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SYLLABUS

SECURITY ANALYSIS &INVESTMENT MANAGEMENT

MBA–3rd SEMESTER, M.D.U., ROHTAK

External Marks : 70

Time : 3 hrs.

Internal Marks : 30

UNIT - I UNIT - II UNIT - III UNIT - IV
UNIT - I
UNIT - II
UNIT - III
UNIT - IV

Decision Support System : Overview, components and classification, steps in

constructing a dss, role in business, group decision support system.

Information system for strategic advantage, strategic role for information system,

breaking business barriers, reengineering business process, improving business

qualities.

Information system analysis and design, information SDLC, hardware and software

acquisition, system testing, documentation and its tools, conversion methods.

Marketing IS, Manufacturing IS, Accounting IS, Financial IS.

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SECURITY ANALYSIS &INVESTMENT MANAGEMENT FINANCE : SPECIALIZATION PAPERS UNIT – I Q. Define Investment. Ans.

SECURITY ANALYSIS &INVESTMENT MANAGEMENT

FINANCE : SPECIALIZATION PAPERS

UNIT – I

Q. Define Investment. Ans. Meaning of Investment : Investment involves making of a sacrifice in
Q.
Define Investment.
Ans.
Meaning of Investment : Investment involves making of a sacrifice in the present with
the hope of deriving future benefits. Investment has many meanings and facets. The two
most important features of an investment are current sacrifice and future benefit.
We can now give a simple yet a broad definition of investment. We can define investment as
“postponed consumption”.
When you postpone consumption, sacrifice takes place n the present and is certain whereas
the benefits occur n future and are uncertain. Therefore, risk and expected return from the
investment are the two key determinants of investment process.
Investment Process : A typical investment decision undergoes a five step procedure
which, in turn, forms the basis of the investment process. These steps are:
(1)
Determine the investment objectives and policy
(2)
Undertake Security Analysis.
(3)
Construct a portfolio.
(4)
Review the Portfolio.
(5)
Evaluate the performance of the portfolio.
Investment Attributes/ Factors Influencing Selection of Investment : In chossing
specific investments, investors will need definite ideas regarding features which their
portfolios should possess. For evaluation of investment avenue, the following attributes are
relevant:
(1) Returns
(2) Capital Appreciation
(3) Safety and Security of Funds.
(4) Tax Benefits

(5) Concealability

(6)

Adequate Liquidity

(7)

Stability of Income

(8) Risk.

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Q. Define Risk. What are the different types of risk influences on investment?

Ans : Meaning of Risk : Risk can be defined as the probability that the expected return from

the security will not materialize. Every investment involves uncertainties that make future

investment returns risk-prone. Uncertainties could be due to the political, economic and

industry factors.

Types of Investment Risk: Investment Risks are:

Types of Investment Risk Systematic Risk Non-Systematic Risk Market Risk Regulation Risk Interest Rate Risk
Types of Investment Risk
Systematic Risk
Non-Systematic Risk
Market Risk
Regulation Risk
Interest Rate Risk
Regulation Risk
Purchasing Power Risk
Regulation Risk
Business Risk
Bull-Bear Risk
Exchange Rate Risk
Management Risk
Default Risk
International Risk
Industry Risk
Country Risk
Liquidity Risk
Dividing total risk into its two components, a general (market) component and a specific
(issuer) component, we have systematic risk and non-systematic risk, which are additive:

Total Risk = General Risk + Specific Risk

= Market Risk + Issuer Risk

= Systematic Risk + Non -Systematic Risk

(A) Systematic Risk : Variability in a security’s total returns that is directly associated with overall movements in the general market or economy is called systematic risk. Virtually all securities have some systematic risk because systematic risk directly

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encompasses interest rate, market, and inflation risks. Systematic risk is attributable to broad macro factors

encompasses interest rate, market, and inflation risks. Systematic risk is attributable to broad macro factors affecting all securities. Different types of systematic risk are

explained as under:

(1)

Market Risk : The variability in a security’s returns resulting from fluctuation in

the aggregate market is known as market risk. Market risk is sometimes used

synonymously with systematic risk. All securities are exposed to market risk

including :

Recession

Wars

Structural changes in the economy

Tax law Changes

Changes in Consumer Preferences.

(2)

Interest Rate Risk : The variability in a security’s return resulting from changes

in the level of interest rates is referred to as interest rate risk. Such changes

generally affect securities inversely; that is, other things being equal, security

prices move inversely to interest rates.

(3)

Purchasing Power Risk : A factor affecting all securities is purchasing power

risk, also known as inflation risk. With uncertain inflation, the real (inflation-

adjusted) return involves risk even if the nominal return is safe. This risk is

related to interest rate risk, since interest rates generally rise as inflation

increases, because lenders demand additional inflation premiums to

compensate for the loss of purchasing power.

(B) Non-Systematic Risk : The variability in a security’s total returns not related to overall

market variability is called the non-systematic (non-market) risk. Non-systematic risk

is specific to an industry or the company individually. This risk is unique to a particular

security and is associated with such factors as business and financial risk as well as

liquidity risk. Different types of non-systematic risks are explained as under:

(1) Regulation Risk : Some investments can be relatively attractive to other

investments because of certain regulations or tax laws that give them an

advantage of some kind. Municipal bonds, for example, pay interest that is

exempt from local, state and federal taxation. As a result of that specific tax

exemption, municipals can price bonds to yield a lower interest rate since the net

after-tax yield may still make them attractive to investors.

(2) Business Risk : The risk of doing business in a particular industry or

environment is called business risk. For example, as one of the largest steel

(3)

producers, U.S. Stee faces unique problems.

Bull-Bear Market Risk : This risk arises form the variability in the market returns

resulting from alternating bull and bear market forces.

When security index rises fairly consistently from a low point, this upward trend is called a bull market. The bull market ends when the market index reaches a peak and starts a downward trend.

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The period during which the market declines, this downward trend is called a bear market.

(4)

Management Risk : Management, all said and done, is made of people who are

mortal, fallible and capable of making a mistake or a poor decision. Errors made

by the management can harm those who invested in their firms.

(5)

Default Risk : It is that portion of an investment’s total risk that results from

changes in the financial integrity of the investment. For example, when c

company that issues securities moves either further away from bankruptcy or

closer to it, these changes in the firm’s financial integrity will be reflected in the

market price of its securities. The variability of return that investors experience,

as a result of changes in the credit worthiness of a firm in which they invested, is

their default risk.

(6)

International Risk : International risk can include country risk and exchange

rate risk.

(i)

Exchange Rate Risk : All investors who invest internationally in today’s

 

increasingly global investment arena face the prospect of uncertainty in

the returns after the convert the foreign gains back to their own currency.

 

(ii)

Country Risk : Country risk, also referred to as political risk, is an

 

important risk for investors today. With more investors investing

internationally, both directly and indirectly, the political and therefore

economic stability and viability of a country’s economy need to be

considered.

(7)

Industry Risk : An industry may be viewed as group of companies that compete

with each other to market a homogeneous product. Industry risk is that portion of

an investment’ s total variability of return caused by events that affect the

products and firms that make up an industry.

(8) Liquidity Risk : Liquidity risk is the risk associated with the particular secondary

market in which a security trades. An investment that can be bought or sold

quickly and without significant price concession is considered liquid. The more

uncertainty about the time element and the price concession, the greater the

liquidity risk.

Measurement of Risk : There are three methods:

(1)

Volatility : Volatility may be described as the range of movement (or price fluctuation)

from the expected level of return. For example, the more a stock goes up and down in

price, the more volatile that stock is.

(2)

Standard Deviation : Investors and analysts should be at least somewhat familiar

with the stud of probability distributions. Since the return an investor will earn from investing is not known, it must be estimated. An investor may expect the total return on a particular security to be 10% for the coming year but in truth this is only a “point estimate”. The formulas of measuring risk with the help of standard deviation are:

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(i) Risk of Portfolio (two assets): 2 s= W 2 + W 2 2 +2

(i) Risk of Portfolio (two assets):

2

s= W

2

+ W

2

2

+2 W W

A

B

AB

A

B

= Standard deviation of portfolio consisting securities A and B

WAWB= Proportion of funds invested in Security A and B

P

A

B

= Standard deviation of returns of Security A and Security B

AB

= Correlation coefficient between returns of Security A and Security B

The correlation coefficient can be calculated as follows:

AB

Cov AB

= ————————

A

B

(ii) Risk of Portfolio (three assets):

P= W 2

2 + W 2

2 + W 2 s 2 +2 WxWy

yz

y

z+ WxWz

xz

x

z

W 1, W2, W3= Proportion of amount invested in securities X, Y and Z

x

y

z = Standard deviation of Securities X, Y and Z

xy

= Correlation coefficient between Securities X and Security Y

yz

= Correlation coefficient between Securities Y and Security Z

xz

= Correlation coefficient between Securities X and Security Z

(3)

Beta : Beta is a measure of the systematic risk of a security that cannot be avoided

through diversification. Beta is a relative measure of risk- the risk of an individual stock

relative to the market portfolio of all stocks. For example, a security with a beta of 1.5

indicates that, on average, security returns are 1.5 times as volatile as market returns,

both up and down.

Q.

Define Return. Also explain its component and types.

Ans.

Meaning of Return : Return is the amount or rate of produce, proceeds, profits which

accrues to an economic agent from an undertaking or investment. It is a reward for and a

motivating force behind investment, the objective of which is usually to maximize return.

Determinants of Return : Three major determinants of the rate of return expected by the

investor are:

(i)

The time preference risk-free real rate.

(ii)

The expected rate of inflation

(iii)

The risk associated with the investment, which is unique to the investment.

Required Return = Risk-free real rate + Inflation premium + Risk Premium

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Component of Return : The rate of return from an investment consists of the two:

(i)

Yield : The interest or dividend received is called yield.

(ii)

Capital Appreciation : The difference between the sale price and the

purchased price is the capital appreciation.

Formula:

Rate of Return (Rt) =

It+ [Pt – Pt-1]

———————————-

Pt-1

Rt

= Rate of return per time period ‘t’

It

= Income for the period ‘t’

Pt

= Price at the end of time period ‘t’

Pt-1

= Initial price, i.e., price at the beginning of the period ‘t’

The above equation can be split into two components:

Rate of Return (Rt) =

It

[Pt – Pt-1]

—— + ———————

Pt-1

Pt-1

Where

It

———— is called the current yield,

Pt-1

And

[Pt – Pt-1]

—————— is called the capital gain yield

Pt-1

Or

Example : The following information s given for a corporate bond.

Price of the bond at the beginning of the year = Rs. 90

Price of the bond at the end of the year = Rs. 95.40

Interest received for the year = Rs. 13.50

Compute the rate of return.

Solution:

The rate of return can be computed as follows:

ROR = Current Yield + Capital Gain Yield

Rate of Return (Rt) =

It+ [Pt – Pt-1]

———————————-

Pt-1

Rate of Return (Rt) =

13.50+ [95.40 – 90]

————————————— = 21% per annum

90

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The return of 21% consists of 15% current yield and 6% capital gain yield Return

The return of 21% consists of 15% current yield and 6% capital gain yield

Return of Portfolio (Two Assets) :

The expected return from a portfolio of two or more securities s equal to the weighted

average of the expected returns from the individual securities.

(R ) = W

p

A

(R ) + W

A

B

(R )

B

(Rp) = Expected return from a portfolio of two securities

WA

= proportion of funds invested in Security A

WB

= Proportion of funds invested in Security B

RA

= Expected return of Security A

RB

= Expected return of Security B

WA+WB = 1

Example : A Ltd.’s share gives a return of 20% and B Ltd.’s share gives 32% return. Mr.

Gotha invested 25% in A Ltd.’s share and 75% of B Ltd.’s shares. What would be the

expected return of the portfolio?

Solution :

Portfolio Return = .25 (20) + .75 (32) = 29%

Types of Return :

(1)

Internal Rate of Return : The internal rate of return (IRR) is the rate of discount which

makes the present value of all the revenues (cash flows) from the investment equal to

the total cost of that investment. This is also known as the yield or yield rate.

(2)

Bond Rate : It is the interest rate received on the face value or the par value of the

bond. If a company or the government issues a 10-ear bond with Rs. 100 as face value

and 15 per cent rate of interest, it would be described as 15 per cent bond.

(3) Realised and Expected Return : Return is not as simple a concept as it appears to be

because it is not guaranteed, it is mostly expected, and it may or may not be realized.

Thus expected return is an anticipated, predicted, desired which is subject to

uncertainty. Realised return, on the other hand, is actually earned.

(4) Holding Period Return/Return : Holding period yield (HPY) measures the total

return from an investment during a given time period in which the asset is held b the

investor. It is to be noted that HP does not mean that the security is actually sold and

the gain or loss is actually realised by the investor. The concept of HPY is applicable

whether one is measuring the realized return or estimating the future return. It can be

calculated as follows:

Any cash payments received + price change over the holding period HPY = ————————————————————————————————— Price at which the asset is purchased (beginning price)

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(5)

Redemption Yield or Yield to Maturity (YTM) : Redemption yield is the indicated or promised rate of return an investor will receive from a bond purchased at the current

market price and held till maturity.

Annual Interest + Average annual appreciation or depreciation

YTM = ————————————————————————————————

Redemption or face value

(6)

Dividend Yield : Dividend yield is the ratio of per share expected dividends, to the

current market price of the share.

(7)

Earnings Yield : Earnings yield is the ratio of expected earnings per share of the firm

to the current marker price of the share. The dividend yield and earnings yield do not

differ if the firm distributes all net earnings in the form of dividends i.e. if it practices 100

per cent dividend payout ratio.

(8)

Nominal and Real Return : While the nominal return is the return in nominal rupees,

the real return is equal to the nominal return adjusted for changes in prices i.e. rate of

inflation.

(9)

Gross and Net Yield : While gross yield refers to the yield realized by the investor

before paying taxes, the net yield is what remains with him after paying the taxes. The

net yield can be calculated as follows:

Net Yield = Gross Yield (1- Tax Rate)

Q.

Explain the Operations of Indian Stock Market.

Ans.

Meaning of Stock Exchange : Stock exchange means an organized market where

securities issued by companies, government organizations and semi-organisations are sold

and purchased. Securities include:

(i)

Shares

(ii)

Debentures

(iii)

Bonds etc.

Definition of Stock Exchange :

According to Pyle :

“Stock Exchange are market places where securities that have been listed thereon,

may be bought and sold for either investment or speculation.”

Features of Stock Exchange : The main features of stock exchange are as follows:

(1) Organised Market : Stock Exchange is an organized market. Every stock exchange

has a management committee, which has all the rights related to management and

control of exchange. All the transactions taking place in the stock exchange are done

as per the prescribed procedure under the guidance of management committee.

(2) Dealing in Securities issued by various concerns : Only those securities are traded in the stock exchanges which are listed there. After fulfilling certain terms and conditions, a company gets it security listed on stock exchange.

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(3) Dealing only through Authorised Members : Investors can sale and purchase securities in stock

(3)

Dealing only through Authorised Members : Investors can sale and purchase securities in stock exchange only through authorized members. Stock exchange is a

specified market place where only the authorized members can go. Investor has to

take their help to sale and purchase.

(4)

Necessary to obey the Rules and Bye-Laws : While transacting in stock exchange,

it is necessary to obey the rules and bye-laws determined by stock exchange.

Functions of Stock Exchange : The main functions performed b stock exchange are as

follows:

(1)

Providing Liquidity and Marketability to existing securities : Stock exchange is a

market place where previously issued securities are traded. Various types of

securities are traded here on regular basis. Whenever required, investor can invest his

money through this market into securities and can reconvert this investment into cash.

(2)

Pricing of Securities : A stock exchange provides platform to deal in securities. The

forces of demand and supply work freely in the stock exchange. In this way, prices of

securities are determined.

(3)

Safety of Transactions : Stock exchanges are organized markets. The fully protect

the interest of investors. Each stock exchange has its own laws and be-laws. Each

member of stock exchange has to follow them and any member found violating them,

his membership is cancelled.

(4)

Contributes to Economic Growth : Stock exchange provides liquidity to securities.

This gives the investor a double benefit-first, the benefit of the change in the market

price of securities and secondly, n case of need for money they can be sold at the

existing market price at any time.

(5)

Spreading Equity Cult : Share market collects every types of information in respect

of the listed companies. Generally this information is published or otherwise n case of

need anybody can get it from the stock exchange free of any cost. In this way, the stock

exchange guides the investors by providing various types of information.

(6)

Providing Scope for Speculation : When securities are purchased with a view to

getting profit as a result of change in their market price, it s called speculation. It is

allowed or permitted under the provisions of the relevant Act. It is accepted that in

order to provide liquidity to securities, some scope for speculation must be allowed.

The share market provides this facility.

Stock Exchange in India : There are 24 stock exchanges functioning currently in India. The

names are given below:

(1) Mumbai Stock Exchange OR

(13) Cochin Stock Exchange

Bombay Stock Exchange-BSE (2) National Stock Exchange (NSE) (3) Over the Counter Exchange of India (OTCEI)

(14) Coimbatore Stock Exchange (15) Guwahati Stock Exchange

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(4) Calcutta Stock Exchange(CSE) (5) Delhi Stock Exchange (DSE)

(16) Jaipur Stock Exchange (17) Kanpur Stock Exchange

(6) Chennai Stock Exchange

(18) Ludhiana Stock Exchange

(7) Ahmedabad Stock Exchange

(19) Mangalore Stock Exchange

(8) Hyderabad Stock Exchange

(20) Meerut Stock Exchange

(9) Bangalore Stock Exchange

(21) Patna Stock Exchange

(10) Indore Stock Exchange

(22) Pune Stock Exchange

(11) Baroda Stock Exchange

(23) Rajkot Stock Exchange

(12) Bhubaneswar Stock Exchange

(24) Capital Stock Exchange

Kerala Ltd.

Q. Define of New Issue Market. Write on functions of new issue market.

Ans. New Issue Market OR Primary Market : New issue market is the segment in which

new issues are made. In the new issue market, new issues may be made in three ways

namely:

(i)

Public Issue

(ii)

Rights Issue

(iii)

Private Issue.

Classification of New Issue Market : The new market can be classified as:

(i)

A market where firms go to the public for the first time through initial public offering

(IPO).

(ii)

A market where firms which are already trade raise additional capital through

seasoned equity offering (SEO).

Functions of New Issue Market : The main function of new issue market is to facilitate

transfer resources from savers to the users. The savers are individuals, commercial banks,

insurance company etc. the users are public limited companies and the government. The

new issue market plays an important role in mobilizing the funds from the savers and

transferring them to borrowers for production purposes, an important requisite of economic

growth. The main function of new issue market can be divided into three service functions:

(1)

(1)

Origination

(2)

Underwriting

(3)

Distribution

Origination : Origination offers to the work of investigation, analysis and processing

of new project proposals. Origination starts before an issue is actually floated in the

market. There are two aspects in these functions:

(i) Technical, Economic and Financial AnalysisH : A careful study of the technical, economic and financial viability to ensure soundness of the project. This is a preliminary investigation undertaken b the sponsors of the issue.

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(ii) Advisory Services : Advisory services which improve the quality of capital issues and ensure

(ii) Advisory Services : Advisory services which improve the quality of capital issues and ensure its success. The advisor services include:

Type of issue

Magnitude of issue

Time of floating an issue

Pricing of an issue- whether shares are to be issue at par or at premium

Methods of issue.

Technique of selling securities

The function of origination is carried out by merchant banker, who may be commercial

banks, and Indian financial institutions, or private firms.

(2) Underwriting : Underwriting is an agreement whereby the underwriter promises to

subscribe to a specified number of shares or debentures or a specified amount of

stock in the event of public not subscribing to the issue. If the issue is fully subscribed

then there is no liability for the underwriter. If a part of share issues remains unsold, the

underwriter will buy these shares. Thus underwriting is a guarantee for the

marketability of shares.

Methods of Underwriting : An underwriting agreement may take any of the following

three forms:

(i)

Standing behind the issue: Under this method, the underwriter guarantees

the sale of a specified number of shares within a specified period. If the public do

not subscribe to the specified amount of issue, the underwriter buys the balance

in the issue.

(ii)

Consortium Method: Underwriter is jointly done by a group of underwriters in

this method. This method is adopted for large issue.

Advantages of Underwriting : Underwriting assumes great significance as it offers the

following advantages to the issuing company:

(i)

The issuing company is relied from the risk of finding buyers for the issue offered

to the public. The company is assured of raising adequate capital

(ii)

The company is assured of getting minimum subscription within the stipulated

time, a statutory time, and statutory obligation to be fulfilled by the issuing

company.

(iii)

Underwriters undertake the burden of highly specialized function of distributing

securities.

(iv)

Provide expect advice with regard to timing of security issue, the pricing of issue,

the size and type of securities to be issued etc.

(v)

Public confidence on the issue enhances when underwritten by reputed underwriter.

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Underwriter in India : The underwriters in India may be classified into two categories:

(i)

Institutional Underwriters:

Life Insurance Corporation of India (LIC)

Unit Trust of India (UTI)

Industrial Development Bank of India (IDBI)

Industrial Credit and Investment Corporation of India (ICICI)

Commercial Banks and general insurance companies.

(ii)

Non-Institutional Underwriters

(3)

Distribution : Distribution is the function of sale of securities to ultimate investors,

Brokers and agents, who maintain regular and direct contact with the ultimate

investors, perform this service.

Q.

Define New Issue Market. What are the methods of floating new issues? Explain

in detail.

Ans : New Issue Market OR Primary Market : New issue market is the segment in which

new issues are made.

Classification of New Issue Market : The new market can be classified as:

(i)

A market where firms go to the public for the first time through initial public offering

(IPO).

(ii)

A market where firms which are already trade raise additional capital through

seasoned equity offering (SEO).

Methods of Floating New Issues : The various methods which are used in the floating of

securities in the new issue market are:

(1) Public Issues : Under this method, the issuing company directly offers to the general

public/institutions a fixed number of shares at a stated price through a document

called prospects. This is the most common method followed by join stock companies

to raise capital through the issues of securities. The following information are given in

the prospectus:

(i)

Name of the Company

(ii)

Address of the registered office of the company

(iii)

Existing and proposed activities

(iv)

Location of the industry

(v)

Name of Directors

(vi)

Authorized and proposed issue capita to the public

(vii)

Dates of opening and closing the subscription list

(viii)

Minimum Subscription

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(ix) Names of brokers/underwriter/bankers/managers and registrars to the issue. (x) A statement b the company

(ix)

Names of brokers/underwriter/bankers/managers and registrars to the issue.

(x)

A

statement b the company that it will apply to stock exchange for quotations of

its shares.

According to the Companies Act, 1956 every application form must be accompanies

by a prospectus.

(2)

Offer of Sale: The method of offer of sale consists in outright sale of securities through

the intermediary of issue houses or share brokers. In other words, the shares are not

offered to the public directly. This methods consists of two stages:

(i)

The first stage is a direct sale by the issuing company to the issue house and

 

brokers at an agreed price.

 

(ii)

In the second stage, the intermediaries resell the above securities to the

 

ultimate investors. The issue houses or stockbrokers purchase the securities at

a

negotiated price and resell at a higher price. The difference between in the

purchase and sale price is called turn or spread.

 

Advantages : One chief advantage of this method is that the company is relieved from

the problem of printing and advertisement of prospectus and making allotment of

share. Offer of sale is not common in India.

(3)

Placement :

Under this method, the issue houses or brokers buy the securities

outright with the intention of placing them with their clients afterwards. Here, the

brokers act as almost wholesaler selling them in retail to the public. The brokers would

make profit in the process of reselling to the public. The issue houses or brokers

maintain their own list of client and through customer contact sell the securities.

Advantages : Placement has the following advantage:

(i)

Timing of issue is important for successful floatation of shares. In a depressed

market conditions when the issues are not likely to draw public response though

prospectus, placement method is a useful method of floatation of shares.

(ii)

This method is suitable when small companies issue their shares.

(4) Right Issues : If an existing company intends to raise additional funds, it can do so by

borrowing or b issuing new shares. One of the most common methods for a public

company to use is to offer existing shareholder the opportunity to subscribe further

shares. This mode of finance is called ‘Right Issues’. The existing shareholders have

right ot entitlement of further shares in proportion to their existing shareholding. The

rights of entitlement of a shareholder, who does not want to buy the right share, can be

sold to someone else.

Number of outstanding shares

N = ———————————————————————- Number of new shares to be offered

Where N= Number of rights needed to buy one new share

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Provisions regarding Right Issues : Section 81 of the Companies Act, 1956 deals with the provisions relating to rights issues:

Any company

 

(i)

Which has completed two years after its incorporation or

(ii)

Which has completed one year from the first allotment of shares after its

 

incorporation

Whichever is earlier, if it proposes to increase its subscribed capital by allotment of

further shares, then the subsequent provisions shall apply.

Those further shares shall be first be offered to the existing shareholder in proportion

to the shares held by them in the paid up capital, on the date of such offer.

At least 15 days notice shall be given from the date of offer. The notice shall specify the

number of shares offered and the limiting time of the offer.

The notice shall mention that if the offer is not accepted within the time of offer, will be

deemed to have been declined.

Advantages of Right Issue :

(i)

To Companies : The company benefits from lower issue costs, in that administration

and underwriting costs are lower and the issue is made at the discretion of the

directors rather than via a general meeting of the company.

(ii)

To the Shareholders : The main attraction of the rights issue for current shareholders

is that they are able to maintain their original proportion of share ownership.

Q.

What do you mean listing of securities? Explain.

Ans.

Listing of Securities : Listing means admission of the securities to dealings on a

recognized stock exchange. The securities of any public limited company, central or state

government, quasi government and other financial institutions/corporations, municipalities,

etc.

When listing is granted to a company, it means that the securities are included in the official

list of the stock exchange for the purpose of trading. Security listing ensures that a company

is solvent and its existence is legal. Government security is not required to be listed.

Objectives of Listing : The objectives of listing are mainly to:

(i)

Provide liquidity to securities.

(ii)

Mobilize savings for economic growth.

(iii)

Protect interest of investors by ensuring full disclosures.

Advantages of Listing on Stock Exchange :

(i) Detailed information about the company is available. (ii) Information increases the activity of purchase
(i)
Detailed information about the company is available.
(ii)
Information increases the activity of purchase and sale of the security of that
organization.
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(iii) Continuous dealing raises the value of security. (iv) Convenience of sale of security, lending

(iii)

Continuous dealing raises the value of security.

(iv)

Convenience of sale of security, lending liquidity to the shares.

(v)

There is safety in dealing.

(vi)

It ensures creditworthiness.

(vii)

Widens the market of the security.

Rules for Listing of Securities : The following statutory rules have been laid down for the

listing of securities under SEBI. A company requiring a quotation for its shares must apply in

the prescribed form supported b the documentary evidence given below:

(1)

Documents to be Attached :

(i)

Copies of Memorandum and Articles of Association, Prospectus or Statement in

 

lieu of Prospectus, Director’s reports, Balance Sheets and Agreement with

Underwriters etc.

 

(ii)

Specimen copies of share and debentures Certificates, letter of allotment, etc.

(iii)

Particulars regarding its capital structure.

(iv)

A statement showing the distribution of shares.

(v)

Particulars of dividends and cash bonuses during the last ten years.

(vi)

A brief history of the company’s activities since its incorporation.

(2)

Criteria for Listing : The stock exchange has to direct special attention to the

following particulars while scrutinising the application:

(i)

Articles:

(a)

Whether the Articles contain the following provisions:

A common form of transfer shall be used.

Fully paid shares will be free from lien

Calls paid in advance may carry interest, but shall not confer aw right to

 

dividend.

 

Unclaimed dividends shall not be forfeited before the claim becomes time

 

barred.

(b)

Whether at least 49% of each class of securities issued was offered to the public

for subscription through newspapers for not less than three years.

(c)

Whether the company is of a fair size, has a broad-based capital structure and

there is sufficient public interest in its securities.

(3) Listing of Agreement : After scrutiny of the application, the stock exchange

authorities may, if they are satisfied call upon the company to execute a listing

agreement, which contains the obligations and restrictions which listing will entail.

This agreement contains 39 clauses with a number of sub-clauses. These covers

various aspects of :

(i) Issue of letters of allotment (ii) Share Certificates 74
(i)
Issue of letters of allotment
(ii)
Share Certificates
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SECURITY ANALYSIS & INVESTMENT MANAGEMENT
SECURITY ANALYSIS & INVESTMENT MANAGEMENT

(iii)

Transfer if Shares

(iv)

Information to be given to the stock exchanges regarding closure of register of

members for the purpose of payment of dividend

(v)

Issue of bonus and right shares and convertible debentures

(vi)

Holding of meeting of the board of directors for recommendation or declaration

of dividend or issue of rights, bonus shares or convertible debentures

(vii)

Submission of copies of director’s report

(viii)

Submission of copies of annual accounts.

(ix)

Submission of other notices

(x)

Resolution and so on to the shareholders.

A company enlisting the securities of a company for the purpose of trading insists that all

applicants for shares will be treated with equal fairness in the matter of allotment. Infact, in

the event of over-subscription, the stock exchange will advise the company regarding the

basis for allotment of shares. It will try to ensure that applicants for large blocks of shares are

not given undue preference over others.

Q.

What are the main features of OTCEI? Explain the trading process of OTCEI.

Ans.

Over the Counter Exchange of India (OTCEI): The OTCEI is a completely

computerized and special ringless stock exchange which is different from the traditional

stock exchange and on which the buying and selling of securities is absolutely transparent

and moves at a great speed. Its counters are spread all over the country where transactions

are made with the help of telephone.

The OTCEI was established under section 25 of the Companies Act, 1956 in October, 1990.

The promoters of the OTCEI are the following financial and other institutions:

The Unit Trust of India

The Industrial Credit and Investment Corporation of India.

The Industrial Development Bank of India

The Industrial Finance Corporation of India

The Life Insurance Corporation of India

The General Insurance Corporation of India

The SBI Capital Market Limited

The Canbank Financial Services Limited.

Features or Nature of OTCEI : The main features of the OTCEI are the following:

(1) Ringless Trading : There s no particular place for transacting business in securities under the OTCEI. This exchange has its counters/offices throughout the country. Any buyer or seller of securities can go the counter/officer and have transaction through the medium of the operator.

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89
(2) Nation Network : The OTCEI has its network all over the country. All the

(2)

Nation Network : The OTCEI has its network all over the country. All the counters are linked with the central terminal through the medium of computers. Therefore, the

facility of nationwide listing is available here. In other words by listing on one

exchange, one can have transactions with all the counters in the whole country.

(3)

Exclusive List of Companies : On the OTCEI only those companies are listed whose

issued capital is 30 lakhs or more. In the old share markets this amount used to be ten

crores on the BSE and three crores on the other exchanges and hence, listing was not

possible in case the issued capital was less than three crores. Those companies

which have been listed on the old share markets cannot be listed on the OTCEI.

(4)

Fully Computerised : This exchange is fully computerized. It means that all the

transactions done on this exchange are done through the medium of computers.

(5)

Sponsorship : In order to get listed on the OTCEI, a company has to find a member to

sponsor it. The main job of a sponsor is market making. T means a sponsor has to be

read to buy or sell the shares of that company at least for a period of 18 months. In this

way, a sponsor creates liquidity in securities.

(6)

Investor’s Registration : All the investors doing transactions on the OTCEI have got

to register themselves compulsorily. Registration can be got done b giving an

application at an counter. The registration is called the INVESTOTC CARD. On the

basis of this card, one can do transactions of securities at any counter throughout the

country.

(7)

Greater Liquidity : There is greater liquidity in securities because of the sponsor’s job

of market making.

(8)

Transparency in Transactions : All the transactions are done in the presence of the

investor. The rates of buying and selling can be seen on the computer screen. The

operator cannot do any fraud or mischief with the transactions.

(9) Faster Delivery and Payment : On the OTCEI, delivery in case of buying and

payment in case of selling are both very fast. The work of delivery and payment in case

of listed securities and permitted securities is completed within seven days and 15

days respectively.

(10) Two ways of Public Offer : A company listed on the OTCEI can issue security n two

was. Firstly, the company can go directly to the public. This is called Direct Offer

System. Secondly, the company sells its securities to the sponsor at a particular price.

Then the sponsor sells them to the public. This is called Indirect Offer System.

Easy Access : In the big cities the counters of the OTCEI can be seen like ordinary

shops. Any body can go the counter and do buying and selling of securities.

Trading Process : One can trade in securities b going to any counter of the OTCEI. All the counters are linked with the central computer at the OTCEI headquarter. This office is in Mumbai. There can be three types of trading on the OTCEI:

(11)

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(1)

Initial Allotment : When an investor is allotted shares through the medium of OTCEI, he is given a receipt which is called counter receipt-CR. This receipt is just like the

share certificate. Selling and buying can be done through the medium of this receipt.

(2)

Buying in the Secondary Market : For the purpose of buying shares listed on the

OTCEI, a person has to get himself registered (if he is not already registered). After

this, he informs the counter operator about the number of the shares to be purchased.

The counter operator displays the rates on the screen. After getting himself satisfied

with the rate, the investor hands over the cheque to the operator. On the encashment

of the cheque, the CR is handed over to the investor. This procedure takes about a

week.

(3)

Selling in the Secondary Market : An investor who has purchased shares from the

OTCEI can sell his shares at any counter of the OTCEI. After getting himself satisfied

with the rate displayed on the screen, the investor hands over the Counter Receipt and

the Transfer Deed to the Operator. The operator prepares the Sales Confirmation Slip

(SCS) and a copy of it is handed over to the seller. The operator sends the CR, TD and

SCS to the Registrar for confirmation. After confirming every detail the Registrar sends

them back to the counter operator. In the end the operator issues a cheque to the seller

and receives back the SCS from the seller.

Purposes of OTCEI : The objects of the establishment of the OTCEI may be described as

under:

(1)

Liquidity : The first object for the establishment of the OTCEI is o maintain liquidity in

the securities of the small companies. The sponsor has got to do the job of market

making.

(2)

Transparency : The second aim of this share market is to maintain transparency of

transactions. Here all the transactions are made on the computer screen. This

eliminates any chance of fraud.

(3)

Investor’s Grievances : An important aim of the establishment of the OTCEI is the

speed solution of the problems of the investors.

(4)

Quick Settlement : In the traditional share markets both the delivery and payment

take time. This problem has been overcome with the help of the OTCEI.

(5)

Listing of Small Companies : Small companies remain deprived of being listed

because they are unable to fulfil the conditions laid down by the old share markets.

(6)

Access : This stock exchange is of the ringless type and therefore, has its counters all

over the country.

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SECURITY ANALYSIS &INVESTMENT MANAGEMENT FINANCE : SPECIALIZATION PAPERS UNIT – II Q. Explain the Mechanics

SECURITY ANALYSIS &INVESTMENT MANAGEMENT

FINANCE : SPECIALIZATION PAPERS

UNIT – II

Q. Explain the Mechanics of security trading in Stock Exchange OR Q. Explain the mechanics
Q.
Explain the Mechanics of security trading in Stock Exchange
OR
Q.
Explain the mechanics of Investing in Securities.
Ans.
Introduction : An investor must have some knowledge of how the securities markets
operate. The marketing of old or new securities on the stock markets can be done only
through members of the Stock Exchange. These members are either individuals or
partnership firms. An individual; must use the facilities of these members for trading
insecurities unless he himself is a registered dealer or member of an organized stock
exchange. Trading among the members of a recognized stock exchange is to be done under
the statutory regulations of the stock exchange. The members carrying on business are
known as ‘brokers’ and can trade only on listed securities. These members execute
customer’s orders to buy and sell on the exchange and their firms receive negotiated
commissions on those transactions.
Process of Investing in Securities : There are the following steps involved in the process
of investing in securities:
(1)
Finding a Broker: The selection of a broker depends largely on the kind of services
rendered by a particular broker as well as upon the kind of transaction that a person
wishes to undertake. An individual usually prefers to select a broker who can render
the following services:
(i)
Provide information
(ii)
Availability of Investment literature.
(iii)
Appoint competent representatives
(2) Selection of Brokers : There are following types of brokers:

(i) Commission Broker : All brokers buy and sell securities for earning a commission. From the investor’s point of view, he is the most important member of the exchange because his main function and responsibility is to buy and sell stock for his customers. He acts as an agent for his customer and earns a

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commission for the service performed. He is independent dealer in securities. He purchases and sells securities in his own name. He is not allowed to deal with

the non-members. He can either deal with a broker or another jobber.

(ii)

Floor Broker : Floor brokers are not many in number. They execute orders for

fellow members and receive a share brokerage commission charged by a

commission broker to his/her constituent. He helps other brokers when they are

busy.

(iii)

Tarniwala : He/she is a jobber or specialist in selected shares. He/she makes

the market i.e. provide continuity to dealings. They specialize in stocks which

are traded inactively.

(iv)

Dealer in Non-cleared Securities : He/she deals in securities that are not on

the active list.

(v)

Odd-lot Dealer : He/she specializes in buying and selling in amounts that are

less than present trading units. They buy and sell odd lots, make them up into

marketable trading units. These dealers receive commission. The odd-lot dealer

has become an important operator since the growth of new issues.

(vi)

Budiwalas : He/she specializes in buying and selling simultaneously in different

markets. The difference between the buying prices in other markets constitutes

his profit.

(vii)

Security Dealer : This dealer specializes in trading in government securities.

He/she many acts as a jobber and takes risks inherent in ready purchase and

sale of securities. They maintain daily contacts with the Reserve Bank of India

as well as commercial banks and other financial institutions.

(3) Opening an Account with Broker : After a broker has been selected, the investor

has to place an order on the broker. The broker will open an account n the name of the

investor in his books. He will also ask the investor for a small sum of money called

margin money advance. In case, the investor wishes to sell his securities, he will have

to deposit with the broker share certificates and transfer deeds. He will also have to

sign in the transferor’s column on the transfer deed. The physical preference of share

certificates is not required any more in India if shares have been through the ‘demat’

process.

(4) Order: Brokers receive a number of different types of buying and selling orders from

their customers. Brokerage orders very as to the price at which the order may be filled,

the time for which the order is valid, and contingencies which affect the order. The

customer’s specifications are strictly followed. The broker is responsible for getting the

best price for his customer at the time of the order is placed.

Exercising Choice of Orders : Types of orders are:

(i) Spot Delivery : Spot delivery means delivery and payment on the same day as the date of the contract or on the next day.

(5)

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(ii) Hand Delivery : Hand delivery is the transaction involving delivery and payment within the

(ii)

Hand Delivery : Hand delivery is the transaction involving delivery and payment within the time of the contract or on the date stipulated when entering into the

bargain, which time or date is usually not more than 14 days following the date of

the contract.

(iii)

Special Delivery : Special deliver is the delivery and payment exceeding 14

days.

(iv)

Market Orders : Market orders are instruction to a broker to buy or sell at the

best price immediately available. Market orders are commonly used when

trading in active stocks or when a desire to buy or sell is urgent.

(6)

Giving Margin Money to Broker : Marin is the amount of money provided by

customer to the brokers who have agreed to trade their securities. It may also be called

a

provision to absorb any probable loss when a customer bus on margin, the customer

pays only part of the margin, the broker lend the remainder.

(7)

Execution of order in the Stock Exchange : When the broker receives the margin

money and is clear about the order received by him, he puts the details n the ‘order

book’. The broker in the beginning of his career makes the deal himself. Once his

business grows, he employs clerks to transact his orders.

(8)

Preparing Contract Note in the Stock Exchange : The clerk takes the details of the

day’s transaction to the broker at the end of the working day. The broker scrutinizes all

transactions of the day and prepares a contract note and signs it on a prescribed form.

The contract note gives the details of the contract for the purchase or sale of securities.

It

records the number of shares, rate and date of purchase or sale.

(9)

Settlement of Contracts : The last step is the settlement of the contract by the broker

for his client. The procedure for settlement is to be made for (a) ready delivery

contracts and (b) for forward delivery contracts.

(i)

Ready Delivery Contracts : A ready delivery contract s to be settled within

three days in Kolkata Stock Exchange and 7 days at the Mumbai and Chennai

Stock Exchange. A read delivery contract is also called a ‘spot’ contract. The

settlement under this contract can be made on the same day or during the

maximum period of 7 days and there can be no extension or postponement of

the time of settlement.

(ii)

Forward Delivery Contracts : Forward dealings can be made n stock

exchange only n those securities which are placed on the forward list by an

exchange. Forward delivery contracts are done with the object of making profit. These forward delivery contracts are settled on a fixed settlement day occurring at fortnightly intervals. The date of transaction can be postponed.

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Q.

Write a brief note on different types of brokers.

Ans.

Broker : Stock broker means a member of a stock exchange. Trading on stock

exchanges is carried out through brokers and dealers. All members can act as brokers and

for this purpose the have to maintain security deposits. Brokers act as agents buying and

selling or other for which they receive brokerage commission at stipulated rates. Dealers act

as principals and sell securities on ther own accounts.

Types of Brokers : Types of brokers are:

(1)

Commission Broker : All brokers buy and sell securities for earning a commission.

From the investor’s point of view, he is the most important member of the exchange

because his main function and responsibility is to buy and sell stock for his customers.

He acts as an agent for his customer and earns a commission for the service

performed. He is independent dealer in securities. He purchases and sells securities

in his own name. He is not allowed to deal with the non-members. He can either deal

with a broker or another jobber.

(2)

Floor Broker : Floor brokers are not many in number. They execute orders for fellow

members and receive a share brokerage commission charged by a commission

broker to his/her constituent. He helps other brokers when they are busy and as

compensation, receives a portion of the brokerage charged by the commission agent

to his customer.

(3)

Tarniwala : He/she is a jobber or specialist in selected shares. He makes an orderly

and continuous auction in the market n the stock n which he specializes He/she makes

the market i.e. provide continuity to dealings. They specialize in stocks which are

traded inactively.

(4)

Dealer in Non-cleared Securities : He/she deals in securities that are not on the

active list.

(5) Odd-lot Dealer : He/she specializes in buying and selling in amounts that are less

than present trading units. They buy and sell odd lots, make them up into marketable

trading units. These dealers receive commission. The odd-lot dealer has become an

important operator since the growth of new issues.

(6) Budiwalas : He/she specializes in buying and selling simultaneously in different

markets. The difference between the buying prices in other markets constitutes his

profit.

(7) Security Dealer : This dealer specializes in trading in government securities. The

purchase and sale of government securities is carried on the stock exchange by

Security Dealers. He/she many acts as a jobber and takes risks inherent in ready

purchase and sale of securities. They maintain daily contacts with the Reserve Bank

of India as well as commercial banks and other financial institutions. Dealings in government securities are transacted between 12 p.m. and 3 p.m. on the Bombay Stock Exchange.

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Q. Write a note on Investment Companies. Ans. Meaning of Investment Companies : Investment companies

Q.

Write a note on Investment Companies.

Ans.

Meaning of Investment Companies : Investment companies are firms that invite

individual investors to subscribe to their capital, combine the capital thus collected into a

common pool of investible resources and then seek to accomplish the investment objectives

of the investors by investing these resources in an appropriate portfolio of securities.

Investment companies may have a number of different schemes catering to the specific

investment objectives of different classes of investors.

Portfolio Management Process in Investment Companies : Portfolio management in

investment companies is a four stage process comprising the following stages:

Identifying the objectives, and level of risk acceptable to, the target group of

investors and setting goals and objectives for the scheme so as to meet the

Stage 1 :

objectives of this target group of investors.

Stage 2 : Evaluating individual securities with respect to their risk-return characteristics.

Stage 3 : Identifying the set of efficient portfolios and selecting an optimal (with respect to

the expectations of the target group of investors) portfolio out of this set of

Stage 4 :

efficient portfolios.

Reviewing the portfolio on a continuous basis and reforming it as and when

required.

Investment Companies in India : By our definition of investment companies, we can

identify quite a large number of investment companies in India. The Investment Companies

in India are:

(1) Unit Trust of India (UTI) : The UTI was established in 1964 with the objective of

making available the benefits of industrial growth to small savers. The UT collects

investible resources from investors through the sale of securities called ‘units’. These

funds arte then invested by UTI in various financial assets. Holders of ‘units’ received

dividends from UTI. Since its inception, UTI has offered various schemes to cater to

the need of different classes of nvestors. Most of these schemes are:

(i)

Income Oriented Schemes : These funds offer a return much higher than the

bank deposits but with less capital appreciation. The emphasis being on regular

returns, the pattern of investment in general is oriented towards fixed income

yielding securities like non-convertible debentures of consistently good

dividend paying companies, etc.

Example : Income-Oriented Scheme issued by UTI:

Units Scheme of 1964

Growing Income Unit Scheme of 1987

(ii)

Growth Oriented Schemes : These funds do not offer fixed regular returns but provide substantial capital appreciation in the long run. The pattern of investment in general is oriented towards shares of high growth companies.

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Example: Growth-Oriented Scheme issued b UTI:

Master Share

Master Share Plus

Master Gain

UGS-200

(iii)

Open-Ended Scheme : In open-ended funds, there is no limit to the size of the

funds. Investors can invest as and when the like.

(iv)

Close-ended Scheme : These funds are fixed in size as regards the corpus of

the fund and the number of shares. In close-ended funds, no fresh units are

created after the original offer of the scheme, expires.

(v)

Tax Planning Schemes : The investments made under these schemes are

deductible from the taxable income up to certain limits, thus providing

substantial tax relief to the investors.

Example: Tax planning schemes issued by UTI is Unit Linked Insurance Plan of

UTI.

(2) Mutual Funds of Commercial Banks (MFS) : Since 1987, the nationalized

commercial banks like the Canara Bank, State Bank of India, Indian Bank etc. have

been floating mutual fund schemes. Over the ears, the merchant banking subsidiaries

of these banks have been offering numerous schemes catering to the investment

needs of a wide variety of investors. There are various schemes issued by

Commercial Banks such as :

(i)

Open-ended schemes

 

(ii)

Close-ended schemes

(iii)

Income-oriented Schemes : Example of Income-oriented schemes are:

Magnum Monthly Income Schemes

SBI Mutual Fund

Rising Monthly Income Schemes

BOI Mutual Fund

Swarna Pushpa

Indbank Mutual Fund

PNBRIPS

PNB Mutual Fund

(iv)

Growth Oriented Schemes : Example of Growth Schemes are:

(a)

Magnum Express, Magnum Multiplier

SBI Mutual Fund

(b)

Cabshare, Canstar Cap, Cangrowth, Canbonus

Canbank Mutual Fund.

(c)

Ind Ratna, Ind Sagar, Ind Moti

Indbank Mutual Fund

(v)

Growth and Income Funds : Example of Growth and Income Funds are:

Canstock, Can Double

PNB Premium Plus-91

Canbank Mutual Fund

PNB Mutual Fund

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(vi) Tax Planning Schemes : Example of tax planning schemes are: PNB ESS PNB Mutual

(vi) Tax Planning Schemes : Example of tax planning schemes are:

PNB ESS

PNB Mutual Fund

MELS-91

SBI Mutual Fund

Ind Shelter

Indbank Mutual Fund

(vii) Schemes targeted at small individual investors, large individual investors and

corporate investors.

(3) Life Insurance Corporation (LIC) : The premium collected by the LIC from its

insurance policy holders is administered b LIC and invested in the capital markets. LIC

has been one of the largest players in the stock market of India. Of late, it has started

floating specific investment schemes targeted at different investor’s groups, which

provide both an insurance cover and a share in the returns from the investments made

by LIC. Schemes issued by LIC are:

Tax Planning Schemes : Tax planning Scheme issued by LIC:

Schemes of LIC Mutual Fund : These offer some or all of the following

benefits:

(a)

Life Insurance Cover

(b)

Accident Insurance Cover

(c)

Safety of Capital

(d)

Reasonable Capital Appreciation

(e)

Units are not transferable, but bank loan facility is available

(f)

Tax exemption on dividends

Q.

Define Market Indices. How are stock market indices useful?

Ans.

Indices : An index is used to provide information about the price movements of

products in the financial, commodities or any other markets. Financial indices are

constructed to measure price movements of stocks, bonds, T-bills and other forms of

investments. Stock market indices are meant to capture the overall behaviour of equity

markets. A stock market index is created by selecting a group of stocks that are

representative of the whole market or a specified sector or segment of the market. An index

is calculated with reference to a base period and a base index value.

Usefulness of Stock Market Indices : Stock market indices are useful for a variety of

reasons. Some of them are:

(1)

Historical Comparison of Returns : The provide a historical comparison of returns

on money invested n the stock market against other forms of investments such as gold

or debt.

(2)

Comparison of Performance of Equity Fund : They can be used as a standard against which to compare the performance of an equity fund.

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(3)

Indicator of the Performance of the Overall Economy : It is a lead indicator of the performance of the overall economy or a sector of the economy.

(4)

Up to date Information : Stock indexes reflect highly up to date information.

(5)

Important role in Financial Investment and Risk Management : Modern financial

applications such as Index Funds, index Futures, index Options play an important role

in financial investments and risk management.

The stock market index captures the behaviour of the overall market. The ups and downs of

an index reflect the changing expectations of the stock market about future dividends of the

corporate sector. When the index goes up, it is because the stock market thinks that the

prospective returns in the future will be better than previously anticipated. When the

prospects of dividends in the future become pessimistic, the index drops. Every stock price

moves for two possible reasons :

(a)

News about the company e.g. a product launch, closure of the factory etc.

(b)

News about the country e.g. budget announcement etc.

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SECURITY ANALYSIS &INVESTMENT MANAGEMENT FINANCE : SPECIALIZATION PAPERS UNIT – III Q. Define Investment. Write

SECURITY ANALYSIS &INVESTMENT MANAGEMENT

FINANCE : SPECIALIZATION PAPERS

UNIT – III

Q. Define Investment. Write a brief note on investment avenues OR Investment Alternatives. Ans. Meaning
Q.
Define Investment. Write a brief note on investment avenues OR Investment
Alternatives.
Ans.
Meaning of Investment : Investment involves making of a sacrifice in the present with
the hope of deriving future benefits. Investment has many meanings and facets. The two
most important features of an investment are current sacrifice and future benefit.
We can now give a simple yet a broad definition of investment. We can define investment as
“postponed consumption”.
When you postpone consumption, sacrifice takes place n the present and is certain whereas
the benefits occur n future and are uncertain. Therefore, risk and expected return from the
investment are the two key determinants of investment process.
Investment Alternatives/Investment Avenues : Two basic investment avenues are:
(A)
Investment in Financial Assets
(B)
Investment in Physical Assets
Further classification of Investment can be presented with the help of following diagram
Investment Alternatives
Investment in
Investment in
Financial Assets
Physical Assets
Securitized
Non-Securitized
Gold,
Real
Investment
Investment
Silver,
Estate
Fixed Income
Preference Shares
Equity
Bond
Money Market Instruments
Government Securities
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Bank Deposit Diamond etc.

Post office Scheme

Small Saving Certificate

Mutual Funds

Others

(A)

Investment in Financial Assets : Investment in financial assets consists of:

(1)

Securitized Investment

(2)

Non-Securitized Investment

(1)

Securitized Investment : The term ‘securities’ is used in the broadest sense,

consisting of those papers that are quoted and are transferable. Securitized

investment are divided into three categories:

(a) Fixed Income Securities : In fixed income securities we include those

securities on which rate of return are fixed. Fixed income securities includes:

(i)

Preference Shares : Preference shares are a hybrid security. They have

some features of bonds and some of equity shares. Preference dividends

are specified like bonds. This has to be done because they rank prior to

equity share for dividends. Preference shares are less risky than equity

because their dividends are specified and all arrears must paid before

equity holders get dividends. They are, however, more risky than bonds

because the latter earn priority in payment and liquidation.

(ii)

Bonds : Bond contains a promise to pay a stated rate of interest for a

defined period and then to repay the principal at a given date of maturity.

(iii)

Government Securities : Government securities or gilts are sovereign

securities, which are issued by the Reserve Bank of India (RBI) on behalf

of the Government of India (GOI). The GOI uses these funds to meet its

expenditure commitments.

Dated Securities : These securities generally carry a fixed interest

rate and have a fixed maturity period.

Zero Coupon Bonds : These securities are issued at discount to

the face value and redeemed at the par i.e. they are issued at below

face value and redeemed at face value.

Partly Paid Stock : In these securities, the payment of principal is

made in installment over a given period of time.

Floating Rate Bonds : These types of securities have a variable

interest rate, which is calculated as a fixed percentage over a

benchmark rate. Capital Indexed Bonds:These securities carry an interest rate, which is calculated as a fixed percentage over the wholesale price index.

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(b) Equity : On equity shares, there is no fixed rate of dividend. First of

(b)

Equity : On equity shares, there is no fixed rate of dividend. First of all dividends are paid on preference share, after that dividend is paid on equity shares. Equity

share are more risky in comparison to bonds and preference shares.

(c)

Money Market Instruments : A money market is the market in which short-term

funds are borrowed and lent. The money market does not deal in cash or money

but in trade bills, promissory notes and government papers, which are drawn for

short periods. These short-term bills are known as near money.

Types of Money Market Instruments : The major short-term credit instruments

dealt with in a money market include:

Trade Bills : These are bills exchange arising out of bona fide commercial

transactions. They include both inland bills and foreign bills.

Banker’s Acceptance : These are bills of exchange accepted b

commercial banks on behalf of their customers. The fact that a bank of

repute accepts a bill increases its creditworthiness, which, in turn, means

that t can easily be discounted.

Short-dated Government Securities : These are securities issued by

the government for short periods. Long-term government securities that

are nearing maturity are also sometimes included in this category.

Commercial Papers : These are short-term unsecured securities issued

b highly creditworthy large companies. Commercial papers are regulated

by RBI.

Zero Coupon Bonds : These securities are issued at discount to the face

value and redeemed at the par i.e. they are issued at below face value and

redeemed at face value.

(2)

Non-Securitized Investments : In India, the household sector’s investment in non-

security forms constitutes a major proportion of its total investment in financial assets.

There are a large number of non-security forms of financial assets that are available to

investors in India. Most of the investments are illiquid but are generally accepted as

good collateral for borrowing from banks.

Bank Deposit

Post office Scheme

Small Saving Certificate

Mutual Funds

Others

(B)

Investment in Physical Assets : Another popular investment avenue is the

investment in physical assets such as

(1) Gold (2) (3) Diamonds (4) Silver Real Estate : In real estate assets we
(1) Gold
(2)
(3)
Diamonds
(4)
Silver
Real Estate : In real estate assets we include:
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Residential House

Source of Housing Finance

Features of Housing Finance

Guidelines for buying a flat

Commercial Property.

Agricultural Land.

Suburban Land

Time share in a holiday resort

Unimproved Land

Improved real Estate

New and used residential property

Vacation homes

Other Income-Producing real estate such as:

Office Buildings

Shopping Centres

Industrial or Commercial Properties.

Q.

What are the various models of valuation of fixed income securities?

Ans.

Fixed Income Securities : Fixed income securities contains a promise to pay a stated

rate of interest for a defined period and then to repay the principal at a given date of maturity.

Therefore, their primary role in an investment portfolio is to provide continuity of income

under all reasonably conceivable conditions.

Valuation of Fixed Income Securities : For the purpose of valuation we include the

following two securities:

1)

Meaning of Bond : A Bond contains a promise to pa a stated rate of interest for a defined

period and then to repay the principal at a given date of maturity.

Bond Features :

Valuation of Bond :

Maturities : Maturities vary widely. Bonds are usually grouped by their maturity

classes.

Interest Payments : Bond interest is usually paid sem-annually, though annual

payments are also popular.

Types of Bonds :

Convertible Bonds Non-Convertible Bonds Income Bonds 75
Convertible Bonds
Non-Convertible Bonds
Income Bonds
75
Redeemable Bonds Irredeemable Bonds Participating Bonds Secured Bonds Bond Valuation : Debt securities issued

Redeemable Bonds

Irredeemable Bonds

Participating Bonds

Secured Bonds

Bond Valuation : Debt securities issued by governments, government and quasi-

govrnment organizations, and private business firms are fixed income securities. Bonds and

debentures are the most common examples.

The intrinsic value of bond or debenture is equal to the present value of its expected cash

flows. The coupon interest payment, and the principal repayment are known and the

present value is determined by discounting these future payments from the issuer at an

appropriate discount rate.

Preference Shares

Formula : The usual present value calculation are made with the help of the following

equation:

 

n

C

C

PV =

————— + ————

t = 1

(1+r)t

(1+r) n

Where

PV = Present value of the security today

C

=

Coupon or interest payment pr time period‘t’

R

=

Appropriate discount rate

N

=

number of years to maturity

Example :

Consider a Rs. 1000 bond issued with a maturity of five years at par to yield 10%. Nterest s

paid annually and the bond is newly issued.

Solution:

The value of the bond would be as follows:

100

100

100

100

100

PV = ————— + ————— + ————— + —————+ —————

(1+.10)

1

(1+.10)

2

(1+.10)

3

(1+.10)

4

(1+.10)

5

= 100 x .90.91 + 100 x .8264 + 100 x .7513 + 100 x .6830 + 100 x .6209

= 90.91 + 82.6 + 75.13 + 68.30 + 682.99

= 999.97 or approx.

Estimating returns on Fixed Income Securities:

Stated (coupon) interest per year Current Yield = ———————————————————— Current market price

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Example : 15% Rs. 200 debenture is currently selling for Rs. 220, the annual current yield would be :

30

Current Yield = ————— = 13.64%

220

2) Valuation of Preference Shares :

Meaning of Preference Shares : Preference shares are a hybrid security. They have some

features of bonds and some of equity shares. Preference dividends are specified like bonds.

This has to be done because they rank prior to equity share for dividends. Preference shares

are less risky than equity because their dividends are specified and all arrears must paid

before equity holders get dividends. They are, however, more risky than bonds because the

latter earn priority in payment and liquidation.

Valuation Formula : The intrinsic value of shares will be estimated from the following

equation:

D

VP = —————

Kps

VP

=

Value of Preference Share

D

=

Dividend

Kps

=

Required rate of return

Example : What s the value of a preference share where the dividend rate is 18% on a Rs.

100 par value. The appropriate discount rate for a stock of this risk level is 15%.

Solution :

18

VP = ————— = 120

0.15

Q.

What are the various models of valuation of variable income securities?

Ans.

Variable Income Securities : Variable income securities are those on which rate of

return is not fixed. In variable income securities we include equity shares because return on

equity shares is depend on the volume of profitability after taxes. If profits are more, then

more dividend is paid on equity and vice-versa.

Equity Valuation Model : The actual models of equity valuation are:

(1) Dividend Valuation Model : A difficult problem in using the dividend valuation model

is the timing of cash flows from dividends. Since equity shares have no finite measure, the investor must forecast all future dividends. This might imply a forecast of intently long stream of dividends. Clearly, this would be almost impossible. An therefore, in

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order to manage the problem, assumptions are made with regard to the future growth of

order to manage the problem, assumptions are made with regard to the future growth

of the dividend of the immediately previous period available at the time the investor

wants to determine the intrinsic value of his/her equity shares. The assumptions can

be:

(i)

Dividends do not grow in future i.e., the constant or zero growth assumption.

(ii)

Dividends grow at a constant rate in future i.e., the constant assumption.

The dividend valuation model is now discussed with these assumptions:

(a) The Zero-growth Case : In zero-growth case, the formula will be:

 

D1

 

V

= ———

 

K

V

=

Value of Share

D

1

=

Dividend per share

K

=

Required rate of return

Example : Assume that the dividend per share is estimated to be Rs. 4.00 per year

indefinitely and the investor requires a 20% of return.

4

V = ———- = Rs. 20

0.20

(b) Constant Growth Case : When dividends grow in all future periods at a uniform rate

‘g’, the formula will be :

D1

V = —————

K-g

V

=

Value of Share

D

1

=

Dividend per share

K

=

Required rate of return

g

=

Growth Rate

Example : A ltd. Paid a dividend of Rs. 2.00 per share for the year ending March 31, 1991. A

constant growth of 10% income has been forecast for an indefinite future period. Investor’s

required rate of return has been estimated to 15%. You want to buy the share at a market

price quoted on July1, 1991 in the stock market at Rs. 60.00. What would be our decision?

Solution : This is a case of constant growth rate situation. The above equation can be used

to find out the intrinsic value of the equity share as under:

D1 2(1.10) 2.20 V = ———- = ——————— = ————— = Rs. 44.00 K-g 0.15-0.10
D1
2(1.10)
2.20
V = ———- = ——————— = ————— = Rs. 44.00
K-g
0.15-0.10
0.05
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SECURITY ANALYSIS & INVESTMENT MANAGEMENT

The intrinsic value of Rs. 44 is less than the market price of Rs. 60.00. Hence, the share is overvalued and you should not buy.

(2)

Models Based on Price Ratio Analysis : According to this method, the price of an

equit share is calculated by the following formula:

P = EPS X P/E ratio

The P/E ratio is an important ratio frequently used by analyst in determining the value of an

equity share. It is frequently reported in the financial press and widely quoted in the

investment community.

This approach seems quite straight and simple. There are, however important problems

with respect calculation of both P/E ratio and EPS. Pertinent question often asked are:

(i)

How to calculate the P/E ratio?

(ii)

What is the normal P/E ratio?

(iii)

What determines P/E ratio?

(iv)

How to relate company P/E?

Decision Rule :

(i)

Higher the P/E ratio, other things remaining the same, higher would be the value of an

equity share.

(ii)

Lower the P/E ratio, other things remaining the same, lower would be the value of an

equity share.

Q.

Explain the Risk-Return Trade-Off.

OR

Q.

Explain the Risk-Return Relationship in Investment Decision.

Ans.

Meaning of Risk : Risk can be defined as the probability that the expected return from

the security will not materialize. Every investment involves uncertainties that make future

investment returns risk-prone. Uncertainties could be due to the political, economic and

industry factors.

Meaning of Return : Return is the amount or rate of produce, proceeds, profits which

accrues to an economic agent from an undertaking or investment. It is a reward for and a

motivating force behind investment, the objective of which is usually to maximize return.

Risk-Return Relationship : The objective of maximizing return can be pursued only at the

cost of incurring higher risk. The financial markets offer a wide range of assets from very safe

to very risky. While selecting the asset for investment, the investor has to consider both its

return potential and the risk involved. The empirical evidence shows that generally there is a high correlation between risk and return over longer periods of time. The securities are generally priced such that high risk is rewarded with high return, and low risk is accompanied by a corresponding low return. This relationship is known as risk-return trade-off.

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The risk and return are directly variable, i.e., an investment with higher risk should produce

The risk and return are directly variable, i.e., an investment with higher risk should produce higher return.

Low levels of uncertainty (low risk) are associated with low potential returns. High levels of

uncertainty (high risk) are associated with high potential returns. The risk-return trade-of is

the balance between the desire for the lowest possible risk and the highest possible return.

Graphic Presentation of Risk-Return Relationship : The figure below represents the

relationship between risk and return.

High Risk Average Low Risk Risk Return
High Risk
Average
Low Risk
Risk
Return

M

Degree of Risk

The slope of market line indicates the return per unit of risk required by all investors. Highly

risk-averse investors would have a steeper line, and vice-versa.

Risk-Return Relationship of Different Stocks :

Ordinary Shares Preference Shares Subordinate loan stock Unsecured loan Debenture with floating charge Mortgage loan
Ordinary Shares
Preference Shares
Subordinate loan stock
Unsecured loan
Debenture with floating charge
Mortgage loan
Government Stock (risk-free)
0
Degree of Risk
Rate of Return
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The risk-return trade-off tells us that the higher risk gives us the possibility of higher returns. But there are no guarantees. Just as risk means higher potential returns, it also means

higher potential losses.

Q.

Explain Government Securities (G-secs).

OR

Q.

Ans.

sovereign securities, which are issued by the Reserve Bank of India (RBI) on behalf of the

Meaning of Government Securities (G-secs) : Government securities or gilts are

Explain Gilts.

Government of India (GOI). The GOI uses these funds to meet its expenditure

commitments.

Types of Government Securities :

1)

Dated Securities : These securities generally carry a fixed interest rate and have a

fixed maturity period.

For example an 11.40% GOI 2010 G-sec. In this case, 11.40 is the interest rate and it is

maturing in the year 2010.

Features of Dated Securities : The salient features of dated securities are:

 

(i)

These are issued at the face value.

(ii)

The rate of interest and tenure of the security is fixed at the time of issuance and

 

does not change till maturity.

 

(iii)

The interest payment is made on half yearly rest.

(iv)

On maturity the security is redeemed at face value.

2)

Zero Coupon Bonds : These securities are issued at discount to the face value and

redeemed at the par i.e. they are issued at below face value and redeemed at face

value.

Features of Zero Coupon Bonds : The salient features of zero coupon bonds are:

The tenure of these securities is fixed.

No interest is paid on these securities.

3)

Partly Paid Stock : In these securities, the payment of principal is made in installment

over a given period of time.

Features of Partly Paid Stock : The salient features of partly paid stock are:

(i)

These types of securities are issued at face value and the principal amount is

paid in installment over a period of time.

(ii)

The rate of interest and tenure of the security is fixed at the time of issuance and

does not change till maturity.

(iii)

The interest payment is made on half yearly rest.

(iv)

These are redeemed at par on maturity.

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4) Floating Rate Bonds : These types of securities have a variable interest rate, which

4)

Floating Rate Bonds : These types of securities have a variable interest rate, which is calculated as a fixed percentage over a benchmark rate.

Features of Floating Rate Bonds : The salient features of floating rate bonds are:

(i)

These are issued at the face value.

(ii)

The interest rate is fixed as a percentage over a predefined benchmark rate. The

 

benchmark rate may be a bank rate, Treasury bill rate etc.

 

(iii)

The interest payment is made on half yearly rests.

(iv)

The security is redeemed at par on maturity, which is fixed.

5)

Capital Indexed Bonds : These securities carry an interest rate, which is calculated

as a fixed percentage over the wholesale price index.

Features of Capital Indexed Bonds : The salient features of capital indexed bonds

are:

These securities are issued at face value.

The interest rate changes according to the change in the wholesale price index,

as the interest rate is fixed as a percentage over the wholesale price index.

The maturity of these securities is fixed and the interest is payable on half yearly

rates.

The principal redemption is linked to the wholesale price index.

Invest in Government Securities : Entities registered in India including:

(i)

Banks

(ii)

Financial Institutions

(iii)

Primary Dealers

(iv)

Partnership firms

(v)

Mutual Funds

(vi)

Foreign Institutional Investors

(vii)

State Governments

(viii)

Provident funds

(ix)

Trusts

(x)

Research Organizations

(xi)

Nepal Rashtra Bank

And Individuals can invest in government securities.

Advantages of Investing in Government Securities :

(1)

Minimal Default Risk : The main advantage of investing in G-secs is that there is a minimal default risk, as the instrument is issued b the GOI.

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(2)

Long-term Debt : G-secs especially dated securities, offer investors the opportunity to invest in very long-term debt (at times with maturity over 20 years), which is usually

not available from the private sector.

(3)

Liquidity : Although some issues of G-secs tend to be illiquid, there is adequate

liquidity in most other issues.

Disadvantages of Investing in Government Securities : The main disadvantage of

investing in G-sec is the same as in the case