Tag: University of Mumbai BMS Notes

An oscillator is a technical analysis indicator that varies over time within a band (above and below a center line, or between set levels). Oscillators are used to discover short-term overbought or oversold conditions.

Oscillators are indicators that are used when viewing charts that are ranging (non-trending) to determine overbought or oversold conditions. Moving averages (MA) and trends are extremely important when studying the direction of a stock. A technician will use oscillators when the charts are not showing a definite trend in either direction. Oscillators are most beneficial when a company’s stock is either in a horizontal or sideways trading pattern or has not been able to establish a definite trend in a choppy market.

When the stock is in either an overbought or oversold situation, the true value of the oscillator is exposed. For example, a chartist can use oscillators to see when the stock is running out of steam on the upside the point at which the stock moves into an overbought situation. This simply means that the buying volume has been diminishing for a number of trading days, which means traders will then start to sell their shares. Conversely, when a stock has been sold by a greater number of investors for a consistent period of time, the stock will enter an oversold situation.

Oscillators are another group of tools used to identify overbought or oversold market conditions. They are also based on prices but are scaled in such a way that they “oscillate” around a certain value or between high and low values. For oscillators extreme high values indicate overbought markets while extreme low values indicate oversold markets.

Oscillators are perhaps most useful in identifying convergence and divergence. Convergence happens when the oscillator confirms the same pattern as the price movement. Divergence occurs when the oscillator contradicts the price pattern.

For the exam you need to know four different types of oscillators:

• Rate of Change (ROC) Oscillator
• Relative Strength Index (RSI)
• Moving Average Convergence/Divergence (MACD)
• Stochastic Oscillator

Rate of Change (ROC) Oscillator

ROC shows the percentage difference between the current price and the price n periods ago. In other words it measures the percentage change in price over a given period. The higher the percentage change in price the higher the ROC. Note the ROC oscillates around zero. When the price goes up, ROC goes down and vice versa.  Traders will often buy if the oscillator goes from negative to positive in an uptrend, or sell when it goes from positive to negative in a downtrend. If it crosses zero in the opposite direction of the trend it is usually ignored.

Relative Strength Index (RSI)

RSI measures the relative strength of a security against itself.  It is scaled to oscillate between 0 and 100 with high values (> 70) showing an overbought market and low values (< 30) showing an oversold market.

• RSI > 70, Sell Signal
• RSI < 30, Buy Signal

Moving Average Convergence/Divergence (MACD)

MACD (pronounced Mac-Dee) is an exponential moving average that shows the difference between short and long term moving averages. The MACD signal line itself then oscillates around zero (but is not bounded).

MACD can signal convergence or divergence as well as overbought and oversold conditions. Points where the MACD line crosses the ‘signal’ line can be used as trading signals. As you might have guessed, the shorter-term average crossing above the longer term line shows upside momentum increasing and is thus a bullish signal.

Stochastic Oscillators

The stochastic oscillator measures the relationship between the closing, high, and low prices and is also used to identify overbought and oversold markets. It is usually calculated using a 14 day period and always ranges between 0-100%.  In an uptrend the closing price tends to be near the high price of the period and a downtrend is marked by the low and closing prices being close together. Generally a buy signal occurs if the oscillator crosses above the 20% level and a sell signal is triggered if it crosses below the 80% level.

Sentiment Indicators (Non-Price Signals)

Sentiment indicators can include polls/surveys of market participants or, more commonly, calculated statistical indices. We’ll rip through the ones in the curriculum, again much of this is in the weeds and unlikely to show up with any significance on the exam.

Put/Call Ratio:

This is a contrarian indicator. The higher (lower) the ratio the more bearish (bullish) the signal. However if the ratio is skewed to one extreme or the other things are different. For example an extremely high ratio demonstrates excessively negative sentiment and the price is likely to rise.

Volatility Index (VIX): Calculated by the Chicago Board Options Exchange, the VIX measures options volatility. A high or rising VIX is a bearish sign, however, market participants use the VIX as a contrarian schedule.

Margin Debt – Increases in margin debt outstanding indicate increasing bullishness amongst investors.

Short interest ratio: Short interest is the number of shares investors have borrowed and sold short. The short interest ratio is that number divided by the average trading volume. A high short interest ratio indicates traders expect prices to decline, however, it also means at some point there will be greater buying demand as the traders have to cover their shorts (if this happens in the short term it can result in a short squeeze)

Flow of Funds Indicators: Indicate the relative supply and demand in the market. One particularly useful ratio is the arms index or short-term trading index.

The TRIN measures funds flowing into advancing and decreasing stocks. A ratio close to one suggests an even distribution, a ratio greater than one means more money is flowing into declining stocks. Spikes upwards have historically corresponded to large daily losses.

Other flow of funds indicators include the aforementioned margin debt, the mutual fund cash position (ratio of cash to total assets). Traders use this as a contrarian indicator. When cash balances increase there is future buying demand and traders expect the markets to rise.

New Equity Issuances: IPOs etc. A lagging indicator thought to coincide with market peaks since an IPO becomes more attractive to the business owners as prices rise.

Asset allocation refers to an investment strategy in which individuals divide their investment portfolios between different diverse asset classes to minimize investment risks. The asset classes fall into three broad categories: equities, fixed-income, and cash and equivalents. Anything outside these three categories (e.g., real estate, commodities, and art) is often referred to as alternative assets.

Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor’s risk tolerance, goals and investment time frame. The focus is on the characteristics of the overall portfolio. Such a strategy contrasts with an approach that focuses on individual assets.

Factors Affecting Asset Allocation Decision

An investors’ portfolio distribution is influenced by factors such as personal goals, level of risk tolerance, and investment horizon.

1. Goals factors

Goals factors are individual aspirations to achieve a given level of return or saving for a particular reason or desire. Therefore, different goals affect how a person invests and risks.

2. Risk tolerance

Risk tolerance refers to how much an individual is willing and able to lose a given amount of their original investment in anticipation of getting a higher return in the future. For example, risk-averse investors withhold their portfolio in favor of more secure assets. On the contrary, more aggressive investors risk most of their investments in anticipation of higher returns. Learn more about risk and return.

3. Time horizon

The time horizon factor depends on the duration an investor is going to invest. Most of the time, it depends on the goal of the investment. Similarly, different time horizons entail different risk tolerance. For example, a long-time investment strategy may prompt an investor to invest in a more volatile or higher risk portfolio since the dynamics of the economy are uncertain and may change in favor of the investor. However, investors with short-term goals may not invest in riskier portfolios.

Allocation strategy

There are several types of asset allocation strategies based on investment goals, risk tolerance, time frames and diversification. The most common forms of asset allocation are: strategic, dynamic, tactical, and core-satellite.

Strategic asset allocation

The primary goal of strategic asset allocation is to create an asset mix that seeks to provide the optimal balance between expected risk and return for a long-term investment horizon. Generally speaking, strategic asset allocation strategies are agnostic to economic environments, i.e., they do not change their allocation postures relative to changing market or economic conditions.

Dynamic asset allocation

Dynamic asset allocation is similar to strategic asset allocation in that portfolios are built by allocating to an asset mix that seeks to provide the optimal balance between expected risk and return for a long-term investment horizon. Like strategic allocation strategies, dynamic strategies largely retain exposure to their original asset classes; however, unlike strategic strategies, dynamic asset allocation portfolios will adjust their postures over time relative to changes in the economic environment.

Tactical asset allocation

Tactical asset allocation is a strategy in which an investor takes a more active approach that tries to position a portfolio into those assets, sectors, or individual stocks that show the most potential for perceived gains. While an original asset mix is formulated much like strategic and dynamic portfolio, tactical strategies are often traded more actively and are free to move entirely in and out of their core asset classes.

Core-satellite asset allocation

Core-satellite allocation strategies generally contain a ‘core’ strategic element making up the most significant portion of the portfolio, while applying a dynamic or tactical ‘satellite’ strategy that makes up a smaller part of the portfolio. In this way, core-satellite allocation strategies are a hybrid of the strategic and dynamic/tactical allocation strategies mentioned above.

Problems with asset allocation

There are various reasons why asset allocation fails to work.

• Investor behavior is inherently biased. Even though investor chooses an asset allocation, implementation is a challenge.
• Investors agree to asset allocation, but after some good returns, they decide that they really wanted more risk.
• Investors agree to asset allocation, but after some bad returns, they decide that they really wanted less risk.
• Investors’ risk tolerance is not knowable ahead of time.
• Security selection within asset classes will not necessarily produce a risk profile equal to the asset class.
• The long-run behavior of asset classes does not guarantee their shorter-term behavior.

A strategy used by investors to manage risk. By spreading your money across different assets and sectors, the thinking is that if one area experiences turbulence, the others should balance it out. It’s the opposite of placing all your eggs in one basket.

The term often crops up during periods of economic turbulence, when there’s a lot of uncertainty in financial markets. Rather than leaving themselves exposed to stock market swings, investors might look to spread their money across other assets like bonds and commodities too.

All investments carry some degree of risk and, as a result, you can’t avoid it completely. But the good news is that risk diversification can at least help you to avoid over-exposing yourself to one particular area.

Diversifying your investments doesn’t simply mean spreading your money across different assets. Instead, you can also spread it between companies of varying sizes, different sectors, and a range of geographic regions.

Risk diversification can also be important in the business world. For example, rather than specialising in a single area, a company may choose to expand into new products and sectors.

Diversification is the art of entering product markets different from those in which the firm is currently engaged in. It is helpful to divide diversification into ‘related’ diversification and ‘unrelated’ diversification.

Diversification is venerable rule of investment which suggests “Don’t put all your eggs in one basket”, spreading risk across a number of securities.

Diversification may take the form of unit, industry, maturity, geography, type of security and management. Through diversification of investments, an investor can reduce investment risks.

Investment of funds, say, Rs. 1 lakh evenly among as many as 20 different securities is more diversified than if the same amount is deployed evenly across 7 securities. This sort of security diversification is naive in the sense that it does not factor in the covariance between security returns.

The portfolio comprising 20 securities could represent stocks of one industry only and have returns which are positively correlated and high portfolio returns variability. On the other hand, the 7-stock portfolio might represent a number of different industries where returns might show low correlation and, hence, low portfolio returns variability.

Meaningful diversification is one which involves holding of stocks of more than one industry so that risks of losses occurring in one industry are counterbalanced by gains from the other industry. Investing in global financial markets can achieve greater diversification than investing in securities from a single country. This is for the fact that the economic cycles of different countries hardly synchronize and as such a weak economy in one country may be offset by a strong economy in another.

Fig. 5.2 portrays meaningful diversification. It may be noted from the figure that the returns overtime for Security X are cyclical in that they move in tandem with the economic fluctuations. In case of Security Y returns are moderately counter cyclical. Thus, the returns for these two securities are negatively correlated.

If equal amounts are invested in both securities, the dispersion of returns, up, on the portfolio of investments will be less because some of each individual security’s variability is offsetting. Thus, the gains of diversification of investment portfolio, in the form of risk minimization, can be derived if the securities are not perfectly and positively correlated.

A related diversification is one in which the two involved businesses have meaningful commonalties, which provide the potential to generate economies of scale or synergies based upon the exchange of skills or resources. In a related diversification the resulting combined business should be able to achieve improved ROI because of increased revenues, decreased costs, or reduced investment, which are attributable to the commonalties.

An important issue in any diversification decision is whether, in fact, there is a real and meaningful area of commonality that will benefit the ultimate ROI. If such a meaningful commonality is lacking, the diversification may still be justifiable, but the rationale will need to be different.

Related diversification

1. Exchanging skill and resources

Related diversification provides the potential to attain synergies by the exchanged or sharing of skills or resources. One business unit must have skills or resources that are ‘exportable’ to another company or business unit. Thus, a first condition for successful related diversification is to identify skills or resources that are exportable or that are needed and can be ‘imported!

The second condition is to find a partner or business unit that can either provide or use them. The third is to ascertain whether the organizational integration needed to accomplish the exchange is feasible. Skills or resources that can be usefully imported or exported can take a variety of forms.

2. Brand name

One commonly found resource that is exportable is a strong established brand name like Coca-Cola, Microsoft, Pepsi, Puma, BMW, or Nivea.

3. Marketing skills

Usually a firm will either possess or lack a strong skill in marketing for a particular market. Thus, a frequent motive to diversify is to export or import a marketing talent. The typical case in this regard is the introduction of Microsoft products into the People’s Republic of China (PRC). PRC was moving from the socialistic pattern of society to market economy.

During the 1990s, urbanization started increasing and a shift was seen from agriculture to the service sector. Agriculture, science and technology, industry and defence were targeted for modernization. Richard Fade, vice-president in charge of Microsoft’s Far-east operations, pondered Microsoft’s planned introduction of products into China.

In the Chinese computer hardware industry of 36 domestic vendors accounted for 82 per cent of the units of domestically manufactured PCs. In the software industry, State Owned Enterprises (SOEs) dominated the market. Since, the SOEs were answerable to the government, all their revenues accrued directly to national government.

The following are the key tasks that need to be done while localizing:

(i) The local character sets need to be supported.

(ii) The interface needs to be translated in a form that is familiar to the local user.

(iii) All documents should be in local language.

(iv) Configure the software so that it can support locally available software and hardware.

(v) Provide local customer service.

Microsoft in 1984 signed its first OEM agreement in Taiwan, home of over 3,000 PC systems and component manufacturers, before opening an office in 1989. Five years later Microsoft opened an office in China. It was estimated that 95 per cent of PCs had the English version of Microsoft DOS installed together with one of the many Chinese shells.

Microsoft had worked with SV earlier on a smaller project and so it agreed to work with them on P-DOS project. Based on their earlier experience, it was understood that it was very difficult to parcel out a particular major software localization task to one SV and hence opted for a ‘consortia’ of SVs and set UP a product development centre. This eventually paid the company a ‘prize reward’ by limiting other competitors in the market.

4. Service

A small company can often create or enter a market area and do well with an innovative product. As the market matures, however, the necessity for a strong service organization becomes important. The smaller firm might then consider joining forces with a larger firm which has a service organization that can be adapted to the involved product. Typical example is the Bluetooth technology of Blackberry.

5. R&D and product development

A firm may be highly skilled at R&D and new product development, but it may lack skills in either marketing or production. Godrej is marketing the mosquito repellent Good knight and mango juice Jumpin, which are typical products of small entrepreneurs. Sun silk shampoo of HUL is manufactured in SSI units of Pondicherry.

6. Exploiting excess capacity

One type of resources that is often easily exchanged is excess capacity. Bottling plants of SDC (Soft Drink Concentrates) are now widely engaged in bottling fresh juices of orange, apple, mango, pineapple, grapes, tender coconut and lemon juice for MNCs Pepsi and Coke in India.

7. Achieving economies of scale

Related diversification can sometimes provide economies of scale. Two smaller consumer product firms, for example, may not be able to afford an effective sales force, new product development or testing programme, or warehousing and logistics systems. However, the two firms together may be able to operate at an efficient level. Similarly, two firms when combined may be able to justify an expensive piece of automated production equipment.

8. Risks of related diversification

Even related diversification can be risky. There are three major problems. First, relatedness and potential synergy simply don’t exist. Strategists delude themselves that there is a synergistic justification not on the basis of judgement supported by a thorough external and self-analysis, but by manipulating semantics.

Second, potential synergy may exist but is never realized because of implementation problems. This happens when the diversification move involves integrating two organizations that have fundamental differences and/or because one of the two organizations lacks the ability or motivation to undertake necessary programmes to make the diversification work.

Third, possible violations of antitrust laws in the west and MRTP (Monopolies and Restrictive Trade Practice) law in India create an additional risk when an acquisition or merger is involved. Ironically, as the degree of relatedness and the synergy potential increase so does the possibility of an antitrust or MRTP problem. Jet Airways and Sahara deal is a typical example.

Jet Airways has extended its service to the mass market under Jet Lite. Similarly, Kingfisher acquired Air Deccan and symbolically kept the Kingfisher logo in the wings and POS outlets in the country, which includes all post offices and petrol pumps.

Unrelated Diversification

Unrelated diversification lacks commonality in markets, distribution channels, production technology, and R&D thrust to provide the opportunity for synergy through the exchange or sharing of assets or skills. Reliance entered into retailing by allocating Rs25, 000 crore in a phased manner is a typical example.

1. Manage and allocate cash flow

Unrelated diversification can balance the cash flows of SBU entities. A firm, which has many SBUs that merit investment might buy or merge with a cash cow to provide a source of cash. The acquisition of the cash cow may reduce the need to raise debt or equity over time, although if the cash cow is acquired, resources will need to be expected.

Typical example is Kingfisher Airlines, where the chairman and CEO Vijay Mallya himself routed the surplus cash from this liquor business to give the ‘Fly the good times’ experience to Indian aviation. So there’s KF Fun TV with seven channels (lifestyle, entertainment, sports, English premium, toon (cartoon), flight guide and view from the top channels, and KF Radio with 10 channels chartbusters and hindi pop, hindi retro (the golden oldies), Hindi Easy Listening, ghazals, english pop, english retro (an earful of vintage), Easy Listening (Honey trenched notes that remind the listener that world is still a wonderful place), Club (dance floor) Jazz and Blues and Lounge (lie back in the lap of lounge with the soothing notes of lounge music) supported with state of the art aircraft and technology for in-flight, catering. The reservation system is a remarkable attempt to reposition the image of the Indian industry.

2. Entering business areas with high ROI prospects

A basic diversification motivation is to improve ROI by moving into business areas with high ROI prospects. One approach is to enter high growth business areas. According to life style consumption study by Edelweiss Securities, organized retail trade in India is now finding its feet. Its share in the total retail pie is set to increase from the current 2 per cent to about 10 per cent by 2010. This will translate into approximately Rs1, 400 billion of retail trade by 2010 (Figure 8.19).

The study further says retail space is expected to increase from 10 million sq. ft. in 2002 to 80 million sq. ft. in 2010. Retail space development in leading centres will provide high impetus to retail growth as about 38 per cent of India’s high income households live in the top five cities (Mumbai, Delhi, Kolkata, Chennai and Bangalore), and an additional 28 per cent stay in mid-sized cities.

Significant growth in organized retailing during the next three years is expected in the metros and mini-metros through better performance of the existing stores, as well as opening of new stores. From 25 operational malls in 2003, the country is expecting over 600 malls by 2010. Accordingly Videocon Industries spotted organized retailing as the bright spot for future investments to the tune of Rs25, 000 crore by 2010.

3. Obtaining a ‘bargain’ price for a business

Another way to improve the ROI is to acquire a business at a ‘bargain’ price so the involved investment is low and the associated ROI is therefore high.

4. The potential to restructure a firm

Allen, Oliver, and Schwallie, three Booz Allen acquisition specialists have suggested another possibility: that an acquisition can provide the basis for a restructuring of the acquired firm, the acquiring firm, or both.

5. Reducing risk

The reduction of risk can be another motivation for unrelated diversification. The heavy reliance upon a single product line can stimulate a diversification move. Reducing risk can also lead to entering into businesses that will counter or reduce the cyclical nature of the existing earnings.

6. Risks of unrelated diversification

The very concept of an unrelated business, where by definition there is no possibility to improve that business through synergy, suggests risk and difficulty. Many knowledgeable people have made blanket statements warning against unrelated diversification. Peter Drucker claims that all successful diversification requires a common core or unity represented by common markets, technology, or production processes. He states that without such a unity, diversification can never work; financial ties alone are insufficient.

The beta (β) of an investment security (i.e. a stock) is a measurement of its volatility of returns relative to the entire market. It is used as a measure of risk and is an integral part of the Capital Asset Pricing Model (CAPM). A company with a higher beta has greater risk and also greater expected returns.

The beta coefficient can be interpreted as follows:

• β =1 exactly as volatile as the market
• β >1 more volatile than the market
• β <1>0 less volatile than the market
• β =0 uncorrelated to the market
• β <0 negatively correlated to the market

Examples of beta

High β: A company with a β that’s greater than 1 is more volatile than the market. For example, a high-risk technology company with a β of 1.75 would have returned 175% of what the market return in a given period (typically measured weekly).

Low β: A company with a β that’s lower than 1 is less volatile than the whole market. As an example, consider an electric utility company with a β of 0.45, which would have returned only 45% of what the market returned in a given period.

Negative β: A company with a negative β is negatively correlated to the returns of the market. For an example, a gold company with a β of -0.2, which would have returned -2% when the market was up 10%.

Equity Beta and Asset Beta

Levered beta, also known as equity beta or stock beta, is the volatility of returns for a stock taking into account the impact of the company’s leverage from its capital structure. It compares the volatility (risk) of a levered company to the risk of the market.

Levered beta includes both business risk and the risk that comes from taking on debt. It is also commonly referred to as “equity beta” because it is the volatility of an equity based on its capital structure.

Asset beta, or unlevered beta, on the other hand, only shows the risk of an unlevered company relative to the market. It includes business risk but does not include leverage risk.

Project Beta

For simplicity throughout previous chapters we have used a general beta factor (b) applicable to the overall systemic risk of portfolios, securities and projects. But now our analysis is becoming more focused, precise notation and definitions are necessary to discriminate between systemic business and financial risk. Table 7.1 summarizes the beta measures that we shall be using for future reference and also highlights a number of problems.

b = total systematic risk, which relates portfolio, security and project risk to market risk.

b = the business risk of a specific project (project risk) for investment appraisal.

bf = the published equity beta for a company that incorporates business risk and systematic financial risk if the firm is geared.

bA = the overall business risk of a firm’s assets (projects). It also equals a company’s

deleveraged published beta (bf) which measures business risk free from financial risk.

bD = the beta value of debt (which obviously equals zero if it is risk-free).

bf„ and bfG are the respective equity betas for similar all-share and geared companies.

When an all-equity company is considering a new project with the same level of risk as its current portfolio of investments, total systematic risk equals business risk, such that:

When a company is funded by a combination of debt and equity, this series of equalities must be modified to incorporate a premium for systematic financial risk. As we shall discover, the equity beta (bE) will be a geared beta reflecting business risk plus financial risk, which measures shareholder exposure to debt in their firm’s capital structure. Thus, the equity beta of an all-share company is always lower than that for a geared firm with the same business risk.

Irrespective of a gearing problem, Table 7.1 reveals a further weakness of the CAPM. A company’s asset beta (bA) should produce a discount rate that is appropriate for evaluating projects with the same overall risk as the company itself. But what if a new project does not reflect the average risk of the company’s assets? Then the use of bA is no more likely to produce a correct investment decision than the use of a WACC calculation.

To illustrate the point, Figure 7.1 graphs the Security Market Line (SML) to show the required return on a project for different beta factors, with a company’s WACC. The use of the overall cost of capital to evaluate projects whose risk differs from the company’s average will be sub-optimal where the IRR of the project is in either of the two shaded sections. To calculate the correct CAPM discount rate using Equation (45), we must determine the project beta.

Figure 7.1: The SML, WACC and Project Betas

The company’s average beta, shown in the diagram, provides a measure of risk for the firm’s overall returns compared with that of the market. However, management’s investment decision is whether or not to invest in a project. So, like the WACC, if the project involves diversification away from the firm’s core activities, we must use a beta coefficient appropriate to that class of investment. The situation is similar to a stock market investor considering whether to purchase the shares of the company. The individual would need to evaluate the share’s return by using the market beta in the CAPM.

Even if diversification is not contemplated, the project’s beta factor may not conform to the average for the firm’s assets. For example, the investment proposal may exhibit high operational gearing (the proportion of fixed to variable costs) in which case the project’s beta will exceed the average for existing operations.

A serious conflict (the agency problem) can also arise for those companies producing few products, or worse still a single product, particularly if management approach their capital budgeting decisions based on self-interest and short-termism, rather than shareholder preferences. Shareholders with well-diversified corporate holdings who dominate such companies may prefer to see projects with high risk (high beta coefficients) to balance their own portfolios. Such a strategy may carry the very real threat of bankruptcy but in the event may have very little impact their overall returns. For corporate management, the firm’s employees and its suppliers, however, the policy may be economic suicide.

Fortunately, if a beta is required to validate the CAPM for project appraisal, help is at hand. Management can obtain factors for companies operating in similar areas to the proposed project by subscribing to the many commercial services that regularly publish beta coefficients for a large number of companies, world wide. Their listings also include stock exchange classifications for industry betas. These are calculated by taking the market average for quoted companies in the same industry. Research reveals that the measurement errors of individual betas cancel out when industry betas are used. Moreover, the larger the number of comparable beta constituents, the more reliable the industry factor.

So, if management wish to obtain an estimate for a project’s beta, it can identify the industry in which the project falls, and use that industry’s beta as the project’s beta. This approach is particularly suitable for highly diversified and divisionalised companies because their WACC or market beta would be of little relevance as a discount rate for its divisional operations.

As an alternative to stock market data, management can also estimate a project’s beta from first principles by calculating its F-value.

The F-value of a project is rather like a beta factor in that it measures the variability of a project’s performance, relative to the performance of an entity for which a beta value exists.

The entity could be the industry in which the project falls, the firm undertaking the project, or a division within the firm that is responsible for the project.

A project’s F-value is defined as follows:

As a result, we can obtain an estimate of a project’s beta through one of three routes:

Portfolio Beta

Calculating the volatility, or beta, of your stock portfolio is probably easier than you think. A beta of 1 means that a portfolio’s volatility matches up exactly with the markets. A higher beta indicates great volatility, and a lower beta indicates less volatility. To do it, you’ll need to know the percentage of your portfolio by individual stock and the beta for each of those stocks.

The first step is to multiply the percentage of your portfolio and the beta for each individual stock. Once that is done, simply add up the results and you’ll have your portfolio beta.

This method is a simple weighted average calculation. It’s an easy way to quickly assess your entire portfolio’s volatility. It only works though if the individual stock’s betas are calculated correctly and comparably. Using a six month time period to calculate one stocks beta and a six year period to calculate the other will give you a much different result than using the same time period across the board. Likewise, it’s wise to use the same index for each individual stock’s beta so that your portfolio beta will have consistency with that index as well. For most portfolios, the S&P 500 is a reasonable index to start with.

It’s not required to use the same time period and index for each stock, but it is important to understand how differences in each individual stock’s beta will impact the result for your entire portfolio.

An investment bank is a financial services company or corporate division that engages in advisory-based financial transactions on behalf of individuals, corporations, and governments. Traditionally associated with corporate finance, such a bank might assist in raising financial capital by underwriting or acting as the client’s agent in the issuance of securities. An investment bank may also assist companies involved in mergers and acquisitions (M&A) and provide ancillary services such as market making, trading of derivatives and equity securities, and FICC services (fixed income instruments, currencies, and commodities). Most investment banks maintain prime brokerage and asset management departments in conjunction with their investment research businesses. As an industry, it is broken up into the Bulge Bracket (upper tier), Middle Market (mid-level businesses), and boutique market (specialized businesses).

Investment banking is the division of a bank or financial institution that serves governments, corporations, and institutions by providing underwriting (capital raising) and mergers and acquisitions (M&A) advisory services. Investment banks act as intermediaries between investors (who have money to invest) and corporations (who require capital to grow and run their businesses).

All investment banking activity is classed as either “sell side” or “buy side”. The “sell side” involves trading securities for cash or for other securities (e.g. facilitating transactions, market-making), or the promotion of securities (e.g. underwriting, research, etc.). The “buy side” involves the provision of advice to institutions that buy investment services. Private equity funds, mutual funds, life insurance companies, unit trusts, and hedge funds are the most common types of buy-side entities.

Full-service banks offer the following services:

• Underwriting: Capital raising and underwriting groups work between investors and companies that want to raise money or go public via the IPO process. This function serves the primary market or “new capital”.
• Mergers & Acquisitions (M&A): Advisory roles for both buyers and sellers of businesses, managing the M&A process start to finish.
• Sales & Trading: Matching up buyers and sellers of securities in the secondary market. Sales and trading groups in investment banking act as agents for clients and also can trade the firm’s own capital.
• Equity Research: The equity research group research, or “coverage”, of securities helps investors make investment decisions and supports trading of stocks.
• Asset Management: Managing investments for a wide range of investors including institutions and individuals, across a wide range of investment styles.

Underwriting Services in Investment Banking

Underwriting is the process of raising capital through selling stocks or bonds to investors (e.g., an initial public offering IPO) on behalf of corporations or other entities. Businesses need money to operate and grow their businesses, and the bankers help them get that money by marketing the company to investors.

There are generally three types of underwriting:

• Firm Commitment: The underwriter agrees to buy the entire issue and assume full financial responsibility for any unsold shares.
• Best Efforts: Underwriter commits to selling as much of the issue as possible at the agreed-upon offering price but can return any unsold shares to the issuer without financial responsibility.
• All-or-None: If the entire issue cannot be sold at the offering price, the deal is called off and the issuing company receives nothing.

Role

Investment Banks serve as an intermediary between investors and corporations. It helps corporations by pricing securities resulting in maximization of revenue. Investment banks help their clients in meeting regulatory requirements while raising capital as well.

When companies issue IPO, an investment bank may buy all the shares from the company and will sell it in the market as a proxy company. It helps the company in contracting out the IPO to the investment bank itself. It provides advisory services in relation to underwriting services and mergers and acquisitions.

Objectives

In the past, the primary objective of investment banking was to bridge the gap between investors and corporations, individuals, government bodies who needed funds to grow and run their business. 

But nowadays, there is no defined limit on the activities that fall in the purview of investment banking. Apart from underwriting and merger & acquisition-related advisory services, investment banks also provide different kinds of ancillary services to their clients like equity trading, market-making, facilitation of transactions, derivative trading, assistance in the analysis of risk associating with managing big projects.

Functions of Investment Banking

• Acts as an intermediary between investors and the company.
• It helps companies in raising capital.
• Provide advisory services for underwriting and merger & acquisition.
• Provide ancillary services like equity, derivative trading, facilitating transactions, market-making, promotion of securities, etc.

Importance of Investment Banking

• In a growing economy where all the companies want to raise capital through stock and shares, Investment Bank with their expertise helps these companies by providing underwriting services, so that businesses can maximize their revenue while staying within the regulatory requirement.
• They provide other ancillary advisory services as well to their clients. Therefore, in a nutshell, these organizations play a pivot role by helping corporate, individuals, and government bodies.
• With their expertise, they help in the growth of the local, national, and the global economy as a whole.

Equity Mutual Funds can be categorized based on the market capitalization of the companies they invest in. They can be classified into three types, large-cap, mid-cap, and small-cap funds. In this article, we will look at understanding these funds and talk about the difference between small-cap, large cap and mid cap funds.

Market Capitalization, in simple words, is the market value of the company’s outstanding shares. It is not the share price but the value of the share.

Number of outstanding shares x share price

Based on the market cap, companies are classified as large-cap companies, mid-cap companies, and small-cap companies. In order to ensure that equity schemes follow uniform norms for defining large, mid, and small caps, the Securities and Exchanges Board of India (SEBI) has defined them as follows:

• Large-cap companies: 1st to 100th company in terms of market capitalization
• Mid-cap companies: 101st to 250th company in terms of market capitalization
• Small-cap companies: 251st company onwards in terms of market capitalization

It is important to note that since the share price keeps fluctuating, the market cap of a company keeps changing too. Also, when a company issues more shares to the public, it’s market capitalization increases. On the other hand, in the case of a buyback, the market cap dips. Having understood, market cap, let’s look at large, mid, and small-cap funds.

Large Cap funds are open-ended, equity funds which invest at least 80% of their total assets in large-cap stocks. Large-cap companies are trustworthy and strong companies with an excellent track record. They are known to have generated wealth for their investors.

Mid-cap funds are open-ended, equity funds which invest around 65% of their total assets in equity and equity-related instruments of mid-cap companies. These companies have been around for quite some time and have a good track record too. Some of these will soon transform into large-cap companies. This makes the mid-cap segment an interesting one for growth opportunities with controlled risks.

Small-cap funds are open-ended equity funds which invest a minimum of 65% of their total assets in small-cap stocks. These are the smaller companies or the new entrants in the market. These funds have a high potential for growth but also carry a high amount of risk. They are usually recommended for investors with higher risk tolerance.

Here are some key differences between large-cap, mid-cap, and small-cap funds.

The term investment refers to exchange of money wealth into some tangible wealth.  The money wealth here refers to the money (savings) which an investor has and the term tangible wealth refers to the assets the investor acquires by sacrificing the money wealth. By investing, an investor commits the present funds to one or more assets to be held for some time in expectation of some future return in terms of interest or capital gain. Investment can be defined as commitment of funds that is expected to generate additional money.

The term Investment Environment encompasses all types of investment opportunities and the market structure that facilities buying and selling these investments. Different types of securities, institutional set-up and the market intermediaries are the components of investment environment.

Market prices / rates are volatile and this is the chief risk faced in financial / real asset markets and this takes place in the investment environment.

The investment environment is the international economy and the domestic economy, developments in which have an effect on the values (prices) of the assets of the asset classes. It is well known that the prices of financial assets, particularly shares, can be extremely volatile, and this introduces the element of risk in financial markets. Investment risk is broadly defined as volatility in asset prices and it is measured in these terms.

Ultimately, gross domestic product (GDP) growth is the major driver of asset prices, and asset price changes (positive and negative) are often exacerbated by the irrational behavior of participants in the investment arena (known as the “herd instinct”). GDP is driven by gross domestic expenditure (GDE) and the trade account balance (TAB). GDE is driven by the consumption expenditure (C) and investment expenditure (I) of the private and government sectors, such that C + I = GDE. This is domestic demand. Foreign demand for local products is reflected in exports (X) while imports (M) reflect domestic demand for foreign goods. So, X – M = TAB = net foreign demand. The “big picture” (the entire economy) is complete:

C+I = GDE

GDE + TAB = GDP

Given asset price volatility, fund managers (or “investment houses”) and broker-dealers (who service the fund managers) employ the services of investment analysts and specialist economists to anticipate future asset price developments. The investment analysis process they undertake has four parts, as presented in Figure 8.

It is a well know fact that asset class allocation is the most critical decision made in asset management. It is responsible for a significant proportion of asset / portfolio performance (some analysts say up to 80%). Asset class allocation is critically based on macroeconomic (domestic and international) analysis. In this regard we conclude with a relevant view of an asset manager:

“All investment decisions, particularly those relating to asset allocation, implicitly or explicitly rest on some forward-looking macro-economic assumption. Any change to the macro-economic assumption will inevitably influence the intrinsic or fair value of that investment or asset class. For example, a decision to buy long-term government bonds is based on some assumption about future inflation; if the investor assumed low future inflation and the outcome is high inflation, the value of such an investment would turn out to be dramatically lower than anticipated.

Figure 8: investments analysis: four steps

“One pillar of our investment philosophy is the recognition that the economic future could easily turn out to be very different from the assumptions. Overconfidence in their ability to read the future is a classic mistake made by investors. We guard against this risk by incorporating more than one economic scenario into our investment strategy.

“We consider as wide a range of potential economic scenarios as possible. From these possibilities we typically choose two or three scenarios that we believe cover a significant range of potential outcomes. In this way we acknowledge and mitigate the risk attached to an uncertain, and often unpredictable, future.

“For each economic scenario we make assumptions about short and long-term interest rates, and about economic growth and inflation, both locally and internationally. Using these economic assumptions as our basic input, we estimate the intrinsic or fair value of each asset class that we explore.

“The scenarios have a strong international flavor. In a globalizing world, with integrated financial markets, we believe international influences will dominate over time. The scenarios are projected over rolling five-year periods, a time frame typically used by most successful long-term investors.

“We attach probabilities to each scenario. The use of probabilities skews the macro-economic input in the direction that we believe is the most likely outcome. This means that our investment strategy is based on a core macro-economic view, although the element of future surprise is minimized through the incorporation of various scenarios.

“Another pillar of our philosophy is diversification across a range of asset classes. Diversification also hedges our investment strategy against the potential for the future to surprise.”

The last mentioned, i.e. diversification, is one of the pillars of asset management; it is given some attention in a later following section.