MF0001 – Security Analysis and Portfolio Management

(Book ID: B1035)

Assignment Set- 1 (30 Marks)

Note: Each question carries 10 Marks. Answer all the questions.

Question 1. What is portfolio management style? Why this is necessary for an investor
while setting his/her investment policy?

Answer:
It is rare to find investors investing their entire savings in a single security. Instead, they tend to
invest in a group of securities. Such a group of securities is called a portfolio. Most financial
experts stress that the in order to minimize risk, an investor should hold a well-balanced
investment portfolio. The investment process describes how an investor must go about
making decision with regard to what securities to invest in while constructing a portfolio, how
extensive the investment should be, and when the investment should be made. This is a
procedure involving the following five steps:

• Set investment policy

• Perform security analysis
• Construct a portfolio
• Revise the portfolio
• Evaluate the performance of portfolio

While setting the investment policy, for an investor it is necessary to select one of the
portfolio management styles i.e active or passive because it plays an important role in
achieving financial goals. the various styles are defined below:

Active Management is the process of managing investment portfolios by attempting to time

the market and/or select ‘undervalued ‘ stock to buy and ‘overvalued’ stock to sell based upon
research, investigation and analysis.

Active asset management is based on a belief that a specific style of management or analysis
can produce returns that beat the market. It seeks to take advantage of inefficiencies in the
market and is typically accompanied by higher than average costs (for analysts and managers
who must spend time to seek out these inefficiencies).

For those who favor an active management approach, stock selection is typically based on
one of two styles:

• Top-down - Managers who use this approach start by looking at the market as a whole,
then determine which industries and sectors are likely to do well given the current
economic cycle. Once these choices are made, they then select specific stocks based
on which companies are likely to do best within a particular industry.

• Bottom-up - This approach ignores market conditions and expected trends. Instead,
companies are evaluated based on the strength of their financial statements, product
pipeline, or some other criteria. The idea is that strong companies are likely to do well
no matter what market or economic conditions prevail.
Passive Management is the process of managing investment portfolios by trying to match the
performance of index or asset class of securities as closely asses possible by holding all or a
representative sample of securities in the index or asset class. This portfolio management
style does not use market timing or stock selection strategies.
Passive asset management is based on the concept that markets are efficient, that market
returns cannot be surpassed regularly over time, and that low cost investments held for the
long term will provide the best returns.
Passive management concepts to know include the following:

• Efficient market theory - This theory is based on the idea that information that affects
the markets (such as changes to company management, Fed interest rate
announcements, etc.) is instantly available and processed by all investors. As a
result, this information is always taken into account in market prices. Those who
believe in this theory believe there is no way to consistently beat market averages.

• Indexing - One way to take advantage of the efficient market theory is to use index
funds (or to create a portfolio that mimics a particular index). Since index funds tend to
have lower than average transaction costs and expense ratios, they can provide an
edge over actively managed funds which tend to have higher costs.
Question 2. Select any 5 investment avenues of your choice. Explain their risk,
return, tax benefits, marketability, liquidity, safety features.

Answer:

Different investment avenues are available to investors. Mutual funds also offer good
investment opportunities to the investors.

Like all investments, they also carry certain risks. The investors should compare the
risks and expected yields after adjustment of tax on various instruments while taking
investment decisions. The investors may seek advice from experts and consultants
including agents and distributors of mutual funds schemes while making investment
decisions.

There are a large number of investment instruments available today.

To make our lives easier we would classify or group them under 4 main types of
investment avenues. We shall name and briefly describe them.

1. Financial securities: These investment instruments are freely tradable and

negotiable. These would include equity shares, preference shares, convertible
debentures, non-convertible debentures, public sector bonds, savings certificates,
gilt-edged securities and money market securities
.
2. Non-securitized financial securities: These investment instruments are not
tradable, transferable nor negotiable. And would include bank deposits, post office
deposits, company fixed deposits, provident fund schemes, national savings
schemes and life insurance.

3. Mutual fund schemes: If an investor does not directly want to invest in the
markets, he/she could buy units/shares in a mutual fund scheme. These schemes
are mainly growth (or equity) oriented, income (or debt) oriented or balanced (i.e.
both growth and debt) schemes.

4. Real assets: Real assets are physical investments, which would include real
estate, gold & silver, precious stones, rare coins & stamps and art objects.

Before choosing the avenue for investment the investor would probably want to
evaluate and compare them. This would also help him in creating a well diversified
portfolio, which is both maintainable and manageable.

Certain features characterize all investments. The following are the main
characteristic features if investments:

1. Return:
All investments are characterized by the expectation of a return. In fact,
investments are made with the primary objective of deriving a return. The return
may be received in the form of yield plus capital appreciation. The difference
between the sale price & the purchase price is capital appreciation. The dividend or
 interest received from the investment is the yield. Different types of investments
promise different rates of return. The return from an investment depends upon the
nature of investment, the maturity period & a host of other factors.

2. Risk:
Risk is inherent in any investment. The risk may relate to loss of capital, delay in
repayment of capital, nonpayment of interest, or variability of returns. While some
investments like government securities & bank deposits are almost risk less, others
are more risky. The risk of an investment depends on the following factors.

The longer the maturity period, the longer is the risk.

The lower the credit worthiness of the borrower, the higher is the risk.

The risk varies with the nature of investment. Investments in ownership securities
like equity share carry higher risk compared to investments in debt instrument like
debentures & bonds.

3. Safety:
The safety of an investment implies the certainty of return of capital without loss of
money or time. Safety is another features which an investors desire for his
investments. Every investor expects to get back his capital on maturity without loss
& without delay.

4. Liquidity:
An investment, which is easily saleable, or marketable without loss of money & without
loss of time is said to possess liquidity. Some investments like company deposits, bank
deposits, P.O. deposits, NSC, NSS etc. are not marketable. Some investment instrument
like preference shares & debentures are marketable, but there are no buyers in many
cases & hence their liquidity is negligible. Equity shares of companies listed on stock
exchanges are easily marketable through the stock exchanges.

An investor generally prefers liquidity for his investment, safety of his funds, a good
return with minimum risk or minimization of risk & maximization of return.
Question 3. Explain the following terms with diagrams:
a. Moving Average convergence Divergence (MACD)
b. Stochastic Oscillator

Answer:

Moving Average Convergence Divergence (MACD)

MACD is a momentum indicator and it is made up of two exponential moving averages. The
MACD plots the difference between a 26-day exponential moving average and a 12-day
exponential moving average. A 9-day moving average is generally used as a trigger line.
When the MACD crosses this trigger and goes down it is a bearish signal and when it crosses
it to go above it, it’s bullish signal. This indicator measures short-term momentum as
compared to longer term momentum and signals the current direction of momentum. Traders
use the MACD for indicting trend reversals.

Developed by Gerald Appel in the late seventies, Moving Average Convergence-Divergence

(MACD) is one of the simplest and most effective momentum indicators available. MACD turns
two trend-following indicators, moving averages, into a momentum oscillator by subtracting
the longer moving average from the shorter moving average. As a result, MACD offers the
best of both worlds: trend following and momentum. MACD fluctuates above and below the
zero line as the moving averages converge, cross and diverge. Traders can look for signal line
crossovers, centerline crossovers and divergences to generate signals. Because MACD is
unbounded, it is not particular useful for identifying overbought and oversold levels.

Calculation
MACD: (12-day EMA - 26-day EMA)
Signal Line: 9-day EMA of MACD
MACD Histogram: MACD - Signal Line
Standard MACD is the 12-day Exponential Moving Average (EMA) less the 26-day EMA.
Closing prices are used to form the moving averages so MACD is based on closing prices. A
9-day EMA of MACD is plotted along side to act as a signal line to identify turns in the
indicator. The MACD-Histogram represents the difference between MACD and its 9-day EMA,
the signal line. The histogram is positive when MACD is above its 9-day EMA and negative
when MACD is below its 9-day EMA.

Interpretation:
As its name implies, MACD is all about the convergence and divergence of the two moving
averages. Convergence occurs when the moving averages move towards each other.
Divergence occurs when the moving averages move away from each other. The shorter
moving average (12-day) is faster and responsible for most of the MACD movement. The
longer moving average (26-day) is slower and less reactive to price changes in the underlying
security.

Positive MACD indicates that the 12-day EMA is above the 26-day EMA. Positive values
increase as the shorter EMA trades further above the longer EMA. This means upside
momentum is increasing. Negative MACD indicates that the 12-day EMA is below the 26-day
EMA. Negative values increase as the shorter EMA trades further below the longer EMA. This
means downside momentum is increasing. There are times when MACD crosses the zero
line, which is also known as the centerline. This signals that the 12-day EMA has crossed the
26-day EMA. The direction of the centerline cross, of course, depends on direction of the
moving average cross.
In the example above, the yellow area shows MACD in negative territory as the 12-day EMA
trades below the 26-day EMA. The initial cross occurred at the end of September (black arrow)
and MACD moved further into negative territory as the 12-day EMA diverged further from the
26-day EMA. The orange area highlights a period of positive MACD, which is when the 12-day
EMA was above the 26-day EMA. Notice that the 12-day EMA remained below 1 during this
period (red dotted line). This means the distance between the 12-day EMA and 26-day EMA
was less than 1 point, which is not a big difference.

Signal Line Crossovers:

Signal line crossovers are the most common MACD signals. The signal line is a 9-day EMA of
MACD. As a moving average of the indicator, it trails MACD and makes it easier to spot turns
in MACD. A bullish crossover occurs when MACD turns up and crosses above the signal line.
A bearish crossover occurs when MACD turns down and crosses below the signal line.
Crossovers can last a few days or a few weeks, it all depends on the strength of the move that
causes the crossover.
Signal crossovers are quite common. As such, due diligence is required before relying on
these signals. Signal line crossovers at positive or negative extremes should be viewed with
caution. Even though MACD is an unbounded oscillator, chartists can estimate historical
extremes with a simple visual assessment of the indicator. It takes a strong move in the
underlying security to push momentum to an extreme. Even though the move may continue,
momentum is likely to slow and this will usually produce a signal line crossover at the
extremities. Volatility in the underlying security can also increase the number of crossovers.

Chart 2 shows IBM with its 12-day EMA (green), 26-day EMA (red) and MACD (12,26,9) in the
indicator window. There were eight signal line crossovers in six months: four up and four
down. There were some good signals and some bad signals. The yellow area highlights a
period when MACD surged above 2 to reach a positive extreme. There were two bearish
signal line crossovers in April and May, but IBM continued trending higher. Even though
upward momentum slowed after the surge, upward momentum was still stronger than
downside momentum in April and May. The third bearish signal line crossover in May resulted
in a good signal.

Centerline Crossovers:

Centerline crossovers are the next most common MACD signals. A bullish centerline
crossover occurs when MACD moves above the zero line to turn positive. This happens when
the 12-day EMA of the underlying security moves above the 26-day EMA. A bearish centerline
crossover occurs when MACD moves below the zero line to turn negative. This happens when
the 12-day EMA moves below the 26-day EMA.

Centerline crossovers can last a few days or a few months. It all depends on the strength of
the trend. MACD will remain positive as long as there is a sustained uptrend. MACD will
remain negative when there is a sustained downtrend. Chart 3 shows Pulte Homes (PHM)
with at least four centerline crosses in a nine month period. The post-crossover moves were
quite strong so the resulting signals worked well.
Chart 4 shows Cummins Inc (CMI) with seven centerline crossovers in five months. Taking
these signals would have resulted in numerous whipsaws.
Chart 5 shows 3M (MMM) with a bullish centerline crossover in late March 2009 and a bearish
centerline crossover in early February 2010. This signal lasted 10 months. In other words, the
12-day EMA was above the 26-day EMA for 10 months. This was one strong trend.

Divergences:

Divergences form when MACD diverges from the price action of the underlying security. A
bullish divergence forms when a security records a lower low and MACD forms a higher low.
The low lower in the security affirms the current downtrend, but the higher low in MACD shows
less downside momentum. The slowing of the downtrend sometimes foreshadows a trend
reversal or a sizable rally. Chart 6 shows Google (GOOG) with a bullish divergence in
October-November 2008. First, notice that I am using closing prices to identify the divergence.
The MACD moving averages are based on closing prices and we should consider closing
prices in the security as well. Second, notice that there were clear reaction lows in October as
Google bounced for a few weeks and MACD moved above its signal line. Third, notice that
MACD formed a higher high as Google formed a lower low in November.
A bearish divergence forms when a security records a higher high and MACD forms a lower
high. The higher high in the security is normal for an uptrend, but the lower high in MACD
shows less upside momentum. Waning upward momentum can sometimes foreshadow a
trend reversal or sizable decline. Chart 7 shows Gamestop (GME) with a large bearish
divergence from August to October. The stock forged a higher high above 38, but MACD fell
short of its prior high and formed a lower high. The subsequent signal line crossover and
support break in MACD were bearish. Notice how broken support in the stock turned into
resistance and on the throwback in November.
Divergences should be taken with caution. Bearish divergences are commonplace in a strong
uptrend, while bullish divergences occur often in a strong downtrend. Yes, you read right.
Uptrends often start with a strong advance that produces a surge in upside momentum
(MACD). Even though the uptrend continues, it continues at a slower pace and this causes
MACD to decline from its highs. The opposite occurs at the beginning of a strong downtrend.
Chart 8 shows the S&P 500 ETF (SPY) with four bearish divergences from August to
November 2009. Despite waning upside momentum, the ETF continued higher because the
uptrend was strong. Remember, upside momentum is stronger than downside momentum as
long as MACD is positive. MACD may have been less positive as the advance extended, but it
was still largely positive.
Conclusions:
MACD is special because it brings together momentum and trend in one indicator. This means
MACD will never be far removed from price action. MACD's unique blend of trend and
momentum can be applied to daily, weekly or monthly charts. The standard setting for MACD
is the difference between the 12 and 26-period EMAs. Chartists looking for more sensitivity
may try (5,35,5). Chartists looking for less sensitivity may consider (20,50,10). A less sensitive
MACD will still oscillate above/below zero, but the centerline crossovers and signal line
crossovers will be less frequent.

MACD is not particularly good for identifying overbought and oversold levels. Even though it is
possible to identify levels that historically represent overbought and oversold, MACD does not
have any upper or lower limits to bind its movement. MACD can continue to overextend
beyond historical extremes.

MACD calculates the absolute difference between two moving averages and not the
percentage difference. A $20 stock may have a MACD range of -1.5 to 1.5, while a $100 stock
may have a MACD range from -10 to +10. It is not possible to compare MACD for securities
that vary in price. An alternative is to use the Percentage Price Oscillator (PPO), which shows
the percentage difference between two moving averages.

Stochastic Oscillator

The stochastic Oscillator is one of the most recognized momentum indicators. This indicator
provides information about the location of a current closing price in relation to the period’s high
and low prices. The closer the closing price is to the period’s high, the higher is the buying
pressure, and the closer the closing price is to the period’s low, the move is the selling
pressure. The idea behind this indicator is that in an uptrend, the price should be closing near
the highs of the trading range, signaling upward momentum in the security. In downtrends, the
price should be closing near the lows of the trading range, signaling downward momentum.
The stochastic oscillator is plotted within a range of zero and 100 and signals overbought
conditions above 80 and oversold conditions below 20.

Stochastic Oscillator (Fast, Slow, and Full)

Introduction
Developed by George C. Lane in the late 1950s, the Stochastic Oscillator is a momentum
indicator that shows the location of the current close relative to the high/low range over a set
number of periods. Closing levels that are consistently near the top of the range indicate
accumulation (buying pressure) and those near the bottom of the range indicate distribution
(selling pressure).

CALCULATION:
A 14-day %K (14-period Stochastic Oscillator) would use the most recent close, the highest
high over the last 14 days and the lowest low over the last 14 days. The number of periods will
vary according to the sensitivity and the type of signals desired. As with RSI, 14 is a popular
number of periods for calculation.

%K tells us that the close (115.38) was in the 57th percentile of the high/low range, or just
above the mid-point. Because %K is a percentage or ratio, it will fluctuate between 0 and 100.
A 3-day simple moving average of %K is usually plotted alongside to act as a signal or trigger
line, called %D.

Slow versus Fast versus Full

There are three types of Stochastic Oscillators: Fast, Slow, and Full. The Full Stochastic is
discussed later. For now, let's look at Fast versus Slow. As shown above, the Fast Stochastic
Oscillator is made up of %K and %D. In order to avoid confusion between the two, I'll use %K
(fast) and %D (fast) to refer to those used in the Fast Stochastic Oscillator, and %K (slow) and
%D (slow) to refer to those used in the Slow Stochastic Oscillator. The driving force behind
both Stochastic Oscillators is %K (fast), which is found using the formula provided above.
In the CSCO example, the Fast Stochastic Oscillator is plotted in the box just below the
price plot. The thick black line represents %K (fast) and the thin red line represents %D (fast).
Also called the trigger line, %D (fast) is a smoothed version of %K (fast). One method of
smoothing data is to apply a moving average. To smooth %K (fast) and create %D (fast), a
3-period simple moving average was applied to %K (fast). Notice how the %K (fast) line
pierces the %D (fast) line a number of times during May, June and July. To alleviate some of
these false breaks and smooth %K (fast), the Slow Stochastic Oscillator was developed.

The Slow Stochastic Oscillator is plotted in the lower box: the thick black line represents %K
(slow) and the thin red line represents %D (slow). To find %K (slow) in the Slow Stochastic
Oscillator, a 3-day SMA was applied to %K (fast). This 3-day SMA slowed (or smoothed) the
data to form a slower version of %K (fast). A close examination would reveal that %D (Fast),
the thin red line in the Fast Stochastic Oscillator, is identical to %K (Slow), the thick black line
in the Slow Stochastic Oscillator. To form the trigger line, or %D (slow) in the Slow Stochastic
Oscillator, a 3-day SMA was applied to %K (Slow).

The Full Stochastic Oscillator takes three parameters. Just as in the Fast and Slow versions,
the first parameter is the number of periods used to create the initial %K line and the last
parameter is the number of periods used to create the %D (full) signal line. What's new is the
additional parameter, the one in the middle. It is a "smoothing factor" for the initial %K line. The
%K (full) line that gets plotted is a n-period SMA of the initial %K line (where n is equal to the
middle parameter).

The Full Stochastic Oscillator is more advanced and more flexible than it's Fast and Slow
cousins. You can even use it to duplicate the other versions. For example, a (14, 3) Fast
Stochastic is equivalent to a (14, 1, 3) Full Stochastic and a (12, 2) Slow Stochastic is equal to
a (12, 3, 2) Full Stochastic.
%K and %D Recap
• %K (fast) = %K formula presented above using x periods
• %D (fast) = y-day SMA of %K (fast)
• %K (slow) = 3-day SMA of %K (fast)
• %D (slow) = y-day SMA of %K (slow)
• %K (full) = y-day SMA of %K (fast)
• %D (full) = z-day SMA of %K (full)

Where x is the first parameter, y is the second parameter and (in the case of Full stochastics),
z is the third parameter. In the case of Fast and Slow Stochastics, x is typically 14 and y is
usually set to 3.

Use
Readings below 20 are considered oversold and readings above 80 are considered
overbought. However, Lane did not believe that a reading above 80 was necessarily bearish
or a reading below 20 bullish. A security can continue to rise after the Stochastic Oscillator has
reached 80 and continue to fall after the Stochastic Oscillator has reached 20. Lane believed
that some of the best signals occurred when the oscillator moved from overbought territory
back below 80 and from oversold territory back above 20.

Buy and sell signals can also be given when %K crosses above or below %D. However,
crossover signals are quite frequent and can result in a lot of whipsaws.

One of the most reliable signals is to wait for a divergence to develop from overbought or
oversold levels. Once the oscillator reaches overbought levels, wait for a negative divergence
to develop and then a cross below 80. This usually requires a double dip below 80 and the
second dip results in the sell signal. For a buy signal, wait for a positive divergence to develop
after the indicator moves below 20. This will usually require a trader to disregard the first break
above 20. After the positive divergence forms, the second break above 20 confirms the
divergence and a buy signal is given.

Example
In the IBM example above, it is clear that acting solely on overbought and oversold
crossovers can generate false signals. Using crossovers of %D (slow) by %K (slow) can result
in some good signals, but there are still whipsaws. By looking for divergences and
overbought/oversold crossovers together, the 14-day Slow Stochastic Oscillator can produce
fewer yet more reliable signals. The Slow Stochastic Oscillator produced 2 solid signals in IBM
between Aug-99 and Mar-00. In Nov-99, a buy signal was given when the indicator formed a
positive divergence and moved above 20 for the second time. Note that the double top in
Nov-Dec (gray circle) was not a negative divergence – the stock continued higher after this
formed. In Jan-00, a sell signal was given when a negative divergence formed and the
indicator dipped below 80 for the second time.