sapm - fifth (5) sem bbi

7/27/2019 Sapm - Fifth (5) Sem BBI

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SAPM -Security Analysis and Portfolio

Management

Overview Lecture No.1


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Meaning of Security

A document that gives its owner a specific claim of ownership of a particular

financial asset

Securities are financial instruments which are bought and sold in the financial

market for investment

Important financial instruments are Shares, fixed deposits, insurance policiesbonds etc.

There are various financial instruments which leads to giving Investment

alternatives

Class Exercise

Please list all the alternative investment avenues that you are aware of

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3

Investment

Avenues

Various types of Deposits

Bank Deposits

Post office Deposits

Company Deposits Provident Fund Deposits

Bonds:

Government Securities

Government Agency Securities

PSU Bonds Debentures of Private Sector

Companies

Preference Shares

Other Investments

Life Insurance

Mutual funds

Real estate

Precious objects

Shares and derivatives

Equities

Various financial derivatives

e.g. Futures, options etc.


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Comparison of Investment Avenues and investment

Objectives

Return on Investment Period of Investment

Safety of the Instrument/ market standing of the issuing

agency

Risk in investment

Loan facility

Tax benefits

Age of the person investing

Future marketability of the investment

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Investment and Speculation

Investment and speculation are two terms that are closely related.

Both involve the purchase of assets like shares and securities.

Traditionally investment is distinguished from speculation with respect to

three factors, viz.

Risk

Capital gain Time period

Risk:

It refers to the possibility of incurring a loss in a financial transaction. It

arises from the possibility of variation in returns from an investment. Risk isinvariably related to return. Higher return is associated with higher risk.

No investment is completely risk free. An investorgenerally commits his

funds to low risk investment, whereas a speculator commits his fund to

higher risk investments. A speculator is prepared to take higher risk in

order to receive higher returns.5


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Question

When money is put in Shares is it

Investment or is it Speculation

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Investment and Speculation. (Contd)

Capital Gains:

The speculators motive is to achieve profits through price

changes, i.e. he is interested in capital gains rather than the

income from the investment. if purchase of securities is

preceded with proper investigation and analysis to receive

stable returns and capital appreciation over a period oftime, it is investment. Thus speculation is related with buying

low and selling high with the hope of making high capital

gains.

A speculator consequently engages in frequent buying

and selling transactions

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Question

Is buying a house investment orspeculation?

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Time period:

Investment is long term in nature (Why?), whereas

speculation is only short-term.

An investor commits his funds for a longer period and waits for

his return. But a speculator is interested in short-term gainsthrough buying and selling of investment instruments.

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Investment and Speculation. (Contd)


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Financial Eco-System

FinancialEco-System

FinancialInstitutions

FinancialMarkets

FinancialInstruments

FinancialServices

Banks

InsuranceCompanies

Mutual fund

companies

Stock

exchanges

( BSE andNSE)

Commodity

Exchanges

Money

Market

Stocks (Primary

and Secondary)

BondsInsurance

policies

Fixed Deposits

Loans etc.

Intermediaries

and mainlinecompanies

which offer

these financial

instruments


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Portfolio Management

Meaning of Portfolio

An investor considering investment in securities is faced with

the problem of choosing from among a large number of

securities such as Shares, Debentures, bonds, mutual funds

etc. This set of securities that he holds is called Portfolio

Characteristics of a Portfolio

They have different risk return characteristic

Different periods of maturity

Different yields/ return

Objective of a portfolio

To reduce risk by diversification and to maximise gains

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Portfolio Management

Portfolio management comprises all the processes

involved in the creation and maintenance of an

investment portfolio.

It deals specifically with Security analysis,

Portfolio analysis,

Portfolio selection,

Portfolio revision and

Portfolio evaluation

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OBJECTIVES OF PORTFOLIO MANAGEMENT

Security/Safety of Principal: Security not only involves keeping the principal sum intact but

also keeping intact its purchasing power.

Stability of Income: Stability of income so as to facilitate planning more accurately andsystematically the reinvestment or consumption of income.

Capital Growth: Capital growth which can be attained by reinvesting in growth securities or

through purchase of growth securities.

Marketability: The case with which a security can be bought or sold. This is essential for

providing flexibility to investment portfolio.

Liquidity: Liquidity i.e. nearness to money. It is desirable for the investor so as to take

advantage of attractive opportunities upcoming in the market.

Diversification: The basic objective of building a portfolio is to reduce the risk of loss of

capital and income by investing in various types of securities and over a wide range of

industries.

Favourable Tax Status: The effective yield an investor gets from his investment depends on

tax to which it is subject. By minimizing the tax burden, yield can be effectively improved.13


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Basic Principles of Portfolio Management

There are two basic principles for effective Portfolio Management:

1) Effective investment planning for the investment in securities by considering thefollowing factors:

Fiscal, financial and monetary policies of the Government of India and the

Reserve Bank of India.

Industrial and Economic environment and its impact on industry prospects in

terms of prospective technological changes, competition in the market, capacity

utilization with industry and demand prospects etc.

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2) Constant review of investment: Portfolio managers are required to review their

investment in securities and continue selling and purchasing their investment inmore profitable avenues. For this purpose they will have to carry the following

analysis:

Assessment of quality of management of the companies in which investment

has already been made or is proposed to be made.

Financial and Trend analysis of companies, Balance Sheet/Profit and Loss

accounts to identify sound companies with optimum capital structure and betterperformance and to disinvest the holding of those companies whose

performance is found to be slackening.

The analysis of securities market and its trend is to be done on a continuous

basis.

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Basic Principles of Portfolio Management


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Construction of a Portfolio

Portfolio construction means determining the actual composition of portfolio. It is a

critical stage because asset mix is the single most determinant of portfolioperformance.

The components of portfolio construction are

a) Asset allocation means setting the asset mix

b) Security selection involving choosing the approporiate security to meet the

portfolio targets

c) Portfolio structure involving setting the amount of each security to be included

in the portfolio

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Approach to Portfolio Allocation

Interior Decorating Approach It is a approach which is tailor made to the

investment objectives and constraints of each investor Protective Investments

Tax oriented investments

Fixed income investments

Emotional investments

Speculative investments Growth investments

With the help of these variety of investments, an attempt can be made to develop

a matrix for matching the individual characteristics of specific investments so that

multiple portfolio can be developed

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Approach to Portfolio Allocation - Markowitz Approach

A Markowitz Efficient Portfolio is one where no added diversification can

lower the portfolio's risk for a given return expectation (alternately, no additionalexpected return can be gained without increasing the risk of the portfolio). The

Markowitz Efficient Frontier is the set of all portfolios that will give the highest

expected return for each given level of risk. These concepts of efficiency were

essential to the development of the Capital Asset Pricing Model

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http://en.wikipedia.org/wiki/Capital_Asset_Pricing_Modelhttp://en.wikipedia.org/wiki/Capital_Asset_Pricing_Model


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Process of Portfolio Composition

Collecting the Basic Data of the person

a) Satisfying the basic needs Food, clothing, housing and transportation

Education, Medical and other needs

Long term needs, Saving for emergency

b) Investments done Shares, Bonds, Life insurance, pension plan etc.

c) Future earning capability, number of years etc.

Formulating the Portfolio Objectives

a)Need for current income to meet the expenses

b)Need for constant income to face inflation

c)Ability to liquidate the investment in short notice

d)Need for tax exemptione)Need to get returns commensurate with the risk taken

Weighing Constraints When and how much can be invested

Selecting the Securities Based on above to select securities19


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Risk and Return

Lecture No.3


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Risk and Return

Risk and return will be very central terms in our analysis and it isessential that we clearly understand the meaning of each term and howassets with different payout structures can be compared.

General utility theory suggests that the average investor is risk averse.Given the same expected return of two assets with different risks, hewould prefer the one with less risk. (This assumption may not beperfectly true for all individuals in all situations, but for the investor community as a whole it is probably true).

For an asset with uncertain cash flows and payoffs, which are normallydistributed, the mean of the distribution will be the expected return whilethe standard deviation forms some kind ofrisk.

Choosing the less risky asset therefore comes down to choosing theasset with the lowest standard deviation in its payout distribution.

An investor could also approach the problem from the other direction,choosing among assets with the same risk and then choose the assetwith the highest expected return.


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1

1

1

1 1

n

i

i

n

ni

i

X Xn

X X

Statistical Terms

MeanBy mean one often refers to the simple average of a number of observations. This

value is more correctly denoted as arithmetic mean, to distinguish it from the

geometric mean. In order, the formulas below show the arithmetic and the

geometric mean, respectively:

VarianceThe variance measures the fluctuation of the observations around their mean. The

larger the value of variance, the greater the fluctuation.

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(sigma squared)[Ri E(R)]2 X P

= Mean = X = E(R)Different Symbols of Mean


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Statistical Terms

Standard DeviationThe standard deviation also measures the variability of observations around themean. It is defined as the square root of the variance. The standard deviation will

as a consequence have the same unit as the observation and is in a way easier to

interpret. In financial terms, variability measured as standard deviation equals risk

and the notion of risk has a very central place in the financial theory. From the

definition of variance above follows that the standard deviation is given by:

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[Ri E(R)]2 X P


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The Bell Curve

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= Mean = X = E(R)
http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/


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Small cap stocks

Greater Variance/ SDGreater risk, Greater

returns

Large cap stocks

Lesser Variance/ SD

Lesser risk,Lesser returns

Municipal Bonds

Even Lesser Variance/ SD

Lesser risk,

Lesser returns
http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/http://greatwealth.com/2009/04/16/from-golf-scores-back-to-stock-and-bond-investments/investment-bell-curves1/


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Risk and Return

Risk and return will be very central terms in our analysis and it isessential that we clearly understand the meaning of each term and howassets with different payout structures can be compared.

General utility theory suggests that the average investor is risk averse.Given the same expected return of two assets with different risks, hewould prefer the one with less risk. (This assumption may not beperfectly true for all individuals in all situations, but for the investor community as a whole it is probably true).

For an asset with uncertain cash flows and payoffs, which are normallydistributed, the mean of the distribution will be the expected return whilethe standard deviation forms some kind ofrisk.

Choosing the less risky asset therefore comes down to choosing the

asset with the lowest standard deviation in its payout distribution.

An investor could also approach the problem from the other direction,choosing among assets with the same risk and then choose the assetwith the highest expected return.


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Risk Preference of investors

Investors could be Risk seeking This means that investors are willing to make

investments of increasing higher risk for the promise of increasingly smallerincrements of return

Investors could be Risk indifferent They would be willing to continue to buying

investments of higher risk by receiving the same increase in return. A risk

indifferent investor receives the same incremental utility for each increase in

wealth

Investors could be Risk averse when investors require successfully greater

increments of return to compensate them for each additional unit increase in

risk, they are known as risk-averse investors. They receive smaller increments

of utility for each additional increment of wealth. They will accept additional risk,

but only if they are adequately compensated for doing so and adequate

compensation for a risk averter means being paid more and more for

accepting higher risk

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Meaning of Return and Measure of Return

Meaning

Return means the profit earned on the capital invested in the business

Measures of Return

Return can be measured as a rate of return on capital invested. To measure the

rate of return an investor wants to know three items:

1) The period of time that the measurement covers How long2) The amount needed to establish and maintain the investment How much to

invest

3) The net profit of the investment over the time period - What is the return

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Holding Period return

Rt = Pt Pt-1 + Yt

Rt = The holding Period return on the investment

Pt-1 = The price of the security at the time (t-1) the beginning of the holding

period

Pt = The price of the security at the time t at the end of the holding periodYt = Income from the investment during the holding period

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Pt-1


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Time Value ofMoney


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The Time Value o f Money

The Interest Rate

Simple Interest Compound Interest

Amortizing a Loan

Compounding More ThanOnce per Year


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Obviously, Rs.10,000 today.

You already recognize that there isTIME VALUE TO MONEY!!

The In teres t Rate

Which would you prefer -- Rs10,000

today orRs10,000 in 5 years?


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TIME allows you the oppor tun i tyto

postpone consumption and earn

INTEREST.

Why TIME?

Why is TIME such an important

element in your decision?


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Types o f In teres t

Compound Interest

Interest paid (earned) on any previousinterest earned, as well as on the

principal borrowed (lent).

Simple Interest

Interest paid (earned) on only the original

amount, or principal, borrowed (lent).


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Simp le In terest Formu la

Formula SI = PV(i)(t)

SI: Simple Interest

PV: Deposit today (t=0)

R: Interest Rate per Period

t: Number of Time Periods


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SI = PV*

(R)(t)

= Rs.1,000(.07)(2)

= Rs.140

Simp le In teres t Examp le

Assume that you deposit Rs.1,000 in an

account earning 7% simple interest for

2 years. What is the accumulatedinterestat the end o f the 2nd year?


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FV =PV+SI=Rs.1,000+Rs.140

=Rs.1,140

Future Value is the value at some futuretime of a present amount of money, or a

series of payments, evaluated at a given

interest rate.

Simp le In teres t (FV)

What is the Future Value (FV) of the

deposit?


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ThePresent Valueis s imply the

Rs.1,000you or ig ina lly deposi ted.

That is the value today!

Present Value is the current value of afuture amount of money, or a series of

payments, evaluated at a given interest

rate.

Simp le In teres t (PV)

What is the Present Value (PV) of the

previous problem?


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0

5000

10000

15000

20000

1st Year 10th

Year

20th

Year

30th

Year

Future Value of a Single Rs1,000 Deposit

10% SimpleInterest

7% CompoundInterest

10% CompoundInterest

Why Compound Interest?

Future

Value(Rupees)


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Assume that you deposit Rs.1,000

at a compound interest rate of7%

for2 years.

Future Value

Sing le Depos it (Graph ic)

0 1 2

Rs.1,000

FV2

7%

F t V l


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FV1 = PV (1+i)1 = Rs.1,000 (1.07)

= Rs.1,070

Compound Interest

You earned Rs.70 interest on your

Rs.1,000 deposit over the first year.

This is the same amount of interest you

would earn under simple interest.

Futu re Value

Sing le Depos it (Formu la)


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FV1 = PV (1+R)1 = Rs.1,000 (1.07)

= Rs.1,070

FV2 = FV1 (1+R)1= PV (1+R)(1+R) =

Rs.1,000(1.07)(1.07) = PV (1+R)2

= Rs.1,000(1.07)2= Rs.1,144.90

You earned an EXTRA Rs.4.90in Year 2 with

compound over simple interest.

Future Value



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FV1 = PV(1+R)1

FV2

= PV(1+R)2

General Future Value Formula:

FVn = PV (1+R)n

or FVn = PV (FVIFR,n) -- See Tab le A-

3

General Futu re

Value Formu la

etc.


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FVIFR,n is found on Table A-3

at the end of the Chapter.

Valuation Us ing Tab le A-3

Period 6% 7% 8%1 1.060 1.070 1.080

2 1.1241.145

1.166

3 1.191 1.225 1.260

4 1.262 1.311 1.360

5 1.338 1.403 1.469


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FV2 = Rs.1,000 (FVIF7%,2)

= Rs.1,000 (1.145)

= Rs.1,145 [Due to Rounding]

Using Futu re Value Tab les

Period 6% 7% 8%1 1.060 1.070 1.080

2 1.1241.145

1.166

3 1.191 1.225 1.260

4 1.262 1.311 1.360

5 1.338 1.403 1.469


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Julie Miller wants to know how large her deposit

ofRs.10,000 today will become at a compound

annual interest rate of10% for5 years.

Story Prob lem Examp le

0 1 2 3 4 5

Rs.10,000

FV5

10%


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Calculation based on Table I:

FV5 = Rs.10,000 (FVIF10%, 5)= Rs.10,000 (1.611)

= Rs.16,110 [Due to Round ing]

Story Prob lem So lut ion

Calculation based on general formula:

FVn = PV (1+R)n

FV5 = Rs.10,000 (1+ 0.10)5

= Rs.16,105.10


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We will use the Rule-of-72.

Doub le Your Money!!!

Quick! How long does it take to

double Rs.5,000 at a compound

rate of 12% per year (approx.)?


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Approx . Yearsto Double= 72/ R%

72/ 12% = 6 Years

[Actual Time is 6.12 Years]

The Rule-of-72

Quick! How long does it take to

double Rs.5,000 at a compound

rate of 12% per year (approx.)?

P t V l


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Assume that you need Rs.1,000 in 2 years.Lets examine the process to determinehow much you need to deposit today at a

discount rate of7% compounded annually.

0 1 2

Rs.1,000

7%

PV1PV0

Presen t Value

Sing le Depos it (Graph ic)

P t V l


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PV0 = FV2/ (1+R)2 = Rs.1,000/ (1.07)2

= FV2/ (1+R)2 = Rs.873.44

Presen t Value


0 1 2

Rs.1,000

7%

PV0

G l P


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PV0 = FV1/ (1+R)1

PV0 = FV2/ (1+R)

2

General Present Value Formula:

PV0 = FVn/ (1+R)n

or PV0 = FVn (PVIFR,n) -- See Table A-1

General Present

Value Formu la

etc.


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PVIFR,n is found on Table A-1

at the end of the book.

Valuation Using Tab le II

Period 6% 7% 8%

1 .943 .935 .9262 .890 .873 .857

3 .840 .816 .7944 .792 .763 .7355 .747 .713 .681


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PV2 = Rs.1,000 (PVIF7%,2)

= Rs.1,000 (.873)

= Rs.873 [Due to Rounding]

Using Presen t Value Tab les

Period 6% 7% 8%

1 .943 .935 .926

2 .890.873

.857

3 .840 .816 .794

4 .792 .763 .735

5 .747 .713 .681


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Ram Krishna wants to know how large of a

deposit to make so that the money will

grow to Rs.10,000 in 5 years at a discount

rate of10%.

Story Prob lem Examp le

0 1 2 3 4 5

Rs.10,000

PV0

10%


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Calculation based on general formula:

PV0 = FVn/ (1+R)n

PV0 = Rs.10,000/ (1+ 0.10)5

= Rs.6,209.21

Calculation based on Table A-I:

PV0 = Rs.10,000 (PVIF10%, 5)= Rs.10,000 (.621)

= Rs.6,210.00 [Due to Round ing]

Story Prob lem So lut ion


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Types o f Annui t ies

Ordinary Annuity: Payments or receipts

occur at the end of each period.

Annuity Due: Payments or receipts

occur at the beginning of each period.

An Annu i tyrepresents a series of equal

payments (or receipts) occurring over a

specified number of equidistant periods.


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Examples o f Annu i ties

Student Loan Payments

Car Loan Payments Insurance Premiums

Mortgage Payments Retirement Savings


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Parts o f an Annui ty

0 1 2 3

Rs.100 Rs.100 Rs.100

(Ordinary Annuity)

End of

Period 1

End of

Period 2

Today Equal Cash FlowsEach 1 Period Apart

End of

Period 3


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Parts o f an Annui ty

0 1 2 3

Rs.100 Rs.100 Rs.100

(Annuity Due)

Beginning of

Period 1

Beginning of

Period 2

Today Equal Cash FlowsEach 1 Period Apart

Beginning of

Period 3

Overview of an


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FVAn = A(1+R)n-1 + A(1+R)n-2 +

... + A(1+R)1 +A(1+R)0

Overview of an

Ordinary Annui ty -- FVA

A A A

0 1 2 t t+1

FVAn

A = Periodic

Cash Flow

Cash flows occur at the end of the period

R% . . .

= A[(1+R)t-1]

R

E l f


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FVA3 = Rs.1,000(1.07)2 +

Rs.1,000(1.07)1 + Rs.1,000(1.07)0

= Rs.1,145 + Rs.1,070 + Rs.1,000

= Rs.3,215

Example o f an

Ordinary Annui ty -- FVA

Rs.1,000 Rs.1,000 Rs.1,000

0 1 2 3 4

Rs.3,215 = FVA3

7%

Rs.1,070

Rs.1,145


= A[(1+R)t-1]

R


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Hint on Annui ty Valuat ion

The future value of an ordinaryannuity can be viewed as

occurring at the endof the lastcash flow period, whereas thefuture value of an annuity due

can be viewed as occurring atthe beginningof the last cash

flow period.


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FVAt = A (FVIFAR%,t)

FVA3 = Rs.1,000 (FVIFA7%,3)

= Rs.1,000 (3.215) = Rs.3,215

Valuation Using Tab le III

Period 6% 7% 8%1 1.000 1.000 1.000

2 2.060 2.070 2.080

3 3.184 3.215 3.246

4 4.375 4.440 4.506

5 5.637 5.751 5.867

Overview View of an


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FVADt = A(1+R)t + A(1+R)t-1 +

... + A(1+R)2 + A(1+i)1 = FVAt (1+R)

Overview View of an

Annu ity Due -- FVAD

A A A A A

0 1 2 3 t-1 t

FVADt

R% . . .

Cash flows occur at the beginning of the period

Example o f an


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FVAD3 = Rs.1,000(1.07)3 +

Rs.1,000(1.07)2 + Rs.1,000(1.07)1

= Rs.1,225 + Rs.1,145 + Rs.1,070

= Rs.3,440

Example o f an

Annui ty Due -- FVAD

Rs.1,000 Rs.1,000 Rs.1,000 Rs.1,070

0 1 2 3 4

Rs.3,440 = FVAD3

7%

Rs.1,225

Rs.1,145


Overview of an


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PVAn = A/(1+i)1 + A/(1+i)2

+ ... + A/(1+i)n

Overview of an

Ord inary Annu ity -- PVA

A A A

0 1 2 t t+1

PVAn

A = Periodic

Cash Flow

R% . . .


Example o f an


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PVA3 = Rs.1,000/(1.07)1

+Rs.1,000/(1.07)2 +

Rs.1,000/(1.07)3

= Rs.934.58 + Rs.873.44 +

Rs.816.30 = Rs.2,624.32

Example o f an

Ord inary Annu ity -- PVA

Rs.1,000 Rs.1,000 Rs.1,000

0 1 2 3 4

Rs.2,624.32 =PVA3

7%

Rs.934.58

Rs.873.44

Rs.816.30



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Hint on Annui ty Valuat ion

The present value of an ordinaryannuity can be viewed as

occurring at the beginningof thefirst cash flow period, whereasthe future value of an annuity

due can be viewed as occurringat the endof the first cash flow

period.


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PVAn = A (PVIFAi%,t)

PVA3 = Rs.1,000 (PVIFA7%,3)

= Rs.1,000 (2.624) =Rs.2,624

Valuation Using Tab le IV

Period 6% 7% 8%1 0.943 0.935 0.926

2 1.833 1.808 1.783

3 2.673 2.624 2.577

4 3.465 3.387 3.312

5 4.212 4.100 3.993

Overview of an


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PVADn = A/(1+i)0 + A/(1+i)1 + ... + A/(1+i)n-1

= PVAn (1+i)

Overview of an

Annui ty Due -- PVAD

A A A A

0 1 2 t-1 t

PVADn

A: Periodic

Cash Flow

R% . . .


Example o f an


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PVADn = Rs.1,000/(1.07)0 + Rs.1,000/(1.07)1 +

Rs.1,000/(1.07)2 = Rs.2,808.02

Example o f an

Annui ty Due -- PVAD

Rs.1,000.00 Rs.1,000Rs.1,000

0 1 2 3 4

Rs.2,808.02 = PVADn

7%

Rs. 934.58

Rs. 873.44


Steps to Solve Time Value


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1. Read problem thoroughly

2. Create a time line

3. Put cash flows and arrows on time line4. Determine if it is a PV or FV problem

5. Determine if solution involves a singleCF, annuity stream(s), or mixed flow

6. Solve the problem

Steps to Solve Time Value

of Money Problems


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Julie Miller will receive the set ofcash

flows below. What is the Present Value

at a discount rate of10%.

Mixed Flows Examp le

0 1 2 3 4 5

Rs.600 Rs.600 Rs.400 Rs.400 Rs.100

PV0

10%


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1. Solve a piece-at-a-t ime by

discounting each pieceback to t=0.

2. Solve a group-at-a-t ime by first

breaking problem into groups of

annuity streams and any single

cash flow groups. Then discount

each groupback to t=0.

How to Solve?


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Piece-At-A-Time

0 1 2 3 4 5

Rs.600 Rs.600 Rs.400 Rs.400 Rs.100

10%

Rs.545.45

Rs.495.87

Rs.300.53

Rs.273.21

Rs. 62.09

Rs.1677.15 = PV0 of the Mixed Flow


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Group-At-A-Time (#1)

0 1 2 3 4 5

Rs.600 Rs.600 Rs.400 Rs.400 Rs.100

10%

Rs.1,041.60

Rs. 573.57

Rs. 62.10

Rs.1,677.27 = PV0 of Mixed Flow [Using Tables]

Rs.600(PVIFA10%,2) = Rs.600(1.736) = Rs.1,041.60

Rs.400(PVIFA10%,2)(PVIF10%,2) = Rs.400(1.736)(0.826) = Rs.573.57

Rs.100 (PVIF10%,5) = Rs.100 (0.621) = Rs.62.10


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Group-At-A-Time (#2)

0 1 2 3 4

Rs.400 Rs.400 Rs.400 Rs.400

PV0 equals

Rs.1677.30.

0 1 2

Rs.200 Rs.200

0 1 2 3 4 5

Rs.100

Rs.1,268.00

Rs.347.20

Rs.62.10

Plus

Plus

Frequency o f


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General Formula:

FVt = PV0(1 + [i/m])mt

t: Number of Years

m: Compounding Periods per Year

R: Annual Interest Rate

FVt,m: FV at the end of Year t

PV0: PV of the Cash Flow today

Frequency o f

Compound ing


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Julie Miller has Rs.1,000 to invest for

2 Years at an annual interest rate of

12%.

Annual FV2 = 1,000(1+ [.12/1])(1)(2)

= 1,254.40

Semi FV2 = 1,000(1+ [.12/2])(2)(2)

= 1,262.48

Impact o f Frequency


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Qrtly FV2 = 1,000(1+ [.12/4])(4)(2)

= 1,266.77

Monthly FV2 = 1,000(1+ [.12/12])(12)(2)

= 1,269.73

Daily FV2 = 1,000(1+[.12/365])(365)(2)

= 1,271.20

Impact o f Frequency

Effect ive Annual


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Effective Annual Interest Rate

The actual rate of interest earned

(paid) after adjusting the nomina lratefor factors such as the number

ofcompounding periods per year.

(1 + [ R/ m ] )m - 1

Effect ive Annual

In teres t Rate

BWs Effect ive


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Basket Wonders (BW)has a

Rs.1,000 CD at the bank. The

interest rate is 6% compoundedquarterly for 1 year. What is the

Effective Annual Interest Rate

(EAR)?

EAR = ( 1 + 6%/ 4 )4 - 1

= 1.0614 - 1 = .0614 or6.14%!

BWs Effect ive

Annual In teres t Rate


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HOW A RATIO IS EXPRESSED?


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HOW A RATIO IS EXPRESSED?

As Percentage - such as 25% or 50% . For exampleif net profit is Rs.25,000/- and the sales isRs.1,00,000/- then the net profit can be said to be

25% of the sales.

As Proportion - The above figures may be expressedin terms of the relationship between net profit to salesas 1 : 4.

As Pure Number /Times - The same can also beexpressed in an alternatively way such as the sale is 4times of the net profit or profit is 1/4th of the sales.

CLASSIFICATION OF RATIOS


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Balance SheetRatio

P&L Ratio orIncome/RevenueStatement Ratio

Balance Sheet andProfit & Loss Ratio

Financial Ratio Operating Ratio Composite Ratio

Current RatioQuick Asset Ratio

Proprietary Ratio

Debt Equity Ratio

Gross Profit RatioOperating Ratio

Expense Ratio

Net profit Ratio

Stock Turnover Ratio

Fixed Asset TurnoverRatio, Return on

Total Resources

Ratio,

Return on Own Funds

Ratio, Earning perShare Ratio, Debtors

Turnover Ratio,

FORMAT OF BALANCE SHEET FOR RATIO ANALYSIS


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LIABILITIES ASSETSNET WORTH/EQUITY/OWNED FUNDSShare Capital/Partners Capital/Paid up Capital/

Owners Funds

Reserves ( General, Capital, Revaluation & OtherReserves)

Credit Balance in P&L A/c

FIXED ASSETS : LAND & BUILDING, PLANT &MACHINERIES

Original Value Less Depreciation

Net Value or Book Value or Written down value

LONG TERM LIABILITIES/BORROWED FUNDS :Term Loans (Banks & Institutions)

Debentures/Bonds, Unsecured Loans, Fixed

Deposits, Other Long Term Liabilities

NON CURRENT ASSETSInvestments in quoted shares & securities

Old stocks or old/disputed book debts

Long Term Security DepositsOther Misc. assets which are not current or fixed

in nature

CURRENT LIABILTIESBank Working Capital Limits such as

CC/OD/Bills/Export Credit

Sundry /Trade Creditors/Creditors/Bills Payable,Short duration loans or deposits

Expenses payable & provisions against various

items

CURRENT ASSETS : Cash & Bank Balance,Marketable/quoted Govt. or other securities,

Book Debts/Sundry Debtors, Bills Receivables,

Stocks & inventory (RM,SIP,FG) Stores & Spares,Advance Payment of Taxes, Prepaid expenses,

Loans and Advances recoverable within 12

months

INTANGIBLE ASSETSPatent, Goodwill, Debit balance in P&L A/c,

Preliminary or Preoperative expenses

SOME IMPORTANT NOTES


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Liabilities have Credit balance and Assets have Debit balance

Current Liabilities are those which have either become due for

payment or shall fall due for payment within 12 months from

the date of Balance Sheet

Current Assets are those which undergo change in theirshape/form within 12 months. These are also called Working

Capital or Gross Working Capital

Net Worth & Long Term Liabilities are also called Long TermSources of Funds

Current Liabilities are known as Short Term Sources of Funds Long Term Liabilities & Short Term Liabilities are also called

Outside Liabilities Current Assets are Short Term Use of Funds



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Assets other than Current Assets are Long Term Use of Funds Installments of Term Loan Payable in 12 months are to be taken as

Current Liability only for Calculation of Current Ratio & Quick Ratio.

If there is profit it shall become part of Net Worth under the headReserves and if there is loss it will become part ofIntangible Assets

Investments in Govt. Securities to be treated current only if these aremarketable and due. Investments in other securities are to be

treated Current if they are quoted. Investments inallied/associate/sister units or firms to be treated as Non-current.

Bonus Shares as issued by capitalization of General reserves and assuch do not affect the Net Worth. With Rights Issue, change takes

place in Net Worth and Current Ratio.

Liquidity Ratios


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1. Current Ratio : It is the relationship between the currentassets and current liabilities of a concern.

Current Ratio = Current Assets/Current LiabilitiesIf the Current Assets and Current Liabilities of a concern are

Rs.4,00,000 and Rs.2,00,000 respectively, then theCurrent Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1

The ideal Current Ratio preferred by Banks is 1.33 : 1

2. Net Working Capital : This is worked out as surplus of LongTerm Sources over Long Tern Uses, alternatively it is the

difference of Current Assets and Current Liabilities.

NWC = Current Assets Current Liabilities

q y

Current Assets : Raw Material, Stores, Spares, Work-in Progress. Finished


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Goods, Debtors, Bills Receivables, Cash.

Current Liabilities : Sundry Creditors, Installments of Term Loan, DPG etc.

payable within one year and other liabilities payable within one year.

This ratio must be at least 1.33 : 1 to ensure minimum margin of 25% of current

assets as margin from long term sources.

Current Ratio measures short term liquidity of the concern and its ability tomeet its short term obligations within a time span of a year.

It shows the liquidity position of the enterprise and its ability to meet current

obligations in time.

Higher ratio may be good from the point of view of creditors. In the long run

very high current ratio may affect profitability ( e.g. high inventory carrying cost)

Shows the liquidity at a particular point of time. The position can changeimmediately after that date. So trend of the current ratio over the years to be

analyzed.

Current Ratio is to be studied with the changes of NWC. It is also necessary to

look at this ratio along with the Debt-Equity ratio.

Profitability Ratios


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3. GROSS PROFIT RATIO : By comparing Gross Profit percentage to Net Sales

we can arrive at the Gross Profit Ratio which indicates the manufacturingefficiency as well as the pricing policy of the concern.

Gross Profit Ratio = (Gross Profit / Net Sales ) x 100

Alternatively , since Gross Profit is equal to Sales minus Cost of Goods Sold, itcan also be interpreted as below :

Gross Profit Ratio = [ (Sales Cost of goods sold)/ Net Sales] x 100A higher Gross Profit Ratio indicates efficiency in production of the unit.




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4. OPERATING PROFIT RATIO :

It is expressed as => (Operating Profit / Net Sales ) x 100

Higher the ratio indicates operational efficiency

5. NET PROFIT RATIO :

It is expressed as => ( Net Profit / Net Sales ) x 100

It measures overall profitability.


Solvency Ratios


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6. PROPRIETARY RATIO : This ratio indicates the extent to which TangibleAssets are financed byOwners Fund.Proprietary Ratio = (Tangible Net Worth/Total Tangible Assets) x 100

The ratio will be 100% when there is no Borrowing for purchasing of Assets.

7. DEBT EQUITY RATIO : It is the relationship between borrowersfund (Debt) and Owners Capital (Equity).

Long Term Outside Liabilities / Tangible Net WorthLiabilities of Long Term NatureTotal of Capital and Reserves & Surplus Less Intangible AssetsFor instance, if the Firm is having the following :

Capital = Rs. 200 LacsFree Reserves & Surplus = Rs. 300 LacsLong Term Loans/Liabilities = Rs. 800 Lacs

Debt Equity Ratio will be => 800/500 i.e. 1.6 : 1

Solvency Ratios


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8. Interest Coverage Ratio : This ratio indicates the extent to which companywill be able to service the debt that it has takenInterest Coverage Ratio = ( PBIT/ Interest on Debt) x 100


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9. STOCK/INVENTORY TURNOVER RATIO :


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(Average Inventory/Sales) x 365 for days(Average Inventory/Sales) x 52 for weeks(Average Inventory/Sales) x 12 for months

Average Inventory or Stocks = (Opening Stock + Closing Stock)

-----------------------------------------

2

. This ratio indicates the number of times the inventory isrotated during the relevant accounting period

10. DEBTORS TURNOVER RATIO : This is also called Debtors

Velocity or Average Collection Period or Period of Credit given


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Velocity or Average Collection Period or Period of Credit given .

(Average Debtors/Sales ) x 365 for days

(52 for weeks & 12 for months)

11. ASSET TRUNOVER RATIO : Net Sales/Tangible Assets

12. FIXED ASSET TURNOVER RATIO : Net Sales /Fixed Assets

13. CURRENT ASSET TURNOVER RATIO : Net Sales / Current Assets

14. CREDITORS TURNOVER RATIO : This is also called Creditors

Velocity Ratio, which determines the creditor payment period.

(Average Creditors/Purchases)x365 for days

(52 for weeks & 12 for months)


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15. RETRUN ON ASSETS : Net Profit after Taxes/Total Assets

16. RETRUN ON CAPITAL EMPLOYED :

( Net Profit before Interest & Tax / Average Capital Employed) x 100

Average Capital Employed is the average of the equity share

capital and long term funds provided by the owners and the

creditors of the firm at the beginning and end of the accounting

period.

Composite Ratio


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17. RETRUN ON EQUITY CAPITAL (ROE) :

Net Profit after Taxes / Tangible Net Worth

18. EARNING PER SHARE : EPS indicates the quantum of net profit

of the year that would be ranking for dividend for each share of

the company being held by the equity share holders.

Net profit after Taxes and Preference Dividend/ No. of Equity

Shares

19. PRICE EARNING RATIO : PE Ratio indicates the number of timesthe Earning Per Share is covered by its market price.

Market Price Per Equity Share/Earning Per Share

20. DEBT SERVICE COVERAGE RATIO : This ratio is one of the most

important one which indicates the ability of an enterprise to


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important one which indicates the ability of an enterprise to

meet its liabilities by way of payment of installments of Term

Loans and Interest thereon from out of the cash accruals and

forms the basis for fixation of the repayment schedule in

respect of the Term Loans raised for a project. (The Ideal DSCR

Ratio is considered to be 2 )

PAT + Depr. + Annual Interest on Long Term Loans & Liabilities---------------------------------------------------------------------------------

Annual interest on Long Term Loans & Liabilities + Annual

Installments payable on Long Term Loans & Liabilities

( Where PAT is Profit after Tax and Depr. is Depreciation)


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Technical Analysis

109 Deloitte

Technical Analysis is a study of market data in terms of factors affecting

supply and demand schedules, such as prices, volume of trading etc.

What is Technical Analysis and its


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difference from Fundamental Analysis

At the most basic level, a technical analyst approaches a security from the

charts, while a fundamental analyst starts with the financial statements.

Fundamental analysis takes a relatively long-term approach to analyzing

the market compared to technical analysis. While technical analysis can be

used on a timeframe of weeks, days or even minutes, fundamentalanalysis often looks at data over a number of years.

Trading Versus Investing

Not only is technical analysis more short term in nature that fundamental

analysis, but the goals of a purchase (or sale) of a stock are usually

different for each approach. In general, technical analysis is used for atrade, whereas fundamental analysis is used to make an investment.

A Fundamental analyst believes that stock market is 10% psychological

and 90% logical where as the Technical analyst thinks the stock market is

10% logical and 90% pscyhological

What is A Chart?

A chart is a tool both investors and traders use to help them determine whether to buy

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111 Deloitte

or sell a stock, a bond, commodity or a currency. In one neat package, a huge amount

of data can be viewed and as they say:

A picture is worth a thousand words.

Types of Chart Line Chart


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112 Deloitte

The most basic of the four charts is the line chart because it representsonly the closing prices over a set period of time. The line is formed by

connecting the closing prices over the time frame. Line charts do not

provide visual information of the trading range for the individual points such

as the high, low and opening prices. However, the closing price is often

considered to be the most important price in stock data compared to the

high and low for the day and this is why it is the only value used in linecharts.

Types of Chart Bar Chart
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113 Deloitte

Bar Charts

The bar chart expands on the line chart by adding several more key pieces

of information to each data point. The chart is made up of a series of

vertical lines that represent each data point. This vertical line represents

the high and low for the trading period, along with the closing price. The

close and open are represented on the vertical line by a horizontal dash.

The opening price on a bar chart is illustrated by the dash that is located

on the left side of the vertical bar. Conversely, the close is represented bythe dash on the right. Generally, if the left dash (open) is lower than the

right dash (close) then the bar will be shaded black, representing an up

period for the stock, which means it has gained value. A bar that is colored

red signals that the stock has gone down in value over that period. When

this is the case, the dash on the right (close) is lower than the dash on the

left (open).
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114 Deloitte

Types of Chart Candlestick Chart


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115 Deloitte

Candlestick ChartsThe candlestick chart is similar to a bar chart, but it differs in the way that it

is visually constructed. Similar to the bar chart, the candlestick also has a

thin vertical line showing the period's trading range. The difference comes

in the formation of a wide bar on the vertical line, which illustrates the

difference between the open and close. And, like bar charts, candlesticks

also rely heavily on the use of colors to explain what has happened duringthe trading period. A major problem with the candlestick color

configuration, however, is that different sites use different standards;

therefore, it is important to understand the candlestick configuration used

at the chart site you are working with. There are two color constructs for

days up and one for days that the price falls. When the price of the stock is

up and closes above the opening trade, the candlestick will usually bewhite or clear. If the stock has traded down for the period, then the

candlestick will usually be red or black, depending on the site. If the stock's

price has closed above the previous days close but below the day's open,

the candlestick will be black or filled with the color that is used to indicate

an up day.
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Trend Lines


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There are three basic kinds

of trends: An Up trend where prices are

generally increasing.

A Down trend where prices are

generally decreasing.

A Trading Range.

Support & Resistance


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Support & Resistance

Support and resistance lines

indicate likely ends of trends.

Resistance results from the

inability to surpass prior highs.

Support results from the inabilityto break below to prior lows.

What was support becomes

resistance, and vice-versa.

Support Resistance

Breakout

Price Patterns


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Technicians look for many patterns in the historical time series of prices.

These patterns are reputed to provide information regarding the size and timing of

subsequent price moves.

But dont forget that the EMH says these patterns are illusions, and have no real

meaning. In fact, they can be seen in a randomly generated price series.

Head and Shoulders


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This formation is

characterized by two small

peaks on either side of a

larger peak.

This is a reversal pattern,

meaning that it signifies a

change in the trend.

Head

Head

Left Shoulder

Left Shoulder

Right Shoulder

Right Shoulder

Neckline

Neckline

H&S Top

H&S Bottom

Head & Shoulders Example


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Sell Signal

Minimum Target Price

Based on measurement rule

Double Tops and Bottoms


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These formations are

similar to the H&S

formations, but there is no

head.

These are reversal patterns

with the same measuring

implications as the H&S.

Target

Double Top

Double Bottom

Target

Double Bottom Example


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Triangles


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Triangles are continuationformations.

Three flavors: Ascending

Descending Symmetrical

Typically, triangles shouldbreak out about half tothree-quarters of the way

through the formation.

Ascending

Descending

Symmetrical

Symmetrical

Flag and PennantFlag and Pennant


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These two short-term chart patterns are continuation patterns that are formed when

there is a sharp price movement followed by a generally sideways price movement.

This pattern is then completed upon another sharp price movement in the same

direction as the move that started the trend. The patterns are generally thought to

last from one to three weeks.

As you can see in Figure there is little difference between a pennant and a flag. Themain difference between these price movements can be seen in the middle section of

the chart pattern. In a pennant, the middle section is characterized by converging

trendlines, much like what is seen in a symmetrical triangle. The middle section on

the flag pattern, on the other hand, shows a channel pattern, with no convergence

between the trendlines. In both cases, the trend is expected to continue when the

price moves above the upper trendline.

Falling WedgeWedge
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Wedge

The wedge chart pattern can be either a continuation or reversal pattern. It is

similar to a symmetrical triangle except that the wedge pattern slants in an

upward or downward direction, while the symmetrical triangle generally showsa sideways movement. The other difference is that wedges tend to form over

longer periods, usually between three and six months.

Technical indicators
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The short interest ratio theoryWhat Does Sho rt Interest RatioMean?

A sentiment indicator that is derived by dividing the

short interest by the average daily volume for a stock.

This indicator is used by both fundamental andtechnical traders to identify the prevailing sentiment the

market has for a specific stock.



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Confidence IndexIt is a ratio of lower grade bonds to higher grade bonds,

when this ratio is higher then the market is aggressive

and if the ratio is lower then the market is conservative

People prefer to save in higer grade bonds when theyare conservative



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SpreadsLarge spreads between yields indicate Bearishness

Advance Decline ratio

When the number of stock advances are higher than

the number of stock declines then this ratio is higher

and it indicates bullishness



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Odd Lot Ratio Small investors trade in odd lotshence higher the number indicates a possibility of

revision in the market

Insider Transaction

When Insiders start buying or selling It is indicative ofbullish or bearish trend

Moving Average

This is the average price for the last pre-definednumber of days. Typically it is either 10,20,50,100 days

DERIVATIVES DEFINED


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Derivative is a product whose value is derived from the

value of one or more basic variables, called bases(underlying asset, index, or reference rate), in a contractual

manner.

The underlying asset can be equity, forex, commodity or

any other asset.

For example, wheat farmers may wish to sell their harvest

at a future date to eliminate the risk of a change in prices by

that date.

Such a transaction is an example of a derivative. The price

of this derivative is driven by the spot price of wheat whichis the "underlying".

FACTORS DRIVING THE GROWTH OF DERIVATIVES


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1. Increased volatility in asset prices in financial markets,

2. Increased integration of national financial markets with the international

markets,

3. Marked improvement in communication facilities and sharp decline in their

costs,

4. Development of more sophisticated risk management tools, providing

economic agents a wider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine the risks andreturns over a large number of financial assets leading to higher returns,

reduced risk as well as transactions costs as compared to individual

financial assets.

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DERIVATIVE PRODUCTS


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Derivative contracts have several variants. The most common variants are

forwards, futures, options and swaps. We take a brief look at various

derivatives contracts that have come to be used.

Forwards:A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today's pre-agreed

price.

Futures:A futures contract is an agreement between two parties to buy or sell an

asset at a certain time in the future at a certain price. Futures contracts are specialtypes of forward contracts in the sense that the former are standardized

exchange-traded contracts.

Options: Options are of two types - calls and puts. Calls give the buyer the

right but not the obligation to buy a given quantity of the underlying asset, at

a given price on or before a given future date. Puts give the buyer the right,

but not the obligation to sell a given quantity of the underlying asset at a given

price on or before a given date.

133

Operators in the derivatives market


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2009 Deloitte LLP. All rights reserved.

Hedgers - Operators, who want to transfer a

risk component of their portfolio.

Speculators - Operators, who intentionallytake the risk from hedgers in pursuit of profit.

Arbitrageurs - Operators who operate in the

different markets simultaneously, in pursuit ofprofit and eliminate mis-pricing.

Over the Couter (OTC) contracts - FORWARDS


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1. The management of counter-party (credit) risk is decentralized and

located within individual institutions,

2. There are no formal centralized limits on individual positions, leverage,

or margining,

3. There are no formal rules for risk and burden-sharing,

4. There are no formal rules or mechanisms for ensuring market stability

and integrity, and for safeguarding the collective interests of market

participants, and5. The OTC contracts are generally not regulated by a regulatory authority

and the exchange's self-regulatory organization, although they are

affected indirectly by national legal systems, banking supervision and

market surveillance.

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FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on a specified date for a


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A forward contract is an agreement to buy or sell an asset on a specified date for a

specified price. One of the parties to the contract assumes a long position and agrees

to buy the underlying asset on a certain specified future date for a certain specified

price. The other party assumes a short position and agrees to sell the asset on thesame date for the same price. Other contract details like delivery date, price and

quantity are negotiated bilaterally by the parties to the contract. The forward contracts

are normally traded outside the exchanges.

The salient features of forward contracts are: They are bilateral contracts and hence exposed to counter-party risk.

Each contract is custom designed, and hence is unique in terms of contract size,

expiration date and the asset type and quality.

The contract price is generally not available in public domain.

On the expiration date, the contract has to be settled by delivery of the asset.

If the party wishes to reverse the contract, it has to compulsorily go to the same

counter-party, which often results in high prices being charged.

136

LIMITATIONS OF FORWARD MARKETS


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Forward markets world-wide are afflicted by several problems:

Lack of centralization of trading,

Illiquidity, and

Counterparty risk

In the first two of these, the basic problem is that of too much flexibility and

generality. The forward market is like a real estate market in that any two

consenting adults can form contracts against each other. This often makes them

design terms of the deal which are very convenient in that specific situation, butmakes the contracts non-tradable.

Counterparty risk arises from the possibility of default by any one party to the

transaction. When one of the two sides to the transaction declares bankruptcy, the

other suffers. Even when forward markets trade standardized contracts, and hence

avoid the problem of illiquidity, still the counterparty risk remains a very seriousissue.

137

INTRODUCTION TO FUTURES


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Futures markets were designed to solve the problems that exist in forward markets.

A futures contract is an agreement between two parties to buy or sell an asset at a

certain time in the future at a certain price. But unlike forward contracts, the futurescontracts are standardized and exchange traded. To facilitate liquidity in the futures

contracts, the exchange specifies certain standard features of the contract. It is a

standardized contract with standard underlying instrument, a standard quantity and

quality of the underlying instrument that can be delivered, (or which can be used for

reference purposes in settlement) and a standard timing of such settlement. A

futures contract may be offset prior to maturity by entering into an equal andopposite transaction. More than 99% of futures transactions are offset this way.

The standardized items in a futures contract are:

Quantity of the underlying

Quality of the underlying

The date and the month of delivery The units of price quotation and minimum price change

Location of settlement

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DISTINCTION BETWEEN FUTURES AND FORWARDS

CONTRACTS


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Forward contracts are often confused with futures contracts. The confusion is

primarily because both serve essentially the same economic functions of

allocating risk in the presence of future price uncertainty. However futures are

a significant improvement over the forward contracts as they eliminate

counterparty risk and offer more liquidity.

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FUTURES TERMINOLOGY


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Spot p r ice: The pr ice at which an asset trades in the spot m arket.

Futures pr ice: The pr ice at wh ich the futures contract trades in the

futures market.

Contract cycle: The per iod over which a contract trades. The index

futures contracts on the NSE have one- month, two-months and threemonths

expiry cycles which expire on the last Thursday of the month.

Thus a January expiration contract expires on the last Thursday of

January and a February expiration contract ceases trading on the lastThursday of February. On the Friday following the last Thursday, a new

contract having a three- month expiry is introduced for trading.

Expiry date: It is the date speci f ied in the futu res con tract. This is the

last day on which the contract will be traded, at the end of which it will

cease to exist. Contract size: The amoun t of asset that has to be del ivered under

one contract. Also called as lot size.

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FUTURES TERMINOLOGY


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Basis: In the context of f in ancial futu res, basis can be def ined as thefutures price

minus the spot price. There will be a different basis for each delivery month for each

contract. In a normal market, basis will be positive. This reflects that futures pricesnormally exceed spot prices.

Cost of carry: The relat ion ship between futures pr ices and spot pr icescan be

summarized in terms of what is known as the cost of carry. This measures the storage

cost plus the interest that is paid to finance the asset less the income earned on the

asset.

Ini t ial margin: The amou nt that mu st be depos i ted in the marginaccount at the

time a futures contract is first entered into is known as initial margin.

Marking-to-market: In the fu tures m arket, at the end o f eachtrading day, the

margin account is adjusted to reflect the investors gain or loss depending upon the

futures closing price. This is called marking-to-market.

Maintenance margin: This is somewhat lower than the ini t ial margin.This is set to ensure that the balance in the margin account never becomes negative.

If the balance in the margin account falls below the maintenance margin, the investor

receives a margin call and is expected to top up the margin account to the initial

margin level before trading commences on the next day.

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INTRODUCTION TO OPTIONS

O ti f d t ll diff t f f d d f t t t A ti


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Options are fundamentally different from forward and futures contracts. An option

gives the holder of the option the right to do something. The holder does not have

to exercise this right. In contrast, in a forward or futures contract, the two partieshave committed themselves to doing something. Whereas it costs nothing (except

margin requirements) to enter into a futures contract, the purchase of an option

requires an up-front payment.

Option is a form of Insurance The person buying an option is buying a insurance

and the option writer is the Insurer!!

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OPTION TERMINOLOGY

I d t i Th t i h th i d th d l i


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Index opt ion s: These op t ions have the index as the und er ly ing .

Some options are European while others are American. Like index

futures contracts, index options contracts are also cash settled.Stock opt ions: Stock op t ions are opt ions on ind iv idual stoc ks. Opt ions

currently trade on over 500 stocks in the United States. A contract gives the

holder the right to buy or sell shares at the specified price.

Buyer of an opt ion: The buyer of an opt ion is the one who by paying the

option premium buys the right but not the obligation to exercise hisoption on the seller/writer.

Writer of an opt ion : The wri ter of a cal l /pu t opt io n is the on e who receives

the option premium and is thereby obliged to sell/buy the asset if the

buyer exercises on him.

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Th t b i t f ti ll ti d t ti


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There are two basic types of options, call options and put options.

Cal l opt ion : A cal l op t ion g ives the holder the r ight but n ot the ob l igat ion to

buy an asset by a certain date for a certain price. Put opt ion: A put o pt ion gives the holder the r ight b ut no t the obl igation to

sell an asset by a certain date for a certain price.

Opt ion pr ice/premium: Opt ion pr ice is the pr ice which the opt ion buyer

pays to the option seller. It is also referred to as the option premium. Expirat ion d ate: The date speci f ied in the opt ion s con tract is known as

the expiration date, the exercise date, the strike date or the maturity.

Str ike pr ice: The pr ice speci f ied in the opt ion s con tract is known as the

strike price or the exercise price.

American op t ions : American op t ions are opt ions th at can be exercised atany time upto the expiration date. Most exchange-traded options are American.

European op t ions : Europ ean op t ions are op t ions that can be exercised

only on the expiration date itself

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Participants in the F&O Market

Exchanges : provide an infrastructure for carrying out the dealings on assets


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Exchanges :- provide an infrastructure for carrying out the dealings on assets

CBOT (Chicago Board of Trade), SFE (Sydney Futures Exchange), LIFFE (London

International Finance Futures Exchange), TIFFE.Clearing House :- acts as a nerve centre of contract execution and completion.

Custodians :- require the participants to deposit their securities before starting

trading.

Banks :- handle large volume of fund movements that take place between members

and clearing house.

The regulator :- creates confidence among the transacting members of the exchange

Market makers : decide the market price depending upon the demand and supply of

the underlying asset. (jobbers)

Brokers :- perform the task of bringing together the buyers and sellers

Arbitrageurs :- players who enter into such contracts that can earn riskless profits

through the process of arbitrage.

Speculators :- provide the liquidity and the volume to market which helps reducing

costs.

Hedgers : - provide for locking in the future expected price at which to buy or sell.

They safeguard their position from falling rates and prices.

Formulaes for calculation of Portfolio Risk

Variation 1:


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1

1

1

1 1

n

i

i

n

n i

i

X Xn

X X

[Ri E(R)]2 X P [Ri E(R)]2 X P

Variation 1:

Various values of X is given

Various values of Y is givenCalculate mean of X

Calculate mean of Y

Calculate Standard deviation of X

Calculate standard deviation of Y

Calculate Mean of Portfolio = proportion of X * Mean value of X + Proportion of Y *Mean Value of Y

Standard Deviation of portfolio =

P1 = Proportion of investment in X

P2 = Proportion of Investment in Y

r = Correlation coefficient between X and Y

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P12

s

2X + P

22

s2

Y +2P1

P2

rsX sYsCombined Portfolio

Formulae for correlation Coefficient and covariance

Correlation Coefficient (r) = co variance between x and y


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Correlation Coefficient (r) = covariance between x and y

sX sY

Calculation of Covariance = S xi - x Yi - Y n1

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Calculation of Beta

B t (b


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Beta (b = covariance between security and market

s2m

Covariance between security and market = S Ri - RiRm - Rm n1

s2m =S Rm - Rm 2

n1

sapm - fifth (5) sem bbi

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