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SECUARITY ANALYSIS ANDSECUARITY ANALYSIS AND

INVESTMENT MANAGEMENTINVESTMENT MANAGEMENT (NMBA FM 01)(NMBA FM 01)

By

Sarvendu Tiari

!"D(!)# M$!"i%# MBA # M$C&'# UGCNET

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Meaning of securityMeaning of security-The state of being free from danger or threat.-A thing deposited or pledged as a guarantee of the fulfilment of an

undertaking or the repayment of a loan, to be forfeited in case of

default.-Investment in capital market is made in various financial instruments, which areall claims on money. These instruments may be of various categories with

different characteristics. These are all called securities in the market parlance. In

a legal sense also, the Securities Contracts Regulation Act, (1956) has defined

the security as inclusive of shares, stocks, bonds, debentures or any othermarketable securities of a like nature or of any debentures of a company or body

corporate, the Government and semi-Government body etc. It includes all rights

and interests in them including warrants, and loyalty coupons etc., issued by any

of the bodies, organisations or the Government. The derivatives of securities and

Security Inde are also included as securities in the above definition in !""#.

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Deini*i&n & ana%y+i+Deini*i&n & ana%y+i+

$or making proper investment involving both risk andreturn, the investor has to make a study of the alternative

avenues of investment% their risk and return characteristics

and make proper pro&ection or epectation of the risk and

return of the alternative investments under consideration. 'e

has to tune the epectations to his preferences of the risk and

return for making a proper investment choice

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Deini*i&n & +e,uri*y ana%y+i+Deini*i&n & +e,uri*y ana%y+i+The process of analysing the individual securities and the

market as a whole and estimating the risk

and return expected from each of the investments with a view to

identifying undervalued securities for buying and overvalued

securities for selling is both an art and a science and this is

what is called security analysis.

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Meaning of portfolioMeaning of portfolio

managementmanagementA combination of such securities with different risk-return characteristics will

constitute the portfolio of the investor. Thus, a portfolio is a combination of

various assets and(or instruments of investments. The combination may have

different features of risk and return, separate from those of the components. The

portfolio is also built up out of the wealth or income of the investor over a period

of time, with a view to suit his risk or return preferences to that of

the portfolio that he holds.

The portfolio analysis is thus an analysis of the risk-return characteristics of

ini!iual securities in the portfolio an changes that "ay take place inco"#ination $ith other securities ue to interaction a"ong the"sel!es an

i"pact of each one of the" on others %

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Investments: meaningInvestments: meaning

Investment may be defined as an activity that commits funds inany financial(physical form in the present with an epectation of

receiving additional return in the future.

Investment is an activity that is undertaken by those who have

savings. Savings can be defined as the ecess of income overependiture.

)-Ty-e. Economic and Financial investments

:-Characteristics of investment

The features of economic and nancial investmentscan be

summarised as:

Return,

Risk,

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Investment vs.Investment vs.

SpeculationSpeculationInvestment can be distinguished from speculation by risk bearing

capacity, return epectations, and duration of trade. The capacity to

bear risk distinguishes an investor from a speculator.

An investor prefers low risk investments, whereas a speculator is

prepared to take higher risks for higher returns. Speculation focuses

more on returns than safety, thereby encouraging fre*uent trading

without any intention of owning the investment. The speculator+s

motive is to achieve profits through price change, that is, capital

gains are more important than the direct income froman investment. Thus, speculation is associated with buying low and

selling high with the hope of making large capital gains

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Investment Vs GamblingInvestment Vs GamblingInvestment can also to be distinguished from gambling.

amples of gambling are horse race, card games,lotteries, and so on.

Gambling involves high risk not only for high returns but

also for the associated ecitement. Gambling is unplanned

and unscientific, without the knowledge of the nature of

the risk involved. It is surrounded by uncertainty and a

gambling decision is taken on unfounded market tips and

rumours. In gambling, artificial and unnecessary risks arecreated for increasing the returns.

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Capital Market-Capital Market-

IntroductionIntroduction

Indian Stock arkets are one of the oldest in Asia. Its history

dates back to nearly // years ago. The earliest records of

security dealings in India are meager and obscure. The ast

India 0ompany was the dominant institution in those days and

business in its loan securities used to be transacted towards the

close of the eighteenth century.

1y !#2/3s business on corporate stocks and shares in 1ank and0otton presses took place in 1ombay. Though the trading list

was broader in !#2", there were only half a do4en brokers

recogni4ed by banks and merchants during !#5/ and !#6/.

The !#6/3s witnessed a rapid development of commercialenterprise and brokerage business attracted many men into the

field and by !#7/ the number of brokers increased into 7/.

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Introduction Continued.Introduction Continued.In !#7/-7! the American 0ivil 8ar broke out and cotton supplyfrom 9nited States to urope was stopped: thus, the 3Share

ania3 in India begun. The number of brokers increased to about// to 6/. 'owever, at the end of the American 0ivil 8ar, in!#76, a disastrous slump began ;for eample, 1ank of 1ombayShare which had touched where they wouldconveniently assemble and transact business. In !##=, theyformally established in 1ombay, the @ative Share and Stock

1rokers3 Association@ ;which is alternatively known as @ TheStock change @>. In !#"6, the Stock change ac*uired a premise in the same street and it was inaugurated in !#"". Thus,the Stock change at 1ombay was consolidated.

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Structure of Capital Market inStructure of Capital Market in

India.India.

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Securities market ! StockSecurities market ! Stock

MarketMarket. to attract ne! ca"ital by means of issuance ne!

security #securiti$ation of debt%,&. to transfer real asset into nancial asset,

'. to invest money for short or lon( term "eriods !iththe aim of derivin( "rot.

). commercial function #to derive "rot from o"erationon this market%

*. "rice determination #demand and su""ly balancin(,the continuous "rocess of "rices movements(uarantees to state correct "rice for each security so

the market corrects mis"riced securities%+. informative function #market "rovides all "artici"ants

!ith market information about "artici"ants andtraded instruments%

. re(ulation function #securities market creates the

rules of trade%.

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"ole of Stock Market"ole of Stock Market•"aising capital for businesses

•Mobili#ing savings for investment

•$acilitating company gro%th

•Corporate governance

•Creating investment opportunities forsmall investors

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&evels of securities market&evels of securities market'rimary market

(he primary market s that "art of the ca"italmarkets that deals !ith the issue of ne!securities. -om"anies, (overnments or "ublicsector institutions can obtain fundin( throu(h

the sale of a ne! stock or bond issue. This isty"ically done throu(h a syndicate of securitiesdealers.

The ne! issue market for securities is the

"rimary securities market !hich brin(sto(ether the su""ly and demand/ or sourceand uses/ for ne! ca"ital funds. 0n this marketthe "rinci"al source of funds is the domestic

savin(s of individuals and businesses1 other

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&evels of securities market&evels of securities market'rimary market

The "rinci"al uses of funds are: the lon(2termnancin( of the investment in housin(#mort(a(es%, the lon(2term investment ofcor"orations and other businesses, and the lon(2term borro!in( of (overnment.

The ultimate su""liers of funds are those sectors!ith a sur"lus of current income over e4"enditure#savin(s%1 and these funds 5o! to their ultimateusers, namely, economic units !hich issuesecurities to nance a sur"lus of e4"enditures over

their current incomes.0n a hi(hly develo"ed ca"ital market by far thelar(est "ro"ortion of individuals6 savin(s reachesthe ne! issues market indirectly via a nancialintermediary. For e4am"le, the savin(s of most

individuals are channeled to an ultimate user, say acor"oration desirin( to nance an e4"ansion of its

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'rimary market $eatures'rimary market $eatures). (his is the market for ne% long term e*uity capital.

(he primary market is the market %here thesecurities are sold for the +rst time. (herefore it isalso called the ne% issue market ,IM.

/. In a primary issue0 the securities are issued by thecompany directly to investors.

1. (he company receives the money and issues ne%

security certi+cates to the investors.2. 'rimary issues are used by companies for the

purpose of setting up ne% business or fore3panding or moderni#ing the e3isting business.

4. (he primary market performs the crucial functionof facilitating capital formation in the economy.

5. (he ne% issue market does not include certainother sources of ne% long term e3ternal +nance0such as loans from +nancial institutions. 6orro%ersin the ne% issue market may be raising capital forconverting private capital into public capital7 this iskno%n as 8going public.8

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'rimary market 'rimary'rimary market 'rimary

$unctions$unctions). 9rigination- eals %ith 9rigin of ne% Issue. (he

proposal is analy#ed in terms of the nature of thesecurity0 the si#e of the issue0 time of the issue and;oatation method of the issue.

/.

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'rimary market Secondary'rimary market Secondary

$unctions$unctions). (o promote a ne% company

/. (o help to e3pand a ne% company

1. (o help in diversi+cation of the product

2. (o channeli#e the savings of the

investors.4. (o help the companies to raise capital

5. (o help the secondary market inhelping in trading of the securities.

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'articipant in 'rimary'articipant in 'rimary

MarketMarket

). Manager to the issue-• -onstruction of the "ros"ectus.

• ""ointment of the re(istrar

• ""ointment of the banker

• ""ointment of the under!riter.

• ;ud(et for the 0ssue

/. "egistrar to the issue-• Receive the share a""lication from various collection centers.

• Recommend the basis of allotment

•

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'rimary market'rimary market

Secondary market "elationSecondary market "elation. (he securities issued in the e% Issue Market are

invariably listed on a recognised stock e3change0subse*uent to their issue. (his is of immense utility topotential investors %ho feel assured that should theyreceive an allotment of ne% issues0 they %ill subse*uentlybe able to dispose them of at any time. (he facilitiesprovided by the secondary markets0 thus0 %iden the initialmarket for them.

/. Secondly0 the stock e3changes e3ercise considerablecontrol over the organisation of ne% issues. In terms of theregulatory frame%ork relating to dealings in securities0 ne%issues0 %hich seek stock e3change *uotation have to comply%ith statutory rules as %ell as regulations framed by thestock e3changes %ith the ob?ect of ensuring fair dealings in

them.

1. $undamentally0 the markets for ne% and old securitiesare0 economically0 an integral part of a single market theindustrial securities market. (hus they are susceptible tocommon in;uence and act and react upon each other.6roadly0 ne% issues increase %hen stock values are risingand vice versa.

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'rimary market Secondary'rimary market Secondary

market i@erencesmarket i@erences

.0n the rst "lace, >e! 0ssue =arket deals !ith ?ne!6 securities, i.e.securities !hich !ere not "reviously available and are o9ered to theinvestin( "ublic for the rst time. The market, therefore, derives its namefrom the fact that it makes available a ne! block of securities for "ublicsubscri"tion.

&. The stock market on the other hand, is a market for ?old6 securities i.e.those !hich have already been issued and have been (ranted stocke4chan(e listin(. These are "urchased and sold continuously amon( investors

!ithout involvement of the com"anies !hose securities constitute the stock2in2trade e4ce"t in the strictly limited sense of havin( to re(ister the transferof o!nershi" of the securities.

'. related as"ect of these t!o "arts is the nature of their contribution toindustrial nancin(. The >e! 0ssue =arket "rovides the issuin( com"any !ithadditional funds for startin( a ne! enter"rise or for either e4"ansion ordiversication of an e4istin( one, and thus its contribution to com"anynancin( is direct. The role of the stock e4chan(e vis2a2vis su""ly of ca"ital is

indirect.)."art from this, the t!o "arts of the market di9er or(anisationally, e.(. thestock e4chan(es have "hysical e4istence and are located in "articular(eo(ra"hical areas. The >e! 0ssue =arket en@oys neither any tan(ible formnor any administrative or(anisational setu", and nor is sub@ect to anycentralised control and administration for the e4ecution of its business it isreco(nised by the services that it renders to the lenders and borro!ers ofca"ital funds at the time of any "articular o"eration.

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Investor 'rotection inInvestor 'rotection in

'rimary market'rimary market). 'rovision of all the relevantInformation

/. 'rovision of =ccurate information

1. (ransparent allotment procedure%ithout any bias.

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Investor 'rotection in 'rimaryInvestor 'rotection in 'rimary

marketmarket. 7ro@ect ""raisal

&. Ander!ritin(

'.

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Secondary MarketSecondary Market stock e3change is a form of e4chan(e !hich"rovides services for stock brokers and traders totrade stocks, bonds, and other securities. Stock

e4chan(es also "rovide facilities for issue andredem"tion of securities and other nancialinstruments, and ca"ital events includin( the"ayment of income and dividends. Securitiestraded on a stock e4chan(e include shares issued

by com"anies, unit trusts, derivatives, "ooledinvestment "roducts and bonds.

To be able to trade a security on a certain stocke4chan(e, it must be listed there. Asually, there is

a central location at least for record kee"in(, buttrade is increasin(ly less linked to such a "hysical"lace, as modern markets are electronic net!orks,!hich (ives them advanta(es of increased s"eedand reduced cost of transactions. Trade on ane4chan(e is by members only.

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"ole and $unctions of Secondary Market"ole and $unctions of Secondary Market"ole•Creating investment opportunities for smallinvestors•'ro+t sharing•$acilitating company gro%th•Mobili#ing savings for investment•Common forms of capital raising

•"aising capital for businesses$unctions•Maintain =ctive (rading•$i3ation of 'rice•Ansure safe and $air trade 'ractices

•=ids in $inancing the Industry•issemination of the information•'erformance Inducer

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Re(ulatory =echanism in Secondary =arketRe(ulatory =echanism in Secondary =arket

Three tier structure

.=inistry of nance

&.SE;0

'.Bovernin( ;oard

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Re(ulatory =echanism in Secondary =arketRe(ulatory =echanism in Secondary =arket

=inistry of nance. Su"ervisory function over SE;0

&. ""ellate function a(ainst SE;0

'. Licensin( of dealers

). Reco(nition to stock e4chan(e*. ""ointment of the board of (overnors

SE;0. Re(ulation of ;usiness

&. 0nvestor 7rotection

'. 7revent Fraudulent trade "ractices

). Takeover and mal(amation

*. 8ther "o!ers

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Re(ulatory =echanism in Stock =arketRe(ulatory =echanism in Stock =arket Bovernin( ;oard. -onsist of ' members.

&. + members from !ithin

'. ' "ublic re"resentatives nominated by theboard of (overnors

). >ot more than' members a""ointed by thecentral (overnment

*. >ot more than three by SE;0.

+. E4ecutive directors by the stock e4chan(e.

. 8ne third of the elected members are retires at

B=. They can be re elected.C. There are also 7residents and Dice "resident

elected by the (overnin( board.

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$unctioning of Stock Market$unctioning of Stock Market member broker in an 0ndian stock e4chan(e can act as ana(ent, buy and sell securities for his clients on a commissionbasis and also can act as a trader or dealer as a "rinci"al, buy

and sell securities on his o!n account and risk, in contrast !iththe "ractice "revailin( on >e! Hork and London StockE4chan(es, !here a member can act as a @obber or a broker only.

The nature of tradin( on 0ndian Stock E4chan(es are that of a(eold conventional style of face2to2face tradin( !ith bids and o9ers

bein( made by o"en outcry. Io!ever, there is a (reat amount ofe9ort to moderni$e the 0ndian stock e4chan(es in the very recenttimes.

9ver (he Counter A3change of India,9(CAI The traditional tradin( mechanism "revailed in the 0ndian stock

markets (ave !ay to many functional ineJciencies, such as,absence of liquidity, lack of trans"arency, unduly lon( settlement"eriods, !hich a9ected the small investors to a (reat e4tent. To"rovide im"roved services to investors, the countryKs rstelectronic stock e4chan(e 2 8T-E0 2 !as created in GG& bycountryKs "remier nancial institutions 2 Anit Trust of 0ndia,0ndustrial -redit and 0nvestment -or"oration of 0ndia, 0ndustrial

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$unctioning of Stock Market$unctioning of Stock Market8T- has a unique feature of tradin( com"ared to othertraditional e4chan(es. That is, certicates of listed securities andinitiated debentures are not traded at 8T-. The ori(inal

certicate !ill be safely !ith the custodian. ;ut, a counter recei"tis (enerated out at the counter !hich substitutes the sharecerticate and is used for all transactions.

0n the case of "ermitted securities, the system is similar to atraditional stock e4chan(e. The di9erence is that the deliveryand "ayment "rocedure !ill be com"leted !ithin ) days.

-om"ared to the traditional E4chan(es, 8T- E4chan(e net!orkhas the follo!in( advanta(es:•8T-E0 has !idely dis"ersed tradin( mechanism across thecountry !hich "rovides (reater liquidity and lesser risk ofintermediary char(es.•

Breater trans"arency and accuracy of "rices is obtained due tothe screen2based scri"less tradin(.•Since the e4act "rice of the transaction is sho!n on thecom"uter screen, the investor (ets to kno! the e4act "rice at!hich she is tradin(.•Faster settlement and transfer "rocess com"ared to othere4chan(es.•0n the case of an 8T- issue #ne! issue%, the allotment "rocedure

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6ene+ts and limitations of Stock6ene+ts and limitations of Stock

MarketMarket6ene+ts.-reatin( a market for the com"anyKs shares

&.Enhancin( the status and nancial standin( of the com"any'.0ncreasin( "ublic a!areness and "ublic interest in thecom"any and its "roducts

).7rovidin( the com"any !ith an o""ortunity to im"lementshare o"tion schemes for their em"loyees

*.ccessin( to additional fund raisin( in the future by meansof ne! issues of shares or other securities

+.Facilitatin( acquisition o""ortunities by use of thecom"anyKs shares

.89erin( e4istin( shareholders a ready means of reali$in(their investments

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6ene+ts and limitations of Stock6ene+ts and limitations of Stock

MarketMarket&imitations•0ncreasin( accountability to "ublic shareholders

•>eed to maintain dividend and "rot (ro!th trends

•-hances of "ossible takeover and mer(er.

•>eed to observe and adhere strictly to the rules

and re(ulations by (overnin( bodies•0ncreasin( costs in com"lyin( !ith hi(her level ofre"ortin( requirements

•Su9erin( a loss of "rivacy as a result of media

interest

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(he Security and A3change 6oard of(he Security and A3change 6oard of

IndiaIndia• 0t !as oJcially act by The Bovernment of 0ndia in the year GCC and (ivenstatutory "o!ers in GG& !ith SE;0 ct GG& bein( "assed by the 0ndian7arliament. SE;0 has itKs Ieadquarter at the business district of ;andra Murla-om"le4 in =umbai, and has >orthern, Eastern, Southern and NesternRe(ional 8Jces in >e!

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9b?ectives of Security and A3change9b?ectives of Security and A3change

6oard of India6oard of India To "romote and develo" stock

market To "rotect the interest of the

investors in stock market.

To re(ulate the stock market

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$unctions of Security and A3change$unctions of Security and A3change

6oard of India6oard of India0n order to "ursue the ob@ectives SE;0

has the follo!in( functions:. Re(ulate the !orkin( of the stock market.

&. Re(istration and licensin( of the "artici"ants.

'. Re(istration and re(ulation of the collective investmentschemes.

). 7romotion of self re(ulatory or(ani$ation

*. 7reventin( unfair trade "ractices.

+. 7romotin( investor education.

. Trainin( of the intermediaries.

C. 7reventin( 0nsider tradin(, circular tradin(.G. Re(ulatin( =er(ers, takeovers, mal(amations etc.

.Andertakin( 0ns"ections, -allin( for the information,audits of the stocks, sei$ure of the accounts.

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(he Security and A3change 6oard of(he Security and A3change 6oard of

IndiaIndia 9rgani#ation9rgani#ation7rimary

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SE;06s Role in 7rimary =arketSE;06s Role in 7rimary =arket

. Entry >orms• ' year of

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SE;06s Role in Secondary =arketSE;06s Role in Secondary =arket

. Bovernin( ;oard

&. 0nfrastructure

'. Settlement and clearin(

). 7rice stabili$ation

*.

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Concept of "isk Concept of "isk

"isk is the "otential of loss #an undesirable outcome, ho!ever notnecessarily so% resultin( from a (iven action, activity andor

inaction. The notion im"lies that a choice havin( an in5uence onthe outcome sometimes e4ists #or e4isted%. 7otential lossesthemselves may also be called risks. ny human endeavorcarries some risk, but some are much riskier than others.

"isk can be dened in di9erent !ays

. "robability or threat of dama(e, in@ury, liability, loss, or any otherne(ative occurrence that is caused by e4ternal or internalvulnerabilities, and that may be avoided throu(h "reem"tiveaction.

&. Finance: The "robability that an actual return on an investment !illbe lo!er than the e4"ected return. Financial risk can be dividedinto the follo!in( cate(ories: ;asic risk, -a"ital risk, -ountry risk,

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(ypes of "isk (ypes of "isk

Systematic and unsystematic risk components

0n nance, di9erent ty"es of risk can be classied undert!o main (rou"s, vi$.,• Systematic risk.• Ansystematic risk.

T!o main (rou"s under !hich ty"es of risk are classiedis de"icted belo!.

http://lh5.googleusercontent.com/-64dBMtOISq8/Tx9KC5eaD6I/AAAAAAAAFpg/ytuR-nFhUAY/s800/Types-of-Risk.png

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Systematic "isk

Systematic risk is due to the in5uence of e4ternal factors on anor(ani$ation. Such factors are normally uncontrollable froman or(ani$ationKs "oint of vie!.

Systematic risk is a macro in nature as it a9ects a lar(e numberof or(ani$ations o"eratin( under a similar stream or samedomain. 0t cannot be "lanned by the or(ani$ation.

Ty"es of risk under the (rou" of systematic risk are listed asfollo!s:

0nterest rate risk. =arket risk.

7urchasin( "o!er or 0n5ationary risk.

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Systematic "isk

Systematic risk is due to the in5uence of e4ternal factors on an or(ani$ation. Suchfactors are normally uncontrollable from an or(ani$ationKs "oint of vie!.

Systematic risk is a macro in nature as it a9ects a lar(e number of or(ani$ationso"eratin( under a similar stream or same domain. 0t cannot be "lanned by theor(ani$ation.

Ty"es of risk under the (rou" of systematic risk are listed as follo!s:• 0nterest rate risk.• =arket risk.• 7urchasin( "o!er or 0n5ationary risk.

http://lh5.googleusercontent.com/-kA9VWLSjI8s/Tx9Q6VqkBcI/AAAAAAAAFps/7aX16rWxtQo/s800/Systematic-Risk.png

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). Interest rate risk

0nterest2rate risk arises due to variability in the interest rates from time to time. 0t"articularly a9ects debt securities as they carry the 4ed rate of interest.

The interest2rate risk is further classied into follo!in( ty"es.

•7rice risk.

•Reinvestment rate risk.

The ty"es of interest2rate risk are de"icted belo!.

The meanin( of various ty"es of interest2rate risk is discussed belo!.

•'rice risk arises due to the "ossibility that the "rice of the shares, commodity,

investment, etc. may decline or fall in the future.•"einvestment rate risk results from fact that the interest or dividend earned from aninvestment canKt be reinvested !ith the same rate of return as it !as acquirin( earlier.

f i k

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/. Market risk

=arket risk is associated !ith consistent 5uctuations seen in the tradin( "rice of any"articular shares or securities. That is, it is a risk that arises due to rise or fall in the tradin(

"rice of listed shares or securities in the stock market. The market risk is further classied into follo!in( ty"es.

•bsolute risk.

•Relative risk.

•on2directional risk.

•;asis risk.

•Dolatility risk.•=bsolute Risk is the risk !ithout any content. For e.(., if a coin is tossed, there is fty"ercenta(e chance of (ettin( a head and vice2versa.

•"elative risk is the assessment or evaluation of risk at di9erent levels of businessfunctions. For e.(. a relative risk from a forei(n e4chan(e 5uctuation may be hi(her if thema4imum sales accounted by an or(ani$ation are of e4"ort sales.

•irectional risks are those risks !here the loss arises from an e4"osure to the "articularassets of a market. For e.(. an investor holdin( some shares e4"erience a loss !hen the

market "rice of those shares falls do!n.•on-irectional risk arises !here the method of tradin( is not consistently follo!ed by thetrader. For e.(. the dealer !ill buy and sell the share simultaneously to miti(ate the risk.

•6asis risk is due to the "ossibility of loss arisin( from im"erfectly matched risks. For e.(.the risks !hich are in o9settin( "ositions in t!o related but non2identical markets.

•Volatility risk is the risk of a chan(e in the "rice of securities as a result of chan(es in thevolatility of a risk factor. For e.(. volatility risk a""lies to the "ortfolios of derivativeinstruments, !here the volatility of its underlyin( is a ma@or in5uence of "rices.

( f "i k

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1. 'urchasing po%er or in;ationary risk

7urchasin( "o!er risk is also kno!n as in5ation risk. 0t isso, since it emanates #ori(inates% from the fact that ita9ects a "urchasin( "o!er adversely. 0t is not desirable toinvest in securities durin( an in5ationary "eriod.

The "urchasin( "o!er or in5ationary risk is classied intofollo!in( ty"es.

•

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/. $inancial or credit risk

Financial risk is also kno!n as credit risk. This risk arises due to chan(e in the ca"ital structure ofthe or(ani$ation. The ca"ital structure mainly com"rises of three !ays by !hich funds are

sourced for the "ro@ects. These are as follo!s:

•8!ned funds. For e.(. share ca"ital.

•;orro!ed funds. For e.(. loan funds.

•Retained earnin(s. For e.(. reserve and sur"lus.

The nancial or credit risk is further classied into follo!in( ty"es.

•E4chan(e rate risk.

•Recovery rate risk.•-redit event risk.

•>on2

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1. 9perational risk

8"erational risks are the business "rocess risks failin( due to human

errors. This risk !ill chan(e from industry to industry. 0t occurs due tobreakdo!ns in the internal "rocedures, "eo"le, "olicies and systems.

The o"erational risk is further classied into follo!in( ty"es.•=odel risk.•7eo"le risk.•Le(al risk.

•7olitical risk.Model risk is the risk involved in usin( various models to value nancialsecurities. 0t is due to "robability of loss resultin( from the !eaknesses inthe nancial model used in assessin( and mana(in( a risk.

'eople risk arises !hen "eo"le do not follo! the or(ani$ation6s"rocedures, "ractices andor rules. That is, they deviate from theire4"ected behavior.

&egal risk arises !hen "arties are not la!fully com"etent to enter ana(reement amon( themselves. Furthermore, this relates to re(ulatory risk,!here a transaction could con5ict !ith a (overnment "olicy or "articularle(islation #la!% mi(ht be amended in the future !ith retros"ective e9ect.

'olitical risk is the risk that occurs due to chan(es in (overnment"olicies. Such chan(es may have an unfavorable im"act on an investor. This risk is es"ecially "revalent in the third2!orld countries.

M f i k d t dM f i k d t d

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Measures of risk and return andMeasures of risk and return and

CalculationCalculation

State 'robability

"eturn on

Stock =

"eturn on

Stock 6

) &O *O *O

/ 'O O 'O

1 'O *O O

1 &O &O 2O

Varian,e and S*andard Devia*i&n

Risk reflects the chance that the actual return on an investment may be very different than the expected

return. One way to measure risk is to calculate the variance and standard deviation of the distribution of

returns.Consider the probability distribution for the returns on stocks A and B provided below.

The expected returns on stocks A and B were calculated on the Expected Return page. The expected return

on tock ! was found to be "#.$% and the expected return on tock & was found to be #'%.

(iven an asset)s expected return* its variance can be calculated using the following e+uation,

!here> P the number of states,"

i

P the "robability of state i,

Ri P the return on the stock in state i,

andEQR P the e4"ected return on thestock. The standard deviation is calculated

as the "ositive square root of thevariance.

M f i k d t dM f i k d t d

http://www.zenwealth.com/BusinessFinanceOnline/RR/ExpectedReturn.htmlhttp://www.zenwealth.com/BusinessFinanceOnline/RR/ExpectedReturn.html

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Measures of risk and return andMeasures of risk and return and

CalculationCalculationVariance and Standard eviation on Stocks = and 6 AB"= D )/.4E and AB"6 D /FE

Stock =

Stock 6

lthou(h Stock 6 o9ers a hi(her e4"ected return than Stock =,it also is riskier since its variance and standard deviation are(reater than Stock =Ks. This, ho!ever, is only "art of the "icturebecause most investors choose to hold securities as "art of adiversied "ortfolio.

"i k d " t ( d @"i k d " t ( d @

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"isk and "eturn (rade o@ "isk and "eturn (rade o@ fundamental investment conce"t is the tradeo9 bet!een risk and return. Theconce"t is based on t!o realities of investments and investment "erformance.First, all investments carry some de(ree of risk the reality that you could lose some

or all of your money !hen you buy stocks, bonds, mutual funds or other investments.Second, not only do di9erent ty"es of investments carry di9erent levels of risk, butthe more risk you assume, the (reater the investment return you are likely to achieve.Risk comes in many forms, but !hen talkin( about the risk2return tradeo9, the"rimary measure of risk is volatility, or the de(ree to !hich an investment 5uctuatesin "rice.

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"isk and "eturn (rade o@ "isk and "eturn (rade o@ Avaluate our (olerance $or "isk

Hour risk tolerance !ill de"end in "art on ho! much money you can a9ord to lose !hich, for most investors, is not a lar(e "ercenta(e of one6s total investment amount.

;ut risk tolerance also involves ho! !ell you emotionally handle the u"s and do!nsof the market. 0f the market6s short2term "eaks and valleys don6t bother you, youhave a hi(her tolerance for risk and "robably are more likely to risk losin( money toachieve better results. 8n the other hand, if you6re "rone to !orryin( about5uctuations in the value of your investments, you have a lo!er tolerance for risk andmay feel better about allocatin( your investments to assets that do not 5uctuate asmuch, such as bonds, even !hen you have a relatively lon( investment time hori$on.Even if you shrink from market risk, remember that there is also the risk that lo!2

return investments !on6t "rovide the lon(2term (ro!th you need to build investmentvalue over time, es"ecially durin( "eriods of hi(h in5ation !here your rate of returnmay be less than the rate of in5ation.

t f it i t tature of e*uity instruments

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ature of e*uity instrumentsature of e*uity instruments There are t!o "rinci"al !ays in !hich a com"any can obtain additional nances necessary too"erate or e4"and. 8ne is by sellin( equity and the other is by takin( on debt. Sellin( equity can beaccom"lished throu(h the sale of common stock. 7referred stock has characteristics of both debtand equity.

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A*uity Valuation ModelsA*uity Valuation ModelsStock Valuation MethodsStocks have t!o ty"es of valuations. 8ne is a value created usin( somety"e of cash 5o!, sales or fundamental earnin(s analysis. The other value

is dictated by ho! much an investor is !illin( to "ay for a "articular shareof stock and by ho! much other investors are !illin( to sell a stock for #inother !ords, by su""ly and demand%. ;oth of these values chan(e overtime as investors chan(e the !ay they analy$e stocks and as they becomemore or less condent in the future of stocks.

The fundamental valuation is the valuation that "eo"le use to @ustify stock"rices. The most common e4am"le of this ty"e of valuation methodolo(y is7E ratio, !hich stands for 7rice to Earnin(s Ratio. This form of valuation isbased on historic ratios and statistics and aims to assi(n value to a stockbased on measurable attributes. This form of valuation is ty"ically !hatdrives lon(2term stock "rices.

The other !ay stocks are valued is based on su""ly and demand. The more

"eo"le that !ant to buy the stock, the hi(her its "rice !ill be. ndconversely, the more "eo"le that !ant to sell the stock, the lo!er the "rice!ill be. This form of valuation is very hard to understand or "redict, and itoften drives the short2term stock market trends.

There are many di9erent !ays to value stocks. The key is to take eacha""roach into account !hile formulatin( an overall o"inion of the stock. 0f

the valuation of a com"any is lo!er or hi(her than other similar stocks,

A*uity Valuation ModelsA*uity Valuation Models

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A*uity Valuation ModelsA*uity Valuation Models'rice to Aarnings ,'!A >o! that you have several E7S (ures #historical and forecasts%, youKll be able to look at the mostcommon valuation technique used by analysts, the "rice to earnin(s ratio, or 7E. To com"ute this

(ure, take the stock "rice and divide it by the annual E7S (ure. For e4am"le, if the stock is tradin(at and the E7S is .*, the 7E is & times. To (et a (ood feelin( of !hat 7E multi"le a stocktrades at, be sure to look at the historical and for!ard ratios. Iistorical 7Es are com"uted by takin( the current "rice divided by the sum of the E7S for the lastfour quarters, or for the "revious year. Hou should also look at the historical trends of the 7E byvie!in( a chart of its historical 7E over the last several years #you can nd on most nance siteslike Hahoo Finance%. S"ecically you !ant to nd out !hat ran(e the 7E has traded in so that youcan determine if the current 7E is hi(h or lo! versus its historical avera(e.

For!ard 7Es re5ect the future (ro!th of the com"any into the (ure. For!ard 7Es are com"uted bytakin( the current stock "rice divided by the sum of the E7S estimates for the ne4t four quarters, orfor the E7S estimate for ne4t calendar or scal year or t!o.7Es chan(e constantly. 0f there is a lar(e "rice chan(e in a stock you are !atchin(, or if the earnin(s#E7S% estimates chan(e, the ratio is recom"uted.

The "E has the follo!in( advanta(es:.7E ratio indicates "rice "er ru"ee of the share earnin(. This !ould hel" to com"are the "rices of

stocks, !hich have di9erent E7S.&.7E ratio are hel"ful in analysin( the stocks of the com"anies that do not "ay dividend but haveearnin(s. 0t should be noted that !hen there is loss, 7E ratio analyses is diJcult to use.'.The variables used in 7E ratio model are easier to estimate than the variables in the discountin(models.

Nith this ratio model the investor can only nd the relative "osition of the di9erent stocks. 0t doesnot indicate !hat "rice is a""ro"riate for a "articular stock.

A*uity Valuation ModelsA*uity Valuation Models

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A*uity Valuation ModelsA*uity Valuation Models'resent Value of the "eturn Model

7rice of the share,

7oP

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6onds ature and Avaluation of6onds ature and Avaluation of

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6onds0 ature and Avaluation of6onds0 ature and Avaluation of

6onds6onds The bond market is by far the lar(est securities market in the!orld, "rovidin( investors !ith virtually limitless investmento"tions. =any investors are familiar !ith as"ects of the market,but as the number of ne! "roducts (ro!s, even a bond e4"ert ischallen(ed to kee" "ace. 8nce vie!ed as a means of earnin(interest !hile "reservin( ca"ital, bonds have evolved into a Gtrillion (lobal market"lace that can o9er many "otential benets toinvestment "ortfolios, includin( attractive returns.

;onds can be bou(ht and sold in the secondary market/ afterthey are issued. Nhile some bonds are traded "ublicly throu(he4chan(es, most trade over the counter bet!een lar(e broker2dealers actin( on their clients6 or their o!n behalf.

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(he role of bonds in a portfolio(he role of bonds in a portfolio

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(he role of bonds in a portfolio(he role of bonds in a portfolioSince (overnments be(an to issue bonds more frequently in the early t!entieth century and(ave rise to the modern bond market, investors have "urchased bonds for several reasons:ca"ital "reservation, income, diversication and as a "otential hed(e a(ainst economic!eakness or de5ation. Nhen the bond market became lar(er and more diverse in the Gs

and GCs, bonds be(an to under(o (reater and more frequent "rice chan(es and manyinvestors be(an to trade bonds, takin( advanta(e of another "otential benet: "rice, or ca"ital,a""reciation.

Capital preservation: Anlike equities, bonds should re"ay "rinci"al at a s"ecied date, ormaturity. This makes bonds a""ealin( to investors !ho do not !ant to risk losin( ca"ital and tothose !ho must meet a liability at a "articular time in the future. ;onds have the added benetof o9erin( interest at a set rate that is often hi(her than short2term savin(s rates.

Income: =ost bonds "rovide the investor !ith 4ed/ income. 8n a set schedule, !hetherquarterly, t!ice a year or annually, the bond issuer sends the bondholder an interest "ayment,!hich can be s"ent or reinvested in other bonds. Stocks can also "rovide income throu(hdividend "ayments, but dividends tend to be smaller than bond cou"on "ayments, andcom"anies make dividend "ayments at their discretion, !hile bond issuers are obli(ated tomake cou"on "ayments.

Capital appreciation: ;ond "rices can rise for several reasons, includin( a dro" in interestrates and an im"rovement in the credit standin( of the issuer. 0f a bond is held to maturity, any"rice (ains over the life of the bond are not reali$ed1 instead, the bond6s "rice ty"ically revertsto "ar #% as it nears maturity and re"ayment of the "rinci"al. Io!ever, by sellin( bondsafter they have risen in "rice and before maturity investors can reali$e "rice a""reciation,also kno!n as ca"ital a""reciation, on bonds. -a"turin( the ca"ital a""reciation on bondsincreases their total return, !hich is the combination of income and ca"ital a""reciation.

0nvestin( for total return has become one of the most !idely used bond strate(ies over the /

6ond "isk6ond "isk

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6ond "isk 6ond "isk Interest "ate "isk

Dariability in return from the debt to investors is caused by the chan(es is in the marketinterest rate.

efault "isk The failure to "ay the a(reed amount of the debt instrument by the issuer in full, on time orboth are default risk.

Marketability "isk Dariability in return caused by the diJculty in sellin( the bonds quickly !ithout

havin( to make a substantial concession is kno!n as marketability risk.

Callability "isk

The uncertainty created in the investors return by the issuer ability to call the bondsat any time.

6ond "eturn:

Ioldin( 7eriod ReturnP #7rice (ain or Loss durin( the holdin( "eriod U -ou"on interest rate% 7rice at the be(innin( of the holdin( "eriod

ield (o Maturityield (o Maturity

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ield (o Maturity ield (o Maturity HT= is the sin(le discount factor that "resent value of the future cash 5o!s from a bond equalto the current "rice of the bond. Ne can also say that HT= is the rate of the return an investorcan e4"ect to earn if the bond is held till maturity.

=ssumption:

.There should not be any default.&.The investor hold the bond till maturity.'.ll the cou"on should be reinvested immediately at the same time interest rate as the sametime yield to maturity of the bond.

(he formula is :

H P - U #7 or

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6ond (heorems0 term structure and6ond (heorems0 term structure and

Interest "ateInterest "ate(heorem-) : 'rice and interest rates move inverselyLets assume ' year O cou"on "ayin( bond for illustration

Ience it can be concluded that as yield increase "rice of the bond decline and vice2versa.

8hen BT C !/D Erice C !//

8hen BT C !!D Erice C "=.66

8hen BT C "D Erice C !/.62

Theorem-2 : A decrease in interest rates raises bond prices by more than a corresponding increase in rates

lowers price

5ets assume 6 year "'% coupon paying bond for illustration

8hen BT C !/D Erice C !//

8hen BT C !!D Erice C "=.66 0hange in price C -.56D

8hen BT C "D Erice C !/.62 0hange in price C F.62D

This the most important theorem of bond which says that price movement of bond with change is interest rate either

side is not e+ual. -rice of the bond increases more than it declines when e+ual change in interest rate is given. 7n

above illustration you can clearly see that when yield declines by "% price increases by #.$6% while in case of

increase in yield by "%* price decline is #.8$%. !s price curve of the bond is convex* you gain more than you lose.

6ond (heorems term structure and6ond (heorems term structure and

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Interest "ateInterest "ate

E4am"le ;ond ;ond ;

7ar Dalue Rs Rs

-ou"on Rate O O

Hield *O *O

=aturity 7eriod & '

=arket 7rice GC. CC*.C+

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Interest "ateInterest "ate(heorem 20f the bond yield remain constant over it6s life, the discount or "remium amount !ill decrease atan increasin( rate as it6s life (et6s shorter. -onsider a bond !ith the face value Rs. , andmaturity "eriod of * years !ith yield to maturity O .

Hield to =aturity The 7resent Dalue

* +&.G

) +C'.

' *.'

& C&+.)

GG.

6ond (heorems0 term structure and Interest6ond (heorems0 term structure and Interest

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6ond (heorems0 term structure and Interesto d eo e s0 e s uc u e a d e es

"ate"ateTheorem 5The change in price will be lesser for a percentage change in bond9s yield if its coupon rate is higher. 7t is

explained by the following examples,

A3ample 6ond = 6ond 6

-ou"on rate O CO

Hield CO CO

=aturity 7eriod ' '

7rice Rs. *.*

Face value Rs Rs

Hield raise O O

7rice after Hieldraise

Rs. &.*' Rs G.)

7ercenta(e-han(e in 7rice

&.)O &.*'O

Conve3ity of ield CurveConve3ity of ield Curve

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Conve3ity of ield CurveConve3ity of ield CurveTheorem-1 : Price and interest rates move inversely

:hen ;T< / "'%

-rice / "''

:hen ;T< / ""%

-rice / =>.$$:hen ;T< / =%

-rice / "'#.$6

Theorem-2 : A decrease in interest rates raises bond prices by more than a corresponding increase in rates

lowers price

:hen ;T< / "'%

-rice / "''

:hen ;T< / ""%

-rice / =>.$$Change in price / ?#.8$%

:hen ;T< / =%

-rice / "'#.$6

Change in price / 2#.$6%

This the most important theorem of bond which says that price movement of bond with change is interest rate either

side is not e+ual. -rice of the bond increases more than it declines when e+ual change in interest rate is given. 7n

above illustration you can clearly see that when yield declines by "% price increases by #.$6% while in case of

increase in yield by "%* price decline is #.8$%. !s price curve of the bond is convex* you gain more than you lose.

(he term Structure of the Interest rate ,ield(he term Structure of the Interest rate ,ield

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,,

CurveCurveThe bond porfolio manager is often concerned with two aspects of the interest rate,the level of the interest rate the term structure of the interest rate. The relationship

between the yield and the time or years to maturity is called the term structure. The

term structure is also known as yield curve. 7n analy@ing the effect of maturity on yieldcurve other influences held constant. Asually pure discount instrument are selected to

eliminate the effect of coupon payment. The bond chosen do not have early

redemption features. The maturity dates are different but the risks* tax liabilities and

redemption possibilities are similar.

urationuration

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urationuration

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Macaulay urationMacaulay urationFor bonds !ith 4ed cash 5o!s a "rice chan(e can come from t!osources:.The "assa(e of time #conver(ence to!ards "ar%. This is of course totally

"redictable, and hence not a risk.&. chan(e in the yield. This can be due to a chan(e in the benchmarkyield, andor chan(e in the yield s"read.'.The yield2"rice relationshi" is inverse, and !e !ould like to have ameasure of ho! sensitive the bond "rice is to yield chan(es. The modiedduration is a measure of the "rice sensitivity to yields and "rovides a

linear a""ro4imation. For lar(e yield chan(es conve4ity can be added to"rovide a quadratic or second2order a""ro4imation. lternatively, andoften more usefully, conve4ity can be used to measure ho! the modiedduration chan(es as yields chan(e. Similar risk measures #rst andsecond order% used in the o"tions markets are the delta and (amma.).=acaulay duration and modied duration are both termed duration

and have the same #or close to the same% numerical value, but it isim"ortant to kee" in mind the conce"tual distinctions bet!een them.=acaulay duration is a time measure !ith units in years, and really makessense only for an instrument !ith 4ed cash 5o!s. For a standard bondthe =acaulay duration !ill be bet!een and the maturity of the bond. 0tis equal to the maturity if and only if the bond is a $ero2cou"on bond.

$undamental analysis$undamental analysis

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$undamental analysis$undamental analysis. Economic nalysis&. 0ndustry analysis'. -om"any nalysis

. Economic nalysisEconomic 0ndicators• Bational 0ncome• Em"loyment

• 0n5ationRe(ression =odel

&. 0ndustry nalysis• Bro!th• -ost Structure and 7rotability

• >ature of the 0ndustry• >ature of the -om"etition• Bovernment "olicy• Labor market condition• Research and develo"ment

$undamental analysis ! (echnical$undamental analysis ! (echnical

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$undamental analysis ! (echnical$undamental analysis ! (echnical

=nalysis=nalysis'. -om"any analysis• -a"ital structure• Bro!th of the com"any and sales

• Stability of the sales• Earnin( of the com"any• Financial statement

(echnical =nalysis0t is the "rocess of identifyin( the time reversal at an earlier sta(e to

formulate buyin( and sellin( strate(ies. Nith the hel" of manyindicators !e can "rdict the "rice volume and demand su""ly of thestocks.

ssum"tions:. The market discount everythin(.&. The market value is determined by the demand and su""ly.'. The market al!ays moves in trend

(echnical =nalysis(echnical =nalysis

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(echnical =nalysis(echnical =nalysis(echnical tools:.

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(echnical =nalysis(echnical =nalysis'rimary (rends:. The security "rice trend may be either increasin( or decreasin(. Nhen the

market e4hibit the increasin( trend it is called bull market. The bull market

sho!s three clear cut "eaks. Each "eak is hi(her than the "revious one.. Thebottoms are also hi(her then the "revious ones.

• First 7hase is Revival of the market• Bood cor"orate earnin(• S"eculation 7hase

&. The reverse is also true !ith the bear market.

• Loss of ho"es• Recession "hase•

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(echnical =nalysis(echnical =nalysisVolume of trade L

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(echnical =nalysis(echnical =nalysis

6asis $undamental =nalysis (echnical =nalysis

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erivativeserivativesBerivatives are a contract between two parties that specify conditions 1especially the dates*

resulting values and definitions of the underlying variables* the parties) contractual

obligations* and the notional amount3 under which payments are to be made between the

parties.

The most common underlying assets include commodities* stocks* bonds* interestrates and currencies* but can also be other derivatives* which adds another layer of

complexity to proper valuation.

Importance-There are several risks inherent in financial transactions. Berivatives are used toseparate risks from traditional instruments and transfer these risks to parties willing to bear

these risks. The fundamental risks involved in derivative business includes,

Credit is!

This is the risk of failure of a counterparty to perform its obligation as per the contract. !lsoknown as default or counterparty risk* it differs with different instruments.

"ar!et is!

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erivativese a es". &ver-the-co%nter '&TC( derivatives are contracts that are traded 1and

privately negotiated3 directly between two parties* without going through

an exchange or other intermediary. -roducts such as swaps* forward

rate agreements* exotic options D and other exotic derivatives D arealmost always traded in this way. The OTC derivative market is the

largest market for derivatives* and is largely unregulated with respect to

disclosure of information between the parties* since the OTC market is

made up of banks and other highly sophisticated parties* such as hedge

funds. Reporting of OTC amounts is difficult because trades can occur inprivate* without activity being visible on any exchange.

2)*+change-traded derivatives 1ETB3 are those derivatives instruments that are

traded via speciali@ed derivatives exchanges or other exchanges. ! derivatives

exchange is a market where individuals trade standardi@ed contracts that have

been defined by the exchange. ! derivatives exchange acts as an intermediary toall related transactions* and takes initial margin from both sides of the trade to act

as a guarantee.

erivativeserivatives

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erivatives,hat are the vario%s types o derivatives.

Berivatives can be classified into three types,

".utures

#.Options6.waps

The Basic Concept o &ptions !n options contract* whether a call 1buy an asset3 or put 1sell an asset3* grants the holder the right D but not

the obligation D to exercise the option. The holder is entitled to simply let the option expire without investing

further. .

!n option is linked to a specific stock. The price of the option is much less than the price of the underlying

stock* which is a maor reason for the attractiveness of options. 7f the price of the stock changes* the price of

the option also changes* although by a smaller amount. !s the price of a stock goes through its daily ups

and downs* the price of an associated option undergoes related fluctuations.

eature of the options,

".The option is exercisable by the owner 0 buyer only.#.The owner has limited liability.

6.Option owners has no voting right.

8.Options have high degree Of risk to the option writer.

$.These are popular they allow the profit from favourable movement in exchange rate.

F.lexibility in investors needs.

>.Go certificate issued by the company

Call optionsCall options

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Ca op o spThe call option that gives the right to b%y in its contract gives the partic%lars

o the ollowing:1)The name o the company whose shares are to be p%rchased)

2)The n%mber o the shares to be p%rchased)

/)The p%rchase price or the e+ercise price or the stri!e price o the shares to be bo%ght)0)The e+piration date)

*+ample:

5et us ! who owns "'' shares of Reliance 7ndustries* which on "' Bec* #'"# sold for Rs ""= -er share. He

could give 1or sell3 to & the right to buy that "'' shares at any time during the next # months at a price of Rs

"#$ per share. The price Rs"#$ is called the exercise price.. Gow the seller of the option* ! is the option

seller or write. or providing the option* ! will charge premium from &. 5et us assume the premium of Rs 6.7n this condition & has to pay Rs. "''I6/ 6'' as premium to ! to make him sign the contract. :hen the

exercise price is less than the current market price of the underlying stock the option is in the money. or

example the price of the reliance share after # months is Rs"6' it is said to be in the money. &ut if the price

falls to the Rs "#' the option is said to be out of the money. The advantage is that & has to pay only Rs. 6''

and get more profit if the price rise beyond Rs. "#$.

'ut options'ut options

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ppThe p%t option gives the right to sell an asset or sec%rity to someone else) It

is not an obligation b%t an option in its contract gives the partic%lars o the

ollowing:1)The name o the company whose shares are to be sold)

2)The n%mber o the shares to be sold)

/)The p%rchase price or the e+ercise price or the stri!e price o the shares to be sold)

0)The e+piration date)

*+ample:

5et us assume that ! thinks that Reliance industries stock price can decline from its current level of Rs ""=

per share during the next two months. He could buy a put option to sell the "'' shares at Rs "#$ which is

the striking price. ! being the buyer of the option to sell the shares* has to pay premium in order to get thewriter & to sign the contract and to assume risk.

5et us take the premium as Rs $ per share. Gow ! has to pay Rs "''I$/$'' to &. 7f the price falls to Rs ""$*

! stands gain because he can sell it at Rs "#$ i.e. "''I"#$/"#$''. The gain is Rs. "#$''?""$'' 1-resent

value3? $'' premium. !t the same time if the price has increased to Rs "6' per share* ! will not exercise the

option and his loss is only Rs. $''.

8 ti 7 i i = d l8 ti 7 i i = d l

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8"tion 7ricin( =odel8"tion 7ricin( =odel The ;lack2Scholes model for calculatin( the "remium of an o"tion !asintroduced in G' in a "a"er entitled, The 7ricin( of 8"tions and-or"orate Liabilities "ublished in the Journal o Political Econo! . Theformula, develo"ed by three economists Fischer ;lack, =yron Scholes andRobert =erton is "erha"s the !orldKs most !ell2kno!n o"tions "ricin(model. ;lack "assed a!ay t!o years before Scholes and =erton !erea!arded the GG >obel 7ri$e in Economics for their !ork in ndin( a ne!method to determine the value of derivatives #the >obel 7ri$e is not (iven

"osthumously1 ho!ever, the >obel committee ackno!led(ed ;lackKs role inthe ;lack2Scholes model%.

The ;lack2Scholes model is used to calculate the theoretical "rice ofEuro"ean "ut and call o"tions, i(norin( any dividends "aid durin( theo"tionKs lifetime. Nhile the ori(inal ;lack2Scholes model did not take into

consideration the e9ects of dividends "aid durin( the life of the o"tion, themodel can be ada"ted to account for dividends by determinin( the e42dividend date value of the underlyin( stock..

8 ti 7 i i = d l8 ti 7 i i = d l

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8"tion 7ricin( =odel8"tion 7ricin( =odel The model makes certain assum"tions, includin(:

The o"tions are Euro"ean and can only be e4ercised at e4"iration

>o dividends are "aid out durin( the life of the o"tion

EJcient markets #i.e., market movements cannot be "redicted%

>o commissions

The risk2free rate and volatility of the underlyin( are kno!n and constant

Follo!s a lo(normal distribution1 that is, returns on the underlyin( are normallydistributed.

The formula, sho!n in Fi(ure in ne4t slide, takes the follo!in( variables into consideration:

-urrent underlyin( "rice

8"tions strike "rice

Time until e4"iration, e4"ressed as a "ercent of a year 0m"lied volatility

Risk2free interest rates

8 ti 7 i i = d l8 ti 7 i i = d l

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8"tion 7ricin( =odel8"tion 7ricin( =odel

dvanta(es anddvanta(es and

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dvanta(es anddvanta(es and

disadvanta(es of ;lackdisadvanta(es of ;lack

2scholes =odel2scholes =odeldvanta(es: The main advanta(e of the black scholesmodel is s"eed2 it let you to calculate a verylar(e number of o"tion in a very short time.

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;inomial =odel for o"tion;inomial =odel for o"tion

7ricin(7ricin( The -o42Rubenstein #or -o42Ross2Rubenstein% binomial o"tion "ricin( model

is a variation of the ori(inal ;lack2Scholes o"tion "ricin( model. 0t !as rst"ro"osed in GG by nancial economistsen(ineers [ohn -arrin(ton -o4,Ste"hen Ross and =ark Ed!ard Rubenstein. The model is "o"ular because itconsiders the underlyin( instrument over a "eriod of time, instead of @ust atone "oint in time.

This model takes into account e4"ected chan(es in various "arameters overan o"tionKs life, thereby "roducin( a more accurate estimate of o"tion "ricesthan created by models that consider only one "oint in time. ;ecause ofthis, the -o42Ross2Rubenstein model is es"ecially useful for analy$in(merican style o"tions, !hich can be e4ercised at any time u" to e4"iration#Euro"ean style o"tions can only be e4ercised u"on e4"iration%.

The -o42Ross2Rubenstein model uses a risk2neutral valuation method. 0tsunderlyin( "rinci"al "ur"orts that !hen determinin( o"tion "rices, it can beassumed that the !orld is risk neutral and that all individuals #and investors%are indi9erent to risk. 0n a risk neutral environment, e4"ected returns areequal to the risk2free rate of interest.

;inomial =odel;inomial =odel

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;inomial =odel;inomial =odel The -o42Ross2Rubenstein model makes certain assum"tions, includin(:

>o "ossibility of arbitra(e1 a "erfectly eJcient market

t each time node, the underlyin( "rice can only take an u" or a do!n move andnever both simultaneously

The -o42Ross2Rubenstein model em"loys and iterative structure that allo!s for thes"ecication of nodes #"oints in time% bet!een the current date and the o"tionKse4"iration date. The model is able to "rovide a mathematical valuation of the o"tionat each s"ecied time, thereby creatin( a binomial tree 2 a (ra"hicalre"resentation of "ossible values at di9erent nodes.

The -o42Ross2Rubenstein model is a t!o2state #or t!o2ste"% model in that it assumesthe underlyin( "rice can only either increase #u"% or decrease #do!n% !ith time untile4"iration. Daluation be(ins at each of the nal nodes #at e4"iration% and iterationsare "erformed back!ards throu(h the binomial tree u" to the rst node #date ofvaluation%. 0n very basic terms, the model involves three ste"s:

The creation of the binomial "rice tree

8"tion value calculated at each nal node

8"tion value calculated at each "recedin( node

Nhile the math behind the -o42Ross2Rubenstein model is considered lesscom"licated than the ;lack2Scholes model #but still outside the sco"e of thistutorial%, traders can a(ain make use of online calculators and tradin( "latform2based analysis tools to determine o"tion "ricin( values.

;inomial =odel =ethod;inomial =odel =ethod

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FuturesFutures

http://en.wikipedia.org/wiki/File:Arbre_Binomial_Options_Reelles.png

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FuturesFutures

0n nance, a futures contract #more colloquially, futures% is a

standardi$ed contract bet!een t!o "arties to buy or sell a s"eciedasset of standardi$ed quantity and quality for a "rice a(reed u"ontoday #the utures "rice or strike "rice% !ith delivery and "aymentoccurrin( at a s"ecied future date, the deliver! date. The contractsare ne(otiated at a futures e4chan(e, !hich acts as an intermediarybet!een the t!o "arties. The "arty a(reein( to buy the underlyin(

asset in the future, the buyer of the contract, is said to be lon(,and the "arty a(reein( to sell the asset in the future, the seller ofthe contract, is said to be short. The terminolo(y re5ects thee4"ectations of the "arties\the buyer ho"es or e4"ects that theasset "rice is (oin( to increase, !hile the seller ho"es or e4"ectsthat it !ill decrease in near future.

0n many cases, the underlyin( asset to a futures contract may not betraditional commodities at all that is, for nancial futures theunderlyin( item can be any nancial instrument #also includin(currency, bonds, and stocks%1 they can be also based on intan(ibleassets or referenced items, such as stock inde4es and interest rates.

FeaturesFeatures

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FeaturesFeaturesAnlike an o"tion both "arties of a futures contract must fulll the contract on the

delivery date. The seller delivers the underlyin( asset to the buyer, or, if it is a cash2settled futures contract, then cash is transferred from the futures trader !hosustained a loss to the one !ho made a "rot. To e4it the commitment "rior to thesettlement date, the holder of a futures "osition can close out its contractobli(ations by takin( the o""osite "osition on another futures contract on the sameasset and settlement date. The di9erence in futures "rices is then a "rot or loss.

Marking to market-Nhile the futures contract s"ecies a trade takin( "lace in the future, the "ur"ose of

the futures e4chan(e institution is to act as intermediary and minimi$e the risk ofdefault by either "arty. Thus the e4chan(e requires both "arties to "ut u" an initialamount of cash, the mar(in. dditionally, since the futures "rice !ill (enerallychan(e daily, the di9erence in the "rior a(reed2u"on "rice and the daily futures"rice is settled daily also #variation mar(in%. The e4chan(e !ill dra! money out ofone "artyKs mar(in account and "ut it into the otherKs so that each "arty has the

a""ro"riate daily loss or "rot. 0f the mar(in account (oes belo! a certain value,then a mar(in call is made and the account o!ner must re"lenish the mar(inaccount. This "rocess is kno!n as ar#ing to ar#et . Thus on the delivery date, theamount e4chan(ed is not the s"ecied "rice on the contract but the s"ot value #i.e.the ori(inal value a(reed u"on, since any (ain or loss has already been "reviouslysettled by markin( to market%.

Features FeatureFeatures Feature

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Features FeatureFeatures Feature$utures contracts ensure their liquidity by bein( hi(hly standardi$ed, usually

by s"ecifyin(: The underl!ing asset or instrument. This could be anythin( from a barrel of

crude oil to a short term interest rate.

The ty"e of settlement, either cash settlement or "hysical settlement.

The aount and units of the underlyin( asset "er contract. This can be thenotional amount of bonds, a 4ed number of barrels of oil, units of forei(n

currency, the notional amount of the de"osit over !hich the short terminterest rate is traded, etc.

The currency in !hich the futures contract is quoted.

The grade of the deliverable. 0n the case of bonds, this s"ecies !hichbonds can be delivered. 0n the case of "hysical commodities, this s"eciesnot only the quality of the underlyin( (oods but also the manner and

location of delivery. The delivery month.

The last tradin( date.

8ther details such as the commodity tick, the minimum "ermissible "rice5uctuation.

$utures vs 9ptions$utures vs 9ptions

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$utures vs 9ptions$utures vs 9ptions

6asis $utures 9ptions

9bligation

;oth the "arties areobli(ed to "erformthe contract.

;oth the "arties arenot obli(ed to"erform.

'remium >o "remium is "aid The buyer "aid

"remium to the seller.

"isk The holder of thecontract is e4"osedto the entires"ectrum of the risk.

The buyer6s loss isrestricted to theo"tion "remium.

A3ercisedate.

The "arties of thecontract must"erform at thesettlement date.

The buyer cane4ercise o"tion anytime "rior to thee4"iary date.

$or%ard contract$or%ard contract

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$or%ard contract$or%ard contract0n nance, a for%ard contract or sim"ly a for%ard is a non2

standardi$ed contract bet!een t!o "arties to buy or to sell an

asset at a s"ecied future time at a "rice a(reed u"on today. This isin contrast to a s"ot contract, !hich is an a(reement to buy or sellan asset today.

Nith a for!ard contract the transfer of the o!nershi" takes "lace onthe s"ot, but the delivery of the commodity takes "lace does notoccur until some future date.

Therefore in for!ard contract the "arties a(rees to do trade at somefuture date, at a stated "rice and quantity. >o money chan(es

hands at the time deal is si(ned.

For e4am"le, a !heat farmer may !ish to contract to sell theirharvest at a future date to eliminate the risk of a chan(e in "rice by

that date. Such transaction !ould take "lace throu(h a for!ardmarket.

These are not traded on an stock e4chan(e , they are buy and soldover the counter. These quantities of the underlyin( asset and

terms of the contracts are fully ne(otiable. The secondary marketdoes not e4ist for the for!ard contract and faces the "roblem of

liquidity and ne(otiability.

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and Futuresand Futures;asis For!ard -ontract Futures -ontract

o (uarantee of settlement until the date ofmaturity only the for!ard "rice, based onthe s"ot "rice of the underlyin( asset is "aid

;oth "arties must de"osit an initial (uarantee

#mar(in%. The value of the o"eration is markedto market rates !ith daily settlement of "rotsand losses.

-ontract=aturity:

For!ard contracts (enerally mature bydeliverin( the commodity.

Future contracts may not necessarily mature bydelivery of commodity.

E4"irydate:

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