
1
1
1 1
n
i
i
n
ni
i
X Xn
X X
Statistical Terms
MeanBy mean one often refers to the simple average of a number of observations. This
value is more correctly denoted as arithmetic mean, to distinguish it from the
geometric mean. In order, the formulas below show the arithmetic and the
geometric mean, respectively:
VarianceThe variance measures the fluctuation of the observations around their mean. The
larger the value of variance, the greater the fluctuation.
22
(sigma squared)[Ri E(R)]2 X P
= Mean = X = E(R)Different Symbols of Mean
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Statistical Terms
Standard DeviationThe standard deviation also measures the variability of observations around themean. It is defined as the square root of the variance. The standard deviation will
as a consequence have the same unit as the observation and is in a way easier to
interpret. In financial terms, variability measured as standard deviation equals risk
and the notion of risk has a very central place in the financial theory. From the
definition of variance above follows that the standard deviation is given by:
23
[Ri E(R)]2 X P
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The Bell Curve
24
= Mean = X = E(R)
http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/7/27/2019 Sapm - Fifth (5) Sem BBI
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25
Small cap stocks
Greater Variance/ SDGreater risk, Greater
returns
Large cap stocks
Lesser Variance/ SD
Lesser risk,Lesser returns
Municipal Bonds
Even Lesser Variance/ SD
Lesser risk,
Lesser returns
http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/7/27/2019 Sapm - Fifth (5) Sem BBI
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Risk and Return
Risk and return will be very central terms in our analysis and it isessential that we clearly understand the meaning of each term and howassets with different payout structures can be compared.
General utility theory suggests that the average investor is risk averse.Given the same expected return of two assets with different risks, hewould prefer the one with less risk. (This assumption may not beperfectly true for all individuals in all situations, but for the investor community as a whole it is probably true).
For an asset with uncertain cash flows and payoffs, which are normallydistributed, the mean of the distribution will be the expected return whilethe standard deviation forms some kind ofrisk.
Choosing the less risky asset therefore comes down to choosing the
asset with the lowest standard deviation in its payout distribution.
An investor could also approach the problem from the other direction,choosing among assets with the same risk and then choose the assetwith the highest expected return.
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Risk Preference of investors
Investors could be Risk seeking This means that investors are willing to make
investments of increasing higher risk for the promise of increasingly smallerincrements of return
Investors could be Risk indifferent They would be willing to continue to buying
investments of higher risk by receiving the same increase in return. A risk
indifferent investor receives the same incremental utility for each increase in
wealth
Investors could be Risk averse when investors require successfully greater
increments of return to compensate them for each additional unit increase in
risk, they are known as risk-averse investors. They receive smaller increments
of utility for each additional increment of wealth. They will accept additional risk,
but only if they are adequately compensated for doing so and adequate
compensation for a risk averter means being paid more and more for
accepting higher risk
27
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Meaning of Return and Measure of Return
Meaning
Return means the profit earned on the capital invested in the business
Measures of Return
Return can be measured as a rate of return on capital invested. To measure the
rate of return an investor wants to know three items:
1) The period of time that the measurement covers How long2) The amount needed to establish and maintain the investment How much to
invest
3) The net profit of the investment over the time period - What is the return
28
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Holding Period return
Rt = Pt Pt-1 + Yt
Rt = The holding Period return on the investment
Pt-1 = The price of the security at the time (t-1) the beginning of the holding
period
Pt = The price of the security at the time t at the end of the holding periodYt = Income from the investment during the holding period
29
Pt-1
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Time Value ofMoney
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The Time Value o f Money
The Interest Rate
Simple Interest Compound Interest
Amortizing a Loan
Compounding More ThanOnce per Year
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Obviously, Rs.10,000 today.
You already recognize that there isTIME VALUE TO MONEY!!
The In teres t Rate
Which would you prefer -- Rs10,000
today orRs10,000 in 5 years?
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TIME allows you the oppor tun i tyto
postpone consumption and earn
INTEREST.
Why TIME?
Why is TIME such an important
element in your decision?
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Types o f In teres t
Compound Interest
Interest paid (earned) on any previousinterest earned, as well as on the
principal borrowed (lent).
Simple Interest
Interest paid (earned) on only the original
amount, or principal, borrowed (lent).
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Simp le In terest Formu la
Formula SI = PV(i)(t)
SI: Simple Interest
PV: Deposit today (t=0)
R: Interest Rate per Period
t: Number of Time Periods
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SI = PV*
(R)(t)
= Rs.1,000(.07)(2)
= Rs.140
Simp le In teres t Examp le
Assume that you deposit Rs.1,000 in an
account earning 7% simple interest for
2 years. What is the accumulatedinterestat the end o f the 2nd year?
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FV =PV+SI=Rs.1,000+Rs.140
=Rs.1,140
Future Value is the value at some futuretime of a present amount of money, or a
series of payments, evaluated at a given
interest rate.
Simp le In teres t (FV)
What is the Future Value (FV) of the
deposit?
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ThePresent Valueis s imply the
Rs.1,000you or ig ina lly deposi ted.
That is the value today!
Present Value is the current value of afuture amount of money, or a series of
payments, evaluated at a given interest
rate.
Simp le In teres t (PV)
What is the Present Value (PV) of the
previous problem?
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0
5000
10000
15000
20000
1st Year 10th
Year
20th
Year
30th
Year
Future Value of a Single Rs1,000 Deposit
10% SimpleInterest
7% CompoundInterest
10% CompoundInterest
Why Compound Interest?
Future
Value(Rupees)
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Assume that you deposit Rs.1,000
at a compound interest rate of7%
for2 years.
Future Value
Sing le Depos it (Graph ic)
0 1 2
Rs.1,000
FV2
7%
F t V l
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FV1 = PV (1+i)1 = Rs.1,000 (1.07)
= Rs.1,070
Compound Interest
You earned Rs.70 interest on your
Rs.1,000 deposit over the first year.
This is the same amount of interest you
would earn under simple interest.
Futu re Value
Sing le Depos it (Formu la)
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FV1 = PV (1+R)1 = Rs.1,000 (1.07)
= Rs.1,070
FV2 = FV1 (1+R)1= PV (1+R)(1+R) =
Rs.1,000(1.07)(1.07) = PV (1+R)2
= Rs.1,000(1.07)2= Rs.1,144.90
You earned an EXTRA Rs.4.90in Year 2 with
compound over simple interest.
Future Value
Sing le Depos it (Formu la)
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FV1 = PV(1+R)1
FV2
= PV(1+R)2
General Future Value Formula:
FVn = PV (1+R)n
or FVn = PV (FVIFR,n) -- See Tab le A-
3
General Futu re
Value Formu la
etc.
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FVIFR,n is found on Table A-3
at the end of the Chapter.
Valuation Us ing Tab le A-3
Period 6% 7% 8%1 1.060 1.070 1.080
2 1.1241.145
1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
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FV2 = Rs.1,000 (FVIF7%,2)
= Rs.1,000 (1.145)
= Rs.1,145 [Due to Rounding]
Using Futu re Value Tab les
Period 6% 7% 8%1 1.060 1.070 1.080
2 1.1241.145
1.166
3 1.191 1.225 1.260
4 1.262 1.311 1.360
5 1.338 1.403 1.469
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Julie Miller wants to know how large her deposit
ofRs.10,000 today will become at a compound
annual interest rate of10% for5 years.
Story Prob lem Examp le
0 1 2 3 4 5
Rs.10,000
FV5
10%
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Calculation based on Table I:
FV5 = Rs.10,000 (FVIF10%, 5)= Rs.10,000 (1.611)
= Rs.16,110 [Due to Round ing]
Story Prob lem So lut ion
Calculation based on general formula:
FVn = PV (1+R)n
FV5 = Rs.10,000 (1+ 0.10)5
= Rs.16,105.10
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We will use the Rule-of-72.
Doub le Your Money!!!
Quick! How long does it take to
double Rs.5,000 at a compound
rate of 12% per year (approx.)?
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Approx . Yearsto Double= 72/ R%
72/ 12% = 6 Years
[Actual Time is 6.12 Years]
The Rule-of-72
Quick! How long does it take to
double Rs.5,000 at a compound
rate of 12% per year (approx.)?
P t V l
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Assume that you need Rs.1,000 in 2 years.Lets examine the process to determinehow much you need to deposit today at a
discount rate of7% compounded annually.
0 1 2
Rs.1,000
7%
PV1PV0
Presen t Value
Sing le Depos it (Graph ic)
P t V l
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PV0 = FV2/ (1+R)2 = Rs.1,000/ (1.07)2
= FV2/ (1+R)2 = Rs.873.44
Presen t Value
Sing le Depos it (Formu la)
0 1 2
Rs.1,000
7%
PV0
G l P
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PV0 = FV1/ (1+R)1
PV0 = FV2/ (1+R)
2
General Present Value Formula:
PV0 = FVn/ (1+R)n
or PV0 = FVn (PVIFR,n) -- See Table A-1
General Present
Value Formu la
etc.
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PVIFR,n is found on Table A-1
at the end of the book.
Valuation Using Tab le II
Period 6% 7% 8%
1 .943 .935 .9262 .890 .873 .857
3 .840 .816 .7944 .792 .763 .7355 .747 .713 .681
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PV2 = Rs.1,000 (PVIF7%,2)
= Rs.1,000 (.873)
= Rs.873 [Due to Rounding]
Using Presen t Value Tab les
Period 6% 7% 8%
1 .943 .935 .926
2 .890.873
.857
3 .840 .816 .794
4 .792 .763 .735
5 .747 .713 .681
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Ram Krishna wants to know how large of a
deposit to make so that the money will
grow to Rs.10,000 in 5 years at a discount
rate of10%.
Story Prob lem Examp le
0 1 2 3 4 5
Rs.10,000
PV0
10%
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Calculation based on general formula:
PV0 = FVn/ (1+R)n
PV0 = Rs.10,000/ (1+ 0.10)5
= Rs.6,209.21
Calculation based on Table A-I:
PV0 = Rs.10,000 (PVIF10%, 5)= Rs.10,000 (.621)
= Rs.6,210.00 [Due to Round ing]
Story Prob lem So lut ion
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Types o f Annui t ies
Ordinary Annuity: Payments or receipts
occur at the end of each period.
Annuity Due: Payments or receipts
occur at the beginning of each period.
An Annu i tyrepresents a series of equal
payments (or receipts) occurring over a
specified number of equidistant periods.
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Examples o f Annu i ties
Student Loan Payments
Car Loan Payments Insurance Premiums
Mortgage Payments Retirement Savings
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Parts o f an Annui ty
0 1 2 3
Rs.100 Rs.100 Rs.100
(Ordinary Annuity)
End of
Period 1
End of
Period 2
Today Equal Cash FlowsEach 1 Period Apart
End of
Period 3
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Parts o f an Annui ty
0 1 2 3
Rs.100 Rs.100 Rs.100
(Annuity Due)
Beginning of
Period 1
Beginning of
Period 2
Today Equal Cash FlowsEach 1 Period Apart
Beginning of
Period 3
Overview of an
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FVAn = A(1+R)n-1 + A(1+R)n-2 +
... + A(1+R)1 +A(1+R)0
Overview of an
Ordinary Annui ty -- FVA
A A A
0 1 2 t t+1
FVAn
A = Periodic
Cash Flow
Cash flows occur at the end of the period
R% . . .
= A[(1+R)t-1]
R
E l f
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FVA3 = Rs.1,000(1.07)2 +
Rs.1,000(1.07)1 + Rs.1,000(1.07)0
= Rs.1,145 + Rs.1,070 + Rs.1,000
= Rs.3,215
Example o f an
Ordinary Annui ty -- FVA
Rs.1,000 Rs.1,000 Rs.1,000
0 1 2 3 4
Rs.3,215 = FVA3
7%
Rs.1,070
Rs.1,145
Cash flows occur at the end of the period
= A[(1+R)t-1]
R
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Hint on Annui ty Valuat ion
The future value of an ordinaryannuity can be viewed as
occurring at the endof the lastcash flow period, whereas thefuture value of an annuity due
can be viewed as occurring atthe beginningof the last cash
flow period.
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FVAt = A (FVIFAR%,t)
FVA3 = Rs.1,000 (FVIFA7%,3)
= Rs.1,000 (3.215) = Rs.3,215
Valuation Using Tab le III
Period 6% 7% 8%1 1.000 1.000 1.000
2 2.060 2.070 2.080
3 3.184 3.215 3.246
4 4.375 4.440 4.506
5 5.637 5.751 5.867
Overview View of an
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FVADt = A(1+R)t + A(1+R)t-1 +
... + A(1+R)2 + A(1+i)1 = FVAt (1+R)
Overview View of an
Annu ity Due -- FVAD
A A A A A
0 1 2 3 t-1 t
FVADt
R% . . .
Cash flows occur at the beginning of the period
Example o f an
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FVAD3 = Rs.1,000(1.07)3 +
Rs.1,000(1.07)2 + Rs.1,000(1.07)1
= Rs.1,225 + Rs.1,145 + Rs.1,070
= Rs.3,440
Example o f an
Annui ty Due -- FVAD
Rs.1,000 Rs.1,000 Rs.1,000 Rs.1,070
0 1 2 3 4
Rs.3,440 = FVAD3
7%
Rs.1,225
Rs.1,145
Cash flows occur at the beginning of the period
Overview of an
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PVAn = A/(1+i)1 + A/(1+i)2
+ ... + A/(1+i)n
Overview of an
Ord inary Annu ity -- PVA
A A A
0 1 2 t t+1
PVAn
A = Periodic
Cash Flow
R% . . .
Cash flows occur at the end of the period
Example o f an
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PVA3 = Rs.1,000/(1.07)1
+Rs.1,000/(1.07)2 +
Rs.1,000/(1.07)3
= Rs.934.58 + Rs.873.44 +
Rs.816.30 = Rs.2,624.32
Example o f an
Ord inary Annu ity -- PVA
Rs.1,000 Rs.1,000 Rs.1,000
0 1 2 3 4
Rs.2,624.32 =PVA3
7%
Rs.934.58
Rs.873.44
Rs.816.30
Cash flows occur at the end of the period
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Hint on Annui ty Valuat ion
The present value of an ordinaryannuity can be viewed as
occurring at the beginningof thefirst cash flow period, whereasthe future value of an annuity
due can be viewed as occurringat the endof the first cash flow
period.
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PVAn = A (PVIFAi%,t)
PVA3 = Rs.1,000 (PVIFA7%,3)
= Rs.1,000 (2.624) =Rs.2,624
Valuation Using Tab le IV
Period 6% 7% 8%1 0.943 0.935 0.926
2 1.833 1.808 1.783
3 2.673 2.624 2.577
4 3.465 3.387 3.312
5 4.212 4.100 3.993
Overview of an
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PVADn = A/(1+i)0 + A/(1+i)1 + ... + A/(1+i)n-1
= PVAn (1+i)
Overview of an
Annui ty Due -- PVAD
A A A A
0 1 2 t-1 t
PVADn
A: Periodic
Cash Flow
R% . . .
Cash flows occur at the beginning of the period
Example o f an
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PVADn = Rs.1,000/(1.07)0 + Rs.1,000/(1.07)1 +
Rs.1,000/(1.07)2 = Rs.2,808.02
Example o f an
Annui ty Due -- PVAD
Rs.1,000.00 Rs.1,000Rs.1,000
0 1 2 3 4
Rs.2,808.02 = PVADn
7%
Rs. 934.58
Rs. 873.44
Cash flows occur at the beginning of the period
Steps to Solve Time Value
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1. Read problem thoroughly
2. Create a time line
3. Put cash flows and arrows on time line4. Determine if it is a PV or FV problem
5. Determine if solution involves a singleCF, annuity stream(s), or mixed flow
6. Solve the problem
Steps to Solve Time Value
of Money Problems
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Julie Miller will receive the set ofcash
flows below. What is the Present Value
at a discount rate of10%.
Mixed Flows Examp le
0 1 2 3 4 5
Rs.600 Rs.600 Rs.400 Rs.400 Rs.100
PV0
10%
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1. Solve a piece-at-a-t ime by
discounting each pieceback to t=0.
2. Solve a group-at-a-t ime by first
breaking problem into groups of
annuity streams and any single
cash flow groups. Then discount
each groupback to t=0.
How to Solve?
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Piece-At-A-Time
0 1 2 3 4 5
Rs.600 Rs.600 Rs.400 Rs.400 Rs.100
10%
Rs.545.45
Rs.495.87
Rs.300.53
Rs.273.21
Rs. 62.09
Rs.1677.15 = PV0 of the Mixed Flow
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Group-At-A-Time (#1)
0 1 2 3 4 5
Rs.600 Rs.600 Rs.400 Rs.400 Rs.100
10%
Rs.1,041.60
Rs. 573.57
Rs. 62.10
Rs.1,677.27 = PV0 of Mixed Flow [Using Tables]
Rs.600(PVIFA10%,2) = Rs.600(1.736) = Rs.1,041.60
Rs.400(PVIFA10%,2)(PVIF10%,2) = Rs.400(1.736)(0.826) = Rs.573.57
Rs.100 (PVIF10%,5) = Rs.100 (0.621) = Rs.62.10
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Group-At-A-Time (#2)
0 1 2 3 4
Rs.400 Rs.400 Rs.400 Rs.400
PV0 equals
Rs.1677.30.
0 1 2
Rs.200 Rs.200
0 1 2 3 4 5
Rs.100
Rs.1,268.00
Rs.347.20
Rs.62.10
Plus
Plus
Frequency o f
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General Formula:
FVt = PV0(1 + [i/m])mt
t: Number of Years
m: Compounding Periods per Year
R: Annual Interest Rate
FVt,m: FV at the end of Year t
PV0: PV of the Cash Flow today
Frequency o f
Compound ing
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Julie Miller has Rs.1,000 to invest for
2 Years at an annual interest rate of
12%.
Annual FV2 = 1,000(1+ [.12/1])(1)(2)
= 1,254.40
Semi FV2 = 1,000(1+ [.12/2])(2)(2)
= 1,262.48
Impact o f Frequency
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Qrtly FV2 = 1,000(1+ [.12/4])(4)(2)
= 1,266.77
Monthly FV2 = 1,000(1+ [.12/12])(12)(2)
= 1,269.73
Daily FV2 = 1,000(1+[.12/365])(365)(2)
= 1,271.20
Impact o f Frequency
Effect ive Annual
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Effective Annual Interest Rate
The actual rate of interest earned
(paid) after adjusting the nomina lratefor factors such as the number
ofcompounding periods per year.
(1 + [ R/ m ] )m - 1
Effect ive Annual
In teres t Rate
BWs Effect ive
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Basket Wonders (BW)has a
Rs.1,000 CD at the bank. The
interest rate is 6% compoundedquarterly for 1 year. What is the
Effective Annual Interest Rate
(EAR)?
EAR = ( 1 + 6%/ 4 )4 - 1
= 1.0614 - 1 = .0614 or6.14%!
BWs Effect ive
Annual In teres t Rate
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HOW A RATIO IS EXPRESSED?
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HOW A RATIO IS EXPRESSED?
As Percentage - such as 25% or 50% . For exampleif net profit is Rs.25,000/- and the sales isRs.1,00,000/- then the net profit can be said to be
25% of the sales.
As Proportion - The above figures may be expressedin terms of the relationship between net profit to salesas 1 : 4.
As Pure Number /Times - The same can also beexpressed in an alternatively way such as the sale is 4times of the net profit or profit is 1/4th of the sales.
CLASSIFICATION OF RATIOS
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Balance SheetRatio
P&L Ratio orIncome/RevenueStatement Ratio
Balance Sheet andProfit & Loss Ratio
Financial Ratio Operating Ratio Composite Ratio
Current RatioQuick Asset Ratio
Proprietary Ratio
Debt Equity Ratio
Gross Profit RatioOperating Ratio
Expense Ratio
Net profit Ratio
Stock Turnover Ratio
Fixed Asset TurnoverRatio, Return on
Total Resources
Ratio,
Return on Own Funds
Ratio, Earning perShare Ratio, Debtors
Turnover Ratio,
FORMAT OF BALANCE SHEET FOR RATIO ANALYSIS
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LIABILITIES ASSETSNET WORTH/EQUITY/OWNED FUNDSShare Capital/Partners Capital/Paid up Capital/
Owners Funds
Reserves ( General, Capital, Revaluation & OtherReserves)
Credit Balance in P&L A/c
FIXED ASSETS : LAND & BUILDING, PLANT &MACHINERIES
Original Value Less Depreciation
Net Value or Book Value or Written down value
LONG TERM LIABILITIES/BORROWED FUNDS :Term Loans (Banks & Institutions)
Debentures/Bonds, Unsecured Loans, Fixed
Deposits, Other Long Term Liabilities
NON CURRENT ASSETSInvestments in quoted shares & securities
Old stocks or old/disputed book debts
Long Term Security DepositsOther Misc. assets which are not current or fixed
in nature
CURRENT LIABILTIESBank Working Capital Limits such as
CC/OD/Bills/Export Credit
Sundry /Trade Creditors/Creditors/Bills Payable,Short duration loans or deposits
Expenses payable & provisions against various
items
CURRENT ASSETS : Cash & Bank Balance,Marketable/quoted Govt. or other securities,
Book Debts/Sundry Debtors, Bills Receivables,
Stocks & inventory (RM,SIP,FG) Stores & Spares,Advance Payment of Taxes, Prepaid expenses,
Loans and Advances recoverable within 12
months
INTANGIBLE ASSETSPatent, Goodwill, Debit balance in P&L A/c,
Preliminary or Preoperative expenses
SOME IMPORTANT NOTES
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SOME IMPORTANT NOTES
Liabilities have Credit balance and Assets have Debit balance
Current Liabilities are those which have either become due for
payment or shall fall due for payment within 12 months from
the date of Balance Sheet
Current Assets are those which undergo change in theirshape/form within 12 months. These are also called Working
Capital or Gross Working Capital
Net Worth & Long Term Liabilities are also called Long TermSources of Funds
Current Liabilities are known as Short Term Sources of Funds Long Term Liabilities & Short Term Liabilities are also called
Outside Liabilities Current Assets are Short Term Use of Funds
SOME IMPORTANT NOTES
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SOME IMPORTANT NOTES
Assets other than Current Assets are Long Term Use of Funds Installments of Term Loan Payable in 12 months are to be taken as
Current Liability only for Calculation of Current Ratio & Quick Ratio.
If there is profit it shall become part of Net Worth under the headReserves and if there is loss it will become part ofIntangible Assets
Investments in Govt. Securities to be treated current only if these aremarketable and due. Investments in other securities are to be
treated Current if they are quoted. Investments inallied/associate/sister units or firms to be treated as Non-current.
Bonus Shares as issued by capitalization of General reserves and assuch do not affect the Net Worth. With Rights Issue, change takes
place in Net Worth and Current Ratio.
Liquidity Ratios
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1. Current Ratio : It is the relationship between the currentassets and current liabilities of a concern.
Current Ratio = Current Assets/Current LiabilitiesIf the Current Assets and Current Liabilities of a concern are
Rs.4,00,000 and Rs.2,00,000 respectively, then theCurrent Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1
The ideal Current Ratio preferred by Banks is 1.33 : 1
2. Net Working Capital : This is worked out as surplus of LongTerm Sources over Long Tern Uses, alternatively it is the
difference of Current Assets and Current Liabilities.
NWC = Current Assets Current Liabilities
q y
Current Assets : Raw Material, Stores, Spares, Work-in Progress. Finished
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Goods, Debtors, Bills Receivables, Cash.
Current Liabilities : Sundry Creditors, Installments of Term Loan, DPG etc.
payable within one year and other liabilities payable within one year.
This ratio must be at least 1.33 : 1 to ensure minimum margin of 25% of current
assets as margin from long term sources.
Current Ratio measures short term liquidity of the concern and its ability tomeet its short term obligations within a time span of a year.
It shows the liquidity position of the enterprise and its ability to meet current
obligations in time.
Higher ratio may be good from the point of view of creditors. In the long run
very high current ratio may affect profitability ( e.g. high inventory carrying cost)
Shows the liquidity at a particular point of time. The position can changeimmediately after that date. So trend of the current ratio over the years to be
analyzed.
Current Ratio is to be studied with the changes of NWC. It is also necessary to
look at this ratio along with the Debt-Equity ratio.
Profitability Ratios
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3. GROSS PROFIT RATIO : By comparing Gross Profit percentage to Net Sales
we can arrive at the Gross Profit Ratio which indicates the manufacturingefficiency as well as the pricing policy of the concern.
Gross Profit Ratio = (Gross Profit / Net Sales ) x 100
Alternatively , since Gross Profit is equal to Sales minus Cost of Goods Sold, itcan also be interpreted as below :
Gross Profit Ratio = [ (Sales Cost of goods sold)/ Net Sales] x 100A higher Gross Profit Ratio indicates efficiency in production of the unit.
Profitability Ratios
Profitability Ratios
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4. OPERATING PROFIT RATIO :
It is expressed as => (Operating Profit / Net Sales ) x 100
Higher the ratio indicates operational efficiency
5. NET PROFIT RATIO :
It is expressed as => ( Net Profit / Net Sales ) x 100
It measures overall profitability.
Profitability Ratios
Solvency Ratios
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6. PROPRIETARY RATIO : This ratio indicates the extent to which TangibleAssets are financed byOwners Fund.Proprietary Ratio = (Tangible Net Worth/Total Tangible Assets) x 100
The ratio will be 100% when there is no Borrowing for purchasing of Assets.
7. DEBT EQUITY RATIO : It is the relationship between borrowersfund (Debt) and Owners Capital (Equity).
Long Term Outside Liabilities / Tangible Net WorthLiabilities of Long Term NatureTotal of Capital and Reserves & Surplus Less Intangible AssetsFor instance, if the Firm is having the following :
Capital = Rs. 200 LacsFree Reserves & Surplus = Rs. 300 LacsLong Term Loans/Liabilities = Rs. 800 Lacs
Debt Equity Ratio will be => 800/500 i.e. 1.6 : 1
Solvency Ratios
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8. Interest Coverage Ratio : This ratio indicates the extent to which companywill be able to service the debt that it has takenInterest Coverage Ratio = ( PBIT/ Interest on Debt) x 100
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Next Class
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9. STOCK/INVENTORY TURNOVER RATIO :
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(Average Inventory/Sales) x 365 for days(Average Inventory/Sales) x 52 for weeks(Average Inventory/Sales) x 12 for months
Average Inventory or Stocks = (Opening Stock + Closing Stock)
-----------------------------------------
2
. This ratio indicates the number of times the inventory isrotated during the relevant accounting period
10. DEBTORS TURNOVER RATIO : This is also called Debtors
Velocity or Average Collection Period or Period of Credit given
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Velocity or Average Collection Period or Period of Credit given .
(Average Debtors/Sales ) x 365 for days
(52 for weeks & 12 for months)
11. ASSET TRUNOVER RATIO : Net Sales/Tangible Assets
12. FIXED ASSET TURNOVER RATIO : Net Sales /Fixed Assets
13. CURRENT ASSET TURNOVER RATIO : Net Sales / Current Assets
14. CREDITORS TURNOVER RATIO : This is also called Creditors
Velocity Ratio, which determines the creditor payment period.
(Average Creditors/Purchases)x365 for days
(52 for weeks & 12 for months)
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15. RETRUN ON ASSETS : Net Profit after Taxes/Total Assets
16. RETRUN ON CAPITAL EMPLOYED :
( Net Profit before Interest & Tax / Average Capital Employed) x 100
Average Capital Employed is the average of the equity share
capital and long term funds provided by the owners and the
creditors of the firm at the beginning and end of the accounting
period.
Composite Ratio
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17. RETRUN ON EQUITY CAPITAL (ROE) :
Net Profit after Taxes / Tangible Net Worth
18. EARNING PER SHARE : EPS indicates the quantum of net profit
of the year that would be ranking for dividend for each share of
the company being held by the equity share holders.
Net profit after Taxes and Preference Dividend/ No. of Equity
Shares
19. PRICE EARNING RATIO : PE Ratio indicates the number of timesthe Earning Per Share is covered by its market price.
Market Price Per Equity Share/Earning Per Share
20. DEBT SERVICE COVERAGE RATIO : This ratio is one of the most
important one which indicates the ability of an enterprise to
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important one which indicates the ability of an enterprise to
meet its liabilities by way of payment of installments of Term
Loans and Interest thereon from out of the cash accruals and
forms the basis for fixation of the repayment schedule in
respect of the Term Loans raised for a project. (The Ideal DSCR
Ratio is considered to be 2 )
PAT + Depr. + Annual Interest on Long Term Loans & Liabilities---------------------------------------------------------------------------------
Annual interest on Long Term Loans & Liabilities + Annual
Installments payable on Long Term Loans & Liabilities
( Where PAT is Profit after Tax and Depr. is Depreciation)
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Technical Analysis
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Technical Analysis is a study of market data in terms of factors affecting
supply and demand schedules, such as prices, volume of trading etc.
What is Technical Analysis and its
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difference from Fundamental Analysis
At the most basic level, a technical analyst approaches a security from the
charts, while a fundamental analyst starts with the financial statements.
Fundamental analysis takes a relatively long-term approach to analyzing
the market compared to technical analysis. While technical analysis can be
used on a timeframe of weeks, days or even minutes, fundamentalanalysis often looks at data over a number of years.
Trading Versus Investing
Not only is technical analysis more short term in nature that fundamental
analysis, but the goals of a purchase (or sale) of a stock are usually
different for each approach. In general, technical analysis is used for atrade, whereas fundamental analysis is used to make an investment.
A Fundamental analyst believes that stock market is 10% psychological
and 90% logical where as the Technical analyst thinks the stock market is
10% logical and 90% pscyhological
What is A Chart?
A chart is a tool both investors and traders use to help them determine whether to buy
ll t k b d dit I t k h t
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or sell a stock, a bond, commodity or a currency. In one neat package, a huge amount
of data can be viewed and as they say:
A picture is worth a thousand words.
Types of Chart Line Chart
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The most basic of the four charts is the line chart because it representsonly the closing prices over a set period of time. The line is formed by
connecting the closing prices over the time frame. Line charts do not
provide visual information of the trading range for the individual points such
as the high, low and opening prices. However, the closing price is often
considered to be the most important price in stock data compared to the
high and low for the day and this is why it is the only value used in linecharts.
Types of Chart Bar Chart
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Bar Charts
The bar chart expands on the line chart by adding several more key pieces
of information to each data point. The chart is made up of a series of
vertical lines that represent each data point. This vertical line represents
the high and low for the trading period, along with the closing price. The
close and open are represented on the vertical line by a horizontal dash.
The opening price on a bar chart is illustrated by the dash that is located
on the left side of the vertical bar. Conversely, the close is represented bythe dash on the right. Generally, if the left dash (open) is lower than the
right dash (close) then the bar will be shaded black, representing an up
period for the stock, which means it has gained value. A bar that is colored
red signals that the stock has gone down in value over that period. When
this is the case, the dash on the right (close) is lower than the dash on the
left (open).
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Types of Chart Candlestick Chart
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Candlestick ChartsThe candlestick chart is similar to a bar chart, but it differs in the way that it
is visually constructed. Similar to the bar chart, the candlestick also has a
thin vertical line showing the period's trading range. The difference comes
in the formation of a wide bar on the vertical line, which illustrates the
difference between the open and close. And, like bar charts, candlesticks
also rely heavily on the use of colors to explain what has happened duringthe trading period. A major problem with the candlestick color
configuration, however, is that different sites use different standards;
therefore, it is important to understand the candlestick configuration used
at the chart site you are working with. There are two color constructs for
days up and one for days that the price falls. When the price of the stock is
up and closes above the opening trade, the candlestick will usually bewhite or clear. If the stock has traded down for the period, then the
candlestick will usually be red or black, depending on the site. If the stock's
price has closed above the previous days close but below the day's open,
the candlestick will be black or filled with the color that is used to indicate
an up day.
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Trend Lines
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There are three basic kinds
of trends: An Up trend where prices are
generally increasing.
A Down trend where prices are
generally decreasing.
A Trading Range.
Support & Resistance
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Support & Resistance
Support and resistance lines
indicate likely ends of trends.
Resistance results from the
inability to surpass prior highs.
Support results from the inabilityto break below to prior lows.
What was support becomes
resistance, and vice-versa.
Support Resistance
Breakout
Price Patterns
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Technicians look for many patterns in the historical time series of prices.
These patterns are reputed to provide information regarding the size and timing of
subsequent price moves.
But dont forget that the EMH says these patterns are illusions, and have no real
meaning. In fact, they can be seen in a randomly generated price series.
Head and Shoulders
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This formation is
characterized by two small
peaks on either side of a
larger peak.
This is a reversal pattern,
meaning that it signifies a
change in the trend.
Head
Head
Left Shoulder
Left Shoulder
Right Shoulder
Right Shoulder
Neckline
Neckline
H&S Top
H&S Bottom
Head & Shoulders Example
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Sell Signal
Minimum Target Price
Based on measurement rule
Double Tops and Bottoms
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These formations are
similar to the H&S
formations, but there is no
head.
These are reversal patterns
with the same measuring
implications as the H&S.
Target
Double Top
Double Bottom
Target
Double Bottom Example
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Triangles
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Triangles are continuationformations.
Three flavors: Ascending
Descending Symmetrical
Typically, triangles shouldbreak out about half tothree-quarters of the way
through the formation.
Ascending
Descending
Symmetrical
Symmetrical
Flag and PennantFlag and Pennant
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These two short-term chart patterns are continuation patterns that are formed when
there is a sharp price movement followed by a generally sideways price movement.
This pattern is then completed upon another sharp price movement in the same
direction as the move that started the trend. The patterns are generally thought to
last from one to three weeks.
As you can see in Figure there is little difference between a pennant and a flag. Themain difference between these price movements can be seen in the middle section of
the chart pattern. In a pennant, the middle section is characterized by converging
trendlines, much like what is seen in a symmetrical triangle. The middle section on
the flag pattern, on the other hand, shows a channel pattern, with no convergence
between the trendlines. In both cases, the trend is expected to continue when the
price moves above the upper trendline.
Falling WedgeWedge
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Wedge
The wedge chart pattern can be either a continuation or reversal pattern. It is
similar to a symmetrical triangle except that the wedge pattern slants in an
upward or downward direction, while the symmetrical triangle generally showsa sideways movement. The other difference is that wedges tend to form over
longer periods, usually between three and six months.
Technical indicators
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Technical indicators
The short interest ratio theoryWhat Does Sho rt Interest RatioMean?
A sentiment indicator that is derived by dividing the
short interest by the average daily volume for a stock.
This indicator is used by both fundamental andtechnical traders to identify the prevailing sentiment the
market has for a specific stock.
Technical indicators
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Technical indicators
Confidence IndexIt is a ratio of lower grade bonds to higher grade bonds,
when this ratio is higher then the market is aggressive
and if the ratio is lower then the market is conservative
People prefer to save in higer grade bonds when theyare conservative
Technical indicators
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Technical indicators
SpreadsLarge spreads between yields indicate Bearishness
Advance Decline ratio
When the number of stock advances are higher than
the number of stock declines then this ratio is higher
and it indicates bullishness
Technical indicators
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Technical indicators
Odd Lot Ratio Small investors trade in odd lotshence higher the number indicates a possibility of
revision in the market
Insider Transaction
When Insiders start buying or selling It is indicative ofbullish or bearish trend
Moving Average
This is the average price for the last pre-definednumber of days. Typically it is either 10,20,50,100 days
DERIVATIVES DEFINED
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Derivative is a product whose value is derived from the
value of one or more basic variables, called bases(underlying asset, index, or reference rate), in a contractual
manner.
The underlying asset can be equity, forex, commodity or
any other asset.
For example, wheat farmers may wish to sell their harvest
at a future date to eliminate the risk of a change in prices by
that date.
Such a transaction is an example of a derivative. The price
of this derivative is driven by the spot price of wheat whichis the "underlying".
FACTORS DRIVING THE GROWTH OF DERIVATIVES
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1. Increased volatility in asset prices in financial markets,
2. Increased integration of national financial markets with the international
markets,
3. Marked improvement in communication facilities and sharp decline in their
costs,
4. Development of more sophisticated risk management tools, providing
economic agents a wider choice of risk management strategies, and
5. Innovations in the derivatives markets, which optimally combine the risks andreturns over a large number of financial assets leading to higher returns,
reduced risk as well as transactions costs as compared to individual
financial assets.
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DERIVATIVE PRODUCTS
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Derivative contracts have several variants. The most common variants are
forwards, futures, options and swaps. We take a brief look at various
derivatives contracts that have come to be used.
Forwards:A forward contract is a customized contract between two entities, where
settlement takes place on a specific date in the future at today's pre-agreed
price.
Futures:A futures contract is an agreement between two parties to buy or sell an
asset at a certain time in the future at a certain price. Futures contracts are specialtypes of forward contracts in the sense that the former are standardized
exchange-traded contracts.
Options: Options are of two types - calls and puts. Calls give the buyer the
right but not the obligation to buy a given quantity of the underlying asset, at
a given price on or before a given future date. Puts give the buyer the right,
but not the obligation to sell a given quantity of the underlying asset at a given
price on or before a given date.
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Operators in the derivatives market
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2009 Deloitte LLP. All rights reserved.
Hedgers - Operators, who want to transfer a
risk component of their portfolio.
Speculators - Operators, who intentionallytake the risk from hedgers in pursuit of profit.
Arbitrageurs - Operators who operate in the
different markets simultaneously, in pursuit ofprofit and eliminate mis-pricing.
Over the Couter (OTC) contracts - FORWARDS
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1. The management of counter-party (credit) risk is decentralized and
located within individual institutions,
2. There are no formal centralized limits on individual positions, leverage,
or margining,
3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability
and integrity, and for safeguarding the collective interests of market
participants, and5. The OTC contracts are generally not regulated by a regulatory authority
and the exchange's self-regulatory organization, although they are
affected indirectly by national legal systems, banking supervision and
market surveillance.
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FORWARD CONTRACTS
A forward contract is an agreement to buy or sell an asset on a specified date for a
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A forward contract is an agreement to buy or sell an asset on a specified date for a
specified price. One of the parties to the contract assumes a long position and agrees
to buy the underlying asset on a certain specified future date for a certain specified
price. The other party assumes a short position and agrees to sell the asset on thesame date for the same price. Other contract details like delivery date, price and
quantity are negotiated bilaterally by the parties to the contract. The forward contracts
are normally traded outside the exchanges.
The salient features of forward contracts are: They are bilateral contracts and hence exposed to counter-party risk.
Each contract is custom designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality.
The contract price is generally not available in public domain.
On the expiration date, the contract has to be settled by delivery of the asset.
If the party wishes to reverse the contract, it has to compulsorily go to the same
counter-party, which often results in high prices being charged.
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LIMITATIONS OF FORWARD MARKETS
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Forward markets world-wide are afflicted by several problems:
Lack of centralization of trading,
Illiquidity, and
Counterparty risk
In the first two of these, the basic problem is that of too much flexibility and
generality. The forward market is like a real estate market in that any two
consenting adults can form contracts against each other. This often makes them
design terms of the deal which are very convenient in that specific situation, butmakes the contracts non-tradable.
Counterparty risk arises from the possibility of default by any one party to the
transaction. When one of the two sides to the transaction declares bankruptcy, the
other suffers. Even when forward markets trade standardized contracts, and hence
avoid the problem of illiquidity, still the counterparty risk remains a very seriousissue.
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INTRODUCTION TO FUTURES
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Futures markets were designed to solve the problems that exist in forward markets.
A futures contract is an agreement between two parties to buy or sell an asset at a
certain time in the future at a certain price. But unlike forward contracts, the futurescontracts are standardized and exchange traded. To facilitate liquidity in the futures
contracts, the exchange specifies certain standard features of the contract. It is a
standardized contract with standard underlying instrument, a standard quantity and
quality of the underlying instrument that can be delivered, (or which can be used for
reference purposes in settlement) and a standard timing of such settlement. A
futures contract may be offset prior to maturity by entering into an equal andopposite transaction. More than 99% of futures transactions are offset this way.
The standardized items in a futures contract are:
Quantity of the underlying
Quality of the underlying
The date and the month of delivery The units of price quotation and minimum price change
Location of settlement
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DISTINCTION BETWEEN FUTURES AND FORWARDS
CONTRACTS
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Forward contracts are often confused with futures contracts. The confusion is
primarily because both serve essentially the same economic functions of
allocating risk in the presence of future price uncertainty. However futures are
a significant improvement over the forward contracts as they eliminate
counterparty risk and offer more liquidity.
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FUTURES TERMINOLOGY
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Spot p r ice: The pr ice at which an asset trades in the spot m arket.
Futures pr ice: The pr ice at wh ich the futures contract trades in the
futures market.
Contract cycle: The per iod over which a contract trades. The index
futures contracts on the NSE have one- month, two-months and threemonths
expiry cycles which expire on the last Thursday of the month.
Thus a January expiration contract expires on the last Thursday of
January and a February expiration contract ceases trading on the lastThursday of February. On the Friday following the last Thursday, a new
contract having a three- month expiry is introduced for trading.
Expiry date: It is the date speci f ied in the futu res con tract. This is the
last day on which the contract will be traded, at the end of which it will
cease to exist. Contract size: The amoun t of asset that has to be del ivered under
one contract. Also called as lot size.
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FUTURES TERMINOLOGY
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Basis: In the context of f in ancial futu res, basis can be def ined as thefutures price
minus the spot price. There will be a different basis for each delivery month for each
contract. In a normal market, basis will be positive. This reflects that futures pricesnormally exceed spot prices.
Cost of carry: The relat ion ship between futures pr ices and spot pr icescan be
summarized in terms of what is known as the cost of carry. This measures the storage
cost plus the interest that is paid to finance the asset less the income earned on the
asset.
Ini t ial margin: The amou nt that mu st be depos i ted in the marginaccount at the
time a futures contract is first entered into is known as initial margin.
Marking-to-market: In the fu tures m arket, at the end o f eachtrading day, the
margin account is adjusted to reflect the investors gain or loss depending upon the
futures closing price. This is called marking-to-market.
Maintenance margin: This is somewhat lower than the ini t ial margin.This is set to ensure that the balance in the margin account never becomes negative.
If the balance in the margin account falls below the maintenance margin, the investor
receives a margin call and is expected to top up the margin account to the initial
margin level before trading commences on the next day.
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INTRODUCTION TO OPTIONS
O ti f d t ll diff t f f d d f t t t A ti
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Options are fundamentally different from forward and futures contracts. An option
gives the holder of the option the right to do something. The holder does not have
to exercise this right. In contrast, in a forward or futures contract, the two partieshave committed themselves to doing something. Whereas it costs nothing (except
margin requirements) to enter into a futures contract, the purchase of an option
requires an up-front payment.
Option is a form of Insurance The person buying an option is buying a insurance
and the option writer is the Insurer!!
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OPTION TERMINOLOGY
I d t i Th t i h th i d th d l i
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Index opt ion s: These op t ions have the index as the und er ly ing .
Some options are European while others are American. Like index
futures contracts, index options contracts are also cash settled.Stock opt ions: Stock op t ions are opt ions on ind iv idual stoc ks. Opt ions
currently trade on over 500 stocks in the United States. A contract gives the
holder the right to buy or sell shares at the specified price.
Buyer of an opt ion: The buyer of an opt ion is the one who by paying the
option premium buys the right but not the obligation to exercise hisoption on the seller/writer.
Writer of an opt ion : The wri ter of a cal l /pu t opt io n is the on e who receives
the option premium and is thereby obliged to sell/buy the asset if the
buyer exercises on him.
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Th t b i t f ti ll ti d t ti
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There are two basic types of options, call options and put options.
Cal l opt ion : A cal l op t ion g ives the holder the r ight but n ot the ob l igat ion to
buy an asset by a certain date for a certain price. Put opt ion: A put o pt ion gives the holder the r ight b ut no t the obl igation to
sell an asset by a certain date for a certain price.
Opt ion pr ice/premium: Opt ion pr ice is the pr ice which the opt ion buyer
pays to the option seller. It is also referred to as the option premium. Expirat ion d ate: The date speci f ied in the opt ion s con tract is known as
the expiration date, the exercise date, the strike date or the maturity.
Str ike pr ice: The pr ice speci f ied in the opt ion s con tract is known as the
strike price or the exercise price.
American op t ions : American op t ions are opt ions th at can be exercised atany time upto the expiration date. Most exchange-traded options are American.
European op t ions : Europ ean op t ions are op t ions that can be exercised
only on the expiration date itself
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Participants in the F&O Market
Exchanges : provide an infrastructure for carrying out the dealings on assets
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Exchanges :- provide an infrastructure for carrying out the dealings on assets
CBOT (Chicago Board of Trade), SFE (Sydney Futures Exchange), LIFFE (London
International Finance Futures Exchange), TIFFE.Clearing House :- acts as a nerve centre of contract execution and completion.
Custodians :- require the participants to deposit their securities before starting
trading.
Banks :- handle large volume of fund movements that take place between members
and clearing house.
The regulator :- creates confidence among the transacting members of the exchange
Market makers : decide the market price depending upon the demand and supply of
the underlying asset. (jobbers)
Brokers :- perform the task of bringing together the buyers and sellers
Arbitrageurs :- players who enter into such contracts that can earn riskless profits
through the process of arbitrage.
Speculators :- provide the liquidity and the volume to market which helps reducing
costs.
Hedgers : - provide for locking in the future expected price at which to buy or sell.
They safeguard their position from falling rates and prices.
Formulaes for calculation of Portfolio Risk
Variation 1:
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1
1
1
1 1
n
i
i
n
n i
i
X Xn
X X
[Ri E(R)]2 X P [Ri E(R)]2 X P
Variation 1:
Various values of X is given
Various values of Y is givenCalculate mean of X
Calculate mean of Y
Calculate Standard deviation of X
Calculate standard deviation of Y
Calculate Mean of Portfolio = proportion of X * Mean value of X + Proportion of Y *Mean Value of Y
Standard Deviation of portfolio =
P1 = Proportion of investment in X
P2 = Proportion of Investment in Y
r = Correlation coefficient between X and Y
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P12
s
2X + P
22
s2
Y +2P1
P2
rsX sYsCombined Portfolio
Formulae for correlation Coefficient and covariance
Correlation Coefficient (r) = co variance between x and y
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Correlation Coefficient (r) = covariance between x and y
sX sY
Calculation of Covariance = S xi - x Yi - Y n1
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Calculation of Beta
B t (b
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Beta (b = covariance between security and market
s2m
Covariance between security and market = S Ri - RiRm - Rm n1
s2m =S Rm - Rm 2
n1