Set 1

Marks 30

SUBJECT NAME: SECURITY ANALYSIS AND PORTFOLIO

MANAGEMENT

1. Is there any logic behind technical analysis? Explain

meaning and basic tenets of technical analysis.

Answer:

Selecting the right stocks for investment is an important part of

making investment at the stock market but that is not the only thing
that you have to consider. More important than the selection of stocks
is determining the perfect time for investing is that stocks. Stocks have
price movement at the stock market everyday. There are ups and
downs that come in a cyclic way. As an investor you have to determine
what is the exact time or more precisely the optimum price range for
investing in that stock.

The reason behind this is that every stock has a potential price
for a given time. It takes certain time to reach that point and once the
stock reaches that price, it is most likely to fall or stand still at that
level with least movement in the price. In both the scenario it is not
profitable to invest in stock that has already reached that optimum
level, as you will either make loss or get least profit. Therefore, it is not
worth investing in the stocks that are already reached the potential
high for the time being. So as a trader it is important to know what is
the optimum price range for the stock as that will help you to decide
whether it is the right time to invest in a certain stock or not.

Technical analysis is the process that does exactly that.

Technical analysis can give you the idea of the future price movement
of that stock. Based on that analysis you can decide whether it is
profitable in that stock at that point. In technical analysis certain
information like the past performance of the stock, current price of the
stock, trading volume of the stock are considered. With these
information and one the basis of certain principles different types of
graphs and charts are prepared. By comparing these graphs of the
price movements with that of the previous years it is decided by the
experts how the stock will perform in the near future. So, basically
technical analysis is the scientific way of predicting the movement of
the stock price in the market. Technical analysis is performed by the

1
analysts on the basis of different indicators such as cycle’s regressions,
relative strength index, moving averages, regressions, and inter-
market and intra-market price correlations. Different principles are
followed by the analysts to prepare the charts and graphs of the price
movements of the stocks on the basis of these indicators. These
indicators are basically mathematically transformed date derived from
the price of the stocks and trading volume. Here we are presenting
some of the most popular models of technical analysis.

1. Candle Stick Charting – This method was developed by

Homma Munehisa during 18th century. In candle chart method
the price movement of a certain stock is predicted through the
bar style chart. This chart is basically a combination of the
simple line chart and colored bar chart. The candle stick chart
gives a graphical presentation of the opening price, closing price,
high and low price of the stock in a single day for over a period of
time. This graphical presentation helps to predict the future
movements by comparing the previous patterns of price
movement of that stock.
2. Dow Theory – This theory is named after its inventor Charles H.
Dow. He was the first editor of the Wall Street Journal and co-
founder of Dow Jones and Company. The Dow Theory is based on
six basic principles.

• There can be three different types of movements in the stock

market.
• There are three different phases in the market trends.
• Stock market discounts all news.
• Market trends need to be confirmed by trading volume.
• Market average should always confirm each other.
• Market trend can be said have ended only when the definitive
signals prove that.

3. Elliott wave principle - This theory was developed by Ralph

Nelson Elliott and published for the first time in his book The
Wave Principle in the year 1938. In his theory Elliott proclaimed
that the psyche of the stock market investors moves from
pessimism to optimism and this creates the swing creates the
price pattern. This pattern is projected by the three wave
structure of increasing degree in this theory.

Meaning and Basic Tenets

2
Unlike fundamental analysts, technical analysts don’t care whether a
stock is undervalued or not – the only thing that matters to them is a
security’s past trading data and what information that this data can
provide about where the security is moving in the future. Technical
analysis disregards the financial statements of the issuer (the company
that has issued the security). Instead, it relies upon market trends to
ascertain investor sentiments that can be used to predict how a
security will perform.

Technicians, chartists or market strategists (as they are variously

known), believe that there are systematic statistical dependencies in
asset returns – that history tends to repeat itself. They make price
predictions on the basis of price and volume data, looking for patterns
and possible correlations, and applying rules of thumb to charts to
assess ‘trends’, ’support’ and ‘resistance levels’. From these, they
develop ‘buy and sell’ signals.

The field of technical analysis is based on three assumptions:

1. The market discounts everything: Technical analysis

assumes that, at any given point in time, a security’s price
incorporates all the factors that can impact the price including
the fundamental factors. Technical analysts believe that the
company’s fundamentals, along with broader economic factors
and market psychology are all built into the security price and
therefore there is no need to study these factors separately.
Thus the analysis is confined to an analysis of the price
movement. Technical analysis considers the market value of a
security to be solely determined by supply and demand.

2. Price moves in trends: Technical analysis believes that the

security prices tend to move in trends that persist for long
periods of time. This means that after a trend has been
established, the future price movement is more likely to be in the
same direction as the trend than to be against it. Any shifts in
supply and demand cause reversals in trends. These shifts can
be detected in charts/graphs.

3. History tends to repeat itself: History tends to repeat

itself, mainly in terms of price movements. Many chart patterns
tend to repeat themselves. Market psychology is considered to
be the reason behind the repetitive nature of price movements:
market participants react in a consistent manner to similar
market stimuli over a period of time.

3
Technical analysis is based on the assumption that markets are driven
more by psychological factors than fundamental values. Its proponents
believe that asset prices reflect not only the underlying ‘value’ of the
assets but also the hopes and fears of those in the market. They
assume that the emotional makeup of investors does not change, that
in a certain set of circumstances, investors will react in a similar
manner to how they did in the past and that the resultant price moves
are likely to be the same. Technical analysts use chart patterns to
analyze market movements and to predict security prices. Although
many of these charts have been used for more than 100 years,
technical analysts believe them to be relevant even now, as they
illustrate patterns in price movements that often repeat themselves.

Technical analysis can be applied to any security which has historical

trading data. This includes stocks, bonds, futures, foreign exchange
etc. In this unit, we will give examples of stocks but remember that the
technical analysis can be used for any type of security

2. Explain role played by efficient market in economy. Apply

the parameters of efficient market to Indian stock
markets and find out whether they are efficient.

Answer :

It is important that financial markets are efficient for at least three

reasons:

1. To encourage share buying – Accurate pricing is required if

individuals are to be encouraged to invest in companies. If
shares are incorrectly priced, many savers will refuse to invest
because of a fear that when they have to sell their shares the
price may be to their disadvantage and may not represent the
fundamentals of the firm. This will seriously reduce the
availability of funds to companies and retard the growth of the
economy. Investors need the assurance that they are paying a
fair price for their acquisition of shares and that they will be able
to sell their holdings at a fair price – that the market is efficient.
2. To give correct signals to company managers –
Maximization of shareholder wealth is the goal of the managers
of a company. Managers will be motivated to take the decisions

4
 that maximize the share price and hence the shareholder wealth
only when they know that their wealth maximizing decisions are
accurately signaled to the market and gets incorporated in the
share price. This is possible only when the market is efficient. It
is important that managers receive feedback on their decisions
from the share market so that they are encouraged to pursue
shareholder wealth strategies.
3. To help allocate resources –If a badly run company in a
declining industry has shares that are highly valued because the
stock market is not pricing them correctly, then this company will
be able to issue new capital by issuing shares, and thus attract
more of economy’s savings for its use, then it would not be an
optimal allocation of resources. This would be bad for the
economy as these funds would be better utilized elsewhere.

There are three common forms in which the efficient-market

hypothesis is commonly stated—weak-form efficiency, semi-
strong-form efficiency and strong-form efficiency, each of which
has different implications for how markets work.

In weak-form efficiency, future prices cannot be predicted by

analyzing prices from the past. Excess returns cannot be earned in the
long run by using investment strategies based on historical share
prices or other historical data. Technical analysis techniques will not be
able to consistently produce excess returns, though some forms of
fundamental analysis may still provide excess returns. Share prices
exhibit no serial dependencies, meaning that there are no "patterns" to
asset prices. This implies that future price movements are determined
entirely by information not contained in the price series. Hence, prices
must follow a random walk. This 'soft' EMH does not require that prices
remain at or near equilibrium, but only that market participants not be
able to systematically profit from market 'inefficiencies'. However,
while EMH predicts that all price movement (in the absence of change
in fundamental information) is random (i.e., non-trending), many
studies have shown a marked tendency for the stock markets to trend
over time periods of weeks or longer and that, moreover, there is a
positive correlation between degree of trending and length of time
period studied (but note that over long time periods, the trending is
sinusoidal in appearance). Various explanations for such large and
apparently non-random price movements have been promulgated.

The problem of algorithmically constructing prices which reflect all

available information has been studied extensively in the field of
computer science. For example, the complexity of finding the arbitrage
opportunities in pair betting markets has been shown to be NP-hard.

5
In semi-strong-form efficiency, it is implied that share prices adjust
to publicly available new information very rapidly and in an unbiased
fashion, such that no excess returns can be earned by trading on that
information. Semi-strong-form efficiency implies that neither
fundamental analysis nor technical analysis techniques will be
able to reliably produce excess returns. To test for semi-strong-form
efficiency, the adjustments to previously unknown news must be of a
reasonable size and must be instantaneous. To test for this, consistent
upward or downward adjustments after the initial change must be
looked for. If there are any such adjustments it would suggest that
investors had interpreted the information in a biased fashion and
hence in an inefficient manner.

In strong-form efficiency, share prices reflect all information, public

and private, and no one can earn excess returns. If there are legal
barriers to private information becoming public, as with insider trading
laws, strong-form efficiency is impossible, except in the case where the
laws are universally ignored. To test for strong-form efficiency, a
market needs to exist where investors cannot consistently earn excess
returns over a long period of time. Even if some money managers are
consistently observed to beat the market, no refutation even of strong-
form efficiency follows: with hundreds of thousands of fund managers
worldwide, even a normal distribution of returns (as efficiency predicts)
should be expected to produce a few dozen "star" performers.

Efficiency of Indian Stock Markets

Introduction

The term market efficiency in capital market theory is used to explain

the degree to which stock prices reflect all available, relevant
information. The concept of Efficiency Market Hypothesis (EMH) is
based on the arguments put forward by Samuelson (1965) that
anticipated price of an asset fluctuate randomly. Fama (1970)
presented a formal review of theory and evidence for market efficiency
and subsequently revised it further on the basis of development in
research (Fama 1991).

Efficiency of equity markets has important implications for the

investment policy of the investors. If the equity market in question is
efficient researching to find miss-priced assets will be a waste of time.
In an efficient market, prices of the assets will reflect markets‟ best
estimate for the risk and expected return of the asset, taking into
account what is known about the asset at the time. Therefore, there
will be no undervalued assets offering higher than expected return or

6
overvalued assets offering lower than the expected return. All assets
will be appropriately priced in the market offering optimal reward to
risk. Hence, in an efficient market an optimal investment strategy will
be to concentrate on risk and return characteristics of the asset and/or
portfolio. However, if the markets were not efficient, an investor will be
better off trying to spot winners and losers in the market and correct
identification of miss-priced assets will enhance the overall
performance of the portfolio Rutterford (1993). EMH has a twofold
function - as a theoretical and predictive model of the operations of the
financial markets and as a tool in an impression management
campaign to persuade more people to invest their savings in the stock
market (Will 2006).

The understanding of efficiency of the emerging markets is becoming

more important as a consequence of integration with more developed
markets and free movement of investments across national
boundaries. Traditionally more developed Western equity markets are
considered to be more efficient. Contribution of equity markets in the
process of development in developing countries is less and that
resulted in weak markets with restrictions and controls (Gupta, 2006)

In the last three decades, a large number of countries had initiated

reform process to open up their economies. These are broadly
considered as emerging economies. Emerging markets have received
huge inflows of capital in the recent past and became viable
alternative for investors seeking international diversification. Among
the emerging markets India has received it‟s more than fair share of
foreign investment inflows since its reform process began. One reason
could be the Asian crisis which affected the fast developing Asian
economies of the time (also some times collectively called „tiger
economies‟). India was not affected by the Asian crisis and has
maintained its high economic growth during the period (Gupta and
Basu 2005).

Today India is one of the fastest growing emerging economies in the

world. The reform process in India officially started in 1991. As a result,
demand for investment funds is growing significantly and capital
market growth is expected to play an increasingly important role in the
process. The capital market reforms in India present a case where a
judicious combination of competition, deregulation and regulation has
led to sustained reforms and increased efficiency (Datar and Basu
2004).

At this transitional stage, it is necessary to assess the level of

efficiency of the Indian equity market in order to establish its longer
term role in the process of economic development. However, studies

7
on market efficiency of Indian markets are very few. They are also
dated and mostly inconclusive. The objective of this study is to test
whether the Indian equity markets are weak form efficient or not. EMH,
similar to other theories that require future expected prices or returns,
use past actual prices or returns for the tests. Sets of share price
changes are tested for serial independence. Random walk theory for
equity prices show an equities market in which new information is
quickly discounted into prices and abnormal or excess returns can not
be made from observing past prices (Poshakwale 1996).

The next section of this paper provides a brief background of the

Indian equity market and a brief literature review of studies testing
market efficiency in emerging markets. Section 3 explains the
methodology used in this study and data sources, followed by the
results of the analysis in section 4. The last section summarizes the
conclusions and their implications.

METHODOLOGY & DATA

To test historical market efficiency one can look at the pattern of

short-term movements of the combined market returns and try to
identify the principal process generating those returns. If the market is
efficient, the model would fail to identify any pattern and it can be
inferred that the returns have no pattern and follow a random walk
process. In essence the assumption of random walk means that either
the returns follow a random walk process or that the model used to
identify the process is unable to identify the true return generating
process. If a model is able to identify a pattern, then historical market
data can be used to forecast future market prices, and the market is
considered not efficient.

There are a number of techniques available to determine patterns in

time series data. Regression, exponential smoothing and
decomposition approaches presume that the values of the time series
being predicted are statistically independent from one period to the
next. Some of these techniques are reviewed in the following section
and appropriate techniques identified for use in this study.

Runs test (Bradley 1968) and LOMAC variance ratio test (Lo and
MacKinlay 1988) are used to test the weak form efficiency and random
walk hypothesis. Runs test determines if successive price changes are
independent. It is non-parametric and does not require the returns to
be normally distributed. The test observes the sequence of successive
price changes with the same sign. The null hypothesis of randomness

8
is determined by the same sign in price changes. The runs test only
looks at the number of positive or negative changes and ignores the
amount of change from mean. This is one of the major weaknesses of
the test. LOMAC variance ratio test is commonly criticised on many
issues and mainly on the selection of maximum order of serial
correlation (Faust, 1992). Durbin-Watson test (Durbin and Watson
1951), the augmented Dickey-Fuller test (Dickey and Fuller 1979) and
different variants of these are the most commonly used tests for the
random walk hypothesis in recent years (Worthington and Higgs 2003;
Kleiman, Payne and Sahu 2002; Chan, Gup and Pan 1997).

Under the random walk hypothesis, a market is (weak form) efficient if

most recent price has all available information and thus, the best
forecaster of future price is the most recent price. In the most stringent
version of the efficient market hypothesis, εt is random and stationary
and also exhibits no autocorrelation, as disturbance term cannot
possess any systematic forecast errors. In this study we have used
returns and not prices for test of market efficiency as expected returns
are more commonly used in asset pricing literature (Fama (1998).

Returns in a market conforming to random walk are serially

uncorrelated, corresponding to a random walk hypothesis with
dependant but uncorrelated increments. Parametric serial correlations
tests of independence and non-parametric runs tests can be used to
test for serial dependence. Serial correlation coefficient test is a widely
used procedure that tests the relationship between returns in the
current period with those in the previous period. If no significant
autocorrelation are found then the series are expected to follow a
random walk.

A simple formal statistical test was introduced was Durbin and Watson
(1951). Durbin-Watson (DW) is a test for first order autocorrelation. It
only tests for the relationship between an error and its immediately
preceding value. One way to motivate this test is to regress the error
of time t with its previous value.

9
10
 RESULTS

This study conducts a test of random walk for the BSE and NSE
markets in India, using stock market indexes for the Indian markets. It
employs unit root tests (augmented Dickey-Fuller (ADF)). We perform
ADF test with intercept and no trend and with an intercept and trend.
We further test the series using the Phillips-Perron tests and the KPSS
tests for a confirmatory data analysis. In case of BSE and NSE markets,
the null hypothesis of unit root is convincingly rejected, as the test
statistic is more negative than the critical value, suggesting that these
markets do not show characteristics of random walk and as such are
not efficient in the weak form. We also test using Phillip-Perron test
and KPSS test for confirmatory data analysis and find the series to be
stationary. Results are presented in Table 2. For both BSE and NSE
markets, the results are statistically significant and the results of all
the three tests are consistent suggesting these markets are not weak
form efficient.

Table 2: Results of ADF, PP

Inde ADF Test ADF Test PP unit root KPSS (Tau
x Statistic (5 Statistic (5 test, with statistic) for
lags with lags with intercept lag parameter
intercept intercept and 4 lags in 4, 3 and 2
and no and trend) error respectively
trend) process
BSE -24.80770 -24.80455 -56.22748 .13264, .13762, .
14178
NSE -24.16392 -24.16776 -54.82289 .11710, .12203, .
12576

Note: ADF critical values with an intercept and no trend are: -3.435,
-2.863 and -2.567 at 1%, 5% and 10% levels; with and intercept and
trend are: -3.966, -3.414 and -3.129 at 1%, 5% and 10% levels. PP
critical values are: -3.435, -2.863 and -2.567 at 1%, 5% and 10%
respectively. KPSS critical values are: 0.216, 0.176, 0.146 and 0.119 at
1%, 2.5%, 5% and 10% levels. Null of stationarity is accepted if the
tests statistic is less than the critical value. The null hypothesis in the
case of ADF and PP is that the series is non-stationary, whereas in the
case of KPSS test it is series is stationary. Results of the study suggest
that the markets are not weak form efficient. DW test, which is a test
for serial correlations, has been used in the past but the explanatory
power of the DW can be questioned on the basis that the DW only
looks at the serial correlations on one lags as such may not be
appropriate test for the daily data. Current literature in the area of
market efficiency uses unit root and test of stationarity. This notion of

11
market efficiency has an important bearing for the fund managers and
investment bankers and more specifically the investors who are
seeking to diversify their portfolios internationally. One of the
criticisms of the supporters of the international diversification into
emerging markets is that the emerging markets are not efficient and
as such the investor may not be able to achieve the full potential
benefits of the international diversification.

CONCLUSIONS & IMPLICATIONS

This paper examines the weak form efficiency in two of the Indian
stock exchanges which represent the majority of the equity market in
India. We employ three different tests ADF, PP and the KPSS tests and
find similar results. The results of these tests find that these markets
are not weak form efficient. These results support the common notion
that the equity markets in the emerging economies are not efficient
and to some degree can also explain the less optimal allocation of
portfolios into these markets. Since the results of the two tests are
contradictory, it is difficult to draw conclusions for practical
implications or for policy from the study. It is important to note that the
BSE moved to a system of rolling settlement with effect from 2nd July
2006 from the previously used „Badla‟ system. The „Badla‟ system
was a complex system of forward settlement which was not
transparent and was not accessible to many market participants. The
results of the NSE are similar (NSE had a cash settlement system from
the beginning) to BSE suggesting that the changes in settlement
system may not significantly impact the results. On the contrary a
conflicting viewpoint is that the results of these markets may have
been influenced by volatility spillovers, as such the results may be
significantly different if the changes in the settlement system are
incorporated in the analysis. The research in the area of volatility
spillover has argued that the volatility is transferred across markets
(Brailsford, 1996), as such the results of these markets may be
interpreted cautiously. For future research, using a computationally
more efficient model like generalized autoregressive conditional
heteroskesdasticity (GARCH) could help to clear this.

12
3. What do you understand by yield? Explain the concept of
YTM with the help of example

Answer:

Yield, The income return on an investment. This refers to the interest

or dividends received from a security and are usually expressed
annually as a percentage based on the investment's cost, its current
market value or its face value.

The term you will hear about bonds the most is their yield and it can be
the most confusing. We broke this concept out separately because
there are really four different types of yield to explain:

1. Nominal Yield - This is the coupon or interest rate. Nothing else

is factored in to this number. It is actually not very helpful.

2. Current Yield - The current yield considers the current market

price of the bond, which may be different from the par value and
gives you a different return on that basis.
For example, if you bought a $1,000 par value bond with an
annual coupon rate of 6% ($1,000 x 0.06 = $60) on the open
market for $800, your yield would be 7.5% because you would
still be earning the $60, but on $800 ($60 / $800 = 7.5%) instead
of $1,000.

3. Yield to Maturity - Yield to Maturity is the most complicated,

but the most useful calculation. It considers the current market
price, the coupon rate, the time to maturity and assumes that
interest payments are reinvested at the bond's coupon rate. It is
a very complicate calculation best done with a computer
program or programmable business calculator. However, when
you hear the media talking about a bond's "yield" it is usually
this number they are talking about.

13
 4. Yield-to-Call - Most corporate bonds have provisions which
allow them to be called if interest rates should drop during the
life of the bond. When a bond is callable (can be repurchased by
the issuer before the maturity), the market also looks to the
Yield-to-Call. Normally, if a bond is called, the bondholder is paid
a premium over the face value (known as the call premium).
Yield-to-Call calculation assumes that the bond will be called, so
the time for which the cash flows (coupon and principal) occur is
shortened. The YTC is calculated exactly the same as YTM,
except that the call premium is added to the face value for
calculating the redemption value, and the first call date is used
instead of the maturity date.

Yield-to Maturity: This measures the investor’s total return if the

bond is held to its maturity date. That is, it includes the annual interest
payments, plus the difference between what the investor paid for the
bond and the amount of principal received at maturity.

The yield to maturity is the annual rate of return that a bondholder will
earn under the assumptions that the bond is held to maturity and the
interest payments are reinvested at the YTM. The yield to maturity is
the same as the bond’s internal rate of return (IRR). The yield to
maturity (YTM) or simply the yield is the discount rate that equates the
current market price of the bond with the sum of the present value of
all cash flows expected from this investment.

Previously, we had calculated the price of bond value when the

discount rate (r) was given. This discount rate was nothing but the
Yield-to-Maturity (YTM). In the yield to maturity calculations, the
market price of the bond is given, and we have to calculate the
discount rate or the YTM that will equate the present values of all the
coupon payments and the principal repayment to the current market
price of the bond.

To calculate YTM, we use trial and error until we get a discount rate
that equates the present value of coupon payments and principal
repayments to the current market price of the bond. We can also use
approximation formula for calculating the yield to maturity.

14
Suppose a company can issue 9% annual coupon, 20 year bond
with a face value of Rs. 1,000 for Rs. 980. What is the yield-to-
maturity on this bond?

Coupon = 9% x Rs. 1000 = Rs. 90

Face Value = Rs. 1000

Price = Rs. 980

Maturity = 20 year.

Yield = 90 + (1000-980)/20

(1000+980)/2

= 91/990 = .0919 or 9.19%

15