Security Analysis & Portfolio Management

Semester IV

Q.1. Explain the various investment avenues available for an investor in India?
Ans.1 Investment:

When you deposit a part of your savings in a fixed deposit account in a bank or apart of your salary in
your provident fund account, you are making an investment.

As you can see in the above examples, you are sacrificing current consumption or use for receiving
benefits in the future.

This can be depicted in a pictorial form as follows:

B X(1+r)

C (x-y) (1+r)

O X
If the rate of return you receive on your investment is r per annum and you have Rs. X with you today,
you have several alternatives. You can either spend all the money in the current period (represented
by point A) or invest the entire amount for using it after one year (represented by point B). in the
second case you will have an amount x(1+r) for consumption after one year where x.r. represents the
return on your investment for one year. You can also have several other combinations of present and
future consumption e.g. point C represented by a present consumption of Y and (x-y) (1+r) available
for next year.

The important characteristics of an investment are:

Long term Horizon, Limited risk, Return commensurate with risk, Modest return, Careful evaluation.

Investment Alternatives: The avenues can be broadly classified into Financial Assets and Real
Assets.
Real Assets may be in the form of Real Estate, Gold and Silver and precious objects. Art objects like
paintings and sculptures are also avenues in this category.

Financial Assets can be further classified into marketable Financial Assets and Non-Marketable
Financial Assets.
Investment

Financial Assets Real Assets

Non-Marketable Marketable
Financial Assets Financial Assets

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Some examples of non-marketable financial assets are bank deposits, post office deposits and
provident fund deposits.

Marketable financial assets may be in the form of Equity Shares, Bond and money market
instruments.

Investing in Mutual funds enable you participate in the equity market indirectly. Mutual funds pool the
investments from a number of retail investors and invest in equity shares are fixed income securities.

Life Insurance Policies, though primarily sere the purpose of insuring an individual’s life, can also be
used as an investment avenue. Life Insurance Companies offer different types of schemes like Money
Back Policy, Endowment Policy, Children Educational Policy.

Brief discussion on Investment Avenues:-

(A) Non-marketable financial Assets:

The important non-marketable financial assets held by investors are:
• Bank Deposits: These are convenient and very popular with investors. The interest
rates on bank deposits have fallen over the years. At present the rates are around 6%
for periods more than one year. The Deposit Insurance and Credit Guarantee
Corporation (DICGC) provides a guarantee on deposits up to Rs.1,00,000 per
depositor of a bank. Interest earned on bank deposits qualify for section 80L benefits
up to a limit of Rs. 12,000 for a financial year. Many banks now offer the facility of
transferring the balances above a specified limit in the savings account to the fixed
deposit account. Banks also offer cheque facility for fixed deposit accounts making it
convenient to withdraw money from fixed deposits when there is a need.
• Post office monthly Income scheme: Post office monthly income scheme ( Post
Office MIS) has a six year tenure and the rate of return is 8% payable monthly. In
addition, the investor also gets a bonus of 10% of principal at the completion of the
term. Interest earned qualifies for the benefit under section 80L. investors could either
collect the monthly interest or transfer it to a saving or recurring account in the same
post office.
• Public Provident Fund (PPF): Public Provident Fund (PPF) is a good retirement
planning instrument as well as a good tax saving vehicle. It is a 15 year instrument and
carries an interest rate of 8%. The interest rates can be reset at a lower rate depending
on the prevailing interest rates in the market. The principal along with the interest
earned is payable at the end of the term. A minimum contribution of Rs. 500 is to be
made every year. From the seventh year onwards, partial withdrawal facility is
available. Loans can be taken from the third year onwards. After completion of the 15
year term, the tenure can be extended in blocks of five years.
• National Saving Certificate: National Saving Certificate (NSC) has a tenure of six
years and the amount paid on maturity includes the principal amount invested and the
interest earned over the years. The interest earned qualifies for tax benefit under
section 80L up to an overall limit of Rs. 12,000. The unique feature of this instrument is
that the interest accrued each year up to the end of the fifth year is deemed to be
reinvested in the scheme.
• Company Fixed Deposits: The terms of company fixed deposits varies and normally
for one, two or three years. The interest rates on these deposits are higher than that of
bank fixed deposits but it carries a higher risk. For interest income up to Rs. 5,000 in a
financial year, no income tax is deducted at source. There is no benefit under section

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80L for interest earned. Credit rating agencies assign ratings for these and the interest
rates offered vary based on the rating.

• Kisan Vikas Patra: The investment in this instrument doubles on completion of the
term. At present the term us eight years and seven months which translates into a
compounded annual return of 8.4%. There are no tax benefits available on the amount
invested as well as interest earned.

(B) Money Market Instruments:

Debt instruments which have a maturity of less than one year at the time of issue are called
Money Market Instruments. These instruments are highly liquid and have negligible risk. The
government, financial institutions, banks and corporates dominate the money market. Individual
investors do not participate in the money market directly.
• Treasury bills: These are the most important money market instruments. They represent
the obligations of the government of India, which have a primary tenor like 91 days and
364 days. Reserve Bank of India sells these on an auction basis. They are sold at a
discount and redeemed at par. These bills can be transacted readily and there is a very
active secondary market for them.
• Certificates of Deposits: These are short-term deposits, which are transferable from one
party to another. Banks and financial institutions are the major issuers of CDs. CDs are
issued in either bearer or registered form. They generally have a maturity of 3 months to 1
year. CDs are issued at a discount and redeemed at par. They are popular form of short-
term investment for companies due to the flexibility in terms of denominations and
maturities and the risk free nature of these investments. Also they offer a higher rate of
interest than Treasury Bills or term deposits.
• Commercial Paper: These represents short-term unsecured promissory note issued by
firms that are generally considered to be financially strong. A commercial paper usually has
a maturity period of 90 to 180 days. It is sold at a discount and redeemed at par.
• Repos: The term Repo is used as an abbreviation for repurchase agreement or ready
forward. A Repo involves a simultaneous ‘ sale and repurchase’ agreement. Repos are a
very convenient instrument for short-term investment. They are safe and earn a pre-
determined return.
• Government Securities: Debt securities issued by the central government, state
government and quasi government agencies are referred to as government securities or
gilt edged securities. Banks, financial institutions, insurance companies and provident
funds mainly because of certain statutory compulsions typically hold these.
• Government of India Bonds: These bonds particularly the 6.5% tax free bonds are
popular with high networth individuals. The 6.5% tax free bonds which can be redeemed
after five years, offer liquidity to investors as there is a provision for premature encashment
after three years. These bonds cannot be transferred except by way of gilft and are not
tradable in the secondary market. The 8% taxable savings bonds are not liquid as these
can be redeemed only after six years.
• Private Sector Debentures: These are instruments used for raising long term debt. The
obligation of the company towards its debenture holders is to pay interest and principal at
specified periods. When a debenture is sold to the investing public, a trustee (usually a
bank or a financial institution) is appointed through a deed. They are responsible for
ensuring that the borrowing firm fulfills its contractual obligations. Typically, debentures are
secured by a charge on the immovable properties, both present and future, of the company
by way of an equitable mortgage. Debenture issues with a maturity period of more than 18
months have to be credit rated and a debenture redemption reserve has to be created for a

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value equivalent to atleast 50percent of the amount of issue before redemption
commences.
• Public Sector Undertaking Bonds (PSU): PSU Bonds are issued by public sector
undertakings in two varieties : taxable bonds and tax-free bonds. They generally have the
following features : (i) there is no deduction of tax at source on the interest paid on these
bonds (ii) they are transferable by endorsement and delivery, (iii) there is no stamp duty
applicable on transfer, and (iv) they are traded on the stock exchanges.
• Preference Shares: These represent a hybrid form of security that has some
characteristics of equity shares and some characteristics of debentures. The salient
features of preference shares are : (a) they carry a fixed rate of dividend. (b) Preference
dividend is payable only out of distributable profits. (c) Preference dividend is generally
cumulative. (d) Preference shares are redeemable and the redemption period is usually 7
to 12 years.
• Equity Shares : Investment in equity shares provides investors the possibility of higher
returns at a greater risk. The potential rewards and penalties associated with equity shares
make them an interesting and exciting propositions.
• Mutual Funds: Mutual Funds is a mechanism for pooling the resources by issuing units to
the investors and investing funds in securities in accordance with objectives as disclosed in
offer document. Investments in securities are spread across a wide cross section of
industries and sectors and thus the risk is reduced. Mutual fund issues units to the
investors in accordance with the quantum of money invested by them. Investors of mutual
funds are known as unit holders.

Q.6 What are the different types of ratios you would use while analyzing the financial
statements of a company? Give examples of each of these types.

Ans.6 Financial ratio analysis is one of the important tools used for analyzing financial statements.

Based on the specific characteristics, ratio are categorized into:

a. Liquidity Ratios
b. Leverage Ratios
c. Turnover Ratios
d. Profitability Ratios
e. Valuation Ratios

a. Liquidity Ratios: Liquidity Ratios tell us about the ability of a firm to meet its short term financial
obligations. These ratios are based on the relationship between current assets which provide the
sources for meeting the short term obligations and current liabilities which are obligations to be
met within one year.

Current Ratio: Current ratio is defined as the ration between current assets and current Liabilities.
For example:
Current Asset (assumed) = 299
Current Libility (assumed) = 102
Current ratio = Current Asset/ Current liability

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Current Ratio = 299/102= 2.93
A higher value of current ratio indicates a better short term solvency of the firm. In additon, a firm that
has a higher proportion of cash and receivables compared to inventories is better in terms of short
term liquidity.

Acid Test Ratio: = Quick Assets/Current Liabilities.

Quick assets are that part of the current assets which are highly liquid. These consist of current
assets less inventories. It is more stringent measure of liquidity compared to the current ratio.

b. Leverage Ratio: A firm uses a combination of equity and debt for financing its assets. Debt is a
riskier source of finance as it entails a fixed outgo of periodic interest payments and loan
repayments. Leverage ratios help us in assessing the risk arising from the use of debt capital.

Debt Equity Ratio, Interest coverage ratio and debt service coverage ratio are the important leverage
ratios commonly used.

Debt – Equity Ratio = Debt/Equity

Debt(assumed)= 59
Equity(assumed)= 185
Debt Equity Ratio= 59/185= 0.32

The numerator includes all liabilities, short term as well as long term. The denominator is the total of
equity i.e., net worth and preference capital.

Interest Coverage Ratio: = Profit before interest and taxes/ Interest

= 45/1=45
Interest coverage ratio is used by lenders to assess a firm’s ability to meet its interest obligations.

Debt Service Coverage ratio: This ratio is used by financial institutions to assess the capacity of the
borrower to repay the term loan.

Debt Service Coverage ratio=

Profit after tax + Depreciation + other non cash charges + interest on term loan
Interest on term loan + Repayment of term loan

c. Turnover Ratios
Turnover Ratios help us to measure the efficiency of utilization of the assets of a firm. These are also
called activity ratios or asset management ratios.

Inventory Turnover Ratio: This ratio measures how fast the inventory is being converted through the
conversation cycle and generating sales.
Inventory turnover ratio= Net Sales / Inventory
= 309/108= 2.86

Debtor Turnover Ratio: It tells us about the efficiency of credit management.

Debtor Turnover = Net Credit Sales/Debtors
= 309/107 = 2.89
A higher debtors turnover indicates better credit management.

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Average Collection Period: Average collection period is a measure similar to the Debtors turnover,
telling us about the efficiency of credit management. As the name suggests, it indicates the average
number of days taken to collect the receivables or the number of days of credit sales that is locked up
in receivables.

Average collection period= Debtors/ Average daily credit sales

= 365/ Debtor Turnover

= 365/2.89= 126

Fixed Asset Turnover: This ratio measures the efficiency of utilization of fixed assets in creating
sales.
It is measured as the sales per rupee of investment in fixed assets.
Fixed Assets Turnover = Net Sales / Net Fixed Assets
= 309 / 46 = 6.7

Total Asset Turnover: Similar to the Fixed Asset Turnover, this ratio measures the efficiency of
utilization of total assets – both fixed as well as current assets.

Total Asset Turnover = Net Sales / Total Assets

= 309 / 346 = 0.89

d. Profitability Ratios: Profitability ratio can be of two types. The first one are the ratios between
profit and sales. The second type are the ratios between profit and investment. There are called
rate of return measures.

Gross Profit Ratio= gross Profit/Net Sales

= 80/309= 0.26= 26%
Gross profit ratio indicates the margin available after meeting the manufacturing expenses. It is
measure of the efficiency of production and the price realization. The cost structure remaining same, a
better price realization results in higher gross profit ratio. A lower gross profit ratio, with no significant
change in cost structure can indicate a pressure on prices.

Net Profit Ratio:

It is the ratio of net profit to sales.
Net profit Ratio = Net profit / Net Sales
= 30/309 = 0.097= 9.7%

Earning Power: Earning Power measures the profitability of operations without considering the
influence of financial structure and tax rate. It focuses on the operating performance.
Earning Power = Profit before interest and taxes / Total assets
= 45 / 346 = 0.13 = 13%
Return on Equity: Return on Equity measures the profitability of equity funds invested in the firm.

Return on Equity = (Profit after tax – Preference Dividends) / Net Worth

Net Worth = Paid up Capital + Reserves and Surplus.

e. Valuation Ratios

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Valuation ratios are measures of how the equity stock of the company is assessed in the capital
market.
The widely used valuation ratios are Price-Earning Ratio and market Value to book value ratio.

Price Earning Ratio = Market price per share/ Earning per share
Earning per share = Profit after tax – Preference Dividends / No. of outstanding equity shares
Market Value to Book Value Ratio = Market value per share/ Book value per share

Q.8 Explain with illustration how you can reduce risk by diversification.

Ans.8 Avoiding risk is difficult no matter how you choose to invest. Most investors are aware that you
must take greater risks to achieve higher returns. However, no one wants to take more risk than
necessary to achieve one's financial goals. Diversification can help reduce risk.

THE MEANING OF DIVERSIFICATION

Diversification means dividing your investment among a variety of assets. Diversification helps to
reduce risk because different investments will rise and fall independent of each other. The
combinations of these assets more often than not will cancel out each other's fluctuation, therefore
reducing risk.

Diversification in investments can be achieved in many different ways. Individuals can diversify across
one type of asset classification -- such as stocks. To do this, one might purchase shares in the leading
companies across many different (and unrelated) industries. Many other diversification strategies are
also possible. You can diversify your portfolio across different types of assets (stocks, bonds, and real
estate for example) or diversify by regional decisions (such as state, region, or country). Thousands of
options exist.

Luckily, in almost every effective diversification strategy, the ultimate goal is clear -- to improve
performance while reducing risks. Two basic types of risks associated with investments are
unsystematic risk and systematic risk.

Let's see how diversification may be able to help investors reduce these risks.

UNSYSTEMATIC AND SYSTEMATIC RISK

Unsystematic risk (also called diversifiable risk) is risk that is specific to a company. This type of risk
could include dramatic events such as a strike, a natural disaster like a fire or something as simple as
slumping sales. Two common sources of unsystematic risk are business risk and financial risk.
Diversification can help eliminate unsystematic risk from a portfolio. It is unlikely that events such as
the ones listed above would happen in every firm at the same time. Therefore, by diversifying, one
can reduce their risk. There is no reward for taking on unneeded unsystematic risk.
On the other hand, some events can affect all firms at the same time. This is known as systematic
risk. Events such as inflation, war and fluctuating interest rates influence the entire economy, not just
a specific firm or industry. Diversification cannot eliminate the risk of facing these events. Therefore, it
is considered un-diversifiable risk. This type of risk accounts for most of the risk in a well-diversified
portfolio. However, the expected returns on their investments can reward investors for enduring
systematic risks.

DIVERSIFICATION IN STOCKS
Diversification offers you a way to reduce risk. It is possible to have a diversified portfolio of: just
stocks; just bonds; stocks and bonds; or stocks, bonds, and cash, etc. The portfolio design is very
important to effectively minimizing risk.

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When creating an effective diversified portfolio of stocks, considering how to reduce unsystematic risk
is important. For example: it is possible that if you invest in the book publishing industry, that all the
book binders in the industry make a pact to go on strike. The effects of such an event could lead the
prices of all publishing stocks in that industry to plummet. Your holdings in publishing companies
would be left at a deflated level.

However, if you also had holdings in other industries such as oil, consumer durables and electronics,
it is unlikely that the unsystematic risks in the publishing industry will adversely affect your other
holdings. What is more, unfortunate circumstances in the book publishing business may result in a
boom in other industries. The delays in the traditional print publishing business mentioned previously
could cause people to publish materials in electronic form. If you held stock in an electronic publishing
company, your stock might even benefit from the troubles that are slowing the growth of your holdings
in the book publishing industry.

Unsystematic risks can be avoided by diversifying among different industries rather that just investing
in the same one. They may also be effectively mitigated by diversifying across different asset classes
such as (stocks, bonds, mutual funds, real estate holdings, etc.). Let us take a look how this is done.

DIVERSIFICATION ACROSS ASSET CLASSES

Diversification across asset classes provides a cushion against market tremors because each asset
class has different risks, rewards and tolerance to economic events. By selecting investments from
different asset classes, you can minimize risk. Investments whose price movements are opposite
each other are negatively correlated. When negatively correlated assets are combined within a
portfolio, the portfolio volatility is reduced.

As mentioned earlier there are many diversification opportunities. All provide the well-desired
reduction of risk. Diversification is a great process for investors to take advantage of and we hope you
are now more familiar with it.

THE PROS AND CONS OF DIFFERENT DIVERSIFICATION STRATEGIES

As you have seen, diversification can help reduce risk by eliminating unsystematic risk from a
portfolio. By choosing securities of different companies in different industries, you can minimize the
risks associated with a particular company's "bad luck." By diversifying among asset classes that are
negatively or weakly correlated, you further reduce the volatility of your portfolio.

However, diversification can reduce the return of your portfolio as well. By selecting several assets,
the overall return on your portfolio will be the weighted average of the returns of those assets. For
example, let us look at a portfolio made up 50/50 of single stock and a single bond. In one year, the
stock has a total return 30%, the bond 6%. The portfolio return will only be 18% (36 divided by 2).
Whereas, if the entire portfolio was invested in the stock, the return would have been 30%.

SOME FINAL COMMENTS ON DIVERSIFICATION

Diversification can help to reduce portfolio risk by eliminating un-systematic risk for which investors
are not rewarded. Investors are rewarded for taking market risk. Because diversification averages the
returns of the assets within the portfolio, it attenuates the potential highs (and lows). Diversification
among companies, industries and asset classes affords the investor the greatest protection against
business risk, financial risk and volatility.

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Q.22 Describe the different categories of Mutual Funds.

Ans.22
Mutual Funds: A security that gives small investors access to a well diversified portfolio of equities,
bonds, and other securities. Each shareholder participates in the gain or loss of the fund. Shares are
issued and can be redeemed as needed. The fund's net asset value (NAV) is determined each day.
Each mutual fund portfolio is invested to match the objective stated in the prospectus.

The Eight Categories of Mutual Funds

Growth funds also strive for capital appreciation by investing in companies that are positioned for
strong earnings growth potential. Funds in this group vary widely in the amount of risk they take. But
in general, they are less risky than aggressive growth funds because they normally invest in more
well-established companies.

Neither aggressive growth funds nor growth funds strive for dividend income. In fact, the companies
they invest in often do not pay dividends to their shareholders but reinvest the earnings to fuel future
growth.

Growth and income funds strive for both dividend income and capital appreciation by investing in
companies with competitive records of dividend payments and capital gains. Of course, past
performance is not indicative of future results. Most growth and income funds strive for yields equal to
or better than the money market average and to provide capital appreciation that at least beats
inflation. Some growth and income funds emphasize growth while others emphasize income.

In addition, growth and income funds are generally less volatile than pure growth funds and tend to
lag behind the overall market. The investment time horizon of growth and income fund investors tends
to be anywhere from 2 to 10 years.

Balanced funds offer one-stop shopping by combining stocks and bonds in a single portfolio.
Balanced funds are generally more conservative than the previously discussed categories and usually
invest in blue-chip stocks and high-quality taxable bonds. They normally hold up relatively well in
rough markets, because when their stock investments fall, their bonds may do well, and vice versa.
Because they offer broad diversification, balanced funds are often suitable for people with a small
amount of cash to invest.

Sector funds concentrate on one industry (such as technology, financial services, or consumer
goods) or focus on certain commodities (such as gold, gas, or oil). Selected by more experienced
investors who are willing to pay close attention to the market, sector funds are less diversified than the
broader market and hence are often more volatile.

In addition, mutual funds encompass bond funds, money market funds, and global and international
funds.

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Bond funds can be divided into four broad categories. Within these categories, the funds are
segmented by date of maturity, type of issuer, and credit quality of bonds.

• Tax-advantaged bond funds, preferred by people in higher tax brackets, buy bonds issued by state
and municipal agencies.
• Taxable bond funds may invest in all other debt securities.
• High-quality bond funds stick with government and top-rated corporate or municipal bonds that
offer relatively lower interest.

• High-yield bond funds buy lower-rated or non-investment grade corporate or municipal bonds, or
"junk bonds," which may offer higher interest to compensate for the higher risk and volatility that
investors take. Keep in mind that high-yield bonds are subject to greater loss of principal and
interest, including default risk, than higher rated bonds.

Money market funds invest in short-term money market instruments, such as U.S. Treasury bills,
commercial paper, certificates of deposit, and repurchase agreements. Striving to maintain a stable
share price of $1.00, money market funds offer relative safety and liquidity.

Global and international funds can help diversify your assets into a wide array of foreign stocks and
bonds. The difference between the two groups is that global funds may buy a mix of U.S. and foreign
stocks, whereas international funds invest exclusively overseas.

There are many different types of mutual funds – each with differing objectives and exposure to risk.
Below is a listing of the major types of funds that can be found under the broad asset classes of
equities and fixed income. Be sure to consult a qualified financial professional to determine which
funds might be appropriate for your portfolio.

Mutual Fund Performance, 1992-2002

Compare the difference in fluctuating value and long-term performance among different fund
categories. Sector funds generally have performed better, but with wider fluctuations, than growth
and income and bond funds. Past performance is no guarantee of future results.
Source: Standard & Poor's, 12/31/02.

Points to Remember
1. Mutual fund categories determine the types of individual securities that fund managers select for
their funds.
2. Some equity fund categories are aggressive growth, growth, growth and income, balanced, sector,
bond, money market, and global and international.
3. Bond funds include taxable and tax-advantaged funds and are also segmented by maturity, issuer,
and credit quality.

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4. Investors should match their objectives to a particular category but be cautious about focusing too
heavily in any one area.
5. Diversifying among both types and categories of funds is one way to manage risk in your portfolio.
Bond Yield-to-Maturity

Q.18 Write short notes:

Ans
1. Efficient market hypotheses: Market efficiency is generally discussed within the frame work
presented by Fama in the article -*Efficient capital markets: A review of Theory and Empirical
work”

Fama defined efficient markets in terms of a ‘fair game’ where security prices ‘fully reflect’ the
information available. If markets are efficient, securities are priced to provide a normal return for
their level of risk. Fama suggested that the efficient, securities are priced to provide a normal
return for their level of risk. Fama suggested that the efficient market hypothesis (EMH) can be
divided into three categories: the weak form, the semistrong form and the strong form. The
distinction between the weak, semistrong, and strong forms of the EMH are determined by the
level of information being considered.

WEAK-FORM EMH
In the weak from EMH, the type is information being considered is restricted to only historical
prices. If the weak-form EMH is correct, investors should not be able to consistently earn
abnormal profits by simply observing the historical prices of securities. Technical anlaysis which
relies on charts of stock prices over time is particularly vulnerable to the weak form EMH.

SEMISTRONG- FORM EMH

The semistrong – form EMH states that security prices adjust rapidly and correctly to the release
of all publicly available information. Thus, under the semistrong-form current prices fully reflect not
only all past price data but also such information such as earnings reports, dividend
announcements, annual and quarterly reports, and news items in the financial press. In short, any
information that is available to the public should be quickly reflected in security prices so that
investors cannot consistently earn abnormal returns by acting on such public information. Since a
great deal of the information used by security analysts is available to the public at large,

STRONG- FORM EMH

The strong form EMH represents the most extreme form of market efficiency possible. Under the
strong form it is argued that security prices fully reflect all information including both public and
private information.

2. SECURITY MARKET INDICATIORS

Security market indicators are used to measure the general movement of the stock market. Stock
market indices are used as a proxy for overall market movement. Indices can be constructed for
narrower purposes as well for example for specific sectors.

The steps involved in the construction of a stock market index based on market cap weightage are:
i) Selecting a set of scrips to be used: The selection is made in such a way that the selected scrips
reflect the overall market movement. In order to achieve this we will need scrips from various
important industries. The key factors that we have to consider to select the representative scrips
are (a) Market capitalization and (b) Trading volumes
ii) Fixing a starting date.

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iii) Calculating the market capitalization of all companies in the index based on the closing prices on
the starting date. The value of the index on the starting date is taken as 100
iv) Calculating the market capitalization of all companies in the index based on the closing prices on
the required date.
v) Calculating the value of the index on the required date by the formula:
Value of the index on the required date
= Total market capitalization on the required date x 100
Total market capitalization on the starting date

3. HEAD AND SHOULDER FORMATION:

The head and shoulders formation is one of the reliable chart patterns and occurs at both market
tops and market bottoms. The pattern consists of a final rally- the head separating two smaller
though not identical rallies (the shoulders).
Volume characteristics are important in assessing the validity of these patterns. Volumes are
normally large during the formation of the left shoulders and also tends to be quite large as prices
approach the peak. The real indication that a head and shoulder pattern is developing comes with
the formation of the right shoulder, which is accompanies by distinctly lower volume. The line
joining the bottoms of the two shoulders is called the neckline. It is essential to wait for a decisive
break below the neckline. The deeper the pattern, the greater is the bearish significance once it
has been completed. Similarly the longer the period of formation of the pattern, the longer the
ensuring bear trend likely to be.

4. STUDY OF VOLUME IN TECHNICAL ANALYSIS

Studying volume is useful because volume often leads price and thus offers an advance warning of a
potential trend reversal. Some of the general principles that could be used in interpreting volume
changes are given below:

i) A price rise accompanied by expanding volume is a normal market characteristics and carried no
implications of a potential trend reversal.
ii) A rally that reaches a new high in price on expanding volume but has an overall level of activity
lower than the previous rally is suspect and warns of a potential trend reversal.
iii) A rally that develops on contracting volume is suspect and warns of a potential trend reversal in
price.
iv) Sometime both price and volume expand slowly, gradually working into an exponential rise with a
final sharp rise. Following this development, both volume and price fall off equally sharply. This
represent an exhaustion move and is characteristic of a trend reversal. The significance of the
reversal will depend upon the extent of the previous advance and the degree of volume
expansion.
v) When price advances following a long decline and then reacts to a level at, or slightly
above, or marginally below the previous trough, it is a bullish sign if the volume on the
second trough is significantly lower than the volume on the first trough.

5. BREADTH INDICATORS:
Breadth indicators measures the degree to which the vast majority of issues are participating in a
market move. They therefore monitor the extent of a market trend. In general, it is seen that fewer
the number of issues that are moving in the direction of the major averages, the greater the
probability of an imminent reversal in trend.

6. MOMENTUM INDICATORS:
The technique of trendlines, price patterns, and moving average analysis identify a change in
trend after it has taken place. The use of momentum indicators can warn of latent strength or
weakness in the indicator or price being monitored, often well ahead of the final turning point.

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Some of the important momentum indicators used widely are rate of change (ROC), relative
strength indicator (RSI), moving average convergent divergence (MACD), breadth oscillators, and
diffusion index. We will discuss some fo these indicators in detail.

Section – B

Q.25 Find the present value of an annuity of Rs. 15000/- paid at the end of each year for ten
years, if the discount rate is 10%.
Ans Present Value = Annuity x [(1+k)n − 1]
k(1+k)n

Where k= Rate of interest

N=Duration of the annuity

In the above question- Annuity = Rs. 15000; k = 0.10; n= 10

Present value= Rs. 15000 x [(1 + 0.10)10 - 1]

0.10 1 + 0.10)10

= 15000 x [(1.10)10 - 1]
0.10 (1.10)10

= 15000 x [ 2.5937423 - 1]
0.10(2.5937423)
= 15000 x [1.5937423]
0.2593742
= 15000 x 6.1445675 = Rs. 92168.512

Q.28 The Table below gives the weekly data of the value of an index:
Ans.
Date Index 10 Week Total 10 Week Moving Average
Jan. 8 101 - -
Jan. 15 100 - -
Jan. 22 103 - -
Jan. 29 99 - -
Feb. 5 96 - -
Feb. 12 99 - -
Feb. 19 95 - -
Feb. 26 91 - -
Mar. 5 93 - -
Mar. 12 89 966 96.6
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Mar. 19 90 955 95.5
Mar. 26 95 950 95.0
Apr. 2 103 950 95.0

Q. 26.
Sol.
Total Market Capitalization on the required date
Value of the index on the required date = --------------------------------------------------------------------- X 100
Total Market Capitalization on the starting date

Value of Index at base year = 100

Total Market Capitalization on Base Year = Rs. 5,568.00 crores

Price as on Day X No. of outstanding Market Capitalisation on

Security
(in Rs.) shares (in Crores) Day X (in crores)
A 221.55 220.00 48,741.00
B 405.55 105.00 42,582.75
C 4,817.50 6.60 31,795.50
D 55.90 520.00 29,068.00
E 792.25 25.00 19,806.25
F 256.00 53.00 13,568.00
G 144.00 63.00 9,072.00
H 670.20 12.00 8,042.40
I 89.25 79.00 7,050.75
J 228.85 28.00 6,407.80

Total 2,16,134.45

Total Market Capitalization on Day X = Rs. 2,16,134.45

Value of Index on Day X = 2,16,134.45 X 100 = 3,881.725

5,568

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Q. 29.
Sol.

Total Market Capitalization on the required date

Value of the index on the required date = --------------------------------------------------------------------- X 100
Total Market Capitalization on the starting date

Value of Index on Day 1 = 100

Total Market Capitalization on Day 1 = Rs. 96,625.00

Market Market
Price as on No. of shares Price as on
Security Capitalisation Capitalisation
Day 1 (in Rs.) Million Day 2 (in Rs.)
on Day 1 Rs. on Day 2 Rs.
A 55 125 62 6,875.00 7,750.00
B 250 100 245 25,000.00 24,500.00
C 45 250 55 11,250.00 13,750.00
D 20 300 23 6,000.00 6,900.00
E 950 50 940 47,500.00 47,000.00

Total 96,625.00 99,900.00

Total Market Capitalization on Day 2 = Rs. 99,900.00

Value of Index on Day 2 = 99,900.00 X 100 = Rs. 103.389

96,625.00

Q.33 Beta = 0.8

Risk Free Rate = 8%
Market Premium =15%
Expected return = ?

Ans. Expected return = 8% + 0.8 x 15%

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= 8 + 0.12
= 8.12%

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