Security Analysis & Portfolio Management

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Return and Risk Return: Reward earned from investing money (gain/loss). Current Income: Dividends, interest, rent. Capital Gain/Loss: Change in market price. Risk: Possibility that actual return differs from expected; uncertainty or variability. Stable returns $\to$ low risk. Fluctuating returns $\to$ high risk. Higher risk generally associated with higher potential return (Risk-Return tradeoff). Measurement of Return (Individual Security) Actual (Historical) Return $R = \frac{(P_1 - P_0) + D}{P_0}$ $P_0$: Purchase price $P_1$: Selling price or current price $D$: Dividend or income received Expected Return $E(R) = \sum[P_i \times R_i]$ $R_i$: Return in state $i$ $P_i$: Probability of that state Measurement of Risk (Individual Security) Measured by variance ($\sigma^2$) or standard deviation ($\sigma$). $\sigma^2 = \sum [P_i(R_i - E(R))^2]$ $\sigma = \sqrt{\sigma^2}$ Portfolio Return and Risk A portfolio is a combination of two or more securities. Portfolio Return $E(R_p) = W_1E(R_1) + W_2E(R_2) + \dots + W_nE(R_n)$ $W_i$: Proportion of total investment in asset $i$ $E(R_i)$: Expected return of asset $i$ Portfolio Risk (Two Securities) $\sigma_p^2 = W_1^2\sigma_1^2 + W_2^2\sigma_2^2 + 2W_1W_2\sigma_1\sigma_2\rho_{12}$ $\sigma_p = \sqrt{\sigma_p^2}$ $\rho_{12}$: Correlation coefficient between returns of asset 1 and 2 $\sigma_1, \sigma_2$: Standard deviation of returns $W_1, W_2$: Weights (investment proportions) Effect of Correlation ($\rho$) $\rho$ value Relationship Effect on Portfolio Risk +1 Perfect positive correlation No risk reduction 0 No correlation Partial risk reduction -1 Perfect negative correlation Maximum risk reduction (can eliminate risk) Diversification is effective when correlation $ Diversification and Correlation Diversification means investing in different types of securities to reduce overall risk. Positively correlated securities $\to$ small diversification benefit. Negatively correlated securities $\to$ risk greatly reduced. Diversification can eliminate only unsystematic risk , not systematic risk. Types of Risk Type Meaning Example Can it be Diversified? Systematic Risk Market-related risk that affects all securities Inflation, interest rate, war, political instability No Unsystematic Risk Company or industry specific risk Labor strike, management inefficiency, new competitor Yes Factor Pricing Models Explain returns on securities in terms of exposure to common risk factors. Expected return = risk-free rate + risk premiums for systematic risk. Purpose: Identify risk sources, measure sensitivity, determine expected return. General Form of a Factor Model $R_i = E(R_i) + \beta_{i1}F_1 + \beta_{i2}F_2 + \dots + \beta_{ik}F_k + e_i$ $R_i$: Actual return on security $i$ $E(R_i)$: Expected return on security $i$ $F_k$: $k$-th common factor $\beta_{ik}$: Sensitivity of security $i$ to factor $k$ $e_i$: Firm-specific (unsystematic) risk term Interpretation Each factor represents a source of systematic risk. Beta ($\beta$) tells how strongly security reacts to that factor. Error term ($e$) represents firm-unique risk. Types of Factor Pricing Models Type Description Example Single-Factor Models Explain returns using one common factor CAPM Multi-Factor Models Explain returns using two or more factors Arbitrage Pricing Theory (APT), Fama-French 3- or 5-Factor Models Single-Factor Model: Capital Asset Pricing Model (CAPM) Most famous single-factor model. Assumes market risk is the ONLY factor affecting returns. $E(R_i) = R_f + \beta_i[E(R_m) - R_f]$ $E(R_i)$: Expected return on security $i$ $R_f$: Risk-free rate of return $E(R_m)$: Expected return on market portfolio $[E(R_m) - R_f]$: Market risk premium $\beta_i$: Sensitivity of stock to market risk Interpretation Securities with higher $\beta$ have higher expected returns. Investors are compensated only for systematic (market) risk, not for unsystematic risk. Multi-Factor Models Used when more than one source of systematic risk affects returns. Arbitrage Pricing Theory (APT) $E(R_i) = R_f + b_{i1}\lambda_1 + b_{i2}\lambda_2 + \dots + b_{ik}\lambda_k$ $R_f$: Risk-free rate $b_{ik}$: Sensitivity of asset $i$ to factor $k$ $\lambda_k$: Risk premium associated with factor $k$ APT vs. CAPM Aspect CAPM APT No. of Factors One (Market) Multiple Source of Theory Equilibrium model Arbitrage (no-arbitrage condition) Key Assumption Investors hold market portfolio No arbitrage opportunities Simplicity Simpler More flexible, realistic Risk Types Market risk only Any macroeconomic risk factors Fama-French Three-Factor Model (1993) Expands CAPM by adding two factors: Size (SMB) and Value (HML). $E(R_i) - R_f = \alpha + \beta_m(R_m - R_f) + \beta_s(SMB) + \beta_v(HML)$ $R_m - R_f$: Market risk premium $SMB$: "Small Minus Big" $\to$ Size factor (small firms outperform large ones) $HML$: "High Minus Low" $\to$ Value factor (high book-to-market outperform low) Fama-French Five-Factor Model (2015) Adds two more factors to the 3-factor model: Profitability (RMW) and Investment (CMA). $E(R_i) - R_f = \alpha + \beta_m(R_m - R_f) + \beta_s(SMB) + \beta_v(HML) + \beta_r(RMW) + \beta_c(CMA)$ Five key factors: Market risk, Size, Value, Profitability, Investment pattern. Carhart Four-Factor Model (1997) Extension of Fama-French 3-factor model, adds a momentum factor (WML). $E(R_i) - R_f = \alpha + \beta_m(R_m - R_f) + \beta_s(SMB) + \beta_v(HML) + \beta_{mom}(WML)$ $WML$: "Winners Minus Losers" $\to$ Momentum factor (past winners continue to perform well). Economic (Macroeconomic) Factor Models Use real-world macroeconomic variables as factors: Inflation rate, industrial production growth, interest rate changes, exchange rate fluctuations, market index performance. Factor Loadings and Risk Premiums Component Meaning Factor ($F$) Source of systematic risk Factor Loading ($\beta$) Sensitivity of asset to that factor Risk Premium ($\lambda$) Additional return required per unit of factor risk $\alpha$ (Alpha) Abnormal return not explained by factors (manager's skill) Valuation Basics Estimating the intrinsic value (true worth) of a security. Value = Present Value of Expected Future Cash Flows Estimating future cash flows. Choosing an appropriate discount rate (required rate of return). Computing present value (PV) of those cash flows. Fixed Income Valuation (Bond Valuation) A bond promises fixed interest (coupon payments) and repayment of principal at maturity. Components of Bond Cash Flows Periodic Coupon Payments (Interest income) Principal (Face Value) at Maturity Basic Formula for Bond Value $V_0 = \sum_{t=1}^{n} \frac{C}{(1+k)^t} + \frac{F}{(1+k)^n}$ $V_0$: Intrinsic value (price) of the bond $C$: Annual coupon payment $F$: Face (par) value of bond $n$: Number of years to maturity $k$: Required rate of return (YTM) Interpretation If $V_0 >$ Market Price: Bond is undervalued (Buy) If $V_0 Zero-Coupon Bond Valuation Pays no interest, only face value at maturity. $V_0 = \frac{F}{(1+k)^n}$ Relationship Between Bond Price and Interest Rate Inverse relationship: When rates rise, bond prices fall; when rates fall, bond prices rise. Long-term bonds are more sensitive to rate changes than short-term bonds. Equity Valuation (Stock Valuation) Determines the intrinsic value of a share based on expected dividends and capital gains. Concept $V_0 = PV(\text{Expected Dividends}) + PV(\text{Expected Sale Price})$ If $V_0 >$ Market price $\to$ Buy If $V_0 Dividend Discount Models (DDM) 1. Zero-Growth Model (Constant Dividend) Used when company pays a fixed dividend every year. $P_0 = \frac{D}{k_e}$ $P_0$: Intrinsic value of stock $D$: Constant annual dividend $k_e$: Required rate of return (cost of equity) 2. Constant Growth Model (Gordon Growth Model) Used when dividends grow at a constant rate ($g$) forever. $P_0 = \frac{D_1}{k_e - g}$ $D_1$: Dividend expected next year $g$: Constant growth rate $k_e$: Required rate of return 3. Multi-Stage (Two-Stage) Growth Model Used when dividends grow at a high rate initially, then a constant rate. Compute PV of dividends during high-growth period. Compute terminal value using Gordon Model for stable growth. Discount all cash flows to present value. Price/Earnings (P/E) Ratio Valuation $P_0 = (\text{Expected EPS}) \times (\text{Appropriate P/E Ratio})$ Comparison: Bond vs Equity Valuation Aspect Bond Valuation Equity Valuation Cash Flows Fixed (Coupon + Face Value) Variable (Dividends + Capital Gains) Life Definite maturity Indefinite (perpetual) Discount Rate YTM / Required return on bond Cost of equity ($k_e$) Risk Lower (fixed income) Higher (residual income) Formula Type Present value of fixed cash flows Present value of expected future dividends Key Insights Bond valuation uses discounted cash flow of fixed coupons and redemption value. Equity valuation uses expected dividends and growth assumptions. Both depend critically on: Accurate estimation of cash flows, appropriate discount rate, growth rate assumptions. Asset Allocation Techniques Strategies to distribute investments among different asset classes to balance risk and return. Determines most of the portfolio's performance over time. Meaning of Asset Allocation Process of deciding how to distribute an investor's total portfolio among different asset classes: Equities (stocks): Ownership in companies, high risk, high return. Fixed-income securities (bonds): Lending to governments or corporations, moderate risk. Cash or cash equivalents: Money market instruments, lowest risk, low return. Real assets: Real estate, gold, commodities, etc. Alternative investments: Hedge funds, private equity, derivatives. Purpose: Balance risk and return according to investor's goals, time horizon, and tolerance for risk. Asset allocation = deciding what percentage of your portfolio goes into each investment category. Objectives of Asset Allocation Risk Diversification: Reduce portfolio risk by spreading investments. Maximize Return: Achieve best possible return for a given risk level. Maintain Liquidity: Keep part of portfolio in liquid assets. Inflation Protection: Include assets that maintain purchasing power. Stability: Avoid large fluctuations in total portfolio value. Goal Alignment: Match portfolio composition with financial goals. Major Asset Classes and Their Role Asset Class Risk Level Return Potential Liquidity Typical Purpose Equities (Stocks) High High Moderate Growth and capital appreciation Bonds (Debt) Medium Moderate High Regular income and stability Cash / Money Market Low Low Very High Safety and liquidity Real Estate Medium Moderate to High Low Inflation hedge and diversification Commodities (Gold, Oil) Medium to High Varies Medium Inflation protection, diversification Alternatives (Hedge Funds, PE) High High Low High return potential Techniques of Asset Allocation (Detailed) 1. Strategic Asset Allocation Long-term, disciplined approach. Investor sets a target mix based on risk tolerance, financial goals, time horizon. Periodically rebalanced to restore original target proportions. Features: Long-term focus, passive, requires periodic rebalancing, based on MPT. Advantage: Maintains consistent risk level over time. Disadvantage: Ignores short-term market opportunities. 2. Tactical Asset Allocation Short-term and active technique. Temporarily deviates from strategic allocation to exploit market opportunities/conditions. Managers may overweight or underweight certain asset classes. Features: Active management, short-term flexibility, seeks to exploit market inefficiencies. Advantage: Potentially higher short-term returns. Disadvantage: Higher transaction costs, risks due to market timing errors. 3. Dynamic Asset Allocation Continuously adjusting approach based on market trends and portfolio performance. Investors increase holdings in assets performing well and decrease in underperforming assets. Features: Reactive and flexible, constant adjustment, aimed at maximizing growth while controlling downside risk. Advantage: Adapts to market conditions. Disadvantage: Requires frequent monitoring and higher transaction costs. 4. Constant-Weight Asset Allocation Investor maintains fixed percentage allocations and regularly rebalances. Involves buying low and selling high. Features: Passive but disciplined, relies on consistent rebalancing, prevents asset classes from dominating. Advantage: Controls risk and enforces discipline. Disadvantage: May lead to missed opportunities if trends persist. 5. Insured Asset Allocation Combines portfolio insurance with asset allocation. Investor decides a minimum acceptable portfolio value (the floor) . Risky assets purchased only when portfolio value exceeds this floor. If value falls toward the floor, funds moved to safer assets. Features: Capital preservation + growth, active risk control, suited for risk-averse investors. Advantage: Protects downside risk. Disadvantage: Limits upside potential during bull markets. 6. Integrated (Hybrid) Asset Allocation Combination of strategic and tactical techniques. Strategic long-term mix set, but tactical adjustments made based on forecasts/conditions. Advantage: Balances discipline with flexibility. Disadvantage: Complex, may require expert judgment. 7. Core-Satellite Asset Allocation Divides portfolio into: Core: Stable, long-term investments (passive index funds, ETFs). Satellite: Smaller portion in actively managed or high-risk, high-return assets. Core provides stability; Satellite adds potential outperformance. Advantage: Combines passive cost efficiency with active growth potential. Disadvantage: Requires careful monitoring of satellite investments. Factors Influencing Asset Allocation Decisions Factor Description Risk Tolerance Willingness to accept losses for higher returns. Investment Horizon Time available before funds are needed (short-term $\to$ bonds; long-term $\to$ equities). Financial Goals Purpose (e.g., retirement, home purchase). Market Conditions Economic cycles, interest rates, inflation. Liquidity Needs Need for cash in emergencies or expenses. Tax Considerations Different assets have different tax implications. Age and Income Younger investors can take more risks; retirees prefer safety. Importance of Asset Allocation Determines over 90% of portfolio performance. Diversifies risk across markets and instruments. Provides stability during market fluctuations. Ensures discipline and prevents emotional investing. Equity Funds (Stock Funds) Mutual funds/portfolios investing primarily in shares of companies. Goal: Capital appreciation. Returns depend on stock price movements and dividends. Main Objective: Long-term capital growth through ownership. Bond Funds (Fixed Income Funds) Mutual funds/portfolios investing in fixed-income securities (government bonds, corporate bonds, debentures). Provide regular income and capital preservation with moderate risk. Main Objective: Generate steady income and maintain capital stability. Objectives of Managing Equity and Bond Funds Objective Equity Funds Bond Funds Primary Goal Long-term capital appreciation Regular income & stability Risk Level High Low to Moderate Time Horizon Long-term (5+ years) Short- to Medium-term Return Type Capital gains, dividends Interest income, coupon payments Investor Type Growth-oriented, risk-tolerant Income-seeking, conservative Managing Equity Funds a. Selection of Stocks Fundamental Analysis: Study financial statements, industry trends, management quality. Technical Analysis: Analyze stock price patterns, charts, trends to identify entry/exit points. Quantitative Screening: Use ratios and algorithms to select best-performing stocks. b. Portfolio Construction Diversify across: Sectors, Market capitalization, Geographies. Aim for optimal risk-return balance. c. Equity Fund Management Styles Style Description Example Active Management Fund manager selects stocks to outperform the market index. Actively managed mutual funds Passive Management Tracks a market index (e.g., Nifty 50, S&P 500). Index funds, ETFs Growth Investing Focuses on companies with high earnings growth potential. Tech or emerging companies Value Investing Buys undervalued stocks expected to rise in future. Cyclical or turnaround firms Blend / Core Investing Mix of growth and value stocks. Balanced approach d. Risk Management in Equity Funds Diversification: Reduce unsystematic risk. Beta Control: Maintain balanced beta. Stop-Loss Orders: Limit losses. Regular Rebalancing: Adjust weights. Hedging: Use derivatives (futures/options). e. Performance Evaluation (Equity) Measured using: Alpha: Excess return over benchmark. Beta: Market-related risk. Sharpe Ratio: Risk-adjusted return. Treynor Ratio: Return per unit of systematic risk. Jensen's Alpha: Portfolio performance relative to expected CAPM return. Managing Bond Funds a. Selection of Bonds Credit Analysis: Evaluate creditworthiness of issuers (ratings by CRISIL, Moody's, S&P). Interest Rate Forecasting: Predict rate movements (bond prices inversely related to interest rates). Yield Analysis: Focus on Yield to Maturity (YTM), Current Yield, and Yield Spread. b. Portfolio Construction Diversify across: Maturity Periods, Issuer Types, Coupon Types. Goal: Best trade-off between risk, return, liquidity. c. Bond Fund Management Strategies 1. Passive Strategies (low-cost, conservative) Buy and Hold: Purchase bonds and hold till maturity. Indexing: Replicate a bond index. Immunization: Match bond portfolio duration with investor's horizon to eliminate interest rate risk. 2. Active Strategies (outperform benchmark) Interest Rate Anticipation: Adjust duration based on interest rate expectations. Sector Rotation: Move funds between government and corporate bonds. Credit Switching: Replace lower-rated with higher-rated bonds (or vice versa). Riding the Yield Curve: Buy long-term bonds and sell before maturity. d. Risk Management in Bond Funds Interest Rate Risk: Mitigated using duration matching and immunization. Credit Risk: Avoid low-rated issuers; diversify credit exposure. Reinvestment Risk: Use laddered maturities. Liquidity Risk: Maintain mix of tradable bonds. Inflation Risk: Include inflation-indexed bonds. e. Performance Evaluation (Bond) Assessed using: Total Return: Income + capital gains. Duration and Convexity: Sensitivity to interest rate changes. Tracking Error: Deviation from benchmark. Sharpe Ratio: Risk-adjusted performance. Key Differences Between Equity and Bond Fund Management Basis Equity Fund Bond Fund Primary Objective Capital appreciation Income generation Return Source Dividends & capital gains Interest & price appreciation Risk Level High (market volatility) Low to moderate Investment Horizon Long-term Short- to medium-term Market Sensitivity Sensitive to company and market performance Sensitive to interest rates Analysis Focus Company earnings, market trends Interest rates, credit ratings Management Style Active/passive stock selection Duration and yield curve management Combining Equity and Bond Fund Management (Balanced Approach) A well-managed portfolio combines both equity and bond funds to balance growth and safety. This is part of asset allocation. Investor Type Equity Allocation Bond Allocation Purpose Aggressive 70% 30% Maximize growth, tolerate risk Moderate 50% 50% Balanced return and safety Conservative 30% 70% Stability and regular income Mutual Funds Meaning of Mutual Funds A professionally managed investment vehicle that pools money from many investors and invests it in a diversified portfolio of securities (stocks, bonds, money market instruments, etc.). Managed by qualified fund managers. Each investor owns units of the fund. Net Asset Value (NAV) represents the value of one unit. Definition: A financial intermediary that collects savings from numerous investors and invests them in a diversified portfolio of financial instruments in accordance with stated investment objectives. Objectives of Managing Mutual Funds Maximize returns for investors. Minimize risk through diversification. Ensure liquidity for investors. Provide professional management. Achieve specific investment goals. Facilitate small investors to participate in professionally managed portfolios. Structure of Mutual Funds (Indian Context) Sponsor: Promoter of the fund, establishes the trust. Trustee: Holds property for investors, ensures fund operates as per regulations. Asset Management Company (AMC): Manages the fund, takes investment decisions, employs fund managers. Custodian: Responsible for holding and safeguarding securities. Registrar and Transfer Agent: Maintains investor records, issues statements, handles redemptions. Investors / Unit Holders: Provide capital, receive proportionate returns. Process of Managing Mutual Funds Step 1: Defining Investment Objective Growth fund $\to$ capital appreciation Income fund $\to$ steady returns Balanced fund $\to$ mix of both Step 2: Fund Mobilization AMC issues offer documents (prospectus). Investors purchase units during New Fund Offer (NFO) or through ongoing schemes. Step 3: Investment Decision & Portfolio Construction Fund manager allocates money across equity, debt, money market instruments, sectors, industries, regions. Follows diversification principle. Step 4: Fund Monitoring & Rebalancing Continuous monitoring of market performance, economic changes, portfolio returns. Rebalancing ensures portfolio aligns with objectives. Step 5: Valuation & NAV Calculation Net Asset Value (NAV) = (Market value of assets – liabilities) / Total number of units Step 6: Performance Evaluation Compare fund performance against: Benchmarks, Peer funds, Risk-adjusted metrics (Sharpe ratio, Alpha). Step 7: Reporting and Transparency Regular reports to investors about: Portfolio composition, NAV trends, Dividends and realized gains, Expenses (expense ratio). Types of Mutual Funds (by Investment Objective) Type Description Objective Equity Funds Invest mainly in shares of companies Capital appreciation Debt (Bond) Funds Invest in government/corporate bonds Regular income Balanced/Hybrid Funds Mix of equity and debt Balance growth and income Money Market Funds Invest in short-term instruments (T-Bills, CDs) Liquidity and safety Index Funds Track a stock market index Passive returns matching market Sectoral Funds Invest in specific sectors (IT, Pharma) Targeted growth International Funds Invest in global markets Global diversification ELSS (Equity Linked Savings Scheme) Tax-saving mutual fund Wealth creation + tax benefit Mutual Fund Management Strategies A. Active Management Fund manager actively selects securities to outperform the benchmark index. Uses fundamental, technical, and economic analysis. Pros: Higher return potential. Cons: Higher expense ratio, higher risk. B. Passive Management Fund mirrors a market index. No active stock selection. Examples: Index Funds, Exchange-Traded Funds (ETFs). Pros: Low cost, transparent. Cons: Cannot outperform the market. C. Growth-Oriented Funds Focus on capital appreciation by investing in high-growth companies. Suited for long-term investors. D. Income-Oriented Funds Invest in bonds and dividend-paying stocks to generate regular income. E. Balanced or Hybrid Funds Combine both growth and income strategies for stability. Risk Management in Mutual Funds Diversification: Reduce risk by spreading investments. Liquidity Management: Maintain cash reserves. Duration Management: Match asset duration with market conditions (bond funds). Hedging: Use derivatives to reduce exposure. Credit Risk Assessment: Evaluate issuer's creditworthiness. Regulatory Compliance: Adhere to SEBI investment limits and disclosure norms. Performance Evaluation of Mutual Funds Metric Meaning Purpose NAV Growth Change in fund's per-unit value Indicates overall performance Alpha ($\alpha$) Excess return over benchmark Measures fund manager's skill Beta ($\beta$) Sensitivity to market movements Measures systematic risk Sharpe Ratio (Return – Risk-free rate) / Std. Dev. Risk-adjusted return Treynor Ratio (Return – Risk-free rate) / Beta Performance per unit of systematic risk Jensen's Alpha CAPM-based performance Compares actual vs expected returns Regulation and Governance (India) Regulatory Authority: SEBI (Securities and Exchange Board of India) Key Guidelines: AMCs must be registered, full disclosure, investment limits, investor protection. Advantages of Mutual Fund Management Professional Management Diversification (even with small investments) Liquidity (easy redemption) Economies of Scale (reduced cost) Transparency & Regulation Convenience Limitations / Challenges Management Fees and Expenses reduce net returns. No Guaranteed Returns. Market Risk (NAV fluctuates). Lack of Control (investors can't choose individual securities). Possible Over-diversification (reducing potential gains).