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COURSE REVIEW
INVESTMENT ANALSIS &
PORTFOLIO MGMT
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CHAPTERS COVERED CHAPTER 1 - OVERVIEW
A Broad Map of the territory
CHAPTER 2 - INVESTMENT ALTERNATIVES
CHAPTER 3 SECURITIES MARKET
CHAPTER 4 - RISK & RETURN
CHAPTER 5 - TIME VALUE OF MONEY (PRT)
SETTING PORTFOLIO OBJECTIVE
AS DISCUSSED INCLASS (TH)
CHAPTER 7 - PORTFOLIO THEORY (PRT & TH)
CHAPTER 8 - CAPM (PRT)
CHAPTER 9 - EFFICIENT MARKET HYPOTHESIS (TH)
CHAPTER 10 - BEHAVIORAL FINANCE (TH) CHPATER 13 - EQUITY VALUATION (PRT)
CHAPTER 14 & 15 - FUNDAMENTAL ANALYSIS (TH & PRT)
CHAPTER 16 - TECHNICAL ANALYSIS (REF PPT) (TH)
CHAPTER 21 - PORTFOLIO MGMT FRAMEWORK (PRT & TH)
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RISK RETURN
For earning returns investors have to almost invariably bear some risk. While investors
like returns they abhor risk. Investment decisions therefore involve a tradeoff
between risk and return.
The total return on an investment for a given period is :C+ (PEPB)
R =PB
The return relative is defined as:C+P
E
Return relative =
PB
The cumulative wealth index captures the cumulative effect of total returns. It is
calculated as follows:CWIn = WI0 (1 +R1) (1+R2) (1+ Rn)
The arithmetic mean of a series of returns is defined as:nSRi
i=1R = n
The geometric mean of a series of returns is defined as:
GM = [1+ R1) (1+ R2).(1+ Rn) ]1/n
1
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The arithmetic mean is a more appropriate measure of average performance over a single
period. The geometric mean is a better measure of growth in wealth over time
The real return is defined as:1+ Nominal return
-1
1+ Inflation rate The most commonly used measures of risk in finance are variance or its square root the
standard deviation. The standard deviation of a historical series of returns is calculated
as follows:n 1/2S (RiR)
2
t=1s =
n - 1
Risk premium may be defined as the additional return investors expect to get for
assuming additional risk. There are three well known risk premiums: equity risk
premium, bond horizon premium, and bond default premium.
The expected rate of return on a stock is:n
E(R) = S piRii=1
The standard deviation of return is:
s
= ( Spi (RiE(R)2
)1/2
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TIME VALUE OF MONEY
Money has time value. A rupee today is more valuable than arupee a year hence.
The general formula for the future value of a single amount
is :
Future value = Present value (1+r)n
The value of the compounding factor, (1+r)n
, depends on theinterest rate (r) and the life of the investment (n).
According to the rule of 72, the doubling period is obtained
by dividing 72 by the interest rate.
The general formula for the future value of a single cash
amount when compounding is done more frequently thanannually is:
Future value = Present value [1+r/m]m*n
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An annuity is a series of periodic cash flows (payments and
receipts) of equal amounts. The future value of an annuity is:
Future value of an annuity
= Constant periodic flow [(1+r)n1) ] /r The process of discounting, used for calculating the present
value, is simply the inverse of compounding. The present
value of a single amount is:
Present value = Future value x 1/(1+r)n
The present value of an annuity is:
Present value of an annuity
= Constant periodic flow [11/ (1+r)n] /r
The present value of growing annuity is:= A1 [1{(1+gn)/ (1+r)n}] /r-g
A perpetuity is an annuity of infinite duration. In general
terms:
Present value of a perpetuity = Constant periodic flow [1/r]
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SETTING PORTFOLIO OBJECTIVES
Reasons of difficulty in security objectives
Semantics
Indecision
Subjectivity
Multiple beneficiary
Investment Policy & Strategy Precondition for Setting Portfolio
Understanding current needs
Time Horizon
Liquidity Needs
Ethical Consideration
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SETTING PORTFOLIO OBJECTIVESPRIMARY OBJECTIVES
SECONDAR
Y
OBJECTIVE
Stability of
Principle
Income Growth of
Income
Capital
Appreciation
Stability of
Principle
X Debt & Preferred
Stock
Unacceptable ? (low coupon
bonds)
Income Short term debt X At least 40%
equity
? (preference
share)
Growth ofIncome
Unacceptable Varies often >40%
X At least 75%equity
Capital
Appreciation
Unacceptable ? (preference
share)
At least 75%
equity
X
Inconsistent objectives are Unacceptable
Infrequent objectives are ?
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PORTFOLIO THEORY
Portfolio theory, originally proposed by Markowitz, is the
first formal attempt to quantify the risk of a portfolio and
develop a methodology for determining the optimal portfolio.
The expected return on a portfolio ofn securities is :
E(Rp) = wi E(Ri)
The variance and standard deviation of the return on an
n-security portfolio are:
sp2 = wi wjij sisj
sp = wi wjijsisj
A portfolio is efficient if (and only if) there is an alternative
with (i) the sameE(Rp) and a lowersp or (ii) the same sp and
a higherE(Rp), or (iii) a higherE(Rp) and a lowersp
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Given the efficient frontier and the risk-return indifference
curves, the optimal portfolio is found at the tangencybetween the efficient frontier and a utility indifference curve.
If we introduce the opportunity for lending and borrowing at
the risk-free rate, the efficient frontier changes dramatically.It is simply the straight line from the risk-free rate which istangential to the broken-egg shaped feasible region
representing all possible combinations of risky assets.
The Markowitz model is highly information-intensive.
The single index model, proposed by sharpe, is a very helpfulsimplification of the Markowitz model.
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CAPM
The relationship between risk and expected return for efficient portfolios, as given by the
capital market line, is:
E(Ri) =Rf+ sI
= E(RM)Rf
sM
The relationship between risk and expected return for an inefficient portfolio or a single
security as given by the security market line is :
E(Ri) =Rf+ E(RM)Rf x
The beta of a security is the slope of the following regression relationship:
Rit= i + iRMt+ eit
The commonly followed procedure for testing CAPM involves two steps. In the first step,the security betas are estimated. In the second step, the relationship between securitybeta and return is examined.
siMsM
2
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CAPM
Empirical evidence is favour of CAPM is mixed. Notwithstanding this, the CAPM is the
most widely used risk-return model because it is simple and intuitively appealing and itsbasic message that diversifiable risk does not matter is generally accepted.
The APT is much more general in that asset prices can be influenced by factors beyondmeans and variances. The APT assumes that the return on any security is linearly relatedto a set of systematic factors.
SHARPE OPTIMAL PORTFOLIOCUTOFF
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EQUITY VALUATION
While the basic principles of valuation are the same for fixed
income securities as well as equity shares, the factors of growthand risk create greater complexity in the case of equity shares.
Three valuation measures derived from the balance sheet are:
book value, liquidation value, and replacement cost.
According to the dividend discount model, the value of an equityshare is equal to the present value of dividends expected from its
ownership.
If the dividend per share grows at a constant rate, the value of the
share is :P0 =D1/ (rg) A widely practised approach to valuation is the P/E ratio or
earnings multiplier approach. The value of a stock, under thisapproach, is estimated as follows:
P0 =E1 xP0/E1
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In general, we can think of the stock price as the capitalised value
of the earnings under the assumption of no growth plus thepresent value of growth opportunities (PVGo)
E1P0 = + PVGO
r
Apart from the price-earnings ratio, price to book value (PBV)
ratio and price to sales (PSR) ratio are two other widely usedcomparative valuation ratios
Two broad approaches are followed in managing an equity
portfolio : passive strategy and active strategy.
Stock market returns are determined by an interaction of two
factors : investement returns and speculative returns.
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MACROECONOMIC ANALYSIS
A commonly advocated procedure for fundamental analysis
involves a 3step analysis: macroeconomic analysis,industry analysis, and company analysis.
In a globalised business environment, the top-down analysis
of the prospects of a firm must begin with the global
economy. There are two broad classes of macroeconomic policies, viz.
demand side policies and supply side policies.
Fiscal and monetary policies are the two major tools ofdemand side economics.
Fiscal policy is concerned with the spending and tax
initiatives of the government.
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Monetary policy is concerned with money supply and interest
rates.
The macroeconomy is the overall economic environment in
which all firms operate.
Almost every industry goes through a life cycle consisting of
four stages viz., pioneering stage, rapid growth stage,maturity and stabilisation stage, and decline stage.
Michael Porter has argued that the profit potential of an
industry depends on the combined strength of five basiccompetitive forces.
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COMPANY ANALYSIS
In practice, the earnings multiplier method is the most popular
method. The key questions to be addressed in this method are:
what is the expected EPS for the forthcoming year? What is areasonable PE ratio given the growth prospects, risk exposure,
and other characteristics? Historical financial analysis serves as a
foundation for answering these questions.
The ROE, perhaps the most important metric of financial
performance, is decomposed in two ways for analytical purposes.
ROE = Net profit margin x Asset turnover x Leverage
ROE = PBIT efficiency x Asset turnover x Interest burden
x Tax burden x Leverage
To measure the historical growth, the CAGR in variables like
sales, net profit, EPS and DPS is calculated.
h dl h ki d f h h b i i d
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To get a handle over the kind of growth that can be maintained,
the sustainable growth rate is calculated.
Beta and volatility of ROE may be used as risk measures.
An estimate of EPS is an educated guess about the future
profitability of the company.
The PE ratio may be derived from the constant growth dividendmodel, or cross-section analysis, or historical analysis.
The value anchor is :
Projected EPS x Appropriate PE ratio
PBV-ROE matrix, growth-duration matrix, and expectation risk
index are some of the tools to judge undervaluation or
overvaluation.
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TECHNICAL ANALYSIS
Past Prices & Volumes
AssumptionsMarket discounts everything, Moves in trend,History repeats
Fundamentals V/s Technical (chart,time,trading)
Uptrend , downtrend , sideways
Channels, Support Resistance
Scaling & types of charts
Dow Theory (Primary (longterm), intermediate & short term)
Pattern (Reversal(HS,DT,TT & Continuation(CH,TRI,FLAG)
Moving Average(SMA,EMA), RSI, MACD
C A O S S
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EFFICIENT MARKET HYPOTHESIS
Stock prices appear to follow a random walk. The
randomness of stock prices is the result of an efficient market
It is useful to distinguish three levels of market efficiency :
weak form efficiency, semi-strong form efficiency, and strongform efficiency.
The weak form efficient market hypothesis says that thecurrent price of a stock reflects all information found in therecord of past prices and volumes.
The semi-strong form efficient market hypothesis holds that
stock prices adjust rapidly to all available public information.
The strong form efficient market hypothesis holds that all
available information, public and private is reflected in stock
prices.
E i i l id id f
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Empirical evidence seems to provide strong support for
weak-form efficiency, mixed support for semi-strong formefficiency, and weak support for strong-form efficiency.
The efficient market hypothesis is an imperfect and limiteddescription of the stock market. however, at least for the
present, there does not seem to be a better alternative.
The key implications of the efficient market hypothesis are
that technical analysis is of dubious value and routinefundamental analysis is not of much help.
BEHAVIORAL FINANCE
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BEHAVIORAL FINANCE
The central assumption of the traditional finance model is that people
are rational. However, psychologists argue that people suffer from
cognitive and emotional biases. The important heuristic-driven biases and cognitive errors that impair
judgment are: representativeness, overconfidence, anchoring, aversion
to ambiguity, and innumeracy.
The form used to describe a problem has a bearing on decision making.Frame dependence stems from a mix of cognitive and emotional factors.
People feel more strongly about the pain from a loss than the pleasure
from an equal gainabout 2 times as strongly, according to
Kahneman and Tversky. This phenomenon is referred to as lossaversion
People separate their money into various mental accounts and treat a
rupee in one account differently from a rupee in another.
I i f i h f h i l h
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Investors engage in narrow-framingthey focus on changes in wealth
that are narrowly defined, both in a cross-sectional as well as a temporal
sense.
The psychological tendencies of investors prod them to build their
portfolios as a pyramid of assets
People seem to consider a past outcome as factor in evaluating a current
risky decision.
The emotions experienced by a person with respect to investment may beexpressed along an emotional time line.
Thanks to informationcascade, large trends or fads begin when
individuals ignore their private information but take cues from the
action of others.
Due to various behavioural influences, often there is a discrepancy
between market price and intrinsic value.
To overcome psychological biases, a disciplined approach is required.
Th f t l id d i l ti b d i ld
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The factors commonly considered in selecting bonds are : yield
to maturity, risk of default, tax shield, liquidity, and duration.
Three broad approaches are employed for stock selection :
technical analysis, fundamental analysis, and random selection. Motives of trading are cognitive and emotional.
Portfolio revision involves portfolio rebalancing and portfolio
upgrading
The key dimensions of performance evaluation are rate of
return and risk.
Treynor measure, Sharpe measure, and Jensen measure are
three popularly employed performance measures.
PORTFOLIO MANAGEMENT FRAMEWORK
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PORTFOLIO MANAGEMENT FRAMEWORK
Portfolio management is a complex process or activity that may
be divided into seven broad phases.
Investment objectives are expressed in terms of return and risk.
The strategic asset-mix decision (or policy asset-mix decision) is
the most important decision made by the investor.
Investors with greater tolerance for risk and longer investmenthorizon should tilt the asset mix in favour of stocks
The four principal vectors of an active portfolio strategy are :
market timing, sector rotation, security selection, and the use of
a specialised concept.
A passive portfolio strategy calls for creating a well-diversified
portfolio at a pre-determined level of risk and holding itrelatively unchanged over time.
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ALL THE BEST FOR YOUR EXAMS..
HAPPY STUDYING