Security Analysis and Portfolio Management DCOM504/DMGT511 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Copyright © 2011 Sudhindra Bhat All rights reserved Produced & Printed by EXCEL BOOKS PRIVATE LIMITED A-45, Naraina, Phase-I, New Delhi-110028 for Lovely Professional University Phagwara SYLLABUS Security Analysis and Portfolio Management Objectives: This course aims to provide a basic knowledge of the theories and practices of modern portfolio choice and investment decision. The course will acquaint students with some fundamental concepts such as risk diversification, portfolio selection, capital asset pricing model etc. The students are also expected to be able to apply certain techniques to evaluate and analyse risk and return characteristics of securities such as individual stocks, mutual funds, and government and corporate bonds. DMGT511 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sr. No. Description 1. Introduction to Security Analysis. 2. Fundamental Analysis: Economic Analysis, Industry Analysis, Company Analysis. 3. Equity valuation models: balance sheet valuation, dividend discount model, free cash flow models, earnings. 4. Technical Analysis: Charting techniques & technical indicators, Efficient Market Theory 5. Introduction to Portfolio Management, Portfolio Analysis. 6. Capital Asset Pricing Theory (CML & SML). 7. Arbitrage Pricing Theory. 8. Models Markowitz risk-return optimization Single Index Model, Two factor and multi factor models. 9. Portfolio Performance Evaluation. 10. Portfolio Revision. DCOM504 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT Sr. No. Description 1 Introduction to Security Analysis: Introduction, approaches to investment decisions and portfolio management process 2 Fundamental Analysis(Economic Analysis, Industry Analysis and Company Analysis) 3 Equity valuation models (balance sheet valuation, dividend discount model, free cash flow models, earnings),Bond Valuation 4 Technical Analysis (Charting techniques & technical indicators), 5 Efficient Market Theory 6 Models (Markowitz risk-return optimization Single Index Model, Two factor and multi factor models) 7 Introduction to Portfolio Management, Portfolio Analysis 8 Capital Asset Pricing Theory(CML &SML), Arbitrage Pricing Theory 9 Portfolio Performance Evaluation: Sharpe, Treynor and Jensens index. 10 Portfolio Revision: Formula plans; constant rupee plan, constant ratio plan and variable ratio plan CONTENTS Unit 1: Introduction to Capital Market 1 Unit 2: Risk and Return 58 Unit 3: Introduction to Security Analysis 93 Unit 4: Fundamental Analysis 109 Unit 5: Equity Valuation Models 148 Unit 6: Technical Analysis 165 Unit 7: Efficient Market Theory 196 Unit 8: Derivatives 217 Unit 9: Portfolio Management 243 Unit 10: Portfolio Analysis 257 Unit 11: Capital Market Theory 268 Unit 12: Models 297 Unit 13: Portfolio Performance Evaluation 314 Unit 14: Portfolio Revision 332 Corporate and Business Law 6 LOVELY PROFESSIONAL UNIVERSITY Unit 1: Introduction to Capital Market Unit 1: Introduction to Capital Market Notes CONTENTS Objectives Introduction 1.1 Capital Market 1.2 New Issue Market 1.2.1 Functions of New Issue Market 1.2.2 Methods of Floating New Issues 1.2.3 Non-voting Shares 1.2.4 Bought Out Deal 1.3 Stock Exchanges 1.3.1 Stock Market in India 1.3.2 Stock Market Indices 1.3.3 Role and Stock Exchange Functions 1.3.4 Membership, Organization and Management 1.3.5 Trading System 1.3.6 Stock Market Information System 1.3.7 Principal Weaknesses of Indian Stock Market 1.3.8 Directions to Reform the Functioning of Stock Exchanges 1.3.9 National Stock Exchange of India Ltd. 1.3.10 Over the Counter Exchange of India (OTCEI) 1.3.11 Inter-connected Stock Exchange of India 1.3.12 Demutualisation of Stock Exchanges 1.4 Investment Alternatives 1.5 Dematerialization 1.6 Summary 1.7 Keywords 1.8 Self Assessment 1.9 Review Questions 1.10 Further Readings LOVELY PROFESSIONAL UNIVERSITY 1 Security Analysis and Portfolio Management Notes Objectives After studying this unit, you will be able to: Define Capital market Explain introduction to new issue market Discuss functions of new issues market Describe methods of floating new issues Explain Stock Exchanges State reforms in Indian Stock Exchanges Introduction In every economic system, some units which may be individual or institutions are surplus-generating, others are deficit-generating. Surplus-generating units are called savers while deficit-generators are called spenders. In our country, at spectral level, households are surplus-generating while corporate and government are deficit generating. This is, however, true only at an aggregate level. You would definitely come across individual households who are deficit generating and corporate bodies who are surplus generating at some point of time. The question that arises here is: What do the surplus-generating units do with their surpluses or savings? You can now imagine that they have only two alternatives before them. They can either invest or hold their savings in the form of liquid cash. Holding liquid cash is required to meet transactionary, or precautionary or speculative needs. The surplus-generating units could invest in different forms. They could invest in physical assets viz. land and buildings, plant and machinery or in precious metals viz. gold and silver, or in financial assets viz. shares and debentures, units of the Unit Trade India, treasury bills, commercial paper etc. A capital market is a market for securities (both debt and equity), where business enterprises (companies) and governments can raise long-term funds. It is defined as a market in which money is lent for periods longer than a year, as the raising of short-term funds takes place on other markets (e.g., the money market). 1.1 Capital Market The market where investment funds like bonds, equities and mortgages are traded is known as the capital market. The primal role of the capital market is to channelize investments from investors who have surplus funds to the ones who are running a deficit. The capital market offers both long-term and overnight funds. The capital market is the market for securities, where companies and governments can raise long-term funds. It is a market in which money is lent for periods longer than a year. There are a number of capital market instruments used for market trade, including equity instruments, credit market instruments, insurance instruments, foreign exchange instruments, hybrid instruments and derivative instruments. These are used by the investors to make a profit out of their respective markets. All of these are called capital market instruments because these are responsible for generating funds for companies, corporations, and sometimes national governments. This market is also known as securities market because long-term funds are raised through trade on debt and equity securities. 2 LOVELY PROFESSIONAL UNIVERSITY Unit 1: Introduction to Capital Market These activities may be conducted by both companies and governments. Notes Capital Market consists of primary market and secondary market. In primary market newly issued bonds and stocks are exchanged and in secondary market buying and selling of already existing bonds and stocks take place. ! Caution Many people divide the Capital Market into Bond Market and Stock Market. Bond Market provides financing by bond issuance and bond trading. Stock Market provides financing by shares or stock issuance and by share trading. As a whole, Capital Market facilitates raising of capital through the trading of long-term financial assets. 1.2 New Issue Market The New Issue Market or NIM is also called the primary capital market. The securities which are introduced in the market are sold for first time to the general public in this market. This market is also known as the long-term debt market as the fund raised from this market provides long-term capital. Corporate entities may raise capital in the primary market by way of an initial public offer, rights issue or private placement. An Initial Public Offer (IPO) is the selling of securities to the public in the primary market. This Initial Public Offering can be made through the fixed price method, book-building method or a combination of both. In case the issuer chooses to issue securities through the book-building route, then as per SEBI guidelines, an issuer company can issue securities in the following manner: 1. 100% of the net offer to the public through the book-building route. 2. 75% of the net offer to the public through the book-building process and 25% through the fixed price portion. The industrial securities markets in India consist of new issue market and stock exchange. The new issue market deals with the new securities, which were not previously available to the investing public, i.e. the securities that are offered to the investing public for the first time. The market, therefore, makes available a new block of securities for public subscription. The other words, new issue market deals with the raising of fresh capital by companies either for cash or for consideration other than cash. The new issue market encompasses all institution dealing in fresh claim. The forms in which these claims are created are equity shares, preference shares, debentures, rights issues, deposits etc. All financial institutions, which contribute, underwrite and directly subscribe to the securities, are part of new issue markets. 1.2.1 Functions of New Issue Market The main function of new issue market is to facilitate transfer resources from savers to the users. The savers are individuals, commercial banks, insurance company etc. the users are public limited companies and the government. The new issue market plays an important role in mobilizing the funds from the savers and transferring them to borrowers for production purposes, an important requisite of economic growth. It is not only a platform for raising finance to LOVELY PROFESSIONAL UNIVERSITY 3 Security Analysis and Portfolio Management Notes establish new enterprises, but also for expansion/diversification/modernizations of existing units. On this basis, the new market can be classified as: 1. A market where firms go to the public for the first time through Initial Public Offering (IPO).