SAPM Key points Notes 6th Sem BBA

Unit 1: Introduc on to Investments

Investment is the act of pu ng money into something with the expecta on of earning a profit or income
over me. It involves careful planning and decision-making to grow wealth while managing risks. This sec on
explains the basics of inves ng in simple terms.

1. Investment Process

The investment process is a step-by-step approach to making smart investment decisions. It helps investors
choose the right op ons and achieve their financial goals.

 Steps in the Investment Process:

1. Set Financial Goals:

 Decide what you want to achieve (e.g., buying a house, saving for re rement, or
funding educa on).

 Example: Save $50,000 in 10 years for a child’s college fees.

2. Assess Risk Tolerance:

 Determine how much risk you’re comfortable with (e.g., are you okay with losing some
money for higher returns?).

 Example: A young person may take more risks, while someone nearing re rement may
prefer safer op ons.

3. Gather Informa on:

 Research different investment op ons (e.g., stocks, bonds, real estate) and their risks
and returns.

 Example: Read about how stocks perform or consult a financial advisor.

4. Choose Investments:

 Select investments that match your goals, risk tolerance, and budget.

 Example: Invest in a mix of stocks and bonds for balanced growth.

5. Monitor and Adjust:

 Regularly check how your investments are performing and make changes if needed.

 Example: Sell a stock that’s underperforming and invest in a be er op on.

 Significance:

o A structured process reduces mistakes and aligns investments with goals.

o Helps balance risk and reward.

 Example: Priya wants to save for a car. She sets a goal, assesses her risk tolerance, researches mutual
funds, invests, and reviews her por olio yearly.
2. Criteria for Investment

The criteria for investment are the factors investors consider to evaluate and choose investment op ons.
These ensure the investment is suitable and profitable.

 Key Criteria:

1. Return:

 The profit or income earned (e.g., interest, dividends, or price apprecia on).

 Example: A stock may give 10% annual returns through price growth and dividends.

2. Risk:

 The chance of losing money or not achieving expected returns.

 Example: Stocks are riskier than fixed deposits but may offer higher returns.

3. Liquidity:

 How easily an investment can be converted to cash without significant loss.

 Example: Shares in a stock market are more liquid than real estate.

4. Time Horizon:

 The dura on you plan to hold the investment.

 Example: Short-term (1–3 years) for a vaca on, long-term (10+ years) for re rement.

5. Tax Benefits:

 Tax advantages or exemp ons offered by certain investments.

 Example: Some government bonds offer tax-free interest.

6. Cost:

 Fees or expenses involved (e.g., brokerage fees, management fees).

 Example: Mutual funds may charge a 1% annual fee.

 Significance:

o Helps investors compare op ons and make informed choices.

o Balances profitability with safety and convenience.

 Example: Ravi chooses a mutual fund with moderate risk, 8% expected return, high liquidity, and low
fees for his 5-year goal.

3. Types of Investors

Types of investors describe the different categories of people or en es who invest, based on their goals,
risk tolerance, and strategies.
  Key Types:

1. Individual Investors:

 Regular people inves ng personal money for goals like re rement or buying a home.

 Example: A teacher inves ng in mutual funds.

2. Ins tu onal Investors:

 Large organiza ons like banks, insurance companies, or pension funds inves ng huge
sums.

 Example: A pension fund buying government bonds.

3. Conserva ve Investors:

 Prefer low-risk investments with stable returns.

 Example: An elderly person inves ng in fixed deposits.

4. Aggressive Investors:

 Willing to take high risks for poten ally high returns.

 Example: A young entrepreneur inves ng in startup stocks.

5. Ac ve Investors:

 Frequently buy and sell investments to maximize short-term gains.

 Example: A stock trader monitoring market trends daily.

6. Passive Investors:

 Invest for the long term with minimal trading.

 Example: Someone holding index funds for 20 years.

 Significance:

o Understanding investor types helps tailor investment advice and products.

o Reflects diverse financial goals and risk appe tes.

 Example: A conserva ve individual investor chooses bonds, while an aggressive ins tu onal investor
buys tech stocks.

4. Investment, Specula on, and Gambling

These terms describe different approaches to using money with the hope of earning more, but they differ in
risk, me, and decision-making.

 Investment:

o Pu ng money into assets with the expecta on of steady, long-term returns based on research
and analysis.

o Features:
  Low to moderate risk.

 Long-term horizon (years).

 Based on fundamentals (e.g., company performance, economic trends).

o Example: Buying shares of a stable company like Reliance Industries for dividend income and
growth.

 Specula on:

o Taking higher risks for poten ally large, short-term gains based on market trends or
predic ons.

o Features:

 High risk.

 Short-term horizon (days to months).

 Relies on market fluctua ons or rumors.

o Example: Buying a new cryptocurrency hoping its price will skyrocket in weeks.

 Gambling:

o Be ng money on uncertain outcomes with no control or analysis, purely based on chance.

o Features:

 Very high risk, o en total loss.

 Immediate or short-term.

 No research; luck-driven.

o Example: Be ng on a horse race or playing a lo ery.

 Comparison:

o Investment: Calculated, informed, growth-focused.

o Specula on: Risky, short-term, trend-based.

o Gambling: Chance-based, no strategy.

 Significance:

o Investors should focus on investment for sustainable wealth, avoiding specula on or gambling.

 Example: Inves ng in a mutual fund is investment, buying untested stocks based on ps is specula on,
and playing slot machines is gambling.

5. Elements of Investment

The elements of investment are the core components that define and influence the investment decision-
making process.
  Key Elements:

1. Risk and Return:

 Higher returns o en come with higher risks.

 Example: Stocks offer high returns but can be vola le, while bonds are safer but yield
less.

2. Time Horizon:

 The length of me you plan to invest affects the choice of investment.

 Example: Long-term investors choose stocks; short-term investors prefer fixed

deposits.

3. Liquidity:

 Ability to quickly sell or access funds without loss.

 Example: Savings accounts are highly liquid; real estate is less liquid.

4. Diversifica on:

 Spreading money across different investments to reduce risk.

 Example: Inves ng in stocks, bonds, and gold to balance losses.

5. Tax Implica ons:

 Taxes on returns or tax benefits influence net gains.

 Example: Tax-saving mutual funds reduce taxable income.

 Significance:

o These elements guide investors to balance profitability, safety, and flexibility.

o Help create a well-rounded investment por olio.

 Example: An investor diversifies by alloca ng 50% to stocks (high return, high risk), 30% to bonds (low
risk, moderate return), and 20% to a savings account (high liquidity, low return).

6. Investment Avenues

Investment avenues are the various op ons available for inves ng money, each with unique features, risks,
and returns.

 Key Investment Avenues:

1. Stocks (Equi es):

 Buying shares of a company, earning through dividends or price apprecia on.

 Risk: High (market fluctua ons).

 Return: Poten ally high (e.g., 10–15% annually).

 Example: Inves ng in Apple or Tata Motors shares.

2. Bonds:

 Lending money to governments or companies for fixed interest.

 Risk: Low to moderate.

 Return: Moderate (e.g., 5–8% annually).

 Example: Government bonds or corporate bonds.

3. Mutual Funds:

 Pooled funds managed by professionals, inves ng in stocks, bonds, or other assets.

 Risk: Varies (low for debt funds, high for equity funds).

 Return: Varies (e.g., 8–12% for equity funds).

 Example: Inves ng in an SBI Equity Mutual Fund.

4. Fixed Deposits (FDs):

 Deposi ng money in a bank for a fixed period with guaranteed interest.

 Risk: Very low.

 Return: Low to moderate (e.g., 5–7% annually).

 Example: A 5-year bank FD.

5. Real Estate:

 Buying property for rental income or price apprecia on.

 Risk: Moderate to high (market-dependent).

 Return: High (e.g., 8–15% with rental and apprecia on).

 Example: Purchasing an apartment for rent.

6. Gold and Precious Metals:

 Inves ng in gold, silver, or jewelry for value apprecia on.

 Risk: Moderate (price vola lity).

 Return: Moderate (e.g., 5–10% annually).

 Example: Buying gold ETFs or physical gold.

7. Public Provident Fund (PPF):

 Government-backed savings scheme with tax benefits.

 Risk: Very low.

 Return: Moderate (e.g., 7–8% annually).

 Example: Inves ng in PPF for re rement.

8. Cryptocurrencies:
  Digital currencies like Bitcoin, highly specula ve.

 Risk: Very high.

 Return: Poten ally very high but vola le.

 Example: Buying Bitcoin hoping for price surges.

 Significance:

o Offers choices to match goals, risk tolerance, and me horizons.

o Diversifica on across avenues reduces overall risk.

 Example: A balanced por olio might include stocks for growth, bonds for stability, and gold for
hedging.

7. Factors Influencing Selec on of Investment Alterna ves

The factors influencing investment selec on are the considera ons that guide investors in choosing the best
investment op ons for their needs.

 Key Factors:

1. Financial Goals:

 Investments depend on objec ves like wealth crea on, income genera on, or capital
preserva on.

 Example: Stocks for long-term wealth, FDs for short-term savings.

2. Risk Tolerance:

 Comfort with poten al losses affects choices.

 Example: Risk-averse investors choose bonds; risk-takers choose stocks.

3. Income and Net Worth:

 Available funds determine investment size and type.

 Example: High-income individuals invest in real estate; low-income investors choose

mutual funds.

4. Time Horizon:

 Short-term goals favor liquid, low-risk op ons; long-term goals allow riskier
investments.

 Example: FDs for a 2-year goal, stocks for a 10-year goal.

5. Market Condi ons:

 Economic trends, interest rates, or infla on impact returns.

 Example: Bonds perform be er in low-interest-rate environments.

6. Tax Considera ons:

  Tax benefits or liabili es influence net returns.

 Example: PPF offers tax-free returns, a rac ng tax-conscious investors.

7. Liquidity Needs:

 Need for quick access to funds affects choices.

 Example: Savings accounts for emergencies, real estate for long-term holds.

8. Knowledge and Experience:

 Familiarity with investments guides decisions.

 Example: Novices prefer mutual funds; experts trade stocks directly.

 Significance:

o Ensures investments align with personal circumstances and market reali es.

o Helps balance risk, return, and convenience.

 Example: A young professional with high risk tolerance and a long-term goal invests in stocks, while a
re ree with low risk tolerance chooses FDs.

Security Market

The security market is a financial marketplace where securi es—such as stocks, bonds, and deriva ves—are
bought and sold. It plays a vital role in helping companies and governments raise funds and allowing investors
to grow their wealth. This sec on explains the security market, its func ons, and related concepts in simple
terms.

1. Introduc on to Security Market

 Defini on: The security market is a pla orm where financial securi es (like shares, bonds, and
deriva ves) are issued, bought, and sold based on supply and demand. It connects those who need
funds (e.g., companies, governments) with those who have extra money to invest (e.g., individuals,
ins tu ons).

 Types of Security Markets:

o Primary Market: Where new securi es are issued for the first me, such as through an Ini al
Public Offering (IPO). Companies or governments sell directly to investors to raise funds.

o Secondary Market: Where already-issued securi es are traded among investors, like on stock
exchanges. It provides liquidity, allowing investors to buy or sell easily.

 Par cipants:

o Issuers: Companies, governments, or ins tu ons issuing securi es to raise money.

o Investors: Individuals or ins tu ons (e.g., mutual funds, banks) buying securi es.

o Intermediaries: Brokers, underwriters, and credit ra ng agencies facilita ng transac ons.

 Significance:
 o Helps businesses and governments fund projects like expansion or infrastructure.

o Offers investors opportuni es to earn returns through dividends, interest, or price

apprecia on.

o Channels savings into produc ve investments, boos ng economic growth.

 Example: A company issues shares in the primary market through an IPO to raise money for a new
factory. Investors later trade these shares on a stock exchange in the secondary market.

2. Func ons of Security Market

The security market performs several key func ons that support investors, issuers, and the economy.

 Key Func ons:

1. Capital Forma on:

 Channels savings from investors to companies and governments for long-term projects
like building factories or roads.

 Example: Investors buy bonds issued by a company, providing funds for expansion.

2. Liquidity:

 Allows investors to buy or sell securi es easily, conver ng investments into cash when
needed.

 Example: Selling shares on a stock exchange to access funds quickly.

3. Price Discovery:

 Determines the fair price of securi es based on supply and demand, reflec ng
company performance and market condi ons.

 Example: A company’s stock price rises due to strong profits, signaling investor
confidence.

4. Risk Transfer:

 Transfers investment risk from one investor (seller) to another (buyer) in the secondary
market.

 Example: An investor sells risky stocks to another willing to take the risk.

5. Informa on Dissemina on:

 Provides market data (e.g., stock prices, trading volumes) to help investors make
informed decisions.

 Example: Investors analyze stock price trends to decide whether to buy or sell.

6. Regula on and Fairness:

 Ensures transparent and fair trading through rules and oversight, protec ng investors
from fraud.
  Example: SEBI monitors companies to prevent insider trading.

7. Hedging and Risk Management:

 Offers deriva ves (e.g., op ons, futures) to protect against price fluctua ons.

 Example: An investor uses futures to lock in a stock price, reducing risk.

 Significance:

o Supports economic growth by mobilizing funds.

o Enhances investor confidence through liquidity and transparency.

 Example: The security market helps a startup raise funds through an IPO (capital forma on) and
allows investors to sell shares later (liquidity).

3. Secondary Market Opera ons

The secondary market, also called the stock market, is where previously issued securi es are traded among
investors, without involvement from the issuing company.

 Key Features:

o Liquidity: Investors can quickly buy or sell securi es, ensuring flexibility.

o Trading Pla orms: Operates through stock exchanges (e.g., NSE, BSE) or over-the-counter
(OTC) markets.

o Price Determina on: Prices are driven by supply and demand, reflec ng market sen ment
and company performance.

 Types of Secondary Markets:

1. Stock Exchanges:

 Organized pla orms like the Na onal Stock Exchange (NSE) or Bombay Stock Exchange
(BSE) where securi es are traded under strict rules.

 Example: Buying Reliance Industries shares on the NSE.

2. Over-the-Counter (OTC) Markets:

 Decentralized trading directly between par es, o en for unlisted securi es or bonds.

 Example: Trading bonds through a broker outside an exchange.

Opera ons:

3. Trading:

 Investors place buy or sell orders through brokers via electronic trading systems.

 Example: Using a trading app to buy 100 shares of TCS.

4. Clearing:
  A clearing corpora on ensures trades are completed by matching buyers and sellers
and guaranteeing transac ons.

 Example: The Na onal Securi es Clearing Corpora on (NSCC) confirms a trade.

5. Se lement:

 Transfer of securi es to the buyer and funds to the seller, typically within T+1 (trade
date plus one day) in India.

 Example: Shares are credited to the buyer’s demat account a er payment.

6. Price Fluctua ons:

 Prices change based on company performance, economic condi ons, or investor

sen ment.

 Example: A stock price drops a er poor quarterly results.

 Par cipants:

o Brokers: Licensed professionals execu ng trades for clients.

o Market Makers: Provide liquidity by quo ng buy and sell prices.

o Investors: Individuals or ins tu ons trading securi es.

 Significance:

o Provides liquidity, enabling investors to exit investments.

o Enhances market efficiency through price discovery.

o Supports primary market by assuring investors they can sell securi es later.

 Example: An investor buys shares of Infosys on the BSE and sells them a year later when the price
rises, earning a profit.

4. Stock Exchanges in India

Stock exchanges are organized pla orms where securi es like stocks, bonds, and deriva ves are traded under
strict regula ons. They ensure transparency, liquidity, and fair trading.

 Major Stock Exchanges in India:

1. Na onal Stock Exchange (NSE):

 Established in 1992, headquartered in Mumbai.

 India’s largest stock exchange by trading volume and market capitaliza on.

 Offers trading in equi es, deriva ves, and debt instruments.

 Known for the Ni y 50 index, tracking 50 major companies.

 Example: Trading shares of HDFC Bank on the NSE.

2. Bombay Stock Exchange (BSE):

  Established in 1875, Asia’s oldest stock exchange, headquartered in Mumbai.

 Offers trading in equi es, debt, deriva ves, and mutual funds.

 Known for the Sensex, a benchmark index of 30 major companies.

 Example: Buying Adani Enterprises shares on the BSE.

 Other Exchanges:

o Metropolitan Stock Exchange (MSE): Focuses on SMEs and deriva ves.

o Calcu a Stock Exchange (CSE): Regional exchange with limited ac vity.

 Func ons:

o Facilitate trading of securi es through electronic pla orms.

o Ensure liquidity and price discovery.

o Enforce SEBI regula ons for fair prac ces.

o Provide market data and indices (e.g., Ni y, Sensex) for investor analysis.

 Significance:

o Drive capital market growth by enabling fundraising and trading.

o A ract domes c and foreign investors, boos ng the economy.

 Example: An investor uses the NSE’s trading pla orm to buy shares of Tata Motors, benefi ng from
real- me price updates and liquidity.

5. Securi es and Exchange Board of India (SEBI)

The Securi es and Exchange Board of India (SEBI) is the regulatory authority overseeing India’s securi es
markets, established under the SEBI Act, 1992.

 Role and Objec ves:

o Protect Investors: Safeguard investor interests by preven ng fraud and malprac ces.

o Promote Market Development: Encourage growth of securi es markets through innova on

and efficiency.

o Regulate Markets: Ensure fair and transparent opera ons of stock exchanges, brokers, and
companies.

 Key Func ons:

1. Regula on:

 Sets rules for stock exchanges, brokers, and companies.

 Example: Mandates disclosures for IPOs to ensure transparency.

2. Monitoring:

 Inspects intermediaries (e.g., brokers) and companies for compliance.

  Example: Reviews daily reports from stock exchanges.

3. Investor Protec on:

 Inves gates and penalizes viola ons like insider trading.

 Runs investor educa on programs.

 Example: Resolves complaints through the SCORES pla orm.

4. Market Development:

 Introduces new products like REITs and social stock exchanges.

 Example: Launched the Social Stock Exchange for social enterprises.

5. Registra on:

 Licenses brokers, mutual funds, and other intermediaries.

 Example: Approves stockbrokers to operate on exchanges.

 Significance:

o Builds investor confidence by ensuring fairness and transparency.

o Strengthens India’s capital markets, a rac ng global investment.

 Example: SEBI fines a company for hiding financial data, protec ng investors from misinforma on.

6. Government Securi es Market

The government securi es market deals with securi es issued by central and state governments to raise
funds for budget deficits or projects. These are considered low-risk investments.

 Types of Government Securi es:

1. Treasury Bills (T-Bills):

 Short-term securi es with maturi es of 91, 182, or 364 days.

 Zero-coupon (no interest); issued at a discount and redeemed at face value.

 Example: A 91-day T-Bill with a face value of ₹100 is bought for ₹98 and redeemed for
₹100.

2. Dated Government Securi es (G-Secs):

 Long-term securi es with tenures from 5 to 40 years.

 Pay fixed or floa ng interest (coupon) semi-annually.

 Example: A 10-year G-Sec with a 7% coupon pays ₹7 per ₹100 annually.

3. State Development Loans (SDLs):

 Issued by state governments, similar to G-Secs but with slightly higher interest rates.

 Example: A state issues SDLs to fund infrastructure projects.

 4. Special Securi es:

 Includes infla on-indexed bonds or capital-indexed bonds to protect against infla on.

 Example: Treasury Infla on-Protected Securi es (TIPS) adjust principal with infla on.

 Market Opera ons:

o Primary Market: Issued through auc ons by the Reserve Bank of India (RBI).

o Secondary Market: Traded on pla orms like the NSE’s Wholesale Debt Market (WDM).

o Primary Dealers: Specialized intermediaries (e.g., banks) underwrite and trade G-Secs.

 Significance:

o Provides safe investment op ons with guaranteed returns.

o Helps RBI manage public debt and conduct monetary policy.

o Supports fiscal needs of governments.

 Example: An investor buys a 5-year G-Sec at face value, earning 6.5% interest annually, and sells it
later in the secondary market for a profit.

7. Corporate Debt Market

The corporate debt market involves debt securi es issued by companies to raise funds, offering investors
fixed-income opportuni es.

 Types of Corporate Debt Securi es:

1. Corporate Bonds:

 Long-term debt instruments with fixed or floa ng interest.

 Example: A company issues 7% bonds maturing in 10 years.

2. Debentures:

 Unsecured bonds backed by the company’s creditworthiness, not assets.

 Example: Conver ble debentures that can be converted into shares.

3. Commercial Papers (CPs):

 Short-term, unsecured debt (up to 1 year) issued by companies with high credit ra ngs.

 Example: A company issues CPs to fund short-term working capital.

 Market Opera ons:

o Primary Market: Companies issue bonds or debentures through public offers or private
placements.

o Secondary Market: Traded on stock exchanges or OTC markets, though liquidity is lower than
equi es.

o Credit Ra ngs: Agencies like CRISIL assess bonds for risk, influencing investor decisions.
  Significance:

o Provides companies with an alterna ve to bank loans for funding.

o Offers investors steady income with varying risk levels (e.g., high-yield junk bonds vs.
investment-grade bonds).

 Challenges:

o Lower liquidity compared to equi es.

o Credit risk if the issuer defaults.

 Example: An investor buys corporate bonds from a reputable company, earning 8% interest annually,
and holds them un l maturity.

8. Money Market Instruments

The money market deals with short-term, low-risk financial instruments with maturi es of up to one year,
used for liquidity management.

 Key Money Market Instruments:

1. Treasury Bills (T-Bills):

 Short-term government securi es (91, 182, or 364 days).

 Issued at a discount, redeemed at face value.

 Example: A ₹100 T-Bill bought for ₹98 yields a ₹2 profit at maturity.

2. Cer ficates of Deposit (CDs):

 Short-term, tradable deposits issued by banks to raise funds.

 Example: A bank issues a 6-month CD with a 6% interest rate.

3. Commercial Papers (CPs):

 Short-term, unsecured debt issued by companies for working capital.

 Example: A company issues 90-day CPs to pay suppliers.

4. Collateralized Borrowing and Lending Obliga on (CBLO):

 A short-term (1–3 days) lending and borrowing instrument secured by government

securi es.

 Example: A bank borrows funds using CBLO to meet daily cash needs.

5. Repurchase Agreements (Repos):

 Short-term borrowing where securi es (e.g., G-Secs) are sold with an agreement to
repurchase later.

 Example: A bank sells G-Secs and repurchases them a er 7 days, paying interest.
 Significance:

o Provides liquidity for banks, companies, and governments.

o Offers safe, short-term investment op ons for investors.

o Helps RBI regulate money supply through open market opera ons.

 Example: An investor parks surplus funds in a 91-day T-Bill for safety and quick returns, while a
company uses CPs to manage short-term expenses.
 Unit 2

Risk-Return Rela onship

Risk and Return

Risk and return are the two core concepts of inves ng. Risk is the uncertainty or chance of losing money,
while return is the profit or income earned from an investment. Understanding both helps investors make
informed decisions to balance poten al gains with poten al losses.

1. Meaning of Risk

 Defini on: Risk is the possibility that an investment’s actual return will differ from its expected return,
including the chance of losing some or all of the invested money. It reflects uncertainty in outcomes.

 Key Points:

o All investments carry some level of risk; no investment is completely safe.

o Higher risk o en comes with the poten al for higher returns, and vice versa.

o Risk arises from factors like market changes, economic condi ons, or company performance.

 Example: Inves ng in a startup’s stock is risky because the company might fail, but it could also yield
high returns if it succeeds.

2. Types of Risk

Risks in investments are classified into various types based on their sources. They are broadly divided into
systema c and unsystema c risks.

A. Systema c Risk (Market Risk or Non-Diversifiable Risk)

 Defini on: Risk that affects the en re market or a large segment of it, caused by factors beyond an
individual company’s control.

 Examples:

1. Interest Rate Risk: Changes in interest rates affect bond prices and stock markets.

 Example: Rising interest rates reduce bond values.

2. Infla on Risk: Rising prices reduce the purchasing power of returns.

 Example: A 5% return is less valuable if infla on is 6%.

3. Market Risk: General market declines due to economic or poli cal events.

 Example: A stock market crash affects most stocks.

4. Exchange Rate Risk: Currency value changes impact interna onal investments.

 Example: A falling rupee reduces returns on foreign stocks for Indian investors.

 Key Point: Cannot be eliminated through diversifica on; affects all investments.
B. Unsystema c Risk (Specific Risk or Diversifiable Risk)

 Defini on: Risk specific to an individual company or industry, which can be reduced through
diversifica on.

 Examples:

1. Business Risk: Poor management or product failure affects a company.

 Example: A tech company’s stock falls due to a failed product launch.

2. Financial Risk: High debt levels increase a company’s risk of default.

 Example: A company with heavy loans struggles to pay interest.

3. Opera onal Risk: Internal issues like system failures or fraud.

 Example: A factory shutdown due to equipment failure.

4. Liquidity Risk: Difficulty selling an investment at a fair price.

 Example: Real estate takes months to sell compared to stocks.

 Key Point: Can be minimized by inves ng in a variety of assets (diversifica on).

C. Other Types of Risk

 Credit Risk: Risk of the issuer defaul ng on debt payments.

o Example: A company fails to pay interest on its bonds.

 Poli cal Risk: Government policies or instability affect investments.

o Example: New regula ons harm an industry’s profitability.

 Event Risk: Unexpected events like natural disasters or lawsuits.

o Example: A company’s stock drops a er a major data breach.

 Significance: Understanding types of risk helps investors choose investments that match their risk
tolerance and diversify to reduce unsystema c risk.

 Example: An investor diversifies by holding stocks, bonds, and real estate to reduce unsystema c risk
while monitoring market trends to manage systema c risk.

3. Measuring Risk

Measuring risk involves quan fying the uncertainty or variability of an investment’s returns to assess its
poten al for loss.

 Key Measures:

1. Standard Devia on:

 Measures how much an investment’s returns deviate from its average (expected)
return.
  Formula: [ \sigma = \sqrt{\frac{\sum (R_i - \bar{R})^2}{n}} ] Where ( \sigma ) = standard
devia on, ( R_i ) = individual return, ( \bar{R} ) = average return, ( n ) = number of
returns.

 Interpreta on: Higher standard devia on = higher risk (more vola lity).

 Example: Let’s say a stock gives these annual returns:

Year 1: 10%, Year 2: 12%, Year 3: -5%, Year 4: 20%, Year 5: 3%.

 Higher the fluctua on = Higher the standard devia on = Higher risk.

2. Beta:

 Measures an investment’s sensi vity to market movements (systema c risk).

 Interpreta on:

 Beta = 1: Moves with the market.

 Beta > 1: More vola le than the market (e.g., tech stocks).

 Beta < 1: Less vola le (e.g., u lity stocks).

 Example: A stock with a beta of 1.5 rises or falls 1.5 mes more than the market index.

Beta (β):

 Stock A Beta = 1.5 → Moves more than the market. High risk.
 Stock B Beta = 0.7 → Moves less than the market. Lower risk.

1. Variance:

 Measures the spread of returns around the mean, squared form of standard devia on.

 Formula:

 Interpreta on: Higher variance indicates greater risk.

 Example: A mutual fund with high variance has unpredictable returns.

2. Value at Risk (VaR):

 Es mates the maximum poten al loss over a specific period at a given confidence
level.

 Example: A por olio has a 5% VaR of ₹10,000 over one month, meaning there’s a 5%
chance of losing more than ₹10,000.

3. Coefficient of Varia on:

 Compares risk rela ve to return (standard devia on divided by mean return).

 Formula:

 Interpreta on: Lower CV indicates be er risk-adjusted return.

 Example: An investment with a 10% return and 5% standard devia on has a CV of 0.5.
  Significance:

o Helps investors compare the risk of different investments.

o Guides por olio construc on to balance risk and return.

 Example: An investor compares two stocks: Stock A (standard devia on 15%, beta 1.2) and Stock B
(standard devia on 8%, beta 0.8). Stock B is less risky.

4. Risk Preference of Investors

Risk preference describes how comfortable investors are with taking risks, influencing their investment
choices.

 Types of Risk Preferences:

1. Risk-Averse Investors:

 Prefer low-risk investments with stable, predictable returns.

 Characteris cs: Priori ze capital preserva on over high returns.

 Example: Inves ng in fixed deposits or government bonds.

2. Risk-Neutral Investors:

 Focus on expected returns, regardless of risk level.

 Characteris cs: Willing to take moderate risks if returns are propor onate.

 Example: Inves ng in balanced mutual funds with a mix of stocks and bonds.

3. Risk-Seeking Investors:

 Embrace high-risk investments for the chance of high returns.

 Characteris cs: Comfortable with vola lity and poten al losses.

 Example: Inves ng in cryptocurrencies or startup stocks.

 Factors Influencing Risk Preference:

o Age: Younger investors o en take more risks; older investors prefer safety.

o Income and Wealth: Higher income allows greater risk-taking.

o Financial Goals: Short-term goals favor low risk; long-term goals allow higher risk.

o Experience: Experienced investors may handle risk be er.

 Significance:

o Matching investments to risk preference ensures comfort and commitment.

o Helps advisors tailor por olios to investor needs.

 Example: A young, high-earning investor (risk-seeking) buys tech stocks, while a re ree (risk-averse)
chooses fixed deposits.
5. Meaning of Return

 Defini on: Return is the profit or income earned from an investment, expressed as a percentage of
the amount invested. It represents the reward for taking risk.

 Types of Returns:

o Capital Gains: Profit from selling an asset at a higher price than purchased.

 Example: Buying a stock for ₹100 and selling for ₹120 yields a ₹20 capital gain.

o Income: Regular earnings like dividends (stocks) or interest (bonds).

 Example: A bond pays ₹5 annual interest per ₹100 invested.

o Total Return: Combines capital gains and income.

 Example: A stock gives ₹10 dividends and a ₹20 price increase, totaling a ₹30 return.

 Significance:

o Measures investment performance.

o Guides decisions by comparing returns across op ons.

 Example: An investor earns a 10% return on a mutual fund through dividends and price apprecia on.

6. Measures of Return

Measures of return quan fy investment performance, allowing investors to evaluate and compare op ons.

 Key Measures:

1. Holding Period Return (HPR):

 The total return earned over the period an investment is held, including income and
capital gains.

 Formula: [ \text{HPR} = \frac{\text{Ending Value} - \text{Beginning Value} +

\text{Income}}{\text{Beginning Value}} \ mes 100 ]

 Example: A stock bought for ₹100, sold for ₹120, and pays ₹5 dividend: [ \text{HPR} =
\frac{120 - 100 + 5}{100} \ mes 100 = 25% ]

2. Annualized Return:

 Converts the holding period return to an annual rate for comparison, accoun ng for
the investment period.

 Formula (for mul -year holding): [ \text{Annualized Return} = \le ( \le (

\frac{\text{Ending Value}}{\text{Beginning Value}} \right)^{\frac{1}{n}} - 1 \right)
\ mes 100 ] Where ( n ) = number of years.
  Example: A ₹100 investment grows to ₹144 in 2 years: [ \text{Annualized Return} =
\le ( \le ( \frac{144}{100} \right)^{\frac{1}{2}} - 1 \right) \ mes 100 = \le ( 1.2 - 1
\right) \ mes 100 = 20% ]

3. Expected Return:

 The an cipated return based on probable outcomes and their probabili es.

 Formula: [ \text{Expected Return} = \sum (P_i \ mes R_i) ] Where ( P_i ) = probability
of outcome, ( R_i ) = return for outcome.

 Example: A stock has a 50% chance of 10% return, 30% chance of 5% return, and 20%
chance of -2% return: [ \text{Expected Return} = (0.5 \ mes 10) + (0.3 \ mes 5) + (0.2
\ mes -2) = 5 + 1.5 - 0.4 = 6.1% ]

4. Arithme c Average Return:

 The average of periodic returns over me.

 Formula: [ \text{Arithme c Average} = \frac{\sum R_i}{n} ]

 Example: Returns of 10%, 5%, and -2% over 3 years: [ \text{Arithme c Average} =
\frac{10 + 5 - 2}{3} = 4.33% ]

5. Geometric Average Return:

 The compound annual growth rate, accoun ng for compounding effects.

 Formula: [ \text{Geometric Average} = \le ( \prod (1 + R_i) \right)^{\frac{1}{n}} - 1 ]

 Example: Returns of 10%, 5%, and -2%: [ \text{Geometric Average} = \le ( (1.10 \ mes
1.05 \ mes 0.98) \right)^{\frac{1}{3}} - 1 \approx 4.29% ]
 Significance:

o HPR measures total performance, annualized return standardizes for comparison, and
expected return predicts future outcomes.

o Arithme c and geometric averages provide historical insights.

 Example: An investor calculates a stock’s 15% HPR over 6 months, converts it to a 30% annualized
return, and es mates a 7% expected return based on market trends.
7. Investors’ A tude Towards Risk and Return

Investors’ a tude towards risk and return reflects their willingness to accept risk in pursuit of higher returns,
shaping their investment decisions.

 Key A tudes:

1. Risk-Averse:

 Prefer low-risk investments even if returns are lower.

 Characteris cs: Priori ze safety, avoid vola lity.

 Example: Choosing fixed deposits (5–7% return, low risk) over stocks (10–15% return,
high risk).

2. Risk-Neutral:

 Focus on expected returns, indifferent to risk levels if returns are fair.

 Characteris cs: Balance risk and return logically.

 Example: Inves ng in a diversified mutual fund with moderate risk and return.

3. Risk-Seeking:

 Pursue high-risk investments for the chance of high returns.

 Characteris cs: Comfortable with uncertainty, seek growth.

 Example: Buying specula ve stocks or cryptocurrencies.

 Factors Influencing A tude:

o Age: Younger investors are o en risk-seeking; older investors are risk-averse.

o Income/Wealth: Higher wealth allows more risk-taking.

o Goals: Short-term goals (e.g., buying a car) favor low risk; long-term goals (e.g., re rement)
allow higher risk.

o Experience: Knowledgeable investors may take calculated risks.

o Personality: Op mis c or adventurous individuals lean toward risk-seeking.

 Risk-Return Trade-Off:

o Investments with higher poten al returns (e.g., stocks) carry higher risks.

o Low-risk investments (e.g., bonds) offer lower returns.

o Investors choose based on their a tude and goals.

 Significance:

o Understanding a tudes helps tailor por olios to investor preferences.

o Ensures alignment between risk tolerance and investment choices.

 Example: A risk-averse re ree invests in government bonds for stable income, while a risk-seeking
young professional buys tech stocks for growth.
 Unit 3

Introduc on to Investment Analysis

Investment Analysis is the process of evalua ng investment op ons to determine their poten al for profit,
risk, and suitability. It helps investors make informed decisions by analyzing various factors like economic
condi ons, industry trends, and company performance. This sec on explains investment analysis and its key
components in simple terms.

1. Introduc on to Investment Analysis

 Defini on: Investment analysis involves studying and assessing investment opportuni es (e.g., stocks,
bonds, real estate) to decide whether they are worth inves ng in based on their expected returns,
risks, and alignment with financial goals.

 Purpose:

o Iden fy investments that offer the best balance of risk and return.

o Avoid poor investments that may lead to losses.

o Align investments with goals like wealth crea on, income genera on, or capital preserva on.

 Types of Investment Analysis:

1. Fundamental Analysis: Examines the intrinsic value of an investment based on economic, industry,
and company factors.

2. Technical Analysis: Studies price pa erns and market trends using charts and historical data.

3. Quan ta ve Analysis: Uses mathema cal models and sta s cal tools to evaluate investments.

 Process:

o Gather data (e.g., financial statements, economic reports).

o Analyze factors like returns, risks, and market condi ons.

o Compare op ons and make investment decisions.

 Significance:

o Reduces the chances of losses by making decisions based on research.

o Helps investors build a por olio that matches their risk tolerance and goals.

 Example: An investor analyzes a company’s financial health and market trends before buying its
shares to ensure it’s a good investment.

2. Fundamental Analysis

 Defini on: Fundamental analysis is a method of evalua ng an investment by studying its intrinsic
(true) value based on economic, industry, and company-specific factors. It assumes that the market
price of a security will eventually reflect its true value.
  Objec ve:

o Determine whether a security is undervalued (buy opportunity) or overvalued (sell

opportunity).

o Assess the long-term poten al of an investment.

 Key Components:

o Macroeconomic Analysis: Examines broad economic factors like GDP, infla on, and interest
rates.

o Industry Analysis: Studies the industry’s growth, compe on, and trends.

o Company Analysis: Evaluates the company’s financial health, management, and performance.

 Process:

1. Study the economy to understand growth and risks.

2. Analyze the industry to assess its poten al.

3. Examine the company’s financials, opera ons, and strategy.

4. Compare the intrinsic value to the market price to decide whether to invest.

 Tools:

o Financial statements (balance sheet, income statement, cash flow statement).

o Ra os (e.g., P/E ra o, debt-to-equity ra o).

o Economic reports and industry data.

 Significance:

o Provides a deep understanding of an investment’s true worth.

o Suitable for long-term investors seeking value or growth.

 Limita ons:

o Time-consuming and requires exper se.

o May not account for short-term market fluctua ons or specula ve trends.

 Example: An investor uses fundamental analysis to determine that a stock priced at ₹100 has an
intrinsic value of ₹120, indica ng it’s undervalued and a good buy.

3. Macroeconomic Analysis

 Defini on: Macroeconomic analysis examines the overall economy to understand how broad
economic factors affect investments. It looks at na onal and global trends that influence markets.

 Key Factors:

1. Gross Domes c Product (GDP):

 Measures the total value of goods and services produced in a country.

  Impact: High GDP growth signals a strong economy, boos ng stock markets; low
growth may harm investments.

 Example: Strong GDP growth in India encourages investment in Indian companies.

2. Infla on:

 The rate at which prices of goods and services increase.

 Impact: Moderate infla on supports growth; high infla on reduces purchasing power
and hurts fixed-income investments like bonds.

 Example: High infla on may lead investors to avoid bonds and choose stocks or gold.

3. Interest Rates:

 The cost of borrowing set by central banks (e.g., RBI).

 Impact: High interest rates increase borrowing costs, slowing business growth; low
rates encourage investment.

 Example: Lower RBI rates boost stock prices as companies borrow and expand.

4. Unemployment Rate:

 The percentage of people without jobs.

 Impact: High unemployment reduces consumer spending, hur ng companies; low

unemployment supports growth.

 Example: Low unemployment boosts retail stocks due to increased consumer demand.

5. Exchange Rates:

 The value of one currency against another.

 Impact: A strong rupee benefits importers but hurts exporters; a weak rupee boosts
export-driven industries.

 Example: A weak rupee helps IT companies earning in dollars.

6. Fiscal and Monetary Policies:

 Government spending/taxa on (fiscal) and central bank ac ons (monetary) influence

markets.

 Example: A government s mulus package boosts infrastructure stocks.

7. Global Events:

 Poli cal stability, trade policies, or global crises (e.g., pandemics) affect markets.

 Example: A global recession reduces demand for Indian exports, impac ng stocks.

 Significance:

o Helps investors understand the big picture and predict market trends.

o Guides decisions on asset alloca on (e.g., stocks vs. bonds).

  Limita ons:

o Complex and influenced by unpredictable events.

o Broad trends may not apply to specific industries or companies.

 Example: An investor avoids stocks during high infla on and rising interest rates, shi ing to gold as a
hedge.

4. Industry Analysis

 Defini on: Industry analysis evaluates the performance, growth poten al, and compe ve
environment of a specific industry (e.g., IT, pharmaceu cals, automo ve) to iden fy investment
opportuni es.

 Objec ve:

o Assess whether an industry is growing, stable, or declining.

o Iden fy industries with high poten al for returns.

 Key Factors:

1. Industry Life Cycle:

 Stages:

 Pioneering (Startup): High risk, high growth (e.g., electric vehicles).

 Growth: Rapid expansion, profitable (e.g., cloud compu ng).

 Maturity: Stable but slow growth (e.g., banking).

 Decline: Shrinking demand (e.g., tradi onal print media).

 Impact: Growth industries offer high returns but higher risks; mature industries are
safer.

 Example: Inves ng in renewable energy (growth stage) for high poten al.

2. Compe on:

 Analyzed using Porter’s Five Forces:

 Threat of New Entrants: High entry barriers (e.g., capital needs) favor exis ng
firms.

 Bargaining Power of Buyers: Strong buyers reduce profits.

 Bargaining Power of Suppliers: Strong suppliers increase costs.

 Threat of Subs tutes: Subs tutes limit pricing power.

 Industry Rivalry: Intense compe on reduces margins.

 Example: The telecom industry faces high rivalry, squeezing profits.

3. Market Size and Growth:

  Assess the industry’s current size and future growth poten al.

 Example: The Indian e-commerce industry is growing rapidly due to internet

penetra on.

4. Regulatory Environment:

 Government policies or regula ons impact profitability.

 Example: Stricter environmental laws benefit renewable energy firms but hurt fossil
fuel companies.

5. Technological Changes:

 Innova ons disrupt or boost industries.

 Example: AI advancements drive growth in the tech industry.

6. Demand and Supply:

 High demand with limited supply boosts profitability.

 Example: Rising demand for semiconductors with limited produc on capacity benefits
chipmakers.

 Significance:

o Helps investors choose industries with strong growth poten al.

o Narrows down investment op ons before analyzing specific companies.

 Limita ons:

o Industry trends may not apply to all companies within it.

o Rapid changes (e.g., technology) can make analysis outdated.

 Example: An investor chooses the pharmaceu cal industry for investment due to its growth stage,
driven by rising healthcare demand and innova on.

5. Company Analysis

 Defini on: Company analysis evaluates the financial health, performance, and future poten al of a
specific company to determine if its securi es (e.g., stocks, bonds) are worth inves ng in.

 Objec ve:

o Es mate the company’s intrinsic value and compare it to its market price.

o Assess the company’s ability to generate returns and manage risks.

 Key Components:

1. Financial Analysis:

 Examine financial statements to assess profitability, liquidity, and stability.

 Key Ra os:
  Price-to-Earnings (P/E) Ra o: [ \text{P/E} = \frac{\text{Market Price per
Share}}{\text{Earnings per Share}} ]

 Indicates if a stock is overvalued or undervalued.

 Example: A P/E of 15 means investors pay ₹15 for ₹1 of earnings.

 Debt-to-Equity Ra o: [ \text{D/E} = \frac{\text{Total Debt}}{\text{Total Equity}}

]

 Measures financial leverage; high ra os indicate risk.

 Example: A D/E of 1 means debt equals equity.

 Return on Equity (ROE): [ \text{ROE} = \frac{\text{Net

Income}}{\text{Shareholders’ Equity}} \ mes 100 ]

 Shows how efficiently a company uses equity to generate profits.

 Example: An ROE of 20% means ₹20 profit per ₹100 of equity.

 Current Ra o: [ \text{Current Ra o} = \frac{\text{Current

Assets}}{\text{Current Liabili es}} ]

 Measures ability to pay short-term debts.

 Example: A ra o of 2 means ₹2 in assets for every ₹1 in liabili es.

 Example: A company with high ROE and low debt is financially strong.

2. Management Quality:

 Evaluate the competence, vision, and track record of the leadership team.

 Factors: Experience, past performance, ethical prac ces.

 Example: A company with a CEO known for successful turnarounds is a rac ve.

3. Business Model:

 Assess how the company makes money and its compe ve advantage.

 Factors: Unique products, brand strength, cost leadership.

 Example: A company with patented technology has a compe ve edge.

4. Market Posi on:

 Analyze the company’s market share and reputa on.

 Example: A leading company like Reliance Industries dominates its sector.

5. Growth Prospects:

 Evaluate future growth poten al based on new products, markets, or strategies.

 Example: A tech company inves ng in AI has strong growth prospects.

6. Risk Factors:

 Iden fy risks like compe on, regulatory changes, or opera onal issues.
  Example: A company reliant on one product faces high business risk.

 Process:

1. Collect data from financial statements, annual reports, and news.

2. Calculate key ra os and compare with industry benchmarks.

3. Assess qualita ve factors like management and market posi on.

4. Es mate intrinsic value using methods like Discounted Cash Flow (DCF) or rela ve valua on (e.g.,
comparing P/E ra os).

5. Decide if the stock is undervalued (buy), overvalued (sell), or fairly priced (hold).

 Significance:

o Provides a detailed understanding of a company’s strengths and weaknesses.

o Helps iden fy undervalued stocks for long-term gains.

 Limita ons:

o Relies on accurate data, which may be manipulated.

o Qualita ve factors (e.g., management quality) are subjec ve.

 Example: An investor analyzes a company’s low P/E ra o, strong ROE, and innova ve product pipeline,
concluding its stock is undervalued and a good buy.
 Unit 4

Technical Analysis

Technical Analysis is a method used to evaluate and predict the future price movements of securi es (e.g.,
stocks, bonds, commodi es) by analyzing historical price and volume data, primarily through charts and
indicators. It focuses on market trends and pa erns rather than the intrinsic value of an asset. This sec on
explains technical analysis and its key components in simple terms.

1. Meaning of Technical Analysis

 Defini on: Technical analysis is the study of past market data, such as price movements and trading
volume, to forecast future price trends and make investment decisions. It assumes that price pa erns
repeat and that market psychology influences prices.

 Key Assump ons:

1. Prices Reflect All Informa on: All relevant informa on (economic, company-specific, etc.) is
already included in the price of a security.

2. Prices Move in Trends: Prices follow trends (upward, downward, or sideways) that can be
iden fied and used for predic ons.

3. History Repeats Itself: Price pa erns and behaviors tend to recur due to consistent investor
psychology.

 Objec ve:

o Iden fy buying or selling opportuni es based on price trends and pa erns.

o Determine entry and exit points for trades.

 Tools:

o Charts (e.g., line, bar, candles ck).

o Technical indicators (e.g., moving averages, RSI).

o Pa erns (e.g., head and shoulders, support/resistance levels).

 Significance:

o Useful for short-term trading and ming market entry/exit.

o Applicable to various markets (stocks, forex, commodi es).

 Limita ons:

o Relies on historical data, which may not always predict the future.

o Ignores fundamental factors like company performance or economic condi ons.

 Example: A trader no ces a stock’s price rising consistently on a chart and buys it, expec ng the
upward trend to con nue.
2. Fundamental vs. Technical Analysis

Both fundamental analysis and technical analysis are used to evaluate investments, but they differ in
approach, focus, and applica on.

 Fundamental Analysis:

o Defini on: Evaluates an investment’s intrinsic value by analyzing economic, industry, and
company-specific factors (e.g., revenue, profits, GDP).

o Focus: Long-term value and financial health of a company.

o Data Used:

 Financial statements (balance sheet, income statement).

 Economic indicators (infla on, interest rates).

 Industry trends and company management.

o Time Horizon: Long-term (months to years).

o Objec ve: Determine if a security is undervalued (buy) or overvalued (sell).

o Example: Buying a stock because its low P/E ra o and strong earnings suggest it’s undervalued.

o Strengths:

 Provides deep insight into a company’s true worth.

 Suitable for long-term investors.

o Weaknesses:

 Time-consuming and requires financial exper se.

 May miss short-term price movements.

 Technical Analysis:

o Defini on: Analyzes historical price and volume data to predict future price movements using
charts and indicators.

o Focus: Short-term price trends and market psychology.

o Data Used:

 Price charts (line, bar, candles ck).

 Trading volume and technical indicators (e.g., RSI, MACD).

o Time Horizon: Short-term (days, weeks, or months).

o Objec ve: Iden fy op mal entry and exit points for trades.

o Example: Buying a stock when its price breaks above a resistance level on a chart.

o Strengths:

 Quick and effec ve for short-term trading.

  Works across various markets and meframes.

o Weaknesses:

 Ignores fundamental factors like company performance.

 Subjec ve interpreta on of pa erns can lead to errors.

 Comparison:

o Approach: Fundamental analysis is value-driven; technical analysis is trend-driven.

o Data: Fundamental uses financial and economic data; technical uses price and volume data.

o Investor Type: Fundamental suits long-term investors; technical suits traders.

o Goal: Fundamental seeks undervalued assets; technical seeks profitable trades.

 Combined Use:

o Many investors combine both: use fundamental analysis to select strong companies and
technical analysis to me entry/exit points.

o Example: An investor picks a fundamentally strong company like Reliance Industries and uses
technical analysis to buy when the stock shows an upward trend.

 Significance:

o Understanding both approaches allows investors to choose the method that fits their goals
and risk tolerance.

 Example: A long-term investor uses fundamental analysis to buy a stock, while a day trader uses
technical analysis to profit from daily price swings.

3. Char ng Techniques

Char ng techniques involve using visual representa ons of price and volume data to iden fy trends,
pa erns, and poten al trading opportuni es. Charts are the founda on of technical analysis.

 Types of Charts:

1. Line Chart:

 Plots the closing prices of a security over me, connected by a line.

 Use: Shows the overall price trend.

 Example: A line chart shows a stock’s price rising steadily over six months.

 Strength: Simple and easy to read.

 Weakness: Ignores intraday price movements.

2. Bar Chart:

 Displays the open, high, low, and close prices for each me period (e.g., day, week).

 Use: Provides more detail than a line chart.

  Example: A daily bar chart shows a stock’s price range and closing price.

 Strength: Shows price vola lity within a period.

 Weakness: Less visually intui ve than candles ck charts.

3. Candles ck Chart:

 Similar to a bar chart but uses “candles” to show open, high, low, and close prices.

 Components:

 Body: The range between open and close prices (filled for a price drop, hollow
for a price rise).

 Wicks (Shadows): Lines showing the high and low prices.

 Use: Highlights price pa erns and investor sen ment.

 Example: A “bullish engulfing” candles ck pa ern signals a poten al price rise.

 Strength: Visually clear and rich in pa ern informa on.

 Weakness: Requires prac ce to interpret pa erns.

 Common Chart Pa erns:

1. Trend Pa erns:

 Uptrend: Higher highs and higher lows, indica ng rising prices.

 Downtrend: Lower highs and lower lows, indica ng falling prices.

 Sideways Trend: Prices move within a range, indica ng consolida on.

 Example: An uptrend in a stock’s chart suggests a buy signal.

2. Reversal Pa erns:

 Head and Shoulders: Signals a trend reversal (e.g., from uptrend to downtrend).

 Double Top/Bo om: Indicates resistance (top) or support (bo om) levels.

 Example: A head and shoulders pa ern in a stock chart warns of a price drop.

3. Con nua on Pa erns:

 Triangles (Ascending, Descending, Symmetrical): Suggest the trend will con nue a er
a breakout.

 Flags and Pennants: Indicate a brief pause before the trend resumes.

 Example: A symmetrical triangle breakout signals the con nua on of an uptrend.

4. Support and Resistance:

 Support: A price level where buying prevents further decline.

 Resistance: A price level where selling prevents further rise.

  Example: A stock repeatedly bounces back from ₹100 (support) and struggles to break
₹120 (resistance).

 Significance:

o Charts help traders visualize price movements and iden fy ac onable pa erns.

o Pa erns guide decisions on when to buy, sell, or hold.

 Limita ons:

o Subjec ve interpreta on can lead to different conclusions.

o Pa erns may fail in vola le or unpredictable markets.

 Example: A trader uses a candles ck chart to spot a bullish engulfing pa ern and buys a stock,
expec ng a price increase.

4. Technical Indicators

Technical indicators are mathema cal calcula ons based on price, volume, or open interest data, used to
predict future price movements and confirm trends.

 Types of Technical Indicators:

1. Trend Indicators:

 Iden fy the direc on and strength of a trend.

 Examples:

 Moving Averages (MA):

 Smooths price data to show trends.

 Types:

 Simple Moving Average (SMA): Average price over a period

(e.g., 50-day SMA).

 Exponen al Moving Average (EMA): Gives more weight to

recent prices.

 Use: A crossover (e.g., 50-day SMA crossing above 200-day SMA) signals
a buy.

 Example: A stock’s 50-day EMA rises above its 200-day EMA, indica ng
an uptrend.

 Moving Average Convergence Divergence (MACD):

 Compares two EMAs (e.g., 12-day and 26-day) to iden fy momentum.

 Use: A bullish crossover (MACD line above signal line) suggests buying.

 Example: A posi ve MACD signals a stock’s price may rise.

2. Momentum Indicators:

 Measure the speed or strength of price movements.

 Examples:

 Rela ve Strength Index (RSI):

 Measures overbought (above 70) or oversold (below 30) condi ons on

a 0–100 scale.

 Use: RSI below 30 suggests buying; above 70 suggests selling.

 Example: A stock with RSI at 25 is oversold, indica ng a poten al price

rebound.

 Stochas c Oscillator:

 Compares closing prices to price ranges over a period (0–100 scale).

 Use: Below 20 (oversold) or above 80 (overbought).

 Example: A stochas c reading of 15 signals a buy opportunity.

3. Volume Indicators:

 Analyze trading volume to confirm price trends.

 Examples:

 On-Balance Volume (OBV):

 Tracks cumula ve volume to confirm price movements.

 Use: Rising OBV with rising prices confirms an uptrend.

 Example: High OBV during a price rise validates a bullish trend.

 Volume Oscillator:

 Compares short-term and long-term volume averages.

 Use: Rising volume supports trend strength.

 Example: A spike in volume during a breakout confirms the trend.

4. Vola lity Indicators:

 Measure price fluctua ons to assess risk.

 Examples:

 Bollinger Bands:

 Plots two standard devia ons above and below a moving average.

 Use: Prices touching the upper band suggest overbought; lower band
suggests oversold.

 Example: A stock price hi ng the lower Bollinger Band indicates a

poten al buy.
  Average True Range (ATR):

 Measures price vola lity over a period.

 Use: High ATR indicates high vola lity.

 Example: A high ATR warns traders of poten al price swings.

 Significance:

o Indicators provide objec ve signals to confirm trends, momentum, or reversals.

o Help traders make data-driven decisions rather than relying solely on intui on.

 Limita ons:

o Indicators can give false signals in choppy markets.

o Over-reliance on one indicator may lead to poor decisions; combining indicators is be er.

 Example: A trader uses RSI (oversold at 28) and a bullish MACD crossover to confirm a buy signal for
a stock.

5. Tes ng Technical Trading Rules

Tes ng technical trading rules involves evalua ng the effec veness of trading strategies based on technical
analysis to determine their profitability and reliability.

 Purpose:

o Verify if a trading rule (e.g., buy when RSI < 30) consistently generates profits.

o Iden fy op mal parameters (e.g., 50-day vs. 200-day moving average).

 Methods:

1. Backtes ng:

 Apply the trading rule to historical price data to simulate past performance.

 Process:

 Select a rule (e.g., buy when 50-day SMA crosses above 200-day SMA).

 Use historical data (e.g., 5 years of stock prices).

 Calculate returns, accoun ng for transac on costs (e.g., brokerage fees).

 Example: Backtes ng a moving average crossover strategy on a stock shows a 10%

annual return.

 Tools: So ware like MetaTrader, TradingView, or Python.

2. Forward Tes ng (Paper Trading):

 Test the rule in real- me markets without real money (simulated trades).

 Process:
  Apply the rule to current market data.

 Track hypothe cal profits/losses over weeks or months.

 Example: Paper trading a Bollinger Band strategy for 3 months to assess its success.

3. Walk-Forward Analysis:

 Combine backtes ng and forward tes ng by op mizing the rule on past data and
tes ng it on subsequent periods.

 Example: Op mize a MACD strategy on 2018–2020 data and test it on 2021–2022.

4. Monte Carlo Simula on:

 Test the rule under various random scenarios to assess robustness.

 Example: Simulate 1,000 market condi ons to check a strategy’s consistency.

 Key Metrics:

o Profitability: Net returns a er costs.

o Win Rate: Percentage of profitable trades.

o Risk-Adjusted Return: Returns rela ve to risk (e.g., Sharpe Ra o).

o Drawdown: Maximum loss from peak to trough during tes ng.

 Significance:

o Ensures trading rules are reliable before risking real money.

o Helps refine strategies to improve performance.

 Limita ons:

o Past performance doesn’t guarantee future results.

o Over-op miza on (curve-fi ng) may lead to unrealis c expecta ons.

 Example: A trader backtests an RSI-based strategy, finding it yields 8% annual returns with a 60% win
rate, and forward tests it to confirm reliability.

6. Evalua on of Technical Analysis

Evalua on of technical analysis assesses its effec veness, reliability, and limita ons as a tool for investment
decisions.

 Strengths:

1. Timeliness: Quickly iden fies trading opportuni es based on real- me data.

 Example: Spo ng a breakout pa ern for immediate ac on.

2. Versa lity: Applicable to any market (stocks, forex, commodi es) and meframe (daily,
hourly).

 Example: Using RSI for both stocks and cryptocurrencies.

 3. Objec ve Signals: Indicators like MACD or RSI provide clear buy/sell signals.

 Example: RSI below 30 prompts a buy decision.

4. Focus on Market Psychology: Captures investor behavior through price pa erns.

 Example: A head and shoulders pa ern reflects shi ing sen ment.

5. Complementary Use: Enhances fundamental analysis by ming entry/exit points.

 Example: Buying a fundamentally strong stock during a technical uptrend.

 Weaknesses:

1. Subjec vity: Chart pa erns and indicators can be interpreted differently.

 Example: Two traders may disagree on a triangle pa ern’s breakout direc on.

2. False Signals: Indicators may mislead in vola le or sideways markets.

 Example: A moving average crossover fails during choppy price movements.

3. Ignores Fundamentals: Misses cri cal factors like earnings or economic condi ons.

 Example: A stock in an uptrend may crash a er poor earnings.

4. Lagging Indicators: Many indicators rely on past data, delaying signals.

 Example: Moving averages confirm trends a er they’ve started.

5. Over-Reliance Risk: Blindly following signals without context can lead to losses.

 Example: Buying based on RSI without checking news may miss a company scandal.

 Cri ques:

o Efficient Market Hypothesis (EMH): Argues that prices reflect all informa on, making
technical analysis ineffec ve. However, behavioral finance supports technical analysis by
highligh ng irra onal investor behavior.

o Random Walk Theory: Suggests price movements are random, challenging the predictability
of pa erns.

 Empirical Evidence:

o Studies show mixed results: some strategies (e.g., momentum-based) work in certain markets,
but consistent outperformance is rare.

o Success depends on market condi ons, trader discipline, and risk management.

 Best Prac ces:

o Combine technical analysis with fundamental analysis for robust decisions.

o Use mul ple indicators to confirm signals (e.g., RSI with MACD).

o Test strategies thoroughly and adapt to changing markets.

o Incorporate risk management (e.g., stop-loss orders).

 Significance:

o Effec ve for short-term traders and ming trades, but requires skill and cau on.

o Complements other methods to enhance decision-making.

 Example: A trader evaluates technical analysis, finding it useful for day trading stocks with RSI and
candles ck pa erns, but combines it with fundamental checks to avoid risky companies.
 Unit 5

Por olio Analysis, Selec on, and Evalua on

Por olio Analysis involves evalua ng a collec on of investments (a por olio) to op mize returns while
managing risk. It includes selec ng the best mix of assets, diversifying to reduce risk, and evalua ng
performance to ensure goals are met. This sec on explains por olio-related concepts in simple terms.

1. Meaning of Por olio

 Defini on: A por olio is a collec on of financial assets, such as stocks, bonds, mutual funds, real
estate, or cash, held by an investor to achieve financial goals like wealth growth or income genera on.

 Key Points:

o Combines different assets to balance risk and return.

o Can be tailored to an investor’s risk tolerance, goals, and me horizon.

o Managed ac vely (frequent trading) or passively (long-term holding).

 Example: An investor’s por olio might include 50% stocks, 30% bonds, 10% gold, and 10% fixed
deposits.

2. Reasons to Hold a Por olio

Investors hold por olios for several reasons to achieve financial objec ves while managing risk.

 Key Reasons:

1. Diversifica on:

 Spreading investments across assets reduces the impact of a single asset’s poor
performance.

 Example: If stocks fall, bonds in the por olio may remain stable.

2. Risk Management:

 Combining assets with different risk levels lowers overall por olio risk.

 Example: Including low-risk bonds offsets vola le stocks.

3. Return Op miza on:

 A mix of assets can achieve higher returns compared to a single investment.

 Example: Stocks offer growth, while bonds provide steady income.

4. Goal Alignment:

 Por olios can be customized for specific goals (e.g., re rement, buying a house).

 Example: A young investor’s por olio focuses on growth, while a re ree’s emphasizes
income.
 5. Flexibility:

 Allows adjustments based on market condi ons or personal needs.

 Example: Shi ing from stocks to bonds during a market downturn.

6. Liquidity:

 Including liquid assets (e.g., stocks) ensures access to cash when needed.

 Example: Selling shares to fund an emergency.

 Significance:

o Por olios provide a structured way to grow wealth while minimizing risks.

 Example: An investor holds a por olio of stocks, bonds, and gold to diversify risk, earn returns, and
save for re rement.

3. Diversifica on Analysis

 Defini on: Diversifica on is the strategy of spreading investments across different assets, industries,
or regions to reduce risk without significantly sacrificing returns.

 Key Concepts:

o Systema c Risk: Market-wide risk (e.g., economic downturns) that cannot be diversified away.

o Unsystema c Risk: Asset-specific risk (e.g., a company’s failure) that can be reduced through
diversifica on.

o Diversifica on lowers unsystema c risk by including assets with low or nega ve correla ons
(i.e., they don’t move in the same direc on).

 Types of Diversifica on:

1. Asset Class Diversifica on:

 Inves ng in stocks, bonds, real estate, gold, etc.

 Example: A por olio with 60% stocks and 40% bonds.

2. Industry Diversifica on:

 Inves ng in different sectors (e.g., IT, healthcare, energy).

 Example: Holding shares in a tech company and a pharmaceu cal firm.

3. Geographic Diversifica on:

 Inves ng in domes c and interna onal markets.

 Example: Including U.S. and Indian stocks.

4. Time Diversifica on:

 Inves ng over different me periods (e.g., short-term bonds, long-term stocks).

 Example: Combining 1-year fixed deposits with 10-year equity funds.

  Benefits:

o Reduces por olio vola lity and poten al losses.

o Improves risk-adjusted returns.

 Limita ons:

o Over-diversifica on may dilute returns.

o Does not eliminate systema c risk.

 Example: An investor diversifies by holding stocks in IT and consumer goods, bonds, and gold,
reducing the impact of an IT sector downturn.

4. Markowitz’s Model (Modern Por olio Theory)

 Defini on: Developed by Harry Markowitz, this model provides a framework for op mizing a
por olio by balancing risk and return through diversifica on. It introduced the concept of the efficient
fron er.

 Assump ons:

1. Investors are ra onal and aim to maximize returns for a given risk level.

2. Returns are normally distributed (follow a bell curve).

3. Investors base decisions on expected returns, variance, and covariance of assets.

4. Risk is measured by the standard devia on of por olio returns.

5. All investors have access to the same informa on.

 Specific Model:

o Por olio Expected Return: The weighted average of individual asset returns.

 Formula: [ E(R_p) = \sum (w_i \cdot E(R_i)) ] Where ( E(R_p) ) = por olio expected
return, ( w_i ) = weight of asset ( i ), ( E(R_i) ) = expected return of asset ( i ).

 Example: A por olio with 50% Stock A (10% return) and 50% Stock B (6% return): [
E(R_p) = (0.5 \cdot 10%) + (0.5 \cdot 6%) = 8% ]

o Por olio Risk: Measured by the standard devia on of por olio returns, accoun ng for asset
correla ons.

 Formula (for two assets): [ \sigma_p = \sqrt{w_1^2 \sigma_1^2 + w_2^2 \sigma_2^2

+ 2 w_1 w_2 \rho_{12} \sigma_1 \sigma_2} ] Where ( \sigma_p ) = por olio standard
devia on, ( w_1, w_2 ) = weights, ( \sigma_1, \sigma_2 ) = standard devia ons, (
\rho_{12} ) = correla on coefficient.

 Example: If Stock A and B have standard devia ons of 15% and 10%, weights of 50%
each, and correla on of 0.5, por olio risk is calculated accordingly.

 Risk and Return Op miza on:

 o The model selects asset combina ons that offer the highest return for a given risk level or the
lowest risk for a given return.

o Achieved by adjus ng asset weights to minimize variance.

 Efficient Fron er:

o A curve represen ng all possible por olios that offer the highest return for each level of risk.

o Por olios on the efficient fron er are op mal; those below it are subop mal.

o Example: A por olio with 60% stocks and 40% bonds may lie on the efficient fron er if it
maximizes return for its risk level.

 Efficient Por olios:

o Por olios on the efficient fron er, offering the best risk-return trade-off.

o Example: A por olio with 8% return and 10% risk may be efficient if no other por olio offers
higher returns for the same risk.

 Leveraged Por olios:

o Por olios that use borrowed funds to increase investment size, amplifying both returns and
risks.

o Example: Borrowing ₹50,000 to add to a ₹100,000 por olio increases poten al gains but also
losses.

 Corner Por olios:

o Specific por olios on the efficient fron er where asset weights change significantly (e.g.,
shi ing from 100% bonds to including stocks).

o Used to construct other efficient por olios by combining corner por olios.

o Example: A corner por olio might be 100% bonds; another might be 80% stocks and 20%
bonds.

 Significance:

o Provides a scien fic approach to por olio construc on.

o Emphasizes diversifica on to reduce risk.

 Limita ons:

o Assumes perfect informa on and ra onal investors, which may not hold.

o Requires accurate es mates of returns, variances, and correla ons, which are uncertain.

o Computa onally complex for large por olios.

 Example: An investor uses Markowitz’s model to create a por olio of stocks and bonds on the efficient
fron er, achieving 9% return with 12% risk.
5. Sharpe’s Single Index Model

 Defini on: Developed by William Sharpe, the Single Index Model simplifies por olio analysis by
assuming that asset returns are influenced by a single market index (e.g., Ni y 50). It reduces the
complexity of Markowitz’s model.

 Key Concepts:

o Systema c Risk: Risk ed to the market, measured by beta (( \beta )).

o Unsystema c Risk: Asset-specific risk, independent of the market.

o Market Index: A benchmark (e.g., Sensex) represen ng overall market performance.

 Model Formula:

o Asset Return: [ R_i = \alpha_i + \beta_i R_m + e_i ] Where ( R_i ) = return of asset ( i ), ( \alpha_i
) = asset’s excess return (independent of market), ( \beta_i ) = sensi vity to market return, (
R_m ) = market return, ( e_i ) = random error (unsystema c risk).

o Por olio Return: [ E(R_p) = \sum (w_i \cdot E(R_i)) ]

o Por olio Risk: [ \sigma_p = \sqrt{\beta_p^2 \sigma_m^2 + \sum (w_i^2 \sigma_{e_i}^2)} ]

Where ( \beta_p ) = por olio beta, ( \sigma_m ) = market standard devia on, ( \sigma_{e_i} )
= unsystema c risk of asset ( i ).

 Assump ons:

1. Asset returns are linearly related to a single market index.

2. Unsystema c risks of different assets are uncorrelated.

3. Investors aim to op mize risk and return.

 Steps:

1. Es mate ( \alpha ), ( \beta ), and unsystema c risk for each asset using historical data.

2. Calculate expected por olio return and risk based on asset weights.

3. Op mize by selec ng assets that maximize return for a given risk level.

 Significance:

o Simplifies calcula ons compared to Markowitz’s model by using a single index.

o Focuses on systema c risk, making it easier to analyze large por olios.

 Limita ons:

o Assumes a single market index captures all systema c risk.

o Ignores correla ons between assets’ unsystema c risks.

o Relies on historical data, which may not predict future performance.

 Example: An investor uses the Single Index Model to construct a por olio with stocks ed to the Ni y
50, calcula ng a por olio beta of 1.2 and expected return of 10%.
6. Por olio Evalua on Measures

Por olio evalua on measures assess the performance of a por olio by comparing its returns to its risk,
helping investors determine if the por olio manager has outperformed the market or peers.

A. Sharpe’s Performance Index

 Defini on: Developed by William Sharpe, the Sharpe Ra o measures the excess return per unit of
total risk (standard devia on).

 Formula: [ \text{Sharpe Ra o} = \frac{R_p - R_f}{\sigma_p} ] Where ( R_p ) = por olio return, ( R_f )
= risk-free rate (e.g., government bond yield), ( \sigma_p ) = por olio standard devia on.

 Interpreta on:

o Higher Sharpe Ra o = be er risk-adjusted performance.

o Nega ve ra o = por olio underperforms the risk-free rate.

 Example: A por olio with a 12% return, 5% risk-free rate, and 10% standard devia on: [ \text{Sharpe
Ra o} = \frac{12 - 5}{10} = 0.7 ]

 Significance:

o Evaluates total risk (systema c + unsystema c).

o Useful for comparing por olios with different risk levels.

 Limita on:

o Assumes returns are normally distributed.

o Sensi ve to standard devia on es mates.

B. Treynor’s Performance Index

 Defini on: Developed by Jack Treynor, the Treynor Ra o measures the excess return per unit of
systema c risk (beta).

 Formula: [ \text{Treynor Ra o} = \frac{R_p - R_f}{\beta_p} ] Where ( \beta_p ) = por olio beta.

 Interpreta on:

o Higher Treynor Ra o = be er performance rela ve to market risk.

o Nega ve ra o = por olio underperforms the risk-free rate.

 Example: A por olio with a 12% return, 5% risk-free rate, and beta of 1.2: [ \text{Treynor Ra o} =
\frac{12 - 5}{1.2} = 5.83 ]

 Significance:

o Focuses on systema c risk, suitable for diversified por olios.

o Useful for comparing por olios with similar market exposure.

 Limita on:

o Ignores unsystema c risk, less relevant for undiversified por olios.

 o Relies on accurate beta es mates.

C. Jensen’s Performance Index

 Defini on: Developed by Michael Jensen, Jensen’s Alpha measures the por olio’s excess return over
the return predicted by the Capital Asset Pricing Model (CAPM).

 Formula: [ \alpha_p = R_p - [R_f + \beta_p (R_m - R_f)] ] Where ( R_m ) = market return, ( \alpha_p )
= Jensen’s Alpha.

 Interpreta on:

o Posi ve alpha = por olio outperforms CAPM expecta ons (superior management).

o Nega ve alpha = underperformance.

o Zero alpha = performance matches expecta ons.

 Example: A por olio with a 12% return, 5% risk-free rate, beta of 1.2, and market return of 10%: [
\alpha_p = 12 - [5 + 1.2 (10 - 5)] = 12 - [5 + 6] = 1% ]

 Significance:

o Directly measures the manager’s ability to generate excess returns.

o Widely used to evaluate ac ve por olio management.

 Limita on:

o Depends on accurate CAPM inputs (beta, market return).

o Assumes CAPM is a valid model, which may not always hold.

 Example: A mutual fund with a posi ve alpha of 2% indicates the manager’s skill in bea ng the
market.

MWCMC Mysuru