INVESTMENT - Kopykitab

ivPREFACEvaluation have been reviewed. Private equity and venture capital have been added in thispart to emphasis the new sources of financing and investment. Role of primary dealers,crucial in successfully managing the public debt, has been dealt in detail since the governmentsecurities issued from time to time and the yield structure of the government securities, theuses of yield curve, default risk and interest rates, inflation and interest rates, the fishereffect has increased the complexity and excitement. The knowledge of sovereign wealthfunds is now essential as it has emerged as an important government–owned investmentvehicle in response to the strong accumulation of foreign assets by the official sector.Various non-security forms of investment, which attract a major proportion of the householdsector’s investment in total investment in financial assets, have also been analysed in thispart. Further, since the real estate offers an attractive way to diversify an investmentportfolio, an exclusively coverage is on the real estate investments. Finally, as investment inshort-term (money market) instruments involves a tradeoff between liquidity, the ability tosell a security quickly without suffering a price decline at a small transactions cost, and theyield, managing the short-term investment requires an accumulation of information aboutthe firm, the markets and instruments, the economic environment, and a selection of investmentoptions—all in a very short period of time. The measurement of liquidity and the factors thatlead to a strategy of using marketable securities to provide backup liquidity and yield is afunction of the maturity, the marketability, the default risk, and the taxability of the security.In making the trade off between the liquidity and yield, a number of money market securitiesthat are appropriate are available. This part concludes with the principal investmentinstruments of the money market and review of the recent Reserve Bank of India’s initiativesand developments in the money market.Part III - Security Analysis presents a discussion of stock market forecasting, theindependence of stock market, and the role market exercises in the investment decisionmaking. The economic-industry- company analysis is linked in order to reach consideredestimates of return and risk on individual securities in the fundamental analysis. A detailedsystematic approach has been adopted on technical analysis by focusing on the rationale,methods employed by technical school which concentrates on supply and demandrelationships in the market and historical price and volume relationship to predict themovement of the market as well as the movement of the prices of individual securities. Thelast segment of part is devoted to the idea of efficient markets and the theory of random walk,covering evidence related to the efficient market hypothesis including consideration of thegrowing number of anomalies and the usefulness of the book value / market value ratio. Theefficient market notion questions the validity of technical analysis and raises some seriousquestions about fundamental analysis.Part IV - Portfolio Analysis And Management directs attention to the problem of portfoliomanagement, both in theory and practice. Many of the models and techniques are complexand difficult but they are effective and are widely employed throughout the investmentcommunity by investment and portfolio analysts. A deep understanding of them can meanthe difference between success and failure in decision-making. There is an extensive coverageof stock price volatility and its measurement, the concept of portfolio selection by portfoliopioneer, Harry Markowitz and the development of a simplified model for portfolio analysisby William Sharpe. The extensive coverage given to the predictive power of factor models inthe industry and, at the same time, paves the way for an easy grasp of the assumptionsunderlying the arbitrage pricing theory. More specifically, this part covers the why, what,whose—and more importantly the subject of investment portfolio-decision making. How canan investor reduce expected risk through diversification, why this risk reduction resultsfrom proper diversification, and how the investor may estimate the expected risk and returnCreated with Print2PDF. To remove this line, buy a license at: http://www.software602.com/

PREFACEvlevel of a given portfolio of assets, Markowitz’s model is widely used to allocate wealthacross different types of assets. Markowitz demon-strated how to create a frontier of optimal(or “efficient”) portfolios, each having the highest possible expected rate of return for a givenlevel of risk. However, this technique was so computationally demanding (given the availabletechnology) that practical application of his optimal allocation model was difficult. Followingthe discussion on the application of the utility theory and indifference curve in the portfoliochoice, Markowitz Model: Mean -Variance Criterion for the selection of portfolios has beencritically examined. William Sharpe developed a simplified version of his mentor’s model,one that was less demanding with respect to computational effort. It was based on anapproximating formula for portfolio return variance known as the single index model. Thismodel, combined with technological advances, allowed contemporary portfolio theory to bereadily applied in the real world. Today, Sharpe’s model is widely used to allocate wealthwithin asset groups, especially equity shares.Prior to the dissemination of portfolio theory into the real world, the following questionhas been raised: Suppose everyone managed his or her investments using portfolio theory andinvested in the portfolios on the frontier, how would that affect the pricing of securities? To answerthis question, the capital asset pricing model (CAPM) was developed. This model has reigned asthe premier model in the field of finance and been widely used in the real world to measureportfolio performance, value securities, make capital budgeting decisions, and even regulatepublic utilities. The model was questioned since it is empirically impossible to verify itssingle economic prediction and an alternative to the capital asset pricing model was beingdeveloped, called the arbitrage pricing theory (APT). This theory argued that expected returnmust be related to risk in such a way that no single-investor could create unlimited wealththrough arbitrage. APT is less demanding in terms of its assumptions and it is testable, atleast in principle, but still CAPM, though being seriously called into question, is widelyused in the real world. In fact, CAPM and APT are just versions of a much older valuationtechnique—the risk-premium model. The risk-premium model assigns increasingly highreturns for increasing risks. An investment with the lowest possible return would be aninvestment with no risk. The return on this risk-free investment compensates the investor forhis or her illiquidity (having the invested funds tied up) over the life of the investment. Inaddition, the bond portfolio management strategies, covering the factors to be considered inthe selection of a portfolio, distinction between active portfolio strategies and structuredportfolio strategies, and the various techniques applied to measure and evaluate the investmentperformance of a fixed-income portfolio manager have been discussed. Shortcomings in theasset pricing models led the practitioners to use performance measurement procedures thatare free of dependence on particular asset pricing models .The performance measures helpin discriminating among those who have skill, those who are lucky, and those who can earnhigher returns merely because they take risks. It is imperative to understand how theperformance measures work, and the nature of their assumptions, and their relative strengthsand weaknesses. Measuring portfolio performance with and without asset pricing modelshas been given a complete and exhaustive coverage.Part V – Derivatives: Risk Management, an integral part of the world of finance, use hasper-meated almost every aspect of domestic and international capital and money markets.They are transforming every aspect of finance from investing to raising capital to managerisk. New products and strategies are being developed at the stunning speed into anenormous, pervasive and controversial force, which is placing an enormous strain onfinancial professionals who must keep abreast of all the changes. Derivatives have been avery successful innovation in the capital market and as in the modern life financial engineeringapproach keep investors and business going. The investment manager must be able to useCreated with Print2PDF. To remove this line, buy a license at: http://www.software602.com/

viPREFACEall the tools available to control a company’s exposure to financial risk. Hence, a broadbased exposure both to the technical aspects of the main clauses of derivatives and marketsin which they are traded is essential. By exploiting derivatives markets, the finance managercan create new instruments that have highly specialised and desirable risk and returncharacteristics. Some derivatives are traded on exchanges ;others are traded in the over-thecounter market, or added to new issues of debt and equity securities. The successfulimplementation of various investment strategies necessitates a sound working knowledgeof the fundamentals of derivatives trading.A number of initiatives for the further development of OTC derivatives in India havebeen initiated. Some of the major ones are:-New Products: The product on anvil is the CreditDefault Swap (CDS). CDS on corporate bonds issued by single legal residential entities havebeen proposed, with the underlying bonds to be listed ones, but with two exceptions:unlisted but rated bonds of infrastructure companies and unlisted/unrated bonds issuedby the SPVs set up by infrastructure companies. Trade Repository: CCIL has been acting as thetrade repository for IRS transactions since August 2007. There is no such trade repositorystructure for the FX derivatives at present. There are proposals to introduce repositorystructure for USD-INR forwards (including swaps) and options. Central Counterparty Clearing:CCIL has put in place guaranteed settlement for FX forward transaction effective from thedate of contract since December 2009. In case of IRS, CCIL has been providing non- guaranteedsettlement since November 2008. It is expected to transit to guaranteed settlement for IRStransactions shortly. Portfolio Compression: An important innovation in OTC derivativemarkets introduced during the last few years relates to portfolio compression services. Sincethe only way to exit a position in an OTC derivative is to enter into another with oppositepay-off, the gross notional outstanding multiplies manifold as a result. Huge build-up ingross notional outstanding demands higher capital charges and reduces the availablecounter-party limits for undertaking other business transactions. Moreover, it does notcapture the economic essence of the portfolios. CCIL is in the process of developing tradecompression services.Generally speaking, Indian approach to financial markets development has beencalibrated, keeping in mind the overall objectives of financial sector development. Particularlyat this juncture, while expanding the set of products and instruments available, the emphasiseis on the improvement in the pre and post-trading infrastructure as well as consolidation ofthe regulatory regime so that financial stability is not threatened. A thorough understandingof the rudiments helps the investors to formulate an appropriate desirable strategy.Determining suitability is nothing new to the stock market investors, for stocks themselvesare not suitable for every investor. This part provides a broad-based introduction to both thetechnical aspects of the main classes of derivatives and the markets in which they are traded,and the underlying concepts. This is a comprehensive, industry- independent explorationof financial derivatives, which offers an insightful look inside a revolutionary field that issweeping the world of corporate, bank, and investment finance. From reviewing the basicbuilding blocks of financial derivatives to systematically examining the myriad of processesinvolved in creating innovative financial instruments, three main types of traders identifiedin these markets are: hedgers, speculators, and arbitrageurs, to provide realist understandingof the derivatives by covering options, futures, swaps, carry trades, convertible securities,warrants and hedging. To analyse the application of derivatives on commodity exchanges,various principles underlying the practices have also been discussed along with the criticalview of the strategies adopted. Trading is as a rule fully computerised, so that portfolioswitching can be affected on a large scale within the shortest possible time regardless ofgeography. The contracts volume and trading practices are tailored to the professionalCreated with Print2PDF. To remove this line, buy a license at: http://www.software602.com/

PREFACEviimarket players. Bearing this in mind, it is not a surprising that the derivatives markets arecharacterised by exceptionally high degree of internationality. The infrastructure of derivativesmarkets is geared to international transactions. Indeed, they are probably the most importantdevelopments in the capital markets since the abandonment of the gold standard.Part-VI - International Financial Flows stresses the global aspects of investing as thefinancial markets are growing global and global finance is becoming a reality. Withglobalisation of financial markets, portfolio flows (bonds and equities) have quadrupled inthe last few years. While traditionally portfolio managers used to diversify the investmentportfolio in domestic securities, there has been an ever increasingly a strong tendency to goglobal, seeking higher profits and more stable portfolio which benefits from diversificationin various economies. Three main factors explain the present global trend of extendingfinancial integration from the developed into the developing countries. First and foremost,the improved macroeconomic performance in the recipient countries— the adjustment tostructural reforms that have taken place since coming out of the debt crisis—have helped inbringing about this phenomenon. The second is a structural shift that has to do with the verysame reform process: the dominance of the private sector in the incremental growth in manyof these countries accounts for the fact that there is a need for private capital to come intoprivate hands. The third is monetary developments in the industrial countries, which haveled to favourable interest rate differentials, making it important to find out how much of theflows is hot money, which could also reverse.The benefit for the developing economies of this type of capital inflow is the greater riskbearing by investors, unlike the syndicated bank lending of the 1970s. The greater diversificationof investment finance and the better incentives with this type of finance should help in themanagement of the investment process. It also helps to foster the development of the localcapital markets, which would then enhance the domestic resource mobilisation in thesecountries. If one looks at the benefits for investors in industrial countries, it is clear that itpays to diversify portfolios—which are still very much home-biased, as returns in differentcountries are little correlated.Along with the benefits are costs, warnings, and policy implications. One importantconcern is hot money. Today, huge amounts of capital can move from one place to anotherjust by pressing a button and the speed of adjustment in asset markets is very quick. But thecommodities and factors cannot move much more speedily than before. Extensive capitalinflows, accompanied by a real appreciation of the exchange rate, may hurt exports. Sincethese movements may not be symmetric when capital flows out, the detrimental effects onexports are not easily reversed. In some sense, the phenomenon can be of a small tail that canwag a large dog—a very small change in portfolios of the industrial countries can lead tolarge changes in the flows to developing countries, with possible detrimental effects on theireconomies. A warning is that the predominance of the private sector in these flows does notmean that governments don’t have an important role. The more integrated capital marketsare and the more important portfolio shifts become, the more crucial it is to have the rightdomestic institutional framework for channeling these flows effectively. Laissez-faire doesnot mean that the government should not have its hands on some very important regulatoryroles.Financial innovations, internationalisation and institutionalisation of investmentactivities are different but ultimately inseparable aspects of the radical fundamental changesin the world financial markets. World financial markets provide exposure to the currentdevelopments in the developed and emerging financial markets. Foreign portfolio investmentis emerging as an alternate source of financing with a higher future potential. The modernportfolio theory-oriented approach provides an assess to the riskiness of foreign claims andCreated with Print2PDF. To remove this line, buy a license at: http://www.software602.com/

viiiPREFACEtechniques of portfolio investment. The nature of foreign portfolio investment, and thevarious issues and challenges posed by foreign portfolio investment to the policy-makershave been examined. Foreign portfolio investment in India: emerging trends and policydevelopments in the context of liberalisation and market-oriented process has been discussedsubsequently. Manias, panics, crashes in the financial markets has been included in thispart to analyse the human expectations and various crashes in world stock markets, coveringpyramid and ponzi schemes, speculative bubbles, The Great Crash, Oct.’87 Stock marketCrash and its aftermath and the Scam of early 1990s and the Market Scam 2001 in India.Finally, the part ends with the discussion on established behaviour patterns that mayinfluence security prices, the common mistakes that investors make while investing inmutual funds, myths about financial derivatives, winning in options, trading strategies ofprofessionals in futures, and the golden rules to achieve success in investment world.The 19th edition of the Investment Management: Security Analysis and Portfolio Managementdiffers in a significant way from the previous edition. The current volume covers recentchanges in the world financial markets and the changing compositions of the portfolios.The recent global financial crisis has brought to light the weaknesses of the OTC derivativesmarket. The complexity and opacity of the OTC market facilitated excessive risk-taking bythe market participants. The lack of information about the counterparties coupled with nonavailability of the transaction information with the regulators led to seizure of the market.Further, the bilateral counterparty risks have become complex given the variety of structuresand asset classes used by the market participants. With increase in volumes and complexitiesof the OTC derivatives, the infrastructure for clearing and settlement became a majorimpediment. To cover exhaustively financial derivatives market in India, a new chapter hasbeen added. The major change between this edition and the previous one has to do withupdating the coverage. Each chapter of the book presents information in a logical sequentialfashion. Many chapters build on the information presented in the preceding chapters. Thereader who is using the text as a reference-perhaps scanning one of the later chapters- mayfind the terms are being encountered that has been defined in an earlier chapter. The indexmay be of use since some subjects are described, in varying levels of complexity, in more thanone place in the book. The text provides illustrative charts, tables, diagrammes and fullworked out examples and cases. The exercises and case studies are designed to help readersunderstand the practical application of the concepts. All the financial calculations arebroken down in a step-by-step process designed to help those who prefer to see numbersrather than formulae.Since the book is synthesis, it uses findings at various places from the published results.I hope that I have interpreted them correctly. I have made acknowledgments of every ideawhose source I have been able to identify, but some writers may have been missedunintentionally. I am indebted to my colleagues, both academic and professional, and tocountless students. It would be impossible to list them all. Finally, I wish to express thanksto the members of the S. Chand & Company Pvt. Ltd. for their wholehearted support andcooperation.V.K. BHALLADisclaimer : While the author of this book has made every effort to avoid any mistake or omission and has used his/her skill,expertise and knowledge to the best of their capacity to provide accurate and updated information. The author and S. Chanddo not give any representation or warranty with respect to the accuracy or completeness of the contents of this publication andar

INVESTMENT MANAGEMENT SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT [For the Students of Management, Commerce, Professional Course of CA, CS, ICWA, Professionals of Financial Institutions and Policy Makers] V.K. BHALLA Professor, Faculty of Management Studies, University of Delhi, DELHI S. CHAND & COMPANY PVT. LTD. (AN ISO 9001 : 2008 COMPANY)