Chapter 1 The Investment Environment
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Chapter 1(The Investment environment)
1. Investment: An investment is an asset or item acquired with the goal of generating income or
appreciation. Appreciation refers to an increase in the value of an asset over time. When an
individual purchases a good as an investment, the intent is not to consume the good but rather to
use it in the future to create wealth. An investment always concerns the outlay of some asset today
—time, money, or effort—in hopes of a greater payoff in the future than what was originally put
in.
2. Real Assets: Real assets are physical assets that have an intrinsic worth due to their substance
and properties. Real assets include precious metals, commodities, real estate, land, equipment, and
natural resources.
3. Fixed-Income (debt) Securities: A fixed-income security is an investment that provides a return
in the form of fixed periodic interest payments and the eventual return of principal at maturity.
Unlike variable-income securities, where payments change based on some underlying measure—
such as short-term interest rates—the payments of a fixed-income security are known in advance.
4. Equity: Equity, typically referred to as shareholders' equity (or owners’ equity' for privately held
companies), represents the amount of money that would be returned to a company’s shareholders
if all of the assets were liquidated and all of the company's debt was paid off.
In addition, shareholder equity can represent the book value of a company. Equity can sometimes be
offered as kind. It also represents the pro-rata ownership of a company's shares. Equity can be found on a
company's balance sheet and is one of the most common pieces of data employed by analysts to assess the
financial health of a company.
5. Derivative Securities: A derivative is a financial security with a value that is reliant upon or
derived from, an underlying asset or group of assets—a benchmark. The derivative itself is a
contract between two or more parties, and the derivative derives its price from fluctuations in the
underlying asset.
The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest
rates, and market indexes. These assets are commonly purchased through brokerages.
6. Agency Problem: The agency problem is a conflict of interest inherent in any relationship where
one party is expected to act in another's best interests. In corporate finance, the agency problem
usually refers to a conflict of interest between a company's management and the company's
stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to
make decisions that will maximize shareholder wealth even though it is in the manager’s best
interest to maximize his own wealth.
7. Security Analysis: Security analysis refers to the method of analyzing the value of
securities like shares and other instruments to assess the total value of business which will be
useful for investors to make decisions. There are three methods to analyze the value of securities –
fundamental, technical, and quantitative analysis.
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1. Investment: An investment is an asset or item acquired with the goal of generating income or
appreciation. Appreciation refers to an increase in the value of an asset over time. When an
individual purchases a good as an investment, the intent is not to consume the good but rather to
use it in the future to create wealth. An investment always concerns the outlay of some asset today
—time, money, or effort—in hopes of a greater payoff in the future than what was originally put
in.
2. Real Assets: Real assets are physical assets that have an intrinsic worth due to their substance
and properties. Real assets include precious metals, commodities, real estate, land, equipment, and
natural resources.
3. Fixed-Income (debt) Securities: A fixed-income security is an investment that provides a return
in the form of fixed periodic interest payments and the eventual return of principal at maturity.
Unlike variable-income securities, where payments change based on some underlying measure—
such as short-term interest rates—the payments of a fixed-income security are known in advance.
4. Equity: Equity, typically referred to as shareholders' equity (or owners’ equity' for privately held
companies), represents the amount of money that would be returned to a company’s shareholders
if all of the assets were liquidated and all of the company's debt was paid off.
In addition, shareholder equity can represent the book value of a company. Equity can sometimes be
offered as kind. It also represents the pro-rata ownership of a company's shares. Equity can be found on a
company's balance sheet and is one of the most common pieces of data employed by analysts to assess the
financial health of a company.
5. Derivative Securities: A derivative is a financial security with a value that is reliant upon or
derived from, an underlying asset or group of assets—a benchmark. The derivative itself is a
contract between two or more parties, and the derivative derives its price from fluctuations in the
underlying asset.
The most common underlying assets for derivatives are stocks, bonds, commodities, currencies, interest
rates, and market indexes. These assets are commonly purchased through brokerages.
6. Agency Problem: The agency problem is a conflict of interest inherent in any relationship where
one party is expected to act in another's best interests. In corporate finance, the agency problem
usually refers to a conflict of interest between a company's management and the company's
stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to
make decisions that will maximize shareholder wealth even though it is in the manager’s best
interest to maximize his own wealth.
7. Security Analysis: Security analysis refers to the method of analyzing the value of
securities like shares and other instruments to assess the total value of business which will be
useful for investors to make decisions. There are three methods to analyze the value of securities –
fundamental, technical, and quantitative analysis.
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8. Passive Management: Passive management is a style of management associated with mutual
and exchange-traded funds (ETF) where a fund's portfolio mirrors a market index. Passive
management is the opposite of active management in which a fund's manager(s) attempt to beat
the market with various investing strategies and buying/selling decisions of a portfolio's securities.
Passive management is also referred to as "passive strategy," "passive investing," or " index
investing."
9. Active Management: The term active management implies that a professional money
manager or a team of professionals is tracking the performance of a client's investment
portfolio and regularly making buy, hold, and sell decisions about the assets in it. The goal of the
active manager is to outperform the overall market.
10.Financial Intermediaries: A financial intermediary is a firm or an institution that acts an
intermediary between a provider of service and the consumer. It is the institution or individual
that is in between two or more parties in a financial context. In theoretical terms, a financial
intermediary channels savings into investments. Financial intermediaries exist for profit in the
financial system and sometimes there is a need to regulate the activities of the same. Also, recent
trends suggest that financial intermediaries role in savings and investment functions can be used
for an efficient market system or like the sub-prime crisis shows, they can be a cause for concern
as well.
11.Investment Banker: Investment bankers are intermediaries who help their clients – whether
individuals, businesses, or governments – wisely invest their money. Investment bankers are also
responsible for buying and selling stocks and securities on behalf of their clients.
12.Primary Market: A primary market issues new securities on an exchange for companies,
governments, and other groups to obtain financing through debt-based or equity-based securities.
Primary markets are facilitated by underwriting groups consisting of investment banks that set a
beginning price range for a given security and oversee its sale to investors.
Once the initial sale is complete, further trading is conducted on the secondary market, where the bulk of
exchange trading occurs each day.
13.Secondary Market: A secondary market is a market where investors purchase securities or
assets from other investors, rather than from issuing companies themselves.
14.Venture Capital: Venture capital is a form of private equity and a type of financing that
investors provide to startup companies and small businesses that are believed to have long-term
growth potential.
15.Private Equity: Private equity is an alternative investment class and consists of capital that is not
listed on a public exchange. Private equity is composed of funds and investors that directly invest
in private companies, or that engage in buyouts of public companies, resulting in the delisting of
public equity. Institutional and retail investors provide the capital for private equity, and the
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and exchange-traded funds (ETF) where a fund's portfolio mirrors a market index. Passive
management is the opposite of active management in which a fund's manager(s) attempt to beat
the market with various investing strategies and buying/selling decisions of a portfolio's securities.
Passive management is also referred to as "passive strategy," "passive investing," or " index
investing."
9. Active Management: The term active management implies that a professional money
manager or a team of professionals is tracking the performance of a client's investment
portfolio and regularly making buy, hold, and sell decisions about the assets in it. The goal of the
active manager is to outperform the overall market.
10.Financial Intermediaries: A financial intermediary is a firm or an institution that acts an
intermediary between a provider of service and the consumer. It is the institution or individual
that is in between two or more parties in a financial context. In theoretical terms, a financial
intermediary channels savings into investments. Financial intermediaries exist for profit in the
financial system and sometimes there is a need to regulate the activities of the same. Also, recent
trends suggest that financial intermediaries role in savings and investment functions can be used
for an efficient market system or like the sub-prime crisis shows, they can be a cause for concern
as well.
11.Investment Banker: Investment bankers are intermediaries who help their clients – whether
individuals, businesses, or governments – wisely invest their money. Investment bankers are also
responsible for buying and selling stocks and securities on behalf of their clients.
12.Primary Market: A primary market issues new securities on an exchange for companies,
governments, and other groups to obtain financing through debt-based or equity-based securities.
Primary markets are facilitated by underwriting groups consisting of investment banks that set a
beginning price range for a given security and oversee its sale to investors.
Once the initial sale is complete, further trading is conducted on the secondary market, where the bulk of
exchange trading occurs each day.
13.Secondary Market: A secondary market is a market where investors purchase securities or
assets from other investors, rather than from issuing companies themselves.
14.Venture Capital: Venture capital is a form of private equity and a type of financing that
investors provide to startup companies and small businesses that are believed to have long-term
growth potential.
15.Private Equity: Private equity is an alternative investment class and consists of capital that is not
listed on a public exchange. Private equity is composed of funds and investors that directly invest
in private companies, or that engage in buyouts of public companies, resulting in the delisting of
public equity. Institutional and retail investors provide the capital for private equity, and the
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capital can be utilized to fund new technology, make acquisitions, expand working capital, and to
bolster and solidify a balance sheet.
A private equity fund has Limited Partners (LP), who typically own 99 percent of shares in a fund and
have limited liability, and General Partners (GP), who own 1 percent of shares and have full liability. The
latter are also responsible for executing and operating the investment.
16.Securitization: Securitization is the procedure where an issuer designs a marketable financial
instrument by merging or pooling various financial assets into one group. The issuer then sells this
group of repackaged assets to investors. Securitization offers opportunities for investors and frees
up capital for originators, both of which promote liquidity in the marketplace.
In theory, any financial asset can be securitized—that is, turned into a tradeable, fungible item of
monetary value. In essence, this is what all securities are. However, securitization most often occurs with
loans and other assets that generate receivables such as different types of consumer or commercial debt. It
can involve the pooling of contractual debts such as auto loans and credit card debt obligations.
17.Systematic Risk: Systematic risk refers to the risk inherent to the entire market or market
segment. Systematic risk, also known as “undiversifiable risk,” “volatility” or “market risk,”
affects the overall market, not just a particular stock or industry. This type of risk is both
unpredictable and impossible to completely avoid. It cannot be mitigated through diversification,
only through hedging or by using the correct asset allocation strategy.
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bolster and solidify a balance sheet.
A private equity fund has Limited Partners (LP), who typically own 99 percent of shares in a fund and
have limited liability, and General Partners (GP), who own 1 percent of shares and have full liability. The
latter are also responsible for executing and operating the investment.
16.Securitization: Securitization is the procedure where an issuer designs a marketable financial
instrument by merging or pooling various financial assets into one group. The issuer then sells this
group of repackaged assets to investors. Securitization offers opportunities for investors and frees
up capital for originators, both of which promote liquidity in the marketplace.
In theory, any financial asset can be securitized—that is, turned into a tradeable, fungible item of
monetary value. In essence, this is what all securities are. However, securitization most often occurs with
loans and other assets that generate receivables such as different types of consumer or commercial debt. It
can involve the pooling of contractual debts such as auto loans and credit card debt obligations.
17.Systematic Risk: Systematic risk refers to the risk inherent to the entire market or market
segment. Systematic risk, also known as “undiversifiable risk,” “volatility” or “market risk,”
affects the overall market, not just a particular stock or industry. This type of risk is both
unpredictable and impossible to completely avoid. It cannot be mitigated through diversification,
only through hedging or by using the correct asset allocation strategy.
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Chapter 2(Asset Classes and Financial Instruments)
1. The Instruments of Money Market
i Treasury Bill
ii Commercial Paper
iii Banker’s Acceptance
iv Certificate of Deposit (CD)
v Repurchase Agreement (Repo)
vi Short-term treasury notes and bonds
vii International emergency deposit
2. Treasury bill is government promissory letters. The government receives short-term loan (short-
term liabilities) through it. Treasury bill is the written document by which the government is
pledged to pay the due loan back with interest after three months. The interest is the difference
between the purchase price and the price paid either at maturity (face value) or the price of the bill
if sold prior to maturity. Theoretically, the government of Bangladesh issued three types of T-bills
through auctions, namely 91 days, 182days and 364 days.
Treasury Bills:
Most marketable of all money market securities.
Simplest form of borrowing.
Government raises money by selling bills to the public
Investors buy the bills at a discount from the stated maturity value
Maturities may be 4, 13, 26, or 52 weeks
Exempt from all state and local taxes
3. Certificate of Deposit (CD) is a savings certificate entitling the bearer to receive interest. A
banking certificate bears a maturity date, a specified fixed interest rate and can be issued in any
denomination. CDs are generally issued by the commercial banks. The term of a CD ranges from
one month to 05 years.
Certificates of Deposit (CD):
Time deposit with a bank
Interest bearing deposits at commercial banks or savings and loan associations
The bank pays interest & principle to the depositor only at the end of the fixed term of CD
4. Commercial Paper is a common form of unsecured, short-term debt issued by a corporation.
Commercial paper is typically issued for the financing of payroll, accounts payable, inventories,
and meeting other short-term liabilities. Maturities on most commercial paper ranges from a few
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1. The Instruments of Money Market
i Treasury Bill
ii Commercial Paper
iii Banker’s Acceptance
iv Certificate of Deposit (CD)
v Repurchase Agreement (Repo)
vi Short-term treasury notes and bonds
vii International emergency deposit
2. Treasury bill is government promissory letters. The government receives short-term loan (short-
term liabilities) through it. Treasury bill is the written document by which the government is
pledged to pay the due loan back with interest after three months. The interest is the difference
between the purchase price and the price paid either at maturity (face value) or the price of the bill
if sold prior to maturity. Theoretically, the government of Bangladesh issued three types of T-bills
through auctions, namely 91 days, 182days and 364 days.
Treasury Bills:
Most marketable of all money market securities.
Simplest form of borrowing.
Government raises money by selling bills to the public
Investors buy the bills at a discount from the stated maturity value
Maturities may be 4, 13, 26, or 52 weeks
Exempt from all state and local taxes
3. Certificate of Deposit (CD) is a savings certificate entitling the bearer to receive interest. A
banking certificate bears a maturity date, a specified fixed interest rate and can be issued in any
denomination. CDs are generally issued by the commercial banks. The term of a CD ranges from
one month to 05 years.
Certificates of Deposit (CD):
Time deposit with a bank
Interest bearing deposits at commercial banks or savings and loan associations
The bank pays interest & principle to the depositor only at the end of the fixed term of CD
4. Commercial Paper is a common form of unsecured, short-term debt issued by a corporation.
Commercial paper is typically issued for the financing of payroll, accounts payable, inventories,
and meeting other short-term liabilities. Maturities on most commercial paper ranges from a few
4 | P a g e
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weeks to months. Commercial paper is usually issued at a discount from face value and reflects
prevailing market interest rates.
Commercial Paper:
Issued by well-known companies
Short-term unsecured debt
Maturities 270 days
5. Banker's Acceptance is a form of payment that is guaranteed by a bank rather than an individual
account holder. Banker's Acceptances are most frequently used in international trade to finalize
transactions with relatively little risk to either party. Banker's acceptances are traded at a discount
in the secondary money markets.
Banker’s Acceptances
Order to a bank by a bank’s customer to pay a sum of money at a future date.
Maturities 6 months or less than one year.
Similar to postdated cheque.
Widely used in foreign trade.
6. Eurodollars are time deposits denominated in US dollars at banks outside the US banking system
(especially in the European banking system) and thus Eurodollars are not subject to regulations by
the Federal Reserve. So, Eurodollars are dollar-denominated deposits at foreign banks or at the
overseas branches of US banks.
Eurodollars
Dollar-denominated time deposits in commercial banks outside United States
Eurodollars deposits cannot be traded and they are not negotiable
7. Repo (Repurchase Agreement) means the purchase of securities with the agreement to sell them
at a higher price at a specific future date. For the party selling the security (and agreeing to
repurchase it in the future) it is a repo; for the party on the other end of the transaction (buying the
security and agreeing to sell in the future) it is a reverse repurchase agreement.
Repos are classified as a money-market instrument. They are usually used to raise short-term capital.
Bangladesh Bank sells this instrument to the commercial banks with the agreement that it will be bought
back after a certain period of time. It is used to control the supply of money in the economy.
8. Reverse Repo (Reverse Repurchase Agreement) is an act of buying securities with the intention
of returning—reselling—those same assets back in the future at a profit. This process is the
opposite side of the coin to the repurchase agreement. The central bank uses this tool when it feels
there is too much money floating in the banking system.
If the reverse repo rate is increased, it means Bangladesh Bank will borrow money from the bank and
offer them a lucrative rate of interest. As a result, banks would prefer to keep their money with
Bangladesh Bank (which is absolutely risk-free) instead of lending it out. Consequently, banks would
5 | P a g e
prevailing market interest rates.
Commercial Paper:
Issued by well-known companies
Short-term unsecured debt
Maturities 270 days
5. Banker's Acceptance is a form of payment that is guaranteed by a bank rather than an individual
account holder. Banker's Acceptances are most frequently used in international trade to finalize
transactions with relatively little risk to either party. Banker's acceptances are traded at a discount
in the secondary money markets.
Banker’s Acceptances
Order to a bank by a bank’s customer to pay a sum of money at a future date.
Maturities 6 months or less than one year.
Similar to postdated cheque.
Widely used in foreign trade.
6. Eurodollars are time deposits denominated in US dollars at banks outside the US banking system
(especially in the European banking system) and thus Eurodollars are not subject to regulations by
the Federal Reserve. So, Eurodollars are dollar-denominated deposits at foreign banks or at the
overseas branches of US banks.
Eurodollars
Dollar-denominated time deposits in commercial banks outside United States
Eurodollars deposits cannot be traded and they are not negotiable
7. Repo (Repurchase Agreement) means the purchase of securities with the agreement to sell them
at a higher price at a specific future date. For the party selling the security (and agreeing to
repurchase it in the future) it is a repo; for the party on the other end of the transaction (buying the
security and agreeing to sell in the future) it is a reverse repurchase agreement.
Repos are classified as a money-market instrument. They are usually used to raise short-term capital.
Bangladesh Bank sells this instrument to the commercial banks with the agreement that it will be bought
back after a certain period of time. It is used to control the supply of money in the economy.
8. Reverse Repo (Reverse Repurchase Agreement) is an act of buying securities with the intention
of returning—reselling—those same assets back in the future at a profit. This process is the
opposite side of the coin to the repurchase agreement. The central bank uses this tool when it feels
there is too much money floating in the banking system.
If the reverse repo rate is increased, it means Bangladesh Bank will borrow money from the bank and
offer them a lucrative rate of interest. As a result, banks would prefer to keep their money with
Bangladesh Bank (which is absolutely risk-free) instead of lending it out. Consequently, banks would
5 | P a g e
have lesser funds to lend to their customers. This helps stem the flow of excess money into the economy.
Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while repo
signifies the rate at which liquidity is injected.
Repos and Reverses
Dealers in government securities use repurchase agreements
Seller of such instrument may agree to repurchase it for a agreed-on price at a later date.
Collateralized loan from buyer to seller.
Bond Market Instruments
9. Treasury Notes & Bonds are marketable securities the government sells in order to pay off
maturing debt and to raise the cash needed to run the federal government. When a person buys one
of these securities, s/he is lending his/her money to the government of the Bangladesh. Treasury
notes and bonds are securities that have a stated interest rate that is paid semi-annually until
maturity. What make notes and bonds different are the terms to maturity. Notes are issued in two-,
three-, five- and 10-year terms. Conversely, bonds are long-term investments with terms of more
than 10 years.
10. Treasury bond refers to a certificate issued by the government acknowledging that money has
been lent to it and will be paid back with interest. Bond is a debt investment in which an investor
loans money to an entity (typically governmental) which borrows the funds for a defined period of
time at a variable or fixed interest rate. Bonds are used by sovereign governments to raise money
and finance a variety of projects and activities.
Treasury notes and bonds:
Treasury notes are similar to the treasury certificate accept with regard to time of maturity. Notes
have a maturity of one to ten years when they are newly issued.
Bonds mature and repay their face value within a period from ten to thirty years from the date of
issue. Some bond issues are callable or redeemable prior to maturity.
11. Treasury Inflation-Protected Securities (TIPS) are a form of US Treasury bonds designed to
help investors protect against inflation. These bonds are indexed to inflation, have the US
government backing, and pay investors a fixed interest rate as the bond's par value adjusts with the
inflation rate.
12. Federal Agency Debt Securities represents the face value of securities held by the Federal
Reserve. Agency securities are obligations of the Federal government agencies or government
sponsored agencies.
13. International Bonds: An international bond is a debt obligation that is issued in a country by a
non-domestic entity in its native currency. International bonds are usually corporate bonds.
International bonds can offer portfolio diversification, but are highly subject to currency risk.
6 | P a g e
Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks, while repo
signifies the rate at which liquidity is injected.
Repos and Reverses
Dealers in government securities use repurchase agreements
Seller of such instrument may agree to repurchase it for a agreed-on price at a later date.
Collateralized loan from buyer to seller.
Bond Market Instruments
9. Treasury Notes & Bonds are marketable securities the government sells in order to pay off
maturing debt and to raise the cash needed to run the federal government. When a person buys one
of these securities, s/he is lending his/her money to the government of the Bangladesh. Treasury
notes and bonds are securities that have a stated interest rate that is paid semi-annually until
maturity. What make notes and bonds different are the terms to maturity. Notes are issued in two-,
three-, five- and 10-year terms. Conversely, bonds are long-term investments with terms of more
than 10 years.
10. Treasury bond refers to a certificate issued by the government acknowledging that money has
been lent to it and will be paid back with interest. Bond is a debt investment in which an investor
loans money to an entity (typically governmental) which borrows the funds for a defined period of
time at a variable or fixed interest rate. Bonds are used by sovereign governments to raise money
and finance a variety of projects and activities.
Treasury notes and bonds:
Treasury notes are similar to the treasury certificate accept with regard to time of maturity. Notes
have a maturity of one to ten years when they are newly issued.
Bonds mature and repay their face value within a period from ten to thirty years from the date of
issue. Some bond issues are callable or redeemable prior to maturity.
11. Treasury Inflation-Protected Securities (TIPS) are a form of US Treasury bonds designed to
help investors protect against inflation. These bonds are indexed to inflation, have the US
government backing, and pay investors a fixed interest rate as the bond's par value adjusts with the
inflation rate.
12. Federal Agency Debt Securities represents the face value of securities held by the Federal
Reserve. Agency securities are obligations of the Federal government agencies or government
sponsored agencies.
13. International Bonds: An international bond is a debt obligation that is issued in a country by a
non-domestic entity in its native currency. International bonds are usually corporate bonds.
International bonds can offer portfolio diversification, but are highly subject to currency risk.
6 | P a g e
14. Municipal Bonds: A municipal bond is a debt security issued by a state, municipality or county to
finance its capital expenditures, including the construction of highways, bridges or schools. They
can be thought of as loans that investors make to local governments. Municipal bonds are exempt
from federal taxes and most state and local taxes, making them especially attractive to people in
high income tax brackets.
15. Corporate Bond is a debt security issued by a company in order for it to raise capital. An investor
who buys a corporate bond is effectively loaning money to the company in return for a series of
interest payments, but these bonds may also actively trade on the secondary market. Corporate
bonds are typically seen as somewhat riskier than U.S. government bonds, so they usually have
higher interest rates.
Corporate Bonds
Private firms borrow money directly from the public or when the corporations go to the capital
market to obtain money for all corporate purposes
Long-term debt securities
16. Mortgage is a debt instrument, secured by the collateral of specified real estate property that the
borrower is obliged to pay back with a predetermined set of payments. Mortgages are also known
as "liens against property" or "claims on property." With a fixed-rate mortgage, the borrower pays
the same interest rate for the life of the loan. Individuals and businesses use mortgages to make
large real estate purchases without paying the entire purchase price up front. Over many years, the
borrower repays the loan with interest until she or he owns the property free and clear.
17. Mortgage-Backed Security (MBS): A mortgage-backed security (MBS) is an investment similar
to a bond that is made up of a bundle of home loans bought from the banks that issued them.
Investors in MBS receive periodic payments similar to bond coupon payments. The MBS is a type
of asset-backed security. As became glaringly obvious in the subprime mortgage meltdown of
2007-2008, a mortgage-backed security is only as sound as the mortgages that back it up.
18. How a Mortgage-Backed Security Works?
First, a bank or mortgage company makes a home loan. The bank then sells that loan to an investment
bank. It uses the money received from the investment bank to make new loans. The investment bank adds
the loan to a bundle of mortgages with similar interest rates. It puts the bundle in a special company
designed for that purpose. It's called a Special Purpose Vehicle (SPV) or Special Investment Vehicle
(SIV). That keeps the mortgage-backed securities separate from the bank's other services. The SPV
markets the mortgage-backed securities.
Mortgages and mortgage backed securities
➢ Ownership claim in a pool of mortgages or an obligation that is secured by such a pool
7 | P a g e
finance its capital expenditures, including the construction of highways, bridges or schools. They
can be thought of as loans that investors make to local governments. Municipal bonds are exempt
from federal taxes and most state and local taxes, making them especially attractive to people in
high income tax brackets.
15. Corporate Bond is a debt security issued by a company in order for it to raise capital. An investor
who buys a corporate bond is effectively loaning money to the company in return for a series of
interest payments, but these bonds may also actively trade on the secondary market. Corporate
bonds are typically seen as somewhat riskier than U.S. government bonds, so they usually have
higher interest rates.
Corporate Bonds
Private firms borrow money directly from the public or when the corporations go to the capital
market to obtain money for all corporate purposes
Long-term debt securities
16. Mortgage is a debt instrument, secured by the collateral of specified real estate property that the
borrower is obliged to pay back with a predetermined set of payments. Mortgages are also known
as "liens against property" or "claims on property." With a fixed-rate mortgage, the borrower pays
the same interest rate for the life of the loan. Individuals and businesses use mortgages to make
large real estate purchases without paying the entire purchase price up front. Over many years, the
borrower repays the loan with interest until she or he owns the property free and clear.
17. Mortgage-Backed Security (MBS): A mortgage-backed security (MBS) is an investment similar
to a bond that is made up of a bundle of home loans bought from the banks that issued them.
Investors in MBS receive periodic payments similar to bond coupon payments. The MBS is a type
of asset-backed security. As became glaringly obvious in the subprime mortgage meltdown of
2007-2008, a mortgage-backed security is only as sound as the mortgages that back it up.
18. How a Mortgage-Backed Security Works?
First, a bank or mortgage company makes a home loan. The bank then sells that loan to an investment
bank. It uses the money received from the investment bank to make new loans. The investment bank adds
the loan to a bundle of mortgages with similar interest rates. It puts the bundle in a special company
designed for that purpose. It's called a Special Purpose Vehicle (SPV) or Special Investment Vehicle
(SIV). That keeps the mortgage-backed securities separate from the bank's other services. The SPV
markets the mortgage-backed securities.
Mortgages and mortgage backed securities
➢ Ownership claim in a pool of mortgages or an obligation that is secured by such a pool
7 | P a g e
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Equity Securities
19. Common Stock and Preferred Stock: Common stock and preferred stock are the two main types
of stocks that are sold by companies and traded among investors in the open market. Each type
gives stockholders a partial ownership in the company represented by the stock.
20. Common Stock is the most common type of stock that is issued by companies. It entitles
shareholders to share in the company’s profits through dividends and/or capital appreciation.
Common stockholders are usually given voting rights with the number of votes directly related to
the number of shares owned. Of course, the company’s board of directors can decide whether or
not to pay dividends as well as how much is paid. Owners of common stock have “pre-emptive
rights” to maintain the same proportion of ownership in the company over time. If the company
circulates another offering of stock, shareholders can purchase as much stock as it takes to keep
their ownership comparable. Common stock has the potential for profits through capital gains. The
return and principal value of stocks fluctuate with changes in market conditions. Shares (when
sold) may be worth more or less than their original cost. Shareholders are not assured of receiving
dividend payments. Investors should consider their tolerance for investment risk before investing
in common stock.
21. Preferred Stock is generally considered less volatile than common stock but typically has less
potential for profit. Preferred stockholders generally do not have voting rights as common
stockholders do, but they have a greater claim to the company’s assets. Preferred stock may also
be “callable” which means that the company can purchase shares back from the shareholders at
any time for any reason although usually at a favorable price. Preferred stock shareholders receive
their dividends before common stockholders receive their dividends and these payments tend to be
higher. Shareholders of preferred stock receive fixed, regular dividend payments for a specified
period of time, unlike the variable dividend payments sometimes offered to common stockholders.
Of course, it is important to remember that fixed dividends depend on the company’s ability to
pay as promised. In the event that a company declares bankruptcy, preferred stockholders are paid
before common stockholders. Unlike preferred stock, common stock has the potential to return
higher yields over time through capital growth.
22. Why is preferred stock referred to as a hybrid security?
Preferred stock is a hybrid security because it combines features of common stocks and bonds. At the
same time, it has several unique features that set it apart from both.
Preferred stock is sometimes referred to as a hybrid security because of its bond-like characteristics. Like
bonds, preferred stocks have a par value which is affected by interest rates. When interest rates rise, the
value of the preferred stock declines. However, the value of common stock shares is regulated by demand
and supply of the market participants. In general, preferred stocks are less volatile than common stocks.
However, like all assets in an open market, there have been times when preferred stocks have been
volatile and lost value.
8 | P a g e
19. Common Stock and Preferred Stock: Common stock and preferred stock are the two main types
of stocks that are sold by companies and traded among investors in the open market. Each type
gives stockholders a partial ownership in the company represented by the stock.
20. Common Stock is the most common type of stock that is issued by companies. It entitles
shareholders to share in the company’s profits through dividends and/or capital appreciation.
Common stockholders are usually given voting rights with the number of votes directly related to
the number of shares owned. Of course, the company’s board of directors can decide whether or
not to pay dividends as well as how much is paid. Owners of common stock have “pre-emptive
rights” to maintain the same proportion of ownership in the company over time. If the company
circulates another offering of stock, shareholders can purchase as much stock as it takes to keep
their ownership comparable. Common stock has the potential for profits through capital gains. The
return and principal value of stocks fluctuate with changes in market conditions. Shares (when
sold) may be worth more or less than their original cost. Shareholders are not assured of receiving
dividend payments. Investors should consider their tolerance for investment risk before investing
in common stock.
21. Preferred Stock is generally considered less volatile than common stock but typically has less
potential for profit. Preferred stockholders generally do not have voting rights as common
stockholders do, but they have a greater claim to the company’s assets. Preferred stock may also
be “callable” which means that the company can purchase shares back from the shareholders at
any time for any reason although usually at a favorable price. Preferred stock shareholders receive
their dividends before common stockholders receive their dividends and these payments tend to be
higher. Shareholders of preferred stock receive fixed, regular dividend payments for a specified
period of time, unlike the variable dividend payments sometimes offered to common stockholders.
Of course, it is important to remember that fixed dividends depend on the company’s ability to
pay as promised. In the event that a company declares bankruptcy, preferred stockholders are paid
before common stockholders. Unlike preferred stock, common stock has the potential to return
higher yields over time through capital growth.
22. Why is preferred stock referred to as a hybrid security?
Preferred stock is a hybrid security because it combines features of common stocks and bonds. At the
same time, it has several unique features that set it apart from both.
Preferred stock is sometimes referred to as a hybrid security because of its bond-like characteristics. Like
bonds, preferred stocks have a par value which is affected by interest rates. When interest rates rise, the
value of the preferred stock declines. However, the value of common stock shares is regulated by demand
and supply of the market participants. In general, preferred stocks are less volatile than common stocks.
However, like all assets in an open market, there have been times when preferred stocks have been
volatile and lost value.
8 | P a g e
Unlike common shares, preferred stocks also have a callability feature which gives the issuer the right to
redeem the shares from the market after a predetermined time. Investors buying preferred shares have a
real opportunity for these shares to be called back at a redemption rate representing a significant premium
over their purchase price. Markets for preferred shares often anticipate call backs and prices may increase
accordingly.
Common Stock:
Ownership shares in a corporation
Amount of money paid by the owners of the organization measured as the product of par value
(face value) and number of shares outstanding.
Preferred Stock:
It promises to pay its holder a fixed amount of income each year
The amount which is measured by the par value of any shares outstanding promising to pay fixed
rate of return in the form of fixed dividend.
Stock and Bond Market Indexes
23. Stock Market Index is an index that measures a stock market (or a subset of the stock market)
that helps investors compare current price levels with past prices to calculate market performance.
Investors use the calculated values of stock market indexes as an indicator of the current value of
their component stocks, and they can determine returns over time by comparing current and past
index levels.
24. Dow Jones Industrial Average (DJIA): The Dow Jones Industrial Average (DJIA) is an index
that tracks 30 large, publicly-owned blue chip companies trading on the New York Stock
Exchange (NYSE) and the NASDAQ. The Dow Jones is named after Charles Dow who created
the index back in 1896 along with his business partner Edward Jones.
25. New York Stock Exchange (NYSE) is an American stock exchange located at 11 Wall Street,
Lower Manhattan, New York City, New York. NYSE is the largest equities-based exchange in the
world based on the total market capitalization of its listed securities. At the end of 2019, its total
market capitalization rose to US$30.1 trillion.
26. Nasdaq Stock Market (also known as Nasdaq) is an American stock exchange located at One
Liberty Plaza in New York City. It is ranked second on the list of stock exchanges by market
capitalization of shares traded — behind only the New York Stock Exchange (NYSE).
27. S&P 500 Index – Standard & Poor's 500 Index: The S&P 500 Index or the Standard & Poor's
500 Index is a market-capitalization-weighted index of the 500 largest US publicly traded
9 | P a g e
redeem the shares from the market after a predetermined time. Investors buying preferred shares have a
real opportunity for these shares to be called back at a redemption rate representing a significant premium
over their purchase price. Markets for preferred shares often anticipate call backs and prices may increase
accordingly.
Common Stock:
Ownership shares in a corporation
Amount of money paid by the owners of the organization measured as the product of par value
(face value) and number of shares outstanding.
Preferred Stock:
It promises to pay its holder a fixed amount of income each year
The amount which is measured by the par value of any shares outstanding promising to pay fixed
rate of return in the form of fixed dividend.
Stock and Bond Market Indexes
23. Stock Market Index is an index that measures a stock market (or a subset of the stock market)
that helps investors compare current price levels with past prices to calculate market performance.
Investors use the calculated values of stock market indexes as an indicator of the current value of
their component stocks, and they can determine returns over time by comparing current and past
index levels.
24. Dow Jones Industrial Average (DJIA): The Dow Jones Industrial Average (DJIA) is an index
that tracks 30 large, publicly-owned blue chip companies trading on the New York Stock
Exchange (NYSE) and the NASDAQ. The Dow Jones is named after Charles Dow who created
the index back in 1896 along with his business partner Edward Jones.
25. New York Stock Exchange (NYSE) is an American stock exchange located at 11 Wall Street,
Lower Manhattan, New York City, New York. NYSE is the largest equities-based exchange in the
world based on the total market capitalization of its listed securities. At the end of 2019, its total
market capitalization rose to US$30.1 trillion.
26. Nasdaq Stock Market (also known as Nasdaq) is an American stock exchange located at One
Liberty Plaza in New York City. It is ranked second on the list of stock exchanges by market
capitalization of shares traded — behind only the New York Stock Exchange (NYSE).
27. S&P 500 Index – Standard & Poor's 500 Index: The S&P 500 Index or the Standard & Poor's
500 Index is a market-capitalization-weighted index of the 500 largest US publicly traded
9 | P a g e
companies. The S&P is a float-weighted index, meaning company market capitalizations are
adjusted by the number of shares available for public trading.
28. Sensex is the benchmark index of the Bombay Stock Exchange (BSE) in India. Sensex comprises
30 of the largest and most actively-traded well-capitalized stocks on the BSE — providing an
accurate gauge of India's economy. The BSE Sensex has been on a growth curve since India
opened up its economy in 1991. Most of its growth has occurred in the 21st century. The index's
composition is reviewed in June and December each year. Initially compiled in 1986, the Sensex
is the oldest stock index in India. Analysts and investors use the Sensex to observe the overall
growth, development of particular industries, and ups and downs of the Indian economy.
29. Equal-Weighted Index: An equal-weighted index is a stock market index comprised of a group
of publicly traded companies that invests an equal amount of money in the stock of each company
that makes up the index. Thus, the performance of each company's stock carries equal importance
in determining the total value of the index.
Top 10 largest stock exchanges in the world by market capitalization
01. New York Stock Exchange (USA) [$30.1 trillion]
02. NASDAQ (USA) [$10.9 trillion]
03. Tokyo Stock Exchange (Japan) [$5.7 trillion]
04. Shanghai Stock Exchange (China) [$5.5 trillion]
05. Hong Kong Stock Exchange (Hong Kong) [$4.9 trillion]
06. Euronext (Eurozone) [$4.5 trillion]
07. London Stock Exchange (UK) [$4.5 trillion]
08. Shenzhen Stock Exchange (China) [$3.5 trillion]
09. Toronto Stock Exchange (Canada) [$2.9 trillion]
10. Bombay Stock Exchange (India) [$2.2 trillion]
11. National Stock Exchange (India) [$2.2 trillion]
The Market Capitalization of Dhaka Stock Exchange (DSE) stood at Taka 3,804,693 million in August
2019.
30. Bond Market Index is a method of measuring the value of a section of the bond market. It is
computed from the prices of selected bonds (typically a weighted average). It is a tool used by
investors and financial managers to describe the market, and to compare the return on specific
investments.
Derivative Markets
10 | P a g e
adjusted by the number of shares available for public trading.
28. Sensex is the benchmark index of the Bombay Stock Exchange (BSE) in India. Sensex comprises
30 of the largest and most actively-traded well-capitalized stocks on the BSE — providing an
accurate gauge of India's economy. The BSE Sensex has been on a growth curve since India
opened up its economy in 1991. Most of its growth has occurred in the 21st century. The index's
composition is reviewed in June and December each year. Initially compiled in 1986, the Sensex
is the oldest stock index in India. Analysts and investors use the Sensex to observe the overall
growth, development of particular industries, and ups and downs of the Indian economy.
29. Equal-Weighted Index: An equal-weighted index is a stock market index comprised of a group
of publicly traded companies that invests an equal amount of money in the stock of each company
that makes up the index. Thus, the performance of each company's stock carries equal importance
in determining the total value of the index.
Top 10 largest stock exchanges in the world by market capitalization
01. New York Stock Exchange (USA) [$30.1 trillion]
02. NASDAQ (USA) [$10.9 trillion]
03. Tokyo Stock Exchange (Japan) [$5.7 trillion]
04. Shanghai Stock Exchange (China) [$5.5 trillion]
05. Hong Kong Stock Exchange (Hong Kong) [$4.9 trillion]
06. Euronext (Eurozone) [$4.5 trillion]
07. London Stock Exchange (UK) [$4.5 trillion]
08. Shenzhen Stock Exchange (China) [$3.5 trillion]
09. Toronto Stock Exchange (Canada) [$2.9 trillion]
10. Bombay Stock Exchange (India) [$2.2 trillion]
11. National Stock Exchange (India) [$2.2 trillion]
The Market Capitalization of Dhaka Stock Exchange (DSE) stood at Taka 3,804,693 million in August
2019.
30. Bond Market Index is a method of measuring the value of a section of the bond market. It is
computed from the prices of selected bonds (typically a weighted average). It is a tool used by
investors and financial managers to describe the market, and to compare the return on specific
investments.
Derivative Markets
10 | P a g e
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31. Options:
➢ Call Option
➢ Put Option
32. Call Option is an option contract giving the owner the right, but not the obligation, to buy a
specified amount of an underlying security at a specified price within a specified time. The
specified price is known as the strike price and the specified time during which a sale is made is
its expiration or time to maturity. Call options may be purchased for speculation, or sold for
income purposes. They may also be combined for use in spread or combination strategies.
33. Put Option is a contract giving the owner the right, but not the obligation, to sell, or sell short, a
specified amount of an underlying security at a pre-determined price within a specified time
frame. Put options are available on a wide range of assets, including stocks, indexes, commodities
and currencies. Put option prices are affected by the underlying asset price and time decay. They
increase in value as the underlying asset falls in price, and lose value as time to expiration nears.
34. Future Contracts:
➢ Long Position
➢ Short Position
1. Long Position refers to the purchase of an asset with the expectation it will increase in value. A
long position in options contracts indicates the holder owns the underlying asset. A long position
is the opposite of a short position. In options, being long can refer either to outright ownership of
an asset or being the holder of an option on the asset. Being long on a stock or bond investment is
a measurement of time.
2. Short Position refers to a trading technique in which an investor sells a security with plans to buy
it later. Shorting is a strategy used when an investor anticipates the price of a security will fall in
the short term. In common practice, short sellers borrow shares of stock from an investment bank
or other financial institution, paying a fee to borrow the shares while the short position is in place.
11 | P a g e
➢ Call Option
➢ Put Option
32. Call Option is an option contract giving the owner the right, but not the obligation, to buy a
specified amount of an underlying security at a specified price within a specified time. The
specified price is known as the strike price and the specified time during which a sale is made is
its expiration or time to maturity. Call options may be purchased for speculation, or sold for
income purposes. They may also be combined for use in spread or combination strategies.
33. Put Option is a contract giving the owner the right, but not the obligation, to sell, or sell short, a
specified amount of an underlying security at a pre-determined price within a specified time
frame. Put options are available on a wide range of assets, including stocks, indexes, commodities
and currencies. Put option prices are affected by the underlying asset price and time decay. They
increase in value as the underlying asset falls in price, and lose value as time to expiration nears.
34. Future Contracts:
➢ Long Position
➢ Short Position
1. Long Position refers to the purchase of an asset with the expectation it will increase in value. A
long position in options contracts indicates the holder owns the underlying asset. A long position
is the opposite of a short position. In options, being long can refer either to outright ownership of
an asset or being the holder of an option on the asset. Being long on a stock or bond investment is
a measurement of time.
2. Short Position refers to a trading technique in which an investor sells a security with plans to buy
it later. Shorting is a strategy used when an investor anticipates the price of a security will fall in
the short term. In common practice, short sellers borrow shares of stock from an investment bank
or other financial institution, paying a fee to borrow the shares while the short position is in place.
11 | P a g e
Chapter 3(How securities are traded)
1. Primary Market: Primary Market is a place where companies bring a new issue of shares for
being subscribed by the general public for raising funds to fulfill their long-term capital
requirement like expanding the existing business or purchasing new entity. It plays an important
role in the mobilization of savings in the economy. Various types of an issue made by the
corporation are Public Issue, Right Issue and Bonus Issue. The company which brings the IPO is
known as the issuer, and the process is regarded as a public issue. The process includes many
merchant bankers (investment banks) and underwriters through which the shares,
Debentures, and bonds can directly be sold to the investors. These investment banks and underwriters
need to be registered with the Bangladesh Securities and Exchange Commission (BSEC).
2. Secondary Market: Secondary Market is a type of capital market where existing shares,
debentures, bonds, options, commercial papers and treasury bills of the corporate companies are
traded amongst investors. The secondary market can either be an auction market where trading of
securities is done through the stock exchange or a dealer market — popularly known as Over The
Counter where trading is done without using the platform of the stock exchange.
The securities are firstly offered in the primary market to the general public for a subscription where the
company receives the money from the investors and the investors get the securities; thereafter they are
listed on the stock exchange for the purpose of trading. These stock exchanges are the secondary market
where maximum trading of the company is done. The two stock exchanges of Bangladesh are Dhaka
Stock Exchange (DSE) and Chittagong Stock Exchange (CSE).
An investor can trade in securities through the stock exchange with the help of brokers who provide
assistance to their client for purchasing and selling. The brokers are the registered members of the
recognized stock exchange in which the investor is trading his/her securities. The brokers are allowed to
trade on the advanced trading system. The BSEC issues a certificate of registration to the member brokers
through which an investor can identify whether a broker is registered or not.
Difference Between Primary Market and
Secondary Market
Basis for
Comparison Primary Market Secondary Market
Meaning The marketplace for new shares is
called Primary Market.
The place where formerly
issued securities are traded is
known as Secondary Market.
Type of purchasing Direct Indirect
Financing
It supplies funds to budding
enterprises and also to existing
companies for expansion and
diversification
It does not provide funding to
companies
How many times a
security can be sold? Only once Multiple times
Buying & selling Company and investors Investors
12 | P a g e
1. Primary Market: Primary Market is a place where companies bring a new issue of shares for
being subscribed by the general public for raising funds to fulfill their long-term capital
requirement like expanding the existing business or purchasing new entity. It plays an important
role in the mobilization of savings in the economy. Various types of an issue made by the
corporation are Public Issue, Right Issue and Bonus Issue. The company which brings the IPO is
known as the issuer, and the process is regarded as a public issue. The process includes many
merchant bankers (investment banks) and underwriters through which the shares,
Debentures, and bonds can directly be sold to the investors. These investment banks and underwriters
need to be registered with the Bangladesh Securities and Exchange Commission (BSEC).
2. Secondary Market: Secondary Market is a type of capital market where existing shares,
debentures, bonds, options, commercial papers and treasury bills of the corporate companies are
traded amongst investors. The secondary market can either be an auction market where trading of
securities is done through the stock exchange or a dealer market — popularly known as Over The
Counter where trading is done without using the platform of the stock exchange.
The securities are firstly offered in the primary market to the general public for a subscription where the
company receives the money from the investors and the investors get the securities; thereafter they are
listed on the stock exchange for the purpose of trading. These stock exchanges are the secondary market
where maximum trading of the company is done. The two stock exchanges of Bangladesh are Dhaka
Stock Exchange (DSE) and Chittagong Stock Exchange (CSE).
An investor can trade in securities through the stock exchange with the help of brokers who provide
assistance to their client for purchasing and selling. The brokers are the registered members of the
recognized stock exchange in which the investor is trading his/her securities. The brokers are allowed to
trade on the advanced trading system. The BSEC issues a certificate of registration to the member brokers
through which an investor can identify whether a broker is registered or not.
Difference Between Primary Market and
Secondary Market
Basis for
Comparison Primary Market Secondary Market
Meaning The marketplace for new shares is
called Primary Market.
The place where formerly
issued securities are traded is
known as Secondary Market.
Type of purchasing Direct Indirect
Financing
It supplies funds to budding
enterprises and also to existing
companies for expansion and
diversification
It does not provide funding to
companies
How many times a
security can be sold? Only once Multiple times
Buying & selling Company and investors Investors
12 | P a g e
between
Beneficiary Company Investors
Intermediaries/Agents Underwriters Brokers
Price Fixed price The price fluctuates depending
on the demand and supply
force
Market Organization Not rooted to any specific spot or
geographical location It has physical existence.
(For example — DSE and
CSE).
3. Public Limited Company: Public Limited Company is the legal designation of a limited liability
company that trades on the stock exchange and has limited liability and offers equity shares to
general public (investors).
4. Publicly Traded Companies: When a private firm decides to raise capital from a wide range of
investors, it goes public. It will sell its securities to the general public and allow those investors to
freely trade those shares in established securities market.
Key Differences between Public Offering and Private Placement
Private companies that seek to raise capital through issuing securities have two options—
offering securities to the public or through a private placement. An initial public offering
(IPO) is underwritten by investment banks which then make the securities available for sale
on the open market. Private placement offerings are securities released for sale only to
accredited investors such as investment banks, pensions or mutual funds.
Initial Public Offering (IPO) Private Placement
An IPO is under the regulation by the
Securities and Exchange Commission (SEC)
and require strict financial reporting criteria
on a regular basis to remain available for
trade by investors. In an IPO, the issuer
obtains the assistance of an underwriting
firm to help determine what type of security
to issue, the best offering price, the number
of shares to be issued and the time to bring it
to market.
Companies using private placements
generally seek a smaller amount of capital
from a limited number of investors.
Public offering is one of the methods of
selling securities to the general public where
there are a large number of investors.
Private Placement is one of the methods of
selling securities directly or privately to a
few/a group of individual investors or
institutional investors.
Large scale company generally raises fund
through public offering. Small scale company raises fund through
private placement.
In case of public offering, investment banker
acts as a middleman which hiring together
suppliers and users of long term fund in
capital market.
In case of private placement, there is no
middleman as it is the direct negotiation
between issuing company and the investors.
13 | P a g e
Beneficiary Company Investors
Intermediaries/Agents Underwriters Brokers
Price Fixed price The price fluctuates depending
on the demand and supply
force
Market Organization Not rooted to any specific spot or
geographical location It has physical existence.
(For example — DSE and
CSE).
3. Public Limited Company: Public Limited Company is the legal designation of a limited liability
company that trades on the stock exchange and has limited liability and offers equity shares to
general public (investors).
4. Publicly Traded Companies: When a private firm decides to raise capital from a wide range of
investors, it goes public. It will sell its securities to the general public and allow those investors to
freely trade those shares in established securities market.
Key Differences between Public Offering and Private Placement
Private companies that seek to raise capital through issuing securities have two options—
offering securities to the public or through a private placement. An initial public offering
(IPO) is underwritten by investment banks which then make the securities available for sale
on the open market. Private placement offerings are securities released for sale only to
accredited investors such as investment banks, pensions or mutual funds.
Initial Public Offering (IPO) Private Placement
An IPO is under the regulation by the
Securities and Exchange Commission (SEC)
and require strict financial reporting criteria
on a regular basis to remain available for
trade by investors. In an IPO, the issuer
obtains the assistance of an underwriting
firm to help determine what type of security
to issue, the best offering price, the number
of shares to be issued and the time to bring it
to market.
Companies using private placements
generally seek a smaller amount of capital
from a limited number of investors.
Public offering is one of the methods of
selling securities to the general public where
there are a large number of investors.
Private Placement is one of the methods of
selling securities directly or privately to a
few/a group of individual investors or
institutional investors.
Large scale company generally raises fund
through public offering. Small scale company raises fund through
private placement.
In case of public offering, investment banker
acts as a middleman which hiring together
suppliers and users of long term fund in
capital market.
In case of private placement, there is no
middleman as it is the direct negotiation
between issuing company and the investors.
13 | P a g e
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Under public offering, floatation cost is
included as there is the need of underwriter. Under private placement, floatation cost is
excluded as there is no need of underwriter.
The IPO is a very public manner in which a
company’s business can expand and involve
outside investors.
A private placement is less spectacular but
can be equally effective in helping the
company reach its potential.
5. IPO (Initial Public Offering): An IPO is the first time that the stock of a private company is
offered to the public. IPOs are often issued by smaller and younger companies seeking capital to
expand, but they can also be done by large privately owned companies looking to become publicly
traded. In an IPO, the issuer obtains the assistance of an underwriting firm which helps determine
what type of security to issue, the best offering price, the amount of shares to be issued and the
time to bring it to market. After the IPO, shares are traded freely in the open market at what is
known as the free float.
6. Underwritings: Underwriting refers to the guarantee taken by investment banker that the issuer of
new securities will receive certain amount cash for them. Public offering of both stocks and bonds
typically are marketed by investment bankers. The managing underwriter forms an underwriting
syndicate the members of which literally buy the securities from the issuing firm on the day of the
offering. When the securities actually sold to the public, they are sold either by members of the
underwriting syndicate or by members of the selling group. The members of selling group are
broker-dealer firms buying the securities from the underwriter and in turn resell them to their
customers.
7. Self-Registration: Self Registration allows firm to registrar securities and gradually sell them to
the public for 2 years following the initial registration. Shelf registration is a type of public
offering where certain issuers are allowed to offer and sell securities to the public without a
separate prospectus for each act of offering and without the issue of further prospectus. Instead,
there is a single prospectus for multiple, undefined future offerings. The prospectus (often as part
of a registration statement) may be used to offer securities for up to several years after its
publication. A shelf registration statement is a filing with the SEC to register a public offering,
usually where there is no present intention to immediately sell all the securities being registered. A
shelf registration statement permits multiple offerings based on the same registration. Shelf
registration is mostly used for sales of new securities by the issuer (primary offerings), although it
might possibly be used for re-sales of outstanding securities (secondary offerings) or a
combination of both.
8. Prospectus: A preliminary registration statement must be filled with the Securities and Exchange
Commission (SEC) describing the issue and the prospects of the company. When the statement is
in final form and accepted by the SEC. It commonly provides investors with material information
about mutual funds, stocks, bonds and other investments, such as a description of the company's
business, financial statements, biographies of officers and directors, detailed information about
their compensation, any litigation that is taking place, a list of material properties and any other
material information.
14 | P a g e
included as there is the need of underwriter. Under private placement, floatation cost is
excluded as there is no need of underwriter.
The IPO is a very public manner in which a
company’s business can expand and involve
outside investors.
A private placement is less spectacular but
can be equally effective in helping the
company reach its potential.
5. IPO (Initial Public Offering): An IPO is the first time that the stock of a private company is
offered to the public. IPOs are often issued by smaller and younger companies seeking capital to
expand, but they can also be done by large privately owned companies looking to become publicly
traded. In an IPO, the issuer obtains the assistance of an underwriting firm which helps determine
what type of security to issue, the best offering price, the amount of shares to be issued and the
time to bring it to market. After the IPO, shares are traded freely in the open market at what is
known as the free float.
6. Underwritings: Underwriting refers to the guarantee taken by investment banker that the issuer of
new securities will receive certain amount cash for them. Public offering of both stocks and bonds
typically are marketed by investment bankers. The managing underwriter forms an underwriting
syndicate the members of which literally buy the securities from the issuing firm on the day of the
offering. When the securities actually sold to the public, they are sold either by members of the
underwriting syndicate or by members of the selling group. The members of selling group are
broker-dealer firms buying the securities from the underwriter and in turn resell them to their
customers.
7. Self-Registration: Self Registration allows firm to registrar securities and gradually sell them to
the public for 2 years following the initial registration. Shelf registration is a type of public
offering where certain issuers are allowed to offer and sell securities to the public without a
separate prospectus for each act of offering and without the issue of further prospectus. Instead,
there is a single prospectus for multiple, undefined future offerings. The prospectus (often as part
of a registration statement) may be used to offer securities for up to several years after its
publication. A shelf registration statement is a filing with the SEC to register a public offering,
usually where there is no present intention to immediately sell all the securities being registered. A
shelf registration statement permits multiple offerings based on the same registration. Shelf
registration is mostly used for sales of new securities by the issuer (primary offerings), although it
might possibly be used for re-sales of outstanding securities (secondary offerings) or a
combination of both.
8. Prospectus: A preliminary registration statement must be filled with the Securities and Exchange
Commission (SEC) describing the issue and the prospects of the company. When the statement is
in final form and accepted by the SEC. It commonly provides investors with material information
about mutual funds, stocks, bonds and other investments, such as a description of the company's
business, financial statements, biographies of officers and directors, detailed information about
their compensation, any litigation that is taking place, a list of material properties and any other
material information.
14 | P a g e
9. Road Show: Road Show is the publicity of the offerings of new stock around the country by the
investment bankers after the registration statement and preliminary prospectus have been
distributed to the interest investors.
10. Book Building: Book building is a systematic process of generating, capturing and recording
investor demand for shares. Large buyers such as financial institutions or high net-worth
individuals communicate their interests in purchasing shares of the IPO to the underwriters. These
indications of interest are called a book and the process of pulling the potential investors is called
book building.
11. Direct Search Market. Direct Search Market is a situation in which buyers and sellers (especially
of securities but also of other goods and services) seek each other out and conduct trades without
brokers or other financial institutions mediating. This is the opposite of an intermediated market.
12. Brokered Markets: Brokered market is the market where trading of goods is active and brokers
find it profitable to offer search services to buyer and sellers. A broker in the securities markets is
an intermediary representing buyers and sellers in securities transactions. Brokers develop
specialized knowledge on valuing assets traded in that market. For doing this job, the broker is
compensated by a commission.
13. Dealer Markets: The market where dealers specialize in various assets, purchase these assets or
their own accounts and later sell them for a profit from their inventory. A dealer may take
positions in various securities. If the dealer has a long position, the stocks declines in price and the
dealer losses money. On the other hand, if the dealer has a short position in a stock, he has
temporarily sold more stocks than it owns. The spreads between dealers buy (bid) prices and sell
(ask) prices are a source of profit. Dealer markets save traders on search costs because market
participants can easily look up the prices at which they can buy from and sell to dealers.
14. Auction Markets: Auction Market is the market where all traders converge at one place either
physically or electronically to buy or sell an asset. The traders need not search across dealers to
find the best price or a good. If all participants converge, they can arrive at mutually agreeable
prices and save the bid-ask spread.
15. Bid Price: Bid Price is the price that dealer wishes to pay to the seller of the securities.
16. Ask Price: Ask Price is the price at which dealer will sell a security.
17. Bid-Ask Spread: The bid–ask spread is the difference between the prices quoted (either by a
single market maker or in a limit order book) for an immediate sale (offer) and an immediate
purchase (bid) for stocks, futures contracts, options, or currency pairs. The size of the bid–ask
spread in a security is one measure of the liquidity of the market and of the size of the transaction
cost. If the spread is 0 then it is a frictionless asset.
15 | P a g e
investment bankers after the registration statement and preliminary prospectus have been
distributed to the interest investors.
10. Book Building: Book building is a systematic process of generating, capturing and recording
investor demand for shares. Large buyers such as financial institutions or high net-worth
individuals communicate their interests in purchasing shares of the IPO to the underwriters. These
indications of interest are called a book and the process of pulling the potential investors is called
book building.
11. Direct Search Market. Direct Search Market is a situation in which buyers and sellers (especially
of securities but also of other goods and services) seek each other out and conduct trades without
brokers or other financial institutions mediating. This is the opposite of an intermediated market.
12. Brokered Markets: Brokered market is the market where trading of goods is active and brokers
find it profitable to offer search services to buyer and sellers. A broker in the securities markets is
an intermediary representing buyers and sellers in securities transactions. Brokers develop
specialized knowledge on valuing assets traded in that market. For doing this job, the broker is
compensated by a commission.
13. Dealer Markets: The market where dealers specialize in various assets, purchase these assets or
their own accounts and later sell them for a profit from their inventory. A dealer may take
positions in various securities. If the dealer has a long position, the stocks declines in price and the
dealer losses money. On the other hand, if the dealer has a short position in a stock, he has
temporarily sold more stocks than it owns. The spreads between dealers buy (bid) prices and sell
(ask) prices are a source of profit. Dealer markets save traders on search costs because market
participants can easily look up the prices at which they can buy from and sell to dealers.
14. Auction Markets: Auction Market is the market where all traders converge at one place either
physically or electronically to buy or sell an asset. The traders need not search across dealers to
find the best price or a good. If all participants converge, they can arrive at mutually agreeable
prices and save the bid-ask spread.
15. Bid Price: Bid Price is the price that dealer wishes to pay to the seller of the securities.
16. Ask Price: Ask Price is the price at which dealer will sell a security.
17. Bid-Ask Spread: The bid–ask spread is the difference between the prices quoted (either by a
single market maker or in a limit order book) for an immediate sale (offer) and an immediate
purchase (bid) for stocks, futures contracts, options, or currency pairs. The size of the bid–ask
spread in a security is one measure of the liquidity of the market and of the size of the transaction
cost. If the spread is 0 then it is a frictionless asset.
15 | P a g e
18. Limit Order: Investors specifies the price at which he will buy or sell securities. A limit buy
order specifies the maximum price the investors want to pay for some expected securities. A limit
sell order stipulates the minimum price at which an investor wants to sell some quantity of
securities. A limit order may either be day order or open order. A limit day order exists until the
end of the current trading day. A limit open order is good until cancelled.
19. Over The Counter (OTC) Market: OTC Market means large collection of broker and dealers
connected electronically by telephones and computers that provides for trading in unlisted
securities.
20. Market Orders: Market Orders means buy or sell orders that are to be executed immediately at
current market prices. As long as there are willing sellers and buyers, market orders are filled.
Market orders are used when certainty of execution is a priority over the price of execution.
21. Contingent Order (Conditional Order): A contingent order is one that relies on a specific event
to occur. A contingent order is also known as a conditional order. Orders can be contingent on
each other — such as when two or more orders need to be executed at the same time. Orders can
be contingent on another order or event — such as when a stop loss is automatically sent out once
a trade has been
22. Stop Orders: Stop Order is an order that specifies a certain price at which a market order takes
effect. Sometimes called stop loss order it is executed to protect an investor’s existing profit or to
limit losses. A stop loss order is an order by which an investor instructs his broker to sell certain
number of securities if the price goes down to whatever level the former specifies.
23. Margin: A margin is cash or marketable securities deposited by an investor with his or her broker.
The margin in the account is the portion of the purchase price contributed by the investor.
24. Maintenance Margin: Maintenance Margin that ensures that the balance in the margin account
never becomes negative.
25. Margin Call: The broker may at any time revise the value of the collateral securities (margin)
after the estimation of the risk based on market factors. If this results in the market value of the
collateral securities for a margin account falling below the revised margin, the broker or exchange
immediately issues a "margin call", requiring the investor to bring the margin account back into
line. To do so, the investor must either pay funds (the call) into the margin account, provide
additional collateral, or dispose some of the securities. If the investor fails to bring the account
back into line, the broker can sell the investor's collateral securities to bring the account back into
line.
16 | P a g e
order specifies the maximum price the investors want to pay for some expected securities. A limit
sell order stipulates the minimum price at which an investor wants to sell some quantity of
securities. A limit order may either be day order or open order. A limit day order exists until the
end of the current trading day. A limit open order is good until cancelled.
19. Over The Counter (OTC) Market: OTC Market means large collection of broker and dealers
connected electronically by telephones and computers that provides for trading in unlisted
securities.
20. Market Orders: Market Orders means buy or sell orders that are to be executed immediately at
current market prices. As long as there are willing sellers and buyers, market orders are filled.
Market orders are used when certainty of execution is a priority over the price of execution.
21. Contingent Order (Conditional Order): A contingent order is one that relies on a specific event
to occur. A contingent order is also known as a conditional order. Orders can be contingent on
each other — such as when two or more orders need to be executed at the same time. Orders can
be contingent on another order or event — such as when a stop loss is automatically sent out once
a trade has been
22. Stop Orders: Stop Order is an order that specifies a certain price at which a market order takes
effect. Sometimes called stop loss order it is executed to protect an investor’s existing profit or to
limit losses. A stop loss order is an order by which an investor instructs his broker to sell certain
number of securities if the price goes down to whatever level the former specifies.
23. Margin: A margin is cash or marketable securities deposited by an investor with his or her broker.
The margin in the account is the portion of the purchase price contributed by the investor.
24. Maintenance Margin: Maintenance Margin that ensures that the balance in the margin account
never becomes negative.
25. Margin Call: The broker may at any time revise the value of the collateral securities (margin)
after the estimation of the risk based on market factors. If this results in the market value of the
collateral securities for a margin account falling below the revised margin, the broker or exchange
immediately issues a "margin call", requiring the investor to bring the margin account back into
line. To do so, the investor must either pay funds (the call) into the margin account, provide
additional collateral, or dispose some of the securities. If the investor fails to bring the account
back into line, the broker can sell the investor's collateral securities to bring the account back into
line.
16 | P a g e
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26. Short Sales: Short selling refers to the selling of securities that the trader does not own —
borrowing them from a broker, and later purchases the share of the same stock in order to replace
the share that was borrowed.
27. Self-Regulation: Self-regulation consists of several stages, and individuals must function as
contributors to their own motivation, behavior, and development within a network of reciprocally
interacting influences. In addition to government regulation, the securities market exercises
considerable self-regulation.
Chapter 5(Risk, return and the Historical record)
1. Nominal Rate of Interest: The nominal rate of interest is the equilibrium real rate plus the
expected rate of inflation. In general, we can directly observe only nominal interest rates; from
them, we must infer expected real rates, using inflation forecasts.
2. Real Rate of Interest: Real interest rates depends on the willingness of households to save, as
reflected in the supply curve of funds, and on the expected profitability of business investment in
plant, equipment, and inventories, as reflected in the demand curve for funds. It depends also on
government fiscal and monetary policy.
3. The equilibrium expected rate of return: The equilibrium expected rate of return on any
security is the sum of the equilibrium real rate of interest, the expected rate of inflation, and a
security-specific risk premium.
4. Interest Rate: An interest rate is the amount of interest due per period as a proportion of the
amount lent deposits or borrowed.
5. Effective Annual Rate: Effective Annual Rate is the real return on a saving account or any
interest paying investment when the effects of compounding over time are taken into account.
6. Annual Percentage rate: Annual Percentage rate refers to the annual rate of interest charged to
borrowers and paid to investors. It is expressed as a percentage that represents the actual yearly
cost of funds over the term of a loan or investments.
7. Inflation: Inflation is a quantitative measure of the rate at which the average price level of a
basket of selected goods & services in an economy increase over some period of time.
8. Time series analysis: Time series analysis comprises methods for analysing time series data in
order to extract meaningful statistics and other characteristics of the data.
17 | P a g e
borrowing them from a broker, and later purchases the share of the same stock in order to replace
the share that was borrowed.
27. Self-Regulation: Self-regulation consists of several stages, and individuals must function as
contributors to their own motivation, behavior, and development within a network of reciprocally
interacting influences. In addition to government regulation, the securities market exercises
considerable self-regulation.
Chapter 5(Risk, return and the Historical record)
1. Nominal Rate of Interest: The nominal rate of interest is the equilibrium real rate plus the
expected rate of inflation. In general, we can directly observe only nominal interest rates; from
them, we must infer expected real rates, using inflation forecasts.
2. Real Rate of Interest: Real interest rates depends on the willingness of households to save, as
reflected in the supply curve of funds, and on the expected profitability of business investment in
plant, equipment, and inventories, as reflected in the demand curve for funds. It depends also on
government fiscal and monetary policy.
3. The equilibrium expected rate of return: The equilibrium expected rate of return on any
security is the sum of the equilibrium real rate of interest, the expected rate of inflation, and a
security-specific risk premium.
4. Interest Rate: An interest rate is the amount of interest due per period as a proportion of the
amount lent deposits or borrowed.
5. Effective Annual Rate: Effective Annual Rate is the real return on a saving account or any
interest paying investment when the effects of compounding over time are taken into account.
6. Annual Percentage rate: Annual Percentage rate refers to the annual rate of interest charged to
borrowers and paid to investors. It is expressed as a percentage that represents the actual yearly
cost of funds over the term of a loan or investments.
7. Inflation: Inflation is a quantitative measure of the rate at which the average price level of a
basket of selected goods & services in an economy increase over some period of time.
8. Time series analysis: Time series analysis comprises methods for analysing time series data in
order to extract meaningful statistics and other characteristics of the data.
17 | P a g e
9. Scenario Analysis: Scenario Analysis is the process of estimating the expected value of a
portfolio after a given change in the value of key factors takes place. It is primarily used to
evaluate the pores & cons of organizational decision.
10. Geometric Average Return: Geometric Average Return takes into account the compound
interest over the number of periods. It is the way to calculate the average rate of return on an
investment that is compound over multiple periods.
11. Sharp Ratio: The sharp ratio is a measure of risk adjusted return. It describes how much excess
return we have received for the volatility.
12. Normal distribution: A normal distribution is a type of continuous probability distribution for a
real valued random variable.
13. VAR: Value at Risk is a measure of the risk of loss for investments. It estimates how much a set
of investments might loss given normal market condition in a set time period.
14. Sortino Ratio: Sortino Ratio measures the risk adjusted return of an investment asset, portfolio or
strategy. It is a variation of the Sharpe ratio that differentiates harmful volatility from total overall
volatility by using the assets standard deviation.
15. Portfolio return: Portfolio return refers to the gain or loss realized by an investment portfolio
containing several types of investments
16. Long term investment: Long term investment is an account on the asset side of a company’s
balance sheet that represent the company’s investment, including stocks, bond and so on. Long
term investment are asset that a company intends to hold for more than a year.
18 | P a g e
portfolio after a given change in the value of key factors takes place. It is primarily used to
evaluate the pores & cons of organizational decision.
10. Geometric Average Return: Geometric Average Return takes into account the compound
interest over the number of periods. It is the way to calculate the average rate of return on an
investment that is compound over multiple periods.
11. Sharp Ratio: The sharp ratio is a measure of risk adjusted return. It describes how much excess
return we have received for the volatility.
12. Normal distribution: A normal distribution is a type of continuous probability distribution for a
real valued random variable.
13. VAR: Value at Risk is a measure of the risk of loss for investments. It estimates how much a set
of investments might loss given normal market condition in a set time period.
14. Sortino Ratio: Sortino Ratio measures the risk adjusted return of an investment asset, portfolio or
strategy. It is a variation of the Sharpe ratio that differentiates harmful volatility from total overall
volatility by using the assets standard deviation.
15. Portfolio return: Portfolio return refers to the gain or loss realized by an investment portfolio
containing several types of investments
16. Long term investment: Long term investment is an account on the asset side of a company’s
balance sheet that represent the company’s investment, including stocks, bond and so on. Long
term investment are asset that a company intends to hold for more than a year.
18 | P a g e
Chapter 6 (Capital allocation to risky assets)
1. Risk premium: The market risk premium is the difference between the expected return on a
market portfolio and the risk free rate.
2. Fair game: A fair game is a risky prospect that has a zero risk premium. It will not be undertaken
by a risk averse investor.
3. Risk Aversion: Risk aversion is the behaviour of investors, who exposed to uncertainty and
reluctant to take risks.
4. Speculation: Speculation is the undertaking of a risky investment for its risk premium. The risk
premium has to be large enough to compensate a risk-averse investor for the risk of the
investment.
5. Utility: Utility refers to the total satisfaction received from consuming a good or service.
Utility score: U = E(r) – ½ As2
6. Risk neutral: It refers to a mind-set where an individual is indifferent to risk when making an
investment decision. This mind-set is not derived from calculation or rational deduction but rather
from an emotional preference
7. Risk lover: A risk lover is a person who has a preference for risk and willing to take more risk in
order to higher return.
8. Mean variance (M-V) Criteria: The selection of portfolio based on the mean and variance of
their return. The choice of the higher expected return portfolio for a given level of variance or the
lower variance portfolio for a given expected return.
9. Indifference curve: Indifference curve connects points on a graph representing different
quantities of two goods, points between which a consumer is indifferent.
10. Complete portfolio: Complete portfolio is defined as a combination of a risky asset portfolio and
risk free asset.
11. Risk free asset: It is used to describe assets that are considered secure in terms of yielding the
expected return.
12. Capital Allocation Line: Capital Allocation Line is a line created on graph of all possible
combination of risky free and risky asset.
19 | P a g e
1. Risk premium: The market risk premium is the difference between the expected return on a
market portfolio and the risk free rate.
2. Fair game: A fair game is a risky prospect that has a zero risk premium. It will not be undertaken
by a risk averse investor.
3. Risk Aversion: Risk aversion is the behaviour of investors, who exposed to uncertainty and
reluctant to take risks.
4. Speculation: Speculation is the undertaking of a risky investment for its risk premium. The risk
premium has to be large enough to compensate a risk-averse investor for the risk of the
investment.
5. Utility: Utility refers to the total satisfaction received from consuming a good or service.
Utility score: U = E(r) – ½ As2
6. Risk neutral: It refers to a mind-set where an individual is indifferent to risk when making an
investment decision. This mind-set is not derived from calculation or rational deduction but rather
from an emotional preference
7. Risk lover: A risk lover is a person who has a preference for risk and willing to take more risk in
order to higher return.
8. Mean variance (M-V) Criteria: The selection of portfolio based on the mean and variance of
their return. The choice of the higher expected return portfolio for a given level of variance or the
lower variance portfolio for a given expected return.
9. Indifference curve: Indifference curve connects points on a graph representing different
quantities of two goods, points between which a consumer is indifferent.
10. Complete portfolio: Complete portfolio is defined as a combination of a risky asset portfolio and
risk free asset.
11. Risk free asset: It is used to describe assets that are considered secure in terms of yielding the
expected return.
12. Capital Allocation Line: Capital Allocation Line is a line created on graph of all possible
combination of risky free and risky asset.
19 | P a g e
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13. Passive Strategy: A passive investment strategy disregards security analysis, targeting instead the
risk-free asset and a broad portfolio of risky assets such as the S&P 500 stock portfolio. If in 2012
investors took the mean historical return and standard deviation of the S&P 500 as proxies for its
expected return and standard deviation, then the values of outstanding assets would imply a degree
of risk aversion.
14. Capital Market line: Capital Market line is a graphical representation of all the portfolios that
optimally combine risk and return. It is the tangent line drawn from the point of the risk free asset
to the feasible region for risky asset.
Chapter 7(Optimal risky portfolio)
1. MPT (Markowitz modern Portfolio theory): Modern portfolio theory (MPT) is a theory on how
risk-averse investors can construct portfolios to maximize expected return based on a given level
of market risk.
MPT assumes that investors are risk-averse, meaning they prefer a less risky portfolio to a
riskier one for a given level of return.
It argues that an investment's risk and return characteristics should not be viewed alone,
but should be evaluated by how the investment affects the overall portfolio's risk and
return.
2. Correlation coefficient: Correlation coefficient is the degree in which the change in a set of
variables is related. This means that we are trying to find out if the two variables have a
correlation at all, how strong the correlation is and if the correlation is positive or negative.
Example: An example of positive correlation would be height and weight. Taller people tend to
be heavier.
3. Covariance: Covariance measures the total variation of two random variables from their expected
values. Using covariance, we can only gauge the direction of the relationship. However, it does
not indicate the strength of the relationship, nor the dependency between the variables.
Example: John is an investor. His portfolio primarily tracks the performance of the S&P 500 and John
wants to add the stock of ABC Corp. Before adding the stock to his portfolio, he wants to assess the
directional relationship between the stock and the S&P 500.
John does not want to increase the unsystematic risk of his portfolio. Thus, he is not interested in
owning securities in the portfolio that tend to move in the same direction.
4. Portfolio: A portfolio is a collection of financial investments like stocks, bonds, commodities,
cash, and cash equivalents, including closed-end funds and exchange-traded funds (ETFs).
5. Portfolio risk: Portfolio risk is a chance that the combination of assets or units, within the
investments that you own, fail to meet financial objectives. Each investment within a portfolio
carries its own risk, with higher potential return typically meaning higher risk.
20 | P a g e
risk-free asset and a broad portfolio of risky assets such as the S&P 500 stock portfolio. If in 2012
investors took the mean historical return and standard deviation of the S&P 500 as proxies for its
expected return and standard deviation, then the values of outstanding assets would imply a degree
of risk aversion.
14. Capital Market line: Capital Market line is a graphical representation of all the portfolios that
optimally combine risk and return. It is the tangent line drawn from the point of the risk free asset
to the feasible region for risky asset.
Chapter 7(Optimal risky portfolio)
1. MPT (Markowitz modern Portfolio theory): Modern portfolio theory (MPT) is a theory on how
risk-averse investors can construct portfolios to maximize expected return based on a given level
of market risk.
MPT assumes that investors are risk-averse, meaning they prefer a less risky portfolio to a
riskier one for a given level of return.
It argues that an investment's risk and return characteristics should not be viewed alone,
but should be evaluated by how the investment affects the overall portfolio's risk and
return.
2. Correlation coefficient: Correlation coefficient is the degree in which the change in a set of
variables is related. This means that we are trying to find out if the two variables have a
correlation at all, how strong the correlation is and if the correlation is positive or negative.
Example: An example of positive correlation would be height and weight. Taller people tend to
be heavier.
3. Covariance: Covariance measures the total variation of two random variables from their expected
values. Using covariance, we can only gauge the direction of the relationship. However, it does
not indicate the strength of the relationship, nor the dependency between the variables.
Example: John is an investor. His portfolio primarily tracks the performance of the S&P 500 and John
wants to add the stock of ABC Corp. Before adding the stock to his portfolio, he wants to assess the
directional relationship between the stock and the S&P 500.
John does not want to increase the unsystematic risk of his portfolio. Thus, he is not interested in
owning securities in the portfolio that tend to move in the same direction.
4. Portfolio: A portfolio is a collection of financial investments like stocks, bonds, commodities,
cash, and cash equivalents, including closed-end funds and exchange-traded funds (ETFs).
5. Portfolio risk: Portfolio risk is a chance that the combination of assets or units, within the
investments that you own, fail to meet financial objectives. Each investment within a portfolio
carries its own risk, with higher potential return typically meaning higher risk.
20 | P a g e
6. Diversification: Diversification strategy is a business growth strategy identified by a company
developing new products in new markets.
7. Systematic risk/ nondiversifiable/ market risk: systematic risk is the fluctuation of returns
caused by the macroeconomic factors that affect all risky assets.
8. Unsystematic risk/ diversifiable/ firm specific risk/ unique risk: Unsystematic risk is
something that affects a single company or even an entire industry, but is not present in other
industries. Take, for example, the risk that transport operatives go on strike. If someone holds only
stock from the transport industry, they would face high unsystematic risk. To prevent this, it is
commonly advised to diversify by investing in a range of industries or sectors.
9. Portfolio beta: Portfolio beta is a measure of the overall systematic risk of a portfolio of
investments. It’s the securities sensitivity to the index. It is the amount by which security returns
tends to increase or decrease for every single 1% increase or decrease in the returns on the index.
10.Portfolio standard deviation: Portfolio standard deviation is the standard deviation of a portfolio
of investments. It is a measure of total risk of the portfolio.
11. Sharp ratio: The ratio describes how much excess return you receive for the extra volatility you
endure for holding a riskier asset. Volatility is a measure of the price fluctuations of an asset or
portfolio.
developed by Nobel laureate William F. Sharpe
The greater the value of the Sharpe ratio, the more attractive the risk-adjusted return.
12. Optimal risky portfolio: The optimal portfolio consists of a risk-free asset and an optimal risky
asset portfolio. The optimal risky asset portfolio is at the point where the CAL is tangent to the
efficient frontier. This portfolio is optimal because the slope of CAL is the highest, which means
we achieve the highest returns per additional unit of risk.
13. Minimum variance portfolio: A minimum variance portfolio is a collection of securities that
combine to minimize the price volatility of the overall portfolio. Volatility is a statistical measure
of a particular security's price movement (ups and downs). An investment’s volatility is
interchangeable in meaning with “market risk”. Therefore, the greater the volatility of an
investment (the wider the swings up and down in price), the higher the market risk. So, if you
want to minimize risk, you want to minimize the ups and downs.
14. Risk-Free Asset:
An asset with zero standard deviation
Zero correlation with all other risky assets
Provides the risk-free rate of return (RFR)
Will lie on the vertical axis of a portfolio graph
15. Efficient frontier: The efficient frontier is the set of optimal portfolios that offer the highest
expected return for a defined level of risk or the lowest risk for a given level of expected return
21 | P a g e
developing new products in new markets.
7. Systematic risk/ nondiversifiable/ market risk: systematic risk is the fluctuation of returns
caused by the macroeconomic factors that affect all risky assets.
8. Unsystematic risk/ diversifiable/ firm specific risk/ unique risk: Unsystematic risk is
something that affects a single company or even an entire industry, but is not present in other
industries. Take, for example, the risk that transport operatives go on strike. If someone holds only
stock from the transport industry, they would face high unsystematic risk. To prevent this, it is
commonly advised to diversify by investing in a range of industries or sectors.
9. Portfolio beta: Portfolio beta is a measure of the overall systematic risk of a portfolio of
investments. It’s the securities sensitivity to the index. It is the amount by which security returns
tends to increase or decrease for every single 1% increase or decrease in the returns on the index.
10.Portfolio standard deviation: Portfolio standard deviation is the standard deviation of a portfolio
of investments. It is a measure of total risk of the portfolio.
11. Sharp ratio: The ratio describes how much excess return you receive for the extra volatility you
endure for holding a riskier asset. Volatility is a measure of the price fluctuations of an asset or
portfolio.
developed by Nobel laureate William F. Sharpe
The greater the value of the Sharpe ratio, the more attractive the risk-adjusted return.
12. Optimal risky portfolio: The optimal portfolio consists of a risk-free asset and an optimal risky
asset portfolio. The optimal risky asset portfolio is at the point where the CAL is tangent to the
efficient frontier. This portfolio is optimal because the slope of CAL is the highest, which means
we achieve the highest returns per additional unit of risk.
13. Minimum variance portfolio: A minimum variance portfolio is a collection of securities that
combine to minimize the price volatility of the overall portfolio. Volatility is a statistical measure
of a particular security's price movement (ups and downs). An investment’s volatility is
interchangeable in meaning with “market risk”. Therefore, the greater the volatility of an
investment (the wider the swings up and down in price), the higher the market risk. So, if you
want to minimize risk, you want to minimize the ups and downs.
14. Risk-Free Asset:
An asset with zero standard deviation
Zero correlation with all other risky assets
Provides the risk-free rate of return (RFR)
Will lie on the vertical axis of a portfolio graph
15. Efficient frontier: The efficient frontier is the set of optimal portfolios that offer the highest
expected return for a defined level of risk or the lowest risk for a given level of expected return
21 | P a g e
Chapter 8(index models)
1. Index model: A model of stock returns using a market index such as the S&P 500 to represent
common or systematic risk factors. A statistically derived market-wide index used to correlate the
effects of specific risks on capital assets.
2. Single-Index Model: The relationship between a security's performance and the performance of a
portfolio containing it. The market model states that the security's performance is related to its
portfolio's performance, according to its beta. It is calculated as follows:
Return on security = alpha + beta * return on portfolio + residual return
3. Single-Factor Model: A mathematical calculation of the extent to which one macroeconomic
factor affect the securities in a portfolio. Single-factor models attempt to account for contingencies
like changes in interest rate or inflation. Usually, however, a single-factor model considers how
the market return affects the return on the portfolio.
The single factor is usually the market return.
A model of security returns that acknowledges only one common factor.
4. Active portfolio strategy: An active portfolio strategy tries to generate maximum value by using
as much information that is available and forecasting techniques to outperform a buy and hold
portfolio.
Portfolio managers say that an active portfolio strategy probably performs better than a
buy-and-hold portfolio.
The fund manager uses his/her experience, knowledge and time for market research.
The risk associated with them is also higher than passive funds.
For example, active portfolio managers, whose benchmark is the Standard and Poor’s 500
index, will attempt to generate returns that outperform the index.
22 | P a g e
1. Index model: A model of stock returns using a market index such as the S&P 500 to represent
common or systematic risk factors. A statistically derived market-wide index used to correlate the
effects of specific risks on capital assets.
2. Single-Index Model: The relationship between a security's performance and the performance of a
portfolio containing it. The market model states that the security's performance is related to its
portfolio's performance, according to its beta. It is calculated as follows:
Return on security = alpha + beta * return on portfolio + residual return
3. Single-Factor Model: A mathematical calculation of the extent to which one macroeconomic
factor affect the securities in a portfolio. Single-factor models attempt to account for contingencies
like changes in interest rate or inflation. Usually, however, a single-factor model considers how
the market return affects the return on the portfolio.
The single factor is usually the market return.
A model of security returns that acknowledges only one common factor.
4. Active portfolio strategy: An active portfolio strategy tries to generate maximum value by using
as much information that is available and forecasting techniques to outperform a buy and hold
portfolio.
Portfolio managers say that an active portfolio strategy probably performs better than a
buy-and-hold portfolio.
The fund manager uses his/her experience, knowledge and time for market research.
The risk associated with them is also higher than passive funds.
For example, active portfolio managers, whose benchmark is the Standard and Poor’s 500
index, will attempt to generate returns that outperform the index.
22 | P a g e
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5. Passive portfolio strategy: A strategy that involves minimal expectational input, and instead
relies on diversification to match the performance of some market index.
It follows the efficient market hypothesis
Assumes that the marketplace will reflect all available information in the price paid for
securities.
Returns may be equal to the benchmark’s returns or lesser.
6. Linear Equation: An equation that makes a straight line when it is graphed.
Often written in the form y = mx+b
7. Regression Equation: The Regression Equation is the algebraic expression of the regression
lines.
The Regression Line is the line that best fits the data, such that the overall distance from
the line to the points (variable values) plotted on a graph is the smallest.
Determine the probable change in one variable for the given amount of change in another.
8. Macroeconomic factors:
Interest rates (the cost of borrowing)
Economic growth (changes in demand)
Confidence/expectations
Technological developments (productivity of capital)
Availability of finance from banks.
Others (depreciation, wage costs, inflation, government policy)
9. Firm specific factors:
Customers
Employees
Distribution Channels and Suppliers
Level of Competition
Investors
Media and the General Public
10. Security characteristics line: Security characteristic line (SCL) is a regression line, plotting
performance of a particular security or portfolio against that of the market portfolio at every point
in time.
The SCL is plotted on a graph where the Y-axis is the excess return on a security over the risk-free
return and the X-axis is the excess return of the market in general. The slope of the SCL is the
security's beta, and the intercept is its alpha.
23 | P a g e
relies on diversification to match the performance of some market index.
It follows the efficient market hypothesis
Assumes that the marketplace will reflect all available information in the price paid for
securities.
Returns may be equal to the benchmark’s returns or lesser.
6. Linear Equation: An equation that makes a straight line when it is graphed.
Often written in the form y = mx+b
7. Regression Equation: The Regression Equation is the algebraic expression of the regression
lines.
The Regression Line is the line that best fits the data, such that the overall distance from
the line to the points (variable values) plotted on a graph is the smallest.
Determine the probable change in one variable for the given amount of change in another.
8. Macroeconomic factors:
Interest rates (the cost of borrowing)
Economic growth (changes in demand)
Confidence/expectations
Technological developments (productivity of capital)
Availability of finance from banks.
Others (depreciation, wage costs, inflation, government policy)
9. Firm specific factors:
Customers
Employees
Distribution Channels and Suppliers
Level of Competition
Investors
Media and the General Public
10. Security characteristics line: Security characteristic line (SCL) is a regression line, plotting
performance of a particular security or portfolio against that of the market portfolio at every point
in time.
The SCL is plotted on a graph where the Y-axis is the excess return on a security over the risk-free
return and the X-axis is the excess return of the market in general. The slope of the SCL is the
security's beta, and the intercept is its alpha.
23 | P a g e
11. Alpha: In investing, the definition of alpha is the excess or abnormal rate of return of an
investment. Alpha measures the amount that how well (or badly) a stock has performed in
comparison to a benchmark index.
An alpha of 1.0 means the investment outperformed its benchmark index by 1%.
An alpha of -1.0 means the investment underperformed its benchmark index by 1%. If the
alpha is zero, its return matched the benchmark.
A high alpha is always good.
12. Information ratio: The information ratio (IR) is a measurement of portfolio returns above the
returns of a benchmark, usually an index such as the S&P 500, to the volatility of those returns.
The information ratio is used to evaluate the skill of a portfolio manager at generating returns in
excess of a given benchmark.
13. Tradeoff: A technique of reducing or forgoing one or more desirable outcomes in exchange for
increasing or obtaining other desirable outcomes in order to maximize the total return or
effectiveness under given circumstances.
14. Risk-return tradeoff: The risk-return tradeoff is an investment principle that indicates that the
higher the risk, the higher the potential reward.
To calculate an appropriate risk-return tradeoff, investors must consider many factors,
including overall risk tolerance, the potential to replace lost funds and more.
For example, Rohan faces a risk return trade off while making his decision to invest. If he
deposits all his money in a saving bank account, he will earn a low return i.e. the interest
rate paid by the bank, but all his money will be insured up to an amount of Rs 1 lakh
(currently the Deposit Insurance and Credit Guarantee Corporation in India provides
insurance up to Rs 1 lakh).
However, if he invests in equities, he faces the risk of losing a major part of his capital
along with a chance to get a much higher return than compared to a saving deposit in a
bank.
24 | P a g e
investment. Alpha measures the amount that how well (or badly) a stock has performed in
comparison to a benchmark index.
An alpha of 1.0 means the investment outperformed its benchmark index by 1%.
An alpha of -1.0 means the investment underperformed its benchmark index by 1%. If the
alpha is zero, its return matched the benchmark.
A high alpha is always good.
12. Information ratio: The information ratio (IR) is a measurement of portfolio returns above the
returns of a benchmark, usually an index such as the S&P 500, to the volatility of those returns.
The information ratio is used to evaluate the skill of a portfolio manager at generating returns in
excess of a given benchmark.
13. Tradeoff: A technique of reducing or forgoing one or more desirable outcomes in exchange for
increasing or obtaining other desirable outcomes in order to maximize the total return or
effectiveness under given circumstances.
14. Risk-return tradeoff: The risk-return tradeoff is an investment principle that indicates that the
higher the risk, the higher the potential reward.
To calculate an appropriate risk-return tradeoff, investors must consider many factors,
including overall risk tolerance, the potential to replace lost funds and more.
For example, Rohan faces a risk return trade off while making his decision to invest. If he
deposits all his money in a saving bank account, he will earn a low return i.e. the interest
rate paid by the bank, but all his money will be insured up to an amount of Rs 1 lakh
(currently the Deposit Insurance and Credit Guarantee Corporation in India provides
insurance up to Rs 1 lakh).
However, if he invests in equities, he faces the risk of losing a major part of his capital
along with a chance to get a much higher return than compared to a saving deposit in a
bank.
24 | P a g e
Chapter 9(Capital Asset pricing Model)
1. CAPM: The Capital Asset Pricing Model (CAPM) describes the relationship between
systematic risk and expected return for assets, particularly stocks. It shows that the expected return
on a security is equal to the risk-free return plus a risk premium, which is based on the beta of that
security. The formula for calculating the expected return of an asset given its risk is as follows:
2. CAL: When we combine a risky asset portfolio with a risk-free asset, we form a capital allocation
line. This represents the allocation between the risk-free asset and the risky asset based on investor
risk preferences.
3. CML: The capital market line is a special case of the CAL where the portfolio of risky assets is
the market portfolio. Where an investor has defined “the market” to be their domestic stock
market index, the expected return of the market is expressed as the expected return of that index.
4. Active strategy:
Active management strategies is an investing strategy which relies on highly paid
analysists to build a portfolio of stock.
Such analysists use research, forecasts and judgement to recommend whether to buy, hold
or sell.
When the stock price rises above its value they will sell it and earn capital gain.
5. Passive strategy:
Passive management strategy is an investing strategy relies on efficient market hypothesis.
This strategy doesn’t rely on highly paid analysists.
6. Mutual fund theorem: The mutual fund theorem is an investing strategy whereby mutual funds
are used exclusively in a portfolio for diversification and mean-variance optimization.
7. SML: The security market line (SML) is a line drawn on a chart that serves as a graphical
representation of the capital asset pricing model (CAPM)—which shows different levels of
25 | P a g e
1. CAPM: The Capital Asset Pricing Model (CAPM) describes the relationship between
systematic risk and expected return for assets, particularly stocks. It shows that the expected return
on a security is equal to the risk-free return plus a risk premium, which is based on the beta of that
security. The formula for calculating the expected return of an asset given its risk is as follows:
2. CAL: When we combine a risky asset portfolio with a risk-free asset, we form a capital allocation
line. This represents the allocation between the risk-free asset and the risky asset based on investor
risk preferences.
3. CML: The capital market line is a special case of the CAL where the portfolio of risky assets is
the market portfolio. Where an investor has defined “the market” to be their domestic stock
market index, the expected return of the market is expressed as the expected return of that index.
4. Active strategy:
Active management strategies is an investing strategy which relies on highly paid
analysists to build a portfolio of stock.
Such analysists use research, forecasts and judgement to recommend whether to buy, hold
or sell.
When the stock price rises above its value they will sell it and earn capital gain.
5. Passive strategy:
Passive management strategy is an investing strategy relies on efficient market hypothesis.
This strategy doesn’t rely on highly paid analysists.
6. Mutual fund theorem: The mutual fund theorem is an investing strategy whereby mutual funds
are used exclusively in a portfolio for diversification and mean-variance optimization.
7. SML: The security market line (SML) is a line drawn on a chart that serves as a graphical
representation of the capital asset pricing model (CAPM)—which shows different levels of
25 | P a g e
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systematic, or market risk, of various marketable securities. One of the differences between CML
and SML, is how the risk factors are measured. While standard deviation is the measure of risk for
CML, Beta coefficient determines the risk factors of the SML.
8. Expected return-beta relationship: In the Capital Asset Pricing Model, a statement that the
expected rate of return on an investment is directly proportional to its risk premium, as signified
by its beta.
9. Zero beta portfolio: A zero-beta portfolio is a portfolio constructed to have zero systematic risk,
or in other words, a beta of zero. A zero-beta portfolio would have the same expected return as the
risk-free rate.
10. Homogeneous expectations: Homogeneous expectations is an assumption in modern portfolio
theory (CAPM) that all investors expect the same and make identical choices in a given situation.
Chapter 11(efficient market hypothesis)
1. Random walk theory: The random walk theory states that market and securities prices are
random and not influenced by past events. The idea is also referred to as the "weak form efficient-
market hypothesis."
Considers technical analysis undependable because it results in chartists only buying or
selling a security after a move has occurred.
Considers fundamental analysis undependable due to the often-poor quality of information
collected and its ability to be misinterpreted.
Claims that investment advisors add little or no value to an investor’s portfolio.
Also states that all methods of predicting stock prices are futile in the long run.
2. Intrinsic value:
In financial analysis, intrinsic value is the calculation of an asset's worth based on a
financial model.
Analysts often use fundamental and technical analysis to account for qualitative,
quantitative and perceptual factors in their models.
In options trading, intrinsic value is the difference between the current price of an asset
and the strike price of the option.
3. The Efficient Market Hypothesis: This hypothesis states that the stock market reacts
immediately to all the information that is available. Thus a long term investor cannot obtain higher
than average returns from a well-diversified share portfolio.
(a) The prices of securities bought and sold reflect all the relevant information which is available
to the buyers and sellers: in other words, share prices change quickly to reflect all new information
about future prospects.
(b) No individual dominates the market.
(c) Transaction costs of buying and selling are not so high as to discourage trading significantly.
(d) Investors are rational.
26 | P a g e
and SML, is how the risk factors are measured. While standard deviation is the measure of risk for
CML, Beta coefficient determines the risk factors of the SML.
8. Expected return-beta relationship: In the Capital Asset Pricing Model, a statement that the
expected rate of return on an investment is directly proportional to its risk premium, as signified
by its beta.
9. Zero beta portfolio: A zero-beta portfolio is a portfolio constructed to have zero systematic risk,
or in other words, a beta of zero. A zero-beta portfolio would have the same expected return as the
risk-free rate.
10. Homogeneous expectations: Homogeneous expectations is an assumption in modern portfolio
theory (CAPM) that all investors expect the same and make identical choices in a given situation.
Chapter 11(efficient market hypothesis)
1. Random walk theory: The random walk theory states that market and securities prices are
random and not influenced by past events. The idea is also referred to as the "weak form efficient-
market hypothesis."
Considers technical analysis undependable because it results in chartists only buying or
selling a security after a move has occurred.
Considers fundamental analysis undependable due to the often-poor quality of information
collected and its ability to be misinterpreted.
Claims that investment advisors add little or no value to an investor’s portfolio.
Also states that all methods of predicting stock prices are futile in the long run.
2. Intrinsic value:
In financial analysis, intrinsic value is the calculation of an asset's worth based on a
financial model.
Analysts often use fundamental and technical analysis to account for qualitative,
quantitative and perceptual factors in their models.
In options trading, intrinsic value is the difference between the current price of an asset
and the strike price of the option.
3. The Efficient Market Hypothesis: This hypothesis states that the stock market reacts
immediately to all the information that is available. Thus a long term investor cannot obtain higher
than average returns from a well-diversified share portfolio.
(a) The prices of securities bought and sold reflect all the relevant information which is available
to the buyers and sellers: in other words, share prices change quickly to reflect all new information
about future prospects.
(b) No individual dominates the market.
(c) Transaction costs of buying and selling are not so high as to discourage trading significantly.
(d) Investors are rational.
26 | P a g e
(e) There are low, or no, costs of acquiring information.
4. Weak form efficiency: Under the weak form hypothesis of market efficiency, share prices reflect
all available information about past changes in the share price.
Technical analysis is the use of past price movements to predict future price fluctuations.
However, in the weak form of market efficiency, fundamental analysis and non-public
information can be used to earn excess return.
Prashant recently started a job as a broker at the Punjab Stock Exchange. He has developed
a recent interest in investments and has no prior experience. He observed that the price of
Mohali Sports rises on Monday and drops on Friday. One Friday, he purchased 100 shares
of MSE's stock for 11 INR per share hoping to sell them on Monday and earn a profit.
When the market opened on Monday, Mohali Sports declined to INR 10.5 per share.
The market seems to be weak-form efficient, because it is not letting Prashant earn excess
return by just picking stocks based on some past price pattern.
5. Semi-strong form efficiency: Semi-strong form of market efficiency exists where security prices
already reflect all publicly available information and it is not possible to earn excess return.
When a market is semi-strong form efficient, neither technical analysis, which is based on
past pattern of return, nor fundamental analysis, which incorporates current information,
can help predict future price movements. However, non-public information can be used to
earn above average return.
Alex held 100 shares of Cure Inc. which he had purchased on 1 January 20X3 for $25 per
share. Cure Inc. is a company engaged in research and development of new antibiotics
against resistant microbes. Alex is not an active investor so he does not checks the stock
performance daily. On 14 January 20X2 (Sunday), he came across an article shared by his
friend on Facebook. The article was published on 11 January 20X2 (Friday). According to
the article, Cure Inc. has failed in a project worth a net present value of $20 million. Total
outstanding shares of Cure Inc. are 5 million. Alex sold off his holding for $2,050 (at
$20.5 per share) in the opening hours of 15 January 20X2 (Monday). He was glad that he
minimized his loss but towards the end of 15 January 20X2, the company's stock price had
even climbed to $21. He is wondering what happened.
The market seems to be semi-strong form efficient. The market had adjusted itself to the
public information on Friday (11 January 20X2) as soon as the market came to know about
it. Alex should not have used this public information to project a decline on Monday. The
drop in price is almost equal to the net present value per share no longer available ($20
million divided by 5 million).
6. Strong Form Market Efficiency: Strong form of market efficiency is when prices already reflect
both publically available information and inside information. In strong form of market efficiency,
it is not possible to earn access return by any means.
When a market is strong form efficient, neither technical analysis nor fundamental analysis
nor inside information can help predict future price movements.
Shintaro Ishihara works at Osaka Automobiles as their chief engineer. He was working on
a new advanced model of automobiles and the project was a big success. He was sure that
this project will result in an increase in price so he purchased 10,000 shares of Osaka
27 | P a g e
4. Weak form efficiency: Under the weak form hypothesis of market efficiency, share prices reflect
all available information about past changes in the share price.
Technical analysis is the use of past price movements to predict future price fluctuations.
However, in the weak form of market efficiency, fundamental analysis and non-public
information can be used to earn excess return.
Prashant recently started a job as a broker at the Punjab Stock Exchange. He has developed
a recent interest in investments and has no prior experience. He observed that the price of
Mohali Sports rises on Monday and drops on Friday. One Friday, he purchased 100 shares
of MSE's stock for 11 INR per share hoping to sell them on Monday and earn a profit.
When the market opened on Monday, Mohali Sports declined to INR 10.5 per share.
The market seems to be weak-form efficient, because it is not letting Prashant earn excess
return by just picking stocks based on some past price pattern.
5. Semi-strong form efficiency: Semi-strong form of market efficiency exists where security prices
already reflect all publicly available information and it is not possible to earn excess return.
When a market is semi-strong form efficient, neither technical analysis, which is based on
past pattern of return, nor fundamental analysis, which incorporates current information,
can help predict future price movements. However, non-public information can be used to
earn above average return.
Alex held 100 shares of Cure Inc. which he had purchased on 1 January 20X3 for $25 per
share. Cure Inc. is a company engaged in research and development of new antibiotics
against resistant microbes. Alex is not an active investor so he does not checks the stock
performance daily. On 14 January 20X2 (Sunday), he came across an article shared by his
friend on Facebook. The article was published on 11 January 20X2 (Friday). According to
the article, Cure Inc. has failed in a project worth a net present value of $20 million. Total
outstanding shares of Cure Inc. are 5 million. Alex sold off his holding for $2,050 (at
$20.5 per share) in the opening hours of 15 January 20X2 (Monday). He was glad that he
minimized his loss but towards the end of 15 January 20X2, the company's stock price had
even climbed to $21. He is wondering what happened.
The market seems to be semi-strong form efficient. The market had adjusted itself to the
public information on Friday (11 January 20X2) as soon as the market came to know about
it. Alex should not have used this public information to project a decline on Monday. The
drop in price is almost equal to the net present value per share no longer available ($20
million divided by 5 million).
6. Strong Form Market Efficiency: Strong form of market efficiency is when prices already reflect
both publically available information and inside information. In strong form of market efficiency,
it is not possible to earn access return by any means.
When a market is strong form efficient, neither technical analysis nor fundamental analysis
nor inside information can help predict future price movements.
Shintaro Ishihara works at Osaka Automobiles as their chief engineer. He was working on
a new advanced model of automobiles and the project was a big success. He was sure that
this project will result in an increase in price so he purchased 10,000 shares of Osaka
27 | P a g e
Automobiles for $25 per share. He was surprised to see that even after the news of the
project being a success spread, the share price did not increase.
The market seems to be strong form efficient, because it had already adjusted Osaka Automobiles'
stock price for the expected net present value of the new project. It already reflected the inside
information.
7. Technical analysis: technical analysis is a means of examining and predicting price movements
in the financial markets, by using historical price charts and market statistics. It is based on the
idea that if a trader can identify previous market patterns, they can form a fairly accurate
prediction of future price trajectories.
For example, in a shopping mall, unlike a fundamental analyst going to each store and studying
the product being sold, and then deciding on whether to buy it or not, a technical analyst would sit
on a bench and observe people moving in and out of the stores. Ignoring the basic value of
products in the store, the decision of a technical analyst would be based on the patterns or activity
of people moving in and out of each store.
8. Fundamental analysis: Fundamental analysis (FA) is a method of measuring a security's intrinsic
value by examining related economic and financial factors. The end goal is to arrive at a number
that an investor can compare with a security's current price in order to see whether the security is
undervalued or overvalued. Here are some examples of key performance indices that are
commonly used to analyze stocks fundamentally
Earnings per share (EPS)
Price-to-earnings (P/E) ratio
Price-to-book (P/B) ratio
Return on equity
Beta
Example: The beta gives information about the stock price’s correlation to the industry it operates in.
This happens by comparing the stock to a benchmark index. The beta usually varies between -1 and 1.
Sometimes values can go much lower than -1 or much higher than 1.
Values above 0 mean that the stock correlates to the benchmark index. The higher the beta, the higher the
correlation. But the higher beta also means that the volatility is higher as well, meaning that the risk of the
asset increases.
Values below 0 mean that the stock is inversely correlated to the benchmark index. It won’t be as a mirror
image, but the ticks are likely to match. The lower the beta, the higher the inverse correlation. However,
the lower the beta, the lower the volatility.
28 | P a g e
project being a success spread, the share price did not increase.
The market seems to be strong form efficient, because it had already adjusted Osaka Automobiles'
stock price for the expected net present value of the new project. It already reflected the inside
information.
7. Technical analysis: technical analysis is a means of examining and predicting price movements
in the financial markets, by using historical price charts and market statistics. It is based on the
idea that if a trader can identify previous market patterns, they can form a fairly accurate
prediction of future price trajectories.
For example, in a shopping mall, unlike a fundamental analyst going to each store and studying
the product being sold, and then deciding on whether to buy it or not, a technical analyst would sit
on a bench and observe people moving in and out of the stores. Ignoring the basic value of
products in the store, the decision of a technical analyst would be based on the patterns or activity
of people moving in and out of each store.
8. Fundamental analysis: Fundamental analysis (FA) is a method of measuring a security's intrinsic
value by examining related economic and financial factors. The end goal is to arrive at a number
that an investor can compare with a security's current price in order to see whether the security is
undervalued or overvalued. Here are some examples of key performance indices that are
commonly used to analyze stocks fundamentally
Earnings per share (EPS)
Price-to-earnings (P/E) ratio
Price-to-book (P/B) ratio
Return on equity
Beta
Example: The beta gives information about the stock price’s correlation to the industry it operates in.
This happens by comparing the stock to a benchmark index. The beta usually varies between -1 and 1.
Sometimes values can go much lower than -1 or much higher than 1.
Values above 0 mean that the stock correlates to the benchmark index. The higher the beta, the higher the
correlation. But the higher beta also means that the volatility is higher as well, meaning that the risk of the
asset increases.
Values below 0 mean that the stock is inversely correlated to the benchmark index. It won’t be as a mirror
image, but the ticks are likely to match. The lower the beta, the higher the inverse correlation. However,
the lower the beta, the lower the volatility.
28 | P a g e
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9. Abnormal return: Abnormal return, also known as "alpha" or "excess return," is the fraction of a
security's or portfolio's return not explained by the rate of return of the market. Instead, it is a
result of the expertise of the investor.
An abnormal return is referred to as either a positive abnormal return or a negative abnormal
return, depending on where the actual return falls in relation to the normal return. The abnormal
return on an investment is calculated as follows:
R Abnormal = R Actual – R Normal
Example: suppose a stock XYZ experiences a 20% return in a given year. Analysts expected XYZ
to experience a return of 10% for that year. The (positive) abnormal rate of return XYZ is:
20% actual return – 10% projected return = 10% positive abnormal return
XYZ experience a positive abnormal return of 10% during in that year.
10. Cumulative abnormal return: Sum of the differences between the expected return on a stock
(systematic risk multiplied by the realized market return) and the actual return often used to
evaluate the impact of news on a stock price.
The CAR is used to determine the effect that events such as lawsuits or buyouts have on stock
prices. It is also helpful for determining how accurate the asset pricing model is in calculating the
expected return.
11. Anomalies: Anomaly is a term describing an event where actual results differ from results that are
expected or forecasted based on models. Two common types of anomalies in finance are market
anomalies and pricing anomalies. Common market anomalies include the small cap effect and the
January effect.
12. Market capitalization: Market capitalization refers to the total dollar market value of a
company's outstanding shares of stock. Commonly referred to as "market cap," it is calculated by
multiplying the total number of a company's outstanding shares by the current market price of one
share.
As an example, a company with 10 million shares selling for $100 each would have a
market cap of $1 billion. The investment community uses this figure to determine a
company's size, as opposed to using sales or total asset figures. In an acquisition, the
market cap is used to determine whether a takeover candidate represents a good value or
not to the acquirer.
Companies are typically divided according to market capitalization: large-cap ($10 billion
or more), mid-cap ($2 billion to $10 billion), and small-cap ($300 million to $2 billion).
29 | P a g e
security's or portfolio's return not explained by the rate of return of the market. Instead, it is a
result of the expertise of the investor.
An abnormal return is referred to as either a positive abnormal return or a negative abnormal
return, depending on where the actual return falls in relation to the normal return. The abnormal
return on an investment is calculated as follows:
R Abnormal = R Actual – R Normal
Example: suppose a stock XYZ experiences a 20% return in a given year. Analysts expected XYZ
to experience a return of 10% for that year. The (positive) abnormal rate of return XYZ is:
20% actual return – 10% projected return = 10% positive abnormal return
XYZ experience a positive abnormal return of 10% during in that year.
10. Cumulative abnormal return: Sum of the differences between the expected return on a stock
(systematic risk multiplied by the realized market return) and the actual return often used to
evaluate the impact of news on a stock price.
The CAR is used to determine the effect that events such as lawsuits or buyouts have on stock
prices. It is also helpful for determining how accurate the asset pricing model is in calculating the
expected return.
11. Anomalies: Anomaly is a term describing an event where actual results differ from results that are
expected or forecasted based on models. Two common types of anomalies in finance are market
anomalies and pricing anomalies. Common market anomalies include the small cap effect and the
January effect.
12. Market capitalization: Market capitalization refers to the total dollar market value of a
company's outstanding shares of stock. Commonly referred to as "market cap," it is calculated by
multiplying the total number of a company's outstanding shares by the current market price of one
share.
As an example, a company with 10 million shares selling for $100 each would have a
market cap of $1 billion. The investment community uses this figure to determine a
company's size, as opposed to using sales or total asset figures. In an acquisition, the
market cap is used to determine whether a takeover candidate represents a good value or
not to the acquirer.
Companies are typically divided according to market capitalization: large-cap ($10 billion
or more), mid-cap ($2 billion to $10 billion), and small-cap ($300 million to $2 billion).
29 | P a g e
Market Index
1. Index: Since there are thousands of company listed on a stock exchange, hence it’s really hard to
track every single stock to evaluate the market performance at a time. Therefore, a smaller sample
is taken which is the representative of the whole market. This small sample is called Index and it
helps in the measurement of the value of a section of the stock market. The index is computed
from the prices of selected stocks.
Sensex is the index of BSE and consists of 30 large companies from BSE. Nifty is the index of NSE and
consists of 50 large companies from NSE.
2. Stock market indexes: It is a measurement of the value of some or all the shares in a stock
market. Such an index is usually weighted, in order to reflect the relative size and importance of
different stocks. Such market indices have traditionally been used to compare an investor’s
performance against the market as a whole.
Stock market indexes are nothing more than a mathematical average that quickly tells you how the stock
market is doing. I think we over complicated things in our mind especially when it relates to the finance
and industry. But I guarantee all of you are already familiar with indexes. For example if you and ten off
your friends each weight yourself and you calculated the average weight of the entire group that would be
an index. And as you weights changed your index will change to.
3. Price return index: A price return index, also known as a price index, reflects only the prices of
the constituent securities within the index. The price return calculation – the return from the index
in percentage terms – is simply the difference in value between the two periods divided by the
beginning value.
N
i
N
i i
ii
iii
I
II
I
1 1 0
01
0PR
0PR1PR
P
PP
wPRw
V
VV
PR
Total return index: A total return index, in contrast, reflects not only the prices of the constituent
securities but also the reinvestment of all income received since inception. The formula for total return is
the same, except we need to add the income generated from the securities, usually in the form of
dividends:
N
i
N
i i
iii
iiiI
I
IPRII
I
1 1 0
01
0PR
01PR
P
IncPP
wTRwTR
V
IncVV
TR
4. Total Return Index vs. Price Return Index:
The total return index includes both the movement of prices or the capital gain/loss and the
dividend received from the security. In contrast, the price return index only considers the
movement of a price or the capital gain/loss and not the dividend received.
TRI gives a more realistic picture of the return from the stock as it includes all the constituents
associated with it like price change, interest, and dividend where PRI only gives a detail about the
movement of prices, and this is not the real return from the stock.
30 | P a g e
1. Index: Since there are thousands of company listed on a stock exchange, hence it’s really hard to
track every single stock to evaluate the market performance at a time. Therefore, a smaller sample
is taken which is the representative of the whole market. This small sample is called Index and it
helps in the measurement of the value of a section of the stock market. The index is computed
from the prices of selected stocks.
Sensex is the index of BSE and consists of 30 large companies from BSE. Nifty is the index of NSE and
consists of 50 large companies from NSE.
2. Stock market indexes: It is a measurement of the value of some or all the shares in a stock
market. Such an index is usually weighted, in order to reflect the relative size and importance of
different stocks. Such market indices have traditionally been used to compare an investor’s
performance against the market as a whole.
Stock market indexes are nothing more than a mathematical average that quickly tells you how the stock
market is doing. I think we over complicated things in our mind especially when it relates to the finance
and industry. But I guarantee all of you are already familiar with indexes. For example if you and ten off
your friends each weight yourself and you calculated the average weight of the entire group that would be
an index. And as you weights changed your index will change to.
3. Price return index: A price return index, also known as a price index, reflects only the prices of
the constituent securities within the index. The price return calculation – the return from the index
in percentage terms – is simply the difference in value between the two periods divided by the
beginning value.
N
i
N
i i
ii
iii
I
II
I
1 1 0
01
0PR
0PR1PR
P
PP
wPRw
V
VV
PR
Total return index: A total return index, in contrast, reflects not only the prices of the constituent
securities but also the reinvestment of all income received since inception. The formula for total return is
the same, except we need to add the income generated from the securities, usually in the form of
dividends:
N
i
N
i i
iii
iiiI
I
IPRII
I
1 1 0
01
0PR
01PR
P
IncPP
wTRwTR
V
IncVV
TR
4. Total Return Index vs. Price Return Index:
The total return index includes both the movement of prices or the capital gain/loss and the
dividend received from the security. In contrast, the price return index only considers the
movement of a price or the capital gain/loss and not the dividend received.
TRI gives a more realistic picture of the return from the stock as it includes all the constituents
associated with it like price change, interest, and dividend where PRI only gives a detail about the
movement of prices, and this is not the real return from the stock.
30 | P a g e
TRI is more of the latest approach as to how investors benchmark their mutual funds because it
helps them to assess the fund in a better manner since the NAV of a mutual fund portrays not only
the capital loss/gain in the portfolio but also the dividend received from the holdings in the
portfolio. In contrast, PRI is more of the traditional approach where mutual funds were benchmark
against price changes only pertaining to the number of securities that are driving a mutual fund.
TRI is more transparent, and the credibility of the stocks or funds has increased a lot. In contrast,
PRI is more of a misleading scenario because it overstates the performance of a mutual fund,
which attracted a lot of investors to invest in the specific fund without understanding the real
scenario.
5. Market capitalization weighted: In capitalization weighting, also called value weighting, the
share price is multiplied by the number of outstanding shares. The total is then compared to some
arbitrary starting value (base value).
6. Price weighted: A price-weighted index is composed of a single share of each of the index
components, regardless of the price of the share or the size of the underlying company. For
example, the shares of 30 industrial companies make up the Dow Jones Industrial Average
(DJIA). To account for artificial price changes due to stock splits, an index divisor is made use of.
N
i
i
i
i
1
P
P
P
w
7. Equal weighted: An equal-weighted index reflects the performance associated with the selection
of a particular security by chance. It is measured by price change rather than by price alone.
Equally weighted indexes simply gives each stock an equal weight, regardless of stock price or
market capitalization, so, obviously, stock splits and stock dividends will not affect an equally
weighted index. An equally weighted portfolio would have the same amount of money invested in
each unique stock. Therefore, the number of shares of each stock would be different, with more
shares of cheaper stocks. An equally weighted portfolio would have to be rebalanced more
frequently to maintain equal weight, because stocks prices would diverge quickly. Theoretically,
equal weighting is preferable to price weighting.
An equally-weighted index will be more diversified than a value-weighted index, because it will not be
dominated by large companies, so investments based on an equally weighted index may have higher
returns, since small companies generally have a greater growth potential than large companies.
wi
E= 1
N
8. Factor weighted: Fundamental weighting uses measures of a company’s size that are independent
of its security price to determine weights. These measures include book value, cash flow,
revenues, earnings, dividends, and number of employees.
wi
F = Fi
∑
j=1
N
F j
31 | P a g e
helps them to assess the fund in a better manner since the NAV of a mutual fund portrays not only
the capital loss/gain in the portfolio but also the dividend received from the holdings in the
portfolio. In contrast, PRI is more of the traditional approach where mutual funds were benchmark
against price changes only pertaining to the number of securities that are driving a mutual fund.
TRI is more transparent, and the credibility of the stocks or funds has increased a lot. In contrast,
PRI is more of a misleading scenario because it overstates the performance of a mutual fund,
which attracted a lot of investors to invest in the specific fund without understanding the real
scenario.
5. Market capitalization weighted: In capitalization weighting, also called value weighting, the
share price is multiplied by the number of outstanding shares. The total is then compared to some
arbitrary starting value (base value).
6. Price weighted: A price-weighted index is composed of a single share of each of the index
components, regardless of the price of the share or the size of the underlying company. For
example, the shares of 30 industrial companies make up the Dow Jones Industrial Average
(DJIA). To account for artificial price changes due to stock splits, an index divisor is made use of.
N
i
i
i
i
1
P
P
P
w
7. Equal weighted: An equal-weighted index reflects the performance associated with the selection
of a particular security by chance. It is measured by price change rather than by price alone.
Equally weighted indexes simply gives each stock an equal weight, regardless of stock price or
market capitalization, so, obviously, stock splits and stock dividends will not affect an equally
weighted index. An equally weighted portfolio would have the same amount of money invested in
each unique stock. Therefore, the number of shares of each stock would be different, with more
shares of cheaper stocks. An equally weighted portfolio would have to be rebalanced more
frequently to maintain equal weight, because stocks prices would diverge quickly. Theoretically,
equal weighting is preferable to price weighting.
An equally-weighted index will be more diversified than a value-weighted index, because it will not be
dominated by large companies, so investments based on an equally weighted index may have higher
returns, since small companies generally have a greater growth potential than large companies.
wi
E= 1
N
8. Factor weighted: Fundamental weighting uses measures of a company’s size that are independent
of its security price to determine weights. These measures include book value, cash flow,
revenues, earnings, dividends, and number of employees.
wi
F = Fi
∑
j=1
N
F j
31 | P a g e
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9. Market Indices: A market index consists of numbers that represent weighted values of different
components. The components may be shares, bonds, commodities, or prices of goods. The
numbers may also represent inflation rates or GDP growth rates. GDP stands for Gross Domestic
Product, i.e., all the goods and services that a country produces in one year.
US investors are familiar with many different indices. The NYSE Composite Index, and
the Dow Jones Industrial Average (DJIA), for example, are market indices.
The S&P 500 Composite Stock Price Index, the Wilshire 5000 Total Market Index, and
Nasdaq-100 Index are also market indices.
10. Equity Indices: Equity index is a statistical indicator of changes in the market value of a certain
group of shares or stocks. Sometimes it is referred to as stock index. That is, a stock index groups
together a certain list of stocks and usually takes an average of their prices so as to provide an idea
of how the industry or market represented in the stock index is doing.
11. Fixed income index: Fixed income markets are primarily dealer markets who buy and sell
securities from their inventory. Many securities do not trade frequently and index providers must
contact dealers to obtain current prices on constituent securities to update the index or they must
estimate the prices of constituent securities using the prices of traded fixed-income securities with
similar characteristics.
12. Commodity Indices: A commodity index is an index of the prices of items such as wheat, corn,
soybeans, coffee, sugar, cocoa, hogs, cotton, cattle, oil, natural gas, aluminum, copper, lead,
nickel, zinc, gold and silver.
The Goldman Sachs Commodity Index (GSCI) is one of the most popular commodities
indexes. Owned by Standard & Poor’s, the GSCI is weighted according to the global
production levels of a variety of commodities. All of the commodities in the index are
physical commodities; no financial commodities are allowed.
Commodities are raw materials used by virtually everyone. The orange juice on your
breakfast table, the gas in your car, the meat on your dinner plate and the cotton in your
shirt all probably interacted with a commodities exchange at one point. Commodities-
exchange prices set or at least influence the prices of many goods used by companies and
individuals around the globe.
13. Real Estate Indices: REITs are public or private corporations organized specifically to invest in
real estate:
ownership of properties
investment in mortgages
REIT indices are based on publicly traded REITs with continuous market pricing so their value is
calculated continuously.
32 | P a g e
components. The components may be shares, bonds, commodities, or prices of goods. The
numbers may also represent inflation rates or GDP growth rates. GDP stands for Gross Domestic
Product, i.e., all the goods and services that a country produces in one year.
US investors are familiar with many different indices. The NYSE Composite Index, and
the Dow Jones Industrial Average (DJIA), for example, are market indices.
The S&P 500 Composite Stock Price Index, the Wilshire 5000 Total Market Index, and
Nasdaq-100 Index are also market indices.
10. Equity Indices: Equity index is a statistical indicator of changes in the market value of a certain
group of shares or stocks. Sometimes it is referred to as stock index. That is, a stock index groups
together a certain list of stocks and usually takes an average of their prices so as to provide an idea
of how the industry or market represented in the stock index is doing.
11. Fixed income index: Fixed income markets are primarily dealer markets who buy and sell
securities from their inventory. Many securities do not trade frequently and index providers must
contact dealers to obtain current prices on constituent securities to update the index or they must
estimate the prices of constituent securities using the prices of traded fixed-income securities with
similar characteristics.
12. Commodity Indices: A commodity index is an index of the prices of items such as wheat, corn,
soybeans, coffee, sugar, cocoa, hogs, cotton, cattle, oil, natural gas, aluminum, copper, lead,
nickel, zinc, gold and silver.
The Goldman Sachs Commodity Index (GSCI) is one of the most popular commodities
indexes. Owned by Standard & Poor’s, the GSCI is weighted according to the global
production levels of a variety of commodities. All of the commodities in the index are
physical commodities; no financial commodities are allowed.
Commodities are raw materials used by virtually everyone. The orange juice on your
breakfast table, the gas in your car, the meat on your dinner plate and the cotton in your
shirt all probably interacted with a commodities exchange at one point. Commodities-
exchange prices set or at least influence the prices of many goods used by companies and
individuals around the globe.
13. Real Estate Indices: REITs are public or private corporations organized specifically to invest in
real estate:
ownership of properties
investment in mortgages
REIT indices are based on publicly traded REITs with continuous market pricing so their value is
calculated continuously.
32 | P a g e
14. Hedge Fund Indices: A hedge fund index aggregates the performance of many hedge funds into a
singly number. There are a number of companies that produce indexes including Hedge Fund
Research, Barclays, Credit Suisse and Eureka hedge.
There are to major problems with hedge fund indices.
First, you cannot actually purchase an index or invest in all the funds that are in an index.
To invest in hedge funds you need to select a limited number of hedge funds from
thousands of live hedge funds.
Second, there are data problems because hedge funds are not required to report their
performance.
Speculation and Arbitrage
1. Arbitrage: Arbitrage involves the simultaneous buying and selling of an asset in order to profit
from small differences in price. Arbitrage is possible because of inefficiencies in the market.
Arbitrageurs—those who use arbitrage as a strategy—often buy stock on one market such as a
financial market in the U.S. like the New York Stock Exchange (NYSE) while simultaneously
selling the same stock on a different market like the London Stock Exchange (LSE).
2. Speculation: Speculation is a short-term buying and selling strategy. It involves a significant
amount of risk of loss or gains. The reward is the main driver, so if there wasn't any expectation of
gain, there would be no use for speculation. This strategy is generally driven by assumptions or
hunches on the part of the trader, who attempts to profit from rising and falling prices.
A trader, for example, may open a long (buy) position in a stock index futures contract
with the expectation of profiting from rising prices. If the value of the index rises, the
trader may close the trade for a profit. Conversely, if the value of the index falls, the trade
might be closed for a loss.
Speculators may also attempt to profit from a falling market by shorting (selling short or
simply selling) the instrument. If prices drop, the position will be profitable. If prices rise,
however, the trade may be closed at a loss.
3. Arbitrage Pricing Theory (APT): Arbitrage pricing theory (APT) is a multi-factor asset pricing
model based on the idea that an asset's returns can be predicted using the linear relationship
between the asset’s expected return and a number of macroeconomic variables that capture
systematic risk. It is a useful tool for analyzing portfolios from a value investing perspective, in
order to identify securities that may be temporarily mispriced.
Arbitrage pricing theory (APT) is a well-known method of estimating the price of an asset. The
theory assumes an asset's return is dependent on various macroeconomic, market and security-
specific factors.
33 | P a g e
singly number. There are a number of companies that produce indexes including Hedge Fund
Research, Barclays, Credit Suisse and Eureka hedge.
There are to major problems with hedge fund indices.
First, you cannot actually purchase an index or invest in all the funds that are in an index.
To invest in hedge funds you need to select a limited number of hedge funds from
thousands of live hedge funds.
Second, there are data problems because hedge funds are not required to report their
performance.
Speculation and Arbitrage
1. Arbitrage: Arbitrage involves the simultaneous buying and selling of an asset in order to profit
from small differences in price. Arbitrage is possible because of inefficiencies in the market.
Arbitrageurs—those who use arbitrage as a strategy—often buy stock on one market such as a
financial market in the U.S. like the New York Stock Exchange (NYSE) while simultaneously
selling the same stock on a different market like the London Stock Exchange (LSE).
2. Speculation: Speculation is a short-term buying and selling strategy. It involves a significant
amount of risk of loss or gains. The reward is the main driver, so if there wasn't any expectation of
gain, there would be no use for speculation. This strategy is generally driven by assumptions or
hunches on the part of the trader, who attempts to profit from rising and falling prices.
A trader, for example, may open a long (buy) position in a stock index futures contract
with the expectation of profiting from rising prices. If the value of the index rises, the
trader may close the trade for a profit. Conversely, if the value of the index falls, the trade
might be closed for a loss.
Speculators may also attempt to profit from a falling market by shorting (selling short or
simply selling) the instrument. If prices drop, the position will be profitable. If prices rise,
however, the trade may be closed at a loss.
3. Arbitrage Pricing Theory (APT): Arbitrage pricing theory (APT) is a multi-factor asset pricing
model based on the idea that an asset's returns can be predicted using the linear relationship
between the asset’s expected return and a number of macroeconomic variables that capture
systematic risk. It is a useful tool for analyzing portfolios from a value investing perspective, in
order to identify securities that may be temporarily mispriced.
Arbitrage pricing theory (APT) is a well-known method of estimating the price of an asset. The
theory assumes an asset's return is dependent on various macroeconomic, market and security-
specific factors.
33 | P a g e
Fundamental & Technical Analysis
1. Economic analysis: An economic analysis is a process followed by experts to understand how
key economic factors affect the functioning of an organization, industry, region or any other
particular population group, with the purpose of making wiser decisions for the future. It is a
broader term that can mean simple and concise or sophisticated and complex identification, study
and projection of economic variables.
For companies, the goal of an economic analysis is to provide a clear picture of the current
economic climate. Specifically, what the impact of the economic climate is or might be on the
company’s ability to operate commercially.
In this context, ‘economic climate ‘means ‘economic conditions,’ i.e., the state of the overall
economy.
2. Fundamental analysis: Fundamental analysis is the process of evaluating security for creating
forecasts about its future price. Fundamental analysis includes estimations based on many
components related to stock, including:
The global industry
Company financial statements
Company press releases
News releases
Domestic political conditions
Trade agreements and external politics
Competitor analysis
If some fundamental indicators of a company show data that has a bad impact, this is likely to negatively
reflect the share price. On the other hand, if there’s a positive data release, like an outstanding earnings
report, for example, this can boost the stock price of the respective company.
Here are some examples of key performance indices that are commonly used to analyze stocks
fundamentally:
Earnings per share (EPS)
Price-to-earnings (P/E) ratio
34 | P a g e
1. Economic analysis: An economic analysis is a process followed by experts to understand how
key economic factors affect the functioning of an organization, industry, region or any other
particular population group, with the purpose of making wiser decisions for the future. It is a
broader term that can mean simple and concise or sophisticated and complex identification, study
and projection of economic variables.
For companies, the goal of an economic analysis is to provide a clear picture of the current
economic climate. Specifically, what the impact of the economic climate is or might be on the
company’s ability to operate commercially.
In this context, ‘economic climate ‘means ‘economic conditions,’ i.e., the state of the overall
economy.
2. Fundamental analysis: Fundamental analysis is the process of evaluating security for creating
forecasts about its future price. Fundamental analysis includes estimations based on many
components related to stock, including:
The global industry
Company financial statements
Company press releases
News releases
Domestic political conditions
Trade agreements and external politics
Competitor analysis
If some fundamental indicators of a company show data that has a bad impact, this is likely to negatively
reflect the share price. On the other hand, if there’s a positive data release, like an outstanding earnings
report, for example, this can boost the stock price of the respective company.
Here are some examples of key performance indices that are commonly used to analyze stocks
fundamentally:
Earnings per share (EPS)
Price-to-earnings (P/E) ratio
34 | P a g e
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Return on equity
The earnings per share relate to the portion of profit allocated to each of the company’s shares. The EPS
is an indication of the company’s profitability. The higher the earnings per share, the better it is for the
investor. A higher EPS is a symbol of a healthy company. At the same time, if the earnings per share are
unusually high, this could mean one of the following things Earnings can decrease and get back to
normal. The price of the stock can increase to normalize the stock price compared to the earnings.
3. Technical analysis: Technical analysis is a means of examining and predicting price movements
in the financial markets, by using historical price charts and market statistics. It is based on the
idea that if a trader can identify previous market patterns, they can form a fairly accurate
prediction of future price trajectories.
To perform technical analysis, investors start with charts that show the price and trading volume
history of a particular security or index (for example, the Dow Jones Industrial Average) as well
as host of other statistical measures such as moving averages, maximums and minimums, and
percentage changes.
4. EPS growth: The term earnings per share (EPS) represents the portion of a company's earnings,
net of taxes and preferred stock dividends, that is allocated to each share of common stock.
Let's assume that during the fourth quarter, Company XYZ reported net income of $4 million.
During the same time frame, the company had a total of 10 million shares outstanding. In this
particular case, the company's quarterly earnings per share (or EPS) would be $0.40, calculated as
follows:
$4 million / 10 million shares = $0.40 Market Price
5. Price Earnings Ratio: The price earnings ratio, or P/E ratio, measures a company’s share price as
compares with its per-share earnings. For example, a Price to Earnings ratio of 10 means that the
company has $1 of annual, per-share earnings for every $10 in share price. Earnings by definition
are after all taxes, etc.
A company’s P/E ratio is computed by dividing the current market price of one share of a
company’s stock by that company’s per-share earnings. A company’s per-share earnings are
simply the company’s after-tax profit divided by number of outstanding shares. For example, a
company that earned $5M in a calendar year, with a million shares outstanding, had earnings per
share of $5. If that company’s stock sells for $50/share, it has a P/E of 10. Stated differently, at
this price, investors are willing to pay $10 for every $1 of last year’s earnings.
6. Dividend yield: Dividend yield is the annual dividend payment shareholders receive from a
particular stock shown as a percentage of the stock's price. (Dividends are corporate earnings
distributed to company shareholders typically through the two forms of cash or stock.) Company.
A trades at a price of $45. Over the course of one year, the company paid consistent quarterly
dividends of $0.30 per share. The dividend yield ratio for Company A is calculated as follows:
Dividend Yield Ratio = $0.30 + $0.30 + $0.30 + $0.30 / $45 = 0.02666 = 2.7%
35 | P a g e
The earnings per share relate to the portion of profit allocated to each of the company’s shares. The EPS
is an indication of the company’s profitability. The higher the earnings per share, the better it is for the
investor. A higher EPS is a symbol of a healthy company. At the same time, if the earnings per share are
unusually high, this could mean one of the following things Earnings can decrease and get back to
normal. The price of the stock can increase to normalize the stock price compared to the earnings.
3. Technical analysis: Technical analysis is a means of examining and predicting price movements
in the financial markets, by using historical price charts and market statistics. It is based on the
idea that if a trader can identify previous market patterns, they can form a fairly accurate
prediction of future price trajectories.
To perform technical analysis, investors start with charts that show the price and trading volume
history of a particular security or index (for example, the Dow Jones Industrial Average) as well
as host of other statistical measures such as moving averages, maximums and minimums, and
percentage changes.
4. EPS growth: The term earnings per share (EPS) represents the portion of a company's earnings,
net of taxes and preferred stock dividends, that is allocated to each share of common stock.
Let's assume that during the fourth quarter, Company XYZ reported net income of $4 million.
During the same time frame, the company had a total of 10 million shares outstanding. In this
particular case, the company's quarterly earnings per share (or EPS) would be $0.40, calculated as
follows:
$4 million / 10 million shares = $0.40 Market Price
5. Price Earnings Ratio: The price earnings ratio, or P/E ratio, measures a company’s share price as
compares with its per-share earnings. For example, a Price to Earnings ratio of 10 means that the
company has $1 of annual, per-share earnings for every $10 in share price. Earnings by definition
are after all taxes, etc.
A company’s P/E ratio is computed by dividing the current market price of one share of a
company’s stock by that company’s per-share earnings. A company’s per-share earnings are
simply the company’s after-tax profit divided by number of outstanding shares. For example, a
company that earned $5M in a calendar year, with a million shares outstanding, had earnings per
share of $5. If that company’s stock sells for $50/share, it has a P/E of 10. Stated differently, at
this price, investors are willing to pay $10 for every $1 of last year’s earnings.
6. Dividend yield: Dividend yield is the annual dividend payment shareholders receive from a
particular stock shown as a percentage of the stock's price. (Dividends are corporate earnings
distributed to company shareholders typically through the two forms of cash or stock.) Company.
A trades at a price of $45. Over the course of one year, the company paid consistent quarterly
dividends of $0.30 per share. The dividend yield ratio for Company A is calculated as follows:
Dividend Yield Ratio = $0.30 + $0.30 + $0.30 + $0.30 / $45 = 0.02666 = 2.7%
35 | P a g e
The dividend yield ratio for Company A is 2.7%. Therefore, an investor would earn 2.7% on
shares of Company A in the form of dividends.
7. Stock Bonus: Bonus shares are additional shares given to the current shareholders without any
additional cost, based upon the number of shares that a shareholder owns. These are company's
accumulated earnings which are not given out in the form of dividends, but are converted into free
shares.
8. Cash Bonus: A cash bonus refers to a lump sum of money awarded to an employee, either
occasionally or periodically, for good performance. A cash bonus for better-than-expected
performance may be awarded to an individual, division, or the entire organization depending on
the level at which performance targets were exceeded. Most cash bonuses are paid once a year,
and can range from a few hundred to millions of dollars, depending on the employee's position
and the company.
9. Cash dividend: Cash dividend is that portion of profit which is declared by the board of directors
to be paid as dividends to the shareholders of the company in return to their investments done in
the company and then discharging such dividend payment liability by paying cash or through bank
transfer.
Let us assume PQR Company had substantially high profits for the current financial year and
decided to distribute dividends to all its shareholders. Mr ‘C’ owns 150 shares bought at $15 per
share, which makes his total investment of $2,250.
10. Stock dividend: A stock dividend, a method used by companies to distribute wealth to
shareholders, is a dividend payment made in the form of shares rather than cash. Stock dividends
are primarily issued in lieu of cash dividends when the company is low on liquid cash on hand.
The board of directors decides on when to declare a (stock) dividend and in what form the
dividend will be paid.
Bond Valuation
1. Fixed Income Securities: A fixed income security is an investment that pays regular income in
the form of a coupon payment, interest payment or preferred dividend.
To illustrate, suppose an investor owns a Treasury bond with a par value of $1,000 and an annual
yield of 6%. This investor is guaranteed a payment of $60 each year for the life of the bond.
Similarly, an investor who holds preferred stock in Company XYZ might be promised a quarterly
dividend payment of $5 per share, which he can dependably receive for as long as he holds the
shares.
2. Bond: A bond is an agreement between an investor and the company, government, or government
agency that issues the bond. When investors buy a bond, they are loaning money to the issuer in
exchange for interest and the return of principal at maturity. Because bonds traditionally pay the
investor a fixed interest rate periodically, they are also known as fixed-income securities.
36 | P a g e
shares of Company A in the form of dividends.
7. Stock Bonus: Bonus shares are additional shares given to the current shareholders without any
additional cost, based upon the number of shares that a shareholder owns. These are company's
accumulated earnings which are not given out in the form of dividends, but are converted into free
shares.
8. Cash Bonus: A cash bonus refers to a lump sum of money awarded to an employee, either
occasionally or periodically, for good performance. A cash bonus for better-than-expected
performance may be awarded to an individual, division, or the entire organization depending on
the level at which performance targets were exceeded. Most cash bonuses are paid once a year,
and can range from a few hundred to millions of dollars, depending on the employee's position
and the company.
9. Cash dividend: Cash dividend is that portion of profit which is declared by the board of directors
to be paid as dividends to the shareholders of the company in return to their investments done in
the company and then discharging such dividend payment liability by paying cash or through bank
transfer.
Let us assume PQR Company had substantially high profits for the current financial year and
decided to distribute dividends to all its shareholders. Mr ‘C’ owns 150 shares bought at $15 per
share, which makes his total investment of $2,250.
10. Stock dividend: A stock dividend, a method used by companies to distribute wealth to
shareholders, is a dividend payment made in the form of shares rather than cash. Stock dividends
are primarily issued in lieu of cash dividends when the company is low on liquid cash on hand.
The board of directors decides on when to declare a (stock) dividend and in what form the
dividend will be paid.
Bond Valuation
1. Fixed Income Securities: A fixed income security is an investment that pays regular income in
the form of a coupon payment, interest payment or preferred dividend.
To illustrate, suppose an investor owns a Treasury bond with a par value of $1,000 and an annual
yield of 6%. This investor is guaranteed a payment of $60 each year for the life of the bond.
Similarly, an investor who holds preferred stock in Company XYZ might be promised a quarterly
dividend payment of $5 per share, which he can dependably receive for as long as he holds the
shares.
2. Bond: A bond is an agreement between an investor and the company, government, or government
agency that issues the bond. When investors buy a bond, they are loaning money to the issuer in
exchange for interest and the return of principal at maturity. Because bonds traditionally pay the
investor a fixed interest rate periodically, they are also known as fixed-income securities.
36 | P a g e
Unlike stocks, bonds don’t make the investor an owner of the bond issuer: the investor becomes a
lender to a company, city, or government.
Let’s look at an example of how a bond works:
Company Z issues a 10-year bond with a face value of $10,000 and a coupon rate of 5%.
The investor agrees to buy that bond under the conditions that the company will pay $500 each
year (in interest) over a 10-year period.
At the end of those 10 years, the company will repay the investor $10,000.
3. Debenture: A debenture is an instrument used by a lender, such as a bank, when providing capital
to companies and individuals. It enables the lender to secure loan repayments against the
borrower’s assets – even if they default on the payment.
Let’s say company ABC issues a debenture to the value of CHF 100,000, redeemable on 31
December 2019. This is the date on which the company will receive the loan back. It bears 5%
interest per year, payable on 31 July every year. An investor agrees to offer the loan at a fixed
charge. If ABC defaults on the payment, the investor may now sell the company’s assets to raise
the capital needed to fulfil the loan.
4. Par value: Par value is a per share amount that will appear on some stock certificates and in the
corporation's articles of incorporation. Par value is the face value of a bond. It is the principal
amount that the lender (investor) is lending to the borrower (issuer).
Example of Par Value
Let's assume that a share of common stock has a par value of $0.01 and is sold to an investor for
$25. The corporation issuing the stock will debit Cash for $25.00 and will credit Common Stock
for $0.01 and will credit Additional Paid-in Capital for $24.99.
5. Face value: Face value, also referred to as par value or nominal value, is the value shown on the
face of a security certificate, including currency.
6. Coupon rate: Coupon rate is the stated interest rate on a fixed income security like a bond. In
other words, it’s the rate of interest that bondholders receive from their investment. It’s based on
the yield as of the day the bond is issued.
Georgia has a 10-year bond of company XYZ with a nominal value of $1,000 and a 20-year
maturity. The rate pays 8% annually. The coupon’s current yield is 5.22%, and the yield to
maturity is 3.85%. What is the coupon payment Georgia will receive?
The coupon payment on each bond is $1,000 x 8% = $80. So, Georgia will receive $80 interest
payment as a bondholder. In fact, Georgia receives the coupon payment which is calculated at the
bond’s interest rate, and not at the bond’s current yield or yield to maturity.
7. Bond Indenture: A bond indenture is a legal document or contract between the bond issuer and
the bondholder that records the obligations of the bond issuer and benefits owed to the
37 | P a g e
lender to a company, city, or government.
Let’s look at an example of how a bond works:
Company Z issues a 10-year bond with a face value of $10,000 and a coupon rate of 5%.
The investor agrees to buy that bond under the conditions that the company will pay $500 each
year (in interest) over a 10-year period.
At the end of those 10 years, the company will repay the investor $10,000.
3. Debenture: A debenture is an instrument used by a lender, such as a bank, when providing capital
to companies and individuals. It enables the lender to secure loan repayments against the
borrower’s assets – even if they default on the payment.
Let’s say company ABC issues a debenture to the value of CHF 100,000, redeemable on 31
December 2019. This is the date on which the company will receive the loan back. It bears 5%
interest per year, payable on 31 July every year. An investor agrees to offer the loan at a fixed
charge. If ABC defaults on the payment, the investor may now sell the company’s assets to raise
the capital needed to fulfil the loan.
4. Par value: Par value is a per share amount that will appear on some stock certificates and in the
corporation's articles of incorporation. Par value is the face value of a bond. It is the principal
amount that the lender (investor) is lending to the borrower (issuer).
Example of Par Value
Let's assume that a share of common stock has a par value of $0.01 and is sold to an investor for
$25. The corporation issuing the stock will debit Cash for $25.00 and will credit Common Stock
for $0.01 and will credit Additional Paid-in Capital for $24.99.
5. Face value: Face value, also referred to as par value or nominal value, is the value shown on the
face of a security certificate, including currency.
6. Coupon rate: Coupon rate is the stated interest rate on a fixed income security like a bond. In
other words, it’s the rate of interest that bondholders receive from their investment. It’s based on
the yield as of the day the bond is issued.
Georgia has a 10-year bond of company XYZ with a nominal value of $1,000 and a 20-year
maturity. The rate pays 8% annually. The coupon’s current yield is 5.22%, and the yield to
maturity is 3.85%. What is the coupon payment Georgia will receive?
The coupon payment on each bond is $1,000 x 8% = $80. So, Georgia will receive $80 interest
payment as a bondholder. In fact, Georgia receives the coupon payment which is calculated at the
bond’s interest rate, and not at the bond’s current yield or yield to maturity.
7. Bond Indenture: A bond indenture is a legal document or contract between the bond issuer and
the bondholder that records the obligations of the bond issuer and benefits owed to the
37 | P a g e
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bondholder. The bond indenture also includes the details of the rights of ownership as well as the
rights of the bondholder to receive interest payments and principle payments in the future.
Example: Bond indentures are not issued to individual bondholders. It would be pretty impractical
for a company to try to enter into a contract with every single bondholder. That is why the bond
indenture is actually issued to a trustee or third party that represents the bondholders. The trustee
is most often a bank or some other financial institution. If the company breaks the agreement set
forth in the bond indenture, the trustee can sue the company on behave of the bondholders.
8. Zero coupon Bond: A zero-coupon bond is a bond that pays no interest and trades at a discount to
its face value. It is also called a pure discount bond or deep discount bond. U.S. Treasury bills are
an example of a zero-coupon bond.
John is looking to purchase a zero-coupon bond with a face value of $1,000 and 5 years to
maturity. The interest rate on the bond is 5% compounded annually. What price will John pay for
the bond today? Price of bond = $1,000 / (1+0.05)5 = $783.53. The price that John will pay for the
bond today is $783.53.
9. Treasury note: A Treasury note (T-note for short) is a marketable U.S. government debt security
with a fixed interest rate and a maturity between one and 10 years. Treasury notes are available
either via competitive bids, wherein an investor specifies the yield, or noncompetitive bids,
wherein the investor accepts whatever yield is determined.
10. Treasury bond: Treasury bonds ("T-Bonds") are long-term, semiannual bonds issued by the U.S.
Treasury. Their maturities range from 10 to 30 years. T-Bonds are issued with $1,000 par values.
T-Bonds are backed by the full faith and credit of the U.S. government. For this reason, T-Bonds
are generally considered risk-free investments. Due to their lack of default risk and extremely high
level of liquidity, Treasuries usually offer the lowest yields of bonds with similar maturities and
are considered benchmarks of the fixed income asset class.
11. Corporate Bond: Corporate bonds are debt instruments created by companies for the purpose of
raising capital. They are called fixed-income securities because they pay a specified amount of
interest on a regular basis.
12. Callable Bond: A callable bond gives the borrower (issuer) the right to pay back the obligation to
the lender (bondholder) before the stated maturity date. A callable bond (also called a "redeemable
bond") is a bond with an embedded call option. If the issuer agrees to pay more than the face value
amount of the bond when called, the excess of the payment over the face amount is the "call
premium". In most cases, the call price is greater than the par (or issue) price.
To simplify the concept, let's look at an example:
Company ABC decides to borrow $10 million in the bond market. The bond's coupon rate is 8%.
Company analysts believe interest rates will go down during the 7 year term of the bonds. To take
advantage of lower rates in the future, ABC issues callable bonds.
38 | P a g e
rights of the bondholder to receive interest payments and principle payments in the future.
Example: Bond indentures are not issued to individual bondholders. It would be pretty impractical
for a company to try to enter into a contract with every single bondholder. That is why the bond
indenture is actually issued to a trustee or third party that represents the bondholders. The trustee
is most often a bank or some other financial institution. If the company breaks the agreement set
forth in the bond indenture, the trustee can sue the company on behave of the bondholders.
8. Zero coupon Bond: A zero-coupon bond is a bond that pays no interest and trades at a discount to
its face value. It is also called a pure discount bond or deep discount bond. U.S. Treasury bills are
an example of a zero-coupon bond.
John is looking to purchase a zero-coupon bond with a face value of $1,000 and 5 years to
maturity. The interest rate on the bond is 5% compounded annually. What price will John pay for
the bond today? Price of bond = $1,000 / (1+0.05)5 = $783.53. The price that John will pay for the
bond today is $783.53.
9. Treasury note: A Treasury note (T-note for short) is a marketable U.S. government debt security
with a fixed interest rate and a maturity between one and 10 years. Treasury notes are available
either via competitive bids, wherein an investor specifies the yield, or noncompetitive bids,
wherein the investor accepts whatever yield is determined.
10. Treasury bond: Treasury bonds ("T-Bonds") are long-term, semiannual bonds issued by the U.S.
Treasury. Their maturities range from 10 to 30 years. T-Bonds are issued with $1,000 par values.
T-Bonds are backed by the full faith and credit of the U.S. government. For this reason, T-Bonds
are generally considered risk-free investments. Due to their lack of default risk and extremely high
level of liquidity, Treasuries usually offer the lowest yields of bonds with similar maturities and
are considered benchmarks of the fixed income asset class.
11. Corporate Bond: Corporate bonds are debt instruments created by companies for the purpose of
raising capital. They are called fixed-income securities because they pay a specified amount of
interest on a regular basis.
12. Callable Bond: A callable bond gives the borrower (issuer) the right to pay back the obligation to
the lender (bondholder) before the stated maturity date. A callable bond (also called a "redeemable
bond") is a bond with an embedded call option. If the issuer agrees to pay more than the face value
amount of the bond when called, the excess of the payment over the face amount is the "call
premium". In most cases, the call price is greater than the par (or issue) price.
To simplify the concept, let's look at an example:
Company ABC decides to borrow $10 million in the bond market. The bond's coupon rate is 8%.
Company analysts believe interest rates will go down during the 7 year term of the bonds. To take
advantage of lower rates in the future, ABC issues callable bonds.
38 | P a g e
Under the terms of the bonds (the "indenture"), ABC has the option to call the bonds (meaning,
pay them back) any time after year 3. However, if ABC decides to exercise its right to call, it
needs to pay bondholders $102 for every $100 of principal.
Let's assume that in year 4, interest rates fall to 6%. ABC exercises its right to redeem the bonds.
It borrows money from a bank at 6% and pays back the 8% bonds.
Even though ABC had to spend $10.2 million to pay back its current bondholders, it will benefit
going forward because future interest payments will be only $612,000 per year ($10,200,000 *
6%) vs. $800,000 per year ($10,000,000*8%).
13. Preferred Stock: Preferred stock is a class of corporate shares that are separate from common
stock and have specific rights that aren’t available to common shareholders. While preferred stock
usually doesn't carry the same voting rights as common stock, it does have priority when it comes
to dividends and bankruptcy. And like common stock, preferred stock can be bought and sold
through a broker.
14. International Bonds: International bonds are debt instruments that are issued by a non-domestic
company in order to raise money from international investors and are usually denominated in the
currency of the issuing country with the primary objective of attracting more investors on a large
scale.
Foreign companies or governments may issue bonds that are securitized and sold to domestic
investors in the form of international bonds. These bonds are typically denominated and pay
interest in the currency of the issuing country. Therefore, the value of the bond in the domestic
currency will fluctuate depending on the economic conditions and exchange rates between the
domestic country and foreign country.
15. Bond Yields: Bond yield refers to the amount of interest an investor earns annually, expressed as
a percentage of a bond’s price. When you buy a bond, the amount of money in interest payable to
you is a percentage of the bond's issue price. That amount of money never changes. When bonds
are traded, their market value can change. When their market value changes, the amount of money
payable to you now represents a different percentage of the market price. This is a bond's yield.
16. Yield to Maturity: Yield to maturity (YTM) is the total return anticipated on a bond if the bond is
held until it matures. Yield to maturity is considered a long-term bond yield but is expressed as an
annual rate. In other words, it is the internal rate of return (IRR) of an investment in a bond if the
investor holds the bond until maturity, with all payments made as scheduled and reinvested at the
same rate. Yield to maturity is also referred to as "book yield" or "redemption yield."
17. Yield to call: Yield to call (YTC) is a financial term that refers to the return a bondholder receives
if the bond is held until the call date, which occurs sometime before it reaches maturity. This
number can be mathematically calculated as the compound interest rate at which the present value
of a bond's future coupon payments and call price is equal to the current market price of the bond.
39 | P a g e
pay them back) any time after year 3. However, if ABC decides to exercise its right to call, it
needs to pay bondholders $102 for every $100 of principal.
Let's assume that in year 4, interest rates fall to 6%. ABC exercises its right to redeem the bonds.
It borrows money from a bank at 6% and pays back the 8% bonds.
Even though ABC had to spend $10.2 million to pay back its current bondholders, it will benefit
going forward because future interest payments will be only $612,000 per year ($10,200,000 *
6%) vs. $800,000 per year ($10,000,000*8%).
13. Preferred Stock: Preferred stock is a class of corporate shares that are separate from common
stock and have specific rights that aren’t available to common shareholders. While preferred stock
usually doesn't carry the same voting rights as common stock, it does have priority when it comes
to dividends and bankruptcy. And like common stock, preferred stock can be bought and sold
through a broker.
14. International Bonds: International bonds are debt instruments that are issued by a non-domestic
company in order to raise money from international investors and are usually denominated in the
currency of the issuing country with the primary objective of attracting more investors on a large
scale.
Foreign companies or governments may issue bonds that are securitized and sold to domestic
investors in the form of international bonds. These bonds are typically denominated and pay
interest in the currency of the issuing country. Therefore, the value of the bond in the domestic
currency will fluctuate depending on the economic conditions and exchange rates between the
domestic country and foreign country.
15. Bond Yields: Bond yield refers to the amount of interest an investor earns annually, expressed as
a percentage of a bond’s price. When you buy a bond, the amount of money in interest payable to
you is a percentage of the bond's issue price. That amount of money never changes. When bonds
are traded, their market value can change. When their market value changes, the amount of money
payable to you now represents a different percentage of the market price. This is a bond's yield.
16. Yield to Maturity: Yield to maturity (YTM) is the total return anticipated on a bond if the bond is
held until it matures. Yield to maturity is considered a long-term bond yield but is expressed as an
annual rate. In other words, it is the internal rate of return (IRR) of an investment in a bond if the
investor holds the bond until maturity, with all payments made as scheduled and reinvested at the
same rate. Yield to maturity is also referred to as "book yield" or "redemption yield."
17. Yield to call: Yield to call (YTC) is a financial term that refers to the return a bondholder receives
if the bond is held until the call date, which occurs sometime before it reaches maturity. This
number can be mathematically calculated as the compound interest rate at which the present value
of a bond's future coupon payments and call price is equal to the current market price of the bond.
39 | P a g e
18. Current Yield: Current yield represents the prevailing interest rate that a bond or fixed income
security is delivering to its owners.
Even though the current yield is a better measure of bond return than the coupon rate
(which is also called nominal yield), it is not a complete measure because it ignores the
time value of money.
Current yield is to bonds what dividend yield is to common stock. It is because it only
accounts for the current income portion of the bond’s return.
19. Premium Bond: A premium bond is a bond trading above its face value or in other words; it costs
more than the face amount on the bond. A bond might trade at a premium because its interest rate
is higher than current rates in the market.
A bond that's trading at a premium means that its price is trading at a premium or higher
than the face value of the bond.
For example, a bond that was issued at a face value of $1,000 might trade at $1,050 or a
$50 premium. Even though the bond has yet to reach maturity, it can trade in the
secondary market. In other words, investors can buy and sell a 10-year bond before the
bond matures in ten years. If the bond is held until maturity, the investor receives the face
value amount or $1,000 as in our example above.
20. Intrinsic value: Intrinsic value is a way of describing the perceived or true value of an asset. This
is not always identical to the current market price because assets can be over- or undervalued.
Intrinsic value is a common part of fundamental analysis, which investors use to assess stocks, as
well being used in options pricing.
21. Zero growth rate: zero-growth model: An approach to dividend valuation that assumes a
constant, nongrowing dividend stream.
22. Constant growth rate: Also called the Gordon-Shapiro model, an application of the dividend
discount model that assumes (1) a fixed growth rate for future dividends, and (2) a single discount
rate.
23. Multi growth rate: Multi-stage dividend discount model is a technique used to calculate intrinsic
value of a stock by identifying different growth phases of a stock; projecting dividends per share
for each the periods in the high growth phase and discounting them to valuation date,
finding terminal value at the start of the stable growth phase using the Gordon growth model,
discounting it back to the valuation date and adding it to the present value of the high-growth
phase dividends.
The basic concept behind the multi-stage dividend discount model is the same as constant-growth
model, i.e. it bases intrinsic value on the present value of expected future cash flows of a stock.
The difference is that instead of assuming a constant dividend growth rate for all periods in future,
the present value calculation is broken down into different phases.
24. Dividend Discount Model: The dividend discount model (DDM) is a quantitative method used
for predicting the price of a company's stock based on the theory that its present-day price is worth
the sum of all of its future dividend payments when discounted back to their present value.
25. Dividend Growth Rate:
40 | P a g e
security is delivering to its owners.
Even though the current yield is a better measure of bond return than the coupon rate
(which is also called nominal yield), it is not a complete measure because it ignores the
time value of money.
Current yield is to bonds what dividend yield is to common stock. It is because it only
accounts for the current income portion of the bond’s return.
19. Premium Bond: A premium bond is a bond trading above its face value or in other words; it costs
more than the face amount on the bond. A bond might trade at a premium because its interest rate
is higher than current rates in the market.
A bond that's trading at a premium means that its price is trading at a premium or higher
than the face value of the bond.
For example, a bond that was issued at a face value of $1,000 might trade at $1,050 or a
$50 premium. Even though the bond has yet to reach maturity, it can trade in the
secondary market. In other words, investors can buy and sell a 10-year bond before the
bond matures in ten years. If the bond is held until maturity, the investor receives the face
value amount or $1,000 as in our example above.
20. Intrinsic value: Intrinsic value is a way of describing the perceived or true value of an asset. This
is not always identical to the current market price because assets can be over- or undervalued.
Intrinsic value is a common part of fundamental analysis, which investors use to assess stocks, as
well being used in options pricing.
21. Zero growth rate: zero-growth model: An approach to dividend valuation that assumes a
constant, nongrowing dividend stream.
22. Constant growth rate: Also called the Gordon-Shapiro model, an application of the dividend
discount model that assumes (1) a fixed growth rate for future dividends, and (2) a single discount
rate.
23. Multi growth rate: Multi-stage dividend discount model is a technique used to calculate intrinsic
value of a stock by identifying different growth phases of a stock; projecting dividends per share
for each the periods in the high growth phase and discounting them to valuation date,
finding terminal value at the start of the stable growth phase using the Gordon growth model,
discounting it back to the valuation date and adding it to the present value of the high-growth
phase dividends.
The basic concept behind the multi-stage dividend discount model is the same as constant-growth
model, i.e. it bases intrinsic value on the present value of expected future cash flows of a stock.
The difference is that instead of assuming a constant dividend growth rate for all periods in future,
the present value calculation is broken down into different phases.
24. Dividend Discount Model: The dividend discount model (DDM) is a quantitative method used
for predicting the price of a company's stock based on the theory that its present-day price is worth
the sum of all of its future dividend payments when discounted back to their present value.
25. Dividend Growth Rate:
40 | P a g e
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o Dividend growth calculates the annualized average rate of increase in the dividends
paid by a company.
o Calculating the dividend growth rate is necessary for using a dividend discount
model for valuing stocks.
o A history of strong dividend growth could mean future dividend growth is likely,
which can signal long-term profitability.
41 | P a g e
paid by a company.
o Calculating the dividend growth rate is necessary for using a dividend discount
model for valuing stocks.
o A history of strong dividend growth could mean future dividend growth is likely,
which can signal long-term profitability.
41 | P a g e
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